It is so common for small business owners to focus on solving today’s issues and getting the next sale, that they forget to also look ahead. Being forward-thinking is crucial for all businesses because it allows them to identify upcoming opportunities and beat their competition. Forecasting is also essential for predicting the effects of decisions businesses make today. This article explains what you need to know about this crucial tool that all businesses should include in their management practices.
What is Financial Forecasting?
Financial forecasting entails creating documentation or reports that show how a predicted future would look like. It is vital for helping business owners understand the future, confront uncertainties, and make better decisions today for better outcomes tomorrow.
Business leaders create assumptions and estimates about future expenses, revenue and business changes. They then communicate these to the right people through financial statements and forecasts.
Financiers and accountants are heavily involved in creating financial forecasts because they have to analyse historical statements and performance while keeping future expectations in mind.
Types of Business Financial Forecasts
There are three main types of financial forecasts. The first is bottom-up forecasting. This type of forecast considers specific products and customers and uses that data to extrapolate future outcomes. In short, its foundation is lower-level data that is expanded for a clearer picture.
The second is top-down forecasting. This type of forecasting focuses on the big picture first before looking at the specifics. It is the exact opposite of bottom-up forecasting and arguably more important for small businesses.
The business owner or leader first maps their goals for a specific period, typically a year, and then determines the steps or decisions required to meet them. They also set aside resources to help achieve these goals, which sometimes includes hiring new people.
The third is hybrid forecasting which combines elements from the two types of forecasting discussed above. The main benefit of this option is that it maximises their advantages while reducing their disadvantages.
What are the Benefits of Financial Forecasting?
Financial forecasting can help businesses create a long-term vision. It does this by providing a picture of what the business can achieve down the road while giving leaders goals to aim for. Using historical financial data and market trends that business leaders use for their forecasting helps them set strategies to create a winning environment while avoiding what might not have worked in the past.
While investors seek comfort in knowing how a company is currently doing, they also want to know how the business will perform in the future. They also need to know how long it will take for them to recoup their investment or for them to invest again. Forecasts are excellent tools for both of these.
Financial forecasting helps businesses identify opportunities and risks. Every business should avoid risks as much as possible while seizing available opportunities. Forecasting helps businesses know where they stand and learn new ways to attract customers and increase revenue.
Forecasts are also important for predicting cash flow. Cash flow is a challenge for many businesses because they have expenses to take care of. A business must have enough resources to last at least one month, although many experts recommend it should have enough for at least three. Analysing previous financial data can show you the times or seasons when your cash flow dwindles so you can plan for the future with that in mind.
Creating Financial Forecasts for Small Businesses
Business leaders should start by creating their dream business. Take a pen and paper and write what you envision for the business. You can also use a vision board, write a letter to yourself or use a template. If you download a template, it might be a PDF that is difficult to edit.
Make things easier for yourself by using tools that help you convert PDF to Word. A PDF to DOCX conversion makes the template easier to work with, streamlining the process of creating the dream you have about your business.
The dream should also include a target date. An open-ended plan is not always best because it does not instil the sense of urgency required to push you to work towards achieving your goals. Your timeline should be realistic, tailored to your business, and aligned with your goals.
Analyse Historical Financial Information and Performance
Creating a vision and planning for the future can be difficult if you do not understand your past. Analysing past financial information and performance will give you a better understanding of how your business performs under different circ*mstances and at different times of the year.
The periods of analysis should align with your goal’s timeline. For example, you should check the business’s balance sheets, income statements, and other financial documents for a period equal to the one you are forecasting. If you are creating a plan or forecasting 18 months into the future, you should look at data for at least the last three 18-month periods or since you established the business if it is not old enough to have such data.
Create a Pro Forma Income Statement
Now that you understand the company’s past, you can start predicting its future. The standard statements you need to create are cash flow statements, balance sheets, and income statements. If you already use accounting software, you can export this data easily to a spreadsheet; learn more here. Having good accounting software helps ease many things and also lessens the burden of hiring people to complete different financial tasks. If not, you can ask an accountant to compile it for you.
New businesses that do not have enough data can look at how other companies have performed in the past. Keep in mind that there might not be enough information to make informed decisions, especially if the companies are not publicly traded.
Creating a Pro Forma income statement requires two steps:
- Using a growth or decline percentage to estimate future expenses and revenue.
- Checking your estimates to correct them and account for external and internal factors that would affect them.
A growth or decline percentage compares data from different periods. For example, you might compare the second year’s revenue to the first year’s, and the third year’s to the second year’s. You should then know whether your profits are increasing or decreasing and use the percentage change to forecast revenue for the fourth year.
Next, account for how different internal and external factors will affect your revenue. These factors could include investments, hires, creating new products, paying debts, the economy’s performance, changes in taxes and regulations, etc.
Create a Pro Forma Balance Sheet
Your pro forma balance sheet should include your equity, liability and assets, and you can base it on your latest actual balance sheet. You can adjust your cash projections depending on the expenses plan to put on credit, those you plan to pay using cash, and the money you expect to receive once your customers pay what they owe. If you are thinking of making a major investment shortly, you should also include that in your balance sheet.
Lastly, create a cash flow projection statement. This statement will help ensure you are not spending more than you have to hand at any time and give you a better idea of where you might end up at the end of the forecasted period.
A financial forecast is crucial for business owners because it helps them plan for the future. It also helps make crucial decisions regarding investments and business expansion, and it gives business owners something to aim for regarding the growth of their business.
