Financial forecasting can be important, difficult and frustrating, because you will almost always be wrong. But this is perhaps the key reason for doing it. It's a map of where you want to go, and without it, you may be flying blind.
Financial forecasts show your potential revenues, costs, cash flow, assets and financing needs. It may also tell you how much money you need and how you'll get it. But its main importance may be that it tells you when you're going off your expected direction. By catching your variance sooner rather than later, you might take corrective action before it's too late.
Building a Financial Forecast
There are two basic methods to financial forecasting: top-down and bottom-up.
TOP-DOWN: Top-down forecasting means you first forecast the sales for your industry. You might do this with sophisticated economic and econometric methods, or do what most of us may do—read industry publications and find projections from industry experts. If you have many industry forecasts, you might take the average or pick the one you think has the best analysis. In mature industries, a commonly used method is to extrapolate from historical trends using a statistical technique called regression analysis.
—Dileep Rao, clinical professor, Florida International University
A key factor in top-down forecasts is to understand when there are major directional changes in an industry, and when old trends no longer hold. That’s often when fortunes are lost—and potentially made.
You then project your anticipated sales based on your expected market share. You might start by finding or estimating the size of the market you serve, then calculating your market share using your historical sales.
The hard part of top-down forecasting is often estimating your market share when you have no history. To do this accurately may be one of the most difficult tasks in business. Many factors might influence your market share, including your competitive advantage and the customer’s willingness to switch to you.
You might try to come up with a “defendable” number by asking a large sample of potential customers whether they'll buy your product, and then adjusting this downward to be “conservative.” But people don't always tell you the truth about whether they'll switch. They don’t always do what they think they'll do. They may go back to their current vendors after trying you once. What should the “conservative” adjustment be? At the end of the day, you could still be guessing.
BOTTOM-UP: I prefer the bottom-up approach where you start with your sales driver, and the investment in the sales driver, then forecast sales based on that investment and the productivity of the sales driver. Bottom-up may be better because there's no predestined market share that you're entitled to. Getting a sale involves effort, investment and time. If you work from the sales driver, you might estimate the investment in the sales driver, then estimate sales. You might then calculate the potential market share, which is the result of your investment in the sales driver.
As an example, if you plan to sell Norwegian tacos in a store in a mall’s food court, your sales driver would be the number of people walking by the store and your sales investment is the rent you pay for this space. You might get these numbers from the mall managers. Then you could estimate the number who will buy your product and the average purchase to get your sales estimate.
Or you might do a real test. To connect the rent and traffic to the actual level of sales and develop an estimate, you might open a temporary store with minimal investment, or rent a kiosk to see how many customers really buy and thereby tie the traffic to sales.
If you're using other sales drivers, such as advertising or email, you might similarly estimate sales using the bottom-up approach. You might conduct a test by doing some advertising, comparing how many respond for information to those who buy. Then you could tie the cost of the marketing to the volume of sales.
Bottom-up forecasting often allows you to monitor your real sales and then compare your expectations with reality to see how you might adjust.
Bottom-up typically connects two of the biggest unknowns: the connection between your sales expenses and your sales, or the level of sales for each dollar you spend on each sales driver. Other numbers may be more easily estimated either from your contracts (rent, etc.), estimates (utilities, etc.), your industry (gross margins, etc.), or your history or your strategy (interest).
Researching your history often helps find this number. How many sales drivers did you use, how much did you spend on each, and how much sales did you get from each? These historical numbers may inform your projections. Consider checking what your potential competitors are using for sales drivers, and discovering their productivity from industry sources.
After Financial Forecasting
After your financial forecast is complete, what do you do with it?
Financing: Financiers are sometimes skeptical about forecasts, so you might connect your forecasts to your historical numbers for improved credibility. Financiers often look at historical trends and project them. If you've been growing at 5 percent, they may not believe you when your projections show a growth rate of 15 percent. Connecting your projections to industry numbers or your own research may show that they are reasonable.
Monitoring your performance: This may be the most important reason to forecast. You may monitor your actual performance and take corrective action. Smart entrepreneurs often monitor sales and cash daily, cash flow weekly and the entire financial statement monthly.
The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.
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This article was originally published on April 20, 2015.