Financial forecasting is important in business because it gives you a glimpse of your future cash position, helping you make staffing, production, stock level and expansion decisions.
In this guide, we'll look at how forecasting works, why it's vital, and the range of methods used.
What is financial forecasting?
Financial forecasting is any data-driven financial analysis used to predict your business’s future performance. You use data from historical and current performance to project future income, taking into account any known factors likely to impact performance.
How does financial forecasting work?
Financial forecasting analyses data points and creates a snapshot of likely results over time. There are many methodologies, from simple sales projections to complex calculations linking unrelated data points.
Importance and benefits of financial forecasting
Financial forecasting is important because it helps you plan effectively, maximise the potential of your business, and minimise missteps.
Here's a look at how forecasting can drive planning:
Better budgeting
Your forecast tells you what to expect, and your budget shows what you're planning to do about it. Budgeting and forecasting work together – insights from your financial forecast flow into your budget, ensuring that your plans are accurate and realistic.
Identify issues
Because forecasting analyses past performance data, it can help you spot upcoming problems. For example, if your data analytics show declining sales in a particular product category, you can dig deeper to find out why this is happening and decide how to respond.
Minimise overspending
With a financial forecast and budget, you can avoid spending beyond your means, protecting cash flow and profitability.
Drive investment
Financial forecasts are a crucial part of your business plan, particularly if you need investment or a business loan. Forecasts demonstrate careful financial management and help investors decide whether to invest or not.
Traditional vs rolling financial forecasts
Traditional forecasts are different from rolling forecasts. Traditional forecasts don't update as your company changes while rolling forecasts do. Traditional static forecasts show sales and other performance projections over a period, often a year.
Even if your company has a significant spike in sales or the economy slumps, the numbers stay the same until the next forecasting period. Rolling forecasts are continually updated as the industry, economy and your business change.
What are the most common types of financial forecasting?
The four most common types of financial forecasting are sales, cash flow, income and budget:
Sales forecasting
Sales forecasting predicts the number of products or services you can expect to sell within the forecast period, helping you plan for ideal stock and staffing rosters.
Cash flow forecasting
Cash flow forecasting estimates cash flow so you can prepare for any slumps.
Budget forecasting
A budget forecast uses the numbers from your upcoming budget, along with past performance metrics, to predict the likely financial outcome if the budget is followed.
Income forecasting
Income forecasting uses past revenue metrics and your average growth rate to predict income. This helps stakeholders - like investors, suppliers, customers, employees - make decisions around funding your business or working with you.
Creating financial forecasts with pro forma statements
A financial forecast using pro forma statements can predict the outcome of a major transition in your business. Pro forma financial statements use projected numbers, not real-life data, and can analyse hypothetical scenarios – for example, a merger with another company. This lets you build a picture of what your business would look like afterwards. You can also use pro forma forecasts to compare different events or variables, helping you decide the best way forward.
While pro forma forecasts are hypothetical – and not always entirely accurate – they can be useful during times of change.
7 financial forecasting methods (qualitative and quantitative)
These methods include quantitative techniques, which use hard data to make projections, and qualitative strategies based on subjective interpretation:
Per cent of sales
Per cent of sales forecasting calculates factors like cost of goods sold (COGS) and staffing costs as a percentage of total sales. This gives you an overview of how your costs stack up against sales figures for the year.
Straight line
Possibly the simplest method, straight-line forecasting uses past revenue statistics multiplied by your average yearly growth. This helps you predict future revenue but can be less precise than other methods because it doesn't factor in external influences like changes to the market or economy.
Moving average
Moving average forecasting can be an effective way to predict the future value of a product or service. It adds several data points over time and divides the total to find the average. The average ‘moves’ because you recalculate it as price data and other factors change.
Simple linear regression
Simple linear regression looks at the influence of an independent variable on a dependent one via a trend line. For example, the independent variable represented on a chart’s x-axis could be inflation, and the dependent variable represented on the y-axis could be your sales numbers. If inflation increases by 2% over a year, what will that mean for your sales numbers?
Multiple linear regression
Multiple linear regression compares two or more independent variables to a dependent variable to learn which has the most impact and how they relate. For example, you could look at average income and inflation (both independent variables) in relation to your overall profitability (dependent variable).
The Delphi method
The Delphi forecasting method engages industry experts to assess market dynamics and anticipate a company's future performance.
A facilitator distributes questionnaires to these experts, seeking their insights and forecasts regarding the company's business prospects. Then, the facilitator sends these analyses onto additional experts for their feedback and commentary. The ultimate aim is to iteratively refine the forecasts until a consensus is achieved.
Market research
Market research can be used as a form of qualitative forecasting. For example, you can combine audience income and spending data with answers from market research sessions to predict future sales levels, or to scope out new product or service categories.
How to create a financial forecast
To create a financial forecast, get clear on what question you’re answering, then choose a methodology.
Define purpose
Lay out what you want to learn and how you’ll use your findings. This will help you narrow down the metrics for your forecast model. Do you want to look at sales, revenue, product volumes or service levels?
Gather data
Find accurate and up-to-date data to feed into your forecast model. This could mean using your accounting or business management software to generate reports.
Set a time frame
Choose a time frame for the forecast. While a standard forecast looks one year into the future, you could also project several years ahead or just explore the coming months, depending on the goals of your forecast. It’s worth noting that short-term forecasts tend to be more accurate.
Choose a method
Most small businesses use quantitative forecasting, as qualitative methods are subjective. For quantitative forecasting, choose between simple methodologies like the straight-line or per cent of sales models, or more complex options including linear regression and moving average models. If you want to use a mathematical model, you may need expert help to make sure it’s accurate.
Document and monitor
Use information from your financial forecast to inform budgets, future planning and other decision-making in your business. It’s also important to track actual results against your forecast and update your forecast regularly if you want it to keep providing value. Forecasting software can make this process less daunting, giving you a broad overview of results against forecast numbers, and automating updates.
Financial forecasting FAQs
What is the most common type of financial forecast?
Sales forecasting is the most common type of financial forecast. This simple forecasting method looks at past sales data and growth over time and gives you a snapshot of expected sales figures for the next period.
What is the difference between budgeting and forecasting?
The main difference between budgeting and forecasting is that a budget expresses what you want to happen, while a forecast predicts what is likely to happen. Both are part of strong financial management and can feed into each other.
What are the implications associated with poor financial forecasting?
The implications of poor financial forecasting include restricted growth, lost sales and damage to your reputation. Without accurate forecasting, it’s challenging to be sure you have the right stock quantities or staffing levels to grow your business.
Look to the future with MYOB
Forecasting can seem complicated, particularly for small business owners that haven’t done it before. With MYOB Business, you can allow your accountant to access your data so they can help you accurately forecast and manage your finances successfully.
Drive future growth and profitability with MYOB. Get started with MYOB today!
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