Accurate data is the key to successful financial forecasting for small businesses. Unfortunately, the variables in the formulas are constantly changing. Inflation increases costs. Consumer demand fluctuates. Market volatility can quickly increase or decrease share prices. This article will explain how these factors affect financial forecasting. Some key takeaways to look for:
- Long-term financial forecasting should be done by professionals who understand the nuances of the process.
- Your business model and the complexity of your operations will determine which financial forecasting models are right for you.
- Companies often need a combination of several financial forecasting models to evaluate their business needs.
Here’s why financial forecasting is essential for small business growth.
Understanding your finances provides clarity in your business decision-making. This can be as simple as monthly budgeting to cover expenses. Forecasting your revenue for the next thirty days shows how much you can afford. Most of those costs are fixed, and any variation will be minimal because the time frame is relatively short.
Expand this to a quarterly or annual financial forecast. The numbers are higher, and the variation from the mean is more pronounced. Securing investments and preventing cash flow shortages becomes more challenging. Optimizing your operations can reduce some costs, but external conditions can still affect your financial projections.
One-year, three-year, and five-year financial forecasting should be done by professionals who understand the nuances of the process. Accurate projections can facilitate sustainable growth and profitability if done properly. As a small business owner or entrepreneur, you have other responsibilities. Let our firm handle financial forecasting for you.
Let’s take a look at an overview of key financial forecasting models.
There are several ways to do financial forecasting. Your business model and the complexity of your operations will determine which model is right for you. We usually do multiple models and compare quantitative and qualitative data to ensure accurate projections. Statistics are important, but market conditions cannot be ignored. Here are some examples:
Straight-line forecasting is a forecasting model based on your business’s financial history.
In economies that expand and contract frequently, assuming that a company’s historical growth rate will remain constant is risky. We use straight-line forecasting to calculate future sales and revenue based on financial history. The result is a “status quo” value that tells us what will happen if nothing changes. That’s a good baseline for comparison to other models.
Straight-line forecasting is ideal for businesses with steady revenue growth over several years. Unfortunately, economic circumstances in the past five years have not been stable. The pandemic, post-pandemic, and changing government regulations have skewed the numbers. The straight-line forecasting model does not take those factors into account.
The look-back period for straight-line forecasting should be long enough to measure consistent growth. Future revenue is calculated by multiplying the average growth rate of the previous period. For example, if you go back 36 months and the growth rate is 5%, the straight-line forecasting method assumes your growth rate will be 5% for the next twelve months.
Use moving average forecasting to set long-term goals.
Long-term financial forecasting is necessary when you are creating a plan to achieve long-term organizational and financial goals. Moving average forecasting analyzes short-term trends. It’s similar to straight-line forecasting, but the time increments are days, months, and quarters. A moving average is often used to track stock movements and the underlying patterns that drive investor behavior.
A moving average can be applied to revenue or sales. It’s calculated by adding the numbers from each preceding period and dividing the total by the number of periods used. This method is called a moving average because you can add new periods as they occur. Doing this regularly can reveal patterns in incoming revenue and sales.
Using a shorter period can help your company avoid long-term preventable losses. If revenue trends downward, consider it an early detection tool to examine your systems and processes. It’s best to use net revenue for calculations to determine whether rising costs are causing your revenue decline. Consult with our team if you have questions about that.
Scenario planning accounts for changes in the market.
Straight-line forecasting assumes the status quo will continue. Moving average tracks revenue and sales trends as they happen. Scenario planning is the “what if” financial forecasting model. It’s where you can look at best-case, worst-case, and expected-case situations. We use it to create multiple financial projections for different business scenarios.
A good example of scenario planning is preparing financial strategies based on supply chain disruptions. Economic and geopolitical events can have predictable results. For instance, a tariff on goods and supplies coming from Canada could disrupt your supply chain and raise your costs. Scenario planning examines the financial impact that it will have on your company.
One of the tools we use for scenario planning is pro forma financial reports. We create pro forma income statements, balance sheets, and cash flow statements using hypothetical numbers based on events that could disrupt your revenue and cash flow. You can use this data to prepare and respond to these scenarios if and when they occur.
Cash flow forecasting is a great model for small businesses.
Cash flow is the lifeblood of your business. Cash flow forecasting ensures you’ll always have it when you need it. This might be the most important of the four models we’ve profiled here. It’s also the most crucial for startups and businesses with fluctuating income. Maintaining adequate liquidity for operations could be the difference between success and failure.
A simple example of cash flow forecasting is a SaaS (Software as a service) company forecasting cash flow to manage subscription renewals and operational costs. Startups in the technology sector often start with venture funds or bootstrapping to develop their application or platform. Burn rate eventually consumes that money, creating a need for cash flow projections.
Online businesses have different costs from traditional businesses. Brick-and-mortar establishments require cash flow to pay overhead and supply costs. Professionals have legal and compliance costs. Restaurants have food costs. Cash flow forecasting should incorporate revenue targets to ensure these costs are covered.
Get financial forecasting, tax planning, and accounting all in the same place.
Our firm uses a combination of financial forecasting models to evaluate your business needs. The straight-line method gives us a baseline. The moving average shows growth or regression. Scenario planning helps us analyze hypotheticals. Cash flow forecasting gives you targets to shoot for.
Schedule a discovery call today to get started.
Talk soon,
Jeremy A. Johnson, CPA