Learning the difference between financial modeling and forecasting is crucial for business owners because they’re two distinctive tools that you can use to help you get control of your finances.
While many people use the terms financial modeling and financial forecasting interchangeably, they’re not the same.
What Exactly Is Financial Forecasting?
Financial forecasting is a means of better understanding future financial performance using:
· Current internal and external trends
· Historical data
· Current business pipeline
· Other pertinent data
When creating a forecast, it’s not uncommon for the forecast to be updated during the reporting period as conditions change. Additionally, most forecasts are for periods as short as a quarter to as long as a year.
After a year, forecasts tend to become less accurate and unreliable.
Reliability requires the correct data be input, and this is where cash flow software for QuickBooks online or the accounting software you use is important. Forecasting tools make it easier and more cost-effective to generate accurate financial projections.
Forecasting: Why Is It Important?
Why should you spend time running forecasts? Accounting teams prefer to run forecasts at the start of accounting periods or quarters because they provide valuable insights into the business’s cash flow throughout the forecast period.
For example, if a business has negative or low cash flow during the forecast period, this can lead to:
· Securing loans
· Laying off part of the workforce
· Cutting back on investments
However, if cash flow looks to be exceptionally strong during this period, it will be possible to invest in growth initiatives, hire new staff and make different data-driven decisions.
When businesses have an inkling of their cash flow during a forecast period, it will be easier to make smart, lower-risk business decisions.
What Techniques Are Used in Financial Forecasting?
Financial modeling examples will often include one of four main methods, such as:
2. Moving average
3. Simple linear regression
4. Time series
Financial Modeling: What Is It?
Now that you know what financial forecasting entails, let’s answer an important question: what is financial modeling? Financial modeling uses the forecasts provided to begin assessing which scenarios will impact the business’s performance.
For example, modeling may look at the introduction of a new product and how investment in it will:
· Benefit the business
· Put the business at risk
Financial departments will use three main income statements and adjust them to create a model. These statements include:
· Balance sheets
· Cash flow statements
· Income statements
The Importance of Modeling
Financial forecasting models are very important for businesses because the future is always uncertain. Modeling will help business leaders have a clear correlation between current operations and long-term results.
Models are incredibly valuable tools when trying to understand the impact of:
· Capital allocation
Additionally, many businesses will use models to learn how a decision impacts operations. For example, the company may run a model on raising prices to learn how much:
· Business will be lost
· Revenue will be gained
Modeling may find that at a 1% business loss, the rise in price is justified because it will still generate 5% more income. Short-term and long-term financial models are used to understand the effects of business decisions, and they are a very powerful tool for understanding business decision outcomes.
Forecasts and models are often used in conjunction to give a clear picture of business decisions, future finances and cash flow.
Comparing Financial Modeling and Financial Forecasting
Are you still struggling to understand the key difference between modeling and forecasting? Consider the following:
· Similarities: Forecasts and models are both used to understand how a business will perform, its expenses and its revenue during a specific period.
· Similarities: Historical data is used in both modeling and forecasting,
· Similarities: Stakeholders will analyze models and forecasts to better plan and budget for the business’s future.
· Differences: Financial modeling is often done for investors or to learn the impact of a specific business decision.
· Differences: Accountants will build financial models using analytical tools rather than just historical data and current trends.
Financial modeling may or may not be given to investors and internal teams, while forecasts are often included on balance sheets.
Financial modeling and forecasting are two ways to better understand a business’s finances. If you use these tools, you can make data-driven decisions with lower risk for your company.