Financial forecasting: it’s part science, part insight, and part prediction. Above all, it’s an important process to support your financial management strategy. Good forecasting will help your business stay financially ready and resilient, whether events turn out good, bad, or ugly.
What is financial forecasting?
Financial forecasts are predictions about probable (and improbable) future events. They’re used as a basis for budgets and a baseline to make better business decisions. While CFOs and financial controllers ‘own’ the forecasting process, true financial forecasting is a company-wide initiative. It draws in management reports and insight from various departments, such as sales, marketing, and product development.
Once the financial projections have come in from key departments, a CFO acts like chief analyst. They glean the most valuable insights from department-level forecasts, query any brittle assumptions, and bring any central risks or opportunities to the front and center of the boardroom’s thinking and decision-making.
Benefits of regular forecasting
Financial forecasting is useful to large and small businesses for many reasons.
They allow you to create a better budget
Sound forecasts help your leadership team to base budgets on a combination of historical data and future business activities like new product launches or market expansions. You’ll also be well-placed to track business expenses against both forecast and your actual budgets. Recent years have led many businesses to use zero-based budgeting (ZBB), a way of allocating operating budgets based on necessity rather than on historical spending or past assumptions. Because ZBB is budgeting done from scratch, it needs good forecasting to thrive.
They help inform shareholders
Regular forecasting is vital to keeping shareholders and potential investors up to speed, too. Financial forecasts help shareholders plan or adjust their holdings, And in some cases, a positive forecast may help attract more investor interest in the company. And that’s good news because appealing to investors can lead to more fundraising opportunities and capital.
They help with business plan strategy
Forecasts can be used to embed some if-and-then thinking into your high-level business plan, too. For example, new product launches can include forecasts about supply chain expenses and risk scenarios. Or if you’re about to expand into a new market, they can also help you forecast variable and fixed costs of, for example, recruiting, training, and retaining in-country talent.
They help better prepare you for the unexpected
So far this decade has been a cruel lesson for businesses everywhere in the realities of risk and ‘black swan’ events. No forecasting exercise can ever truly prepare a business or its employees for crises from the left field. But forecasting can help embed proper risk management into your financial management mindset. For example, strong forecasting can help businesses to hold the right levels of cash reserves, negotiate more favorable commercial office leases, and right-size their insurance coverages.
3 common financial forecasting methods & how they work
Without diving too deeply into the math involved, there are a number of different ways to think of financial forecasts. These methods include:
A moving average is the average business performance of an important metric (such as sales, churn rate, or recurring revenue) over a set time frame. Some businesses with ‘lumpy’ revenue or a seasonal sales trend may like to forecast with a moving average to better suit that business model.
Straight-line forecasting is used with the assumption of future revenue growth. For example, if your business revenue has grown at 13% in the past 12 months, you could set this as your assumed revenue growth rate for a set time frame, such as 12-36 months.
Linear regressions can help you forecast a correlation between different points of data using an x and y axis. For example, you might want to plot how tax rates—or even GDP—could affect your financials. Here are two common linear regressions:
- Simple linear regression: A simple linear regression has only one x and one y variable, for example income and revenue.
- Multiple linear regression: A multiple linear regression has one y and two or more x variables, for example income and revenue and cost of goods sold.
We’ll touch on when you might want to use each of these methods next.
5 financial forecasting tips
Here are some best practices to follow, starting with choosing how you’re going to build your forecasts.
1. Pick a forecasting method suited for your timescales & growth rates
Here is when and why to consider each of the three forecasting methods explained above:
- Straight line: Use this method if you have a predictable and constant growth rate.
- Moving average: Use this method if you need to make regular and recurring forecasts.
- Linear regression: Use this method if you need to compare one or more independent variables with one dependent variable.
Remember, there’s nothing stopping you using more than one of these methods if you want to test out different forecasting models and business scenarios.
2. Assess your financial statements
You don’t know where you’re going until you know where you’ve been. You should have a solid foundation for building your forecasts, if your historical and current operating expenses have been tracked well with your financial management software. This is why your financial statements can tell you a great deal.
Past data gives you the building blocks to set new goals and benchmarks. Key metrics will depend on your industry. They could include your net profit margin, your customer acquisition costs (CAC), and your cost of goods sold (COGs). In down markets, you may want to pay closer attention to metrics like aged receivables, days sales outstanding (DSO), and the dollar value of accounts over 90 days past due.
3. Draw on departments’ data
Department heads will have granular insights into activities within their own section. Draw on their department-level statistical data and their judgment and expertise. And get your best financial planning and analysis (FP&A) person to liaise with them. This will support the forecasting process by making sure any assumptions are built on realities, not guesses or outdated reports.
4. Prepare for best and worst case scenarios
Uncertainty can be like a temperature gauge. Sometimes it runs right to the top of the gauge and other times it sits safely in the mid-zone. This is why you need to weave different assumptions into your forecasting. For example, you could:
- Prepare for interest rate changes, new regulations, or inflation. Changes in any or all of these factors could significantly impact your business.
- Forecast based on positive scenarios such as several major new customer wins, a large funding round, or exponential demand for a new product or feature.
Preparing for the good and the bad will help you see how different scenarios can affect how you manage cash flow, your balance sheet and your net profit margin.
5. Forecast over multiple timescales
This feeds into your best and worst case scenario planning. By updating your forecasts monthly or on a consistent basis , you can check how your ‘actuals’ are tracking against the assumptions in your forecast.
Financial forecasting relies on organized and accurate books
Forecasts are only valid as long as the data and assumptions used to create them remain valid. And as the world has learned recently, no forecast is ever 100% correct. But well-managed books and modern accounting practices can help you create forecasts that are as accurate as possible in our uncertain world.
Simplify accounting and track spend with ease using Ramp
By providing easily accessed real-time spending data, Ramp is helping organizations to keep forecasts current and make strong plans and risk assessments based on well-managed financials.
Discover how Ramp can help you improve expense tracking and bookkeeping, so you can create financial forecasts with reliable actuals.
The term financial forecasting is defined in our Ramp Finance Glossary.