A version of this post was first published on Early Growth Financial Services’ blog
Financial forecasting can be a shot in the dark if you don’t have the right data. Financial analysts weigh a large number of inputs with different probabilities to arrive at a number within an expected range. If financial forecasting is tough for the professionals, it may appear overwhelming for the entrepreneur.
Fortunately, the mechanics of financial forecasting aren’t too complicated if you know what to look for. It’s an important exercise for any company–from large public companies to startups who are pre-revenue. A good financial forecast can help you get a better understanding of your company’s cash flow needs and help you invest for future growth.
There are two popular forecasting techniques used by financial analysts: top-down and bottom-up. Top-down makes estimates based your company’s growth and share in a market. Whereas bottom-up forecasting takes inputs like customers or products sold. Which approach should you adopt? Let’s examine both.
Top-Down Financial Forecast
A top-down forecast looks at the overall market and uses this information to identify your company demographics and target mark. The assumption is that, given the existing market and potential market growth, your company can expect to capture a certain percentage share of the market in year one, a greater percentage in year two, and so on.
For example, if your company has created an iPhone app, you might take a look at the number of consumers who have purchased apps for their iPhones. If there are 80M active iPhone users and half of iPhone users buy at least one app per month, you can extrapolate from here. Being conservative, you could estimate that of the 40M active iPhone users who purchase apps, 1% of these consumers will purchase your app. That would give you 400K new customers.
Sounds good, right? Unfortunately, too good.
While you want to be optimistic in your projections—enough so as to be interesting to investors—you should not be unrealistic about your potential growth. Entrepreneurs typically tend to be way too optimistic with their forecasting. Grounding your forecasting with facts and creating more realistic projections will provide legitimacy to your business, if there is real potential there.
In addition, a top-down forecasting can give you an incomplete view of your expenses. Especially if you’re growing quickly, managing your cash becomes increasingly important.
So how can you create a more realistic projection? Forecast from the bottom-up.
Bottom-up financial forecast
A bottom-up forecast is a detailed budget with spending plans by department. Hiring plans and operating expenses are calculated based on your expected growth. Potential revenue is calculated by multiplying the number of potential sales per product by the average sale value. Obviously, this is a more strategic approach wherein you take a real look at your current situation and capabilities and see where you can reasonably expect to go from here.
Using our previous example of your new iPhone app, you can see how your revenue projections would substantially shrink using this approach. Now, instead of looking at the market and its potential, you need to look at your own market (for example, your existing customers) and map out how you can parlay your current standing into new sales.
Because you’re looking at real numbers and your real situation, it’s obviously much harder to get huge projections with bottom-up forecasting. With this approach, the only way to grow your numbers is to increase your overall exposure and make sure you are working all the angles to publicize and sell your product/service.
Always be forecasting
Forecasting isn’t just a once-in-a-company’s-lifetime process, of course. Once the sales start rolling in, you’ll need to prepare forecasts on a monthly basis to help you to manage your cash reserves and increase your sales. This is why it’s important to make sure you are diligent in how you forecast your company’s growth. We may not all be financial pros but now we can forecast like one.