Financial Projections and Forecasting
While the terms financial projection and financial forecast are sometimes used interchangeably, they are two entirely different concepts. Understanding the difference is key to making informed decisions regarding your personal financial management.
A financial projection focuses on analyzing past trends in financial data with an aim to identify and quantify potential future scenarios. On the other hand, a financial forecast is a more realistic assessment of the individual’s current financial situation that takes into consideration what has already been planned for and what is likely to unfold in the near future.
There is a certain bit of mysticism that comes with blending these two concepts in order to create a cohesive financial plan. As such, while they serve different purposes, both financial projections and forecasts are essential for any sound financial management strategy. And, that is where the help of a Certified Public Accountant can be invaluable. In addition, CPAs assist in creating precise formulas predicated on hypotheses including, but not limited to, organic market growth rates and inflationary impacts.
Understanding Financial Projections
Financial projections are estimates of an individual’s or a company’s future financial performance. These projections are used to plan for and manage financial resources, as well as to assess the potential risks and rewards of a particular business venture or investment. The projections are often based on a variety of assumptions, such as future market conditions, business plans, and cost estimates.
Financial projections are a key tool used to assess the potential of a business or the growth of individual wealth. They provide insight into the likelihood of achieving financial objectives and can be used to help set realistic expectations and goals, helping you make better-informed decisions.
Types of Financial Projections
Knowing the various types of financial projections available can enable better decision-making for individuals, investors, creditors, entrepreneurs, corporate executives, and their teams. There are several types of financial projections that differ based on time period, assumptions underlying them, purpose, and detail included in the models. The most common types of financial projections include:
- Pro Forma Statements – These projections estimate the financial results of a business based on a certain set of assumptions regarding sales, expenses, and profits. The pro forma statement is typically used to assess the potential profitability of an idea or project prior to investing in it.
- Cash Flow Projection – This projection is used to predict the future cash flows of a company or project. It is typically used for budgeting, forecasting, and financial planning.
- Profit & Loss Statement (P&L) – This projection displays income and expenditures, as well as net profits or losses. It is used to measure the performance of a business over a certain period of time.
- Balance Sheet – This projection is a snapshot of a company’s financial position at a given moment in time. It is used to measure the liquidity, solvency, profitability, and other financial ratios of a business.
- Leverage Calculation – This projection helps assess the degree of leverage utilized by a company or investor. It is used to measure the cost and risk associated with additional debt financing.
Understanding Financial Forecasts
A forecast is a prediction of what financial experts expect the future of a company (or the entire market) to look like. It differs from a projection by focusing more on the likelihood of a given outcome, as opposed to the desired outcome made in projections.
For example, a business may project that it will expand by 15% next fiscal year. Conversely, a forecast may predict that there is roughly a 90% chance the business will grow by more than 10%, but less than 20% the following fiscal year. Financial forecasts are important because they provide valuable insight into what economic trends and outside factors can affect company performance, and they can provide guidance as to when businesses should shift their plans to ensure maximum profitability.
Types of Financial Forecasts
Forecasting is an important process used to assess the future financial performance of a business. There are various types of financial forecasts including:
- Financial Ratios – This metric measures the relationship between two or more financial variables such as operating income, assets and liabilities, and cash flow.
- Income Projection – This forecast estimates the future revenues and expenses of a business over a certain period of time. These projections can be used to plan budgets, analyze cash flows, and assess the long-term potential profitability of a company or project.
- Cash Flow Forecast – This forecast estimated inflows and outflows of cash in order to plan short-term investments and operations. The goal is to ensure that the business maintains adequate liquidity at all times.
- Break-Even Analysis – This forecast determines when the revenue generated will cover all expenses associated with running the business. It helps businesses identify optimal pricing levels that maximize profits while also meeting budgetary goals.
Developing Accurate Financial Projections & Forecasts
The accuracy of financial information is a critical component to ensure that a business is well-positioned for success. An accurate financial projection and forecast can be used as a road map of the direction and stability of the company’s future finances, which can be used to assess risks, plan strategy and identify opportunities. In order to develop such a road map, however, one must understand the process, from gathering financial data through identifying trends and making assumptions to creating scenarios.
Gathering Financial Data
The first step in creating accurate financial projections is gathering financial data relevant to the company’s current position and performance. This includes collecting both historical data related to previous profits and expenses as well as more recent figures reflecting current trends within the industry. Additionally, experts suggest examining external factors such as customer buying habits or pricing structures in order to get a complete picture of where your business may be headed financially.
Data means nothing without a strong analytical process. The analysis of historical data enables trends within a particular industry or market segment to be identified. These trends can include seasonal sales periods during which greater revenue may be expected; increased customer demand due to new product releases; or more regulated items like changes in payroll deductions or employee compensation packages over time.
When developing a financial projection, making certain assumptions helps businesses anticipate future developments that have yet to occur but may take a toll on operations. Making assumptions involves taking both internal and external factors into consideration. Doing this allows owners to prepare accordingly for scenarios either higher than or beneath expectations depending on actual outcomes.
Once all the necessary information has been gathered and appropriate assumptions have been made regarding expected values going forward, generating multiple scenarios can allow businesses to provide detailed projections. Each can be tailored toward whether their overall growth outlook stays constant or occasionally fluctuates due to economic forces beyond their own control. This exercise also reveals what outcomes look like under certain conditions while also showing areas they may need to adjust operations depending on projected returns.
The final step in the process is to routinely review your projections and forecasts to determine where you may be falling short. Comparing projected goals with realized events can reveal areas of weakness to address or strengths to expand upon.
The Essential Role of CPAs in Producing Financial Projections and Forecasts
A CPA is an invaluable resource in the creation of financial projections and forecasts as they combine their professional knowledge of tax and accounting principles with a deep understanding of the business environment to develop sound financial plans tailored to meet company needs. Having a CPA review financial plans, make sure data is properly collected and inputted, and analyze performance measurements can make a huge difference when it comes to the decision-making process.
Additionally, having someone involved with the forecasting process who can ensure everything is up to date with laws and regulations (banking, insurance, taxes, accounting) as well as identify potential risks and opportunities no one else has thought of can be extremely beneficial.
CPAs have helpful insights into managing cash flow and income, reducing liability risks, increasing profits, diversifying investments, and allocating resources effectively. Finally, by clearly displaying financial data, CPAs help organizations form a solid plan of action that will guide them in reaching their strategic goals.
At MucNurlin, Hitchcock & Associates, we offer comprehensive financial projection and forecasting services. Whether you are developing an operational or strategic budget, or creating a five-year plan of action, our CPAs can provide the guidance and expertise needed to produce meaningful projections. Contact us today to get started on your journey toward greater financial success.