Essentially, a financial forecast is a framework that presents past, present, and projected future financial conditions. These forecasts often include different scenarios to see how changes affect a business’s profitability.
These changes could include higher sales, lower expenses, or launching new products, for example.
Why use financial forecasting as a small business?
There are three main reasons why a business should use financial forecasts:
- When starting a business, a financial forecast can help to plan your budget, assess when you could become profitable, and help you set benchmarks for achieving set financial goals.
- Once your business is established, a financial forecast helps you stay on track with your goals.
- If your business is seeking outside investment, financial forecasts can help lenders and investors see the financial health of the business and its growth potential.
There are other reasons why a business chooses to engage in financial forecasting, such as identifying problem areas in the business and planning its annual budget.
Also, it’s important to remember that not every financial pitfall can be predicted with a financial forecast; however, it can help you ease its impact.
The 4 common types of financial forecasting
The type of forecast you produce depends on the reason the business needs to use it.
1. Sales forecasting
If your business produces a physical product, this forecast can be essential in running your business.
Sales forecasting predicts the number of products/services you expect to sell in the specified time frame.
An accurate forecast can help with budgeting, production cycles and marketing needs, allowing you to allocate resources effectively.
2. Budget forecasting
A budget creates a certain expectation within a business about how well it will perform over the period.
When determining the budget, you need to forecast the ideal outcome of the budget and what that would mean for the business.
3. Cash flow forecasting
When looking at the money moving in and out of your business, you might notice trends or be shocked that one month hasn’t seen as much income as expected. It’s these changes that can be predicted using cash flow forecasting.
While cash flow forecasting can help identify budget shortfalls and determine whether you need to look at funding options, they are best used when looking in the short term as more factors can creep in when looking long term, making it less accurate.
4. Income forecasting
There may be a time when your suppliers need to extend a line of credit towards your business. For them to decide how much they’re willing to extend, they need to know how much income your business will generate and, therefore, how much the business will grow.
To create an income forecast, you need to analyse the business’s past revenue performance and current growth rate to estimate future income.
The main steps in financial forecasting
At a minimum, there are five steps you need to take to produce your financial forecast.
1. Define the purpose of your forecast
Think about what you hope to learn from your forecast. Knowing your goals will help you define the type of forecast you’re creating and the period you need to create it for.
2. Gather historical data
To know what’s likely to happen in the future, you need to know what’s happened in the past. If your business is relatively new, you might not have enough data from your business to complete this step, so you need to think about where you’ll get the data from; this could be something like market research and competitor analysis.
3. Select a method for your forecast
There are two types of forecasts you can generate: qualitative and quantitative.
- Qualitative forecasting asks the experts for opinions and sentiments about the business and the markets as a whole.
- Quantitative forecasting uses historical information and data to identify trends and patterns.
4. Project future values
Now you’ve selected collected the data and chosen the method, you need to project the future values. Consider what would happen if something changed, whether there are uncertainties and potential risks.
All of these factors will feed into the forecast and give you projections for the future based on different scenarios.
5. Monitor and repeat
Your financial forecast shouldn’t be static. As changes happen in the business, they need to be reflected in the projections.
For example, if your forecast included a new product launch in January, it may be the case that the launch happened in June, meaning there are months of projections which need to be revised.