Five General Considerations to Guide Your Financial Projection Process
Projecting the future involves a degree of uncertainty, and can be described as both an art and a science. That said, there are various generally accepted considerations incorporated into financial projection methodologies, with five of the most important explained below:
Historical Operating Results As the saying goes, history tends to repeat itself. In the world of financial projections, recent history speaks loudest. When compiling inputs to be used for financial projection purposes, historical results typically serve as the primary basis for future expectations. Projectors should also consider weighting historical operating results so that recent values are more heavily weighted, and older/stale values hold less significance in the projection calculations.
Budgets The budgeting process typically requires a defined series of internal reviews and approvals, and benchmarking is commonly performed to ensure actual results are in line with budgeted values. As such, budgets are a carefully considered blueprint of how an entity plans to deploy capital to fund operations for the year. Instead if independently projecting the first year of operating results, budgets can be a valuable tool to supplement near-term financial projection efforts.
Strategic Plans Looking further into the future, strategic plans serve to guide an organization for the upcoming three to five years. Strategic planning includes expanding (scaling) of operations, winding-up of existing businesses, mergers and acquisitions, etc. Timing (and associated capital needs to execute strategic plans) should be aligned to the respective projected periods to present when (and how) the strategic plan implementation will occur.
Macroeconomic Scenarios In times of macroeconomic stress, most businesses would expect a downturn in their results of operations, while boom times are likely to bring more prosperous results. Independent macroeconomic variables, and the degree to which they directly impact an organization, should be considered in an attempt to capture how such conditions are expected to impact future profitability. Geopolitical conflict, inflation, unemployment levels, etc. are examples of macroeconomic considerations which may impact an organization’s projected bottom line.
Interrelation Anticipated fluctuations in projection inputs rarely occur in a silo. In other words, a change in one input often affects another (or several other) projection attributes. For example, if supply chain issues occur because of political unrest in an overseas manufacturing hub, various expense categories (labor costs, shipping fees, insurance, etc.) and revenue considerations (available units for sale (inventory), pricing considerations, etc.) may all come into play.
As exemplified above, thought should be given to ensure assumptions move in concert with one another. Without considering the interrelation of projection inputs, impacts of specific scenarios/assumptions may not fully be captured by the resulting financial projections.