What is Financial Forecasting?
Financial forecasting is estimating future outcomes for a company over a given period of time, especially for the next year. It uses historical data, including sales, accounting, market, and economic measurements, to predict what will happen financially to your business. Financial forecasting will assist you in ensuring the growth of your business.
To be able to make a financial forecast, you need to prepare Pro-forma financial statements to make your predictions more accurate. The most commonly used Pro-forma financial statement is the Income Statement, which shows all sales revenue minus expenses of the business.
Revenue forecasting is based on historical figures, economies of scale, and market trends. In forecasting expenses, you need to consider the overhead cost and all production and non-production costs of the business. Some of the company’s expenses include rent, utilities, advertising, salaries, and bonuses. Depreciation of equipment and materials should also be treated as an expense. Some forecast the operational cost of their business as a percentage of their revenues.
How to Create a Financial Forecast
You need a financial forecast to show potential investors that your business is on the right track. The financial forecast will be the basis of lenders if your business if worth their money. There are steps to follow in preparing a reliable estimate.
To make estimates or predictions more concrete, you need to prepare pro-forma financial statements. These statements are precisely like the financial statements regularly prepared for your business at the end of every period. The only difference is that pro-forma financial statements are prepared for future months or years in advance. They are the prediction of the future’s financial status of your business, thus called forecast.
A financial forecast is created depending on your goals. The financial forecast can cover six months or a longer period of, for example, three years in the future. To do this, you will need to prepare the three pro-forma financial statements:
- Income Statement
- Cash Flow Statement
- Balance Sheet
These are financial reports based on assumptions based on conditions within the business in the past. These statements help a company present its business to stakeholders like future partners and investors.
Steps in Creating a Financial Forecast
To appropriately do a financial forecast for your business, there are three essential steps you need to follow:
Gather past financial statements
You need to first look at the past finances of your company before you can look into its financial future.
All past financial statements must be ready for you to be able to prepare a more realistic projection of your business. Your company’s past financial statements are the best evidence if your business is growing or not. Historical figures are necessary for preparing forecasts. These will also serve as the bases in the preparation of your Pro-forma financial statements.
Your bookkeeper can help you generate your past financial statements. If you don’t have a bookkeeper, you can get bookkeeping applications and software offered in the market. They can make your task of consolidating historical finances a lot easier. If updated financial reports are already complete, you are now ready to prepare with your projections.
Decide on how to make the projections
There are other data that you need to consider to make your forecast more reliable, aside from historical records.
Your forecast will always depend on historical figures and research-based information. Forecasting will always be a mix of these two factors; otherwise, your projections will not be complete.
The historical data you gathered will help you make a precise guess on the growth of your business within the present year. Preparing a forecast using historical data is easy to do since you only need to analyze and evaluate the available information. You do not need to spend money on gathering data about your business since they are readily available for you.
However, looking within your company will never be enough to have an excellent financial forecast. You need to look into the broader perspective and see the actual market trends. Be aware of your competitors and the leading market trends, and then it is time for research to come in.
Research-based information will give you a more detailed view of the present market, latest technologies, and consumer trends. You can study the business of your competitors and see what you are up against. Most creditors thoroughly look in the research-based data, aside from historical data, before investing in a particular business. The only disadvantage of research is its cost. It may involve hiring researchers and consultants to do the tasks. But research is beneficial to a new company, which has limited financial history to serve as a basis.
Prepare Pro-forma statements
Once your historical data and research results are available, you are now ready to prepare your Pro-forma financial statements.
Pro-Forma Financial Statements
There are three basic pro-forma financial statements you need to make a sound forecast
Pro-Forma Income Statements
The Pro-forma Income Statement is the most commonly used statement. To be able to do this, you need to set a projected revenue or sales within the next six months or so. Your goal here is to project higher sales than in prior years. For example, if your average sales in the last three years are $100,000, you would want to increase it this year to $160,000. You also need to present the increase in sales in your Pro-forma Income Statement, showing the growth each month. You may give a fixed or gradual monthly increase to attain the additional income at the end of the projected year.
The harder part of preparing a Pro-forma Income Statement is determining the projected “loss.” These are the expenses your business may have to achieve the projected sales. You should deduct the cost of goods or services sold and all other operating expenses from your income. You must take into consideration the costs of your business to make an accurate projection. The Pro-forma Income Statements must be able to show how much you expect to earn and spend in the future.
Pro-Forma Cash Flow Statement
A Pro-forma Cash Flow Statement is just like your regular Cash Flow Statement. This statement is based on your prepared Pro-Forma Income Statement, showing how much money you have available at any given time. This statement shows you if your business has enough money to keep it operational. If you have a positive cash flow, then you can pay loans or invest in something else. But if you have a negative cash flow, you might want to consider borrowing money to keep your business afloat.
Pro-Forma Cash Balance Sheet
The Pro-forma Balance Sheet is based on the Pro-Forma Income and Cash Flow Statements you prepared. The Pro-forma Balance Sheet shows a company’s projected assets and liabilities. It presents what a business owns and owes and, generally, its possible financial condition.
When to use all the three Pro-Forma financial statements will all depend on the purpose. If you are trying to secure a loan or possible investment, then all the three financial statements will be beneficial. If you are going to make a forecast for the next six months, then an Income Statement will be enough.
Budgeting versus Forecasting
Budgeting and forecasting are often used in businesses interchangeably. Financial forecasting and budgeting are both planning processes used in operating companies. Although both methods use assumptions and used in making a business plan, they have different and distinct concepts.
In budgeting, you plan to set aside money for your company’s expenses, taking into consideration the business income. In financial forecasting, you try to see where your business is going based on past performances and other market factors. Forecasting is a projection, while budgeting is a plan to ensure that your company’s future will be close to the prediction.
Budgeting is a process of creating a spending plan. The purpose of making a budget is to know whether your business will have enough money to get things done. With a prepared budget, you can determine if your company has money to spend on its daily operations.
A budget is regularly re-evaluated, usually annually, but can also be done quarterly or semi-annually. The budget serves as a baseline to assess how the actual performance varies from the expected one.
The difference of forecasting from budgeting is that forecasts do not evaluate the variance between projections and actual performance. A forecast shows whether a company achieves its goals based on its budget
Financial Forecasting Methods
There are two general approaches used to prepare financial forecasts, the quantitative and qualitative. Businesses usually combine these two approaches to create reliable financial projections.
This approach relies on quantifiable data that can be measured, calculated, and manipulated. Mathematics and statistics are applied to the quantitative forecasting method, including regression analysis, rule of thumb, or decomposition. Below are the two methods using a quantitative approach.
- Cause-Effect Method
- Time-Series Method
A qualitative approach relies on information that is difficult to measure, like opinions of experts and executives. This approach is helpful to business, which just started wherein no historical financial data can still be gathered. Below are some examples of qualitative methods used in forecasting.
- Market research
- Executive Opinions
- Delphi Method
- Sales-Force Polling
- Scenario Writing
Forecast versus Actuals
After creating your business’ financial forecast, your work is not done yet. The most critical part comes in after preparing the estimates. You need to record your company’s performance and compare it to your projections after each month or year. Evaluating actual against projected figures can help you make a better financial forecast in the succeeding year. Take note of what you did wrong if your estimates come out to be way off from the actual figures.
Tools for Financial Forecasting and Budgeting
Many companies use spreadsheets to prepare their financial forecasts and budgets. They manually update, record, store, and share these documents with colleagues via email. This method entails a lot of risks, is prone to error, and very tedious. You find yourself manually encoding and validating data, thus leaving you with not enough time to analyze all available information.
Some websites offer businesses assistance in preparing a financial forecast. There are Pro-forma templates that can be downloaded from the internet for free. Since Pro-forma statements need to be accurate, they can help business owners who have no experience in forecasting. There are also software applications that can help you to prepare financial forecasts and budgets easier and faster.
By utilizing these applications, you and your management team will have more time to evaluate and analyze all the data gathered and computed electronically. Financial information will also be readily available to decision-makers in your company. You will also find these applications and systems more accurate and secure