No one can predict the future – but founders can get close. Financial forecasting models are pivotal tools that founders and financial planners can use to make educated predictions about a company’s future financial performance.
There are several financial models that help founders calculate the health of different aspects of their business. Predictive models aren’t concrete, but with the right data, method, and finance team backing you up, financial forecasting can be your business’s north star.
In this article, we’ll cover various methods of financial forecasting and their different uses.
What Is Financial Forecasting?
The term forecasting is a process using historical and hard data to make predictions on future trends based on the given data. Financial forecasting uses historical monetary data to predict cash trends.
Startups use financial forecasting as a defense against financial surprises relating to runway, cash flow, expenses, and sales.
Budget forecasting is another branch of forecasting that provides a single use. Businesses use this method by pulling numbers from the last budget to give predictive budgets for the next fiscal year.
Why Is It Important?
Understanding your company’s future is the first step in preventing financial surprises. If you’re getting close to your zero cash date unawares, it might be too late to start fundraising. Instead of panicking when revenue takes a nosedive, if the right financial planning and forecasting is in place, you can make changes before cash-in becomes a problem.
Financial Forecasting Categories
There are two different categories of financial forecasting: quantitative and qualitative.
Qualitative forecasting methods use hard data (facts and historical data/numbers) to predict future trends.
Examples of qualitative data:
- Profit margins
Quantitative forecasting methods use soft data (opinions and estimates). This method uses expert judgment instead of basing predictions on statistical data only.
Examples of quantitative data:
- Case studies
Should I Use Qualitative or Quantitative Forecasting?
There are benefits to both methods. Quantitative methods use expert opinions on trends and past business experiences, while qualitative methods use logical and mathematical equations. Startups with less than a year’s data can predict trends, but startups with more longevity and sales should use their data to take a quantitative approach.
If you do need to work qualitatively, take a careful look at who you have on your team that can contribute expert and accurate opinions. If you lack a source of expertise, it may be in your company’s best interest to stick to quantitative methods.
Financial Forecasting Models
Each model has strengths and weaknesses. A beneficial financial model answers the questions hanging in the air and paints a clear picture of a possible upcoming scenario. Picking the right one comes down to what information you have available.
Instead of focusing on revenue and working outward, top-down financial forecasting begins with marketing data and then works downwards to get to revenue. This method is best for predicting company performance.
Here’s how it works:
1. Use in-depth market research to find the total addressable market (TAM)
2. Look at your company’s market share
3. Multiply the market share you think you’ll be able to dominate and multiply it by TAM to predict revenue.
4. Compare predicted revenue to total operational cost, including product building and launch.
The top-down method will estimate how much of the market share you need for your company to be profitable. You can asses company weaknesses and strengths to help enhance performance.
Bottom-up forecasting requires previous numbers to provide accurate projections. Revenue is your starting point, and you work upwards.
1. Calculate current revenue per sale
2. Look at churn and sales per month
3. Multiply monthly sales individual sales by price
Example: Company X has 100 customers per month with a monthly subscription of $50 per month. Monthly churn is 10, and new customers signed up is five.
Current revenue is: 100 x $50 = $5,000
Monthly increase is: 5 x $50 = $250
Delphi is a qualitative method that uses surveys, focus questions, and questionnaires to predict trends in customers and sales. Experts on your team will review the data and make decisions based on what they’ve gathered. If you don’t have experts on your team, you can use a consulting firm to source experts in the field to produce and analyze collected data.
Uses of the Delphi method:
- Sales trends
- New product interest
- Customer churn
A straightforward model – statistics are the foundation of these types of methods. The statistical model is an effective umbrella term for techniques that use different sections of hard data from your company’s finances.
No model is going to offer a completely accurate trend. When a company falls short of a prediction, it doesn’t necessarily mean the model failed. In most cases, it highlights problem areas within its operations. You can address problems and then plan steps to reach the next projection.
Financial Forecasting Methods
There is a large pool of methods to pull from, but we suggested these top four standard methods, especially for founders looking to gain insight without getting bogged down by over-technical procedures.
1. Straight Line
The definition is in the name – it’s a straight-line forecast based on prior numbers. For example, if your sales from the last two years have consistently grown by 10%, it’s easy to surmise that growth will continue at a similar rate for the following year.
2. Simple Linear Regression
Regression analysis determines the relationship between an independent variable and a dependent variable. If a company is looking to launch a new product around the holidays with a goal amount of revenue from that specific product, timing will make a difference should you instead choose to launch that product after the holidays. Your variable correlation would be between the product launch and the impact of holiday sales trends in their market.
3. Multiple Linear Regression
Your investors may want to see a more in-depth analysis of a specific financial prediction. Using multiple independent variables against the dependent variable will give a more detailed projection. Take the holiday example above. In addition to holiday sales trends, the current market environment and the price of comparable products are other factors that may affect revenue.
4. Moving Average
The most common use of moving averages is determining stock direction, but you can use it successfully for financial projections. Most companies project short-term performance with this method by applying data from the last week, month, or quarter to determine the average.
How Zeni Can Help with Financial Forecasting
First-time founders often think they can handle their bookkeeping on their own, but there is a point where it becomes too much. Payments fall through the cracks, numbers are entered wrong, and your books become a mess of errors.
Not only do disorderly books cause problems during tax time you can’t accurately project your company’s profitability, cash flow, or revenue. Beneficial forecasting requires accurate numbers recorded by a financial expert.
At Zeni, we provide clients with a team of experienced bookkeepers and AI-powered bookkeeping software to handle all of your finances while you run your business. We update books daily and calculate burn rates weekly, monthly, or yearly. Easily pull the information you need to produce a factual financial forecast at any time, from anywhere.