These terms, i.e., financial forecast and projection, are often used interchangeably in finance.
While they might seem similar, there are some critical differences between them. Any business or company needs to understand these two terms and their concepts.
In this article, let us hop on to the definition, differences, and usages of each of these terms.
What is financial forecasting?
Financial forecasting is when you make predictions and assumptions about a particular scenario.
In forecasting, you believe in those assumptions and expect them to happen in the future. As they are based on your historical data. The main thing in forecasting is that the assumptions made are achievable
.The financial forecast is based on the financial data that you use. It creates relevant and realistic goals which you can achieve shortly. Every action you will then take should be aligned with the results of the forecasting.
For example, if your forecasts reveal that your expenses will rise by 20%, you should consider managing that upcoming surge.
What is financial projection?
Financial projection presents one or more hypothetical courses of action that are likely or may not happen at all in the future. "What If" scenarios are considered while making a financial projection. Financial projections are less realistic than financial forecasting.
A projection consists of the expected outcomes and the results that the business expects, regardless of external factors. With a projection that management expects to achieve, an organization defines a desired or future goal a member is aiming at, including growth. While projections can help determine an organization's plan to move forward, projection generally reflects what the organization seeks rather than fundamental factors impacting the actual result. Get the best information on forecasting and predictive analytics.
The American Institute of Certified Public Accountants (AICPA) has also defined financial forecasting and projection.
Financial forecasts and projections
The AICPA says that the forecasts are based on the assumption of the responsible person and reflect its expectations of future conditions and actions. The projection is usually meant to present a hypothetical plan of action to evaluate.
Projections outline economic outcomes based upon the possible scenario in theory, whereas forecasting describes financial results based on the actual situation. These have powerful implications on how these analyses are produced, how their audiences use them, and what type of decisions they impact.
Understand more about forecast vs. projection
Here is an interesting example;
Suppose you are the financial advisor of a pharmaceutical company, and the director asks you to analyze what might happen if a new branch is set up in a country or an area. What would you do? You would consider many things before concluding, such as the location, capital requirement, investments, labor requirements, time requirement, expenses, etc. You would explore all the possibilities that might happen after the company opens a new branch. This financial analysis is termed 'Financial Projection.'
Now, let's suppose a different scenario, the company is dead set on setting up a new branch. The decision is already made. Now you are asked to prepare an analysis. Again, what would you do?
You would study the historical data, economic reports, and current and past trends, and you develop an analysis that denotes what should be the expectation of the company in terms of revenues, profits, investments, etc. This analysis is prepared to present the actual condition and is termed 'Forecasting.'
What do financial forecasting and projections include?
Whether you go with any terms, forecast, or projection, you have to prepare a periodic report. These three things are the report's pillars- prospective financial statements and Cash flow.
Financial Statements- A financial statement shows the income (revenue) and other components like expenses and profit for some time. These prospective financial statements are critical because they can provide enormous information about a company's revenue, expenses, profitability, debt load, and ability to meet its short-term and long-term financial obligations.
Balance Sheet- A balance sheet shows the position of your business. It denotes the total assets and liabilities of your business. We can even say that it is a sheet with a combination of assets, equity, and liabilities.
Cash Flow Statement- As the name suggests, the cash flow statement shows how the cash flows in and out of business. This kind of present and past financial or historical financial statements helps you decide whether you have excess cash to invest or need more reserves to keep the cash level high. It is to note that cash flow statements are different from income statement because income statement is based on an accrual basis.
Although financial forecast and projection seem to be similar since they are both responsible parties' assumptions reflecting a company's finances, there are three key differences that we are going to learn now.
The significant difference between financial forecasts and projections is the time duration. Forecasts have a shorter time duration as they are considerate to focus on fulfilling short-term expectations. Financial forecasts are made yearly or quarterly. In most cases, they do not extend more than one year.
Projections show long-term situations. When making financial projections, you look beyond a year or two and think for a more extended period.
When we talk about the outcomes of the Financial Forecast and Projection, there is a difference between what they have in the quest to show.
Forecasts are the assumptions reflecting the conditions in the present and past. The Projections are based on hypothetical situations that might give an outcome or might not.
Usage of the Information
Forecasts are displayed to investors, lenders, analysts, and outsiders. The information received from forecasting can help the investors, lenders, etc., to invest or lend money to the business. Projections are used for internal purposes. Projections answer the "What if" queries of the company.
Financial Forecast or Projection- What to prefer for an entity's expected financial position?
It is up to you and the scenario you want to analyze. The decisions and outcomes will be different for financial forecasts and projections based on your entity's expected financial position.
You can forecast if you want to plan for a shorter duration, say one year or less. On the other hand, if you want to go in-depth for a more extended period, you can create financial projections using advanced drivers such as budget planning, growth capacity, etc.