Financial forecasting is a crucial tool for any business because it enables you to anticipate profits. The ability to accurately predict fluctuations in revenue allows you to overcome cash flow issues and budget accordingly. While there are many methodologies for preparing a financial forecast, two of the most common are top-down and bottom-up analyses.
A top-down analysis starts with a business assessing the market as a whole. First you determine the current market size available for your business and factor in relevant sales trends. Then you can estimate how much of the market will buy your products or services. In the context of these trends, you then examine your company’s strengths and weaknesses and, ideally, how to amplify your strengths and remedy your weaknesses.
On the other hand, a bottom-up analysis is grounded in the product or service itself, from which a projection is made based on what you need to get your offering to the market (i.e. things like how many employees you have, how many factories you can open or how many clients you have). Also known as an operating expense plan, bottom-up forecasts examine factors such as production capacity, department-specific expenses, and addressable market in order to create a more accurate sales projection.
In simple terms, top-down models start with the entire market and work down, while bottom-up forecasts begin with the individual business and expand out. Understanding the pros and cons of both types of financial forecasting is the best way to determine which methodology is ideal for your specific needs.