Planning is an ongoing process; each day, business owners develop and revise both short- and long-term plans. Short-term plans are tactical and aim to respond to routine operational challenges and opportunities. In contrast, long-term plans are more strategic, involving decisions such as whether to expand operations, buy new equipment, or hire additional staff, all of which can significantly impact the company’s financial health. Financial forecasting often plays a crucial role in enabling informed business decisions.
At the simplest level, financial forecasting is based on assumptions and estimates. Sales forecasts, production forecasts, and cash flow forecasts are among the most commonly used financial planning tools. The goal is simple: by analyzing historical data (if available) conducting market research, and making a few key assumptions, financial forecasting is used to create plans for the business’s future.
The Importance of Assumptions
While data is important, typically, "the more data the better" applies to financial forecasting, making some assumptions is required. Since no one can predict the future, the models created rely on assumptions about what may happen: whether sales will increase or decrease and by what percentage; whether labor, materials, costs, etc., will increase or decrease and by what percentage; whether interest rates and the availability of capital will fluctuate, etc.
Assumptions are in effect educated, informed, and hopefully directionally accurate "guesstimates". Many companies create financial forecasts by incorporating various assumptions, considering different levels of projected results. For example, a sales forecast could be built showing a growth in sales of 5%, 10%, 20%, or even reduced sales of -5% or -10%. The key is to model different scenarios and gauge the potential impact on operations and on financial performance − assumptions are a necessary part of building those models.
While existing businesses can rely on historical data that can, in part, indicate future results, new or start-up companies are forced to make a number of assumptions. That’s why a comprehensive business plan based on a broad range of financial models is so critical.
The most basic assumption is usually future sales.
Sales Forecast
Sales fuel a business − without sales, there is no business. The sales forecast aims to predict future sales so that other operational needs, like production planning, can be set accordingly. To estimate sales, most companies analyze sales histories and other known factors that may influence future performance. For instance, market research might reveal that several competitors have exited the marketplace, creating opportunities for increased sales. Conversely, the company may choose to discontinue an underperforming product line, which could cause sales to decline, at least in the short term.
After data is collected and analyzed, sales volume is predicted. Often, companies also include projected price levels in the sales forecast, as price has a dramatic effect on profitability. Most companies develop several sales forecasts based on incremental changes in anticipated sales. A "target" sales figure is used to drive most other models, but plus/minus sales figures can also be used to model the effect on operations. For example, a projected 10% growth in sales can be accommodated by current production capacity. If sales grow by 20%, more capacity will be required, allowing the company to create proactive contingency plans in case sales exceed the forecast.
Again, accurately predicting the future is impossible. The sales forecast is simply the company’s best estimate of future activity and, in most cases, also serves as a goal for the company. Even though the sales forecast does require at least some amount of guesswork, without a sales forecast, there is no real way to create estimates for other operational needs − like production.
Production Forecast
The production forecast is based primarily on assumptions made in the sales forecast. The first step is to build a production plan based on anticipated sales. Doing so is relatively simple, since a good sales forecast predicts sales volume by month or even week. Using sales volume as a basis, a production forecast is created to meet demand. If capacity is flat but sales volume includes spikes, a production plan could be developed that creates excess inventory to meet seasonal fluctuations in volume, or the company could plan to utilize overtime or outsource certain services to meet demand.
Once the production forecast is created, other operational plans can follow, such as determining if new equipment is needed, when new employees are required, and scheduling purchases of materials and supplies. Costs can then be calculated, and profitability can be assessed — all based on a few key assumptions.
In effect, the sales forecast and the production forecast create the foundation of a budget. Think of it this way: if you know sales volume and prices, and you know the costs of producing, marketing, and distributing what you sell, then you have created a blueprint for operations and financial performance (assuming all the assumptions you made are correct).
Cash Forecast
The cash forecast estimates future cash inflows (revenue) and outflows (expenses). Once sales and production forecasts are complete, the timing of many expenses becomes clear: wages, supply costs, utility costs, etc. The sales forecast should also include an estimate of sales and, therefore, revenue. The cash forecast then breaks down revenue and expenses by time period to show whether the company will have enough funds at any given time to meet operational needs.
For example, because of expected volume fluctuations, the company may need to increase production in August by purchasing more materials and supplies than usual and working significant overtime. Sales of the produced items will not happen until October, and payment for those items will not be received until November. As a result, cash flow could become a significant issue, prompting the company to borrow money to cover operating expenses or to utilize its cash on hand.
Without a sales forecast, production forecast, and cash forecast, such financial and operational planning would be impossible, and the company may not have sufficient funds to meet its sales demands.
A few things to keep in mind about financial forecasting:
- Forecasting is based on historical data and educated guesses. If the market changes significantly, historical data and "accumulated wisdom" will be of little use in predicting future events.
- Forecasting is based on assumptions; always develop a variety of forecasts based on different assumption scenarios and create contingency plans for each scenario.
- The longer-term the forecast, the more inaccurate it will usually be. Nothing is certain but change − especially over the long term.