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A Foolproof Guide to (Realistic) Financial Forecasting

Business Finance

A Foolproof Guide to (Realistic) Financial Forecasting

Updated: August 16th, 2023

Powerlines - A Foolproof Guide to (Realistic) Financial Forecasting

As your small business grows, you’ll eventually need a major cash inflow to take your company to the next level. Aside from looking at past numbers, investors and lenders are particularly interested in your projections for your balance sheet, income statement, and cash flow statement. In short, they’re looking for a financial forecast!

Let’s review key steps on how to complete realistic financial forecasting.

Get Started with These Free Templates

First, to save you time on financial forecasting, download our free templates that you can use as a jumping-off point:

Cash Flow Statement Template (link?)

Provides historical data of the cash inflows and outflows of your business and shows how much actual cash on hand you have at the end of a given period.

Income Statement Template (LINK?)

Presents the profitability of your business by subtracting all applicable expenses from your total income. The result is a net profit (or net loss).

Balance Sheet Template (LNK?)

Shows the assets, such as cash, inventory, and equipment, of your small business and how much of them are owned by you (equity) and your lenders (liabilities). A balance sheet provides you with a snapshot of your business’s financial position (what you have and where it came from).

If you need a primer on how to fill out these financial statements, here are two useful resources:

Using invoices, receipts, bank and credit card statements, and other financial data, you can input the information to gauge the financial forecast of your operation for a set period—past or current.

But what about if you’re still in the pre-launch phase, or trying to project for future periods? Let’s tackle the financial forecasting process with this in mind.

Financial Forecasting: Your Cash Flow Statement

1) Costs

Think of a cell phone or Internet plan for your small business; you can gather pricing data for a series of plans up to the next 36 months and choose a reliable estimate for the next three to five years. If you have been in business for a couple of years already, you may even be able to provide an educated guess of the annual price increase of certain expenses (if any).

On the cash flow statement template that you downloaded above, look under Operating Expenses (Lines 11 through 25) for some common business expenses, such as accounting fees, advertising costs, wages, insurance premiums, and rent charges.

Ideally, you’ll want to break down your projections for expenses into months for the next three to five years. If you feel that you can only do a financial forecast for the first year, then it’s alright to present a total for the next two to four years instead.

As you’re gathering your cost data, you’ll find yourself pondering about market trends, past performance, and future revenue. 

  • “If the rumors about the Home Depot warehouse opening nearby within a year are true, I may want to bump up my advertising budget by 30% this and next year so that I can boost awareness around the opening of my hardware store.”  
  • “Over the next two summers, I’m counting on the increasing influx of visiting foreign students that shopped for imported food items at my bodega. That’s why I’m spending an extra 20% on stocking up on that type of inventory over the same period. If immigration laws were to dramatically reduce the amount of visiting foreign students, how would I be affected?”
  • “My small business in Oregon doesn’t offer a retirement plan to our 11 employees. However, the state-mandated retirement plan OregonSaves may require me to enroll some or all my employees in this state-sponsored retirement plan as early as May 15, 2018. Depending on how many of my employees enroll or opt out of the plan, I will incur additional operating costs.”

You should also create three scenarios for the financial forecasting of your expenses:

Regular Scenario

When creating a financial forecast of your expenses, the regular scenario involves analyzing your past spending habits and projecting them into the future.  It is important to include all expenses, both fixed (such as rent or loan payments) and variable (such as equipment purchases or supplies). Once the budget is created, it is important to regularly monitor and adjust it as needed to ensure that expenses stay within your means and financial goals are met.

Best Scenario

A best-case scenario in business financial forecasting would involve the company exceeding its projected revenue and profit goals. This could be due to successful product launches or increased demand for their services.

Additionally, the company may be able to secure funding from investors at a higher valuation than anticipated, allowing for further growth and expansion. In this financial forecast scenario, the company would also be able to manage their expenses effectively, keeping costs low and maximizing profits.

Worst Scenario

There are several worst-case scenarios that can occur in a financial forecast. One example is when a company overestimates its revenue projections, leading to a shortage of cash flow and an inability to meet financial obligations such as paying employees or suppliers. Another scenario is when a company underestimates its expenses, leading to unexpected costs that can eat into profits and leave the company with little or no cash reserves.

In some cases, external factors such as economic downturns or natural disasters can also disrupt a company’s financial planning and lead to unexpected losses.

A good practice is to keep a list of the assumptions for each financial forecasting scenario so that you can have context around  applicable changes in some of the numbers. This is a living, breathing document; don’t be afraid to adjust the assumptions and make changes to your forecasts as necessary.

By completing both best-case and worst-case financial modeling, you won’t be completely blindsided if something unexpected throws a wrench in your original game plan. You’ll also be able to provide articulate answers to the questions that potential lenders and investors have when evaluating the sustainability of your business.

2) Estimate Sales and Costs of Sales

Now that you have three scenarios, you’re in a better position for financial forecasting for your sales (line 6 from cash flow statement template) and corresponding costs of sales (line 7) under those three scenarios.

Estimating sales and costs of sales is a crucial step in financial forecasting because it provides a realistic picture of the revenue and expenses that a business can expect in the future. Accurately forecasting sales and costs of sales allows businesses to plan for the resources they need, such as inventory, staffing, and equipment, and ensure that they have enough cash flow to cover their operating expenses. It also helps businesses  make informed decisions about pricing, marketing, and production strategies. Without this information, businesses may overestimate their revenue or underestimate their expenses, which can lead to financial difficulties and even failure.

To estimate sales, you need to consider the market demand, competition, and pricing strategies. You can use historical sales data, market research, and industry trends to make informed assumptions about future sales. To estimate costs of sales, you need to consider the direct costs associated with producing and delivering your product or service. This includes the cost of materials, labor, and any other expenses directly related to producing the product.

3) Use your revenue projections to double-check expenses. 

Using revenue projections to double-check expenses in financial forecasting is important because it helps to ensure that the business is financially viable and sustainable. By estimating the revenue a business is likely to generate, it becomes easier to determine how much money can be allocated towards expenses such as salaries, rent, and marketing. This helps to avoid overspending and running out of cash, which can be detrimental to the business.

Additionally, comparing revenue projections to expenses can help identify any areas where the business may be overspending or not generating enough revenue, allowing for adjustments to be made to improve profitability.

For example, if you were to project your sales to increase by 50% by offering credit to your clients under the best-case scenario, double-check that you have a realistic number of employees or contract workers to handle the extra orders, account for the extra hours or fees needed to keep track of accounts receivables and make an allowance for payments that you won’t be able to collect from clients. This information is going to come in handy when completing financial forecasting for your balance sheet.

If your small business manufactures products or purchases them for resale, you have the option of including eligible expenses, such as costs of raw materials, storage expenses, and direct labor costs, in your cost of sales (also known as Cost of Goods Sold or COGS for short). As a reminder, the formula for COGS is:

Depending on your type of operation and industry, you may need to break down the cost of sales to keep track of key charges. Just remember: no double-dipping. Once you include certain expenses in your COGS, those costs can’t be listed again under operating expenses.

To complete the cash flow statement starting on line 29 use the guidelines set here.

For additional tips on identifying and using cash flows from operating, investing, and financing activities, refer to our guide on cash flow analysis.

An additional bonus: by using financial forecasting methods to keep track of these expenses throughout the year, businesses can ensure that they are taking advantage of all possible deductions and minimizing their tax liability. Accurate record-keeping can also help businesses avoid penalties and audits from the IRS.

Financial Forecasting: Your Income Statement

By completing the financial forecasting for three to five years of your cash flow statement, you’ve completed most of the necessary legwork for your income statement and balance sheet for the same period.

On the income statement template that you downloaded above, input the same amounts for revenue (lines 9 through 12) and costs (lines 16 through 22). To save you time for future updates, refer cells on the income statement back to the appropriate revenue or cost on your cash flow statement.

This way, any updates made on the cash flow statement will be automatically transferred to the income statement. Edit the document as necessary to account for the specific revenues and costs from your small business.

Note: On the cash flow statement we included taxes (line 19) under operating expenses. On the income statement, you want to calculate your net income before taxes and account for your tax expense on line 26.

The income statement template is set up to automatically add up your total revenue (line 13), total costs (not including taxes, line 23), and net income (line 26). Complete the forecast of your income statement for the next three to five years.

Financial Forecasting: Your Balance Sheet

On the balance sheet template that you downloaded above, you’ll list the assets, liabilities, and owner’s equity from your small business. Here you’ll leverage data from your cash flow and income statement to forecast amounts for these three items.

During the cash flow analysis that you completed during the development of your cash flow statement, you establish the cash flows from operating activities (lines 31-32), financing activities (lines 34-37), and investing activities (lines 38-39).

This analysis will provide some guidelines for the numbers to input on your balance sheet for:

  • Current Assets (lines 9-13)
  • Fixed Assets (lines 17-21)
  • Other Assets (lines 25-27)
  • Current Liabilities (lines 34-40)
  • Long-Term Liabilities (lines 44-47) 
  • Owner’s Equity (lines 51-53)

When making assumptions about debts or capital that you will secure in the future, make sure that you’re able to back up your data with as many facts as possible. 

For example, a startup enrolled in an accelerator program with an initial investment of $25,000 from investors could safely forecast that it’s  expecting to receive up to $75,000 in follow-on funding from those same investors over the next one to two years. However, a small business owner without a business credit score and a FICO score in the 500s could have a hard time proving that he’s going to secure a $200,000 business loan—unless that business owner could show ownership of adequate collateral for the loan.

The balance sheet is set up to automatically add up all totals for each one of these six categories. Complete the balance sheet for the next three to five years, as needed.

Putting It All Together

It should be clear that your cash flow statement, income statement, and balance sheet tell a consistent story. Financial forecasting is a dynamic process that you should revisit at least once every quarter, or whenever a major event takes place.

One way to check for the consistency of your numbers is to use key financial ratios, which your investors and lenders would use to evaluate your statements. Here are two examples:

1) Quick Ratio

Also known as the acid-test ratio, the quick ratio measures the ability of a business to use its most liquid assets to cover its current liabilities. A very low quick ratio is a red flag that a cash crunch could be a major stumbling block for a business.

2) Gross Profit Margin

This ratio measures the efficiency of a business in using its raw materials, labor, and manufacturing-related assets to generate the bottom line. The gross profit margin is a useful test for your best-case scenario. A gross margin that makes a dramatic jump from the regular scenario to the best-case scenario could be an indication that the estimates for expenses are off.

What about other financial ratios out there?

There are dozens of financial ratios and some of them aren’t applicable to some industries. Don’t try to use every single one and stick to the ones that make the most sense to your operation and that your investors and lender are most interested in.

By focusing on a handful of financial ratios, you’ll become more aware of the effects of business decisions on the profitability of your business and have useful benchmarks to evaluate the performance of your small business.

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