Plus, if you ever go looking for more funding, you’ll need financial forecasts to prove that your business is on track for growth.
Here’s everything you need on hand, and the steps you can take, to produce a reliable financial forecast.
What is a financial forecast?
A financial forecast tries to predict what your business will look like (financially) in the future. Pro forma financial statements are how you make those predictions somewhat concrete.
Pro forma statements are just like the financial statements you use each month to see how your business is performing. The only difference is that you prepare pro forma statements in advance, for future months and years.
There are three key pro forma statements you should be familiar with:
Helpful resource: How to Read and Analyze Financial Statements
Depending on your goals, these statements will cover different time spans. If you’re creating a financial forecast for your planning purposes, you should create pro forma statements covering six months to one year in the future.
If you’re presenting your forecast to a lender or investor, though, you should create pro forma statements covering the next one to three years.
Financial forecasting vs. budgeting
When you create a budget for your business, you plan to set aside money for certain costs, taking into account your income and expenses. The budget you make may be based on info from your financial forecast, but it’s distinct from the forecast itself.
Think of financial forecasting as a prediction, and budgeting as a plan. When you make a financial forecast, you see what direction your business is headed in, based on past performance and other factors, and use that to anticipate the future.
When you make a budget, you plan how you’re going to spend money based on what you expect your finances to look like in the future (your forecast).
For instance, if your financial forecast for next year says you’ll have an extra $5,000 in revenue, you might create a budget to decide how it will be spent—$2,000 for a new website, $1,000 for Facebook ads, and so on.
Three steps to creating your financial forecast
Ready to peer into the crystal ball and see the future of your business? There are three steps you need to follow:
- Gather your past financial statements. You’ll need to look at your past finances in order to project your income, cash flow, and balance.
- Decide how you’ll make projections. Besides past records, there’s other data you can draw on to make your projections more accurate.
- Prepare your pro forma statements. Pour a coffee and get ready to crunch some numbers.
Step one: Gather your records
If you’re not looking into the past to see how your business has grown, you’re not really forecasting—you’re just guessing.
You’ll need to gather past financial statements so you can see how your business has developed over time, and then project that development into the future.
Your bookkeeper or bookkeeping software should generate financial statements for you. If you don’t have either, and you don’t have financial statements, you’ll need to take care of that before you can start forecasting. You need complete bookkeeping in order to get the transaction history you base your financial statements on.
Put aside the task for financial forecasting for the moment, and learn how to catch up on your bookkeeping.
Once your books and financial statements are up to date, you’ll have everything you need to start planning for the future.
Step two: Decide how you’ll make your forecast
Depending what resources you choose to use, the type of forecast you create will fall between two poles—historical and researched-based.
Almost every financial forecast includes a little bit of historical forecasting, and a little bit that’s research-based. The blend you choose will depend on your needs and the resources at your disposal.
Remember, the goal is to create a realistic, useful forecast—without breaking the bank or eating up all your time.
When you use your financial history to plot the future, it’s historical forecasting. You’re looking at your last few annual Income Statements, Cash Flow Statements, and Balance Sheets to see how fast you’ve grown in the past. From there, you can make a guess about how fast you’ll grow this year.
The benefit of this is that it’s relatively easy to do and doesn’t take a lot of time, money, or expertise. The drawback is that you’re only using info about your own business, and not looking at broader market trends—like what your competition has been up to.
Historical forecasting is a good bet if you’re forecasting for modest growth, or else creating a quick-and-dirty forecast for your own use—not putting together a presentation for potential investors.
When you do research about broader market trends, you’re using research-based forecasting. You may look at how your industry has performed over the past ten years, investigate new technologies and consumer trends, or try to measure the progress of your competitors. You might look at how companies similar to yours have planned their own growth.
The benefit of research-based forecasting is that you get a detailed, nuanced view of how your business could grow, taking into account a lot of different factors. And it’s the kind of forecast that investors and lenders want to see.
The drawback is that researched-based forecasting can be expensive. You may find you need to hire outside consultants and researchers to handle the heavy lifting.
Research-based forecasting is a good choice if you’re courting investors, or planning on rapid, aggressive growth. It’s also good if your company is brand new, and doesn’t have a lot of financial history to draw on for making projections
Step three: Create pro forma statements
Once you’ve collected the information you need to build your forecast, you can create pro forma statements.
We’ll cover the three key financial statements here. Whether you use all of them is up to you.
If you’re creating a quick forecast for your own planning, you may only need to create pro forma Income Statements. If you’re presenting to lenders or investors, you’ll want to use all three.
Rule of thumb: Any form you’d use in the month-to-month operation of your business should be created pro forma. For instance, if you move a lot of cash around every month, and you rely on Cash Flow Statements to make sure you’ve got enough money on hand to pay your vendors, then it’s wise to create pro forma Cash Flow Statements as part of your forecast.
Creating the pro forma Income Statement
First, set a goal—a projection—for sales in the period you’re looking at.
Let’s say you made $30,000 in sales this year. Next year, you want to make $60,000. So, your total sales will increase by $30,000.
Set a production schedule that will let you reach that goal, and map it out over the time period you’re covering. In our example, there will be 12 Income Statements in the year to come (one each month). Map out that $30,000 increase in sales over the 12 statements.
You could do this by increasing sales a fixed amount every month, or gradually increasing the amount of sales you make per month. It’s up to your instincts and experience as a business owner.
It’s important to take every expense into account so you get an accurate projection. If part of your plan is quadrupling your online advertising, be sure to include an expense that reflects that.
Once you’re done, your pro Forma Income Statements show you how much you can expect to earn and how much you can expect to spend in the time ahead.
Example Pro Forma Income Statement:
Karen’s Falafel Warehouse
Creating the pro forma Cash Flow Statement
You create a pro forma Cash Flow Statement a lot like the way you’d create a regular Cash Flow Statement. That means taking info from the Income Statement, and using the Cash Flow Statement format to plot out where your money is going, and how much you’ll have on hand at any one time.
Your projected cash flow can tell you a few things. If it’s in the negative, it means you’re not going to have enough cash on-hand to run your business, according to your current trajectory. You’ll need to make plans to borrow money and pay it off.
If your net cash flow is positive, you can plan on having enough surplus cash on hand to pay off loans, or save for a big investment.
Example Pro Forma Cash Flow Statement:
Ruth’s Raccoon Rescue and Rehabilitation Center
Creating the pro forma Balance Sheet
Drawing on info from the Income Statement and the Cash Flow Statement lets you create pro forma Balance Sheets. But you’ll also need previous Balance Sheets to make this useful—so you can follow the story of how your business got from “Balance A” to “Balance B.”
The Balance Sheet will project changes in your business accounts over time. That way, you can plan where to move money, when.
Example Pro Forma Balance Sheet:
Big Bill’s Budget Wedding Videos
Forecast vs. actuals
Once you’ve created a financial forecast, your work isn’t done. The vital second stage is to go back and record what your actual financials were in comparison to your forecast once the month or year is over.
Why is this so vital?
It helps you learn to forecast better next year, and when your forecast is way off, you can take notes for yourself on why that was.
- March revenue was much higher than I forecasted for. I didn’t realize there would be a seasonal boost over spring break.
- Sales were lower than I forecasted in the June. There was a miscommunication with the supplier and I didn’t have all the inventory I needed.
These mundane notes to yourself accumulate into invaluable business knowledge that help make every year more successful than the last.
Best, worst, and normal case projections
Whether you’re the kind of person who always sees the glass half full, or the kind who always sees it half empty, it’s a good idea to take into account different possible outcomes for your business.
Humans aren’t very good at predicting the future. Consider creating three different forecasts: One for the best case scenario, one for the worst, and one for the middle or “regular” scenario.
- Maybe the t-shirts you buy wholesale for your online store go up in price, like they did last year. Factor that into your worst case scenario.
- Maybe t-shirt prices stay the same, plus your new advertising plan takes off, and you get more business. Consider that the best case.
- Maybe everything more or less stays the same. Let’s call that the regular case.
The best/worst/regular trifecta is also useful when you’re making a budget for your business. For example, in January you might budget for a regular scenario. In this case, that means monthly sales revenue of $8,000.
However, in February say your revenue hits $10,000, and in March it’s $11,000. At that point, you may want to adjust your budget to the best case to scenario—since you’ll now have more money to reinvest in your business.
At the end of the day, the more robust your forecast, the better you’ll be able to plan the future of your business, and think on your feet. Plus, you’ll impress investors and lenders, by proving you’ve considered (almost) every possible outcome.
The better you understand how financial statements work, the easier you’ll find it to create financial forecasts. Before you start forecasting, take a look at our other helpful resources for understanding your small business financials: