The objectives of financial forecasting are to analyze past, current, and future fiscal data and conditions to shape strategic decisions and policy. A financial forecast is a framework that presents estimates of past, current, and projected financial conditions.
This assists the business in several ways. It helps identify future costs and revenue trends that may influence strategic goals, policies, or services in the near- or long-term. It also enhances the connection between finance and the business and improves decision-making during the annual budget process, enabling delivery of more business collaboration and connection.
The underlying methodology and assumptions that define financial forecasting should be clearly presented and available to the business as part of the budget process.
Financial forecasting involves the creation of specific financial statements that reflect risk and outlook based on relevant facts and trends. These statements are sometimes also called pro-forma statements. The most common financial statements that are important to making financial prediction include:
Income statement. Sometimes called a profit and loss account, an income statement reveals the company’s expenses and revenues during a particular period and shows how the business transforms those revenues into net profit or net income.
Cash flow statement. Also known as a statement of cash flow, a financial statement shows how changes in income and balance sheet accounts affect cash and cash equivalents, and breaks down its analysis into investing, operating, and financing activities.
Pro-forma balance sheet. A pro forma balance sheet and a historical balance sheet are similar, but a pro forma balance sheet contains running balances for the liabilities, assets, and equity we estimate the business will have in the future and represents a projection. Accounts receivable and current cash assets are the first two items on a pro-forma balance sheet.
Financial forecasting is the process of analyzing what happened in the past, what is happening now, and using that information to determine what is going to happen in the future. Businesses use financial forecasting as a tool for planning and adapting to uncertainty by more effectively predicting risks, opportunities and challenges that the business could encounter.
By engaging in a thorough process, enterprises can generate financial plans that estimate their projected expenses, income, and other organization-specific macroeconomic factors affecting financial forecasting. A strong forecast includes short- and long-term outlooks on contingencies for costs not currently viewed as necessary and other conditions that might possibly affect revenues. Effective financial forecasts rely on detailed models, skilled experts, strong business partnerships and connections and tools for information gathering such as financial forecasting software.
Financial forecasts fluctuate with business trends and other factors, and this is in part why financial forecasting is more accurate in the short term than in the long term.
A financial forecast should include:
Financial forecast accuracy is frequently a critical factor in an organization’s ability to survive unforeseen events.
Organizations have many, varied reasons to conduct financial forecasting. For that reason, there are several types of financial forecast:
Historical financial forecast. A historical forecast uses data from past financial statements including balance sheets, cash flow statements, and income statements to project future growth. This is an easy approach and the most common set of documents finance teams use to engage the business.
Sales forecasting. Predicts the amounts of products or services a business will sell during a projected fiscal period using one of two sales forecasting methodologies: bottom-up forecasting or top-down forecasting. Sales forecasting is useful for budgeting, allocating and managing resources more efficiently, and streamlining planning production cycles. Additionally, this is one of the most important forecasts that finance uses to connect and collaborate inside the business.
Cash flow forecasting. Based on factors such as expenses and income, cash flow forecasting involves estimating cash flow in and out of the business across a defined fiscal period. Although cash flow financial forecasting is more accurate over the short term, it has several applications, including budgeting and identifying immediate funding needs.
There are four basic financial forecast models that are quantitative: straight line or run rates, moving average, simple linear regression and multiple linear regression. All rely on large quantities of historical data that can be measured and statistically controlled and rendered to identify trends and patterns.
Financial forecasting methods may also be qualitative. These techniques rely on data that is mission critical for businesses but cannot be measured objectively, such as evolving customer preferences, and new technologies such as machine learning and predictive modeling algorithms.
What’s the right method or combo of methods for your business? That’s based on a number of considerations.
Financial forecast examples of quantitative methods are:
Qualitative forecasts are more likely to be used when little or no historical data is available. Some examples of qualitative forecasting methods are:
The key steps in how to create a financial forecast for business include the following:
Define assumptions that will impact the forecast to create common goals for the process:
Financial forecasts afford insight into the future, from several weeks to several years, although most companies forecast for one fiscal year at a time.
Gather information and insights from the business
To support the forecasting process, use business conversations and statistical data as well as the forecaster’s expertise and accumulated judgment to forecast financial results, build quantitative models, and document results throughout the financial forecasting process. Gather any relevant historical data and records that impact financial decisions and the fiscal environment, including those concerning: income, costs, equity, expenses, investments, liabilities, risks, and revenue.
Business trends, analysis and information should be a collaborative process with finance and the business. The finance team conducts analysis and examination of historical data and relevant economic conditions for consistent patterns or trends and evidence in several areas:
Select the right quantitative and/or qualitative forecasting methods. Three basic forecasting models to consider include:
Implement the forecast using the various forecasting methods described above. Develop a range of possible forecast ranges or outcomes based on various scenarios.
Use forecasts appropriately
The purpose of a forecast is to inform decision-making, so any compelling, functional financial forecast must achieve several goals.
Financial accuracy and credibility is central, and any financial forecast should be transparent and open around key drivers, assumptions and potential outcomes connected to business processes and tactics. Describe why and how actual financial data and results might be lower or higher than the forecast due to forces acting on expenditures or revenues. Discuss possible tactics for how to improve financial forecasting accuracy and stay within acceptable accuracy tolerances for forecasts.
Link the financial forecast to organizational decision-making and the planning and budgeting process to lend a long-term perspective to the financial planning policy.
The difference between financial planning and forecasting is that a financial plan is a concrete, step-by-step process for executing the financial forecast. A financial forecast is a projection or estimate of likely future expenses and revenue or income, while a financial plan sets forth the steps needed to cover future expenses and generate future income.
A financial plan lays out the process for making use of assets such as available capital to meet organizational goals for profit or growth based on the financial forecast. A financial forecast in a business plan lays out how to apply resources to generate optimal revenues.
Organizations use both financial forecasting and budgeting as tools. Budgeting establishes where management hopes the company will go, and financial forecasting confirms progress toward the goals.
Budgeting serves as a baseline for comparison for actual results and expected performance metrics. Typically covering one year, budgets include expected cash flows and debt reduction, estimates of revenues and expenses, and a point of comparison for actual results to calculate variance from financial forecasts.
Financial forecasting examines historical data to estimate a company’s future financial outcomes and looks at how actual performance and changes are guiding future outcomes. It is updated routinely, when there is a change in inventory, operations, and/or business plan.
A management team can use financial forecasting over both the short-term and long-term and take immediate action based on the forecasts or use it to develop its business plan.
Financial forecasting is a process through which organizations can shape realistic expectations surrounding future results and prepare for what’s ahead. In contrast, financial modeling, uses the assumptions from a financial forecast and financial statements to build a predictive financial model. Businesses use these financial models to budget, attain financing, invest, and otherwise make sound business and financial decisions.
Financial modeling allows organizations to summarize a range of variables and financial information that affect the business. Additionally, financial models can be shared with the business in order to conduct their own forecast based on changing key assumptions, drivers or variables. Financial models are the tools which financial forecasts are communicated and built upon.
Financial models are used for budgeting and projecting financial performance, creating pro forma financial statements, historical analysis of businesses, investment research, such as equity analysis, project finance analysis for funding of long-term assets, mergers and acquisitions, and raising capital.
Financial forecasts are a core piece of business planning, operations, budgeting, and funding. They empower finance and the business together to make smarter, more forward-thinking and impactful decisions.
A financial forecast is an integral part of the annual budget process because it estimates future financial outcomes and informs major financial decisions, such as whether to hire ahead of plan, fund a capital project, or seek investment.
A financial forecast enables finance departments to establish relevant, realistic business goals and estimate how the business might perform in the future based on past performance. Financial forecasts are also critical to investor relations, and to analyzing financial data from the past.
How can financial forecasting benefit an organization? Beyond the practical advantages of financial forecasting we’ve already covered, the financial forecast process offers several other benefits:
There is no real downside to financial forecasting—other than the need to do it and the cost to achieve it.
Preparing, analyzing, and forecasting financial statements falls to the finance team, in close partnership with the business. Together, this partnership should inform the leaders and management teams inside and outside the company. Forecasting absolutely needs to be a united team project.
A variety of financial forecasting tools and techniques exist for forecasting future financial returns and measuring performance. Anything that helps analyze and process current internal business and external economic information might be considered a tool for financial forecasting. Home-based or other small businesses might not use financial forecasting tools as often as enterprise-class organizations, but the advent of financial forecasting software and platforms have made these tools more available.
Creating financial forecasts is more complex than it used to be, thanks in part to the availability of so much real-time data and better tools. For example, fraud detection, buying patterns, machine learning, customer segmentation, real-time stock market information, and other details add complexity as they open up more possibilities.
Dedicated financial management software that automatically collects all operational and financial data and KPIs in one location with one data set makes the financial forecasting process quicker and more accurate.
When it comes to how to forecast a company’s financials, there’s no one right way. However, spending any time conducting financial forecasting reveals that pouring over massive amounts of historical data can be exhausting. And spending all of the budget and time on historical data and linear analysis generates financial forecasts that are frequently doomed to irrelevance thanks to changes in consumer behavior or market volatility.
To best prepare for unforeseen situations, engage in ongoing financial forecasting with a continuous planning platform. This allows for more effective scenario analyses that consider unexpected, worst-case market scenarios and other external factors. It also ensures data integration so your financial and non-financial data doesn’t get locked in data silos. Planful offers a centralized platform that finance and the business can communicate, collaborate to drive clear and concise business outcomes through a unified and easy to use action oriented platform.
A powerful FP&A platform with financial forecasting software, Planful supports continuous financial forecasting and other financial planning without consuming excess time. Respond to uncertainties and market shifts much faster with the data at your fingertips.
Curious to learn what else Planful can do to help your team learn how to do financial forecasting more effectively? Contact us for a demo.