Financial Forecast vs Projections
Planning for the future of your business might sound like a challenge, but it’s essential to understand and track your business’s performance. Every smart business strategy begins with understanding where you are now and where you could be heading. This is where financial forecasts and projections offer a detailed analysis of your business’s short and long-term financial health, helping you navigate upcoming challenges and opportunities. The distinction between financial forecasts and projections is clearly outlined by the American Institute of Certified Public Accountants (AICPA), in the AICPA Attestation Standards, Section 301, Financial Forecasts and Projections. The institution defines the two terms as follows:
A financial forecast is a prospective financial statement that presents a business’s expected financial position, results of operations, and cash flows, to the best of the responsible party’s knowledge and belief. These are based on assumptions reflecting conditions the responsible party expects to exist and the actions it anticipates taking. Essentially, it’s what your company expects to happen under normal circumstances, guiding your strategy with informed predictions.
Financial projections, on the other hand, deal with the “What would happen if” of your business scenario. Also outlined by the AICPA, financial projections present a business’s expected financial position, results of operations, and cash flows, to the best of the responsible party’s knowledge and belief, based on one or more hypothetical scenarios, showing how your business might perform if certain conditions occur. This tool is invaluable for strategic planning, risk management, and preparing for various business contingencies. Unlike forecasts, projections are not necessarily about what you expect to happen, but what could happen in a different scenario and the course of action that a business expects would be taken.
How to Create a Financial Forecast
Building a financial forecast is an essential exercise in planning for your business’s short and long-term future, ensuring you’re prepared for the road bumps ahead. Here’s how you can create a robust financial forecast:
1. Define the Reason
Start by identifying the specific objectives and goals you have behind creating the forecast. Are you looking to attract investors, optimize operations, improve your budgeting process, plan for expansion, secure loans, etc.? Clarifying the purpose will guide the level of detail and focus required in your forecast.
2. Collect Historical Data and Financial Statements
Gather as many historical financial statements and data as possible, including income statements, balance sheets, and cash flow statements from past years. This historical data will serve as the basis for projecting future financial outcomes.
3. Choose a Time Frame
Decide on the time frame for your forecast. Most businesses perform a five-year forecast to provide a long-term outlook, but shorter cycles, like annual or quarterly forecasts, may be more appropriate depending on your short-term goals.
4. Choose a Forecasting Method
Primarily there are two types of financial forecasting methods and selecting the method that best suits your needs is critical for achieving accurate and actionable insights.
Quantitative Forecasting or Historical Forecasting: This method uses historical data to predict future outcomes and identify trends. It’s most effective when you have a lot of data that shows clear patterns and past trends of your historical performance. The advantage of this approach is that it is straightforward, cost-effective, and does not require extensive expertise. However, it’s limited in the fact that it focuses solely on internal business data, neglecting broader market dynamics and competitors.
Qualitative Forecasting or Research-Based Forecasting: This approach involves utilizing expert opinions, market research, and industry trends to build a forecast about broader market conditions. The advantage of qualitative or research-based forecasting is that it offers a comprehensive and detailed perspective on potential business growth, incorporating broader market and economic conditions. However, this method can be costly, often requiring the expertise of external consultants and researchers.
5. Analyze New Data and Monitor Results
Once your forecast is in place, continuously track real-world results and compare them to your projections. This ongoing analysis helps you see how well your business is adhering to its financial plan and allows you to adjust your forecasts in response to unforeseen financial conditions or market shifts.
By following these steps, you can create a financial forecast that effectively predicts your business’s financial health and provides you with insights to steer your enterprise toward sustainable growth and success.
How to Create a Financial Projection
Developing a financial projection is vital for understanding potential future conditions and preparing strategic responses. Here’s how to effectively create a financial projection:
1. Define the Reason
Clarify why you are creating a projection. Is it for strategic planning, risk management, investor communications, financing applications, etc.? Identifying the purpose will help tailor your projections to address specific business needs or questions.
2. Collect Historical Data and Market Conditions
Gather any relevant financial information, including historical income statements, balance sheets, and cash flow statements. This data provides a historical perspective that is crucial for predicting future financial conditions accurately.
3. Choose a Time Frame
Select an appropriate time frame for your projections. This could range from a few months to several years, depending on the strategic decisions at hand. Typically, a one to three-year period is common for most business projections.
4. Create Pro Forma Financial Statements
Once you know the purpose of your projection, you’ve collected the historical information you need, and you have picked a specific period, you’re ready to create pro forma financial statements. There are three types of pro forma financial statements which are a pro forma income statement, a pro forma cash flow statement, and a pro forma balance sheet. The choice of which ones to create is dependent on your specific financial goals and the insights you need to obtain. Each type of statement uses historical data from past financial statements to estimate future financial outcomes by projecting the values for a corresponding future period. By analyzing past performance and anticipated changes in operations or market conditions, these pro forma statements provide a comprehensive view of your business’s potential financial trajectory, enabling better decision-making and financial readiness.
5. Analyze New Data and Monitor Results
As new real-world data becomes available, record and compare it against your projections. This monitoring helps track the accuracy of your projections and provides insight into whether your business strategies need adjustment to align with business goals or respond to market changes.
By following these steps, you can build detailed financial projections that help you plan for future financial conditions and drive your business toward its strategic goals.
When To Use Financial Forecasts and Projections
Regularly creating and updating forecasts and projections is a practice that can significantly enhance your business’s strategic agility and financial health. While the frequency can vary, we suggest revisiting financial forecasts and projections at least once a quarter or annually. This helps keep your business aligned with both internal goals and external market conditions.
By understanding when and how to effectively utilize financial forecasts and projections, you can better equip your business to respond to market changes, adjust strategies, and communicate necessary adjustments to stakeholders and decision-makers within your organization.
Building Financial Forecasts and Projections with Cathcap
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