Much of accounting involves evaluating past performance. Financial results demonstrate business success to both shareholders and the public. Planning and preparing for the future, however, is just as important.
Shareholders must be reassured that a business has been, and will continue to be, successful. This requires financial forecasting.
Here's an overview of how to use pro forma statements to conduct financial forecasting, along with seven methods you can leverage to predict a business's future performance.
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Financial forecasting is predicting a company’s financial future by examining historical performance data, such as revenue, cash flow, expenses, or sales. This involves guesswork and assumptions, as many unforeseen factors can influence business performance.
Financial forecasting is important because it informs business decision-making regarding hiring, budgeting, predicting revenue, and strategic planning. It also helps you maintain a forward-focused mindset.
Each financial forecast plays a major role in determining how much attention is given to individual expense items. For example, if you forecast high-level trends for general planning purposes, you can rely more on broad assumptions than specific details. However, if your forecast is concerned with a business’s future, such as a pending merger or acquisition, it's important to be thorough and detailed.
Forecasting with Pro Forma Statements
A common type of forecasting in financial accounting involves using pro forma statements. Pro forma statements focus on a business's future reports, which are highly dependent on assumptions made during preparation, such as expected market conditions.
Because the term "pro forma" refers to projections or forecasts, pro forma statements apply to any financial document, including:
- Income statements
- Balance sheets
- Cash flow statements
These statements serve both internal and external purposes. Internally, you can use them for strategic planning. Identifying future revenues and expenses can greatly impact business decisions related to hiring and budgeting. Pro forma statements can also inform endeavors by creating multiple statements and interchanging variables to conduct side-by-side comparisons of potential outcomes.
Externally, pro forma statements can demonstrate the risk of investing in a business. While this is an effective form of forecasting, investors should know that pro forma statements don't typically comply with generally accepted accounting principles (GAAP). This is because pro forma statements don't include one-time expenses—such as equipment purchases or company relocations—which allows for greater accuracy because those expenses don't reflect a company’s ongoing operations.
7 Financial Forecasting Methods
Pro forma statements are incredibly valuable when forecasting revenue, expenses, and sales. These findings are often further supported by one of seven financial forecasting methods that determine future income and growth rates.
There are two primary categories of forecasting: quantitative and qualitative.
Quantitative Methods
When producing accurate forecasts, business leaders typically turn to quantitative forecasts, or assumptions about the future based on historical data.
1. Percent of Sales
Internal pro forma statements are often created using percent of sales forecasting. This method calculates future metrics of financial line items as a percentage of sales. For example, the cost of goods sold is likely to increase proportionally with sales; therefore, it’s logical to apply the same growth rate estimate to each.
To forecast the percent of sales, examine the percentage of each account’s historical profits related to sales. To calculate this, divide each account by its sales, assuming the numbers will remain steady. For example, if the cost of goods sold has historically been 30 percent of sales, assume that trend will continue.
2. Straight Line
The straight-line method assumes a company's historical growth rate will remain constant. Forecasting future revenue involves multiplying a company’s previous year's revenue by its growth rate. For example, if the previous year's growth rate was 12 percent, straight-line forecasting assumes it'll continue to grow by 12 percent next year.
Although straight-line forecasting is an excellent starting point, it doesn't account for market fluctuations or supply chain issues.
3. Moving Average
Moving average involves taking the average—or weighted average—of previous periods to forecast the future. This method involves more closely examining a business’s high or low demands, so it’s often beneficial for short-term forecasting. For example, you can use it to forecast next month’s sales by averaging the previous quarter.
Moving average forecasting can help estimate several metrics. While it’s most commonly applied to future stock prices, it’s also used to estimate future revenue.
To calculate a moving average, use the following formula:
A1 + A2 + A3 … / N
Formula breakdown:
A = Average for a period
N = Total number of periods
Using weighted averages to emphasize recent periods can increase the accuracy of moving average forecasts.
4. Simple Linear Regression
Simple linear regression forecasts metrics based on a relationship between two variables: dependent and independent. The dependent variable represents the forecasted amount, while the independent variable is the factor that influences the dependent variable.
The equation for simple linear regression is:
Y = BX + A
Formula breakdown:
Y = Dependent variable (the forecasted number)
B = Regression line's slope
X = Independent variable
A = Y-intercept
5. Multiple Linear Regression
If two or more variables directly impact a company's performance, business leaders might turn to multiple linear regression. This allows for a more accurate forecast, as it accounts for several variables that ultimately influence performance.
To forecast using multiple linear regression, a linear relationship must exist between the dependent and independent variables. Additionally, the independent variables can’t be so closely correlated that it’s impossible to tell which impacts the dependent variable.
Qualitative Methods
When it comes to forecasting, numbers don't always tell the whole story. There are additional factors that influence performance and can't be quantified. Qualitative forecasting relies on experts’ knowledge and experience to predict performance rather than historical numerical data.
These forecasting methods are often called into question, as they're more subjective than quantitative methods. Yet, they can provide valuable insight into forecasts and account for factors that can’t be predicted using historical data.
6. Delphi Method
The Delphi method of forecasting involves consulting experts who analyze market conditions to predict a company's performance.
A facilitator reaches out to those experts with questionnaires, requesting forecasts of business performance based on their experience and knowledge. The facilitator then compiles their analyses and sends them to other experts for comments. The goal is to continue circulating them until a consensus is reached.
7. Market Research
Market research is essential for organizational planning. It helps business leaders obtain a holistic market view based on competition, fluctuating conditions, and consumer patterns. It’s also critical for startups when historical data isn’t available. New businesses can benefit from financial forecasting because it’s essential for recruiting investors and budgeting during the first few months of operation.
When conducting market research, begin with a hypothesis and determine what methods are needed. Sending out consumer surveys is an excellent way to better understand consumer behavior when you don’t have numerical data to inform decisions.
Improve Your Forecasting Skills
Financial forecasting is never a guarantee, but it’s critical for decision-making. Regardless of your business’s industry or stage, it’s important to maintain a forward-thinking mindset—learning from past patterns is an excellent way to plan for the future.
If you’re interested in further exploring financial forecasting and its role in business, consider taking an online course, such as Financial Accounting, to discover how to use it alongside other financial tools to shape your business.
Do you want to take your financial accounting skills to the next level? Consider enrolling in Financial Accounting—one of three courses comprising our Credential of Readiness (CORe) program—to learn how to use financial principles to inform business decisions. Not sure which course is right for you? Download our free flowchart.
