Budgeting vs. Financial Forecasting: An Overview
Budgeting and financial forecasting are tools that companies use to establish a plan for where management wants to take the business—budgeting—and whether it is 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 expected revenues that a business wants to achieve for a future period. In contrast, financial forecasting estimates the amount of revenue or income achieved in a future period.
- Budgeting is the financial direction of where management wants to take the company.
- It helps quantify the expectation of revenues that a business wants to achieve for a future period.
- Financial forecasting tells whether the company is headed in the right direction, estimating the amount of revenue and income that will be achieved in the future.
- Budgeting creates a baseline to compare actual results to determine how the results vary from the expected performance.
- Financial forecasting is used to determine how companies should allocate their budgets for 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 typically 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 created for both the 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.
A financial forecast is usually limited in scope, focusing on expense line items and major streams of revenue.
There are critical differences between budgeting and forecasting. For example, budgets are created to meet a goal, such as quarterly growth. Financial forecasting examines whether the budget's target will be met or not throughout the proposed timeline. The content of a budget and financial forecast is different—the former contains specific goals like the number of items to sell or the amount of money to earn. The latter shows the expectations of how the budget will be met.
A budget is made for a specific period and is usually based on past trends or experiences of the company. A financial forecast examines a company's current financial situation and uses the information to forecast whether or not a budget will be met. Financial forecasting may be done frequently while a budget is set for a specific time period and may not be done more than once, twice, or quarterly.
A budget outlines 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 it 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, which 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. A budget may not always be necessary during a fiscal year, although many companies make them. However, a financial forecast is relevant because of the information it provides because it can highlight the need for action. In contrast, a budget may contain targets that cannot be accomplished if the budget is an overreach.
How Can a Budget Help With Financial Planning?
A budget can help set expectations for what a company wants to achieve during a period of time such as quarterly or annually, and it contains estimates of cash flow, revenues and expenses, and debt reduction. When the time period is over, the budget can be compared to the actual results.
What Comes First, a Budget or a Forecast?
Typically a budget is created before a financial forecast. A budget reveals the shape or direction of a company's finance, while the forecast tracks whether or not the company is meeting its financial goals as outlined in the budget. Long-term financial forecasting may be done without first having a budget, but it would likely use past key indicators from previous budgets.
What Are the Steps of Financial Forecasting?
When a company creates a financial forecast report, it will decide on a time frame for the forecast and then gather all past financial documents and necessary paperwork around the time frame. The report will document, monitor, and analyze critical data such as cash flow and income statements, and balance sheets.