Top 7 Financial Forecasting Methods You Should Know About
Accounting often requires assessing previous results. Both shareholders, as well as the general public, can see business success through financial results. However, organizing and making preparations for the future are equally crucial. Shareholders need to be convinced that a business is and will remain successful. Financial planning is necessary here. Here is a summary of the seven most important financial forecasting methods you can use to predict the financial performance of a business, as well as how you can employ pro forma statements for financial forecasting.
Financial Forecasting Methods – Definition
By assessing past success metric data like sales, revenue, expenses, or cash flow, a company’s financial future can be predicted using a thorough financial prediction process. Since there are so many unpredictable factors that might impact business performance, this includes speculation and assumptions. Because it impacts business decision-making on strategic planning, forecasting revenue, recruiting, and budgeting, financial forecasting is crucial. You can keep your eyes on the future with its assistance.
The degree to which each financial prediction is taken into account affects how much focus is given to personal expense items. For basic planning needs, you can, for instance, predict high-level trends by relying more on generalizations than on particular details. However, it’s crucial to be detailed and comprehensive if your project involves a business’ future, like a pending acquisition or even a merger.
Financial Forecasting Methods – Importance
Here are reasons why the financial prediction process is essential:
Cash Flow – Appropriate cash flow control is vital for business success as it permits you to have more financial arrangements and improved operational management. With accurate prediction at the beginning of each financial year you can handle and balance adequate cash flow to meet your financial requirements as you know the volume of cash in hand currently, the amount needed as well as the incoming cash.
Financial Demands – When preparing budgets, the data that financial prediction generates is very valuable. Those responsible for preparing the budget can determine whether the prediction reveals adequate sales or revenue to meet expenditures, such as further recruitments, significant capital expense, as well as investments.
Investing – Whenever a business is searching for investors, financial prediction is quite crucial. To determine whether a business is a good investment and how well it fits with its investment objectives, prospective investors examine financial statements and forecasts.
Decision Making – The management of a company can use financial prediction models to understand the status and position of a business and to make short- and long-term decisions. It is possible to take lessons from history and make accurate predictions, like estimating rivalry and market developments.
Efficacy – While predicting as well as preparing for different outcomes, you can take different situations into account. You may ensure that business operations go efficiently by analysing probable scenarios and making contingencies, reserves, and backup plans.
Plan Enhancement – You may discover and keep track of variances when you implement corrective actions that improve plans by comparing predictions versus end outcomes. To operate a business effectively, take into account reviewing the prediction on the cash flow statement, profit and loss statement, and balance sheet.
Mergers and Acquisitions – Usually, these include the outcomes of financial prediction. Predictions are frequently requested by individuals involved while making important business decisions to evaluate the business’ future.
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Prediction Through the Usage of Pro Forma Statements
Using pro forma statements is a typical method of predicting in financial accounting. Pro forma statements concentrate on a company’s business financial reports, which are heavily reliant on the assumptions that were made during preparation, such as anticipated market circumstances. Pro forma statements apply to any financial document because the phrase “pro forma” refers to estimates or predictions, including cash flow statements, balance sheets, and cash flow statements.
These statements have internal as well as external applications. You can utilise them internally for strategic planning. Future expense and revenue recognition can have a significant impact on business decisions like recruitment and budgeting. By preparing multiple pro forma statements and exchanging the variables, it is possible to compare probable outcomes parallelly to guide endeavors.
Pro forma statements can show the dangers you can face if decide to invest in a business externally. Investors should be aware that although this is a viable technique of predicting, pro forma statements frequently do not adhere to generally accepted accounting principles (GAAP). This is because pro forma statements may not contain once-in-a-while expenses, such as those related to equipment acquisition or company relocations, which allows for higher accuracy since such expenses do not indicate the continuous operations of a company.
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Comprehensive Financial Forecasting Methods and Components
Financial forecasts predict the position of the company’s finances in the upcoming months and years by using information such as present expenses and revenues along with financial goals. Financial predictions should be tracked and updated consistently, typically once per month, for effectiveness. Budgeting and financial prediction are similar but distinct processes. A financial prediction can be used to assist in formulating a company’s budget, but they shouldn’t be used in place of one another.
7 Essential Financial Forecasting Methods
When predicting sales, expenses, and revenue, pro forma statements are quite helpful. One of the seven financial prediction processes that help compute future income as well as growth rates frequently provides additional support for these outcomes. There is a core division of predictions – qualitative and quantitative techniques.
Comprehensive Quantitative Financial Forecasting Procedures
While presenting accurate predictions, business managements usually choose quantitative predictions or assumptions regarding the future dependent on past data.
The volume of Sales Percentage
Internal pro forma statements have been frequently generated utilizing sales prediction as a percentage. With this technique, future financial line item metrics are converted to sales percentages. For instance, it is reasonable to use a similar growth rate prediction for both as the cost of items sold is likely to rise proportionally alongside sales. Evaluate the percentage of every account’s past profit that was connected to sales to predict the percentage of sales. Divide every account through its sales to figure out this, assuming that the numbers won’t change. For instance, if the goods’ cost sold previously accounts for 30% of sales, presumptively this trend will persist.
The straight-line approach bets on the previous growth rate of the company being constant. The past year’s revenue of a company is multiplied by its rate of growth to predict future revenue. Straight-line prediction, for example, predicts that if growth was 12% last year, it will also be 12% the following year. While straight-line prediction is a great point to start, it just doesn’t take supply chain problems or fluctuations in the market into account.
Straight Line Financial Forecasting Methods Example
Over the previous three years, the yearly growth rate of a restaurant chain has been constant at 5%. The company anticipates that growth will continue for the following two years at that rate. The company can forecast with accuracy how many staff will be required to employ as well as the additional payroll costs for every one of those years by computing that next year’s growth will be 5% above this year’s and that the subsequent year’s growth will be 5% above the upcoming year’s growth rate.
Moving Average Financial Forecasting Methods
Using a moving average, you may predict the future by averaging—or weighting—past periods. This approach, which entails assessing more deeply whether a business has high or low demands, is frequently advantageous for short-term prediction. By averaging the past quarter, you may use it, for instance, to predict the sales for the following month. Numerous metrics can be estimated with the use of moving average prediction. Although it is frequently used to predict stock prices, it is also employed to calculate upcoming revenue. For calculating the moving average, you must add the averages of all periods and divide it by the overall periods, i.e. A + A + A +…../T
Note – A = Averages of the periods, T = How many periods are there
Moving average prediction can be made more accurate by highlighting recent periods through weighted averages.
Moving Average Financial Forecasting Methods Example
A retailer wants to compute how much product, if any, he needs to ask the wholesaler to produce, supply, and deliver again. Sales are increasing overall because it is the festive season, but he must be aware of which products are rising in popularity. He computes a moving average for the entire week to demonstrate the trend and steer his inventory buy orders rather than trying to watch irregular small increases and declines in a particular product’s sales during the day or throughout the week.
Simple Linear Regression Financial Forecasting Methods
Metrics are predicted using simple linear regression based on the connection between dependent and independent variables. The independent variable seems to be a factor that affects the dependent variable, and the dependent variable is a representation of the amount that is predicted. To find the metrics, you need to use the following equation.
Y is equal to BX + A
Y represents the dependent variable (the predicted amount)
B stands for the slope of the regression line
X is for the independent variable
A is the Y-intercept
Simple Linear Regression Financial Forecasting Example
Every company’s success depends on two factors: sales and profits. If the trend line representing profit (y-axis) and sales (x-axis) continues to climb up, as calculated by the simple linear regression approach, rises, the company is performing well, and margins are solid. A problem may exist, such as excess supply costs as well as narrow margins, if the trend line descends because sales are rising but profits are dropping. In contrast, if profits increase despite lower sales, the item’s worth is rising. As a result, the company’s expenses and costs are decreasing, and also the linear regression is effective margin percentage rises when profits are also increasing.
Multiple Linear Regression
If either two or more two variables possess a direct impact on a company’s performance, business management chooses multiple linear regression. With this, they can get more accurate predictions, since it is responsible for numerous variables that eventually affect performance. To predict via multiple linear regression, a linear association must be there in both independent as well as dependent variables. Moreover, the independent variable should not be closely corresponding that it becomes unthinkable to say which affects the dependent variable.
Multiple Linear Regression Financial Forecasting Example
The executive of a trucking company intends to forecast fuel prices for the upcoming six months. The mileage from GPS fleet routing systems, Diesel Fuel and EIA Gasoline Updates, Traffic Patterns from Smart City Open Data Platforms, Oil Futures from a Futures Exchange, and the number of trucks the company envisions will be on the road during the period relying on delivery orders are the independent variables he utilises for this approach. This list is merely provided as a guide, and other variables could have an impact as well. In each scenario, each one of the variables not only affects the outcome but is independent of it as well. Relying on the variables, this model makes predictions about the result, in this example, the forecasted fuel prices for the period.
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If it is about predicting, you cannot know the actual story through numbers as there can be extra factors that impact performance and is unquantifiable. Qualitative prediction is based on professionals’ awareness and experience to forecast performance rather than past numerical data. These prediction processes are often criticized as they are more subjective than quantitative procedures. Still, with the help of qualitative methods, you can acquire useful information regarding predictions and be responsible for factors that cannot be forecasted with past data.
Delphi Financial Forecasting Method
When using the Delphi technique of predicting, experts are consulted to assess the state of the market and forecast a company’s success. With questions and a request for company performance forecasts based on their expertise, a facilitator contacts those experts. After assembling their analyses, the facilitator distributes them to additional specialists for feedback. The objective is to keep circulating them until an agreement is achieved.
Market Research Financial Forecasting Method
You cannot execute organizational planning without market research. Through market research, business executives can acquire an entire market perspective depending on consumer habits, rivals, and, changing scenarios. It also becomes crucial for start-up companies when they cannot access any past data. Financial forecasting is advantageous for new businesses because it’s necessary for employing investors and setting up a budget for the initial few months of business operation. Start with a hypothesis while performing market research and then decide what techniques are required. When you don’t have quantitative data to guide decisions, handing out consumer surveys seems to be a great technique to best understand consumer behavior.
A Short Description of Qualitative Prediction Procedures
Qualitative forecasting techniques are inherently less accurate than quantitative ones. They are both art and confusingly described science. That doesn’t mean that it is if of any less value. For instance, a doctor may decide to request specific tests after becoming familiar with the symptoms of a specific disease. Additionally, if a disease is prevalent locally but rare nationwide, the doctor may believe it over another. Business executives acquire expert knowledge about their industry and product line through an experience similar to this. Even if this information isn’t always quantifiable or supported by past data, it nonetheless has business worth.
To generate projections that are typically used for short-term business predictions, qualitative prediction methods employ or mix hard data, like machine data as well as sales data, alongside soft data, like professional calculation or views. The Delphi method is one instance of a methodology that resembles market research methodologies but also contains soft data obtained from experts in the subject. Instead of data acquired via customer feedback on a service or product, it can involve the use of questionnaires.
How to Perform Financial Prediction Methods
Before creating financial prediction techniques, you need to go through the following steps:
1. Recognise Your Goals
Decide the company’s financial document for the upcoming month, quarter, and year before you begin pouring into the finances of your company. Before you launch any other stage within your financial prediction project, ensure a well-defined financial goal (or goals) is in sight. Revenue, debt reduction, or the introduction of new products may be among these goals.
Example – Before the year ends Eleanor’s Boutique hopes to earn an additional 15% profit. Eleanor, the owner of the boutique, aspires to accomplish this without significantly increasing the cost of her goods. A new group of related products will also be introduced, and she aims to hire at least one more person.
2. Collect Necessary Financial Information
After setting well-defined and achievable financial objectives for your business, you have to acquire all the crucial relevant financial documents for your predictions. This may involve things like expenses, statistical documents, revenue, and liabilities. Furthermore, this category also contains views and estimates from professionals in the field.
Example – Eleanor collects her balance sheet, income statement, and cash flow statement. She makes a call to her mentor, the owner of something like a small chain of clothing stores, to talk about industry trends and also other business practices issues that are hard to measure but could affect her financial prediction.
3. Choose Your Approach
Now that you have defined financial objectives and collected financial information, you can choose the approach for your particular financial prediction. There are different methodologies, quantitative and qualitative techniques that could be appropriate for your prediction. Make sure that you have explored the various methods before deciding on the procedures that best suit your requirements. To make things easier, you could hire a chief financial officer or financial advisor who may be able to help you select an approach for your business and also objectives.
Example – Eleanor has a variety of methods at her fingertips. She has decided to employ the Trend Projections technique on the recommendation of her financial advisor. With this method, Eleanor will project the financial data she obtained in the second step over several months as well as years. Although this approach is renowned because of its short-term accuracy, it can be ineffective at forecasting financial losses and profits over the long run. Eleanor should find this approach useful because she plans to amend her financial prediction every month.
3. Execute Process
Execute your prediction using the technique you’ve chosen, the financial information, and the approach based on specialist knowledge. To better prepare for the future, it is a good idea to run a few alternative scenarios. Example – Eleanor employs the information she possesses and applies it to the Trend Estimates Study under the guidance of her financial advisor. To ascertain what must occur for her boutique to achieve its long-term goal of raising an additional 15% in profits, recruiting new staff, and having the capital to launch a new product, they conducted several projections.
4. Examine the Prediction
Many businesses bypass or think that it is the last step and stop there and later run into financial difficulties. Make sure you use the prediction information to guide your financial budgeting and decisions. It is advised that you review your financial prediction often, typically once per month, to update the numbers and ensure that you are on track to reach your long-term financial objectives.
Example – Eleanor changes her statistics to meet her current financial position a month after she creates her initial financial prediction for her boutique. For the boutique to achieve its long-term objectives, the prediction has thus far been accurate and helpful in managing the monthly budget of the store. Eleanor continues to examine and update her monthly financial predictions. She is grateful for the opportunity to recruit a brand-new employee just at end of the year, takes pleasure in a 17% increase in profits, and gets ready to introduce a brand-new collection of handbags.
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Frequently Asked Questions
1. What are the seven critical financial prediction techniques?
The seven most vital financial prediction processes are volume of sales percentage, straight line, moving average, simple linear regression, multiple linear regression, Delphi, and, Market research.
2. How to execute the procedure?
I have explained the same in detail above. Please go through the article and drop in your comments below.
3. How many steps are there in the process?
It is a five-step method.
Conclusion on financial forecasting methods
I hope that this article has helped you a lot in understanding how financial prediction processes can assist you in earning more profits by applying these approaches. Apart from that, you also learned why they are important for your business. Thus, always implement them to achieve optimal performance for business.