What is Financial Forecasting?
No one likes a surprise bill or an unexpected expense. These situations tend to create financial strain—especially for businesses with delicate cash flow. It’s why most businesses engage in financial forecasting. Financial forecasting is the analysis of data trends from the past and present to predict and determine the uncertain future. These estimates affect important financial decisions.
Established companies have a bevy of financial data at their disposal that allows them to make informed decisions about the future. Some projections are simple: if the lease expense each month is $5,200, it’s a fixed expense the business can rely on. Other types of forecasting are less straightforward, such as how many units the company will sell in the upcoming quarter.
Despite the complexities of financial forecasting, companies that practice it consistently put themselves in a position to better-manage finances. Here’s what it takes to forecast effectively.
What Does Financial Forecasting Look at?
Financial forecasting involves all three chief accounting statements: income statement, cash flow statement and balance sheet. Income statements are often the subject of basic forecasting, since they contain the data associated with Selling, General, and Administrative (SG&A) expenses.
Depending on what a business wants to focus on, there are a number of different types of forecasts it can engage in. The most common type of forecast is an Earnings Before Interest and Taxes (EBIT) forecast. This type of forecast provides stakeholders with income statement estimates for the future, which work back into a wide assortment of planning and modeling for the company.
Realistically, the business can engage in forecasting for any financial metric it has data for. This can include everything from measuring COGS within economies of scale, to operational expenses for a specific unit of business. Looking back allows the company to look forward. And while the numbers might not always come to fruition, active forecasting is indisputably better than having no idea as to the trajectory of the business.
How Often Do Businesses Forecast Financial Data?
Companies forecast financial data in different intervals: weekly, monthly, quarterly and annually. Short- and long-term forecasting allow the company to observe and anticipate near-term and macro trends, to make sure the business continues to perform as expected.
For example, a company may use the previous quarter’s sales and revenue data, juxtaposed with the previous year’s figures, to anticipate the upcoming quarter’s sales and revenue. Or, the company might use month-over-month revenue and profit data from the previous year to forecast the current year’s growth trajectory. Some of the most common types of forecast models include:
- Regular forecasting
- Rolling forecasts
- Continuous forecasting
- Scenario forecasts
Companies need to update their financial forecasting as the business changes and grows. For example, if the company gains or loses an enterprise-level customer, it could dramatically alter the forecast. Reforecasting with new data is a healthy part of keeping up with the business’ ebb and flow. Moreover, continuous forecasting can put management in a position to act effectively against obstacles or opportunities as they arise.
Financial Forecasting vs. Financial Modeling
What does a company do with forecast data? They model it. Financial modeling follows forecasting, representing the application of data into informed, forward-looking action plans. Some examples of financial modeling include:
- Budgeting and cost allocations
- Strategic project financing
- Capital raising or funding plans
- Historical analysis of the company
- Investment research (equity analysis)
- Pro forma financial statements
Beyond taking data and sharing it, financial models make informed hypotheses about the financial future of the company based on many variables. For example, if the company wants to finance a new piece of equipment, it’ll use data from various sources to create a model that justifies the most rational course of action for capital raising.
Financial Forecasting vs. Budgeting
Financial forecasting is often confused with budgeting. In fact, the two are different concepts.
Financial forecasting involves looking ahead to make realistic inferences about the company’s future financials and performance. Budgeting is the act of allocating costs based on forecasted information. Budgets are a type of financial modeling tool. They’re used to shape the desired trajectory of the company based on inferred financial performance. While forecasting and budgeting typically go hand-in-hand, they might not necessarily align.
Budgeting is also traditionally less flexible than forecasting. Companies establish budgets annually (sometimes quarterly), which makes it difficult to adapt to changes in forecasting. To combat this, many companies maintain flex spending allocations or over budget, to ensure there’s accessible capital when needed.
As an important aside, budgets don’t justify forecast data. This is why it’s important to separate the concepts. A company can forecast correctly, yet budget poorly (or vice-versa). Forecasting offers a more fact-focused look at a company’s future, whereas budgeting represents the objective focus of the company.
Is the Company Headed in the Right Direction?
Companies engage in financial forecasting for many reasons; the most important of which is to ensure the trajectory of the business is on course for profitability and growth. If models show tight cash flow, mounting debt or worse, insolvency, it’s the business’ opportunity to change what it’s doing now to affect a better future.
In fact, forecasting can help investors recognize stock trends. To learn more, sign up for the Profit Trends e-letter below.
Because most financial forecasting focuses on the income statement and affiliated revenues and expenses, businesses can learn a lot about what they’re doing and how it dictates their future. Investors can glean this same information. Financial statements are public record, which makes it easy for anyone to engage in basic modeling. Used correctly, past data is an asset in forecasting future performance.