In business planning, people often use financial forecasting and financial modelling interchangeably. While the two have similarities, they are actually two distinct functions. Yet, they are complementary to each other and have the same objective of making reasonable estimates of how a business will perform based on historical and presumed variables.
The Difference Between Financial Modelling and Forecasting
Businesses use financial forecasting to project their revenue and expenses, which then help them estimate their financial performance in the future. It can be a standalone process, but can also be incorporated into other functions.
On the other hand, financial modelling is the process of integrating the forecast’s assumptions with the organisation’s financial statements to create different scenarios and conditions and understand how certain decisions can impact their future business performance.
In this article, we’ll discuss further the functions of financial modelling and forecasting, where they are used and how they are created.
Decision-makers analyse financial forecasts to assess their projected income, expenses, and cash flow within a certain period. It determines the sustainability of the business and whether the strategies are viable in the long term, regardless of the economic conditions.
A forecast considers factors such as historical data, market trends, past and current economic performance, etc. to derive information business owners and investors can rely on to make decisions around budgeting, purchasing, even hiring.
In most cases, businesses create financial forecasts and develop benchmarks on a quarterly or yearly basis. They revisit the forecast during the fiscal period to compare the budget to actuals and adjust the direction where it needs to be.
In summary, a financial forecast is used to:
- Assess the viability of the business or a specific activity
- Take control of your cash flow
- Develop benchmarks to assess the success of your campaigns
While forecasts estimate the performance of a business during a specific period, a financial model uses the forecast data to allow businesses to assess how various possible scenarios might affect their short- and long-term performance.
There are tools that analysts use to determine the risks of whatever decisions they are considering such as merges, investments, etc. With reports from a financial forecast about income statements, balance sheets, and cash flow statements, they can create what is called a three-statement model, which is used to estimate the value of a business or compare it to their competitors in the industry.
Financial models can also be used to test various scenarios, calculate capital expenditures, decide on budgets, and allocate corporate funds.
Whereas a financial forecast is the baseline representation of estimated cash flow and expenses, financial models use analytical tools that allow them to understand the potential impact of internal and external scenarios that may impact cash flow and statement.
Forecasts are also done on a regular basis to help with planning and budgeting while financial models are often done for specific reasons like raising capital, analysing the impact of certain business decisions and the risks associated with each.
In conclusion, financial modelling and forecasting should work together to create a company’s budget and determine short- and long-term goals.
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