If you had a crystal ball that could tell your company’s future, making business decisions would be a breeze. But, if you’re like most entrepreneurs, you have to make choices without the gift of clairvoyance.
That’s where tools like financial forecasts come in handy. Forecasts use real data to predict future performance, and they can help you make more informed decisions about your business.
Here’s a closer look at applying financial forecasting in business, common types of financial forecasting, and a step-by-step guide to conducting a forecast for your company.
What is financial forecasting for businesses?
Financial forecasting is the process of using your company’s historical data and current industry trends to predict your future financial performance.
For entrepreneurs, these financial projections are valuable decision-making and financial-planning tools that help you set realistic goals, anticipate risks, identify growth opportunities, manage supply chains, and even attract investors.
Financial forecasting examples
You can use financial forecasting to predict the performance of several areas of business, ranging from sales and revenue to cash flow and income generation.
Sales forecasting
One of the most common examples of financial forecasting is sales, or revenue, projections.
Sales forecasting involves making predictions about your future sales volume and using those projections to estimate how much revenue your business will generate in a given time period, such as a month, quarter, or year.
Budgeting forecasts
Budget forecasts project future revenue and expenses. Predicting both your earnings and expenses helps determine whether or not your business budget is reasonable and monitor if you’re on track to stay within your goals.
Cash-flow forecasting
Cash-flow forecasts predict how money will flow in and out of your business. They are especially useful for short-term business planning and preparing for upcoming expenses.
For startup founders, you can also use cash-flow forecasts to predict the inflow of cash from investors and make sure that funds arrive in time to keep the business running.
Four main financial forecasting models
The most common quantitative methods you should be familiar with are:
- Straight-line method
- Moving averages (MA)
- Simple linear regression (SLR)
- Multiple linear regression (MLR)
The straight-line and moving average methods involve relatively basic math, making them easier to do with Excel or Google Sheets. The two regression models are more complicated statistical methods that are easier to conduct with the help of forecasting software.
Straight-line method
The straight-line forecasting method assumes the growth rate for the previous period applies to your future performance. In other words, if your revenue grew 10% last year, you assume it will also grow 10% in the upcoming year.
Moving averages (MA)
Like the straight-line method, the moving averages method assumes your company’s performance will stay consistent in the future. However, instead of using the total growth rate, it uses an average of the most recent data to make projections.
For example, you may use the average revenue of the past three months to predict the next month’s revenue.
So, to predict January’s revenue, take the average of October, November, and December of last year. Then, when you predict February, the three-month range moves, and you take the average of November, December, January, and so on.
Simple linear regression
In simple linear regression, you use one variable to predict another. For example, you may use free-trial sign-ups to predict sales. If you know from historical data that, on average, 15% of free trials lead to a sale, and if you know how many free-trial sign-ups you have had in a particular period of time, you can forecast expected sales from that data.
Multiple linear regression
Multiple linear regression means you use multiple variables to predict the number you want to project. Say you want to forecast shipping costs for the next quarter. You can use multiple linear regression to project your shipping costs based on your assumptions about future orders and trends in gas prices.
Qualitative forecasting methods
Qualitative methods of forecasting use market research and expert judgment instead of numerical data to make predictions. These are most often used when you don’t have enough past data to use, such as predicting the performance of a new product line or revenue for a brand-new business.
How to do financial forecasting
1. Set a goal for your forecast
The first step of the forecasting process is determining what you hope to achieve.
For example, you may say that the goal of your forecast is to:
- See if you’re on track to meet budget goals
- Determine if your budget goals are reasonable
- Estimate the financial impact of an external trend, such as changes in interest rates
- Project income and revenue as part of a presentation for stakeholders and potential investors
- Make financial decisions such as choosing between different investments or strategies
- Predict upcoming expenditures to understand how long you can keep operating with current investments
Understanding your end goal or purpose will help you figure out what financial metrics you want to predict. It will also affect forecasting decisions such as time frame and method.
2. Choose a time frame for the forecast
Forecasts provide projections about your future financial performance for a given time period. As a business owner, you get to choose how far ahead you want to project.
The further out your forecast, the less accurate your results may be since there’s more time for outside factors to impact your results. You also want to consider how your business’s age affects your ability to predict performance.
Mature businesses have more historical data to inform financial projections. They’re also more likely to have more stable growth patterns, which makes it more feasible to project business performance for multiple years.
New companies, on the other hand, don’t have as much past performance data to work with. And the business performance for startups can be much more volatile, making it possible for long-term projections to become irrelevant quickly.
One year is a common time frame for many business forecasts, but if you expect to experience more volatility, you can use a shorter forecasting schedule, such as quarterly or monthly.
3. Choose a forecasting method
Once you have your goal and time frame established, you can choose a forecasting method. At this point, it’s helpful to consider your team’s expertise and the software you have available.
If you don’t have a background in statistics, it’s easier to start with simpler methods like straight-line or moving averages. But, if you have the right forecasting tools or access to a statistics expert, one of the regression models may be more useful.
4. Gather the relevant data
Financial modeling projections are often based on your past performance. So, you’ll need to gather the relevant data before you make predictions.
Examples of historical data you may use in forecasts are:
- Revenue
- Investments
- Sales volume
- Fixed expenses
- Variable expenses
- Sales conversion rates
- Average purchase value
- Lifetime value of a customer
You can find most of this information in financial reporting documents like balance sheets or income statements from previous years. In addition to using financial statements, you can gather this data from tools like your customer relationship management (CRM) software.
You’ll also make assumptions about your future performance, such as whether your growth will increase, decrease, or stay the same. Research industry trends or economic factors that can help you make more informed guesses about what will happen in the future.
5. Run your forecast
Once you have all the information you need, it’s time to input your past data and assumptions to get your financial projections.
In this step, you can vary your assumptions and predict several possible outcomes.
Say your revenue grew 10% last year. You assume it will stay the same, but you want to make sure you can still be profitable in case growth slows down. In that case, you run projections based on 10% growth and 8% growth.
Running multiple scenarios makes you better prepared for the unexpected, whether that means ensuring you’re still profitable if growth is slow or identifying ways to capitalize off higher-than-predicted growth.
While it’s tempting to keep your tech stack at the bare minimum when you’re a new entrepreneur, Lillian Chen, co-founder and COO of the virtual team-building company Bar None Games, recommends “using forecasting software to automate the process, saving time and providing more accurate results.”
The quality of your financial forecasts impacts the decisions you make, so it may be worth investing in tools that give you better insights.
6. Monitor your performance, adjust as necessary, and repeat
If your business or industry experiences any big changes, you can always update your predictions. This lets you take advantage of any new information that’s impactful to your performance.
Once your current forecast period ends, it’s time to create new projections. Taking time to review the accuracy of previous forecasts helps you manage expectations and improve the accuracy of future predictions.
When you’re running a new or small business, every dollar counts, especially if you’re still working toward generating profits.
Financial forecasting is an essential tool that helps you stay on top of your company’s performance and identify risks early on so you can address them right away and get the most out of your capital.
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