Financial terminology can easily confuse anyone. In a field that requires precision, the last thing you want or need is confusion, especially when it comes to business. For this reason, we have provided a guide to financial forecasting terminology.
Understanding how to analyze and chart your company’s future performance represents an integral part of financial and business planning. Knowing the terminology helps to provide a sound foundation from which to learn and understand more.
Financial Forecast Defined
A company’s financial forecast predicts what the business’s numbers will look like in the short term, often a year or less. Financial forecasts have multiple purposes, depending on the intended audience.
In some cases, a company might prepare a financial forecast for external consumption. Often businesses need to create these when reaching out to obtain needed capital. Whether they seek funding from investors or through a loan, financial forecasts come in handy. When you need to prove to others that your company will remain profitable, you would use a financial forecast.
Financial forecasts can also serve internal purposes. If reliable and backed by substantial evidence, they can provide valuable assistance in making informed decisions. Forecasts that show continued strength can serve as a reason to invest more company resources. Those with less than positive forecasts help to urge caution on spending and structural decisions.
Elements of a Financial Forecast
Financial forecasts often require the inclusion of three types of pro forma statements.
Pro forma financial statements serve as financial reports issued by an organization or even an individual. Often they use hypothetical conditions or educated assumptions about the future. Most often, an organization will use pro forma statements to present a picture of its finances to outsiders, such as investors.
There are several types of pro forma statements, including, but not limited to:
- Full-year pro forma projections, which include year-to-date results and financial projections of what the organization will look like at year’s end
- Investment pro forma projections focus on elements of company finances that would inform an investor on whether or not the company would be worth engaging
- Some pro forma statements emphasize risk analysis, projecting the results of potential decisions based upon financial, market, and other data
Pro forma statements, since they come from the organization itself, will tend to focus on information that puts the company in a positive or optimistic light. Generally, investors and others take pro forma reports with a grain of salt unless the company has a strong reputation for transparency.
The pro forma reports that help to compose a financial forecast will have to include information on important aspects of the business’s finances. They will include income statements, cash flow statements, and the balance sheet. These reports may cover different time spans as well, so an overall narrative may need to link them together.
To create the building blocks of your financial forecast, you will need to bring together information to start crafting pro forma statements and other reports that the forecast will incorporate.
The first step in charting out the future lies in researching the past. Assemble financial statements from the past several years and start analyzing them. Find developments that produced impacts while also searching for any relevant trends. Where your business has been will give strong indications of where it is going. These will help to provide evidence to back up projections of income, cash flow, and your overall financial stability.
Next, you must determine your methodology for how to put together and present the projections that form the meat and potatoes of a financial forecast. You will also need to determine how to assemble and use your pro forma statements.
Historical Versus Research-Based Financial Forecasting
Almost every financial forecast contains elements of research and historical based predictions. Most will rely more heavily on one than the other.
Historical-based financial forecasting is relatively easier to accomplish. It draws almost all information from sources that should be easily accessible. The information that you will draw from these will chart out for readers how your company has grown and developed. For example, if your company has grown consistently for three years, you can predict future growth, assuming that important variables remain unchanged, such as the market and company resources.
Companies usually use historical financial forecasting for internal use. It rarely draws on outside sources to build context from the market, changing government regulations, or other areas. External stakeholders, such as investors, will demand more information before acting on a financial forecast such as this.
Research-based financial forecasting involves much more than extrapolating potential future performance from one’s own paperwork. Since these types of forecasts are mostly produced for external consumption, they must reflect a more in-depth approach.
Research-based forecasts use information from at least a decade about not only company performance, but also contextual information, such as market conditions. Research-based forecasting also includes information about your competition and how it reacted to the same external conditions and stimuli. Companies that have not been around very long will rely more heavily on contextual info rather than their own company’s information.
Difference Between a Financial Forecast and the Budget
Although both terms refer to reports on how a business uses money, the budget represents a different kind of report than a financial forecast.
A budget serves as the organization’s plan on how it will spend money in the fiscal year. It works off of revenues already accumulated or those that the organization knows will be in place when the time comes to spend.
Budgets include, but are not limited to, the following elements:
- Estimates of both revenues and expenses
- Anticipated cash flows
- Anticipated reduction of debt, if any
- Revenue and spending goals for the year
Most of the time, budgets cover an entire fiscal year. In some cases, however, an organization may need to incorporate flexibility into the process, amending as conditions change.
Budgets should rarely, if ever, work off of assumptions or guesses.
This does not mean there is no relationship between a budget and a financial forecast. In fact, the two can feed off of each other for greater clarity. Should a trusted financial forecast, for example, reveal an upcoming windfall, the chief financial officer can amend the budget and allow for the funds to be spent.
Difference Between Financial Forecast and Sales Projections
Sales projections, like budgets, have purposes and information that overlap that of a financial forecast but also serve different purposes.
A sales projection simply indicates the amount of revenue that the company expects to generate through sales in a given period. It focuses mostly on external factors, such as market trends and the competition. Sales projections serve as a strong indicator of a company’s health.
They can form an important part of the supporting information for financial forecasts, but by themselves, they cannot replace the more comprehensive, big-picture look.
A sales projection’s primary purpose, however, lies in helping companies to make crucial decisions about:
- Inventory management
- Supply chain needs
- Sales Planning
Financial Forecast Versus Financial Projections
Financial forecasts and financial projections have similar and overlapping functions, but different purposes. While some financial projections cover a year, most try to describe conditions expected to develop over the long term.
One of the key differences between a financial forecast and a financial projection lies in scope. A financial forecast aims to predict likely events during a given period. Financial projections, however, expand from this to include any number of hypothetical scenarios, which can enhance a company’s ability to plan for the future.
Financial projections come in two forms. A short-term financial projection covers the first year of business and chart expectations month to month. Mid-term projections cover three years and are broken down by year.
Financial projections also serve another essential purpose. They require your team to stand back and take a look at the business’s performance from an objective point of view. Financial projections also give your team the chance to creatively explore the potential opportunities and consequences of pursuing or ignoring certain decisions.
What a Financial Projection Template Is and Why You Should Use One
A financial projection template helps your company break down the numbers researched and analyzed into an easy-to-understand format. It includes all pertinent information placed onto a spreadsheet.
A financial projection template has several different components, each important to the task of providing a comprehensive picture of where the company expects to be in the future.
Payroll in the Current Year
The financial projection should prioritize a business’s most important, and often most expensive, overhead. This section should break down each component, including part-time, full-time, and contract employees. It should also break down salary, taxes, FICA, insurance, and other components.
Once you have completed the more difficult task of creating the payroll template with the current year, you can create forecasts for upcoming years. If done right, you can input numbers, and the program will automatically perform the math for you.
Your financial projection should include expected numbers on sales this year. In the current sales year template, input the unit sales price, number of units sold, and per-unit costs. Once entered into the spreadsheet, the numbers will automatically calculate. When you create your sales forecast for beyond this year, it will also populate automatically as with payroll.
As with sales and payroll, input the key terms and numbers. When the operating expenses spreadsheet is completed, you should be able to easily get figures for the future.
Link to values in the sales worksheets and operating expense forms to calculate income for this year and forecast into the future.
Balance Sheet for the Current Year
The current year balance sheet features two main sections. These are the balance sheet and the supporting sections. You will manually input such items as accounts receivable, inventory, accounts payable, and retained earnings. Cash, property and equipment, and long-term debt will link to other parts of the template.
Balance Sheet Forecast
You assemble the balance sheet forecast section by taking the template created by the current year and calculate the following years’ assumptions. These will come from inputs such as accounts receivable days, inventory days, accounts payable days, and capital expenditures.
Cash Flow Statements Both Current and Forecast
Cash flow statements for the current and forecast sections use amounts calculated in the income statement, balance sheets, and supporting schedules. The closing cash balance will always link back to the balance sheet. Cash will show under the heading of “current assets.”
Financial Ratio Analysis
The final section of the financial projection template lies in the financial ratio analysis. This will include all of the commonly used financial ratios.
These include profitability ratios, efficiency ratios, liquidity ratios, leverage ratios, and coverage ratios. Previous worksheets will help to build these numbers automatically.
Numbers from this section indicate the health and stability of the company currently and as projections into the future.
What a Financial Projection Template Can Do for You
The financial projection works to ensure that your company has a thorough, organized, and easily communicated report on its current state.
A new business can use a projection to get the best possible assessment of initial performance. The owner or leadership team will get a better picture of what went right, what went wrong, and what needs improvement.
Established businesses can use them to attract investors or other stakeholders to offer support.
They also serve as a benchmark and a record for the future. Their accuracy or lack thereof can serve as a tool to guide better recordkeeping, decision making, and other processes going forward.
If projections consistently fall behind, they serve as a prime indicator that your business needs to adopt structural or other changes. Businesses consistently outperforming expectations indicate that you may need to hire more people, expand production, or engage in some other type of growth.
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