An essential factor in business management is the ability to discern where the company is headed and what course to chart for maximum profitability. Intuition and guesswork are not sufficient to create a rational roadmap for the future. For that, the process of financial forecasting is invaluable.
What Is Financial Forecasting?
Financial forecasting is creating an educated prediction of future business performance over a set period. It helps business leaders create budgets, plan resources, anticipate risks, improve profitability, and manage growth. While it is impossible to make such a prediction with 100% accuracy, there are several ways to ensure that a financial forecast is reasonable and on track.
Financial forecasting should not be a one-time effort. As circ*mstances and trends change, the forecast should be updated regularly. It is wise to compare actual financials to the forecast at the end of each accounting period and adjust the forecast accordingly. This ensures your forecast stays accurate and relevant so it can be used as a regular tool to inform business decisions.
What Are the Elements of Financial Forecasting?
A complete financial forecast includes three elements: a balance sheet, cash flow statement, and income statement. These are considered “pro forma” documents, or documents that are based on projections or presumptions. These documents are the same as the ones you prepare each accounting period, except that they cover the future rather than the past.
A financial forecast might also include a position statement, an analysis of industry trends and competitor positioning, or other documents appropriate to the purpose of the forecast.
The methods of collecting data for your pro forma documents fall into two general categories: historical and research-based. You will probably use some mixture of both in building your forecast. The more data you collect and analyze, the more accurate your forecast is likely to be.
Historical (Quantitative) Data Gathering
Note: Forecasts are more easily prepared and understood by outside parties such as investors or lenders when financial statements have been prepared on an accrual basis rather than a cash basis.The association of revenues with expenses is more clearly understood and more universally accepted or required on an accrual basis.
Reviewing past financial statements and looking for trends can help you determine what to put in your forecast. For instance, if you had a consistent 3% increase in month-to-month sales over the last year and nothing major has changed or is expected to change, then you could reasonably predict the same growth pattern for next year. It is likely that there will be a corresponding increase in variable expenses as well. If you look at past records and see a pattern of decreased sales over the summer (seasonality), you can anticipate the same for the coming year.
Historical data gathering is basically observing past business performance and projecting similar performance into the future. This data is particularly useful if you anticipate steady growth and few operational changes. The disadvantage is that it does not take into account new developments such as market trends or increasing competition. It may also be skewed by anomalous circ*mstances such as the effects of the COVID-19 pandemic.
Historical data is relatively easy to collect and analyze. It is the quickest and least expensive way of creating financial forecasts for internal use within a company or department. It may not, however, be sufficient for presenting to a potential lender or investor.
Research-Based (Qualitative) Data Gathering
Looking outside your company to discover what others are doing may give you insights into what your business has the potential to achieve. This can best be done by observing competitors whose companies are similar to yours in size and scope. You may not be able to get exact figures, but you can see what is and is not working for them and estimate their profits and expenses. Customer ratings and comments on their social media pages may help you find areas where you might gain a competitive edge. For instance, if customers are complaining about your competitor’s slow delivery times, you might investigate what delivery services they are using and consider the possible financial benefit of using a faster service for your own deliveries.
You may gain insights into the future by interviewing knowledgeable people inside and outside your company. Industry publications will often provide information on upcoming developments, market trends, and changes in consumer sentiment. All these things may be considered as you make your financial projections.
Research-based data is not necessarily measurable, but it considers important factors that cannot be found in historical reports. This type of information gathering is necessary for new companies or new projects where little historical information is available. It is also necessary when you are preparing a presentation for a lender or financial partner.
Take the Middle Ground
When creating a financial forecast, particularly if you are using qualitative data, it is best to avoid being too optimistic. On the other hand, an overly conservative forecast may discourage investors or disincentivize innovation. Many financial experts (including outsourced CFOs) usually create three financial forecasting scenarios: a worst case, best case, and expected case.
Constant reassessment of your forecasts will help you make them more realistic. At Preferred CFO, our outsourced CFO team uses financial forecasts as a rolling budget to continually update the forecast as an accurate roadmap for the future.
Why Do You Need a Financial Forecast?
There are four primary reasons for doing a financial forecast.
- Quantify goals. The primary reason is to clearly identify and quantify the company’s financial goal and as part of that identify the steps and the costs required to achieve those goals. This will include capital as well as operational expense projections. The projected balance sheet and associated cash flow forecast will determine if the company can achieve those goals with the current capital level.
- Stakeholder Assurance. The second is to provide investors, lenders, and stakeholders with assurance that the company is on track to meet its targets
- The third is to be able to be more quickly able to determine when things don’t go as planned so necessary adjustments can be made to overcome the challenge or remedy the situation.
- Maximize outcomes. The fourth is to easily test financial decisions and their impact on the bottom line so the business may maximize outcomes.
While some companies forecast only a few months or a year or two into the future, others find it highly beneficial to maintain a 5-year forecast. Ideally, you will maintain short-term, mid-term, and long-term projections.
In Summary
Financial forecasting combines historical data with market research to make informed predictions of future business performance. This allows a company to confidently plan the future, prepare for eventualities, and set a course for growth. The more robust the forecast, the greater the benefit to the company. If you would like further information or assistance with your financial forecasting, we invite you to contact Preferred CFO.
