Finance and Accounting

A quick guide to financial forecasting

In business development, the past and the present are indicators of what the future may look like. Leaders and CFOs need to keep an eye on the future of their business and here’s where reliable financial forecasting becomes crucial to driving business growth. Without it, you are just flying blind with no navigational support.

What is financial forecasting?

Financial forecasting involves forecasting or projecting the future performance of a business. Although it may sound similar to fortune telling using a crystal ball, financial forecasting is a well-defined method that organisations use to anticipate future revenues, costs, and cash flows using past data, external market conditions, and economic factors to simulate future scenarios.

The benefits of financial forecasting

Financial forecasting helps businesses in understand where they are headed as well as in strategising measures for growth. Financial planning and forecasting work together — the insights from forecasting help businesses in building accurate strategies for budgeting, cash flows, and other financials during a fiscal period. Moreover, mitigating risks and setting realistic goals with the help of forecasting help businesses avoid overspending and diverting capital on uncertain investments.

Financial forecasting helps in identifying problem areas through data analysis. Finally, regular financial forecasting benefits the image of the company. It also provides investors with an insight into the business goals and potential returns on their investments. Mergers and acquisitions also demand financial forecasts to assess the future of the company.

Financial forecasting methods

Financial forecasting involves using pro forma or forecasting financial statements that form the basis of further analysis. These projections are based on both internal and external assumptions. The three important pro forma statements are:

• Income statement:

  It shows the profit or loss over a period. Financial projections show how various variables may affect income, cost of goods sold, and other factors impacting the bottom line.

• Cash flow statement:

  It shows the possible amount of cash coming in and going out in the future. Income statement and balance sheet forecasts help determine the future cash status, which is critical to running a business.

• Pro forma balance sheet:

  It shows the company’s position at a point in time. Through projections of debtors, creditors, cash collections, and other aspects, the pro forma balance sheet shows what the position of the business will be in the future.

Financial forecasting methods are classified into two types:

• Quantitative
• Qualitative

Quantitative forecasting methods produce accurate forecasts with numbers and past business data.

• The percent of sales method uses historical data, which is expressed as a percentage of sales, such as profit or cost of goods sold, and applies the same growth rate for other future financial metrics.
• The straight line method posits that the business’ historical growth rate will remain constant. Forecasting future revenue entails multiplying a company's sales from the previous year by its growth rate. However, it does not account for market fluctuations or other factors that may affect growth rate.
• The moving average method is more granular and involves considering the highs and lows of historical data and taking the weighted average of previous years to forecast the future. This method is beneficial for short-term forecasting.
• Simple linear regression shows the relationship between two variables: one dependent and another independent. The dependent variable provides the forecast amount, while the independent variable is the factor that affects the dependent variable.
• Multiple linear regression works when more than one factor affects business performance. For this method to show accurate results, one dependent and other independent variables must have a linear correlation. Moreover, the independent variables should not be closely related to make it easier to identify the factor that affects the forecast variable.

Qualitative forecasting is more subjective but provides deeper insight into factors that can’t be predicted using historical data.

• Delphi method involves getting expert advice on subjective matters such as market conditions, usually with the help of a questionnaire. When the opinions are collated and reviewed, second or multiple rounds of consultations occur with another set of experts until there is a consensus.
• Market research is essential for organisational planning and especially helpful when there is no historical data, such as for start-ups. It gives a comprehensive view of the market based on competition, market fluctuations, customer behaviour, and other external factors affecting the industry.

Financial forecasting versus financial modelling

Often confused with each other, financial forecasting and modelling are two different activities carried out by a business with the same goals of knowing the future of business growth. If financial forecasting is the ‘why’ of financial planning, then financial modelling is the ‘how.’ It involves creating models of probable scenarios and looking at how financial metrics will perform under hypothetical circumstances. Businesses use different forecasting models such as top-down, bottom-up, Delphi, correlation-based, statistical, and asset and liability management.

A quick guide to financial forecasting

• Define the purpose of the financial forecast as it helps to determine the metrics and factors to consider while carrying out the forecast. The goals could range from estimating revenue to understanding how a merger might affect the bottom line.
• Gather accurate historical data such as revenue, losses, liabilities, investments, equity, expenses, fixed costs, and other numbers relevant to the forecast.
• Choose a time frame for the forecast. Financial forecasts typically show greater accuracy in the short term than in the long run. Usually, businesses carry out projections for one fiscal year.
• Select a forecasting method based on the purpose and available data.
• Monitor the results to understand how financial forecasting has reflected the latest developments and document the changes and deviations to understand the factors causing the changes.
• Analyse the data to know if the forecasts have been accurate. Continuous financial management assists in understanding the current performance and preparing the following year’s financial forecasting.
• Repeat the process according to the decided time frame. It helps in collecting, recording, and analysing data for accurate financial forecasting in the future and staying in control of your business.

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How can Infosys BPM help?

Financial forecasting and modelling can be a tedious yet sensitive process that requires in-depth expertise and accuracy. The simplified end-to-end digital finance solutions of Infosys BPM improve the accuracy of F&A processes and metrics through automation, AI/RPA and data analytics. The comprehensive solutions help clients align and enhance their enterprise capabilities with scalable finance technology.