Budgeting and financial forecasting are tools that companies use to establish a plan regarding where management ideally wants to take the company (budgeting) and whether it is actually heading in the right direction (financial forecasting). Although budgeting and financial forecasting are often used together, distinct differences exist between the two concepts. Budgeting quantifies the expectation of revenues that a business wants to achieve for a future period, whereas financial forecasting estimates the number of revenues that will be achieved in a future period.
A budget is an outline of expectations for what a company wants to achieve for a particular period, usually one year. Characteristics of budgeting include:
- Estimates of revenues and expenses
- Expected cash flows
- Expected debt reduction
- A budget is compared to actual results to calculate the variances between the two figures.
Budgeting represents a company's financial position, cash flow and goals. A company's budget is usually re-evaluated periodically, usually once per fiscal year, depending on how management wants to update the information. Budgeting creates a baseline to compare actual results to determine how the results vary from the expected performance.
While most budgets are created for an entire year, that is not a hard-and-fast rule. For some companies, management may need to be flexible and allow the budget to be adjusted throughout the year as business conditions change.
Financial forecasting estimates a company's future financial outcomes by examining historical data. Financial forecasting allows management teams to anticipate results based on previous financial data. Characteristics of financial forecasting include:
- Used to determine how companies should allocate their budgets for a future period. Unlike budgeting, financial forecasting does not analyze the variance between financial forecasts and actual performance.
- Regularly updated, perhaps monthly or quarterly, when there is a change in operations, inventory, and business plan.
- Can be both short-term and long-term. For example, a company might have quarterly forecasts for revenue. If a customer is lost to the competition, revenue forecasts might need to be updated.
- A management team can use financial forecasting and take immediate action based on the forecasted data.
Financial forecasting can help a management team make adjustments to production and inventory levels. Additionally, a long-term forecast might help a company's management team develop its business plan.
The Bottom Line
A budget is an outline of the direction management wants to take the company. A financial forecast is a report illustrating whether the company is reaching its budget goals and where the company is heading in the future.
Budgeting can sometimes contain goals that may not be attainable due to changing market conditions. If a company uses budgeting to make decisions, the budget should be flexible and updated more frequently than one fiscal year so there is a relationship to the prevailing market.
Budgeting and financial forecasting should work in tandem with each other. For example, both short-term and long-term financial forecasts could be used to help create and update a company's budget.