Overview: What is financial forecasting?
Most owners only think about forecasts when required to submit one by a lender or investor, but financial forecasting can offer profound insight into your business’s future. Businesses create financial forecasts to play out a predicted future. Shown through forward-looking financial statements, forecasts reflect how your business might look according to your estimates and assumptions about future revenue, expenses, and changes in your business. Forward-looking forecasts depend on historical accounting records so clean books are essential.
As a small business owner, you need a plan for what’s next. Financial forecasts can alert you to guide your financial resources when you see sales shortfalls or the payment of a massive debt on the horizon. It can also show you that it’s time to hire more staff when you’re expecting an increase in demand for your products or services.
Several reasons a company needs financial forecasting include:
· Control over cash flow
· More efficient business planning
· Scaling for growth
· Securing investment
What is the difference between Forecasting & Budgeting?
Financial forecasting and budgeting share close similarities. The difference comes from how they’re used and why they’re created. Budgets are a roadmap to reaching a company’s goal, be that annual, monthly, or quarterly. Most budgets focus acutely on revenue and expenses, and they can get pretty granular.
Compared to budgets, financial forecasts lose some detail and gain some scope. They’re often used to assess current strategy and how decisions made now can produce a desired outcome in the future.
You’re meant to experiment with a financial forecast, coming back to it as you consider investments in and changes to your business. The forecast reflects, within a margin of error, the bottom-line impact of potential decisions. Long-term forecasts can address a time frame that looks years beyond where your budgets end. Sometimes as long as 20 long years.
How does a small business create a forecast?
Large businesses dedicate a portion of their finance staff to financial planning and analysis. They create complex models teeming with variables and assumptions. But you don’t need all these resources to get an idea of where your business is headed.
1. Envision your future business
Have a talk with your future self to articulate where you see your business.
Set your target on a date in the future, whether it’s six months, a year, or five years from now. Imagine the products and services you’re offering, the property you’re owning, and the long-term projects in which you’re investing.
2. Consider upcoming investments and debt payments
Coming back to the here and now, think about what projects you’ve agreed to start and any significant payments coming due in the time frame of your forecasted financials. Think about big expenses before you begin forecasting financial statements, called.
3. Analyze your historical financial statements
For this exercise, pull up your company’s balance sheets and income statements for the past three periods. If you’re looking to make a financial forecast for the next six months, look at financial statements from the last three six-month periods.
Start by calculating the percent change in your five major account types: revenue, expenses, assets, liabilities, and equity. You can extract these account balances from your accounting software (QBO, Xero, etc). For the growth rate use the following calculation –
Month-over-month Growth = (Current Month Value/Prior Month Value) – 1
4. Fill in pro forma financial statements
At the final step, you’ll need to fill in your forecast with the projected growth numbers for the upcoming months (depending on how far in the future you’re forecasting). These numbers can be the same (if you’re expecting to grow 3% every month, for example) or differ from month to month, depending on the trends you have found. For instance, you know that certain months are less profitable than others due to seasonality (if you sell kayaks, you can expect your sales to shrink during the winter months and increase closer to spring and summer, for example).
Once you’re done with that, you can start creating your pro forma statements for the upcoming months applying your change rates to get the estimated values for your revenues and expenses. Here, the biggest challenge is to calculate the results and fill in all the lines in your pro forma financial statements correctly.
This article shows a simple example of forecasting. In real life, you’ll be analyzing more variables from different financial statements, such as a change in liabilities, equity, and more. There will be more calculations and more effort and caution needed to fill everything in correctly. Moreover, you might want to include some planned changes in the business or other scenarios you want to see the impact of. Here, you might proceed with projections and financial modeling over simply forecasting.
From the point of view of a business owner, this is a task that you won’t regret delegating to a professional, as knowing where the numbers come from can help understand the forecasts better. If you would like help preparing your forecasts, reach out to Bubble Rock Advisors, and we can handle the process for you.
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