Financial forecasting is how we take existing accounting data and financial statements and put that data to use. Today, I’m going to explain financial forecasting in the context of its core and extended benefits.
- Business performance
- Decision-making and risk mitigation
- Forecasting in preparation of financial analysis
Let’s start with the essentials of financial forecasting for small businesses so you can begin thinking about use cases for your business. Remember, awareness is valuable in and of itself, so I’ll answer some of the key questions first:
- What is forecasting?
- How do forecasts differ from budgets and projects?
- What role does forecasting play in financial analysis?
Let’s get going.
What is forecasting?
Financial forecasting for small businesses means predicting future revenue, expenses, and cash flow based on past performance and current market conditions.
It’s a time-consuming process that involves analyzing financial data like profit, cash flow, and liabilities and factoring in events like business expansion and stock market corrections.
Then, you bring together all that information to make informed predictions.
Financial forecasts are different from projections and budgets.
As I mentioned above, a forecast is an estimate of future financial performance based on historical data, current trends, and assumptions about the future.
A projection, on the other hand, deals with a hypothetical situation. By assuming a given variable remains unchanged, a business can evaluate potential outcomes and make informed financial decisions.
Here’s an example projection: You assume a 10% increase in customer demand next year. Based on that hypothetical, you may be able to project expected revenue, expenses, and profit margins for the year.
Forecasting is not budgeting.
A budget is simple. What can your business afford to spend and still make money? Okay, it’s a bit more than that. Planning and prioritizing are involved, and it’s necessary to know the expected income and expenses over a set time in some degree of detail.
After creating a budget, you’ll use it as a guide for your financial activities. Budgets are usually made for an entire year, whereas forecasts tend to be updated monthly or quarterly.
In short, a budget sets a fixed financial plan for a specific period, while a forecast gives you an evolving estimate based on data and trends. Small business efforts in financial forecasting make for better budgeting.
There are three benefits of financial forecasting.
Really, there are many more than that. Because financial forecasting gives you clarity on future outcomes, it’s valuable in countless ways. But these are the three I want to focus on for small businesses.
1. Forecasting allows you to predict performance.
It’s an absolute necessity if you want to be able to set realistic goals and budgets for your business.
With insights from forecasting, you can identify patterns and make informed predictions about revenue, expenses, and cash flow.
2. It also helps you manage uncertainty.
Financial forecasting won’t let you see the future, but it can help you manage uncertainty more efficiently.
It gives you the data you need to anticipate market shifts and respond to changes in demand or cost. A business with robust forecasting is better positioned for best- and worst-case scenarios.
3. Appeal to investors.
Investors want to see a clear picture of your business’s future—which is beyond knowing how much your business is worth. Maintaining a system for financial forecasting will help them understand your revenue potential, growth strategies, and how you plan to capitalize on opportunities. It also helps them efficiently allocate capital to different aspects of your business.
We’re focused on quantitative forecasting.
Quantitative forecasting means predicting outcomes based on hard data and statistical analysis. This method uses historical data, like sales, costs, and trends, to identify patterns. Then, it uses those patterns to estimate future performance.
Here are some of the common techniques in quantitative forecasting you’ll hear about:
- Time Series Analysis
- Regression Models
- Moving Averages
Yes, regression models are considered a forecasting tool, as they use statistical analysis to identify relationships between variables and predict future values based on historical data, allowing for estimations of future trends and outcomes and making them valuable for forecasting in various business scenarios.
The more data, the more accurately they’re able to forecast future events.
Let’s touch briefly on qualitative forecasting.
There’s another forecasting methodology that I must mention for the sake of thoroughness. I am talking about qualitative forecasting. Qualitative forecasting is not my area of expertise, but I’ve worked with clients who’ve explored it with some success.
So, we can simply say that qualitative forecasting involves human factors—behavioral trends like productivity, job satisfaction, and managerial performance within organizations and in reference to the respective industries.
Qualitative forecasting deals with data, but that data is not numerical. Merging qualitative and quantitative forecasting is a tremendous challenge.
I’ll close with this: intuition is powerful, especially when it comes from individuals with experience. So, when I talk about the benefits of financial forecasting, I’m in no way discounting the very real utility of business acumen and good instincts.
Like all functions in your business, forecasting is a process.
Here’s a basic step-by-step process that’ll give you an idea of time and workload.
1. Evaluate your business’s current market position and identify what you want to achieve with your forecast.
2. Next, gather historical financial data. Things like revenue reports, profit and loss statements, and balance sheets will give you the data you need.
3. Analyze historical data to create forecasts of expected revenue, expenses, and cash flow.
4. Continually review and adjust your forecasts, preferably on a monthly basis.
Accurate and timely data is critical. Bad data creates confident decision-makers who confidently make bad decisions. Data is the end and the beginning.
Financial forecasting is not a roadmap. It’s specific, even down to individual financial statements.
Financial forecasting, as a whole, starts with detailed projections for individual financial statements. Here are a few of the most common:
1. Pro Forma Financial Statements
A pro forma financial statement is a prediction of how your business will perform in a specific future scenario. To make one, you need to collect data, figure out a few assumptions about the market and your plans, and then use those assumptions to estimate future financial numbers.
2. Income Statements
Forecasting an income statement means predicting your business’s future profits and losses. You’ll want to start by figuring out your expected annual growth rate. Then, examine how much your revenue has increased in past periods and use that to determine what your future revenue might look like.
3. Balance Sheets
Businesses often create balance sheet forecasts, which aim to predict the total number of assets and liabilities on your books at a future date.
Start by inputting your short- and long-term assets, then account for current and long-term liabilities. Once you’ve worked all that out, subtract your liabilities from your assets, and you’ll have a sense of what your finances will look like on a certain future date.
4. Cash Flow
To forecast your cash flow, estimate your expected cash inflows for a specific period. Then, add your anticipated cash outflows for expenses, investments, and other costs during that same timeframe.
Forecasting is a step toward high Return on Investment (ROI) financial analysis.
Forecasting is a must. It helps you predict what’s likely to happen and make decisions based on that knowledge.
But it’s not enough. You also need analysis to dig deeper into the “why” behind those trends. You want to understand the present to make sure your predictions are meaningful.
The real value of a forecast is as a tool to understand further factors like customer behavior, market conditions, and inefficiencies.
Get started with powerful financial analysis.
Make informed decisions, capitalize on opportunities, mitigate risk, and plan for growth. To get started with powerful financial analysis tailored to your business, schedule a call with me today.
Talk soon,
Jeremy A. Johnson, CPA