Financial forecasting estimates future expenses, profits, and cash flow for your business based on historical financial data and a best estimate of future events.
Forecasting is essential for many reasons:
- Monitoring of cash flow and budget for upcoming periods
- Identifying ongoing financial risks
- Presenting financials to banks or investors
- Guiding your stakeholders about your company’s future
Based on your business needs, you can forecast using one of two methods: qualitative and/or quantitative. Quantitative financial forecasting is statistical and tangible, relying on past historical data – for example, e-commerce retail businesses can expect more sales during the holiday season. On the other hand, qualitative financial forecasting uses market research, insights, and trends to make predictions.
What are Some Different Types of Financial Forecasting?
Forecasting may seem difficult or even overwhelming, but there are several types of forecasting that a business might apply depending on its priorities and goals.
Sales Forecasting
A sales forecast predicts revenue within the projected fiscal period. Sales forecasting considers the pricing of your products and services, the cost of goods sold, and the number of units sold. In addition, it could be worth considering how many new customers you can expect and your service/product mix as well.
There are two methods of sales forecasting: top-down and bottom-up forecasting. Top-down forecasting looks at the overall market and then narrows it based on your company’s products and goals to predict estimates. For example, if your business sells school furniture for children, you can start looking at the overall commercial furniture market, narrow it down to school furniture, and then estimate what market share you believe you can capture. This approach is common for new businesses that don’t have historical data. With bottom-up forecasting, your forecasting process starts with specific company sales/operational data and then expands to view the overall market.
Cash Flow Forecasting
A cash flow forecast is a proactive, and often detailed, process that predicts your company’s available cash, based on projected payments, collections, and other receipts to manage liquidity and meet financial obligations.
This forecast identifies inflows and outflows, providing transparency to your operations. The cash flow forecast can detect potential cash shortfalls for upcoming periods. This provides advance time and warning to react proactively to problems. Over time, your cash flow process will tend to become more accurate. It can then serve as a highly effective tool to manage your business and make data-driven decisions for strategic and operational planning.
Income/Budget Forecasting
Income forecasting predicts your income (Revenues less Expenses) by applying both the quantitative and qualitative factors discussed above. The goal is to project earnings, set goals, establish budgets, and more.
How Do You Create a Financial Forecast?
You can create a financial forecast with the following process:
- Define your goals: What type of financial forecasting does your business prioritize right now? Are you forecasting for the short term or the long term? Sales only or income? Cash focused or accrual-based? Do you need a complete forecast for internal purposes or for potential investors?
- Gather past financial statements: These statements include revenue, liabilities, investments, fixed costs, and more. It is also crucial that all of these statements be accurate and consistent so your forecasts have quality data to apply forward.
- Choose a financial forecast method: Does your business want to perform quantitative or qualitative financial forecasting or both? Do you have high-quality historical data? Do you believe that the future business conditions are similar and different to past conditions?
- Create the forecast: After gathering all relevant data, your business can create a financial forecast tailored to your goals and purpose.
- Monitor the results: Your business should keep evaluating the results after creating the forecast. As your business consistently assesses the financial information, your team can see potential problems within the actual results. You can also compare the estimates and the results to see if they are accurate and make better predictions next time.
Once the current forecast period has passed and you have actual results, it is important to update your forecasts. Repeating forecasts for the next period ensures ongoing accuracy and relevance. As your business collects more relevant statements, data, and results, it will become easier to develop future forecasts. Financial ratios from past historical data will also contribute to making these forecasts more accurate.
How Can the Financial Forecast Be Reliable?
Forecasting is not valuable if it is not reasonably accurate and consistent. Multiple factors can affect the reliability of your financial forecasts.
- Accuracy of Historical Data: Accurate historical data is necessary because inaccurate data will simply produce inaccurate forecasts. Sometimes, businesses have to generate data from business intelligence and market databases. It may be valuable to use multiple data sources to validate the information and ensure accuracy. In addition, there are technologies and software that could reduce errors and save countless hours through automation.
- Assumptions: Businesses must make assumptions about how certain variables will change over time, which includes inflation, interest rates, and exchange rates.
- Unpredictable External Factors: Events such as changes in government policies, natural disasters, and economic downturns can be unpredictable. An option to plan for these events is through scenario planning, in which you can create multiple forecasts based on different potential events and assumptions so that your business can proactively react if the event happens.
- Consistency of Process and Version Control: Sometimes, there are mistakes in data entry, calculations, and analysis. Version control is critical so that you aren’t relying on outdated information. Additionally, having multiple people review the reports, both in detail and at a high level, helps ensure reasonableness. This process will mitigate the possibility of mistakes.
Forecasts will give you the projections you need to make well-informed, data-driven decisions to drive growth and success for your company.
While many software programs can be useful to support your financial forecasting process, it is also important to have a qualified Controller, CFO, or FP&A professional, whether in-house or external, because they can apply the methods and judgments required to create reliable forecasts. Consequently, these forecasts can be used to minimize business risks and seize high-potential opportunities.
How Can We Help?
Sabre Financial Group offers CFO and Controller services for small to middle-market businesses. These services are available across many industries on a fractional or interim basis.
Please contact our team to schedule a consultation so we can discuss how to create financial forecasts for your growth and stability.