Financial forecasting is the process of developing an prediced business mode of future business performance over a specified time period. Forecasting assists business leaders in developing budgets, planning resources, anticipating risks, increasing profitability, and managing growth. While such a prediction cannot be made with 100% accuracy, there are several ways to ensure that a financial forecast is reasonable and on track.
Financial forecasting should not be done only once, the forecast should be updated on a regular basis as circ*mstances and trends change. At the end of each accounting period, business owner need to compare actual financials to the forecast and adjust the forecast accordingly. This ensures that your forecast remains accurate and relevant so that it can be used to inform business decisions on a regular basis.
3 Important Elements of Financial Forecasting
A full financial forecast consists of three parts: Balance Sheet, Cash Flow Statement, and Income Statement. These are "pro forma" documents, or documents that are based on assumptions or projections. These documents are similar to the ones you create for each accounting period, except they cover the future rather than the past.
A financial forecast may also contain a position statement, an analysis of industry trends and competitor positioning, or other documents relevant to the forecast's purpose.
Data collection methods for your pro forma documents fall into two broad categories: historical and research-based. In creating your forecast, you will most likely use a combination of both. The more data you gather and analyze, the more precise your forecast will be.
1. Historical (Quantitative) Data Gathering
Note: When financial statements are prepared on an accrual basis rather than a cash basis, forecasts are easier to prepare and understand by outside parties such as investors or lenders. On an accrual basis, the relationship between revenues and expenses is more clearly understood and widely accepted or required.
Examining previous financial statements and looking for trends can help you decide what to include in your forecast. For example, if you had a consistent 3% increase in month-to-month sales over the previous year and nothing major changed or is expected to change, you could reasonably predict the same growth pattern for next year.
Variable expenses are likely to rise in lockstep with fixed expenses. If you look at past data and notice a pattern of decreased sales over the summer (seasonality), you can expect the same this year.
Gathering historical data entails observing past business performance and projecting similar performance into the future. This information is especially useful if you anticipate steady growth with few operational changes. The disadvantage is that it does not take new developments into account, such as market trends or increased competition. It could also be skewed by unusual circ*mstances, such as the COVID-19 pandemic.
2. Research-Based (Qualitative) Data Gathering
Looking outside your company to see what others are doing may provide you with insights into what your company is capable of. This is best accomplished by observing competitors whose businesses are similar in size and scope to yours. You may not be able to obtain precise figures, but you can observe what works and does not work for them and estimate their profits and expenses. Customer ratings and comments on their social media pages may assist you in identifying areas where you can gain a competitive advantage. For example, if customers complain about your competitor's slow delivery times, you might look into what delivery services they use and consider the financial benefits of using a faster service for your own deliveries.
Interviewing knowledgeable people inside and outside your company can provide you with insights into the future. Industry publications frequently provide information on upcoming developments, market trends, and consumer sentiment changes. All of these factors should be considered when making financial projections.
Research-based data is not always measurable, but it takes into account important factors that historical reports do not. This type of information gathering is required for new companies or projects with little historical information. It's also useful when putting together a presentation for a lender or financial partner.
3. Take the Middle Ground
It is best to avoid being overly optimistic when creating a financial forecast, especially if you are using qualitative data. An overly conservative forecast, on the other hand, may discourage investors or disincentive innovation. Many financial experts create three financial forecasting scenarios: a worst-case scenario, a best-case scenario, and an expected case.
Constant re-evaluation of your forecasts will assist you in making them more realistic. Our outsourced CFO team at Preferred CFO uses financial forecasts as a rolling budget to constantly 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 goals, as well as the steps and costs necessary to achieve those goals. This will include both capital and operational expense projections. The projected balance sheet and associated cash flow forecast will determine whether the company can meet those objectives with its current capital.
- Stakeholder Assurance- The second goal is to reassure investors, lenders, and stakeholders that the company is on track to meet its goals.
- Face Challeneges - 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 goal is to easily test financial decisions and their impact on the bottom line so that the company can maximize its results.
While some businesses only forecast a few months or a year or two ahead, others find it extremely beneficial to maintain a 5-year forecast. You should aim to keep short-term, mid-term, and long-term projections.
In Summary
Financial forecasting uses historical data and market research to make educated predictions about future business performance. This enables a company to confidently plan for the future, prepare for unforeseen events, and chart a course for growth. The greater the accuracy of the forecast, the greater the benefit to the company. If you require any additional information or assistance with your financial forecasting, please contact Jordensky.
About Jordensky
At Jordensky, we specialize in accounting, taxes, MIS, and CFO services for Startups and growing business and are focused on delivering an experience of unparalleled quality.
When you work with Jordensky, you get a team of finance experts who take the finance work off your plate – ”so you can focus on your business.”
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