What is financial forecasting? Definition, Types + Free Financial Data Guide

Financial forecasts are the finance team’s best estimation of how the company will do in the future.

They can cover any part of the organisation, including a project forecast, a sales forecast a resourcing forecast or a full Profit and Loss, Balance Sheet and Cash Flow forecast for the whole organisation.

Whilst in this article we are going to focus on financial forecasts, any part of the operations, support or strategy of the business can be the subject of a forecast.

Why is Financial Forecasting Necessary? 

Imagine driving your car down an unlit road at night. You’ve never been down that road before and have no headlights. That is essentially the situation that faces a business that doesn’t have a forecast.

A company that hasn’t thought about where it is going and what it might encounter is destined to spend its time being reactive which is arguably the most inefficient way to run a business. 

Planning for business growth

Let’s consider a growing business.

• How do you know what your income is likely to be?
• How do you understand how much your people will cost?
• How do you predict what you will need in terms of office, warehouse and storage space?

If your business is growing rapidly then these are just a few of the questions that you will need to answer and all of these have one thing in common - money.

Whatever your management team decides to do in terms of growth, the finance department will be charged with findning the cash, so having financial and cash flow forecasts is the number one priority.

Optimising resource allocation

Suppose your business has a choice of two projects. They are both profitable but you can only do one.

Which one do you pick?

There are lots of different ways you could choose of course, but in all cases, you will need to know a variety of financial figures before you give the green light.

• How much initial investment is required?
• What does the cash flow look like?
• Can you claim R&D tax credits?
• What is the likely profit profile?

What is the likely life of the project and what will the Return on Investment (POI) be?

But of course, resource allocation isn’t confined to projects. It can be a consideration for service lines, process production or labour recruitment and usage.

Tracking performance

If you’ve read our piece on budgeting in business, you’ll know that a company might set budgets for the organisation as a whole or parts of the business such as sales.

But how do you know; a) how each part of your business is doing compared to budget and b) whether you need to take action to ensure they meet or exceed it?

Rolling or quarterly forecasts help you understand how your business is doing while you still have a chance to make changes rather than finding out when you can do nothing at the end of the financial year.

Gaining investor confidence 

Whether you are looking to bring in equity investment or debt finance, you’ll need to produce top-quality information that will be credible enough to give investors a high level of confidence.

One of the key things included within the investor pack will be a forecast and typically, they will want a base case forecast and a second scenario that will show the impact of their funds and how it changes the organisation.

Improving operational efficiency

A forecast is an interesting document in its own right but where it really comes into its own is in giving managers a forward look at what their year looks like if they continue on the same track.

This also gives them the option of looking at forecasts that show the impact of different decisions. This massively increases operational efficiency as the likelihood of making poor decisions or taking a wrong turn is drastically reduced. 

So that’s the theory but how do you go about producing financial forecasts in practice?

A really good starting point is a budget if you have one. This will show the world as you saw it at the time the budget was produced. You can also use last year’s management accounts as a starting set of figures.

Of course, as time moves on you realise that things haven’t turned out as you expected so you can use the original budget and amend it to show the new information.

• Gathering existing financial data - the bedrock of your forecast is going to be strong, credible and timely financial data so you need to make sure you have good access and that you are able to produce a forecast quickly and easily. This will give you a base case forecast that you can then begin to work on.
• Identifying patterns and trends - once you have a forecast you’ll start to see trends and patterns emerging, especially if you have old forecasts that you can compare with.
• Assessing internal and external factors - a great forecast doesn’t just build on internal data but brings in information from outside to inform the outlook for the business such as predicted interest rates, market information and demographic data.
• Building projections based on available information - once you have all of your internal and external data you can then add richness to your forecasts and start to interrogate your assumptions to see if they still hold true.
• Reviewing and adjusting forecasts - once you have produced your final base case forecast you can review and sense-check the numbers. Do they look sensible? Do they align with current thinking?
• Scenario planning - finally, when you have a robust base case you should use that as a jumping-off point for some scenario planning that will help you to develop alternative views. For example, what happens if sales are 20% less than expected or if it is more difficult (i.e. expensive) to recruit people?

We mentioned above your budget in the context of producing a forecast and this is an area that often confuses people -  what is the difference between a forecast and a budget?

The budget is set at the start of the year or the start of a project. This is based on the strategic aims of the business and is a roadmap for managers as to how the business wants things to go.

If we imagine a budget made in January, we can see that by the time we get to June, the assumptions and data in the original will be at a minimum six months out of date. So managers need information that more accurately reflects the current state of affairs.

A really good example here is the COVID-19 crisis where businesses may have made a budget in January that became outdated as soon as February.

In terms of budgeting versus forecasting, a forecast is made subsequently and in the light of events.

Typically a business may make a monthly cash flow forecast which shows what the cash balances in the bank are likely to be for each day or week.

They may also decide to run a quarterly forecasting exercise which takes the budget as its base case and then makes adjustments for things that have happened since.

It may be unfair to say that a budget is a hoped for outcome and a forecast is a more realistic interpretation but certainly after a few months this is likely to be the practical outcome. 

If all this sounds like a lot of work then unfortunately the truth is that yes, it is.

Large companies devote entire departments to budgeting and forecasting and for many businesses, this can take up a huge amount of time and be very distracting.

We are not going to suggest that you can avoid all work in producing a forecast but certainly, top-quality financial forecasting software can help a great deal.

So how do you forecast financial statements using software?

Really good software makes it a doddle to produce an initial base case forecast and compare this with your original budget. It will also allow you to produce a variety of different scenarios depending on what you are seeing in real life.

In many cases, your financial software will automatically produce your forecast on a set date that you can then set about reviewing.

In short, excellent financial software will do all the leg work whilst you concentrate on the things that really add value like bringing in business and market intelligence.

When your forecast is finished, modern forecasting software will simplify the report production and distribution and even allow self-service and commenting from managers and staff. 

The biggest sin a finance team can make is to produce a supremely detailed financial forecast and then leave it in a metaphorical drawer never to see the light of day again.

Instead, a financial forecast should be distributed to the people who can pull levers to effect change throughout the business.

A good financial forecast will allow the finance team to understand cash flow and choose to either raise short-term cash input in the case of a shortfall or find an efficient home for any cash surplus.

A full business forecast will also give the senior managers an understanding of what projects they can afford to run from a financial point of view and whether they have any money left for other initiatives.

Forecasting is also helpful for tax planning and management and gives advisors a view as to what the outturn for the year is likely to be.

So what should you include in your financial forecast template? Here are our thoughts.

Cash flow forecast

If you do nothing else then your business should have a cash flow forecast. If you are in a cash-poor business then you may want to update this on a daily basis (not as onerous as you may think) or for more ‘steady state’ companies you may only need to revisit once a month.

Either way, your company must have a clear sight of its cash position at all times because you don’t want any nasty shocks in this department.

Profit and loss forecast

This is probably the one that most people think of in terms of forecasting and for good reason.

The P&L is what businesses are all about and you need to be able to show people how the future looks in advance. Again remember driving down that dark road - the P&L forecast is your headlights.

You can produce this at an organisational level, by company in a multi-company group or by department or project. The key is to choose a method that works best for your company.

The Balance Sheet forecast

It may seem that forecasting the balance sheet is a pointless exercise but if you are a company with outside debt funders or performance contracts then you will definitely need this.

Many financing agreements, venture capital documents and contracts have balance sheet clauses that require the business to maintain a certain level of liquidity or fixed assets. If you breach these ‘Covenants’ then your company could be in big trouble.

Operational forecasts

As part of your forecasting process, you may need to produce operational forecasts that then build up to inform the overall company document.

A good example of this would be where a business is mainly service-oriented and a people resource forecast will be required.

This one is very dependent upon the sector you are in and how you are organised but the best advice is to make sure you are producing forecasts that add value to the business.

Final Thoughts

The forecasting process may seem complex and difficult but without a doubt it is also one of the most rewarding and challenging tasks a finance team can do.

Forecasts add real value to the business and allow senior managers and directors to base their decisions on a sound footing rather than blind luck.

The best forecasts include internal data but also bring in external information of both a financial and non-financial nature.

Financial forecasting can be a really time-consuming and difficult process but with the right software it can actually be relatively quick and painless and your business will thank you for a simple financial dashboard and/or report delivery method so investing in capable financial software is a must.

Good luck with your first forecast and remember that the more you do, the better you get.