It’s the question I get asked the most by accountants and business consultants who are beginning Strategic Advising services: “I do budgeting already. What’s the difference between a budget and a financial forecast?”
The answer is fairly straightforward, but also intriguing, in that it has a lot to do with the real value of small business advising: helping your customers survive and thrive. By looking at the key differences between a budget and a forecast, we can start to understand why financial forecasting is important to your advisory services, and how you can use a forecast to build a roadmap for your small business clients.
What is a budget?
A budget is an income and spending plan that outlines the revenue and expenses in a business over a certain period of time. Budgets are typically prepared once a year, and it’s common to compare budget versus actual results as time progresses.
In practice, budgeting is primarily focused on expenses; allocating expenditures for a set period of time, usually in the short-term (quarterly or yearly). Budgets are typically prepared by detailed chart of account line items: office supplies, training, travel, and so on. Income is included, but the budgeting process is most often concerned with setting spending limits through conservative estimates.
Budgets are a useful first step for businesses to understand their financial picture. The income expectations and spending limits establish useful guidelines for a business to follow to remain healthy. Budgets are a good first step to larger, strategic planning. However, due to their limitations and conservative nature, budgeting is really a tactical exercise, concerned with the details of spending to keep profit and cash positive.
What is a financial forecast?
Financial forecasting is the process of making educated guesses about what is reasonably possible for a business, and applying business rules and drivers (a financial model) to turn those guesses into projections. A financial forecast is typically concerned with where a company would like to go in the long-term—its growth. Leveraging a forecast provides a full financial picture of your business—income, cash, and equity.
For instance, if a company is netting X amount in revenues per year and wants to grow to 2x revenues, how will they get from here to there? What will their full financial picture look like when they do? Or, if an economic downturn occurs, and the business must determine how it will respond to survive, what changes will it have to make? A financial forecast is a tool for building these financial scenarios based on desired outcomes.
Complete financial forecasts include all three financial statements: profit and loss, cash flow and balance sheet. The process of forecasting typically begins with sales projections and evolves from there, by referring to historical performance and applying growth patterns over time to reach desired goals. Expenses are then layered in, beginning with direct costs and finally adding indirect expenses to meet desired net profit. Assumptions about cash receipts and payments are added to forecast cash flow, and other assumptions and business rules can be used, like information about inventory needs or financing.
Unlike budgets, forecasts are not prepared by accounting for every line item—they are more of a summary in nature. Instead, you’ll be incorporating your chart of account lines into larger forecast categories, which represent strategic income streams.
What is the importance of financial forecasting?
Forecasting helps a company make long-term strategic decisions like establishing partnerships, sales plans, and staffing. It allows a business to see its full financial picture of profit, cash, and equity in the long term. For this reason, forecasts span a longer period of time than budgets—usually 18 to 36 months, and include all three financial statements: profit and loss, cash flow, and balance sheet.
Once a strategic forecast is built, a well-informed budget can be devised based on the targeted forecast projections. The budget sets detailed spending limits to help achieve the bigger picture forecast goals. This is how the two methods come together to support strong company management.
As a business advisor, consultant or accountant, you might be more familiar with budgeting, and might even build budgets in your client’s accounting software. I encourage you to practice forecasting until you become comfortable with it and then use it as a tool to help your strategic advisory clients plan for growth.
Key differences between budgets and financial forecasts
Focus: Details vs guides
Timing: Annual process vs big picture for the future
Impact on business: Tactical vs strategic
Developing business strategy with forecasting
A well-written financial forecast should be a roadmap for running a business. A forecast is based on business drivers, like unit sales, hours billed, or memberships sold. Those drivers, once revealed and documented, can be tracked and measured, which allows the business owner to stay on top of very practical targets month by month. These are sometimes called key performance indicators, or KPIs.
On the expense side, the financial roadmap will dictate when major expense events can occur, based on sales and net profit. Purchasing capital equipment or hiring new employees are a couple of examples of expense events.
Financial forecasts should be expanded into scenarios for best case, worst case, and working case. This way the business has a plan for growth as well as for lean times. This is especially relevant in periods of economic downturn, where small businesses may be struggling with a decrease in demand and changes to their supply chain.
If business scenarios are only considered using budgeting techniques, the tendency is to be overly cautious. Growth requires stretching the goals and aiming high. The industry term stretch-goal is used to indicate when a business is setting a higher goal than originally sought or thought possible. When reasonable stretch goals are set and recorded, they become the plan of action.
Strategic advising: financial forecasting in action
And here’s where the discussion becomes more interesting and even exciting. What we’re saying is that a business dream, if translated into a goal, can actually be attainable with the right plan. And you can help your small business clients achieve their goals by helping them develop the plan. It’s a wonderful feeling, and work worthy of undertaking.
If your clients are asking for help with budgeting, they may not appreciate the difference between an operational budget and a strategic forecast for long-term growth. Use that as an opportunity to flex your advisory muscles and teach them the difference.
As an advisor, you can turn your savvy with numbers into a wonderful offering to your small business clients by applying this knowledge in your Strategic Advising practices.
Four reasons why financial forecasts are better than budgets – Financial forecasting versus budgeting
Financial forecasting is similar to budgeting, but better in ways that make it more useful as a business management tool. Here are four reasons why:
First, financial forecasting paints an entire financial picture of a business by addressing all three financial statements: profit and loss, cash flow, and balance sheet, sometimes called a three-way forecast.. Budgets are typically more focused on setting expense limits, and are best made after a forecast scenario is built.
In order to build the full picture, the forecast is based on all the elements of the underlying business model. Besides revenue and expenses, things like capital expenditures and debt servicing, and even elements like strategic partners and other resources are considered.
Second, financial forecasting is typically for a longer period of time. A full forecast typically looks out over 12 – 24 months, or even longer depending on the size and maturity of the business, versus budgeting, which is usually for the current fiscal year.
Specific, shorter periods of time can be analyzed and updated based on real world occurrences, but it takes this longer, fuller picture (often called a “look” at the business) to see how a shorter time period can affect the long term. The longer period of time is necessary for making informed decisions. It’s important for a business to see at least 12 months of forecasted profit and cash balances in order to make smart spending decisions.
A third difference is that forecasts are summary information, and budgets contain more detail. A profit and loss forecast for instance, does not contain revenue and expense lines for every account, but rather summaries based on big groups. This helps you more easily review the data, and remain strategic about decisions.
Finally, forecasts are updated monthly, as time progresses and more is known. To be an effective management tool it must be up to date. A forecast is designed to be updated monthly. The update is a key part of the process, because each period’s actual results bring insights to business performance, and reset the forecasted cash and profit figures. This allows for better understanding of the business’s future and more confident decision making.
Budgeting on the other hand is typically done once each year. Budgets are sometimes updated mid-year, but as they are typically more focused on expense limits, the practice of updating them is not as common.
Regular planning is important for a fiscally responsible business. A small business owner should know the sales goals for the year, the direct expenses needed to support them, and the overhead costs and other fixed expenses of their business. But when it comes to budgets versus forecasts, a well used and updated forecast can take the place of a budget.
It’s fine to have both, and a business can certainly start with just a budget, but the forecast will provide the true financial roadmap for the business, guiding decisions and supporting a level of confidence that is unmatched with budgeting alone.