How to Design a Financial Forecasting Model for Business Insights

When it comes to business finance, it’s challenging enough managing the daily incomings and outgoings that keep the company running. But it always pays to look ahead and predict how much money you’re going to make (and spend) in the near future.

That’s where a financial forecasting model comes in, allowing you to develop a clear idea of future performance. You can use this to ensure there’s enough cash to cover likely expenses as well as proving to stakeholders that business will continue to be successful.

In this guide, we’ll show you the different types of forecasting models and explore how to use them to your advantage.

What is financial forecasting?

Simply put, financial forecasting is the process of using current and historical data to make predictions about future business performance. You can then use these projections in your decision-making—for example, setting your marketing budget for the following year or deciding whether or not to expand the company.

Financial forecasting can be divided into two broad types: quantitative and qualitative. Quantitative forecasts are based on historical data, while qualitative forecasting is more subjective and relies on knowledge and experience to make predictions.

Useful information for financial forecasting includes data on sales, revenue, cash flow and expenses. You also need to look at wider economic trends and other potential variables. Although forecasting involves a certain amount of guesswork, using the right methods will help you make accurate projections.

Financial forecasting and accounting

Financial forecasting is a key part of effective financial planning. Essentially, it’s crucial for ensuring that your business has sufficient cash flow to cover its expected outgoings. It also enables you to peer into the future by making educated guesses about market fluctuations and customer behavior.

By making predictions based on accurate information, businesses can make smarter decisions. This applies to everything from day-to-day operations like hiring staff and purchasing inventory to major changes such as seeking investment or selling the company.

Forecasting is also a valuable way to evaluate the company’s current financial health as it forces you to examine the data. What’s more, by comparing forecasts against actual results, you’ll find ways to improve.

Financial data can be complex, so it’s best to adopt online accounting methods. Cloud finance software is particularly beneficial for large corporations and global enterprises with multiple locations as the forecasting capabilities help to save time and reduce errors when working across different accounts, geographies and currencies.

Which financial forecasting model is right for you?

Businesses can choose from a wide range of financial forecasting models and methods, each offering a different way of looking at the data. Choose one that fits your individual needs and goals, and remember that you can use more than one model and compare the results.

Top-down forecasting

The top-down model is pretty straightforward, involving analysis of broad market data. Simply put, you look at your company’s total market size and use your assumed market share to calculate your potential revenue. You can then evaluate potential opportunities for growth, such as developing a new product line or moving into a new sector.

This approach works best for large businesses with multiple revenue sources, although it doesn’t give you a granular view.

Bottom-up forecasting

Bottom-up financial forecasting is the opposite—you look at your own financial statements and sales data rather than market size, and use that data to create a broader revenue projection. For instance, you can calculate potential revenue by taking your average sales value for a particular period and multiplying it by the potential sales per product offered.

However, you’ll also need to take into account other variables such as customer retention rate. This model enables detailed analysis, but can be time-consuming.

Statistical/quantitative forecasting

Cash flow forecasting

Cash flow forecasting involves estimating the amount of cash that’s expected to enter and leave the business during a specific future period. The aim is to ensure you never run short on cash so that you can pay your bills and keep the business running smoothly.

Source

There are two methods you can use. The direct method requires pulling in data from payroll, accounts payable and receivable, and bank accounts. While this can be time-consuming, it’s pretty accurate for short-term forecasts. The indirect method, on the other hand, uses forecasted financial statements instead of historical data to provide a high-level view of expected cash flow.

Cash flow forecast: Beginning cash + Projected inflows - Projected outflows = Ending cash

Percentage of sales

With this method, the future metrics of financial line items are calculated as a percentage of total sales. Divide each account by its sales to calculate the historical profits related to sales for each account. If the numbers tend to remain steady over time, it’s safe to assume that the trends you reveal will continue. Of course, nothing is guaranteed!

Straight-line forecasting

The straight-line method collects approximate growth estimates based on past figures and assumes that your historical rate of growth will remain constant over the coming period.

Multiply the growth rate for a previous period by the revenue you achieved in that same period. Let’s say the growth rate was 15% over the year—the forecast is that you’ll see the same percentage next year. However, this model doesn’t account for variables like market fluctuations.

Source

Moving average

The moving average method is most often used to predict future stock prices, but you can also apply it to future revenue. It helps you to forecast performance in the short term, such as weeks, months, or quarters. For instance, predict next week’s sales by taking the average (or weighted average) from last month.

Here’s the formula:

A1 + A2 + A3 … / N  

(where A = Average for a period and N = Total number of periods)

Linear regression

Linear regression makes predictions based on the relationship between dependent and independent variables. The dependent variable represents the forecasted amount, while the independent variable is the factor that influences it.

The calculation for simple linear regression is:

Y = BX + A

(where Y⁠ = Dependent variable⁠ (the forecasted number), B = Regression line’s slope,

X = Independent variable, and A = Y-intercept)

If more variables directly impact your business’s performance, the simple linear regression analysis may not be enough for an accurate forecast. This is where multiple linear regression comes in, accounting for multiple variables.

To use this method, there must be a linear relationship between the dependent and independent variables. It won’t work if independent variables are too closely correlated, making it impossible to tell which of them is impacting the dependent variable.

Qualitative forecasting

Delphi method

This method sees businesses reach out to financial experts to help them predict performance. Your company would send out questionnaires asking experts to make a forecast based on their experience, knowledge, and analysis of market conditions.

The responses are collated and sent to additional experts for comment. The experts each see a summary of the previous round of forecasts and have the opportunity to adjust their predictions accordingly. The business keeps circulating the questionnaires until the experts have reached a consensus. It’s more objective than in-house forecasting but can take a long time.

Market research

You can also carry out your own market research as part of financial forecasting and scenario planning. This gives you a holistic view of the market based on competition and consumer behavior. Used in combination with quantitative methods, it can give you more information for making decisions.

How to design an accurate financial forecasting model

Here are a few tips for accurate financial forecasting.

Set your goals and plan ahead

Before you begin, identify what it is you want to achieve through financial forecasting and how you intend to do so. For example, are you:

• Aiming to get your cash flow back on track?
• Deciding whether or not to launch a new product?
• Figuring out how much corporation tax you’ll need to pay?

Managing your taxes is a crucial part of financial planning. For this reason, it’s important to read guides around MTD for accountants, IRS policies, and find a compliant software that can help your business store digital records, automate admin and submit returns in an efficient and effective way.

Gather as much as data as possible

Make sure all your financial information, from historical sales figures to cash flow to known expenses, is properly organized and at your fingertips. You’ll need as much data as possible to make accurate predictions, so gather it from all your channels and don’t forget to collect information on market conditions and customer preferences.

Choose the right methodology (and software)

As we’ve seen, there are numerous forecasting techniques to choose from. Decide which model best suits your business and start implementing it. Whether you’re using quantitative or qualitative methods, it’s a good idea to use software to automate your calculations rather than doing it manually.

Evaluate the forecast

Businesses should be aware that however much data they put in, the forecasts are only predictions. So you need to remain agile so you can react to changes and adjust the projections. In other words, don’t create a forecast at the beginning of the year and forget about it—keep checking back to compare it with the actual results.

Final thoughts

Predicting the future with financial forecasting isn’t an exact science, but if you gather enough data and choose the right model, you’ll have a pretty good idea of what’s going to happen. Keep checking your forecast against real results and be ready to make changes if necessary.