Understanding financial forecasting
Written by Michael Feder
Reviewed by Kathryn Uhles, MIS, MSP, Dean, College of Business and IT
What is financial forecasting?
Financial forecasting is an essential accounting function for any business that helps companies anticipate future financial performance and make informed decisions. It involves analyzing and evaluating data, such as financial statements and balance sheets, while considering current and future trends to estimate the company’s potential financial position.
By leveraging historical data, effective financial planning can help businesses understand potential risks and ensure their finance strategies are optimized. This can include predicting income, expenses, cash flow, profits and losses, returns on investments and other key indicators of long-term financial health.
Understanding financial forecasting and implementing sound forecasting methods help companies make intelligent decisions for their business in the long run.
Why financial forecasting is essential
Financial forecasting is essential for effective business decision-making, as it provides valuable insights into potential risks and opportunities. This insight can lead to smarter investments, better budgeting and greater profitability.
Leveraging financial forecasting for any business can yield other benefits too, including the following:
Projecting performance
It’s essential to understand the potential outcomes of different scenarios to make more intelligent decisions and investments. Financial forecasting helps businesses anticipate performance based on current conditions and trends, enabling them better to manage resources and plan for success.
Financial forecasting allows companies to identify growth opportunities and risks, create more accurate budgets, develop strategies for offering new products or services, and take advantage of changes in the market.
Managing uncertainty by planning ahead
Businesses can use financial forecasting to manage change more efficiently, make investment decisions during times of economic hardship, better anticipate market shifts, and develop strategies for responding quickly to sudden changes in demand or cost.
These insights can help businesses plan for best- and worst-case scenarios so they can respond quickly and effectively.
Investor reporting and capital allocation
When it comes to raising capital, financial forecasting can help businesses attract investors by providing a detailed and transparent overview of their financial position. It also helps them manage capital allocation by estimating how much money should be invested in every aspect of their business.
These insights can help businesses identify which projects should be prioritized and how to best use resources.
Who performs financial forecasting?
Anyone who runs a business should be familiar with the fundamentals of financial forecasting. However, for those who wish to delve deeper into this topic, having a background in finance and business administration can help provide an educational foundation to develop critical financial skills.
Untrained business owners can perform basic forecasting through their market knowledge and simple math. However, formal training empowers business owners and employees to more accurately predict cash flow and resource allocation.
With expert knowledge from a budget analyst or an in-depth understanding of the principles behind financial forecasting, business owners can take proactive measures to get ahead of potential issues and remain competitive in their respective markets.
Common methods of financial forecasting
When it comes to forecasting, several methods are available, each with merits depending on the purpose of the forecast and the business model in question. It’s crucial to understand that budgeting and record-keeping are essential parts of forecasting. The more accurate and detailed a forecast is, the more reliable it will be.
The four basic forecasting methods are straight line, moving average, simple linear regression and multiple linear regression. Each approach has pros and cons.
Straight line
Straight-line forecasting is a simple way to predict growth. It uses historical financial data and basic math to show potential future outcomes based on current growth rates.
An advantage of this strategy is its simplicity. A drawback is that it doesn’t consider changing market conditions, making long-term predictions risky.
The straight-line approach can provide valuable insight for short-term budgeting and planning, but a company should use more complex methods to make long-term predictions.
Moving average
The moving average forecasting method evaluates standard financial metrics such as revenue, profit, sales growth and stock prices. It uses short-term calculations to create an ever-evolving average value that helps businesses identify underlying patterns.
An advantage is that this method allows for faster trend identification. A disadvantage is that it can lag if used over long periods. As such, it best serves as a tool to detect changes in the short run.
Simple linear regression
The simple linear regression method forecasts future values of dependent variables based on previous values. It uses a linear relationship between independent and dependent variables to create a trend line.
Pros of this method include ease of implementation, low cost and ability to identify trends. A con is it’s limited in handling complex relationships between variables and can be influenced by outliers.
Multiple linear regression
The multiple linear regression model is the most advanced of forecasting methods. It can account for complex relationships between dependent and independent variables, providing more accurate results than simple linear regression.
Although multiple linear regression is the most accurate forecasting method, it also requires more data and resources than other methods. Multiple linear regression models should be used only when you have sufficient data to predict performance accurately.
Examples of financial forecasting
Financial forecasting doesn’t provide perfect predictions but helps businesses anticipate and plan for different situations. There are many examples of how businesses use financial forecasting to their advantage.
Straight-line forecasting example
An organization that makes and sells widgets may use straight-line forecasting to predict total sales and cash flow for the upcoming quarter.
This method assumes that the average number of monthly sales will remain consistent over the quarter. So, the forecast result can be calculated by multiplying the average monthly sales by three months, which is the length of a quarter.
Simple linear regression example
A company that provides services in a particular geographic region may use simple linear regression to forecast customer demand. This method uses historical data from past years to find the relationship between two variables — for example, customer demand and weather conditions. This information can then be used to predict customer demand more accurately than simply extrapolating from existing trends.
How to learn more about financial forecasting
Financial forecasting is a complex process that requires a combination of math analyses and business judgment. While financial professionals must have training in statistics, economics and other related fields, it’s also critical for them to pay attention to detail when interpreting data and developing forecasts. Ultimately, successful forecasting relies on a combination of factors, including math knowledge, accurate data, consumer behavior, and market trend analyses that can affect future results.
Finance and business programs at University of Phoenix
If you're looking to learn more about online business and finance programs to help teach you skills needed in the field, consider these degrees at University of Phoenix.
- Bachelor of Science in Business — This program teaches leadership, management, operations and communication skills.
- Bachelor of Science in Finance and Technology — If you want to analyze financial data used in financial accounting, planning, management and decision making, this programs is for you. You'll learn to evaluate aspects of financial planning used to grow, manage and protect wealth.
- Bachelor of Science in Accounting with an Associate of Arts with a concentration in Business Fundamentals — In this program, you’ll learn skills such as recording and communicating measurable business activities to stakeholders, analyzing financial statements, and applying accounting principles to domestic and international transactions, taxation and auditing.
- Master of Business Administration — This program aids in developing skills to make important business decisions such as operations, communication, leadership and management skills.
ABOUT THE AUTHOR
A graduate of Johns Hopkins University and its Writing Seminars program and winner of the Stephen A. Dixon Literary Prize, Michael Feder brings an eye for detail and a passion for research to every article he writes. His academic and professional background includes experience in marketing, content development, script writing and SEO. Today, he works as a multimedia specialist at University of Phoenix where he covers a variety of topics ranging from healthcare to IT.
ABOUT THE REVIEWER
Currently Dean of the College of Business and Information Technology, Kathryn Uhles has served University of Phoenix in a variety of roles since 2006. Prior to joining University of Phoenix, Kathryn taught fifth grade to underprivileged youth in Phoenix.
This article has been vetted by University of Phoenix's editorial advisory committee.
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