What is financial forecasting, why is it important, and how to properly conduct financial planning and forecasting
Uncertainty is one of the constant aspects of doing business. Many factors beyond your control can potentially influence the market in ways you didn't expect. For example, new technologies are constantly changing operations across almost all industries at a fundamental level.
It pays to know what to expect in the near future and plan ahead, hence the need for financial forecasting. Every business (including monopolies) could benefit incredibly from regular financial forecasting. Here is a comprehensive guide on the importance of financial forecasting for your business model and how to do it.
What is financial forecasting?
Financial forecasting refers to financial projections performed to facilitate any decision-making relevant for determining future business performance. The financial forecasting process includes the analysis of past business performance, current business trends, and other relevant factors.
However, some aspects of financial forecasting may change depending on the type and purpose of the forecast, as will be discussed later.
Importance of financial forecasting
Hypothetically speaking, failure to conduct regular financial forecasting leaves you flying blind. Regular forecasting has extensive benefits for some of your business' fundamental operations, including:
Annual budget planning
A budget represents your business' cash flow, financial positions, and future goals and expectations for a set fiscal period. Financial forecasting and planning work in tandem, as forecasting essentially offers an insight into your business' future—these insights help make budgeting accurate.
Establishing realistic business goals
Accurate forecasting will help predict whether (and by how much) your business will grow or decline. As such, you can set realistic and achievable goals—and manage your expectations.
Identifying problem areas
Financial forecasting can help you identify ongoing problems by analyzing the business' past performance. Additionally, you can identify potential problems by getting an insight into what the future holds.
Reduction of financial risk
You risk overspending by creating a budget without financial forecasting. In fact, most of your financial decisions would be ill-informed without the input of a financial forecast's results.
Greater company appeal to attract investors
Investors use a company's financial forecast to predict its future performance—and the potential ROIs on their investments. Additionally, regular forecasting shows your investors that you are in control and have a solid business plan prepared for the future.
4 common types of financial forecasting
Businesses conduct financial forecasting for varying purposes. Consequently, forecasting practices are categorized into four types:
1. Sales forecasting
Sales forecasting entails predicting the amounts of products/services you expect to sell within a projected fiscal period. There are two sales forecasting methodologies: top-down forecasting and bottom-up forecasting.
Sales forecasting has many uses and benefits, including budgeting and planning production cycles. It also helps companies manage and allocate resources more efficiently.
2. Cash flow forecasting
Cash flow forecasting entails estimating the flow of cash in and out of the company over a set fiscal period. It's based on factors such as income and expenses. It has many uses and benefits, including identifying immediate funding needs and budgeting. However, it is worth noting that cash flow financial forecasting is more accurate over a short term.
3. Budget forecasting
As a financial guide for your business' future, a budget creates certain expectations about your company's performance. Budget forecasting aims to determine the ideal outcome of the budget, assuming that everything proceeds as planned. It relies on the budget's data, which relies on financial forecasting data.
4. Income forecasting
Income forecasting entails analyzing the company's past revenue performance and current growth rate to estimate future income. It is integral to doing cash flow and balance sheet forecasting. Additionally, the company's investors, suppliers, and other concerned third parties use this data to make crucial decisions. For example, suppliers use it when determining how much to credit the company in supplies.
How to do financial forecasting in 7 steps
Many integral aspects of your company's current and future operations hinge on the results of your financial forecasts. For example, forecasting results will influence investors' decisions, determine how much your company can get in credit, and more.
As such, accuracy cannot be overemphasized. Here is a step-by-step guide to ensure that you do it right:
1. Define the purpose of a financial forecast
What do you hope to learn from the financial forecast? Do you hope to estimate how many units of your products or services you will sell? Or perhaps you wish to see how the company's current budget will shape its future? Defining your financial forecast's purpose is essential to determining which metrics and factors to consider when doing it.
2. Gather past financial statements and historical data
One of the components of financial forecasting involves analyzing past financial data, as explained. As such, it is important to gather all relevant historical data and records, including:
- Comprehensive income
- Earnings per share
- Fixed costs
It's important to ensure that you gather all required information as your financial forecast's results will be inaccurate if you exclude relevant data.
3. Choose a time frame for your forecast
Financial forecasts are designed to give business owners an insight into the company's future. You get to decide how far into the future to look, and it can range from several weeks to several years. However, most companies do forecasts for one fiscal year.
Financial forecasts change over time as factors such as business and market trends change. Consequently, it is worth noting that financial forecasting is more accurate in the short term than in the long term.
4. Choose a financial forecast method
There are two financial forecasting methods:
- Quantitative forecasting uses historical information and data to identify trends, reliable patterns, and trends.
- Qualitative forecasting analyzes experts' opinions and sentiments about the company and market as a whole.
Each method is suitable for different uses and has its strengths and shortcomings. However, qualitative forecasting is more suitable for startups without past data to which they can refer.
5. Document and monitor results
Financial forecasts are never 100% accurate and tend to change over time. As such, it is important to document and monitor your forecast's results over time, especially after major internal and external developments. It is also important to update your forecasts to reflect the latest developments. Using forecasting software to automate related tasks may help too.
6. Analyze financial data
Regularly analyzing financial data is the best way to tell whether your financial forecasts are accurate. Additionally, continuous financial management and analysis helps you prepare better for the next financial forecast and gives you crucial insights into the company's current financial performance.
7. Repeat based on the previously defined time frame
Smart companies conduct regular financial forecasting to stay in the know and in control. As such, it is advisable to repeat the process once the time period set for the current financial forecast elapses. It's also prudent to keep collecting, recording, and analyzing data to improve your financial forecasts' accuracy.
Get accurate metrics for financial forecasting—absolutely free
An efficient system of collecting, storing, and analyzing data is necessary for accurate financial forecasting. ProfitWell Metrics is a subscription analytics software designed to do all of this on one platform. Some of the metrics that you can get using this program include:
- Monthly and annual recurring revenues
- Market and customer segments
- Customer acquisition and retention
- Customer lifetime value
- Churn rate
- The average revenue per user
ProfitWell Metrics collects and records all important metrics, giving you enough data to work with when conducting a financial forecast. Additionally, the data collected in real-time offers crucial insights to help you update your forecasts and other projects accordingly.
ProfitWell Metrics also integrates seamlessly with other popular data analytics programs, including Google Sheets and Stripe. More importantly, it's 100% free and secure.
Financial forecasting FAQs
Some of the most frequently asked questions regarding financial forecasting include:
What is the role of forecasting in financial planning?
Financial forecasting estimates important financial metrics such as sales, income, and future revenue. These metrics are crucial for finance-related operations such as budgeting and financial planning as a whole. Consequently, forecasting functions as a guiding tool (or marking scheme) for financial planning.
What is the difference between financial forecasting and modeling?
On the one hand, financial forecasting entails predicting the business' future performance. On the other hand, financial modeling entails simulating how financial forecasts and other data may affect the company's future if everything goes according to plan. Financial modeling is done for very specific and often discrete purposes.
What is the difference between financial forecasting and budgeting?
Financial forecasting and budgeting work in tandem and are often misinterpreted as meaning the same thing. However, financial forecasting entails estimating and predicting the company's future performance (financially and in other aspects). On the other hand, budgeting is the company's financial expectations for the future (expectations based on financial forecasts and other data).
What are the three pro forma statements needed for financial forecasting?
Pro forma statements are financial reports designed to give insights into how different scenarios would play out based on hypothetical circumstances. There are three pro forma statements:
- Pro forma statements of income
- Pro forma cash flow statements
- Pro forma balance sheets
Pro forma statements may be hypothetical, but they help companies prepare for an uncertain future. Consequently, they're useful when conducting financial forecasts.