It’s the question I get asked the most by accountants 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 advisory services: 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 one to build a roadmap for your small business clients.
What is budgeting?
In practice, a budget has more to do with expenses; budgets allocate expenditures for a set period of time, usually short term (quarterly or yearly). Budgets are typically prepared by detailed chart of account line item: office supplies, training, travel, and so on, and are considered spending limits. Budgets are tactical.
The traditional practice of budgeting has two methods: incremental and zero-based. These methods attempt to cover all the needs of an organization.
- Incremental budgeting is the more prevalent approach, where last year’s budget is amended to increase or decrease each line item for the next budget period.
- Zero-based budgeting starts from a place of zero by line item, and builds up, and is typically done when an organization needs a fresh start or has a major reorganization.
These budgeting protocols take into account how much an organization should allocate to cover their operational needs by setting do-not-exceed limits on expense line items. In this sense, a budget is a useful tool to manage short-term goals, like month-to-month operations and profit—tactical things.
Budgets become much more useful however, when they are tied to a financial forecast.
What is financial forecasting?
Financial forecasting is typically concerned with where a company would like to go in the long-term: its growth. 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? 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 the tool for building these scenarios: financial scenarios based on desired outcomes. Forecasts are strategic.
Forecasting is making educated guesses about what is reasonably possible, and using financial modeling to turn the guesses into projections.
Unlike budgets, forecasts are not prepared by chart of account line item—they are more summary in nature. Forecasts begin with sales projections and evolve from there, by using historical data and applying growth patterns over time as necessary 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.
What is the importance of financial forecasting?
Forecasting helps a company make long term strategic decisions like partnerships, sales plans, and staffing. For this reason, forecasts span a longer period of time than budgets—usually 18 to 36 months. Growth takes time.
Once a strategic forecast is built, a well-informed budget can be devised based on the targeted forecast projections, plus industry benchmarks, and the prior year’s actual data, if it exists. This is how the two methods come together to support strong company management.
Forecasts are strategic and help companies plan for growth. Budgets are tactical and help companies manage their month to month operations.
Forecasts and budgets in practice
Forecasts and budgets work together to plan and manage a business. Ideally, the financial forecast is developed first, so you address business strategy before tactics, but sometimes businesses will start with a budget, because the process is more familiar.
Either way it’s important to remember the place of the strategic forecast for managing growth, and that your small business clients will need your help to develop one.
Here’s an example of starting with a forecast:
A start up needs a forecast to secure an investment. They would then need a budget to ensure responsible spending and manage their use of proceeds. When the company begins generating revenue, they would need an updated forecast scenario to predict sales over time, the necessary expenses, related net profit and forecasted cash flow. And from there, they would modify their budget to detail spending by line item, and ensure their expense limits are set.
Here’s a example of starting with a budget:
A catering company already in business decides to expand by adding meal deliveries. They realize this will take planning. You use their operating budget and last year’s accounting data to develop a baseline financial forecast for the meal delivery scenario. You add sales projections and related cost of goods for the meal deliveries, as well as increased operating expenses and personnel. You help them use the forecast to plan for profitability, capital purchases, and cash flow in the new scenario. Once you develop a working financial forecast scenario, you can update their operating budget per the forecast to set expense limits for this plan.
As a public accountant, you are probably much more familiar with budgeting, and likely do it within your 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.
Forecasting as business planning
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 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, because 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 a public accountant, 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.
This article originally published in January 2018 and has since been updated and revamped by Nina Bamberger.