Financial forecasting helps business owners plan ahead, budgeting accordingly for seasonal trends, new product launches or long-term consumer trends. A quarterly financial forecast, for instance, uses the previous quarters’ data to ensure there will be sufficient cash flow to the business’s operations and liabilities.
There are a few different methods for creating a financial forecast. These four common models fall under three broad categories: qualitative techniques, time series analysis and projection and causal models. Qualitative techniques use data such as expert analysis or information about special events to create a forecast. Time series analyses require focusing on patterns in historical data. And causal models use a combination of historical data and expert opinion in their forecasts.
Here are a few examples of what those three categories of financial forecasting look like in practice.
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The Delphi method
The Delphi method falls under the qualitative category of financial forecasting. This model uses opinions from a panel of experts to understand a specific economic situation and how unfolding market changes could impact the business. Each expert is also asked for their analysis independent of the others to gain deeper insight into that person’s field of expertise. For instance, a business owner might have the directors of sales, marketing, finance and customer service all provide their insight into customer trends together and then give their analysis on their specific departments.
Top-down or bottom-up forecasting
Top-down forecasting is used by startups or for businesses that are expanding into a new market. This method aims to assess the size of the market and estimate how much market share the business could gain. Start by understanding the total size of the market: How many total customers could feasibly purchase from your company? From there, factor in relevant sales trends, as well as your company’s strengths and weaknesses.
Bottom-up forecasting uses current financial statements and sales data to create a projection based on what you need to get your product to market. Sometimes called an “operating expense plan,” this type of forecast will factor in production capacity, head count, expenses for each department and the total market size to try to create an accurate sales projection.
Bottom line: You may choose different financial forecasting models for different points in your business lifecycle.
Whether you choose bottom-up or top-down financial forecasting depends on your company’s maturity as well as your goals. Top-down forecasting can be an effective method for new businesses that have not accumulated enough sales data. It can also provide a more optimistic forecast, useful for entrepreneurs seeking investor support. Bottom-up forecasting is generally seen as better for seasonal businesses that have variable sales throughout the year. It’s a more reliable technique for making budgeting and hiring decisions.
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Correlation forecasting
Correlation forecasting is a type of causal forecasting that involves tracking variables to see how they may influence one another. For instance, you might track supply and demand or pricing and costs. By gaining an understanding of how these variables impact each other, you can better determine how growth in one area impacts the overall business. If you forecast that demand will go up, it may lead you to increase your inventory or to invest more in training and hiring of seasonal workers.
How to choose the best forecasting model
With so many options, which forecasting model is right for your business? The short answer: It depends on the information you have, how the forecast will be used and how relevant historical data will be in estimating future results.
“The selection of a method depends on many factors—the context of the forecast, the relevance and availability of historical data, the degree of accuracy desirable, the time period to be forecast, the cost/benefit (or value) of the forecast to the company, and the time available for making the analysis,” wrote Harvard Business Review.
Bottom line: You may choose different financial forecasting models for different points in your business lifecycle. There’s no one way to try to prepare for the future.
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