Financial forecasting best practices: How to forecast financial statements

Given today’s volatile climate, companies are embracing the idea of predictive financial planning. A critical part of this planning is forecasting financial statements.

While an important piece of your financial forecasting and planning process, forecasting financial statements can seem quite daunting. How does a company go about creating this crucial forecast? The ability to look forward and predict an organization’s financial statement requires first looking at the past.

Financial forecasting best practices: look back to look forward

The best way to predict what your financial position will be is to look back at past performance. To begin building a financial statement forecast as part of your financial forecasting process, arm yourself with some key pieces of information from previous years.

Ideally, you’ll start with at least three years of data. If your business is highly cyclical, or has weathered some economic storms, more data might help, but that’s not always true.

Three years is a good place to start, as it gives a wide enough range of information without causing analysis paralysis.

This is the most important data when forecasting financial statements:

• Sales data
• Costs associated with sales
• Historical depreciation
• Tax rates

These numbers will give you a good place to start to build a base statement forecast.

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Financial statement forecasting: Start with sales

‍Why start with sales? There are a few reasons.

First and foremost, a number of expenses are directly tied to sales. Looking at sales over multiple years will help you identify any seasonality to your sales and understand potential economic factors that might impact your financial position.

How much were your sales for the last 3 years? What was the year over year increase (or decrease)? Find the average to estimate your baseline sales amount for the coming year.

Next, review the percentages for financials directly tied to sales — things like accounts receivable, accounts payable, and inventory. What was your percentage of sales relating to accounts receivable over the last three years?

Compute the average of those to identify the number you can use for your projections. Repeat the process for the other statement numbers tied to sales.

‍Add in other expenses

‍Once you’ve got a handle on your sales numbers and associated statement numbers, you can add in additional expenses that are not directly proportional to sales. Depreciation, as well as tax and interest expenses, are a few areas that can be predicted based on past financial statements.

Disassociated with sales but still potentially variable, interest expense is something that a business has control over. Because interest is directly related to debt, you know that as your debt increases, so does this expense. The reverse is true as debt is repaid.

Tax expenses can also be estimated and included in your financial statement forecast. Estimate this by using last year’s tax expense and dividing that by last year’s pre-tax income. This gives you a baseline percentage to use as you forecast your financial statement.

‍Create scenarios from the base statement

‍With this baseline project, you can begin to formulate what-if financial statements. Projecting higher or lower sales, increasing or decreasing your debt profile, and incorporating assumptions about the economic climate or industry changes, knowing that you have a forecasted financial statement that closely mirrors the company’s previous performance.

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