Of the various tools that finance professionals use, forecasts are considered to be one of the most critical. Financial forecasts are typically performed alongside, and sometimes confused with, budgets.
Both are considered indispensable tools used by FP&A analysts and finance professionals to assist in the implementation and monitoring of corporate strategies.
While budgets and forecasts are typically prepared in tandem, they are very different.
A budget represents management’s expectations on revenue and expenses for a future period, quantifying management’s goals and penning a financial strategy to implement them.
In this FAQ, we will define what a financial forecast is, why it is important, and the basics of preparing a financial forecast.
What Is A Financial Forecast?
As opposed to a budget, a financial forecast is a financial model that attempts to predict and estimate the amount of revenue and expenses a business will incur in the future.
This might sound somewhat similar to a budget, but there is one key difference between the two tools: a budget is designed to execute on management’s strategies and align the staff with the organization’s goals. It is effectively a roadmap created by management.
Financial forecasting is a tool that analysts use to determine whether the organization is performing in-line with the budget by estimating future revenue and expenses.
A financial forecast has various uses. Its most significant application is its ability to assist in determining how an organization should allocate resources.
A financial forecast is not necessarily dependent on a budget. In fact, a budget forecast is a type of financial forecast that uses the baseline budget as its inputs to model what the future results of the business might be if the budget is followed exactly.
This often leads to confusion between budgets and forecasts and the subsequent incorrect grouping of the two as being the same.
A financial forecast does not utilize variance analysis and typically precedes the budget by providing management insight into the future if operations continue as they are today.
The purpose of the forecast is to estimate the future outcome of the business by utilizing and analyzing historical results. By doing this, forecasts can assist managers in making key decisions on operational adjustments.
A forecast is typically updated often, sometimes even weekly, and is often used by management teams to make decisions on how to allocate budgets.
Why a Financial Forecast Is Important
When examining a budget and a forecast, both are inherently important aspects of good financial planning and analysis. They are different activities, and therefore should both be performed regardless of whether they are used in conjunction with one another.
Among the benefits of making financial forecasts, one key aspect makes them extremely useful for management teams — the ability to utilize them for immediate decision making.
Where a budget acts as a guide, a forecast has the ability to tell the actual story. Because they are often regularly updated, they incorporate dynamic changes in the business environment that can impact expectations.
This allows management sufficient insight to anticipate and preempt negative impacts to the enterprise.
Financial forecasts are often prepared for both short- and long-term time frames. Because of this, when short-term changes in the business environment occur, long-term forecasts provide helpful insight into the lasting impact of the changes.
In the same vein, long-term forecasts also provide a unique perspective on the lasting impacts of decisions made by management.
How to Make a Financial Forecast
In the world of accounting, financial forecasts are often referred to as Pro-Forma Financial reporting.
This is because typically financial forecasts are prepared using the three primary financial statements; the balance sheet, income statement, and cash-flow statement.
In some cases, each of these are forecasted individually: for example management might be primarily concerned with creating a balance sheet forecast for liquidity monitoring.
Almost all forecasts can be broken into three primary steps that are progressive. Regardless of the technique you use to forecast, the three steps typically remain the same.
Step 1: Gather Historical Data
This is a mandatory step as all financial forecasts rely on historical data in some manner. The most basic forms of data would be the historical financial statements. At a minimum, you will always require the previous period’s ending financial statements.
When projecting any future values, the result will always be dependent on your stating information.
This requires that those performing a forecast collect relevant, and accurate, beginning balances to move forward with. Typically, audited financial statements are the most widely accepted starting points.
Step 2: Decide On Your Forecast Method
You can make a forecast solely based on historical trends, or you can utilize a research-based approach. Using previous financial results is typically the fastest and easiest approach to forecasting. Be sure to incorporate a few years of information in your trend analysis.
A research-based approach requires more analysis on the business environment, shifts in market condition, changes in demand, or perhaps significant disruptions to the supply chain.
In any case, a comprehensive view of the business environment typically produces the most relevant and accurate results but requires more time and resources.
Step 3: Create Pro Forma Financial Statements
Begin by forecasting the income statement and use these income and expense assumptions in conjunction with cash flow assumptions to build your forecasted cash flow statement.
Finally, use your income statement and cash-flow forecast in conjunction to forecast the balance sheet. Once the balance sheet forecast has been created, the process is complete.
Using DataRails to Build Your Financial Forecast
Every finance department knows how tedious building a financial forecast can be. Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails is an enhanced data management tool that can help your team create and monitor financial forecasts faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes financial forecasting from time-consuming to rewarding.