Financial Forecasting: Meaning, Examples, Methods, Importance

Meaning Of Financial Forecasting

The process of estimating and predicting the future performance of a business with the help of historical performance data such as sales, expenses, revenue, cash flow, etc. is called Financial forecasting. It involves a lot of guesswork and assumption because many unforeseen factors affect the performance of a business.

In simple words, we can define financial forecasting as a method of knowing what will happen in the future by examining what happened in the past and what is happening now. With the help of financial forecasting, business professionals can estimate a business’s projected expenses and projected income. Other important aspects of financial forecasting are estimating future fixed and variable costs, and capital. The future ahead in time, the less accurate the forecast will be. Both macroeconomic factors, as well as macroeconomic conditions, are included in a solid financial forecast.

Financial forecasting is a rigorous task that is inclusive of extensive data analysis, deep knowledge of the business, and updated customer and market insights. A business’s finance team plays a vital role in the company’s success. In bad times financial forecasting professionals are considered no less than superheroes.

Even if the process of financial forecasting is difficult but is very necessary for a business enterprise as it allows us to analyze quantified objectives which if traced properly can immensely help in the growth of the business in good conditions.

Example Of Financial Forecasting

Forecasting a business enterprise’s sales is the most common example of financial forecasting. A majority of the financial statements are related to sales, forecasting sales of an enterprise can help it to make other financial decisions that will eventually help it to achieve its goals.

In our example of financial forecasting, we have included a sales forecast of a hotel, organized by a variety of services with the bed’s occupancy forecast broken down based on the season.

NameJan 2021Jan 2022Jan 2023
Peak season – weekend46,51052,88060,250
Peak season – week34,72038,99044,550
Low season – weekend22,90025,58024,750
Low season – week36,10030,70038,650

A forecast must be based on deep and reliable market research and analysis to ensure a fair and realistic evaluation of the company’s revenue. Factors like pricing policy, distribution strategy, and competition offerings must be taken into consideration as well.

Examples of financial statements to be included in your forecast:

Three financial statements are included in a forecast –

1)     The P&L statement –

The profit and loss statement helps us to access information like:

  1. The growth of an enterprise by evaluation of turnover of several historical years.
  2. The profit of the company by examining the difference between expected costs incurred and expected revenue from the sales.

The only drawback of the profit and loss statement is that it does not take cash flows into account. Thus to overcome this we need to look at the second financial statement in our forecast i.e. cash flow statement.

2)     Cash flow statement –

This statement shows the value of all anticipated cash inflows and outflows for a given year. With the help of a cash flow statement, an individual can gather information like –

  1. Financing and investing policies of the enterprise.
  2. The ability to generate operating cash flow.

The profit and loss statement and cash flow statement go hand in hand and are complementary to each other as they when combined give an individual a clear picture of the company’s profit or loss, cash inflow and outflow, and the investments made.

3)     Balance sheet –

A company’s net worth at any given point in time can be known with the help of a balance sheet. This is the last link in the chain of financial statements used in financial forecasting. It can be used by forecasting professionals to gather information like –

  1. Total asset value of the company.
  2. Total working capital of the company.
  3. The value of debt a company holds.
  4. The value of shareholder’s equity in the company.

Methods Of Financial Forecasting

There are two main methods of financial forecasting: qualitative and quantitative. Under these two heads, there is a wide range of financial forecasting methods used frequently in the finance world. Out of all those methods, in this article, we are going to discuss the top four methods which are used to predict the future expenses, costs, and revenues of a business. The four top methods of financial forecasting are listed below –

1)     Straight Line Method

A straight line method is considered one of the simplest and easy to use financial forecasting methods. With a minimum level of mathematics involved a financial analyst predicts the future revenue growth using historical data and trends.

This method is commonly used when a business expects a rise in future revenues and wishes to estimate future growth. For example, if an entity has seen a growth of 14% in revenue in the past 5 years, under the straight-line method it is reasonable to use that same growth rate to predict future revenues.

Although the revenue of a company is also affected by many other factors which are not taken into consideration while using the straight-line method of financial forecasting. Still, a lot of people find the straight-line method convenient for setting up internal goals.

2)     Moving Average Method

This method of financial forecasting uses patterns in the company’s data set to predict the future financial performance of the enterprise.

Under the moving average method of financial forecasting, the extensive data is divided into smaller portions. Then the average of each smaller subset is taken into consideration to predict the average future financial performance of the company over short time slabs.

The level of uncertainty is reduced by analyzing data for shorter time frames like three to four months rather than for many years in the future. The most common types are the 3 months moving average and 5 months moving average. It also shows seasonal and cyclic trends that may affect the finances of the organizations. The straight-line method lacks in this aspect.

3)     Simple Linear Regression Method

Simple linear regression is a tool or method of financial forecasting that is widely used in the finance world to show a relationship between two variables for future performance prediction purposes. Mathematical models are used in this method to describe the relationship between two variables. For example, how a change in the GDP could affect sales. 

This method can be used when one wants to get information like –

  1. The intensity of the relationship between two variables.
  2. The value of the dependent variable at a certain value of the independent variable.

This method is a parametric test which means it makes some assumptions about the data which includes homogeneity of variance, independence of observations, normal distribution and the relationship between two variables is linear.

4)     Multiple Linear Regression Method

The multiple linear regression method of financial forecasting is used to forecast revenues when two or more independent variables are required for the analysis.  It is an extension of linear regression which sometimes is called by the name multiple regression. The variable whose value we want to predict is called the dependent variable, and the variable with the help of which we predict the value of the dependent variable is called the independent variable.

The assumptions used in multiple linear regression are –

  1. The relationship between the dependent and independent variables is linear.
  2. The independent variables are not highly correlated with each other.
  3. The residual value of the variance is constant.
  4. The observations made are independent.

Importance of Financial Forecasting

Apart from projecting future revenues, expenses, capital, etc., effective financial forecasting has the following benefits-

  1. With the help of financial forecasting we can assess the financial sustainability of a new business enterprise and construct a model of how efficiently the business might run if some strategies, plans, and assumptions are carried out in a right and effective manner.  
  2. Financial forecasting provides information like future cash needs and whether borrowing or private equity is required.
  3. Investors and lenders like banks use financial forecasting information before deciding on laying out a loan or investing in the business. Thus, with the help of a solid financial forecast, it is easier to grab loans and funds.
  4. Potential risks and cash shortfalls are identified with the help of a financial forecast and eventually, it helps to keep the business out of trouble.
  5. A Financial forecast helps business professionals to guide their business in the right direction.
  6. A Financial forecast also helps to compare the actual financial operation against the forecasted one and make changes wherever necessary. 

Limitations Of Financial Forecasting

Financial forecasting is a great concept but there are some disadvantages or limitations of this concept which are mentioned below –

1)     Time-consuming –

If a person has no experience and is not familiar with the financial forecasting concept then the process of creating a financial forecast may consume a lot of time.  Even for an expert at financial forecasting, it’s still a fairly time-consuming task. 

Thus before an enterprise starts putting a forecast it should make sure that it’s the best use of its time.

2)     Inaccurate information –

When a financial forecast is based on something other than historical data there are high chances of forecasts being inaccurate. If financial analysts take any decision based on such inaccurate forecasts it may cause some serious problems for the enterprise. Thus a forecast needs to be as accurate as possible, or else it will be very unhelpful for the enterprise.

3)     Difficult for new business –

Financial forecasting is extremely difficult for new businesses. There are a lot of methods for new companies to put together a new forecast but all these methods are less accurate and more time-consuming. so there are a lot of advantages of financial forecasting but this toll of the finance world is not that great for startups or new businesses.

Purpose Of Financial Forecasting

The main reason business enterprises conduct financial forecasting is to put a financial context to their business plans. Creating forecasts can help a business enterprise to get in touch with the actual status of their business. Potential problems can be foreseen with the help of financial forecasting and thus better decisions can be made and the impact of those decisions can be calculated.

Most people believe that the main purpose of a forecast is to predict the revenue but there are a lot of other factors as well some of which are listed below –

1)     Cash –

At every point in time an enterprise must know the amount of cash it holds and how much more will it need. Being the most important factor to forecast it makes it very important to go through the income statements and track revenue and expenses.

2)     Hiring –

Under hiring, forecasting helps to find out if the company needs more manpower or when the company will need it. Also, forecasting helps in finding out the answer of whether the increased sales revenue by recruiting more employees will outweigh their actual costs or not.

3)     Pricing Models –

There is always an ideal price point for each product out there in the market. Forecasting helps in revealing the price point at which one can see the optimal sales revenue stream. With a solid financial forecast, financial analysts can even determine the impact on revenue, cash flow, and income, even if the price of the product is changed by one dollar or the pricing method is changed from yearly to monthly.

4)     Customer Acquisition –

While acquiring a new customer there are a lot of questions that need to get answered like how much it costs to bring a new customer, how long will it take them to pay back what you paid them to get on board, lifetime value of the business they bring to the company, etc. financial forecasting has got answers to all these questions and can guide a business enterprise to know exactly who should they sell to.