What is Financial Forecasting?

Financial Forecasting is the process of estimating, or predicting a business’s future

performance. With a financial prognosis you try to predict how the business will
look financially in the future.

A financial forecast is a projection or estimation of likely future income or

expenses and revenue, whereas a financial plan lays out the fundamental steps in
generating future income and cover future expenses. On the other hand, a financial
plan can be looked at as what a company or individual or company plans to do
with whatever income or revenue or income is received.

While both these processes plan for financial activity in the future, they are quite
different in nature. A financial plan is a road map that is drafted to be followed
over time, whereas a financial forecast is a projection of estimates of future
outcomes predicted today. A financial plan is a strategic financial approach that
marks a definitive road map to follow into the future while a financial forecast is
an estimate of future outcomes arrived at using one of several methods, which
includes making projections using strategic models.

BASIS FOR
FORECASTING PLANNING
COMPARISON

Meaning Forecasting alludes to Planning is a process of

estimating future looking ahead and
performance of an entity, projecting the future
considering past and course of action for the
current performance and firm and also for various
facts. other units, within it.

Based on Postulations and Relevant information,

assumption, that involves a forecasts and objectives.
certain degree of guess.

Concerned with Estimating future event or Assessing the future and

trend. providing for it.
 BASIS FOR
FORECASTING PLANNING
COMPARISON

Stresses on Facts Facts and expectations

Responsibility Different levels of Top level managers

managers or sometimes
experts are employed by
the management.

Definition of Forecasting
Forecasting is used to mean the analysis and elucidation of a future state,
concerning the operations of the undertaking. It is a process that takes into
account past and present information and facts to anticipate future events.
Simply put, forecasting refers to looking forward and predetermine future
trends and events, along with their impact on the business organization.
Forecasting is performed by managers working at various levels, however,
sometimes experts like analysts, economists and statisticians are
employed by the firm for making forecasts. There are two methods of
forecasting:
On the basis of past and present performance of the firm, revenue can be
estimated as:
YEAR REVENUE

March, 2014 50,00,000

March, 2015 80,00,000

March, 2016 1,25,00,000

March, 2017 2,00,00,000

 YEAR REVENUE

Forecasting (for 2018) 3,00,00,000

Planning (for 2018) 3,50,00,000

Importance financial Forecasting

Financial Forecasting is a tool for entrepreneurs and CEOs to make better business
decisions in a multitude of scenarios. It also helps with:

 Convincing investors to finance a company

 Setting objectives and budgets
When running a company, it’s tempting to only look in the rear mirror by
analyzing financial data from the past. But the result is that questions like the ones
below will remain unanswered:

 How will the future financial situation of my company look?

 How much money can we pay out to shareholders this year?
 How much money can we generate this year to repay debts?
 How long until all debts are repaid?
 What will the organization’s profitability and cash flow look like for the next
six to eighteen months?
 How can we achieve our financial objectives?
When financial forecasting is done correctly by a young business owner, the
following questions may arise:

 Do I understand the business model well enough to make a projections of what

is likely to happen in the coming months or years?
 Are there uncertainties that management will have to address in order to meet
financial smart objectives?
 Does the organisation have a plan to manage risks that might disrupt growth
plans?
 How will the organisation use new opportunities in order to grow and increase
profitability and cash flow?
Methods of Financial Forecasting

 In general, financial forecasts are done in two ways. These are:

1. Quantitative Methods:
a. Pro-forma financial statements
b. Time series analysis
c. Cause effect method

2. Qualitative Methods
a. Expert opinions and vision
b. Reference forecast
c. Delphi method
d. Consumer research
e. Scenario forecast
Quantitative forecasts

Quantitative forecasts use analyses of large quantities of historical data to identify

trends and patterns. Quantitative forecasts are – generally speaking – less
susceptible to skewing than speculative forecasts.

However, if there isn’t much historical data available, the quantitative method
becomes less effective. That’s why quantitative and speculative forecasts are often
used in tandem.

Examples of quantitative forecasting methods are:

Pro-forma financial statements

Pro-forma financial statements mainly use the sales figures and expected costs of
previous years as the basis for making forecasts.

Straight line
A straight-line forecasting method is one of the easiest to implement, requiring
only basic math and providing reasonable estimates for what businesses can
anticipate in future financial scenarios. Straight-line forecasting is commonly used
when a business is assuming revenue growth in the future.
Your business may use its past revenue growth rate as a standard for growth in the
future. If revenues have grown by an average of seven percent over the past three
years, for example, you could assume a similar growth rate for the next three to
five years with the straight-line method.
Of course, many variables will affect not only your revenue growth, but also your
net profits over that period of time. But this method can still be effective when
you’re setting financial goals and budgets, and creating plans for the future based
on where you expect your company to be.

Moving average
A moving average is the average performance of a specific metric over a specific
period of time. Typically, a moving average is used to evaluate on monthly time
frames, rather than yearly time frames. It’s often used to evaluate revenues, profits,
sales growth, stock prices, and other common financial metrics.
A moving average is great for smoothing out performance over time to get a better
understanding of your company’s financial trends. If you’re in an industry where
sales and revenue can fluctuate over time, a three- or five-month moving average
can help you make sense of the peaks and valleys that take place from one month
to the next.
Time series analysis
The time series forecast is a popular quantitative forecasting technique that
involves collecting data during a certain period in order to identify trends. Time
series analyses are one of the simplest ways to use and can be quite accurate,
particularly in the short term.

Time series is an umbrella term representing a few different approaches to

financial forecasting. The strategy behind this forecasting method is to identify
patterns in historical data that will repeat in the future, enabling data-driven
forecasting across a range of financial metrics.
You can use this in cases where performance is expected to be fairly steady. For
example, time series forecasting can use sales and revenue growth from prior
months to estimate performance in the upcoming month. Or, if a straight
translation of these trends isn’t accurate to your business results, you could
embrace a smoothing approach to time series forecasting, using averages of these
numbers to eliminate extremes and forecast a time-bound pattern for performance
into the future.
In cases where seasonal or other trends can affect forecasts, time series forecasting
also allows for historical data to be adjusted based on these trends. If you’re a
retailer experiencing peak sales and revenue in the fourth quarter of every year, for
example, this can be accounted for in time series forecasting.

Cause-effect method
In the Cause-effect method, the forecaster looks for cause-effect relationships of
variables with other variables like changes in disposable income of consumers,
level of consumer confidence, interest rates, unemployment, etc. This method uses
time series from the past for many of the relevant variables based on which the
forecast is created.

Linear regression
Linear regression is a graphical representation of the relationship between two or
more data points. It uses the relationship between x and y variables to chart a trend
line illustrating the relationship between the two.
Sales and profits serve as an easy example. If sales increase, profits are likely to
increase, creating a linear regression that shows a positive correlation between the
two. But if sales increase and profits decrease, it can indicate other problems, such
as rising expenses that are cutting into profits—including, potentially, an increased
cost per conversion that is reducing the value of your company’s sales efforts.
The trend line produced by this linear regression can be used to forecast future
results, supporting better budgeting and helping business leaders make strategic
decisions that improve business performance.

Qualitative forecasts

Speculation is something that’s done based on intuition and experience. The

human mind is able to see connections between events and understand the context
in ways that computers can’t.

However, people are also prone to having certain biases that make it a challenge to
process and analyse large quantities of data. Speculative forecasts are best used in
small businesses with little or no historical data available.
Examples of qualitative forecasting methods are:

Expert opinions and visions

For this method, the opinions and key personnel from departments like production,
sales, procurement, and operations are gathered to arrive at a forecast.

Reference forecasts
This method is about forecasting the outcomes of planned actions based on similar
scenarios from other time periods or places. These forecasts are purely based on
human judgments.

Delphi method
For the Delphi method, a series of questionnaires is created and filled out by a
group of experts, independently from each other. After the results of the first
questionnaire have been collected, a second one is created based on the results of
the first.
The second document is again presented to the experts who are then asked to re-
evaluate the answers they gave in the first questionnaire. This process will be
repeated until the researchers arrive at a shared list of widely held opinions.

Consumer research
Companies often conduct market research among consumers. Data is collected via,
for instance, phone calls, interviews, questionnaires, or sample tests. The enormous
amount of information that is yielded by this is subjected to analyses in order to
generate forecasts.

Scenario forecasts
In this method, the forecaster generates various results based on the outcomes of
different scenarios. The management team has final say about which is the most
likely outcome of the many scenarios.