What Is Top-Down Forecasting? Benefits, Steps, And Importance

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January 27, 2023 Jayant Sharma Financial Modeling, Knowledge

Business decision-making is a long and exhaustive process that involves a lot of moving parts. Financial data, stakeholder intention, and market situation are just some aspects that need understanding for making sound financial decisions. However, choices ripple out to create economies or diseconomies, so only informed decision-making must be performed. The financial exercise of forecasting, especially top-down forecasting comes in handy under such situations. Businesses rely on forecasting to ignite the planning procedures that shape their business performance in the long term. If you are a rookie in the business world and want to know more, this article is for you.

Before diving into the deep end of top-down forecasting and the step-by-step procedure for conducting it and the reasons for doing so, we need to develop a basis for your understanding. As an aspiring businessperson or stakeholder in an organization, you need to understand the concepts before you reach top-down forecasting. A brief understanding of finance and financial economics is necessary for realizing the critical juncture where you find yourself often while running business procedures as the owner of an organization. Familiarity with the concepts of financial planning and financial modeling are essential; however, the difference between them and the different conditions for their usage is even more important.

Furthermore, before deciding upon the procedural setup required to conduct top-down forecasting we need to understand the relevance of financial forecasting in general. Businesses cannot survive without reliable financial forecasting and you must know the key features and the value it carries for your future business. Some businesses even conduct such forecasts before generating any revenue through their product or services. Why is it so? You’ll find out by reading this article in its entirety. Lastly, a differentiation between the different types of financial forecasting is presented wherein less known forecasting techniques are mentioned coupled with their uses so you are ready to utilize and gain from them as soon as you begin your practice or launch your first product. Now that you are aware of the pattern of the article at hand let’s try to start with…

The Role of Top-down forecasting in Financial Economics:

Financial economics is a field of study wherein lies the concept of financial forecasting and top-down forecasting. The discipline is centered on economic variables and the changes that affect them. Quantification of such phenomena and their active variability are the goals of this discipline. It is a discipline that is concerned with two streams of thought, mainly, corporate finance and investment. It has a microeconomic scope and deals with the decision-making processes in ambiguous environments of the market where dynamic economic forces and government regulations are fully functioning. It has a focused objective of deriving meaningful policies and the resulting implications resulting from their imposing that often go unnoticed. These policies are derived through models and forecasting of different kinds that function based on well-informed assumptions of the market and industry-specific conditions.

Financial economics grapples with the financial conditions and their measurement and equilibrium conditions under the status of economic certainty and uncertainty. It has produced theories over the years trying to explain the phenomenon of opportunity costs, uncertainty, risk, and their respective impact on the overall lucrative value of a financial decision. It is a form of modern economics that deals with the practical applicability of microeconomic concepts rather than the pure construction of theories and their differing shades.

Traditionally, the economics of most kinds is spare with its interest in accounting principles and deals only in value received or meted out. Where financial economics takes swerve from the traditional path is that it is not only concerned with one-sided value gains or losses but with the options of exchange and the factors that act to make that choice a reality.

Since it’s a practical study, it is concerned with means of managing risk and improving investment by methods like diversification of portfolios and hedging of assets as well as bulk buying. Its major contributions to our article today are the procedures of financial planning, modeling, and forecasting, such as top-down forecasting. The role played by this field is essential and thus, everyone should be an homage to its importance in serving the ends of businesses and securing better practices for them.

Now that we have a simplistic grasp on the discipline that top-down forecasting falls under, we should move on to other financial concepts like…

Financial Models and Their Need:

When hearing the term for the first time you might imagine models to be physical entities or stacks of code that are created and utilized by financial experts. A financial model simply does not come close to aligning with the idea that you conceive of it initially as it is a spreadsheet with interlinked variables that determines the financial cost/revenue from future financial conditions in real value. It computes the financial data of the specific business, its industry, and the general market conditions in past, present, and future scenarios. Some real-world examples are when models are utilized to predict a firm’s sales growth.

These models are the veritable artillery of the financial battle against uncertainty. Though they require a framework and extreme testing and support, they also leave the biggest impact of all. Because models generate tangible monetary value, they are extremely valuable and tackle multiple major business problems i.e. allocation of resources & funds, the total quantum of funds stipulated.

Top-down forecasting and other kinds of financial forecasts are necessarily required for financial modeling to operate properly. Uncertainty prevails in markets of all kinds and it’s a variable that can be mitigated but remains to a certain degree with the risks taken during the expansion and sustenance of an enterprise. For conducting a modeling procedure there are a few requirements that need to be met before beginning the setup of a model. The balance sheet, income statement, cash flow statement, and sensitivity or other analyses. However, financial forecasts are seemingly very different from models that they aid in the creation of, therefore let us under the difference between…

Financial Modeling and Financial Forecasting:

Before we continue to differentiate the two concepts, we should try to know forecasting a little more since it hasn’t been discussed previously. Financial forecasting is the process of creating a viable estimate of future prediction of the company’s performance. Forecasts like income statements and balance sheets are quite common business practices. It is a thorough process that relates present and past conditions and extends into the uncertain future while keeping tabs on extraneous variables.

It is the underlying factor that prompts financial planning activities to get underway. Without suitable predictions, there can be little hope of financial planning, much less forecasting. The allocation of resources, average costs, revenues, security funds, and those spent on the replacement of worn-out fixed capital assets are all given shape through the process of forecasting. Forecasting and modeling also share similarities in the aspect of accuracy. They may not be the perfect tools for giving the most precise results and calculations but often give a framework with limitations to business that supply some level of understanding and procedural value to businesses and their future capital investment options.

Historical data and patterns of sales generating revenue and the systematic data compiled by industry are compiled together under the same banner for the benefit. The major task of prediction is that of confirming the value of the financial revenue scored by a business and the costs involved over time in the continuation of business processes. Cashflow valuation and its analysis are also given extreme importance in this process.

Forecasting Can Be Categorized into Two Major Types of Financial Forecasting Types. These Are:

Quantitative forecasting refers to information-driven forecasting that delves into minute details of business processes to confer plenty of objectives and reliability to stakeholders to perform the necessary responsibilities required of them. Sales and product-driven departments of a business consistently perform quantitative forecasting to keep checks on performance and communicate essential requirements and necessities to the creme de la creme in a firm’s hierarchy. This forecasting is completely run by concepts of mathematics and statistics.

Some methods that fall under this kind of forecasting are as follows:

RRR Forecasting
Historical Data Growth Rate Forecasting
Linear Regression Analysis & Forecasting
Naive Forecasting Methodology
Seasonal Forecasting Methodology
Qualitative forecasting is the subjective option for forecasting available to businesses. It is a diametrically opposite method to its objective counterpart and completely relies on the experience and insight of professionals in the trends of financial markets. Sometimes the statistical data paints a continuing picture of current trends while the market might take a swerve in the other direction. Furthermore, dealing with the subjective goals of financial entities requires expertise that simply cannot be left to the processing of statistical and mathematical computations. It takes charge of the special information available to a business. For example, the customer journey and the expertise of particular leadership need to be accounted for and enhanced for a complete picture of forecasting to surface.

Statistical analysis and planning work best in an environment replete with financial information and records. It cannot manifest results in newly emerging or rapidly growing markets with sufficient accuracy to lead business actions. Therefore, expert knowledge of markets obtained through years of research and practice as well as noting the pulse of customer behavior are key to processes of business expansion and business goal achievement. These are only made possible through qualitative forecasting.

Top-down forecasting is a different category of forecasting altogether, so it won’t be found in the sub-types of the aforementioned forecasting, however, there are many other methodologies of use under qualitative forecasting, namely:

Executive Opinion-Based Decisions
Consultancy Services
Delphi Qualitative Methodology

After ingesting all that information now, you are ready to understand the intricate differences between forecasting and modeling. Models are tools that a company deploys with interlinked variables that are inserted with values mirroring the company’s income statement and balance sheet. The usage of spreadsheet format and Excel functions are prevalent in modeling procedures. On the other hand, forecasting is aimed to discover expectations and trends for the future of a firm. It is created based on certain limitations that are external as well as internal yet aims to achieve certain set goals agreed upon by business stakeholders. These are well-researched and reviewed by planners to form the assumptions under which the forecast functions and statements are released. These may be standardized or specialized as per business convenience. The forecast may lend direction to the company and inform on highlights that may happen shortly. It is the financial model however, that manages the crunching of the figures and not only presents the value of the change (negative or positive) but also shows the numerical effects of the results on the balance sheet, income statement, and cash flow structure of the business.

These are enumerated differences between the two concepts and seeing the differences you must have understood the differences between the two. However, seeing the differences let us not forget that they are symbiotic concepts that work in tandem with each other to provide established businesses with the best predictions of returns as well as rendering a direction to operations and the respective benefit or loss each of them incurs. Regardless, financial forecasting as a concept needs to be understood in more detail before we can begin to learn top-down forecasting.

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Financial Forecasting: Benefits & Steps:

There are multi-purpose uses for financial models but that’s not limited to models alone. Top-down forecasting and another financial forecasting of other kinds follow unique procedures to conduct their research and study, which result in the development of insights for the future requirements and returns of the business. It might be a process that entails all kinds of business planning without which businesses can be equated to William Tell, the mythical shooting to hit a target that has not been established. The risk and uncertainty that reign supreme without a clear financial plan-based credible forecasts is not something to shirk away. Expected and unexpected losses impact businesses differently and can induce states of panic selling of equity in open markets if the board of management does not seem informed well about the current state of business. Furthermore, a clear prediction of stable returns is alluring to venture capitalists and other investors looking to diversify their portfolios. Thus, the clarity provided by financial forecasting can boost revenue and add to profits and

Free Cash Flows are Available to a Business. The Steps to Conducting the Same Are as Follows:

Clarifying the purpose of a financial forecast
Collecting records & statements for checking business patterns and trends
Picking the appropriate timeframe for conducting a forecast
The methodology for the forecast needs to be selected.
Decipher results and interpret them on business documents.
Financial data received is analyzed.
Rinsing & repeating the same process as per different timeframes

Such is the process of financial forecasting. We have offered only the skeleton and several variables need to be managed effectively to perform accurate forecasting.

Finally, we can now discuss top-down forecasting in detail. Let us first understand…

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Top-Down Forecasting & Bottom-Up Forecasting –The Difference:

Top-down forecasting is an effective tool for businesses that operate by researching the market conditions prevailing and the factors that enable the current trends to continue. Furthermore, it narrows it focus down to the industry of the company and the shape of the company, and how that affects the economic situation of the business. The industry is considered with a focus on the products that sell in large quantities and what enables them to do so. It also takes into account the practices at play in the industry and how deliberates over highlighting the strengths and weaknesses of the client firm. It is a type of forecasting that puts the big picture up front and center; giving you the possible options that you as a businessperson could take to grow the sales of your business.

It brings to your notice avenues full of expansion possibilities and audiences that are being served inadequate services and products. They could become your target audience in the future if you can capitalize on the opportunity presented to you through this forecasting. It also helps your business locate extraneous variables from the larger market that are costing your business, giving you sufficient information to mitigate damages and remove your reliance on the particular service at the earliest. Ultimately, it is a process that grapples with the forecasting of business metrics regarding revenue and capital and takes a broad approach to handle the calculations of the same.

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Bottom-up forecasting is a diametrically opposite approach to forecasting but is still just as effective as its counterpart. It is a narrowed-down approach that focuses on the details of certain products and services produced by the businesses and also the financial forecasting of other business expenses such as selling general & administrative costs. All activities that are initiated by the business, regardless of the size of the activity itself, are forecasted by the business. All such activities influence the financial conditions of the business in the long run. This is a detailed approach that looks at the competing costs of other businesses and aims to identify why business processes are costing more in terms of money. Furthermore, this forecasting explores the different scenarios a business might find itself in such as ‘What if my sales from this particular section of my audience were reduced by ten percent?’. Bottom-up forecasting acts in a manner that thoroughly investigates and then since the variability of these factors is expected and contingencies to manage them have been secured, the big picture constructed after painstaking hours of market research and refining of products and services is one that is reliable and credible.

Thus, the differences between the two approaches issue from the comparison of these approaches. While the top-down focus on the big picture and on understanding the effects of variables that are outside the reach of the business while the bottom-up is concerned with the internal resources and thorough research that allows for refining the target audience and the product for the audience as well. For instance, the top-down approach is concerned with the development of a percentage of market share that is reliably profitable under extreme circumstances while the bottom-up rigorously execute investigations into different variables of products like soap branding and figuring out what offers given on them will be most beneficial. For services offered, the bottom-up approach looks for ways to enhance the customer experience by offering discounts and free trial sessions as well as other services that leave a good impression on the consumer.

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FAQs: (Top-Down Forecasting)

Q1. What are the essential steps to the top-down process of forecasting?

The process of this type of forecasting is not difficult to understand. Here are the major steps that can be utilized to produce a sound forecast for a business:

Collect the data for outlining the total addressable market i.e., the market that is available for sale of the product or service that is being provided and is a concept that is used to generate the potential revenue gained if all of the market shares were swallowed up by the firm.
The next step includes the computation of sales figures and the total expected revenue of the company and how that relates to the total sales of the business in terms of market share. It also looks for trends in this market share and forecasts whether there is potential for an increase or decrease and to what degree.
Lastly, the revenue of the company is generated and may be discounted into current value, or it may even be transmuted into sale volume depending on the business and its goals.

Q2. Is the financial forecasting job an important one?

Yes, the job of financial forecasting is incredibly important to businesses as without it, businesses are often bogged down by problems and lack proper direction.

Q3. What is a three-statement model?

A three-statement financial model has an interlinked income statement, balance sheet, and cash flow statement and is considered a staple financial model that is simplistic yet accurate in telling the financial condition of a business shortly.

Conclusion:

We hope you learned something valuable through this article. Thank you for reading.

What Is Top-Down Forecasting? Benefits, Steps, And Importance