Financial forecasting is important regardless of the size of your company—even if you haven’t formally launched your small business yet. It is necessary in order to obtain capital from banks or investors as well as to understand how to assure the success of your organization.
Business financial forecasting is definitely difficult to start a business, and it is even more difficult to forecast how the firm will perform in the future. It can also be a very emotional experience. When the economy as a whole is in a state of flux, these issues can become even more complex. Even so, a financial projection is essential for determining what success looks like in dollars and cents for a small business.
What Is Financial Forecasting?
Forecasting is a planning method that aids management in dealing with future uncertainty. It identifies trends and forecasts future outcomes using historical and current data. Forecasting is a technique for predicting a company’s financial future and determining predicted revenue and expenses.
Companies employ forecasts in a variety of ways. Management can use projection to make choices about staffing or inventory levels or establish a budget or chart a course for the company’s short- and long-term strategic goals.
Here are the three primary tools for financial forecasting:
- An income statement shows how much money enters and exits a company;
- Pro forma balance sheets include assets, liabilities, and equity. Data from other documents or accounting reports are used to build them. The quality of financial forecasting will depend on the accuracy of the data used;
- A cash flow statement shows incoming and outgoing cash during a specific time period.
Financial forecasting vs. budgeting: What’s the difference?
Budgeting and financial forecasting work in the same way but the reasons and ways in which business owners use them are different.
Budgets are a company’s roadmap to achieving its annual profit target. Even organizations that use flexible budgeting, which changes expenditure based on predicted income swings, must adhere to budgets in order to keep operations operating smoothly.
Most budgets appear to be extremely focused on revenue and expenses and may get quite detailed.
Financial predictions lose some depth and gain some scope when compared to budgets. They help to evaluate current business strategy and how current decisions can lead to a desired future conclusion.
Explore more about: Budgeting Vs Financial Forecasting
Why do Small Businesses Need Financial Forecasting?
It makes sense for a small business owner to use a formulaic method to understand how their company should grow over time. A financial forecast establishes benchmarks and objectives that the organization should revisit on a regular basis. In most circumstances, a small business owner should consider developing a financial plan that covers the following six to twelve months.
It is, however, prudent to devise a strategy that extends even further into the future. Most banks and angel investors require a detailed financial plan covering a two to a five-year term.
Many small business owners choose to make a plan for this extended term in case they run into financial difficulties and require a loan or fundraising — it is far less stressful to make a financial prediction when you are just starting out than it is when you are struggling for cash.
Every company should revisit and update a financial forecast once per quarter or whenever a noteworthy event occurs.
A Guide to Financial Forecasting for Small Businesses
Usually, the company’s finance staff handles financial planning and analysis. They build complicated models with a plethora of variables and assumptions. However, you don’t need all of the information to get a sense of where your company is going. This will require a financial model or a breakdown of your company’s expenses and earnings. The following are some of the essential areas to start generating financial projections:
Make a vision for your business
You must truly write down your business concepts and ideas on paper. Prepare a chart depicting your company’s vision and where you hope to see it in the future.
Along with the dates, you might provide relevant benchmarks or milestones. This will help you gain a better understanding of what has to be accomplished in the time allotted. You can also input any long-term investments you wish to make and see how they might turn out when the timeframe is completed.
Make a budget for future purchases and debt repayments
This step requires you to think about the plans you’ve made for the new initiatives that are about to start. These initiatives will necessitate your participation, and now is the time to consider and carefully develop a final version of the project expectations. What method will you use to raise funds? What method will be used to repay the loan or debt? As substantial expenses, they necessitate the use of your Pro Forma financial accounts to begin financial forecasting.
Examine your financial records
Examine the last three years’ balance sheet and income statement for the company. Determine your three most recent financial statements while projecting your financial status for the following six months.
Identify each of the five major account categories by the % change: revenue, expenses, assets, liabilities, and equity. Your accounting program will reveal account balances.
Examine the ratios
Because analyzing ratios is difficult, you may skip this step if you have enough data from the previous stage to back up your claim.
By comparing projected results to actual results, you can determine whether you’re on track or need to make adjustments to meet your goals. For financial estimates, consider purchasing accounting and planning software. Dashboards and charts that display information at a glance make tracking performance easier and faster. And if you can’t handle it alone you can hire a fofinancial advisor to help you to make all the necessary documentation or take a financial literacy course to help you out with this.
Make a pro forma income statement and develop it
Let’s go ahead and start forecasting now that you’ve looked back at your company’s history.
An income statement, a balance sheet, and a cash flow statement make up a pro forma financial statement. Download the most recent editions of the statements and create a spreadsheet. New businesses can use their sales data as a reference point for forecasting, but established enterprises can rely on their extensive data.
Make sure you have enough cash on hand to pay for cash-only needs and keep accounts payable and receivable for credit payments and sales, respectively.
Make use of projections when making plans
When looking for additional money, projections are crucial. They also assist you in determining when capital expenditures should be made. Projections aid in the analysis of the impact of various business strategies in planning. What if you charge a greater or lower price, for example? What if you could collect invoices more quickly? Running and testing these calculations demonstrates the financial impact of such decisions.
Projected financial statements assist you in planning for the best and worst-case scenarios. You can utilize anticipated financial statements to dig down to the product level and determine when it will be profitable when to ramp up production, and even when it is no longer profitable to produce.
We exist in the current moment, anticipating an unknown future. Financial forecasting can provide insight into your company’s future, but it cannot predict what will happen. Regardless of what the future holds, the discipline of maintaining tight eyes on your accounts and projections will serve you well.
7 Financial Forecasting Method
When businessers tend to forecast their sales, expenses, and revenue, pro forma statements are extremely important. These determinations are more often reinforced by one of the below financial forecasting methods that estimate the upcoming business growth rates and income.
The 7 financial forecasting methods come under 2 major categories for financial forecasting: Quantitative, and Qualitative.
When a business makes accurate forecasts, they generally go for quantitative forecasts or they will make an assumption regarding the future historical data.
1. Percent of Sales
Utilizing the sales forecasting percentage, the internal pro forma statements are prepared. This type of forecasting technique estimates the future metrics of financial line items as sales percentage.
For example, the COGS is possible to raise proportionally with the sales; thus, it is right to apply a similar growth rate estimation to each.
To predict the percentage of sales, examine every historical profit account percentage related to sales. To determine, make sure to divide each of the accounts by its respective sales, considering as the number will stay steady. For example, if the COGS is 30 percent of sales exceptionally, then assume that trend will resume.
2. Straight Line
This type of financial forecasting method just assumes the organization’s historical growth rate as remaining constant. Forecasting your future business revenue will hold – multiplying an organization’s last year’s business revenue by its respective growth rate. For example, consider 12% as the last year’s revenue, now the straight line forecasting will assume that it wil pursue to raise by 12% the upcoming year.
This method of forecasting is a considerably good starting point, but it doesn’t account for supply chain problems or market fluctuations.
3. Moving Average
The moving average method involves, taking the weighted average — or average — of the last periods to predict future finance. This technique involves analyzing the company’s low or high demand. Thus, most probably, it is beneficial for forecasting short term. For an instant, you can also utilize it to predict the upcoming month’s sales by just averaging the last quarter.
Moving average financial forecasting techniques can assist businesses to evaluate several metrics. Moving average forecasting is not only applied commonly to forthcoming stock prices but also it is utilized to calculate future revenue.
The formula to calculate the moving average is,
(A1 + A2 + A3 …) / N
- A represents the average for a period
- N indicates the total no.of periods
4. Simple Linear Regression
The next financial forecasting method in the queue is simple linear regression. This metric is based on the connection between two variables – independent and dependent.
- The independent variable will impact the dependent variable
- The dependent variable indicates the forecasted amount.
The equation or formula for the simple linear regression is,
Y = BX + A
- Y represents the forecasted number (Dependent variable)
- B indicates the Regression line’s slope
- X refers to the Independent variable
- A is Y-intercept
5. Multiple Linear Regression
If either 2 or more variables directly influence the performance of an organization, the respective business leaders may go to this multiple-line regression financial forecasting method. It permits you to the exact forecast, as it accounts for several variables’ performance.
For financial forecasting, to use the multiple linear regression method, there should be a linear relationship between the independent and dependent variables. Also, make sure to note that, the independent variables can never be correlated closely, as it is not possible to explain what affects the dependent variables.
When a business performs financial forecasting, we can never say that – only the numbers can define the whole story. There are some other added factors that impact the performance and those factors are hard to qualify.
Qualitative forecasting will depend on the knowledge of the experts and experiences of the forecast performance instead of historical numerical data. This financial forecasting method is called for the question, because, they are more subjective than the qualitative method. However, it can offer a more valuable insight into forecasts and account for factors that cannot be forecasted by utilizing historical data.
6. Delphi Method
This type of financial forecasting technique engages consulting specialists who examine market conditions to forecast an organization’s performance.
A facilitator reaches the specialists with questionnaires, asking for business performance forecasts as per their expertise and understanding. The facilitator then collects their commentaries and transmits them to other specialists for statements and comments. The objective is to resume circulating them till a consensus is achieved.
7. Market Research
For business budgeting, market research is considerably more essential. With market research, the owners can acquire the market perspective as per the patterns of customers, competition, and fluctuating conditions. Further, it is crucial for startup businesses when there is no historical data to perform financial forecasting. Every new business can benefit from this business’s financial forecasting. This is because it is important for compelling budgeting and investors for the first few months of business operations.
While performing the market research, start with a theory and decide what methods are required. Transmitting the consumer surveys is one of the excellent ways to comprehend consumer behavior when you don’t have any historical data to inform decisions.