An essential factor in business management is the ability to discern where the company is headed and what course to chart for maximum profitability. Intuition and guesswork are not sufficient to create a rational roadmap for the future. For that, the process of financial forecasting is invaluable.
What Is Financial Forecasting?
Financial forecasting is creating an educated prediction of future business performance over a set period. It helps business leaders create budgets, plan resources, anticipate risks, improve profitability, and manage growth. While it is impossible to make such a prediction with 100% accuracy, there are several ways to ensure that a financial forecast is reasonable and on track.
Financial forecasting should not be a one-time effort. As circumstances and trends change, the forecast should be updated regularly. It is wise to compare actual financials to the forecast at the end of each accounting period and adjust the forecast accordingly. This ensures your forecast stays accurate and relevant so it can be used as a regular tool to inform business decisions.
What Are the Elements of Financial Forecasting?
A complete financial forecast includes three elements: a balance sheet, cash flow statement, and income statement. These are considered “pro forma” documents, or documents that are based on projections or presumptions. These documents are the same as the ones you prepare each accounting period, except that they cover the future rather than the past.
A financial forecast might also include a position statement, an analysis of industry trends and competitor positioning, or other documents appropriate to the purpose of the forecast.
The methods of collecting data for your pro forma documents fall into two general categories: historical and research-based. You will probably use some mixture of both in building your forecast. The more data you collect and analyze, the more accurate your forecast is likely to be.
Historical (Quantitative) Data Gathering
Note: Forecasts are more easily prepared and understood by outside parties such as investors or lenders when financial statements have been prepared on an accrual basis rather than a cash basis. The association of revenues with expenses is more clearly understood and more universally accepted or required on an accrual basis.
Reviewing past financial statements and looking for trends can help you determine what to put in your forecast. For instance, if you had a consistent 3% increase in month-to-month sales over the last year and nothing major has changed or is expected to change, then you could reasonably predict the same growth pattern for next year. It is likely that there will be a corresponding increase in variable expenses as well. If you look at past records and see a pattern of decreased sales over the summer (seasonality), you can anticipate the same for the coming year.
Historical data gathering is basically observing past business performance and projecting similar performance into the future. This data is particularly useful if you anticipate steady growth and few operational changes. The disadvantage is that it does not take into account new developments such as market trends or increasing competition. It may also be skewed by anomalous circumstances such as the effects of the COVID-19 pandemic.
Historical data is relatively easy to collect and analyze. It is the quickest and least expensive way of creating financial forecasts for internal use within a company or department. It may not, however, be sufficient for presenting to a potential lender or investor.
Research-Based (Qualitative) Data Gathering
Looking outside your company to discover what others are doing may give you insights into what your business has the potential to achieve. This can best be done by observing competitors whose companies are similar to yours in size and scope. You may not be able to get exact figures, but you can see what is and is not working for them and estimate their profits and expenses. Customer ratings and comments on their social media pages may help you find areas where you might gain a competitive edge. For instance, if customers are complaining about your competitor’s slow delivery times, you might investigate what delivery services they are using and consider the possible financial benefit of using a faster service for your own deliveries.
You may gain insights into the future by interviewing knowledgeable people inside and outside your company. Industry publications will often provide information on upcoming developments, market trends, and changes in consumer sentiment. All these things may be considered as you make your financial projections.
Research-based data is not necessarily measurable, but it considers important factors that cannot be found in historical reports. This type of information gathering is necessary for new companies or new projects where little historical information is available. It is also necessary when you are preparing a presentation for a lender or financial partner.
Take the Middle Ground
When creating a financial forecast, particularly if you are using qualitative data, it is best to avoid being too optimistic. On the other hand, an overly conservative forecast may discourage investors or disincentivize innovation. Many financial experts (including outsourced CFOs) usually create three financial forecasting scenarios: a worst case, best case, and expected case.
Constant reassessment of your forecasts will help you make them more realistic. At Preferred CFO, our outsourced CFO team uses financial forecasts as a rolling budget to continually 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 goal and as part of that identify the steps and the costs required to achieve those goals. This will include capital as well as operational expense projections. The projected balance sheet and associated cash flow forecast will determine if the company can achieve those goals with the current capital level.
- Stakeholder Assurance. The second is to provide investors, lenders, and stakeholders with assurance that the company is on track to meet its targets
- 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 is to easily test financial decisions and their impact on the bottom line so the business may maximize outcomes.
While some companies forecast only a few months or a year or two into the future, others find it highly beneficial to maintain a 5-year forecast. Ideally, you will maintain short-term, mid-term, and long-term projections.
In Summary
Financial forecasting combines historical data with market research to make informed predictions of future business performance. This allows a company to confidently plan the future, prepare for eventualities, and set a course for growth. The more robust the forecast, the greater the benefit to the company. If you would like further information or assistance with your financial forecasting, we invite you to contact Preferred CFO.
About the Author
David Guyaux
David Guyaux brings over 25 years of experience as CFO, VP of Finance, and Controller roles within both public and private enterprises. He has organized finances for companies to turn around operations and meet compliance and governmental requirements, as well as to prepare for mergers and acquisitions.
You may also be interested in...
Does My Business Need a Financial Advisor?
The wise business owner will “know what they don’t know,” and will seek the appropriate experts such as financial advisors to fill those gaps.
3 Reasons you Need a Financial Forecast
If Your Company Doesn't Have a Financial Forecast, You're Wasting Time and Money Every company has goals. Where do you want your organization to be 5 years from now? 10 years? Most even have a general idea of the benchmarks you need to hit to get there—"By increasing...
Know the Significance of Payback Period
Whether implementing a new software system, adding office space, acquiring another company, or any other substantial investment, companies want to know how long it will take to recoup the money they spend on major purchases. The way to determine this is by calculating...
10 Steps to Prepare for Raising Capital
Finding funding for your business is a process that takes a lot of time and effort, especially during the startup phase. Many entrepreneurs fail in their first attempts at fundraising because they are poorly prepared. Others get themselves into trouble by choosing the...
How Can a Fractional CFO Help You Save Money?
In these days of economic challenges and changes, many companies struggle with uncertainty about the future, seeking tools and resources to best position their businesses for financial success. Often it can be beneficial to bring in a financial advisor who has...
What is a Capitalization (Cap) Table and Why Does it Matter?
What is a Cap Table? Capitalization tables, commonly called “cap tables,” are highly useful spreadsheets maintained by companies that have multiple owners or investors. Cap tables are especially important for private companies at startup and in the early stages of the...
Benefits of Finance & Accounting Staff Augmentation
Many companies experience times when they find their accounting departments short on staff or short on expertise. Sometimes emergencies and financial needs arise that are beyond the capability of their financial personnel to address. This is particularly true in times...
Qualities of an Effective Profit & Loss Report
A Profit and Loss (P&L) Report, also called a Profit and Loss Statement, is a key financial document that details a company’s income and expenses over a specific period of time. This time period is typically a month, a quarter or a year. Depending on company needs...
What Is a Quality of Earnings Report?
When a business sale, acquisition, or major investment is contemplated, one important step in the due diligence process is the generation of a Quality of Earnings report, sometimes abbreviated as QOE. Even though a company may have strong financial statements, those...
Complete Guide to Accrual Accounting
There are two methods of accounting: cash and accrual. In cash accounting, transactions are recorded when payment occurs. In the accrual method, revenues and expenses are matched and recorded at the time the good is delivered or the service is performed, regardless of...
3 Things to Know Before Choosing a Supplier
Choosing the right supplier for your business can be complicated, especially if a large portion of your product comes from a single company. For many companies, supplies are secondary only to labor in their expenses. But choosing the right supplier has even more...
A CFO’s Role in Strategic Decisions
In every company, there are important decisions to be made on a daily basis. Some decisions are mundane and have only short-term consequences. Others are strategic and can affect the company’s performance and profits for years. Too often, these critical decisions are...
