What is a Forecast and Why Does it Matter?
What do you think of when you hear the word forecast? If I had to venture a guess, the first thing that comes to mind is the weather. That makes sense. Every day we receive forecasted information specifically related to the weather.
It used to be that we relied on the nightly news to plan for the following day’s weather. But today, most of us consume weather forecasts through apps on our smartphone. Weather forecasts have become more accessible, and as technology and data acquisition have improved, one could argue that they have become more accurate.
The ability to assess the weather in real-time has allowed us to better plan our days. Whether that planning involves what to wear or whether to cancel the bbq scheduled for the weekend; a weather forecast gives us the information we need to make better decisions and plan accordingly.
The same logic can be applied to forecasts in general, including financial forecasts. Webster defines a forecast as the act of trying to predict or calculate a future outcome. So when we are forecasting something we are looking to predict the future to a certain degree, which is not easy but can become easier with the right inputs.
In this post, we are going to dig a bit deeper into forecasting, and specifically, why it is important to your company’s future. Our goal is to shed a bit more light on the general forecasting methodologies we use for Bookvalu as well as unpack forecasting in general. While we won’t go into specific calculations, we want to provide the gist.
Let’s get started
A Starting Point
So how do we go about predicting something that may or may not occur in the future? Well, that’s the tricky part, but the first step is to start. Knowing where to start is critical in creating the most accurate forecasts possible. The starting point of any prediction will set the tone for the entire forecasting process. If you use the wrong starting point, you risk under or overshooting the actual outcome.
A starting point is merely the base value you are going to use for your forecasting calculations. So for example, let’s say that you are trying to predict a major league baseball player’s batting average for an upcoming game. Where would you start?
There are several places you could start and data points you could gather to begin the forecasting process.
Let’s start the process by asking a few questions.
- What is the player’s current batting average?
- How has that batting average trended over the last few games?
- Who is the team playing?
- What is the player’s current batting average against that team?
- How has that batting average trended over the last few games?
If we can answer those questions, we are well on our way to forecasting his batting average in the upcoming games. Let’s analyze the answers and see if we can establish a starting point.
- What is the player’s current batting average? .330
- How has that batting average trended over the last few games? Over the last three games, his batting average has been .265, .310 and .340 respectively.
- Who is the team playing? The Yankees
- What is the player’s current batting average against that team? .280
- How has that batting average trended over the last few games? .260, .300, and .290 respectively
Let’s analyze the answers and see if we can establish a starting point.
So, we can immediately see that this player’s batting average, on the whole, is higher than it is when it is trended explicitly against the Yankees. We can also see that over the last three games his batting average has been a bit sporadic, but lower than this season average. The same can be said for his batting average against the Yankees.
So what should our starting point be? Well, it likely cant be his overall season batting average because that might be too high as he has not performed as well against the Yankees. So, .330 is out.
Ok, so where to next. Well, a player is only as good as his last few playing performances. A good starting point then could be looking at his batting average across the last few games and specifically against the Yankees. If we do that, we will get a batting average somewhere between .283 and .305.
A starting point then needs to take into account a few factors. It must reflect current reality, meaning that is is representative of what is occurring in the most recent past. A starting point also needs to be more specific than it does broadly. By that, I mean that it doesn’t look at the overall performance, but rather specific performance. In this case, batting average against the Yankees.
So where a forecast starts is essential. But what next? We now know what batting average we may want to use as a reference point for a projection, but what does that do for us?
Looking for Direction
Having a starting or reference point allows us to progress forward in a direction. By direction, I mean how are we going turn that reference point into a full-fledged forecast of the players batting average in the upcoming game?
There are several directions we can take when forecasting information. But all of the routes use the starting point we established as a guidepost that we move forward from.
Think of a direction as the methodology that we use in the determining the batting average. But to establish that methodology, we need to think about the inputs and assumptions we need to apply to our starting point.
In baseball, several factors influence a player’s batting average. They range from the obvious, like is the player playing that day, to what the weather is going to be like, to who is pitching that day and if the game is home or away.
Each of those inputs impacts the overall accuracy of our forecast. So for example, if our player has a starting batting average somewhere between .283 and .305 we need to factor in a few other variables to improve the accuracy of our prediction.
The way we do this is by coming up with a list of the most critical factors, then determining how much that will impact the batting average and then applying them to our forecast.
The way we determine how and to what degree each factor will impact our forecast is by weighting each of them. So in other words, how much will each specific element affect our estimate.
The weighting of these external factors allows us to make a more informed forecast that takes into account the player’s ability, historical trend, and outside factors. So we’ve painted a full picture that we can then use to make a prediction.
In practice, this will involve multiplying each of our batting averages against these weighted factors to calculate new estimates of the players forecasted batting average.
A Roadmap not a destination
How can we be sure that in the upcoming game that our player will genuinely bat what we forecast? Well, we can’t. That’s the thing with any forecast; it will likely be different than what we predict. So what’s the point?
The way I would encourage you to look at any forecast or projection is to view it as a roadmap. By that, I mean that you’ve established a starting point, and then determined a direction, and the forecast brings it all together in a roadmap.
A roadmap is used to get from point A to point B. But remember a roadmap is static. Meaning that once a direction has been chosen, it becomes static and will not change unless you adjust the route and select a different roadmap.
There are many ways to get to point B, and there may be unexpected events that occur that cause us to have to change course and take a different direction.
A forecast is the same. It will likely need to be adjusted as we make our way and learn more about current reality. Just like the weather, a forecast will need to be adjusted if the wind changes or there is some factor that changes the forecast.
When we are developing a financial forecast for our companies, we have to keep that in mind. Meaning that we establish a starting point and head in a direction using the best information we have at the time. We know full well that if new information presents itself, we will likely have to update our forecast.
The key is not to react to every bump or pothole. A forecast needs to be robust enough to respond to material changes, but firm enough to understand what is immaterial and does not warrant a shift in direction.
So to recap, the roadmap is the final aggregation of our forecast, and it’s associated methodology. It comes together to set our course and plan for the future. Which brings us to what do we do next?
The beauty of any forecast is that it is likely to be incorrect. Now I don’t say that cynically, but rather in a way anticipates change. Just like the current reality of your business can change, our forecasts need to adapt.
Keeping this in mind – a forecast that is based on historical reality and is adaptable is an excellent way for a business to assess and plan for the future. Using our projections as a guide, we can look into ways to grow the business or ways to reduce costs.
I would suggest that using tools like Bookvalu you make it a practice to review the financial forecasts it provides on a monthly basis. That way you can consider any material changes and react accordingly.
In practice, this may involve downloading the PDF financial report each month and looking at any changes. For those who enjoy working in Excel, I would encourage you to export your financials each month, and with a few basic comparison formulas, you can quickly triage what changed and why.
A weather forecast is a data point that informs a larger context. It may not necessarily define your day, but it certainly helps to steer it. This is true of a well thought out the financial forecast. It won’t necessarily chart the course for your business or define a strategy that you can implement, but it can be deployed as a guide.
We’ve built Bookvalu to include the tenets of a sound financial forecast that were covered in this post. But as I explained, a financial forecast is an informed estimate that is likely incorrect. We are always looking to improve the application, so we welcome your ideas and suggestions in the comments below.
Bookvalu is QuickBooks Forecasting, Ratio Analysis, and Valuation software that provides financial visibility and insight for your Small Business.