If there is anything certain in a business, it is uncertainty. There are a plethora of factors that are beyond your control, and they can influence the market in unexpected ways.
Thus, it is essential to know what you can expect in the near future and plan accordingly.
This is where financial forecasting comes to the rescue. A business can benefit a lot from regular financial forecasting. So, we present a comprehensive guide to explain the importance of financial forecasting and how you can do it.
Financial forecasting – What is it?
Let us first understand what financial forecasting is.
It is basically predicting a company’s financial future by examining its historical data (cash flow, sales or expenses), current business trends and some other relevant factors. Financial forecast involves assumptions and guesswork since numerous unforeseen factors influence business performance.
Financial forecasting is necessary as it helps with business decision-making regarding budgeting, hiring, revenue predictions and strategic planning. It is also useful in maintaining a forward-focused mindset.
Importance of financial forecasting
A financial forecast helps a business put together realistic goals and plans. Financial forecasts are extremely useful as showpieces for lenders and investors.
Annual budget planning
A budget represents a business’ financial position and cash flow along with expectations and future goals for a fiscal period.
Financial forecasting and financial planning work hand in hand. Why? Because forecasting offers an insight into the future of the business. These insights are necessary to make the budgeting more accurate.
Identifying problem areas
By analysing the past performance of the business, financial forecasting can help in the identification of ongoing problems. With a little insight into what the future holds for your business, you can identify potential problems.
Establishing realistic business goals
Accurate forecasting can help you predict the growth of your business. You can predict whether the business will grow or decline, along with an estimate of how much. As a result, you can set realistic goals and manage your expectations.
Greater company appeal to attract investors
Investors need to know the potential ROIs on their investments in a business, and financial forecasting can provide them with exactly that. A company’s financial report can help investors predict future performance.
Along with this, with regular financial forecasting, you can show the investors that you have a solid business plan ready for the future and that you are in control.
Reduction of financial risk
Creating a budget without a financial forecast puts you at the risk of overspending. In such a case, the majority of your financial decisions may be ill-informed without the input of a forecast’s results.
Types of Financial Forecasts
There are a number of purposes for which a business conducts financial forecasting. As a result, forecasting practices are categorised into the following kinds:
In this type of forecasting, the amounts of services and products you expect to sell within a projected financial period are predicted.
Sales forecasting has many benefits and uses, such as in budgeting and planning production cycles. With financial forecasts, a company can manage and allocate resources more efficiently.
Budget forecasting is useful in the determination of the ideal outcome of the budget with the assumption that everything proceeds as planning. Since the budget provides a financial guide for the future of the business, it helps in creating specific expectations about the performance as well.
This kind of forecasting relies on financial forecasting data.
Cash flow forecasting
Cash flow forecasting involves estimating the flow of cash in and out of a business over a fiscal period. This forecasting is purely based on factors like income and expenses, and it helps with the identification of immediate funding needs and budgeting.
However, this kind of forecasting is more accurate over a short term rather than a longer period.
Income forecasting involves analysing the past revenue performance of the company and the current growth rate to estimate future income. Income forecasting is essential to doing cash flow and balance sheet forecasting.
Moreover, this data is also used by investors, suppliers and concerned third parties when they have to make crucial decisions. Suppliers, for instance, use this data when they have to determine how much to credit the company in supplies.
Forecasting mistakes that you need to avoid at all costs
When it comes to financial forecasts, there are certain mistakes you must avoid. So here are those:
- Although it is good for you to look forward to the growth of your business, being too optimistic will discard the purpose of the report. You must have realistic expectations with your business.
- Do not just include the primary services or products while creating your financial forecast. You must have a holistic approach and include the whole company, as it will provide you with a more accurate picture. As a result, you will also have a stronger plan of action.
Forecasting vs. budgeting
Although financial forecasting and budgeting are often used together, there are some key differences that you should know of.
A budget is the outline of expectations for what a company wishes to achieve for a specific period (usually a year). The characteristics include:
- Expected debt reduction
- Expected cash flows
- Estimates of revenue and expenses
- A budget is compared to real results to calculate the differences between the two figures.
Budgeting shows the financial position, cash flow and goals of a company. The budget is usually re-evaluated periodically, generally once per fiscal year, as per when the management wishes to update the information.
It creates a baseline for the comparison of actual results, which helps you determine how these results vary from the expected performance.
Although the majority of budgets are created for the whole year, it is not mandatory. In the circumstances where adjustment of budget is necessary as per the changing business conditions, the management can be flexible.
With the financial forecast, estimation of the future financial outcomes is done by examining the company’s historical data. It also allows the management team to anticipate results as per the previous financial data.
The following are the characteristics of financial forecasting:
- It is used by the company to determine how to allocate their budgets for a future period.
- It is regularly updated when there’s a change in the inventory, operations, and business plan. It can be monthly or quarterly.
- It can be created for the short-term and long-term.
- It can be used by the management team to take immediate action based on the forecasted data.
Let us pay attention to the differences between the two.
A budget is created to meet a certain goal, for instance, quarterly growth. A financial forecast, on the other hand, examines if the budget’s target will be met throughout the proposed timeline.
The content of both is different. While the budget contains certain goals (such as the number of products to sell), financial forecasting tells the expectations of how the budget will be met.
A budget is made for a certain period and is based on past experiences or trends of the company, whereas a financial forecast examines the current financial situation of the company. The latter uses the information to forecast whether the budget will be met or not.
Financial Forecasting – 7 Steps to help you
A lot of essential aspects of the company’s current and future operations depend upon the results of your financial forecasts. Forecasting results will influence the decision-making of investors, determine how much credit your company can get and more.
Seeing the importance of financial forecasting, here are seven steps to guide you:
Define the purpose of the financial forecast.
The very first step that you should take when it comes to financial forecasting is defining the purpose of it.
What is the primary goal you aim to achieve through the financial forecast? Is it to project the potential sales volume of your products or services? Or do you intend to assess how the present budget of the company will influence its future?
Gather the historical data and past financial statements
Since financial forecasting involves analysing past financial data, it is necessary that you gather all the needed historical data and records, such as:
- Earnings per share
- Comprehensive income
- Fixed costs
Choose a time frame for the forecast
Financial forecasting gives the business owners an insight into the future of the company.
It is up to you how far you wish to look into the future, as it can range from a couple of weeks to a couple of years. A lot of the companies do these forecasts once in a fiscal year.
It is worth noting that the financial forecasts change with time since factors like business and marketing trends also change. As a result, financial forecasting is more accurate in the short term.
Choose a financial forecasting method
You can choose one of the following two financial forecasting methods:
- Qualitative forecasting
- Quantitative forecasting
The former financial forecasting method uses historical data and information to identify trends and reliable patterns. The latter analyses expert’s sentiments and opinions about the company as well as the market.
Although both financial forecasting methods are good for different uses and have their own strengths and shortcomings, qualitative forecasting is preferred for startups that do not have any past data to refer to.
Monitor and document the results
Financial forecasts are inherently subject to change and, thus, can never be 100% accurate. Therefore, it is crucial to maintain a record of your forecast’s outcomes and continuously track them, particularly following significant internal or external developments.
Additionally, it’s vital to keep your forecasts up-to-date to incorporate the most recent developments.
Analyse financial data
One way to tell if your financial forecasts are accurate or not is through regular analysis.
Furthermore, ongoing financial management and analysis not only assist in better preparation for future financial forecasts but also provide invaluable insights into the present financial performance of the company.
Last but not least, you should repeat the process once the set time frame for the current financial forecast passes.
It’s best to continue gathering, documenting, and scrutinising data as a means to enhance the precision of your financial forecasts.
Disclaimer: The information on this website is for general purposes only and should not be relied upon for making legal or other decisions. The advice provided in this article is general in nature and is not subject to the personal financial situation and needs of any individual. Clear Tax tries to keep the information accurate and up-to-date; however, you should bear in mind with changing circumstances, the accuracy and reliability of the information will not necessarily remain the same. The information is by no means a substitute for financial advice.