Financial forecasting: What are financial forecasts and why do they matter?

Revolut Contributor

 · July 29, 2020  · 07/29/2020

The financial forecast is the not-so-secret weapon that a business deploys to predict its near-future performance. In the absence of a crystal ball, the forecast is relied upon to estimate the direction of travel for financial metrics like revenue or costs. It’s an educated best-guess of what’s likely to occur.

What is financial forecasting and planning?

There are various flavours of financial forecast, as they are a popular way to understand the likely movements of volatile business metrics such as sales growth or cash flow. Most businesses prepare forecasts for their income and cash-flow statements but it’s common to create one for each of the three primary financial documents:

  • Income statement (i.e. profit-and-loss statement)
  • Cash flow statement
  • Balance sheet

These new documents are often known as ‘pro forma’ financial statements. Don’t be bamboozled by the fancy name, they are still merely financial forecasts. A business should ideally put together its forecast estimates annually, or at least per quarter, to pre-empt problems or spot opportunities. The shorter the time period covered, the more accurate a financial forecast is likely to be.

In fact, should the business be in financial distress or on the verge of securing a significant round of funding, it might create new forecasts on a weekly basis to monitor its short-term cash position or likelihood of achieving a previously agreed performance indicator (i.e. KPI) such as revenue growth.

It’s worth noting that a credible forecast is always at the heart of any business plan – and it will also enable the creation of a coherent budget. We’ll come back to this specific point in a moment.

Why is financial forecasting important?

Forecasts provide valuable insights that enable the business to make sensible decisions about its future. The document might reveal how to allocate resources or identify a looming cash-flow crisis which needs plugging. Investors certainly expect a business seeking funds to have financial forecasts.

Sometimes all of these circumstances converge. In which case, a well-grounded financial forecast can then act as the lightning rod for a long-term solution that will suit everyone. Let’s look at an example.

Lemon Jelly is a fictional retailer of electric scooters based in Manchester. This high-growth business wants to acquire an exclusive import license for a new brand of scooter. Lemon Jelly creates a financial forecast for the year ahead, which identifies that it will need to raise funds to do this.

Based on its sales data for the previous year or two, the business can show a realistic expectation of what is achievable in the near future. This quantifies the scale of the opportunity to new investors. The same forecast also flags-up that Lemon Jelly must take this action soon because the predicted increase in sales will tie-up cash in stock and leave it vulnerable. By securing the equity investment well in advance, the business strengthens its negotiation position to secure this zesty licencing deal.

What are the elements of finance forecasting?

While the primary focus of these forecasts is to predict future financial outcomes, based on the evidence of tangible financial data, there is a role for multiple sources of information here. The most obvious source is the past performance of the business not least because this is so readily available.

In reality, the dark art of financial forecasting is the process of blending together many types of data, or assumptions, to concoct a credible plan for the future. Here are examples of forecasting sources:

  • Historic business data (i.e. previous financial statements of the business)
  • Economic indicators (e.g. inflation or unemployment rate)
  • Regulatory changes (e.g. Brexit or Open Banking)
  • Consumer research (i.e. appetite for new products or services)
  • Industry trends (e.g. sector growth or margins contracting)
  • Market mavens (i.e. opinions of insightful analysts on the above)

Aside from the first one, each of these sources can either be historic data or based on predictions. Some elements of this information will be more certain than others. For instance, the business will probably know the costs of its utility bills or rent and be able to predict these with confidence. By contrast, the price of raw materials is volatile – and when it comes to future demand or churn rates, the whole exercise can be little more than a finger in the wind.

How complex is the fundamental analysis of a financial forecast?

The style of a financial forecast can range from a quick-and-dirty collation of basic data right through to a deeply complex document, which incorporates market research and financial modelling. In simple terms, a model is when a forecast computes various scenarios, such as the best or the worst-case, to quantify what the specific outcomes might be for the business in each situation. It’s a posh prediction.

The more variables a forecast attempts to incorporate (e.g. competitor analysis) the more realistic it is said to become. However, along with that finesse, the forecast will also grow convoluted and volatile. The alternative is a more robust approach of purely historic data or sign-posted trends (e.g. regulatory change). In truth, most financial forecasts involve a bit of mix-and-match and there’s no harm in that.

Naturally, an early-stage business will struggle to put together accurate forecasts, due to its limited trading history on which to base them. For this reason, SMEs tend to rely on what we can charitably describe as optimistic sources. To mitigate this effect, it’s prudent for these businesses to repeat the forecasting exercise more regularly than a mature business. At least that’s what investors should ask.

What’s the difference between a budget and a financial forecast?

While people do use the terms budget or forecast interchangeably, they are not the same thing. The former is an aspiration of how the business wants to perform whereas the other should be grounded in reality, with at least some historic performance data as evidence to back-up its main predictions.

As the managing director of Digithouse one of the UK’s leading providers of outsourced finance functions elegantly explains: “The budget is what you hope that your business will achieve. The forecast is what you expect to achieve with your hand-on-heart.”

The budget contains goals designed to motivate a team and while it should be compared to the actual performance of the business on a month-by-month basis, it is a static document that isn’t updated. By contrast, the forecast reflects the actual spending plans of the business. When circumstances change, it might be necessary to ‘re-forecast’ in order to amend those plans, based on the current projections.

Going back to our fictional Lemon Jelly scooters. The business might well have made overly optimistic assumptions about the growth of its sector, based on the plausible assumption that traffic regulations were due to change to its advantage. If the proposed change doesn’t occur, the business will probably have to adjust its budget but it will not revise its forecast. Even so, it’s sensible to revisit old forecasts and track how accurate they proved to be, if only to learn how to create more effective ones next time.

Some say that financial forecasts are a necessary evil of the business world. Too much emphasis will create paralysis by analysis. Disregarding forecasts entirely in favour of a more ‘intuitive’ approach sounds great when it works-out but leaves a business looking distinctly amateurish when it does not.

As a final thought, remember to expect the unexpected. Lemon Jelly scooters might not have got the pedestrianised streets that it banked on but it would certainly reap the benefits of people’s aversion to public transport during the pandemic. No financial forecast could have predicted this but a coherent approach to this subject will certainly help to keep the show on the road once the ride grows bumpy.

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