February 7, 2023
What is financial forecasting? Why is it important? How do we properly conduct financial planning and forecasting to be successful? These are all very great questions that every business owner should be asking to ensure that they are efficiently planning their business. Uncertainty is a constant aspect of doing business, and many factors are beyond your control. These factors can potentially influence the market in ways you didn’t expect or forecast for. For example, new technologies are constantly changing operations across almost all industries at a fundamental level.
It pays, almost quite literally, to know what to expect in the near future and plan ahead, hence the need for financial forecasting. Every business owner could substantially benefit from regular financial forecasting. Let’s discuss 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 to determining future business performance. The financial forecasting process includes the analysis of past business performance, current business trends, and any other relevant factors.
However, as you may guess, some aspects of financial forecasting may change depending on the type and purpose of the forecast, which we will talk about later.
Importance of Financial Forecasting
Failure to conduct regular financial forecasting exposes you to numerous surprises and leaves you with no vision for the financial aspects of the business. Regular forecasting has extensive benefits for some of your business’ fundamental operations, including:
- Annual budget planning
A budget represents your business’s cash flow, financial positions, and future goals and expectations for a set period. Financial forecasting and planning work together, as forecasting essentially offers an insight into your business’s 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. This allows you to realistically set and achieve your business goals and manage your own, the company’s, and your bank’s expectations.
- Identifying problem areas
Financial forecasting can help you identify ongoing problems by analyzing the business’s past performance. You will then be able to identify potential problems by getting an insight into what the future holds for your business.
- 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 many different purposes. We can categorize forecasting into 4 main types:
- Sales forecasting
Sales forecasting entails predicting how much product and service you expect to sell during a given 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.
- 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.
- Budget forecasting
As a financial guide for your business’s 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.
- 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 for supplies.
How to do Financial Forecasting in 7 steps
Many integral aspects of your company’s current and future operations are dependent upon the results of your financial forecasts. For example, forecasting results will influence investors’ decisions, determine how much credit your company can get, and more. Accuracy cannot be overemphasized. Here is a step-by-step guide to ensure that you do it right:
- 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.
- 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.
- 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 businesses only forecast 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.
- 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 the 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.
- 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.
- 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 help you prepare better for the next financial forecast and give you crucial insights into the company’s current financial performance.
- 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.
We hope that this guide can make your life a little easier when planning the future for your business.