Financial forecasting and financial modeling are often conflated with one another. While these exercises are widely confused, they serve separate purposes and can help your business make decisions with different insights. In this article, we’ll break down when to use financial forecasting versus financial modeling and why you might choose one over the other.
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What is financial forecasting?
Financial forecasting is an exercise in which a company prepares a future outlook, setting expectations for results in the coming months or years. Financial forecasting is a part of budgeting, business planning and operations. With this process, a company can estimate its cash flow and better manage its resources.
Companies use financial forecasting typically at the beginning of each accounting period. The financial forecast is used to predict what cash flow is needed to keep the business operating and cover its financial liabilities. “A valuable forecast indicates the resources needed, when they’re needed and how you’re going to pay for these resources,” wrote the experts at Oracle NetSuite.
One way to create a financial forecast is to focus on sales. A sales forecast can tell you how much revenue you can expect, as well as project the costs associated with meeting your demand. For instance, if you foresee sales increasing over the holiday season, you may also expect to bring on extra help to fulfill orders or manage foot traffic — and budget ahead for those expenses.
What is financial modeling?
Financial modeling is the process through which a company builds its financial representation and is used to make business decisions. Financial models use forecasts to analyze how different scenarios may play out and impact the company’s performance. This analysis allows senior leaders to assess risk, make smarter investments in the company and recruit investors.
“Corporate development teams often use models when considering a potential acquisition, a divestiture or how to allocate capital to better understand how this might impact revenues and expenses,” wrote Oracle NetSuite. “They may also use it to decide if and where to open or close facilities, outsource certain operations or add/reduce headcount.”
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A valuable forecast indicates the resources needed, when they’re needed and how you’re going to pay for these resources.
Rami Ali, Oracle NetSuite
While forecasts can help in the immediate term, financial modeling is more comprehensive. Financial modeling would examine the financial impact a forecasted increase in sales will have on the company’s balance sheet, income statement and cash flow statement.
Financial forecasting vs. financial modeling
When should you use a forecast versus a model? Financial forecasts are best used for making short-term business decisions. Forecasts use historical data to anticipate revenue and expenses for a quarter or fiscal year. Consider forecasts as more of a budgeting tool than a way to make key decisions or recruit investors.
Models use forecasts and other data to try to figure out how a decision may impact business performance. Financial models are typically created with a specific question to answer, such as whether to work with investors, or an outcome to analyze, such as the feasibility of an expansion or different market risk factors.
A popular financial modeling process is to link a company’s income statements, balance sheets and cash flow statements in a “three statement model” and to test how changes to the model impact each of the three individual statements. Some companies also use models like the discount cash flow (DCF) model, merger and acquisition model, consolidation model and budget model.
There are many different tools that can be utilized in financial forecasting. Delphi forecasting, statistical forecasting and bottom-up financial forecasting are different methods that can help project cash flow and improve budgeting. There are also many platforms, such as QuickBooks, that can provide financial modeling and forecasting in just a few clicks.
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