Financial forecasting

Financial forecasting refers to that process by

which a business estimates or predicts how it is
likely to perform in the future.
As noted below, forecasting finances for a
business involves a look at three main financial
statements. 
Here we mention what financial
statements are essential to forecasting and help
you understand the difference between
creating forecasts and models.
• Properly undertaking this process gives the
company a glimpse of its future income and
expenses, helping in revenue management
and expenses calculations.

• Financial forecasts are made for a specific

period, usually for the next year.
• However, it’s possible to project financial
forecasting to cover shorter periods- six
months- or for longer periods than can run up
to three years.
Most common type of financial forecast

• The three financial statements most

commonly used are:

• Income Statement
• Balance Sheet
• Cash Flow Statement
Types of approaches to financial forecasting

A financial forecast is meant to give you a

rough estimate of the direction of the
business in financial terms. Your estimates say
“this is what the future is likely to look like for
our business.”
 Historical financial forecast
• Historical forecasting involves analyzing your
past financial statements and using the data to
project future growth.

• Here you look at the company’s income

statements, balance sheets, and Cash Flow
statements.
From these documents, you can determine
how the business has grown over the past few
years and draw an estimate of what the next
year and so on will be like.
The advantage of this approach is that it’s
somewhat easy and doesn’t require a lot of
expertise.
One of its drawbacks, however, is that as a
quick-and-dirty approach, historical
forecasting doesn’t take into account aspects
of the wider market and competition. It,
therefore, isn’t suitable when looking for a
financial forecast document to present
to potential investors.
 Research-based financial forecast
• Research-based forecasting means you go
beyond your past financial statements.
• A researched-based forecast will take into
account past performances of the broader
industry.
• You also research what competitor businesses
have in their projections and see how that
compares to your company’s.
Other than that, financial consultants will
factor in industry growth- new consumer
trends; changes in technology, and how that
impacts future growth, and other factors that
can impact the whole industry.
 Forecasting the income statement
• The income statement is one of the most
important financial statements for a business,
and projections involving this document are
crucial in showing how the business turns its
revenue into net income.
When working on forecasts for profit and loss
statements, managers and financial teams
look at revenues, cost of goods sold (COGS),
and operational expenses. The pro forma
details also include entries of non-operational
expenses.
 How do you forecast Income Statements?
• If you are looking to forecast your businesses’
income statement, develop a pro format, and
use these steps:

• Check historical data – focus on the company’s

past financial performance and take into
account at least two past periods. For
example, to project 2021, go back to 2020 and
2019.
• Forecast revenues – look at the annual growth
figures and use the rates to make assumptions
regarding future projections.
• Forecast your COGS and operating expenses –
compare these to the company’s revenue.
 Elements of Forecasting

• According to James W. Redfield, there are four

essential elements of forecasting. These are
laying the groundwork, estimating future
business, comparing actual and estimated
results, and refining the forecast process.
• Doing the Groundwork
This is where an orderly investigation of the
business’s products, industry, and business’s
operations is done.
This creates an overall view of what the
present and past of the business look like.
• Estimating Future Business
This is done by using a clear-cut strategy to
work out future performance expectations.
This element considers natural undertakings
by key executives.
• Comparing Actual and Anticipated Results
The obtained results are compared with
projected results and analyzed to find out why
there are discrepancies.
Even when the outcome surpassed
expectations, reasons for the difference
should be tracked down and used in the next
element, which is to refine the forecast
process.
• Refining Forecast Process
This final element involves putting to use the
skills gained through the familiarity of the first
three elements. The goal is to create a more
accurate financial forecast.
 Benefits of the financial forecasting process
• A business or any other entity with a financial
aspect in its operations can benefit from
financial forecasting. Some of those benefits
are:

• It helps to determine the long-term value of

the entity’s activities.
• An entity can use it to control cash flow and to
create a purposeful financial direction.

• It can be used to create financial benchmarks

for future planning.

• Useful for contingency planning in times of

crisis.
• Makes it easy to visualize the impact of new
expenses.
• It can be used to discover financial problems
and their causes.
• Forecasting can minimize financial risks.
• Financial forecasting can help to create an
environment of stability and certainty.
• It can be used to plan future budgets.
 Limitations of Forecasting
• Inaccuracy

• Forecasts are never 100% accurate because it

is not possible to predict the future with
certainty. This can happen even when you
have experts doing it and a well-established
forecasting procedure.
Often, either the product or the market will
encounter some volatility, especially in times
of crisis. Any factor that can influence product
demand can impact the accuracy of your
forecast.
• The best approach to minimizing the
inaccuracy of forecasts is to use conservative
estimates. That can help you to minimize the
margin of error.
• Time and Resources
• Financial forecasting takes time and resources
to execute. Often, it needs the input of all
departments, which makes it disruptive and
resource-intensive to implement.

• However, businesses can lower these costs by

using technology to gather data and
information. Financial planners can then use it
in forecasting.
• Costly to Implement
There is a higher initial cost attached to
financial forecasting. However, if done
properly, it is possible to recoup those costs
over time. And in the long run, the cost
savings from making favorable predictions can
outweigh the initial high investment.
 How to Forecast Financial
Statements
• Small businesses forecast financial statements
by looking at relevant historical data and using
the information to make future predictions
about the financial state of the company.
• There are three fundamental financial
statements that small businesses typically
issue: income statements, balance sheets and
cash flow statements.
• The three financial statements can be looked at
holistically to understand the overall financial
health of your business. Forecasting can be
done for a business’s income statements and
balance sheets. A cash flow forecast can then
be derived from the data in your income
statement and balance sheets.
• Documents showing your business forecasts
are called pro forma financial statements.
Together, these documents can provide
valuable accounting insights to help you better
plan for your business’s future growth.
 What Are Pro Forma Financial Statements
• Pro forma financial statements are based on
certain assumptions and projections about the
business. Pro forma statements allow you to
compare actual financial events to your
financial plan and make any necessary
adjustments throughout the year.
• Most small businesses tend to prepare pro
forma financial statements for periods of six
months or one year.
Pro forma financial statements are usually
required if you need a bank loan or other form
of business financing.
 How to Forecast an Income Statement

• Small businesses can develop a pro forma

income statement to forecast the company’s
profits or losses for a specific time period.
Here are the steps for forecasting your income
statement:
 Analyze Historical Data
• To accurately forecast your company’s profits
or losses, you’ll first need to understand its
past performance and use that data to predict
future financial outcomes. Make sure you’re
using comparable data.
If you’re developing a pro forma income
statement for a one-year period beginning
January 1, 2020, you’ll want to look at
historical data from the same period in
previous years.
Best practices suggest analyzing at least two
periods worth of historical data, so you would
want to look at income statements from
January 1, 2018 and January 1, 2019.
• Forecast Your Revenue
The easiest way to create a revenue (or sales)
forecast is to input your annual growth rate.
Look at the percentage growth in revenue
over previous periods, and use that
information to make an informed assumption
about your future revenue.
• Predict Cost of Goods Sold
As a service-based business, cost of goods sold
might not seem to directly apply to your
company. But service-based businesses should
think of their costs related to labor,
employment tax and benefits as their cost of
goods sold. Sometimes, this is called the cost
of services instead.
• Determine Your Operating Expenses
Analyze your past operating expenses and
compare them to your expected revenue to
determine what your expected operating costs
will be in your forecast.

Operating expenses include office rent,

business insurance, office supplies, salary and
benefits for employees, and more.
 How to Forecast a Balance Sheet
• Forecasting your business’s balance sheet
involves estimating your company’s assets and
liabilities for a future date. A balance sheet is a
financial document that gives a summary of
your business’s financial position on a specific
day.
• Balance sheet forecasts, or pro forma balance
sheets, are used to project how your company
will manage its assets in the future.
 To create a pro forma balance sheet you’ll
follow the following steps:

• Input Your Short-Term and Long-Term Assets

Begin by inputting your short-term assets,
which includes your current cash assets and
your accounts receivable.
Then, input your long-term assets, which
would include things like: buildings, property
and vehicles.
• Include Your Current and Long-Term
Liabilities
• Account for your current liabilities, which
include all liabilities that your business must
settle in cash within the next year. You’ll also
include long-term liabilities, which are all your
liabilities due in more than one year.
• Liabilities include payroll, labor services and
loan payments.
• Calculate Your Final Figures
To figure out your final projections, just
subtract your liabilities from your assets.

This final forecast of your balance sheet will

give you important insights into how secure
your business’s financial position will be at a
future date and can help you decide if you
need to consider cutbacks or apply for loans.
• How to Forecast Cash Flow
• To forecast your business’s cash flow you’ll
estimate the amount of cash flowing into and
out of your company for a specific future
period.
• A pro forma cash flow statement can help you
identify where your business may experience
cash shortfalls in future, so you can plan
accordingly to offset lean times.
• Here are the steps to forecasting your cash
flow statement:
 Estimate Your Anticipated Sales by Month
• Use at least two years of historical sales data
to calculate what sales you can anticipate by
month. Make sure to look at seasonal data to
see if there are patterns to your sales.

• You’ll also want to factor in any future plans,

like if you know that a big new client will sign
on to your business in the coming months.
• Predict When You’ll Receive Payments
• Estimate when you’ll receive future payments
by relying on historical data.
• If you invoice clients using a 30-day billing
cycle, you can predict when you’ll receive
payments based on those due dates.
• If one of your clients frequently pays you after
the due date, you’ll want to factor that into
your projections.
 Estimate Your Costs
• Most small businesses have both fixed and
variable costs. Account for your fixed costs,
including rent and utilities.
• Your variable costs fluctuate based on how
much work you’re producing.
• For a service-based business, variable costs
could include printing, postage and travel
costs related to business meetings.