Forecasting in business is the practice of predicting a company’s financial results at certain points in the future, based on certain assumptions and estimates as well as past performance. At we PATC, we understand that whether the forecasting method is simple or sophisticated, the objective is to enable the company to take certain actions in the present that will position it well in the future. Companies should make it a regular practice to compare actual results to projections. This will give subsequent forecasting the benefit of experience.
Understanding the Purpose of a Financial Forecast
A financial forecast (often called a cash budget, cash flow, or financial plan) helps you achieve your goals and get your business to where you want it to be. A financial forecast is a tool that allows you to use your resources where they’re most needed, so you can control the cash flow of your business, instead of it controlling you. It allows you to control your money, so you are more likely to achieve your desired net profit.
Role of Forecasting
Any business planning — whether simple and intuitive or sophisticated and highly technical – involves forecasting. Small business owners’ views of the future shape all budget decisions, even in the smallest of companies. Companies that are too small to have their own forecasters can subscribe to forecasting reports and newsletters and use them for risk analysis purposes. Risk analysis can alert business owners to economic events that may affect the prospects of their businesses as well as those of important customers and competitors.
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Benefits of Forecasting
The rigor of forecasting gives the management team insight into the possible future performance of the business. The assessment work that goes into building the forecast gives the management team a perception of the business that they would not otherwise have. This perception can influence the business’s development. A specific benefit is that forecasting can lead to better accuracy in budgeting.
The finished forecast can function as a framework for developing new strategies. Because of the discipline involved, forecasting can lead to better management of cash flow.
Forecasting can be used for;
- Strategic planning (long range planning)
- Finance and accounting (budgets and cost controls)
- Marketing (future sales, new products) – Production and operations
Types of forecasting methods
- Qualitative methods
- Rely on subjective opinions from one or more experts.
Importance of Assumptions
The financial forecast depends on assumptions of what may happen with certain business factors in the years to come. In deciding on the assumptions to use in the forecast, management team members must consider their business environment and rely on their intuition and market knowledge. Working from that base of experience and knowledge, the team can build a forecast. They can determine what to expect from sales performance, changes in the cost of labour and materials, the availability of capital, interest rate fluctuations and other data.
Venture capitalists and others who are considering investing in a small business will expect the management team to tell them with certainty when the business will start covering all its expenses and begin making a profit without contributions from investors. The financial projections in the company’s business plan will have to allow for all fixed expenses, such as rent, and variable expenses, such as shipping, that depend on sales volume. Investors naturally prefer to see a break-even point that is not too far in the future. The break-even analysis should yield a date that is realistically achievable for the company.
Components of a Financial Forecast
Creating a financial forecast shows you the financial requirements to start the business, convince you and your bank of the viability of your business or your business growth, and what resources you need to keep the business profitable.
Your financial forecast will be based on information gathered from industry and market research. Since you will be responsible for achieving the predetermined financial objectives, make sure your estimates and assumptions are realistic. Be consistent and make sure that your financial forecast reflects the rest of the business plan. For example, your sales forecast should reflect the capacity of production equipment mentioned in the operational section.
Combine the components of your financial forecasts to generate projected financial statements, (balance sheet, and profit and loss statement). You may need help from your accountant to assemble the figures in the conventional format, but the research and operational assumptions should be your own.
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You can develop your own financial forecast by using the spread sheets to complete the individual components. Then add the timing dimension (when you expect to receive payment and the amount) over 12 months to generate an annual cash flow forecast.