Running a business and uncertainty go hand in hand, and unfortunately, there are many factors that are beyond your control such as changing market trends and economic factors. One of the easiest ways to prepare for the future is through financial forecasts. When was the last time your company put together a financial forecast?
If you need assistance in this area of your business planning, our revenue management consultants at Cultivate Advisors are here to help.
What Is Business Financial Forecasting?
Financial forecasting is an outline of the financial projections of your business that can help facilitate future financial outcomes and decisions for your business. This process considers your financial statements, historical data, cash flow statement, and other relevant factors that contribute to your financial performance. Some financial forecasting methods can change depending on the type and purpose of the forecast.
Why Is Financial Forecasting Important for Your Business?
Without a financial forecasting process, it detracts from your ability to set your company up for success. Here are only some of the benefits of financial forecasting.
Assists with Annual Budget Planning
Your budgeting process outlines the future cash flow of your business, including your goals, financial positions, future revenues, etc. Financial forecasting and budgeting work together as the forecasting process helps to predict future revenues to make budgeting more accurate.
Helps Establish Realistic Business Goals
When you conduct financial forecasting, you help to predict (with values) how much your business will grow or decline. Your business leaders can then set realistic goals that you can actually achieve, also assisting with sales forecasting methodologies.
Pinpoints Problem Areas
Having an understanding of your past financial performance is another benefit of financial forecasting. When you’re able to see potential problems in what the future of your business holds, you can eliminate these issues before they take place.
Reduces Financial Risk
Major financial decisions shouldn’t be made on a whim. Rather than running the risk of overspending, you can use your financial forecasting as a guardrail for your projected financial conditions. The better idea that you have of your projected fiscal period, the less risk that you’ll incur.
Increases Company Appeal to Attract Investors
Financial forecasting is another great way to put together effective financial forecasts to show your investors the potential ROI that they could gain. If your finance team can show your investors that they are in control, it shows them that you have more insights that inform the major financial decisions of the company.
5 Common Types of Financial Forecasting in Business
Business planning involves financial forecasting for many different reasons, and these can be broken out into the following five categories.
1. Sales Forecasting
The sales forecasting process helps you to more accurately predict the amounts of products or services that your company will likely sell within a certain fiscal period. There are two sales forecasting methodologies that you can use: bottom-up forecasting and top-down forecasting.
There are many benefits to sales forecasting methods at your company, one of them being the ability to better plan and budget for your production planning cycles. Sales forecasting can also help you with resource allocation and management.
2. Cash Flow Forecasting
Many businesses fail because they don’t have a strong handle on their cash flow financial forecasting process. This process helps to predict the future revenue and financial situation of your company. To achieve this, it factors in your expected income and expenses to help dictate the future cash position of your company. Cash flow forecasting helps business leaders manage their liquidity and determine if they will have enough cash on hand to meet their financial obligations. One thing to note is that cash flow forecasting methods are the most beneficial when they’re used in the short term.
3. Budget Forecasting
The annual budget process is much more difficult without the use of financial forecasting. Budget forecasting helps to create expectations around the financial performance of your company and informs major financial decisions about the ideal budget outcome. This type of financial forecasting relies heavily on the data from the budget which relies on the financial forecasting data.
4. Income Forecasting
The income statement of your company helps to inform income forecasting methods and it’s used to analyze the past revenue performance of your company combined with your current growth rate to determine future income. When you’re conducting cash flow and balance sheet forecasting, this is integral to your success. Involved third parties utilize data from past financial statements to determine how much credit they want to provide to the company.
5. Expense Forecasting
Simply put, expense forecasting methods help to determine the percentage relationship between expenses and revenue. Once this percentage is determined, it is then used to help with financial planning and financial modeling for future expenses.
7 Common Financial Forecasting Methods
Now that we have a better understanding of the various types of financial forecasting, let’s delve into seven different financial forecasting methods that you can implement at your company. There are two primary methods: quantitative and qualitative forecasting.
When leaders need to put together an accurate forecast, they usually rely on quantitative forecasts that use historical data to predict future financial performance.
1. Percent of Sales
When putting together internal pro forma financial statements, percent of sales forecasting is usually used. This determines line items such as the cost of goods sold as a percentage of sales. For example, as the cost of goods sold typically increases proportionally alongside sales, it will receive the same growth rate estimate.
You’ll need to look at the percentage of each account’s historical profits as they relate to sales; divide each account by its sales. If the cost of goods sold has historically been 25% of sales, it’s likely this will continue.
2. Straight Line
A straight-line method operates under the assumption that the historical growth rate of the company will remain the same. For example, if you had a previous growth rate of 10%, using a straight-line forecast assumes that the next year will also be 10%. Even though this method is a good starting point, it doesn’t factor in supply chain issues or changes in the market.
3. Moving Average
As the name suggests, moving average uses the average, or weight average, of previous financial periods to determine a future prediction. It looks at a business’ high or low demands, making it ideal for short-term forecasting and budgeting. For example, if you are looking to forecast sales for the next month, you can take the average of the previous quarter. This tactic is most often applied to future stock prices but it can also be used to estimate future revenue.
4. Simple Linear Regression
Simple linear regression looks at the relationship between independent and dependent variables. The forecasted amount is the dependent variable and the independent variable is the factor that impacts the dependent variable.
5. Multiple Linear Regression
Multiple linear regression is used by leaders when two or more variables are directly tied to a company’s performance. This helps to create a more accurate forecast as it factors in many variables that dictate the company’s financial performance. There needs to be a linear relationship between the dependent and independent variables in order for this method to be used successfully. However, the independent variables can’t be too closely correlated as it makes it impossible to determine which impacts the dependent variable.
Numbers are important, but they don’t always tell the entire story of the business. There are some factors that simply cannot be quantified, which is where qualitative forecasting comes into play. It relies on the knowledge of experts to predict future performance over historical data.
6. Delphi Method
The Delphi method relies on consulting with experts who help to analyze the market conditions to predict future company performance. There’s a facilitator who reaches out with questionnaires that request business performance forecasts. From there, the facilitator puts together their analyses and distributes them to other experts for comments. Ideally, these will be circulated until a consensus is reached.
7. Market Research
Organizational planning relies heavily on market research as it helps business leaders better understand the market view as a whole. Factors that are considered include fluctuating conditions, competition, consumer patterns, and more. New businesses are especially good candidates for this forecasting method as it helps them get on their feet during the first few months of operation.
When you’re conducting market research, it’s important to start with a hypothesis and determine the needed methods. If you need to better understand consumer behavior and you don’t have numerical data, market research is the ideal approach.
How to Do Financial Forecasting: 7 steps
The accuracy of your financial forecasting cannot be overstated. There are essential facets of your company’s current and future operations that hinge on these results. Here is a list of steps to ensure accuracy.
1. Define the Purpose of a Financial Forecast
What information are you hoping to learn from this forecast? Maybe you want to understand how many units of a product you’re going to sell or you want to understand what your future budget will be. Before you get started, make sure the purpose is clear.
2. Gather Past Financial Statements and Historical Data
You’ll also want to collect and analyze various parts of past financial data such as revenue, liabilities, losses, fixed costs, equity, investments, earnings per share, expenditures, etc. Make sure to take the time to put together these numbers, factoring in all relevant data to produce an accurate result.
3. Select a Time Frame for Your Forecast
How far into the future do you want to look? This could be anywhere from a few weeks from now to a few years from now. Keep in mind that the closer the time period, the more accurate the forecast will be. The majority of companies put together forecasts for one fiscal year.
4. Determine a Financial Forecast Method
As we discussed above, there are two main methods: quantitative and qualitative. Each is ideal for different scenarios and both have strengths and weaknesses. Generally speaking, qualitative forecasting is ideal for startups as they don’t have past data as a reference point.
5. Document and Monitor Your Results
Make sure to document the results over time as there’s no such thing as 100% accuracy. Keep your forecasts updated as the latest developments unfold.
6. Regularly Evaluate Financial Data
To determine whether your forecasts are accurate, you’ll want to analyze them regularly. This will also help you better prepare for the future.
7.Repeat Based on the Established Timeframe
Conducting these forecasts regularly can help you stay in better control of your company and assist with financial modeling and financial planning. This is going to be an ongoing process and although it is tedious, it is worth it in the big picture of your company.
How Cultivate Advisors Can Help
As you can see, financial forecasting is an integral part of your long-term business success. If you aren’t sure where to begin or you have questions about how to go about this process, our financial forecasting consultants at Cultivate Advisors can assist you! We are highly experienced in working with many different business types and sizes and can give you peace of mind. Call us today to schedule an initial session!