Forecasting vs. Budgeting: Which One is Right For Your Case?
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
There's a popular misconception that a startup financial model should include everything related to money.
That includes the 5-years financial forecast, monthly budgeting, tracking incoming and outgoing invoices, supplier payment terms, bills, employee expenses, and more.
That could make a lot of sense. Let's put everything related to the company's financials and constantly update the financial status.
In a perfect world, that might have been the case, however, in reality, it leads to a miss on both fronts, and you get a low-quality financial forecast AND a low-quality budget and tracking file.
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What's The Difference Between Budgeting And Forecasting?
Budgeting and forecasting are both financial tools aimed to help the business manage its financial status.
Budgeting is looking at the short-term aspect of the company's financials. The business budget usually includes a list of expenses that the company expects to have in the next 1 to 12 months and needs to be highly detailed to ensure the company has enough resources every month to pay its bills.
In the short term, a business needs to know precisely how much it must pay for electricity in two months and what is driving that bill.
A business owner must closely manage the company's budget keep the business under control, and accurately estimate the upcoming spending will improve the company's cash flow management.
However, in the long term, there is not much value in trying to come up with a very accurate assessment of electricity payments three years from now. For that purpose, an estimate based on previous experience or a general estimate would be fine.
Forecasting is looking at the long-term horizon and estimating how the company will perform, assuming certain business decisions along the way.
The financial forecast is usually built on a foundation of assumptions that determine the model's output or the company's financial forecast.
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What's Wrong With Trying To Merge The Two?
The financial forecast is a long-term planning tool, and budgeting is a short-term planning tool.
They are like apples and oranges. Both are fruits, but certainly not the same.
When building a budget for the next 12 months, the manager or business owner is looking to understand how the business's cash flow will look.
This is to understand whether there is room to grow one area of the business, what revenues must be generated to cover business needs, whether there will be sufficient funds to pull in projects, or whether some project must be pushed out because the business has insufficient funds for it.
Using historical data and applying a percentage of revenues for some items, which are reasonable methods for long-term planning, will not work when building a budget and will drive the budget off track.
On the other hand, the accuracy needed for short-term budgeting is replaced in long-term planning with scenario planning, margin forecasts, and other elements that are important for the long term.
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Which One Should You Use?
We typically recommend our clients to maintain a separate spreadsheet.
The first spreadsheet is for budgeting and should be used in the day-to-day. This file will include the most up-to-date information about bills, invoices, supplier terms, etc.
The second spreadsheet is the long-term financial forecast. This file will include the essential business assumptions to support the company's growth and company’s financial performance in the upcoming 3 to 5 years.
The budgeting file is essential to the founder or business owner to know the ins and outs of the business and oversee the cash flow management and view how the money is flowing in and out of the company.
The forecasting spreadsheet will enable the founder to understand the bigger picture, where the company is, compared to the bigger picture, and how the fundamental assumptions might have changed throughout time.
