A financial forecast is a useful planning tool that estimates the future results of a company’s operations, including the amount of revenue a company expects to earn in a certain period and the expenses it expects to incur. Unlike a budget, a forecast does not outline a company’s goals. And because a forecast is based on past, present, and future economic realities, it also differs from a projection, which may include hypothetical “what-if” scenarios. When financial forecasting is done properly, it predicts a company’s revenue and expenses and helps business leaders make more informed decisions as they plan for future profits—or losses.
Financial forecasting is more precise than a “finger-in-the-wind” estimate. It’s the end product of internal and external quantitative data analysis, combined with pertinent qualitative factors, industry insights, and an intimate knowledge of a company’s operations. Financial forecasting is part art and mostly science, and it typically focuses on income statement items, such as revenue, expenses, and profits.
Financial forecasts are valuable in terms of extending business leaders’ line of sight, keeping them focused on where profits are heading, rather than looking only at previous and current earnings. A forecast provides similar value to investors, lenders, and other stakeholders and is considered a key part of any business plan, whether for a startup or an established business.
The Two Types of Financial Forecasting
Chief financial officers typically lead the financial forecasting process with support from a company’s financial planning and analysis group and from analysts within a company’s operating groups. At smaller companies, forecasting responsibility often falls to the financial controller, the lead accountant, or the business owner.
Financial forecasts take one of two approaches: a fixed forecast or a rolling forecast.
1. Fixed Forecast
A fixed forecast, which is also known as a traditional forecast or static forecast, is prepared for a defined period, usually a single fiscal year. As each month passes, the forecast is updated with actual results, and the balance of the year is reforecast using current data. For example, a company’s fixed forecast for a calendar year includes 12 months of forecast data on Jan. 1, but by May 1, it would be updated to include four months of actual data and eight months of forecasted data. Fixed forecasts differ from fixed budgets, which are established at one time prior to the start of a fiscal year and are not updated throughout the year.
2. Rolling Forecast
A rolling forecast, or dynamic forecast, is an approach that continuously drops a completed month and replaces it with another month in the future. For example, a 12-month rolling forecast for a company would begin as January through December for year one, and when January actual results are finalized, it would be reforecast as February through January for year two. Rolling forecasts commonly extend for 12, 18, or 24 months and often include more than one fiscal year.
Each approach has its pros and cons. In addition, choosing the right approach for your company may depend on several factors, such as the availability of finance personnel, company and industry characteristics, stakeholder requirements, and the macroeconomic climate. Fixed forecasting generally requires fewer finance resources and is more suitable for stable companies and industries. Rolling forecasts might be preferred in companies and industries with high volatility or during periods when macroeconomic factors are unsettled. Both types of forecasts can be supported by automation.
Regardless of which approach is used, forecasters consider it a best practice to compare actual financial results to previous forecasts as an extension of the monthly accounting process. This provides insight into why variances exist so operations can be adjusted, or future financial forecasts can be improved.
How Financial Forecasts Help Businesses
A budget can be considered a company’s goal and its forecast as an indicator of whether a company is on track to meet that goal. It shows business leaders how a company is likely to perform in the future. Specifically, financial forecasts can:
- Inform day-to-day financial decisions, such as whether to hire new employees and how to allocate other resources
- Provide an early warning for expected changes in a company’s performance
- Set a starting point for the development of future budgets, cash-flow forecasts, and predicted balance sheets
- Assure current external stakeholders that a company is reaching its goals
- Identify trends in revenue and expenses
- Highlight opportunities for growth
- Attract new investors and lenders
- Increase awareness of factors that impact the business’s profitability
- Serve as the basis for creating best-case and worst-case scenario projections
How Do You Create a Financial Forecast?
Creating an initial financial forecast from scratch may seem intimidating. Fortunately, each successive forecast can leverage the previously established forecast models, templates, and processes.
Financial forecasting requires significant data and can be labor-intensive. New forecasters tend to rely on their accounting systems as a good source of data, but these systems may fall short in providing operational statistics and often don’t capture qualitative data.
Many financial forecasts include an income statement, balance sheet, and cash-flow statement, but some small companies may prepare forecasts without all three. Here’s a simple, step-by-step approach to creating a forecasted income statement, which is the most common and is often used to create the balance sheet and cash flow statement:
1. Forecast Revenue
Most forecasters start by forecasting revenue, since it sets the foundation that all other forecast components are built on. You’ll need to determine whether your business is forecasting revenue by product, division, location, or in the aggregate. Businesses with consistent product or service offerings can usually forecast revenue at a combined level. On the other hand, if a company’s offerings are highly differentiated in price or profitability, forecasters may develop revenue forecasts at a more detailed level. The revenue should be broken down by month and weighted to reflect industry norms or company experience. For example, a retailer will usually have more revenue in November and December than other months.
2. Forecast Variable Costs
Once forecasted revenue is set, the next step is to forecast the correlating variable costs needed to fulfill the revenue. Examples of variable costs include expenses for materials, labor, and direct overhead associated with a company’s products or services. Remember to add in any known market factors, such as contracted price changes, volume discounts, or expected inflation.
3. Predict Fixed Costs
Layer fixed costs into the forecast, including payroll, taxes, and indirect overhead, adjusting for known cost changes, such as rent increases, staff raises, and insurance premium hikes. Typically, this step is straightforward.
4. Consider Discretionary Spending
The next task involves adding all discretionary spending items, such as marketing, research, hiring, and special projects. It’s best to get input from the managers in charge of these items for the most up-to-date plans, taking note of the timing of projects and the expected impact on revenue. Often, this category of expenses can be adjusted depending on whether forecasts indicate improved or deteriorated profits.
5. Factor in One-Off Expenses
Finally, reflect any planned one-time events, such as asset purchases or sales, product launches or discontinuances, and new or retired loans.
Throughout this process, forecasters should take historical company data, industry trends, and macroeconomic data into account. They should also incorporate qualitative information at each stage if it is likely to impact operations. Examples include major customers going out of business, labor union contracts in dispute or negotiation, and potential supply chain shortages. As a general rule, the more thoroughly forecasters factor these considerations into the process, the more accurate financial forecasts tend to be.
Financial forecasting requires significant data and can be labor-intensive. New forecasters tend to rely on their accounting systems as a good source of data, but these systems may fall short in providing operational statistics and often don’t capture qualitative data. As the level of complexity in the financial forecasting process increases, many companies will invest in software specifically geared toward financial planning, including machine learning or predictive analytics.
In summary, financial forecasting estimates the likely revenue, expenses, and income of a business and is considered important in determining whether it is headed in the right direction. A financial forecast is the business version of a ship’s lookout in the crow’s nest. No captain of industry should be without one.