January 12, 2022 by Adam Hoeksema
Financial terminologies are often misunderstood, and they are frequently used interchangeably. However, similar-sounding terms like "financial forecast" and "financial projection" don’t technically carry the same definitions.
Financial projections and financial forecasts are both forward-looking statements. Both make predictions about future events based on specific assumptions. Furthermore, both calculate the likelihood of a certain outcome.
Along with their apparent resemblances, they have even more in common. Both are future foreshadowings, and both provide more reliable results in the near term but less so in the long run. So, it's no surprise that the two are frequently confused.
To tease out the differences, it’s necessary to take a deeper look into each of these estimates.
What Is Financial Forecasting?
A financial forecast for a company predicts, processes, or estimates a company's performance in the near future, usually a year or less. It’s an important step in the annual budget process; financial risk reduction, establishing realistic goals, and other planning strategies.
In a nutshell, a financial forecast is a statement of management's expectations. It is based on what senior management expects to happen to and within the organization, as well as the projected financial consequences. This is the information publicly-listed firms make available to stockholders and the broader public.
Financial forecasts help you make better business decisions based on facts and statistics. Making a monthly financial forecast a habit assists you in planning your next moves in terms of finance, operations, and budgeting. You can use previous data to forecast your company’s future and determine whether it's a good time to hire new employees or fund a new project. In addition to that, financial forecasting encourages companies to set more realistic long-term goals.
What to Include in a Financial Forecast?
There are many things to consider in a forecast, but here are some of the key elements:
- Business start-up costs
- Sales figures
- Operational costs
- Cash flow forecast
- Cost of goods sold
Advantages of Financial Forecasts
The advantages of financial forecasting are the ability to attract investors, establish business viability, prepare for future spending, decrease financial risk, and measure and improve your firm. All of the advantages are stated as follows:
- Attracting investors - To attract potential investors, you must share a financial projection. To attract investors or secure bank loans, you must be able to project where your firm will be in six months or a year.
- Determining business viability - If the financial forecast is not promising, the business owner may be advised to revise the business plan.
- Planning for future expenses - You can identify whether business loans or further investments are required by recognizing when sales may be lower or cash flow will be lowered.
- Reducing financial risk - Forecasting lets you take a wide picture of your business and identify areas where resources are wasted, allowing you to repurpose or limit them.
- Measure and improve business performance - You can continually and more precisely anticipate your future performance with each consecutive financial forecast.
How to create a forecast?
Businesses make forecasts to plan for future growth based on the trends and events most likely to occur. To create a forecast, follow the steps below:
- Define the reasons and time frame for your forecast
Before starting, definitions need to be agreed upon and the goals of the forecast set. These will determine which metrics are going to be used in the forecast. For example, are you going to be estimating sales figures or budget limitations?
How long into the future is your forecast going to estimate? Forecasts can look weeks or years into the future, and the length of time your’s covers will be determined by market changes and trends specific to your niche. All forecasts lose accuracy over time, so keep this in mind.
Defining objectives is critical here too. A forecast should direct business policies, so deciding on either a conservative or an objective forecast will determine the balance of caution and/or contingency against anticipated risk.
- Gather information and analyze your past revenue and expenses
Business forecasts require historical information about an organization's financial health to present a more realistic picture of what to expect in the future. You may use these elements to prepare for future development by looking at prior financial records to gain insight into how your firm has evolved.
Gathering both stats and opinions from department heads or founders is important at this stage. The more information you can get for analysis at this step in the forecast, the more accurate it’s likely to be. Looking at the drivers for revenue and expenditures will help in quantitative models.
Analysis will involve taking these data and other relevant economic metrics and selecting the appropriate quantitative techniques. Essentially, this is a pattern-recognition stage; lookout for trends in revenue/expenditures, populations, anomalies, and other variables that might give a clue to the trajectory of the financial forecast.
Excluding data at this stage will affect the accuracy of your forecast, so it’s important to have the right figures.
- Select methods
Determining the correct methods to use in a forecast is critical to its accuracy. More complex models might be accurate in specific circumstances, but often the simpler techniques have a more generalized application and can be just as useful.
The technique chosen will also depend on the experience of the forecaster and the detail of the data available to them. There are three fundamental means for forecasting:
Regression makes use of statistical analysis to describe a linear relationship between an independent and a dependent variable. In practical terms, this might be the effect on sales revenue (dependent) by the price of the product (independent). With regression, the price of the product can predict the revenue.
Extrapolation is the process of using historical data to estimate future trends. This is a very simple form of forecasting and can be as straightforward as looking at the % growth in revenue over the last year and anticipating similar performance in the following one.
Hybrid forecasting works with subjective and objective data. This is essentially a combination of statistical analysis (quantitative) with an expert intuition of the current trends (qualitative) to form a judgment-based hypothesis of the future.
Implementing these methods should involve the primary forecast and perhaps a conservative and objective boundary to give a range of anticipated outcomes that the reality is likely to fall between. But be careful here – the difference between a financial forecast and a financial projection is primarily in these estimates. A financial forecast should be what management expects to happen. We’ll discuss more of the difference later in this article.
Forecasts are designed to affect policy and decision-making, so they must be presented in a trustworthy manner. A credible presenter, a clear message, and a call to action linking the research with a decision-making plan are essential to successfully implementing a forecast.
What is a Financial Projection?
The financial projections meaning revolves around the outcomes and results that a company hopes to accomplish, regardless of external considerations such as market position and brand awareness.
An organization sets a future target or desired outcome, such as expansion, growth, or profit, using a projection, which explains what the organization's members want to achieve in the future.
While these are weighted in probability, they’re more desired outcomes than forecasted ones, designed to project a company’s options and set the course of action.
Financial projections highlight the range of opportunities available to a company and can affect policy regarding the direction a company wants to take and establish its financial goals.
What to Include in a Financial Projection?
Financial projections should include the following information:
- Probable maximum loss (PML) historical data
- Projected cash flow statement
- Projected balance sheet
- Key assumptions and review
Advantages of Financial Projections
The following are the advantages of financial projections:
- Financial situation - This helps you get a clear picture of your company's financial opportunities and the courses it can take in the future.
- Covers ‘what if’ situations around the potential future of your finances.
- Preparation for expenses – This allows you to plan for expenses and revenue based on market supply and demand patterns.
- Establish goals - The financial projection allows you to set objectives by making deliberate commitments to long-term success options highlighted in the projection.
How to make a business projection?
When a company makes a projection, it follows a sequence of procedures that include basic financial data, similar to a forecast. Follow these steps to make a simple business projection that will show you where your company is headed in the future.
- Evaluate current spending and sales
Determine your expenses and revenue values using historical and current data. These two numbers provide a starting point for determining your long-term financial demands, as well as a broad notion of where to put your revenue goals.
- Determine financial output
Make an estimate of the expenses you expect to incur overtime based on your previous financial data. Include all fixed costs and extend them into the budget plan for the coming years. All costs in the PML need to be projected.
- Plan for different circumstances
This phase needs you to consider hypothetical scenarios to plan for success and overcome potential obstacles.
Many firms, for example, develop estimates based on “what if” scenarios. When predicting for desired results, there are a few key questions to consider:
- “The market expands quickly?"
- "There are new entrants into the market?"
- "The company is unable to secure the materials required for production?"
- "Your business investments pay off in unforeseen ways?"
Your business operations, anticipated revenue outcomes, and overall growth and development goals will all influence the hypothetical events you identify that could alter your projections.
- Determine projected expenses
The scenarios you projected in the previous phase can help you foresee the costs you'll face over time. Create a projection for the expenses you plan to incur in order to accomplish your revenue goal by the end of the year.
- Develop a plan of action
Create an action plan that specifies what your firm will do if each condition is to be met, based on your projected revenue and expenses, as well as the desired situations that may be realized in the future.
What initiatives need to be put in place to bring costs down and achieve the desired targets? Develop a plan of action for your organization to meet your estimates, such as if your revenue and expense values depend on a marketing campaign that attracts new leads.
A business projection creates a hypothetical path to what you want to happen in the future.
Services like Projection Hub can simplify the process of designing and implementing financial projections.
Projection vs. Forecast: Is There a Difference in the Financial Forecast and Financial Projections Meaning?
While companies use both financial projections and financial forecasts to anticipate their cash flows and business direction, there are major differences in the meanings of the two terms.
Assumed Outcomes vs. Expected Outcomes.
The difference between assumed and expected outcomes is one of the key differences when considering projections vs. forecasts. Businesses use projections to make financial predictions based on hypothetical or desired scenarios rather than necessary outcomes of current trajectories.
For example, when one or more hypothetical events happen, a business may project a course of action, such as developing a new product to fulfill the need of predicted market growth.
Financial projections often serve as an outline for analyzing the desirable outcomes a business expects to see, including its financial, cash flow, and operational outcomes, because they assume the probability of diverse events occurring.
Forecasts, unlike projections, are based on current and historical patterns and evidence to indicate a planned conclusion given current trends. For example, a business will analyze historical data on past earnings, current production costs, and predicted market activity to determine the most likely outcome to production, growth, and development.
Businesses also think about the existing competition in their marketplaces to better understand how they'll have to compete in the future. A financial forecast can also be more useful for valuing private business investments since projections provide more precise insight into what businesses expect to happen over a specific time period.
Management estimates the best possible outcome and most likely result in a financial forecast. These are often presented to stakeholders outside of the inner workings of the company.
Financial projections may be more affected by management bias since they are desired outcomes, focusing on the internal adjustments required to reach an optimal projected goal.
Projections and forecasts have different ranges in terms of the distance into the future they predict and the business type they’re working for. These horizons are shorter in forecasts, focusing on more immediate expectations, and aim to predict quarterly or annual results.
Projections often cover one or more years in the future and are extensions of current trends.
Forecasts and projections both lose accuracy with longer horizons, but because projections are designed to anticipate the effects of current, established behaviors and trends, they can be extended further to present the effect of these patterns on the long-term outcome of the company.
Although the terms "forecast" and "projection" are sometimes used interchangeably in accounting, there are some crucial distinctions to be aware of.
The differences lie primarily in whether the estimated outcome is realistic or hypothetical. Projections offer a range of possibilities for the direction of a company, and forecasts show what will happen to the company based on its current trajectory.
Both systems offer companies the opportunity to correct course, but each serves an individual and useful purpose.