What is financial forecasting and why is it important?
When it comes to decision-making in business, an up-to-date financial forecast is essential to be able to prepare in a pragmatic way for the future. All companies should look forward in this way to be able to be ready for any unforeseen circumstances and plan for unforeseen opportunities too.
It plays an important role in establishing whether a business is on track to hit particular goals, and allows them to respond flexibly to changes.
Feel the power of financial planning
There’s a lot more to financial forecasting than adding up historical figures and keeping an eye on your business’ bottom line. It can impact everything from an entrepreneur’s personal finances to lenders’ and investors’ confidence.
So, let’s take a deep dive into financial forecasting. We will guide you on how to crunch those key numbers and how we can help you get the most out of your financial planning.
What is a financial forecast?
A financial forecast is a key part of your business plan and offers the best view of what a company’s key financial numbers are going to look like in the future.
An accurate, up-to-date forecast will support important decisions, such as expanding or cutting staff levels, when to increase or reduce prices, and even whether to jump on a potential new revenue opportunity.
Most business owners have at least a five-year plan and, without a forecast, it’s difficult to see whether a company is on target to achieve future growth, alongside other longer-term goals. Agency owners could end up basing their projections on hope rather than data.
The difference between financial forecasting and budgeting
There’s a distinct difference between these two terms which have, on occasion, been defined as the same thing. Let’s clarify the difference for you…
This method of financial forecasting refers to a business owner periodically reassessing where they think their firm will end the year.
A forecast offers future projections of your company performance – including revenues and profits – for three financial statements, including the income statement and pro forma balance sheet.
Financial forecasting software uses financial models that identify trends within your business, as well as the broader industry and economy, that could impact your performance.
This will gather past financial statements, including historical data and reports, to determine how the business is likely to perform. It also takes into account the management team’s view of future plans: hiring, investment in new technology, known cost increases.
It enables decision-making about allocating resources to secure your company’s financial future. A budget should be realistic but also stretching, and is a target for the business to aim for.
It’s the best view of what the end-of-year profit will be.
Forecasting and pro forma financial statements
A key component of forecasting are three financial reports. These reports provide insights into how different scenarios could play out, based on hypothetical circumstances.
Depending on forecasting requirements, a business will need one or all of the following reports to establish the relevant factors behind its financial performance:
- Income statements: also known as the profit-and-loss statement which show business inflows and outflows
- Cash flow statements: this shows how cash flows in and out of the business
- Balance sheet: this helps predict future payments, assets and equity
Companies with accurate and up-to-date versions of these financial statements are then ready to generate financial forecasts for their business.
Which financial forecast model is right for your agency?
Top-down financial forecasts
Under this financial forecasting model, companies examine their potential revenues by examining their high-level targets and aspirations, combined with an idea of what should be achievable for the business.
Generally speaking, top-down forecasting is useful for early-stage firms with little past financial data or bigger companies with a broader range of revenue sources.
Although simple to carry out, top-down forecasts are not as granular as other methods and more often regarded as a starting point for future projections.
Bottom-up financial forecasting
The opposite of top-down forecasting, bottom-up forecasting starts with customer, product or ground-level data and works up to an objectively measured prediction about broader revenues.
We would recommend doing both top-down and bottom up budgeting. There will be a difference between the two numbers, and that is where your management team can have meaningful conversations around what target is achievable or necessary for the business to set itself.
Seasonality in forecasting
The fiscal year has different seasons and it’s important for a business, no matter its sector, to consider them as part of the financial forecasting.
For example, August and December are quiet months for many agencies, and shifts in business cycles can influence decision-making about inventory and investments.
Benefit from your team’s insights, knowledge and experience
Using expert opinions and visions for financial forecasting
Key members of company staff from across several departments, including production, sales, procurement and operations, meet and agree on a financial projection that will support business decisions in the near future.
Scenario financial forecasts
Here, a forecaster produces an array of results based on the outcomes from a variety of scenarios. They can be based on past trends, as well as potential future scenarios, such as ‘what would our profit look like if we lost our biggest customer’ or ‘what would happen to our cashflow if we hired five new team members?’
The business’ management team will then determine which is the most likely outcome for the firm.
What information will a financial forecast give me?
The financial forecasting process covers more than one area of business operations, depending on the reason or reasons behind the financial forecast in the first place.
A financial forecast can be used to generate the following data:
This financial forecast is used to calculate fixed costs, such as rent and payroll, and variable payments, including the cost of sales, which are variable, and staff costs, which can fluctuate depending on the number of employees.
Cash flow statement
This is based on the balance sheet and sales prognoses, and also uses past statements and financial data to predict or project future financial performance as related to cash flow.
This is a prediction of the business’s profit-and-loss statement, and is generated from a cost forecast, as well as sales and cash flow statement prognoses.
Assets and liabilities
Anything not covered in the profit-and-loss statement is mentioned here, for example fixed assets, trade debtors and tax liabilities.
The benefits of financial forecasting
As well as ensuring a company can navigate its particular sector, there are other benefits to producing regular financial forecasts as part of its business model.
Setting achievable company targets
Managing expectations is hugely important to succeed in business, and accurate historical forecasting will help determine whether your business will grow or decline and by how much.
Breaking financial data down into year-by-year targets and comparing your latest forecast to your ambition will enable you to set achievable monthly, quarterly or annual goals: whether they focus on revenue or net income, or take in the whole of the balance sheet.
Identifying problems with financial forecasting
Financial forecasting and analysing a company’s past performance can be crucial in identifying and resolving ongoing issues and problems.
Forecasting can also help a business owner better predict potential headwinds or other operating expenses.
Financial planning and cash flow management
Financial forecasting is critical for managing a company’s cash flow, helping to plan ahead to avoid a future crisis related to a financial squeeze, as well as planning for what to do with excess funds.
Enabling a business valuation
Company owners looking to offer someone or buy back shares, set up an Enterprise Management Incentive (EMI) scheme, a tax-efficient way for employers to grant shares, or even sell the business find the process is made a lot easier if they have a forecast of operational revenue to hand.
Reducing financial risk with forecasting
Company budgets depend on solid financial forecasting to determine spending thresholds. Without them, the business runs the risk of unnecessary overspending and cash flow issues that could store up trouble for future income.
Can a forecast enhance appeal to investors?
Yes. Businesses providing regular financial forecasts are more attractive to potential backers because that operational data allows them to clearly visualise the possible return on their investment. It can also help with getting access to debt funding.
As well as boding well for the company’s future, transparency surrounding the business’ financial planning and forecast revenue, combined with accurate forecasting based on past data, demonstrates both control and stability.
Limitations of financial forecasting
At the start of this blog, we said financial forecasts were the best way to plan for the future for your business, but the fact of the matter is, even the most conservative financial projections, based on diligently gathered data or expert opinion, are not infallible.
Predicting the future with any degree of certainty can be a challenge due to market volatility caused by external forces.
Resource-intensive and costly
Carrying out financial forecasting can require a lot of time and energy across all operations, and not every business has the resources, both in terms of personnel or funding, to invest in top-of-the-line financial forecasting software and tech. That’s where we come in.
Let us help with your financial forecasting
Whether your company goal is to increase net income, gain additional investment or expand sales, getting your financial forecasting right is the first step toward achieving those ambitions and more.
We have helped agencies use financial forecasting software to predict whether their company’s revenue, profit and cash flow is on target for a particular period or determine if they are on track to hit their longer-term plans.
Whatever your requirements
We also understand the importance of the human touch and offer a bespoke service to all our clients. Whether you’re a start-up just taking flight or an established agency looking for a new way to use forecast data, our team can help make forecasting projections that apply to an income statement, balance sheet and cash flow, among other factors. Think of us as your outsourced finance function to guide and support you through the next stage of your agency journey.
Drop us a line on 01372 708090 or use this contact form and we’ll get back to you straight away.