The Better Way of Creating a Basic Financial Forecast

Some business owners react to adversity like the impulsive person who buys a 4-wheel drive vehicle after a late winter blizzard – when springtime is right around the corner. Rather than panic and needlessly overspend, the superior entrepreneur is guided by a plan. The tool of a financial forecast provides this opening for nuance.

A financial forecast presents prospective revenue, expenditures, and resulting cash flow. Most importantly, it conveys capital inflow needs – whether from borrowing or your personal funds – and when those needs are expected to arise. The forecast alerts you to make adjustments in areas you control when surrounding circumstances vary from your estimates. As actual events unfold, any deviation from the forecast is cause for corrective action.

Creation of a financial forecast is often an unfulfilled goal because the process is bounded by uncertainty. The forecast entails estimations about a future that is always somewhat unpredictable. A sound mechanism for maximizing the reliability of estimates in a financial forecast is therefore the root of the entire procedure. Construction of the forecast utilizes either of two methods.

Top-Down

Most small business operators deploy top-down forecasting. This method starts with an estimation of the top line item in a forecast – revenue. A common practice is reliance on past revenue. Added to this figure is an optimistic amount of growth. Sometimes future revenue is projected based on anecdotal evidence about the performance of similar companies in your industry or local competitors. Top-down forecasts frequently estimate the size of a customer market and the expected share of this market the business will capture.

A problem with this analysis is that industry trends constantly alter. Failure to consider the direction of change is a major drawback. Moreover, top-down forecasting is especially difficult for businesses with limited histories from which to base estimations of market share. Customers are often much less willing to switch to your company than you might believe.

Hence, having a dependable top line number is very elusive. When actual revenue strays from the predicted top line, the foundation of the entire forecast is skewed. You constantly adjust the financial forecast with new wild guesses.

Bottom-Up

A bottom-up approach to forecasting takes you out of the backseat into driving the plan. This technique ignores guesswork about market size and market share. Rather, it considers the resources at your disposal and identifies projected revenue based on what you have to invest in the business. Consider how many sales you can make utilizing your available time and money. This endeavor determines the number of customers you’re likely to capture and identifies revenue from multiplying by the average price each customer pays.

Key to bottom-up financial forecasts is what drives your sales. This could be advertising expenditures, rent for an optimal physical location, investing in an efficient inventory tracking system, spending on tools needed for project completion, or reserving funds for necessary business travel. Comparing your eventual revenue and expenditures to forecasted figures reveals the true relationship of spending to revenue. This permits modification to your financial forecast. You uncover what revenue to truly expect and how much additional investment is needed for robust growth.

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