Financial Forecasting: How to Prepare Your Budget

Forecasting is a valuable, sometimes overlooked, part of small business ownership. Business forecasting helps small business owners predict growth and identify where to tighten up expenses or work to expand sales.

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What is Financial Forecasting?

According to Investopedia, forecasting is the use of historical data to determine the direction of future trends. If you’ve ever reviewed the previous month’s revenue to predict how much you’ll make the next month, then you’ve already started forecasting.

Forecasting can show how to allocate your budget or plan for anticipated expenses for an upcoming period of time.

Why is Financial Forecasting Important?

Forecasting can be a great tool for many business functions including:

  • Helps manage the company finances
  • Helps estimate the future revenue (or loss)
  • Helps in the decision-making process
  • Forecasting expenses
  • Inventory reordering
  • New product performance
  • Evaluating recent marketing efforts

Financial Forecasting vs. Budgeting

Although you’ll often see the terms “financial forecasting” and “budgeting” conflated, they’re not quite the same. Financial forecasting should precede budgeting since forecasting predicts future business profit or loss, and the expectations you define will guide your budget.

Only once you’ve finalized your financial forecast for a given period should you start budgeting, which is the process of allocating certain amounts of money to certain departments. For example, if you forecast $25,000 in revenue during Q1, you can budget $5,000 for one expense, $10,000 for another, and $10,000 for yet another. You can assign different budget amounts than these as long as your numbers add up to $25,000.

Learn more about budgeting via the SmartBiz Small Business Blog: How to Make a Business Budget.

How Forecasting Can Help Manage Your Budget

Cash budgeting is a process of predicting cash inflows and allocating cash outflows for a specific time period. Cash budgeting relies heavily on accurate cash flow forecasts.

Up-to-date forecasts help you know when you can estimate cash will come in and go out, expected sales and expected profit. One of the main reasons small businesses fail is because they run out of money to spend on their costs. Forecasting correctly can help prevent this.

Select Forecasting Method

There are a number of different methods by which a business forecast can be made. All the methods fall into one of two overarching approaches: qualitative and quantitative. An easy-to-understand article outlining these approaches can be found on Investopedia here.

Three basic models of forecasting to consider are outlined here. A short summary of each is below.

  • Extrapolation - Extrapolation uses historical revenue data to predict future behavior by projecting the trend forward. The time-series method is a popular quantitative forecasting technique, in which data is gathered over a period of time to identify trends.
  • Regression/Econometrics - Regression analysis is a statistical procedure based on the relationship between independent variables (factors that have predictive power for the revenue or expenditure source) and a dependent variable (expenditure source being predicted).
  • Hybrid Forecasting - Hybrid forecasting combines knowledge-based forecasting, rather than data and statistics, as the basis for the forecast. Hybrid forecasting methods are very common in practice and can deliver accurate results.

Three Steps to Creating Your Financial Forecast

To successfully use any of the above methods to create your financial forecast, you’ll need to take the following steps:

  • Look at your financial statements. An accurate financial forecast uses your company’s historical data to estimate its future performance. That’s why you’ll need your financial statements on hand to develop an accurate forecast. If you’re a brand-new business owner whose company is too young to have financial statements, you should wait until you have enough data to create statements before you start forecasting.
  • Look at market trends. Market trends will always affect your company’s ability to meet its previous revenue levels, so market research can be just as important to your forecasts as is your previous performance. You should incorporate more market research than historical data if you’re presenting your forecast externally, and for internal use, you can learn more on historical data.
  • Create pro forma statements. Lastly, you’ll use historical data and market trends to create pro forma statements. In these data tables, your previous period’s finances will comprise the leftmost columns, and your next several periods’ predictions will comprise the remainder. With pro forma income statements, cash flow statements, and balance sheets, your financial forecast is essentially complete.

Getting Started

To get started, gather the elements you’ll need to build your forecast. Start by reviewing your company balance sheet that reports assets and liabilities at a specific point in time. Put together a list of last year's expenses along with the expected cost of proposed projects and promotions for the next year.

Once you have those numbers, follow these guidelines from the bizfluent blog:

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What Can Impact Your Forecast

When you’re forecasting, it’s important to consider factors that can impact your numbers. These include:

  • State of the Economy and Industry – In a growing economy, consumers will be more likely to buy your products or services. Keep in mind that the local economy may have more of an effect than the national economy. For example, if you offer home improvement services where the housing market is strong, you’ll be in better shape than in a city with falling prices. Look at what financial experts predict locally and nationally when you’re preparing your forecast.
  • Your Competition - Keep an eye on the competition. New businesses in your industry could decrease sales and require a beefed up marketing strategy. Current competitors who increase inventory or advertising could also impact your business negatively.
  • Technology - Failure to adapt can cripple your business. Are your computer systems up to date? Do you have the most advanced payment and fulfillment processes on your website? Being vulnerable to computer hackers and viruses can put your customer’s information at risk. If this isn’t in your wheelhouse, consider hiring a contractor to do a technology audit and suggest how you can get up to speed and protect your online assets.
  • Seasonality - Does your business have seasonal cycles? For example, some businesses move more inventory and have more income during the holiday season. A landscaping business might have a great summer but a not-so-great winter. Looking at your income statement can help you identify the cycles.

Keep in mind that forecasting is not an exact science. If you keep your forecasts up to date, you’ll be more likely to be prepared if something unexpected happens.

Ways to Improve Your Budgeting & Forecasting

To improve your budgeting and forecasting practices, keep the below tips in mind:

  • Don’t be afraid to switch things up . Since forecasts are by their very definition guesses, no budget is perfect. That’s why you should build variance into your budget. If new sales or market data suggests a need to tweak your budget, you shouldn’t hesitate to do so, as no prediction will ever be 100% accurate.
  • Don’t give potential opportunities too much weight . Although working to increase your sales is important when devising a budget, planning for new business opportunities not guaranteed to happen can lead to an unrealistic budget. Instead, build your budget based on your usual activities. You should still pursue new opportunities, but don’t incorporate them into your budget until you have financial statements that reflect them.
  • Get input from all your departments . Although you, the business owner, have the final say on your company’s budget, your budget will falter if it doesn’t meet your departments’ needs. For example, if you predict $25,000 in revenue and allocate $2,000 to sales when your sales head needs $5,000, then you’ve potentially stunted your company’s growth. By getting your sales head’s input, you could have avoided this problem.
  • Know why you’re forecasting . If you’re forecasting just to forecast, then your predictions may prove less meaningful. However, if you’re looking to drive sales so you can finally make that big equipment purchase you’ve been hoping for, your financial forecast may be more useful. Your forecast’s sales projections can help you estimate when you’ll have the money for your purchase, which can boost sales in the long run.
  • Don’t skimp on the details . Even your smallest business expenses should factor into your financial forecast. For example, although your $2,000 rent is significantly more expensive than your $100 monthly gas bill, the latter is still an expense. Likewise, your forecast should incorporate the revenue and cost ramifications of any likely major business moves such as mergers or new locations. In forecasting, everything counts.

Resources

You don’t have to go it alone during the forecasting process. Check out this list from Capterra to find software that can help: Top Sales Forecasting Software Products.

There are also a number of books that address this subject in-depth. Sales and Market Forecasting for Entrepreneurs from business expert Tim Berry is a comprehensive, easy-to-understand guide.

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