More often than not, several successful enterprises fail to beat the existing competition and stay afloat due to a lack of planning. Forecasting may conjure up a feeling of dread among many companies as it involves strategic planning and understanding the nitty-gritty of your business.
Owing to the pandemic and uncertain market conditions, forecasting has become a necessity to increase the chances of success. What was once considered futile among enterprises is now the top priority for small businesses.
Forecasting for the future helps you prepare for worst-case scenarios and make informed business decisions. Thereby, ensuring you stay on track towards achieving your business objectives.
Financial forecasting is an integral process of staying on track with your cash flows, expected payrolls and expenses. In addition to this, estimating future financial decisions based on historical data improves the overall effectiveness of the enterprise.
In this article, we will explore the best practices and techniques related to financial forecasting for small businesses.
What is Financial Forecasting?
Typically, financial forecasting involves the process of estimating a business’ future financial performance. This prediction is primarily based on historical data that the business has gained over the years. Financial forecasting usually involves understanding your future sales, cash flow and expected expenses.
A common example that you might have witnessed is the prediction of your company’s revenue, especially during the start of your business. A brilliant indicator of accurate forecasting is a positive sales figure.
These largely determine where the enterprise is at and its future path. Needless to say, forecasting is imperative for good decision-making and supporting the overall organisational objectives.
Best Practices For Financial Forecasting!
Running a business is an arduous task, even for experienced entrepreneurs. The first step to a stable running business is considering financial forecasting. Besides better decision-making, it acts as a great way to convince investors to fund your business.
Furthermore, it answers critical future questions such as ‘What your future financial situation looks like’ or perhaps ‘How much money can you generate this year to repay debts’. These are pertinent questions to understand your financial standing and improve the overall performance of your business.
Broadly speaking, there are two primary categories of forecasting namely quantitative and qualitative. Based on these two categories, we can understand forecasting better. So, what are the best practices and techniques that you can consider to get cracking on financial forecasting? Let us explore them here:
1. Pro Forma Statements
A very popular type of forecasting involves using pro forma statements. To simplify, these statements focus on a company’s future reports and are highly dependent on assumptions that are made during its preparation. These assumptions could range from potential internal changes in the company to external market conditions.
Pro Forma essentially refers to projections and is applied across various financial documents. These include income statements, cash flow statements and the balance sheet of your company.
They serve both internal and external purposes. Internally you can use these projections for strategic planning. Understanding sources of future revenue and expenses can massively impact your business decisions, particularly related to hiring and budgeting!
For instance, to reduce expenses related to hiring, you can consider investing in an HR software that helps with employee screening, recruitment and onboarding. Such tools help save time and money in the long run. Externally, these statements help understand the risk of investing, especially for investors and venture capitalists.
2. Time Series Forecasting
This method involves collecting data over a period of time to identify trends that are often formed. One of the easiest quantitative methods followed, it is highly accurate and helpful in understanding patterns in the short term.
More often than not, every business forms a recurring pattern in its data. This is more likely to be repeated in the future. With the help of time series forecasting, observing these patterns over equally spaced time intervals can help businesses minimise future risks and make informed business decisions.
Also known as trend analysis, it often uses data mining techniques by breaking large batches of data into meaningful and useful information. This data is effective in developing marketing strategies, increasing sales and reducing overhead costs.
3. Cause and Effect Method
In this method, a forecaster looks for cause-effect relationships of variables with other variables such as interest rates, unemployment, and changes in disposable income. Considered one of the most sophisticated forecasting techniques, it transforms casual relationships into mathematical data. Based on this data, business owners can set the future trajectory of their business.
Comparing business variables to socioeconomic factors, competition in the industry and economic forces can help prevent future mishaps and prepare well for uncertainties.
A classical example of using the cause-and-effect method is the impact of market conditions on salaries. In case of recession, companies are more likely to either reduce salaries or lay off employees. Using mathematical data to predict future scenarios can reduce such scenarios for your business. Creating emergency funds, paying advance salaries and staying on top of immediate expenses can help curtail this.
Qualitative Methods rely heavily on expert knowledge and experience to predict business performance as compared to historical numerical data. Sometimes, numbers do not justify the entire scenario and relying on additional factors that could influence business performance becomes imperative.
As these can’t be quantified in numerical values, they are usually classified under qualitative methods. Owing to their subjective nature, they are often considered questionable.
However, ignoring these would be detrimental to your business as they offer valuable insights and account for factors that often go unnoticed in historical data.
1. Delphi Method
The Delphi Method is a popular forecasting strategy that involves consulting field experts who analyse current market conditions to predict your company’s performance. Typically, a facilitator reaches out to experts with questionnaires that involve questions to understand the industry’s performance.
Based on their experience and knowledge, they forecast future scenarios and how external factors could impact business performance.
These analyses are complied with and further, sent over to other experts for comments. This circulation continues until a consensus is reached. Moreover, the collection of various viewpoints offers a wider perspective to work with.
The Delphi method is used to predict trends in automation or sales. In addition to this, these forecasts offer insights related to economic developments such as income and employment opportunities. For instance, the recent pandemic led to the loss of lives and hampered the economic status of various affected nations. This, in turn, leads to financial instability for small businesses. Application of the Delphi method can limit its impact on your business.
2. Panel Consensus Method
This method brings together all internal experts of your company together for an open discussion about a particular product, service or the future trajectory of the company. Bringing experts from different company verticals helps identify problems better and mutually reach a best-fitted solution to combat them.
This method offers flexibility to voice your opinion, discuss the solution in-depth and act upon it based on mutual understanding. Typically, this method is used for narrowly defined variables or in “less likely scenarios”. For instance, acting on recent political or economic advancements.
It is an effective tool to detect the trends in the market in its initial stages and understand its repercussions on business performance.
3. Consumer Research
Consumer or market research helps forecast future demand with the help of consumer surveys and questionnaires. It is extremely imperative to gain valuable insights from the consumers. This includes changes in taste and preferences, opinions on introducing a new product in the market, understanding buying behaviour and feedback on existing services.
It is a brilliant way to identify potential opportunities in the market, devise appropriate marketing strategies and build effective sales techniques. More often than not, companies use this method to build consumer-oriented marketing policies. This, in turn, increases customer confidence and loyalty in your business. If you are looking to bridge the gap between consumers and your producers, this is an excellent method to experiment with.
Business professionals often use this method to estimate the size of the market, define potential customers, and understand the reasons behind low sales and profitability. By gaining insights into consumers’ pain points, you can create effective strategies that support customer satisfaction and company growth.
Which Way To Go?
Combining quantitative and qualitative methods is an effective way to minimise potential threats and be well-qualified to deal with uncertainties. However, it is imperative to understand that no particular technique is adequate for every industry or situation. Surveys suggest that combining different forecast methodologies adds more value and accuracy to your forecasts.
Furthermore, it acts as a compensatory mechanism to overcome the limitations attributed to any particular technique. Substituting one particular technique’s shortcoming with another’s advantage safeguards you in the long run and enhances growth.
To Sum It Up
In conclusion, we can say that financial forecasting is crucial to create a roadmap for your business. Moreover, it minimises potential risks and helps you make informed business decisions. Preparing for uncertain market conditions becomes easier with the application of forecasting.
Typically, forecasting involves both qualitative and quantitative methods. Qualitative techniques help reduce ambiguity, predict changes and understand customer behaviour. On the other hand, quantitative methods help analyse current scenarios and changes in market trends and build future strategies on recurring patterns.
Lastly, to yield the best results in financial forecasting, combining both these methods can safeguard businesses from volatile situations and build a mindmap to work with.