Why financial forecasting doesn't always work
Accounting Manager Lisa Kennedy on the potential pitfalls involved in financial forecasting
Financial forecasting, which is a fancier term for budgeting, can be a useful tool for businesses. It is a process that involves using historic data and estimates to determine inflows and allocations of resources over a period of time in the future. Practically speaking, a financial forecast provides information that enables business owners or managers to identify potential risks and cash shortfalls, provides a benchmark against which future performance can be measured, and assesses the financial viability of a new business venture.
However, there are many cases where the benefits of financial forecasting aren't achieved. Be sure to follow these tips so that you, and your business, get the most out of your financial forecast.
1. Identify the type of forecast you need
Before you begin developing a budget, you should understand why you need one and what outcome you want to achieve. Sometimes financial forecasts are required by third parties, such as lenders and investors, who want to see a full set of future-oriented financial statements (balance sheet, income statement, cash flow statement). In other instances, internal forecasts are prepared by business owners to focus on one specific area - in most cases, to determine whether they have sufficient cash funds to cover planned expenditures. Forecasts can be prepared using any time period including monthly, quarterly and annually, so you will have to decide which option will address your needs and goals.
2. Be realistic
Business owners have a vested interest in their company and its products and services. This can sometimes mean they are likely to overestimate future sales, especially for a new product where historical data doesn't exist. For this reason it is important to take a step back and develop realistic expectations. Industry trends and market statistics should be researched and will help provide you with reasonable expectations for inputs such as selling price, number of units sold, and expected growth. A sensitivity analysis will allow you to see how the forecast will change as a result of increasing or decreasing various outputs and is helpful if you want to see the outcome under different scenarios.
3. Support your estimates
All too often, people do not conduct enough research or have enough support to substantiate their estimates for expenditures. Since the purpose of a financial forecast is to predict future results, it is important to be as accurate as possible when estimating expenditires. Use historical data, obtain quotes from third parties and discuss costs with others who operate in your industry or may be able to give you additional information. It can require more work upfront, but well-supported figures will ensure a more relevant and reliable forecast.
4. Review and update
Things change, and so should your forecast! Once you've prepared your working document, it shouldn't be filed away in the back of the cabinet. By comparing actual results to the forecast, you are able to see how you performed. Were you able to reach your sales target? Perhaps a significant expenditure was missing from the original forecast. Did you make money in one area and lose money in another? This analysis may lead to revisions in the forecast and will also provide you with information to make better business decisions going forward.
If you would like more detailed information about financial forecasting and how it can help your business or organization, feel free to send me an email: firstname.lastname@example.org