What are you thinking of when you hear the word “forecast?” For many people, forecasts are associated with weather or with fortune telling. However, for small businesses, forecasting is an important part of understanding how the business will perform in the future.
A good financial forecast based on the most accurate information of your statements will help to arrange the budget and plan purchases for your company’s growth. It can also help you understand what to do to improve the financial state of your business.
Even though it sounds complicated, a financial forecast takes three basic steps. So, let’s look at it in detail in this post.
What is financial forecasting?
The basic idea of financial forecasting is taking an objective data set and making a forecast based on that. That is the actual process of making a forecast and projecting the future, which is easy to understand but difficult to implement.
It is based on a thorough analysis of the company’s financial information. In some companies, the process might involve formulating a lot of assumptions, which need to be validated in order to reach a true, predictive result.
The major three financial forecasting tools are:
- An income statement — shows how much money comes in and goes out of business.
- Pro forma balance sheets — redirect assets, liabilities, and equity. They are using data from other company’s reports or documents. The more precise data is used, the more accurate the financial forecast will be.
- A cash flow statement — summarizes how much cash is generated and used during a given time period.
Pro forma statements look like common ones but are more hypothetical and based on the what-if concept, not actual financial results. For example, what if my business gets a $25,000 loan in 2021? The pro forma statements will show what the income, cash flow, and account balance will look like in this particular case. For a successful result, all three statements need to be completed correctly.
The most important part here is to not get confused and mix up the concepts of a financial forecast and financial projections. The easiest way to define these two terms is that a financial forecast shows a possible state of your business in the future based on the previous performance of the company. Financial projections, on the other hand, explore different scenarios and outcomes from each of them.
In simple words, a financial forecast is a straight line to a specific point. And financial projections are rays that might lead you to different possibilities. You create a so-called map that answers the question “What would happen if”.
Why do small businesses need financial forecasting?
If you want to know what causes growth and, therefore, need a financial forecast, you should first think about the resources you have. Of course, the amount of cash on hand, receivables, and debts are always important. However, what’s even more important is the number of sales and the number of orders you receive. Financial forecasts will give you a clearer insight of what’s going on.
Learn more about business financing here.
Financial forecasting will help a business owner in the following scenarios:
- To engage potential investors by showing how their money will be used and how as a result the business will grow.
- As a well-detailed plan for the future to consider the best and worst financial states of business.
- Establish realistic goals based on these reports.
- Get cohesive business performance reports.
- Foresee changes like reaching a new tax bracket.
All that you have to do to make a reliable financial forecast may look like a big challenge. However, divided into smaller steps, it proves to be less complicated than it seems. And of course, there are professionals in this field, so if you’re about to prepare a solid forecast for investors, we recommend turning to a specialist.
How to create a financial forecast in three steps
Even if you are not going to do it yourself but rather delegate the task to a professional, I believe that for you, as a business owner, it would be helpful to know what it takes to create a forecast. Knowing where the details come from, you’ll better understand the final figures. So here are three basic steps to take in financial forecasting.
1. Ensure accurate financial model and statements
The first step is to build a financial model. This includes building accurate financial information, based on relevant business data. To do that, you need a clear vision of your company’s financial goals, a strong knowledge of the tools that can help you achieve those goals, and solid information about your business.
You can divide all the models into two groups:
- Quantitative — the data that can be measured and controlled.
- Qualitative — the data that can not be measured objectively.
Financial statements are the basis for creating a forecast. And as far as they are made using your accounting data, it’s vital to ensure that it is up to date and accurate.
Usually, it’s a bookkeeper’s task to bring the data on all your transactions into the books. But also, various solutions can help to do it and ensure even more accuracy by automatically importing transaction data into accounting with the help of such accounting software as Synder.
Having done it, you can start planning the financial future.
The forecast can be historical or research-based.
You will need the financial information from the past 10 years to calculate your income, expenses, asset position, debt, etc. This list will be long and sometimes complicated, but you don’t need to know everything about it. All you need is some basic information to give you a clear idea.
The historical forecast includes the information of your pro forma statements for the past years. Research-based forecasting means that you have to look at how the industry you work in has performed for the past years. Everything counts, e.g. technologies, trends, analysis of your competitors, etc.
Needless to say that the best strategy for this step is to find a balance between historical and research-based forecasting.
3. Create pro forma statements
When you have enough information gathered for the forecast, it’s time to create the pro forma statements. You choose whether you need three of them for personal use. But if you want to present this information to a third party, it is recommended to include all three.
You should start by estimating the income and expenses in the upcoming months. The forecast of income should include your current business structure, including your sales, your revenue, expenses, your profit margin, etc. And the forecast of expenses should take into account the operating costs, additional expenses and salary expenses. You can use accounting software to help you.
Budgeting vs. Financial forecasting. What’s the difference?
Financial forecasting is often confused with budgeting. And to make it clear we will highlight the differences between these two terms for your better understanding.
Budgeting, in simple terms, is a way of setting up financial goals and intentions for the future. It’s like a puzzle with many pieces that you need to fit together to get the desired result.
It includes the estimates of revenue and expenses, cash flows, debt reduction, and the actual results, and focuses on the difference between the two numbers. Budgeting may target things that cannot be achieved due to some circumstances or changing market conditions. If a company relies on budgeting and makes decisions according to it, the budget should be reconsidered more than once a fiscal year.
The financial forecast, in turn, indicates if the company meets the budget goals and prospects for development in the future. It also helps managers to estimate the number of upcoming deals, moreover, it allows them to develop a business plan.
Can a business do well without financial forecasting?
Yes, it’s possible, but it will result in poor financial management. It’s like getting caught in the rain without an umbrella because you haven’t spent an extra minute to check the forecast for today beforehand.
Many people think that financial forecasting is more of a lottery where t you cannot predict the actual outcome. But if you take the reliable cash flow data of your business and complete all the steps in financial forecasting, this will help not to miss red flags and find growth opportunities. To make it short, no one will blame you for not doing financial forecasting regularly. However, when it comes to making big business growth decisions, they better be data-driven. So here is when financial forecasting will be of solid help.
You cannot predict business trends on an individual basis, but a financial forecast can let you see where you are right now and where you want to go.