Financial forecasting models: 4 methods to consider
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Originally Posted On: https://quickbooks.intuit.com/r/running-a-business/how-to-create-financial-projections-for-your-startup/
Alongside accounting basics, understanding the different financial forecasting models and how to implement the model that’s right for your startup’s business plan is absolutely essential.
Neither is particularly exciting—yet to grow and scale, you’ll need capital. In fact, 36% of people who plan to start a business in the next year identified “getting funding” as one of their top financial priorities, according to a recent QuickBooks survey.
For external funding, financial projections help convince lenders and investors that your business will not only be profitable but will also offer them a return on investment. For internal purposes, accurate forecasting enables you to budget for your new business as well as benchmark your milestones.
Review: What is financial forecasting?
Financial forecasting (sometimes also known as financial projections), is basically a metric of future profits and expenses taken from historical company data and/or estimates. It is important for a number of reasons, such as:
- Pitching to investors for a cash investment based on your future sales and revenue
- Creating budgets and maintaining cash flow for the coming term
- Approaching a financial institution for an investment based on your projection of future cash flows
- Informing stakeholders of the future of the company and possibilities on the horizon
Qualitative vs. quantitative financial forecasting
There are different methods of forecasting that your company can utilize, each with unique nuances that can help create a visual for your financial future.
Quantitative financial forecasting (also known as statistical forecasting) is using hard data such as statistics, facts, and historical numbers to form opinions about the future. For example, using last year’s sales to form a prediction about this year’s sales in the same quarter, not taking into account outside predictions, such as market opinions.
Qualitative financial forecasting is a bit more complex. Instead of just using hard data to form a prediction, researchers might also include soft data. For example, a qualitative forecast could include, opinions or estimates and more intangible factors rather than numbers
4 types of financial forecasting
Along with qualitative and quantitative forecasting methods, there are also different types of financial forecasts you can use. Most of them are similar in that they all form predictions—the main difference is the type of predictions and approach used to come to a conclusive estimate.
1. Sales forecast
A sales forecast can project your sales for at least three fiscal years, including monthly sales for the first year, then quarterly for the following two years. This type of forecast answers questions such as:
- How many customers can you expect?
- How many units will be sold?
- What is the cost of goods sold?
- How will you price your products?
Sales projections can forecast revenue. And when the cost of goods sold is also taken into account, gross profit can be estimated for each of those years.
After accounting for all of your operating costs, subtract this from your gross profit to calculate your actual profit—otherwise known as net income (or profit). Operating expenses can be calculated based on your expense budget.
2. Expense forecast
Operating expenses are any expenses that businesses incur from performing their normal business operations. These include both fixed costs (like rent for your physical location) and variable costs (like marketing expenses). You don’t need to do an incredibly detailed breakdown, such as listing the cost of every office chair, but you do need general figures. This allows you to:
- Plan for upcoming short-term and long-term expenses based on previous years or quarters
- Prepare for unexpected expenses that could possibly occur
- See which expenses only occur periodically, such as subscriptions
- Plan for increased expenses based on operations and projected output
3. Top-down forecast
Top-down forecasting involves taking the market outlook as a whole to project future estimates of the company. This way, you’ll start with a big picture and slowly work your way down to produce a view of the company based on various components.
For example, if you sell car parts, you would:
- Look at the market of car sales as a whole
- Narrow it down to used cars vs. new cars
- Narrow down further to make and model until you get to the parts your service and produce.
This approach is most commonly used for newer companies with little historical data to go off of.
4. Bottom-up forecast
A bottom-up approach works in the exact opposite fashion. Instead of starting with a big picture and working down, you simply reverse.
- Start with the product or service you provide
- Work your way up to view the market of your product or service as a whole
This is a much more involved process than top-down because it uses historical data of the company to make assumptions on achieving certain objectives for the upcoming term. Taking and organizing the historical data of a company can pose an extra step but one well worth the time and effort.
Limitations and benefits of financial forecasting
There is something good and bad to be said about projecting the future financial health of a company. Here are some of the limitations and benefits you should be aware of:
- Is not a completely accurate portrayal of future sales and revenue
- Doesn’t account for market shifts and outside data, like shortages
- Is a baseline prediction and thus could be over or under the outcome projected
- Allows for a general estimate of the financial performance of the company in the coming quarter(s)
- Gives CFOs a baseline to draw conclusions from
- Eliminates blind decision-making for financial analysts
Financial forecasting tips to remember
It can be a challenge for any entrepreneur to create financial forecasts when your business is not yet running on its own. In this case, you do not have any historical data to give you a better sense of future projections. However, with a little market and industry research, you’ll actually have some solid data to work with to help you create a realistic prediction. Here are some tactics to consider:
- User your own industry experience
- Work with an accountant who knows your industry
- Do market research to develop a sustainable business model
1. Use your own industry experience
You may have worked at a similar business within the same industry before branching out on your own. In this case, you might have an idea of what realistic financial projections look like, how long it will take to scale, what growth rate is ideal, and what profit margins are normal within your industry.
2. Work with an accountant who knows your industry
An accountant who is familiar with your industry will know the average expenses, sales, and profits a well-run business can expect. They will likely be able to help you come up with realistic financial projections for your business.
3. Do market research to develop a sustainable business model
Industry associations and publications can help you compile accurate financial data. Look at publicly available information such as Census.gov to better understand your target audience. Find assistance from small business advisors and mentors through SCORE or your local Small Business Development Center (SBDC).
You can also find industry data at BizStats and BizMiner, and you can find sample financial projections at Bplans.
Be optimistic but realistic
Investors and lenders know that your startup’s financial analysis isn’t set in stone, but you do need to make sure it’s realistic. Lending institutions and investors have seen too many entrepreneurs who are overly optimistic about their own businesses.
As a small business owner, your figures will be scrutinized by banks and investors to ensure your business has legitimate potential to grow.
Finally, understand the types of financing you’re seeking with your financial projections. Investors are more willing to take risks, as long as you can prove your proposal is backed by hard data. Lenders, however, are more cautious. They don’t need your business to be the next Google, so long as you are able to pay back the business loan on time.
With QuickBooks services, you can carefully gather information and strike a balance between optimism and realism. Create financial projections that not only guide your business planning but can help you obtain the right type of financing as you grow.
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