Why You Need a Financial Forecast (And How To Create One)
By Indeed Editorial Team
Updated April 1, 2021
Published February 25, 2020
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Businesses need to have financial goals to be successful in the long term. It can be daunting to create a clear set of steps to reach a business goal. Financial forecasting provides businesses with a clear pathway to those goals. In this article, we explain what financial forecasting is, the steps to perform a successful financial forecast and provide an example of how to create a financial forecast.
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What is financial forecasting?
Financial forecasting is a business planning procedure that roughly calculates the financial future of a business. The purpose of a financial forecast is to assess a company's current financial health to estimate future financial successes. With this forecast, a business can make informed decisions about budgets, policies and programs within its organization.
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Elements of a financial forecast
Financial forecasts use information like current revenue and expenses paired with financial goals to estimate where the company's finances will be in the months and years to come. To be effective, you should monitor financial forecasts and update them regularly, usually once a month.
While financial forecasting is similar to budgeting, they are not the same. You can use a financial forecast to help set a company budget, but one should not be substituted for the other.
How financial forecasts differ across industries
Different industries demand different styles of financial forecasting. Some industries rely on internal factors for financial success while others are fully dependent on external elements. For example, banks and credit unions are dependent on interest rates.
Interest rates are set outside of the purview of banks and credit unions, so these organizations will need to monitor interest rates closely and make changes to their financial forecasts when rates move up or down. Similarly, retail businesses depend on consumer demand. It can be difficult to predict sales accurately all the time. This impacts the financial forecast.
How to use financial forecasts
Flexibility is key when creating or updating a financial forecast. The gravest error would be to create a financial forecast at the beginning of the first quarter and then ignore it until the end of the fourth quarter. The organization's financial forecast should be a living document that shifts and updates as new information comes in.
Types of financial forecasts
There are two main types of financial forecasting models: quantitative and qualitative. Quantitative models use mathematics like statistics to make a model projecting future financial health. Qualitative models use harder-to-measure concepts like the opinions of industry experts to inform the financial forecast.
Both methods have positive and negative aspects. Deciding which model to use as a framework and where to take it depends greatly on the type of business and the business's goals.
How to perform financial forecasting
The steps below outline the basics of creating a financial forecast. An example is included with each step showing the basics for creating a financial forecast using an imaginary clothing store, Eleanor's Boutique.
Gather financial information.
Assess the forecast.
1. Identify goals
Before you start digging through your company's financial documents, decide what you want the business's finances to look like next month, next quarter and next year. Have a clear financial goal or goals in mind before you begin any other step in your financial forecasting project. These goals may involve revenue, reducing debt or introducing new products.
Example: Eleanor's Boutique wants to increase profits by 15% by the end of the year. The owner, Eleanor, is hoping to do so without dramatically raising prices on her goods. She also hopes to increase her staff by at least one employee and introduce a new line of products.
2. Gather financial information
After you have set clear, attainable financial goals for your business, it is time to gather all of the relevant financial documents for your forecast. This might include things like statistical documents, liabilities, revenue and expenses. Additionally, this category includes opinions and projections from experts in the field.
Example: Eleanor gathers her income statement, balance sheet and cash flow statement. She calls her mentor, the owner of a small franchise of clothing stores, to discuss industry trends and other business practices that are challenging to quantify, but may impact her financial forecast.
3. Select methodology
You have your financial goals and your current financial information. It is time to select the methodology for your specific financial forecast. There are a variety of methods, both qualitative and quantitative, that may be appropriate for your forecast. Be sure you explore several before determining which will best suit your needs. If you have a financial advisor or a chief financial officer, they can assist in selecting the best methodology for your business and goals.
Example: There are many methodologies that Eleanor could apply. At the advice of her financial advisor, she has decided to use the Trend Projections method. This technique will use the financial information Eleanor gathered in step two and project it out over months and years. This method is known for its short-term accuracy, but it can be poor in predicting long-term financial gains and losses. Since Eleanor intends to update her financial forecast monthly, this method should work well for her purposes.
4. Implement method
Use the financial information, expert knowledge and selected methodology to run your forecast. It is a wise idea to run a few different possible outcomes to help best prepare for the future. At a minimum, have a "best-case scenario" outcome and a "worst-case scenario" outcome.
Example: Eleanor, with the assistance of her financial advisor, takes the data she has and applies it in the Trend Projections analysis. They run several projections to determine what needs to happen for Eleanor's Boutique to meet its long-term goal of increasing profits by 15%, hiring a new employee and having the capital to release a new product.
5. Assess forecast
Many businesses stop at the previous step and then find themselves in financial trouble later. Be sure to use the information in your forecast to guide your financial decisions and budgeting. It is recommended that you look at your financial forecast frequently, usually, about once a month, to update numbers and make sure you are on course to meet your long-term financial goals.
Example: The month after creating her initial financial forecast for Eleanor's Boutique, Eleanor reviews and updates her numbers to reflect her current financial position. So far, the forecast has been accurate and useful in planning the store's monthly budget so that Eleanor's Boutique can meet its long-term goals. Eleanor continues to check and update her financial forecast monthly. At the end of the year, she is pleased to be able to hire a new employee, enjoys a 17% uptick in profits and prepares to release a new line of handbags.
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