Financial Forecasting: How to build assumptions for future revenues and expenses?
Financial Forecasting: How to Build Future Revenue and Expense Assumptions?
Forecasting is not reading a crystal ball; it is the science of building logical assumptions based on historical data and market drivers. While the “Budget” is the plan we want to achieve, the “Forecast” is the realistic expectation of what will happen. In this guide, we master the art of prediction: How do you build a revenue model? How do you project expenses? And how do you use Sensitivity Analysis to prepare for the worst-case scenario?
- The difference between Budgeting (The Goal) and Forecasting (The Reality).
- Top-down vs. Bottom-up forecasting methods: Which one to use?
- Building Assumptions (Drivers): Price, Volume, Inflation, and Growth.
- Visual model (SVG) of the Forecasting Engine.
- Sensitivity Analysis: How to test “What If” scenarios?
- Interactive Tool: Create a simplified 3-year P&L forecast.
- Common traps in forecasting (Optimism bias and ignoring seasonality).
1) Budget vs. Forecast
| Feature | Budget | Forecast |
|---|---|---|
| Purpose | Goal setting & Control | Estimation of reality |
| Frequency | Once a year (Static) | Monthly/Quarterly (Dynamic) |
| Detail | Very detailed (GL level) | High level (Category level) |
| Mindset | “This is what we want” | “This is where we are going” |
2) Top-down vs. Bottom-up Methods
- Top-down: Start with the total market size and estimate your share (e.g., “The market is $1B, we will take 1% = $10M”). Good for new products.
- Bottom-up: Start with operational drivers (e.g., “We have 5 salesmen, each can close 10 deals/month @ $5k = $250k”). More accurate for established businesses.
3) Identifying Key Drivers (Assumptions)
Don’t just guess a revenue number. Build it from variables you can track:
- Revenue Drivers: # of Customers, Average Order Value, Churn Rate.
- Expense Drivers: Headcount (Salaries), Inflation rate (Materials), Rent (Fixed).
4) Visual Logic: The Forecasting Engine
5) Scenario Planning (Sensitivity Analysis)
Always build three versions of the future:
Budget vs Actual Variance Analysis - Excel File
- Base Case: The most likely outcome (50/50 probability).
- Best Case: If everything goes right (Aggressive).
- Worst Case: If major risks materialize (Conservative/Defensive).
6) Interactive Forecast Generator
Generate a 3-Year Forecast based on simple growth assumptions:
7) Common Forecasting Traps
- Hockey Stick Effect: Assuming flat growth now but a magical vertical spike next year without a reason.
- Ignoring Seasonality: Assuming sales are flat across 12 months (December is usually higher for retail).
- Expense Disconnect: Growing revenue by 50% but keeping headcount flat (Unrealistic).
8) Frequently Asked Questions
How often should I update the forecast?
Ideally, monthly. This is called a “Rolling Forecast” (e.g., 12 months into the future at all times). At a minimum, quarterly.
Should I use Excel or specialized software?
For SMEs, Excel is king. It’s flexible and free. As you grow (50+ employees), moving to FP&A software like Planful or Anaplan reduces errors.
9) Conclusion
The summary is simple: Financial Forecasting is your navigation system. Driving without it means you react to obstacles only after you hit them. By building a logical, driver-based forecast, you give management the power to steer the ship proactively.