One of the many responsibilities of the finance department is to provide projections of a company's future results and performance, with the aim of helping business stakeholders make well-informed decisions.
Financial forecasting and financial modeling are critical aspects of this. These terms are sometimes used interchangeably and thought to have the same meaning, and while there are clear similarities between them, there are also some crucial differences.
What is financial forecasting?
Financial forecasting is the process companies follow to come up with projections of future performance and results, with a focus on key indicators such as revenue and expenses.
These predictions can take a wide range of factors into account, including:
- Current market share
- Competitor analysis
- Past company performance
- Historical industry data and trends
One of the most important and commonly used projections is the sales forecast, which many organizations rely on to create a picture of potential future revenue generation. This often proves crucial when the company needs to make other financial decisions that will require a certain level of investment, such as hiring more staff or purchasing new equipment.
Financial forecasts can span multiple accounting periods, or they can be issued for the forthcoming quarter or year. Businesses sometimes issue revised projections during a reporting period, if sales are trending in a different direction to what was predicted or unforeseen factors are impacting performance. The COVID-19 pandemic is the clearest recent example of an event that could force companies to revise their sales forecasts.
When you take a step further than forecasting where the company is headed and start to think about the financial implications of your projections, you're moving into the territory of financial modeling.
What financial forecasting methods are available?
The financial forecasting methods you choose will depend on the unique needs and priorities of the business, as well as any time or capability constraints you have to consider. The most common approaches are:
- Straight-line method: This involves the use of historical figures and data to make informed revenue growth projections, usually with clearly defined start and end dates. The straight-line method is generally considered the simplest way to get started with financial forecasting.
- Moving average: This technique enables you to create moving average models - often covering three-month and five-month time periods - based on repeated forecasts informed by past performance data.
- Simple linear regression: This method can be useful if you want to analyze relationships between different variables and performance indicators within the company. It can be used for tasks such as plotting a trend line for sales and profits, so you can build a more detailed picture of how the business is performing by cross-referencing key data. A rising trend line, in this case, would suggest performance is good and margins are healthy, but a falling trend line - created by increasing sales but falling profits, for example - could alert you to problems such as escalating costs.
- Multiple linear regression: Similar to simple linear regression, this method can be used in more complex situations, particularly when you want to analyze a range of independent variables and create projections for how different combinations of these factors could affect your performance and results.
- Time series: This method focuses on clearly defined time intervals to inform projections over a set term. A basic example of how it could be used is by examining monthly revenue and growth over the past quarter and using these figures to formulate a forecast for the next month.
Using ERP for financial forecasting
Another valuable business tool that's worth considering when thinking about financial forecasting is enterprise resource planning (ERP) software. This technology harnesses the power of automation and data analytics to gather information from various departments and centralize it, giving company leaders and decision-makers a comprehensive view of the current state of the business.
ERP systems offer the potential to unify the most important functions of any organization, including:
- Inventory and order management
- Customer communications
- Human resources
For finance and accounting teams in particular, ERP can prove invaluable for tracking and reporting data across key areas and practices such as accounts payable, accounts receivable and payroll. Financial planners and analysts can use this software to turn large amounts of raw data into actionable reports on fundamental business performance indicators like revenue, expenses and cash flow.
These resources and insights could enable you and other decision-makers to make better informed and ultimately more accurate financial forecasts. In the long term, this will put you in a stronger position to prepare for challenges in your industry and make the most of opportunities that come your way.
What is financial modeling?
Once you've taken all the relevant data into account to create your sales or performance forecasts, you can use this information to shape your thinking about how a particular strategic move or investment could impact business performance.
This is achieved through financial models, which are essentially mathematical tools that link different variables together to help you make well-informed business decisions. They can also help you anticipate the impact future events or challenges could have on the company.
One common approach to financial modeling is the three-statement model, whereby the finance department combines income statements, balance sheets and cash flow statements.
Other frequently used financial models include:
- Discounted cash flow model
- Merger and acquisition model
- Consolidation model
- Budget model
- Forecasting model
- Initial public offering (IPO) model
As the names suggest, the relevance of these frameworks depends on the specific goals and requirements of your business at any given time and what you're hoping to achieve in the future. If you're thinking about going ahead with an IPO and publicly listing shares in your company, for example, a bespoke IPO model will help you gauge the current value of your organization before taking the next step.
5 significant differences between financial forecasting and financial modeling
Understanding the distinctions between these two functions is essential if you want to build the most accurate picture of your company's current performance and make key decisions with all relevant information at your disposal.
1. Modeling plays a bigger role in decisions
It's in the company's decision-making process that arguably the most important difference between financial forecasting and financial modeling becomes clear. While the former focuses on predicting future performance and results, the latter uses this information to create a model the business will rely on when making key decisions.
Financial models are often created for a very specific purpose - to give a representation of the business when you're seeking outside investment, for example. In contrast, forecasting gives a more general overview of sales and other key aspects of performance over a given time period.
3. Different formats
As noted above, financial models can come in a wide range of formats, depending on current challenges or opportunities facing your business, your most important goals or a major decision you have to make in the near future.
Your financial forecasts will appear on income and cash flow statements and balance sheets. That means, if you have shares available for public purchase, these projections will be accessible to your shareholders, which is required to give a transparent picture of your performance and outlook. However, financial models are intended for internal decision-makers and you're under no obligation to share them with outside investors or creditors.
5. Data sources
A wide range of data should be taken into account when producing a financial forecast, from broader economic and industry trends to the past performance and current position of your business. When you reach the financial modeling stage, the forecast you’ve produced will become a key data source in itself, along with any other relevant inputs that can help you make the right strategic decisions.