Financial forecasting: Definition, 7 methods + how to do it

Understanding the different financial forecasting methods and how to use them is important to develop your business plan or manage your business’s finances.

Forecasting helps you identify when you can expect the capital you need to be profitable or grow your business. For external funding, financial forecasts help convince lenders and investors that your business will be profitable and offer them a return on investment. For internal purposes, accurate forecasting enables you to budget for your new business and benchmark your milestones.

In this article, we’ll break down how financial forecasting works, the seven financial forecasting methods, and the types of forecasting you can use.

How financial forecasting works 

Financial forecasting, which is different from creating financial projections, is a metric of future profits and expenses taken from historical company data and estimates. It is important for several reasons, such as:

• Pitching to investors for a cash investment based on your future sales and revenue
• Creating budgets and maintaining cash flow for the coming term
• Approaching a financial institution for an investment based on your projection of future cash flows
• Informing stakeholders of the future of the company and possibilities on the horizon

Note that financial forecasting is also different from financial modeling and budgeting. 

Financial forecasting vs. financial modeling 

Financial forecasting and financial modeling are two distinct concepts in finance. Financial forecasting is the process of estimating financial performance. Financial modeling is the process of creating a quantitative representation. Modeling often uses Excel spreadsheets or financial forecasting software—many of which directly integrate with your QuickBooks accounting software. 

Overall, financial modeling is more comprehensive, encompassing various aspects of a company's financial performance and incorporating different scenarios, such as a best case, base case, and worst case scenario. 

Financial forecasting vs. budgeting 

Financial budgeting is a strategy where you plan your spending. The budget you create can use information from your financial forecast, but it’s separate from the forecast itself. 

When it comes to financial budgeting and forecasting, your forecast will help you understand the money you’ll have available in the future. Budgeting is then how you plan to allocate that money and resources. 

For example, if your financial forecast shows ‌that your revenue will increase by $25,000 this year, you may create a budget to determine how to allocate it, such as $15,000 for a new piece of equipment and $10,000 for marketing.

What are the financial forecasting methods?

Your company can utilize seven key financial forecasting methods, each with unique nuances that can help create a visual for your financial future. They are either quantitative or qualitative. 

• Quantitative financial forecasting methods: Also known as statistical forecasting, these rely on historical figures and statistics. For example, using last year's sales to form a prediction about this year's sales in the same quarter, not considering outside predictions, such as market opinions.
• Qualitative financial forecasting methods: These are a bit more complex. Instead of just using hard data to form a prediction, researchers might also include soft data. For example, a qualitative forecast could include opinions or estimates and more intangible factors rather than numbers. 

Below are the seven types of financial forecasting methods you can use—the first five methods are quantitative, and the last two are qualitative: 

1. Percent of sales

The percent of sales forecasting technique estimates each financial line item as a percentage of sales. The cost of goods sold (COGS) is likely to rise in proportion to sales, so it makes sense to apply an identical growth rate estimate to each.

To project the percent of sales, you would analyze your historical financial statements. You can calculate this by dividing each account by total sales. A breakdown of the percent of sales looks like this:

For example, if the cost of goods sold has consistently been 40%, you may ‌use that assumption for future projections.

2. Simple linear regression

A simple linear regression forecast method is a statistical technique used to predict the relationship between two variables. In the context of financial forecasting, it helps to estimate the future values of one variable, called the dependent variable, based on the historical values of another variable, called the independent variable. 

In simple linear regression, the relationship between the two variables operates under the assumption that the relationship is linear. 

3. Multiple linear regression

When two or more variables directly influence a company's performance, business leaders may use the multiple linear regression method. This method enables a more precise forecast since it considers several variables that affect performance. To utilize multiple linear regression for forecasting, a linear relationship must be present between the dependent and independent variables.

4. Straight line 

The straight-line method presumes a company's historical growth rate will stay consistent. Projecting metrics like future revenue or gross profit entails multiplying the company's revenue from the prior year by its growth rate.

For instance, if the previous year's growth rate was 15%, straight-line forecasting anticipates a continued 15% growth for the upcoming year.

5. Moving average

The moving average method involves using the average or weighted average of previous periods to predict the future. This method focuses more on a business's peaks and troughs in demand, making it particularly useful for short-term forecasting. For example, you can forecast the next quarter’s sales by averaging the previous quarter.

6. Market research

Market research is a qualitative method that plays a key role in organizational planning. It enables business leaders to get a market perspective using competitive dynamics, conditions, consumer trends, or surveys. 

Market research is particularly useful for startups lacking historical data. New businesses can profit from financial forecasting, as it is indispensable for attracting investors and budgeting during the initial months of business.

7. Delphi method

The Delphi method for forecasting entails consulting experts who evaluate market conditions to project a company's performance. You can send these experts questionnaires, asking them to use their expertise to predict business performance. 

Financial forecasting types

Along with qualitative and quantitative forecasting methods, there are also different types of financial forecasts you can use. Financial forecasting methods are the techniques that predict future financial outcomes based on historical data, market conditions, and management insights. 

Additionally, each financial forecasting type refers to a specific financial aspect. There are four types of financial forecasting: 

Sales forecast

A sales forecast can project your sales for at least three fiscal years, including monthly sales for the first year, then quarterly for the following two years. 

This type of forecast answers questions such as:

• How many customers can you expect? 
• How many units will be sold? 
• What is the cost of goods sold? 
• How will you price your products?

Sales projections can forecast revenue. And when the cost of goods sold is also a consideration, you can estimate gross profit for each of those years.

After accounting for your operating costs, subtract this from your gross profit to calculate your actual profit—otherwise known as net income (or profit). Calculate operating expenses based on your expense budget.

Expense forecast

Operating expenses are any expenses businesses incur from performing their normal business operations. These include fixed costs, like rent for your physical location, and variable costs, like marketing expenses. 

The expense forecast model allows you to:

• Plan for upcoming short-term and long-term expenses based on previous years or quarters.
• Prepare for unexpected expenses that could occur.
• See which expenses only occur periodically, such as subscriptions.
• Plan for increased expenses due to operations and output.

You don’t need to do an incredibly detailed breakdown, such as listing the cost of every office chair, but you do need general figures. 

Top-down forecast 

Top-down forecasting involves taking the market outlook as a whole to project future estimates for the company. This way, you’ll start with a big picture and slowly work your way down to produce a view of the company based on various components. 

For example, if you sell car parts, you would:

• Look at the overall market for car sales. 
• Narrow it down to used cars vs. new cars.
• Narrow down further to the make and model of the parts you need to produce. 

This approach is most common for newer companies with little historical data to go off. 

Bottom-up forecast

A bottom-up approach works in the exact opposite fashion. Instead of starting with a big picture and working it down, you simply reverse. For example:

• Start with the product or service you provide.
• Work your way up to view the market of your product or service as a whole.

This is a much more involved process than top-down because it uses historical data on the company to make assumptions about achieving certain objectives for the upcoming term. Taking and organizing your company's historical data can pose an extra step but one well worth the time and effort.

5 steps to create a financial forecast

You can create your own financial forecast in five steps, which includes putting together a series of pro forma financial statements. 

1. Get your past financial statements

To forecast effectively, it is key to analyze past business growth rather than making blind assumptions. You’ll want to gather your previous financial statements to understand your business's development over time and project this growth into the future.

Your accounting software can provide you with financial statements. But make sure your bookkeeping is up-to-date. Once your books and financial statements are current, you will have all the necessary tools to prepare for future financial planning.

2. Figure out why you’re forecasting

Next, figure out what and why you want to forecast. Ask such questions as: 

• What insights do you aim to gain? 
• Are you looking to predict the number of product or service units you will sell? 
• How will the existing budget influence the company's future? 

From there, you’ll also want to determine the forecasting horizon, which may span from a few weeks to multiple years, though most businesses typically forecast for one year.

3. Pick a financial forecast method 

Once you have your prior financial statements and goals, you need to pick a financial forecast method. Recall that: 

• Quantitative forecasting employs historical data and information to find trends and patterns. 
• Qualitative forecasting uses expert opinions and insight. 

Each approach is appropriate for distinct purposes. A qualitative method works best if you don’t have any past financial data, such as in a startup. 

4. Create your pro forma financials

After gathering the necessary information to develop your forecast, you can now create pro forma statements. For businesses looking to complete a quick forecast, such as internal use, a pro forma income statement may suffice. 

If you are presenting a financial forecast to investors or lenders, you’ll want to forecast all financial statements. 

5. Monitor your results

Consistently evaluating financial information is the most effective method for determining the accuracy of your financial forecasts. You’ll want to look at the forecast results vs. the actual results and understand if you were correct. Ongoing financial management and analysis can improve future financial forecasts.

Best practices for a financial forecast

It can be a challenge for any business owner to create financial forecasts, especially in the early days. If you don’t have any historical data to give you a better sense of future projections. 

However, with a little market and industry research, you’ll have some solid data to help you create a realistic prediction. Here are some tactics to consider:

Use your own industry experience

You may have worked at a similar business within the same industry before branching out on your own. In this case, you might know what realistic financial projections look like, how long it will take to scale, what growth rate is ideal, and what profit margins are normal within your industry.

Work with an accountant that knows your industry

An accountant who is familiar with your industry will know the average expenses, sales, and profits a well-run business can expect. They will likely be able to help you develop realistic financial projections for your business.

Do market research to create a sustainable business model

Industry associations and publications can help you compile accurate financial data. Look at ‌‌publicly available information, such as Census.gov, to better understand your target audience. Find assistance from small-business advisors and mentors through SCORE or your local Small Business Development Center (SBDC).

Be optimistic but realistic

Investors and lenders know that your startup’s financial analysis isn’t set in stone, but you need to ensure it’s realistic. Lending institutions and investors have seen too many overly optimistic entrepreneurs about their businesses. 

When starting a business, banks, and investors will scrutinize your figures to ensure growth potential.

Run your business with confidence

Using financial forecasting to understand your finances can be a major benefit for business owners. It can also go a long way when presenting your finances to lenders or investors. 

QuickBooks makes it easy to monitor relevant sales data and manage cash flow in one place. This allows you to grow your business and improve customer success.