Spot the Difference: Financial Forecasting vs. Financial Modeling (2024)

In business development, people often refer to financial forecasting and financial modelinginterchangeably. While there are commonalities between the two, forecasting and modeling aredistinct functions.

The tendency to mischaracterize financial forecasting and financial modeling stems from theircomplementary nature. Both also have similar objectives: gathering information to predict abusiness's future performance to help stakeholders in a company make critical decisions.

employees create financial forecasts to project revenue andexpenses, which then help the business estimate its cash position at a certain period in thefuture. This may be a standalone role in larger companies, while it is often incorporatedinto the responsibilities of finance employees in smaller companies.

Once the team has created forecasts, it can use financial modeling toolsto simulate the effect of decisions using different scenarios andconditions. In effect, financial modeling helps the finance department fullyunderstand the impact of decisions on future business performance.

Increasingly, tools are making it easier for stakeholders outside of FP&A to createmodels in areas such as product development, marketing, human resources and the supplychain.

Key Takeaways

• Financial forecasting is the process of projecting how a business will perform during afuture reporting period.
• Financial modeling is the process of gathering information from forecasts and otherdata, then simulating discrete scenarios to analyze what impact they might have on thecompany’s financial health.
• Business planning teams often rely on business forecasts and models together to developmore granular forecasts, create budgets, assess capital needs and analyze investments.

What Is Financial Forecasting?

Financial forecasting is an essential function within business planning, budgetingand operations management. Business leaders, investors and creditors review theseforecasts to assess projected revenues and expenses so they can estimate a company’scashflow throughout the accounting period. A financial forecast considers trends in external andinternal historical data and projects those trends in order to provide decision-makers withinformation about how the financial performance of the company is likely to be at some pointin the future.

A company’s key stakeholders rely on financial forecasts to make decisions aroundpurchasing,hiring and capital expenditures. Managers need financial forecasts to create budgets.

In most cases, companies issue financial forecasts for the upcoming quarter or year. Often,forecasts will cover multiple reporting periods. Companies sometimes issue revised forecastsduring a reporting period if they determine sales are trending in a different direction dueto unforeseen factors.

Why Is Forecasting Important?

Forecasting is an important step at the outset of each accounting period because itestablishes how the business will maintain the cash flow needed to cover its financialliabilities. It also provides data that leaders rely on when creating budgets. Likewise,financial forecasts weigh heavily in financial decisions about a major capital expense,hiring or other substantial investments. A valuable forecast indicates the resources needed,when they’re needed and how you’re going to pay for these resources.

A business might include the predictions of its forecasts on pro forma financial statements,which are like standard financial statements, except they show results for the past andfuture based on hypothetical conditions. Pro forma statements are often given to investorsor creditors, who will take them into account as they decide whether to give the companyadditional funding. They’re also used to illustrate the impact of a recent or plannedacquisition or merger.

Financial forecasts are also critical for anyone creating a new business plan.

What Are the Methods of Financial Forecasting?

Finance teams create forecasts by gathering any available data that could improve theirprojections, including sales, labor expenses, cost of materials and more. Much of thatinformation comes from prior reporting periods, but finance employees also consider internaland external information that could have an impact on expenses or revenues. Depending on thenature of the business, external data could include economic or industry reports and othervariable factors, such as extreme weather events and geopolitical influences. Examiningfactors that could surface in the future is also important in accurately projecting revenuesand expenses.

The finance department has historically created simple forecasts in Excel spreadsheets, andmany still do. But now that employees have access to more data and tools than ever before,many companies are using Enterprise Resource Planning (ERP)modules for forecasting or dedicated software that integrates forecasting, budgeting andmodeling.

There are four different financialforecasting methods:

1. Straight-line Method: Considered the simplest approach to forecasting, plannersuse historical figures and trends to estimate revenue growth. Financial forecasts usingthis method typically have defined beginning and end dates. Financial analysts can usespreadsheets to create these forecasts, though a tool designed for forecasting makes it easier to respond in arapidly changing market.
2. Moving Average: Moving averages use repeated forecasts to develop estimatesbased on past performance and the patterns within. The most common moving average modelsare for three months and five months out.

3. Simple Linear Regression/Multiple Linear Regression: This is a method ofanalyzing the relationship between a dependent and independent variable. Using thesimple linear regression method, if the trend line for sales (x-axis) and profits(y-axis) rises, then all is well for the company and margins are strong. If thetrend line falls because sales are up but profits are down, something is wrong;perhaps there are rising supply costs or narrow margins.

   A linear regression shows the changes to the dependent variable using a graph line,indicating a trend. identify underlying patterns which you can then use to evaluatecommon financial metrics such as revenues, profits, sales growth and stock prices. Arising moving average indicates an uptrend, whereas a falling moving average pointsto a downtrend. In more complex scenarios, companies may use a multiple linearregression to look at multiple independent variable outcomes. They can then analyzehow those factors will affect business results.

4. Time Series: A time series method uses numbers from specific time intervals,like the last several months, to predict future performance in the short term. Forexample, a distributor may look at revenue numbers and monthly growth over the pastthree months to forecast results for the upcoming month, or an energy company could useit to predict oil prices over the next two months.

What Is Financial Modeling

While forecasting provides the base estimates of a company’s performance during a givenaccounting period, modeling allows analysts to usethose forecasts to assess how various potential scenarios might impact near- and long-termperformance. Financial modeling tools letanalysts manipulate their forecasts as much as they choose to assess the risk of whateverdecisions or investments they are considering.

Financial forecasts are based on income statements, balance sheets and cash flow statements.The finance department can link these three reports to create what is known as athree-statement model—any change to the model affects the three statements. Otherpopularmodels include the discounted cash flow (DCF) model, merger and acquisition model,consolidation model, budget model, forecasting model and pricing model.

Why Is Modeling Important?

A finance team might build models as they create or revise their financial forecasts, whichexplains the frequent confusion between the two functions. But financial models serve otherpurposes, as well, to analyze both current operations and for long-term forecasting.Corporate development teams often use models when considering a potential acquisition, adivestiture or how to allocate capital to better understand how this might impact revenuesand expenses. They may also use it to decide if and where to open or close facilities,outsource certain operations or add/reduce headcount. Models can also help determine theimpact of raising or decreasing prices for various products or services.

During the COVID-19 pandemic in 2020, many planners had to create new financial models toadjust their short-term forecasts based on the sudden and dramatic economic downturn.Integrated budgeting and planning tools helped many companies adapt quickly and mitigate the impact ofCOVID-19. It also helped them see the effects of various possible outcomes relatedto the pandemic.

Now that these tools have become more powerful and easier to use, modeling has moved beyondjust finance. Marketing, sales, supply chain and procurement professionals increasinglycreate models to inform their strategies, decisions and recommendations to executives.

Financial Forecasting vs. Financial Modeling

Commonalities

• Finance professionals build forecasts and models with the objective of offering areasonable estimate of how a business will perform, including both revenue and expenses.They develop this estimate based on historical and presumed future factors.
• Forecasts and models typically use the same historical data and projections of variablecosts to predict a company’s revenue.
• Similar audiences analyze the output of both financial forecasts and models, includinginvestors, lenders and corporate planning and budgeting teams.

Differences

• The financial forecast is the baseline representation of predicted cash flow andexpenses for a given accounting period. It’s represented in pro forma incomestatements,balance sheets and cash flow statements.
• Finance professionals build financial models using analytical tools that allow them tounderstand how different internal and external events might impact cash flow andexpenses.
• Those who create financial models are often doing so for a specific reason, such asseeking investors, analyzing the impact of finite business decisions and the riskfactors associated with each. Forecasts are done on a regular basis to help withplanning and budgeting.