Budgeting and financial forecasting are tools that companies use to establish a plan of where management wants to take the company and whether it's heading in the right direction. Although financial forecasting and budgeting are often used together, there are distinct differences between the two.
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 other words, budgeting lays out the plan for where management wants to take the company, whereas financial forecasting shows whether the company's headed in the right direction.
A budget is an outline of expectations for what a company wants to achieve for a particular period, usually one year. Some of the characteristics of budgeting include:
- Estimates of revenues and expenses for the year
- Expected cash flows
- Expected debt reduction
- A budget is compared to actual results to calculate the variances between the two
Budgeting represents a company's financial position, cash flows 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.
Most budgets are done for an entire year, but that's 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. Financial forecasting characteristics include:
- Companies use financial forecasting to determine how they should allocate their budgets for a future period. Unlike budgeting, financial forecasting does not analyze the variance between financial forecasts and actual performance.
- Financial forecasts are regularly updated, perhaps monthly or quarterly, when there's a change in operations, inventory, and business plan.
- Forecasts can be both short-term and long-term. For example, a company might have quarterly forecasts for revenue. Also, 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.
Forecasts can help management make adjustments to production and inventory levels. Also, a long-term forecast might help a company's management develop its business plan.
A budget is an outline of where management wants to take the company. A financial forecast is a report showing whether the company is getting to its budget or not, and where the company is heading.
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 that there's some relationship to the prevailing market.
A budget and financial forecast should work in tandem with each other. For example, the forecasts both in the short-term and long-term could be used to help create and update the budget.