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Whether you hire an accountant or crunch the numbers yourself, creating a financial forecast for your business is essential. — Getty Images/Hiraman

Financial forecasting is a critical yet often underused tactic for small business owners. In its simplest form, it involves calculating changes based on historical financial statements. The straight-line forecasting method uses data to make quantitative predictions.

Another option is to make assumptions related to your business goals and activities using research-based financial forecasts. The qualitative method considers market trends, industry benchmarks and competitor analysis.

You can use both methods for financial modeling, where you simulate scenarios to see the impact on your company's financial health.

Learn how to make predictions by following these steps to write your financial forecast.

Gather your financial statements

Before looking ahead, it's important to understand your past. First, determine the reporting period for your financial forecast. For business-planning purposes, many business owners predict income for the upcoming year. In comparison, vendors, investors and lenders require financial forecasts for the next three years.

Next, improve accuracy by pulling three years of historical financial statements. Your bookkeeper, accountant or accounting software can generate the following financial statements:

  • Balance sheet.
  • Income statement.
  • Cash flow statement.

Review historical financial statements

For a straight-line forecast, calculate the line item differences for each period. Typically, business owners start with their income statement, also known as a profit and loss (P&L) statement. Ultimately, you'll need a complete model using all three financial statements if you're looking for funding.

Financial planners often recommend creating financial forecasts for worst-, best- and average-case scenarios.

Crunch the numbers line by line to see how your revenue and expenses changed over time. A financial forecast template in Microsoft Excel or Google Sheets can make this process easier. The formula for calculating change finds the difference between two periods (Year Two minus Year One). Then divide the difference by the original number (Year One) to get a decimal. Multiply that figure by 100 to express the change as a percentage.

Here's a financial forecast example based on a fictional company:

  • Flowers Inc. had a gross profit of $30,000 in 2017 (Year One), $50,000 in 2018 (Year Two), $65,000 in 2019 (Year Three) and $55,000 in 2020 (Year Four).
  • Subtract $30,000 (Year One) from $50,000 (Year Two) to get the difference, which is $20,000.
  • Divide $20,000 by $30,000 (Year One) to get the decimal of 0.67.
  • Multiply the decimal by 100 to get the percentage of 67%.

In this example, Flowers Inc. showed growth in profit of 67% in 2018 and 30% in 2019, and a decline in profit of 23% in 2020. Complete this step for each line item on your income statement, balance sheet and cash flow statement

[Read more: Roadmap For Rebuilding: Financial Management]

Make a financial forecast or straight-line prediction

For a straight-line prediction, look at your historical performance and find the average rate for each category. Apply this figure to future years for each section. However, if you're a numbers whiz or have an accountant, you can make assumptions for pro forma statements. A pro forma statement makes predictions that may differ from your historical data.

For example, Flowers Inc. may want 2020's figure to carry less weight than previous years. Plus, the company recently added a delivery service, increasing sales and expenses. Overall, Flowers Inc. expects to achieve a higher gross profit. Since a pro forma statement isn't required to follow generally accepted accounting principles (GAAP), Flowers Inc. can include these predictions on a pro forma statement.

Likewise, Flowers Inc. may also make assumptions about its cost of goods sold (COGS) based on market data and recent cost hikes. Financial planners often recommend creating financial forecasts for worst-, best- and average-case scenarios. Doing so gives you a range of potential outcomes, which helps when planning your overall budget

Start small, dream big

Once you have a basic financial forecast, it's time to play with the numbers and figure out how to reach your business goals. In addition, think about future debt payments or large expenditures that will impact your financial statements. From our example, Flowers Inc. will pay off its startup loan next year, significantly increasing cash flow and decreasing liabilities, so it can purchase a new vehicle for delivery without negatively affecting its balance sheet.

Factor each assumption into your financial forecast for accuracy. Don't forget to update your financial forecast regularly. Doing so allows you to catch potential cash flow problems or adjust expectations over time.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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