Maybe you plan to turn your small business into a corporation. Perhaps you just want to see how much money your home business might make for your family. Or, more realistically, you simply want to gain a better understanding of where your business might land financially in the future. Whatever your reasons, it pays to know how to forecast your future finances.
On today’s Watchman Advisors blog, we will take a quick guided tour into the world of financial forecasting.
Why is financial forecasting important?
Once you understand what a financial forecast does, it’s easy to understand its importance. Simply put, a financial forecast is a projection of where your business might stand financially moving forward. As a business owner, you can look back at your past performance and growth to see what your incoming and outgoing funds may be within the next year or more.
Forms You Need For Financial Forecasting
A financial forecast utilizes forms that help you project growth. Three that are most important are your balance sheet, cash flow statement, and income statement.
A balance sheet is a crucial financial document that gives you an overall view of your company’s cumulative financial health. It shows how much you owe, how much you have, and how much owner’s equity is available in your company.
Cash flow statement.
A cash flow statement might look complex, but, ultimately, it is a simple form that shows how much money you have going in and going out during a particular time frame. Your cash flow statement can break down incoming money from operational and investing activities as well as decreases in cash for things you pay for, such as marketing and inventory.
An income statement is similar to a cash flow statement. The biggest difference is that your income statement shows you everything from gains in revenue to your losses. Losses are not the same as expenses. According to LegalZoom, your income statement is helpful in determining your profits.
Before You Get Started
Even if you already have the documents needed, there are a few things you can do to better familiarize yourself with your business’s finances. First, if accounting isn’t your strong suit, consider taking classes or going back to school to earn an accounting degree. This doesn’t mean that you have to pause your business for four years, and you can take an online degree program that will help you better understand your financial statements and learn to navigate complex accounting practices. You will be able to manage the aspects of your business you already know while learning a valuable skill that will help you grow.
Next, familiarize yourself with financial options, services, and products that you can turn to if you don’t expect to grow enough or if you may grow more than you can handle based on your current cash reserves. You might need to take out a loan, for example, or apply for government assistance.
How To Create A Financial Forecast
Just as there are three main documents you need to create a financial forecast, there are three steps to get you on the right track. Start by gathering your documents, which are the forms we mentioned above. Your past financial statements are necessary to help you look ahead. Ideally, you are already using a financial software, such as QuickBooks, which will generate these documents for you. If you use an accountant, they can provide these.
Your next step is to decide whether you will utilize historical forecasting, research forecasting, or a combination of each. Historical forecasting is perhaps the easiest, and simply involves looking at your past records to spot growth trends. For example, if you’ve grown an average of 20% over the last five years, you might project 20% year-over-year for the next five years.
Research-based forecasting utilizes broader trends within your market. Marketing solutions company DemandJump explains that you can do the research on your own with a bit of work. However, if numbers are not your forte or you are not comfortable with projections, you might outsource this to an accounting firm.
The final step is to create what’s known as “pro forma” statements. These are simply forward-looking versions of your financial statements that outline your potential operating expenses and income.
Once you have generated your first financial forecast, you might think your job is over. It’s not. Importantly, you also have to go back and check your projections against actual numbers. This is quite simple, and all you have to do is compare your calculations against what actually happened during the last month, quarter, or year.
You may find that your revenue was much higher or lower than expected. Either of these scenarios opens up an opportunity for you to see where there is a disconnect so that you can better plan for the next year. An example here is if you experience lower sales than expected. In this case, you may find that your sales representatives were not adequately prepared with information about new products or that your suppliers ran short based on high demand.
Best And Worst Case Scenarios
Any time you are dealing with future numbers, things may not always be down to the dollar. Because of this, you’ll also want to forecast three different models: base case, best case, and worst-case scenarios. A base case scenario, according to Corporate Finance Institute, is based on accepted assumptions. For example, current discounts and cash flow numbers.
A best case scenario looks forward with an accelerated growth rate and other factors that would be considered ideal. Your worst-case might be if you have to provide a high discount to reach sales goals or if your business’s tax rate suddenly increases.
Making financial projections for your business may not always be pleasant. However, as a small business owner, it’s something you must learn how to do. Your professional and personal income depends on your grasp of the numbers. When you don’t understand them, you have to make this a priority. Research where you can and, if you’re still having trouble, don’t be shy about hiring an accountant or increasing your own financial acumen by taking accounting classes.