A Simple Guide to Financial Forecasting
Many people associate forecasting with things like weather prediction or fortune telling. Unexpectedly, financial projections aren’t that far off. Considering prospective clouds on the horizon and planning ways to avoid getting caught in a thunderstorm, organizations use it to forecast their future performance. Businesses won’t need crystal balls or magic potions to forecast anymore. Instead, they’ll utilize their company data, which is an even more effective instrument. Why is financial forecasting important for firms, and what does it entail? What steps are involved in making a financial forecast? Let’s take a closer look at these and the other crucial questions’ responses below.
Financial Forecasting: What Is It?
Financial forecasting, taken in its broadest sense, refers to the process of estimating or simulating a company’s future financial health. All are based on a careful examination of previous financial information. Macroeconomic factors that have an impact on firms directly or indirectly. Such as inflation, consumer spending, employment rates, sector-specific trends, market competitiveness, etc., are taken into account in financial forecasting.
Financial forecasting, when done correctly, is a potent tool that finance teams may use to examine the current health of a company’s finances. And forecast future revenues and expenses based on anticipated demand for goods and services. It also helps to imagine what may occur if circumstances changed for the better or worse. So that you can prepare for the worst-case scenarios in advance. Companies can make both short- and long-term financial forecasts based on their business goals.
One of the key elements impacting well-informed decision-making is financial forecasting. Budgeting, financial modeling, and company planning all benefit immensely from it. Due to this, the accuracy of the data utilized to generate financial forecasts is of utmost significance.
What Are Financial Forecasting’s Main Components?
A corporation would typically rely on three primary financial documents, such as an income statement, a balance sheet, and a cash flow statement, to develop financial predictions.
- An income statement is a financial statement that highlights how revenue is converted into a company’s net income or net profit. This is done by listing all of the business’s profits and expenses for a specific period.
- A balance sheet is a representation of the assets, liabilities, and equity of a corporation at a specific point in time.
- The financial statement known as a cash flow statement lists all of the company’s cash inflows and outflows for a specific period.
Pro Forma Financial Statements: What Are They?
Pro forma statements are financial statements that are constructed based more on assumptions or speculative data than on real data. It implies that you enter the information for future anticipated income and expenses.
You can build these hypotheses on your prior financial data, where you can identify trends and use them to produce pro forma statements. For the past six months, for instance, you have noticed a 5% growth in sales income month over month. Therefore, you can assume that your sales will have increased by a total of 15% at the end of the quarter. And account for this increase in your forecasted balance sheet and income statement (a pro forma balance sheet and income statement) as well as cash flow for the following quarter.
Using Both Quantitative and Qualitative Forecasting
Financial projections can be categorized into two main kinds based on the type of data used to make them: quantitative and qualitative.
To create pro forma statements (balance sheet, revenue, and cash flow statements) utilizing sales data from prior years and expected expenses, quantitative financial forecasting presupposes that measurable historical data will be used.
- Conduct a time series analysis by looking for particular trends in the data over a specified period;
- Examining causal links to determine how shifts in consumer confidence, purchasing power, interest rates, etc. affect your business’s sales.
It’s important to note that if you already have a lot of data to evaluate, quantitative projections are a terrific option. As a result, they might not be as beneficial for startups or early-stage companies.
In qualitative financial forecasting, assumptions are founded on knowledge of the past. As well as an understanding of how events are related to one another.
Tools and techniques for qualitative financial forecasting may include:
- Asking sales and operation professionals for their professional judgment or examining various scenarios that took transpired at various times or locations;
- Distributing a series of forms for specialists to complete on their own. This denotes the use of many rounds and the development of fresh sets of questions based on the outcomes of the previous ones. The previous answers from the experts would need to be reevaluated. The process of evaluating the likelihood of numerous scenarios and the results from each will need to continue. All until you have a list of common opinions (something on which the majority or all of the experts agree).
Businesses without access to historical financial data may find that quantitative financial forecasting is a useful alternative. However, you should be aware that some results may be skewed, which could affect the accuracy of your data.
Forecasts Based on Research and History
There are two sorts of forecasts from the perspective of gathering the data required to construct a financial forecast. Historical and research-based.
The information from your financial accounts for the previous years is included in historical forecasting. Research-based forecasting requires you to consider how your sector has done in recent years. Everything matters, including technology, trends, competitor analyses, etc.
Finding a balance between historical and research-based forecasting is, of course, the ideal approach.
Financial Forecasting Versus Financial Modeling and Projections
Financial projections, financial forecasts, and financial modeling are sometimes used synonymously. This results from the terminology’s hazy distinctions and the fact that they frequently complement one another to provide a more thorough picture of a company and its potential success.
However, forecasts serve a different function than financial projections and models. Let’s do a brief comparison of each of the three.
Financial projections, assuming no changes to the business operation, use the real historical business data to identify specific trends. And based on them, portray business performance in the forthcoming period.
Financial projections are forecasts of an organization’s future performance based on past performance, anticipated (or planned) developments, and occurrences. And assumptions about shifting market circumstances.
Forecasts and other data are typically linked together in financial models to provide a preview of the potential effects of various situations. Both best-case and worst-case, on a corporation. It might involve getting a loan, experiencing a sharp decline in revenues as a result of a vendor going out of business. Or beginning a new project, concluding a deal, and other things.
In short, forecasts help manage money and maintain the health of the firm. Projections illustrate how planned events will turn out, and financial models aid in assessing the probable effects of potential occurrences before making crucial decisions.
A Summary of Financial Forecasting
A corporation can use financial predictions to more precisely estimate the budget required to meet its needs by projecting future income and expenses. And they must be data-driven when making judgments on the expansion of large businesses. When this happens, financial forecasting will be quite beneficial!
Some people believe that financial forecasting is more like playing the lottery because you can never foresee the results. It is most likely a result of a lack of knowledge about the significance of data quality in predicting.
But the information in the financial statements and a financial projection are equal in quality. For this reason, having correct accounting data is crucial for a corporation. You may always have accurate financial reports by working with Your Part Time Accountant to accurately record your sales in accounting.