With your financial reporting, you know how your business has performed. But what about how it will perform in the future?
Getting a picture of your future performance doesn’t require a crystal ball or reading of palms. By collating information from your past reporting and current trends, you can create a profit forecast that helps you plan for growth, appeal to investors, and turn financial uncertainty into strategic success.
What is a profit forecast?
A profit forecast is a calculated projection of a company’s expected profitability and performance over a period of time. It involves forecasting the business’s anticipated revenue and expenses to determine the net profit.
By covering the business’s revenue, expenses, and net profit, profit forecasts are one of the most comprehensive financial projections. This comes with some complications as it requires projecting and assuming multiple variables about how these components are trending to do properly.
But if you’re willing to put in the time and effort, a profit forecast gives the best measure of future performance and financial health.
The components of a profit forecast
A profit forecast is made up of six integral components:
- Revenue projections are the expected income from sales or other income from business-related activities.
- Cost of goods sold (or cost of fulfillment) are the direct costs involved in producing a product or providing a service.
- Operating expenses are overhead costs involved in keeping the business operational, like rent, utilities, and salaries.
- Tax obligations are the estimated state and federal tax liabilities based on expected earnings.
- Non-operating income and expenses are revenue streams and costs that are not associated with business activity.
- Net profit is the end result of the calculation, a simple calculation of subtracting expenses from revenue to find the net dollar amount retained in the business.
All of these components are in some way interconnected. For instance, if you anticipate selling more product, you’ll need to pay more in cost of goods sold unless you negotiate those costs down. Similarly, the more money you earn, the more you’ll owe in taxes.
Consider these interconnections when running a profit forecast. If your sales are changing, many of your costs should as well.
Difference between profit forecasts and revenue forecasts
Both profit forecasts and revenue forecasts are ways of projecting future financial performance. The distinction between the two is how many variables are considered in the process.
A revenue forecast is focused solely on projected sales. The question it aims to answer is “How much will we sell in the future?”
A profit forecast goes the extra mile by including its expected costs. Instead, it answers the question of “How much money will we net in the future?”
Each forecast can tell a different story. Consider a business that’s projecting a large increase in sales volume in the coming year. To prepare for this, it starts to lease a larger warehouse to hold extra inventory.
If the cost of the warehouse outweighs the increase in projected revenue, the profit forecast would show the business losing money, while the revenue forecast would show the business improving.
Why is a profit forecast important?
Running a profit forecast is an invaluable first step in financial planning. In particular, you should use a profit forecast for the following reasons.
Profit forecasts enhance decision-making
Running a profit forecast gives you the picture of where the business is expected to be if no changes are made. If you run the forecast and the business is set to hit its goals, then you can proceed with confidence. But if the forecast flags profit problems, it’s time to make some changes.
From running a profit forecast, you can identify if you need to:
- Re-evaluate your pricing strategy
- Cut costs to increase profits
- Explore opportunities to boost sales
- Make changes based on a high growth potential
- Plan for an upcoming cash flow issue
Profit forecasts improve financial stability
Nothing is guaranteed in life, but that doesn’t mean you can’t anticipate and plan for possible outcomes. Creating a profit forecast signals when there could be potential shortfalls that need to be planned for.
It’s common to use profit forecasts to run simulations of decisions and understand their impact on your profitability. This turns reactive decision-making into proactive planning, maintaining financial stability that goes according to plan.
Profit forecasts attract investors and lenders
To get capital from investors or lenders, you need to prove the business has long-term financial viability. Sales is one aspect of it, but if the business isn’t making a profit, investors won’t earn dividends, and lenders won’t get paid back.
Putting the effort into a well-researched profit forecast shows an understanding of the market and the business’s place within it. If it shows profitability and the logic is valid, an investor or lender is more likely to put their cash behind the business.
How to create a profit forecast
Ready to generate a profit forecast? Follow these steps to start predicting your financial future.
1. Gather historical data
To understand the future, you start by looking to the past. This includes identifying revenue patterns, expense trends, and seasonal periods for the business.
For your expenses, identify the costs that have and will remain constant. For everything else that’s changing, the way it has changed historically can hint at how it will trend moving forward.
2. Identify revenue drivers
Revenue changes for many reasons, both within and outside of the business’s control. Start by picking out potential changes in revenue with a focus on pricing, cart values, new customer acquisition rates, and cohort analysis for existing customers.
3. Project revenue
Building off of your historical data, incorporate market analysis, including end-user market trends, consumption indexes, and consumer confidence. Collate the data across reports to estimate future sales.
If the business has multiple sales channels, it’s best to do this analysis for each individual channel. For example, a company could offer both bikes and bike apparel. It’s possible for bike consumption to be trending downward if everyone has bought bikes recently, but those new bike owners may want new apparel as they become more involved in the hobby.
4. Calculate cost of goods sold
With expected sales, you can estimate the cost of goods sold needed to fulfill those sales.
For some businesses, this will be a straightforward process. But there are some additional factors to consider when estimating your cost of goods sold:
- Suppliers potentially changing their prices
- Discounts for increasing order sizes
- Switching suppliers at some point in the forecast
- Changes to the production process that could affect costs
5. Estimate operating expenses
There are two parts of operating expenses: fixed costs and variable costs.
Fixed costs are the easiest to predict as they are consistent regardless of sales volume. As an example, the rent on a fixed lease is not going to change, no matter how much you sell. Similar to a software subscription or insurance premium.
Variable costs fluctuate with production levels, for example, the salary or wages of customer support staff. Try to tie your estimate of variable costs to the estimated sales level as found in step 3.
6. Include non-operating items
It’s possible to have non-operating items on both the revenue and expense sides of the projection.
Examples of non-operating income include interest earned on savings accounts or sub-leasing of equipment or real estate.
Examples of non-operating expenses include interest payments on credit and depreciation.
In either case, they should be included in the profit forecast for maximum accuracy.
7. Calculate net profit
Once you have your projected revenue and projected expenses, you can calculate your net profit. Simply subtract your expenses from revenue, and you’ll have the net profit for the period.
Consider running the process multiple times based on different assumptions, like once for 5% growth and again for 10% growth. This is called scenario planning, and it helps you plan for multiple possible outcomes.
What to consider when generating a profit forecast?
Many of the assumptions used in generating a profit forecast are based on historical trends within the business. But beyond those factors, you should consider these additional influences and incorporate them in your profit forecast.
Market trends and changing economic conditions
Businesses don’t operate in a vacuum. How a business performs is often influenced by forces outside of its control.
To understand this, simply look back to 2020 and the years that followed the COVID pandemic. The initial reaction was that consumption fell as people experienced financial uncertainty. Then, after the rollout of relief programs, consumer activity bounced back as they had excess money without the typical outlets to spend it on.
You don’t need to (and can’t) prepare for such unpredictable events. But you can incorporate additional economic indicators, like GDP growth, unemployment rates, consumer confidence, and industry trends, to adjust your profit forecast.
Altering operational costs and pricing strategies
Rarely is a business the same at the end of a year as it was at the start. These shifts and changes could increase efficiency, reducing costs and increasing profitability. Alternatively, you may need to take on additional costs to scale your operations for the future, affecting short-term profits.
The same could be said about pricing strategies. Each product or service has an “elasticity,” referring to how much consumption changes as price changes. Businesses that sell inelastic goods could change prices and keep sales volume the same, while highly elastic goods would see sales volume drop. Understanding the elasticity of what you’re offering helps you estimate how much demand would change due to a pricing change.
Don’t assume that revenue or costs will be the exact same throughout the year. It’s difficult to predict these changes, so consider doing scenario planning for possible outcomes.
Influencing customer behavior
It’s estimated that Americans see between 4,000 and 10,000 ads in a day. These ads have one purpose: to influence consumer behavior.
But you don’t need to build out a robust marketing and advertising strategy to influence customer behavior. Simple changes like customer buy-back strategies, bundle promotions, and discounts for long-term contracts can influence how much revenue is earned from a customer.
Your profit forecast should incorporate the effects of any of these initiatives, but be careful not to overestimate their effects. Assuming a highly effective strategy could overestimate profit and lead to poor decision-making and planning.
Common pitfalls to avoid when generating a profit forecast
Forecasting is equally an art and a science. As much as there is a best possible methodology for forecasting revenue and expenses, there’s also human judgment. Avoid these common pitfalls as part of your forecasting process.
Overoptimism
It’s natural to want and believe in the best for a business, but making a forecast based on your hopes could lead to poor decision-making and planning. Every assumption should be backed by logic and documented as part of the process. Don’t simply state that revenue will grow by a certain percent; state the reason why you believe that.
Ignoring seasonality
Sales naturally fluctuate for many businesses based on how in demand the product or service is at that time of year. Think about this as you do a profit forecast, breaking it up into smaller time periods to show how profit trends. You may forecast a profit for the year, but forecasting a loss in the early months helps you plan so you can reap the rewards of the high season.
Overlooking non-operational factors
Beyond operational incomes and expenses, there are non-operational factors to consider in your forecast. For example, if you plan on using your line of credit, there are interest costs to consider. Non-operational income and expenses are likely a small part of your finances, but they make a difference in your planning.
Sticking with static assumptions
A forecast should be dynamic, getting adjusted as new information comes in. If revenue or expenses are coming in higher or lower than expected, the forecast should be adjusted to reflect that.
With how many factors you need to consider, it’s unlikely that your profit forecast will be perfect. If you commit to updating the forecast and your assumptions, it will only get more accurate over time.
Considering factors in a silo
Many of your expenses are connected to your sales volume. The obvious ones are your variable costs, but even some fixed costs may need to be adjusted as your sales levels fluctuate.
If your sales volume increases, you may need to increase your warehouse space, add a new delivery vehicle, or adjust your software subscription to unlock new features.
On the other hand, increasing your marketing budget or launching a new paid partnership would likely increase sales.
Don’t forecast your sales and expenses in isolation. Think about the connections and how changing one component could affect another.
Lack of scenario planning
Rather than preparing one forecast on one set of assumptions, generate multiple forecasts with different assumptions.
Consider going through the process three times: a best-case, worst-case, and most likely outcome. With these three forecasts, you can create plans for each so you’re prepared no matter the actual outcome.
Profit forecasts and financial management software
Profit forecasting is the process of turning historical data into future insights. Doing it effectively means digging through historical reports, formatting information, analyzing trends, and turning them into assumptions.
But what if all of your information was centralized in a single platform? And what if that same platform could turn it into a forecast without lifting a finger?
Enter BILL and its real-time reporting and forecasting. Whether you want to analyze the past, understand the present, or look to the future, BILL Spend & Expense has you covered with comprehensive reports.
Turn forecasts into budgets, managed within the platform, to keep your spending in check and hit your profit goals with confidence.
Reach out to schedule a demo and see how BILL can automate your financial operations, giving you the valuable insights you need when you need them, helping you hit your financial goals.
Frequently asked questions
How do I calculate a profit forecast?
The formula at the core of a profit forecast is:
The complexity comes from projecting each part of the equation. Start by looking at your historical data to see how your revenue and expenses are trending and adjust for any anticipated changes, both in the market and in your business.
What is a profit projection?
Profit projection is used interchangeably with profit forecast, as both are calculated estimates of future performance. However, it’s common to use “projection” for shorter time frames and “forecast” for long-term predictions.
How often should I update a profit forecast?
While there’s no set rule on how often you should update your profit forecast, the frequency should reflect the scale and complexity of the business. A solo entrepreneur may update their profit forecast quarterly, while a large-scale operation could update the forecast monthly, or even weekly.
What is the difference between a profit forecast and a profit estimate?
Profit estimates are an approximation of how much profit a business generated before a financial statement is generated. This means that a profit estimate is an approximation of historical performance. Comparatively, a profit forecast is an estimate of how much profit will be earned in the future.
What is the difference between a profit forecast and a profit and loss forecast?
The terms “profit forecast” and “profit and loss forecast” refer to the same process. Profit and loss forecast refers to the profit and loss statement (or P&L) on which revenues and expenses are reported.
Is a profit forecast the same as a cash flow forecast?
No, profit forecasts and cash flow forecasts look at a business’s financial performance differently. Profit forecasts simply look at the income and expenses that a business accrues throughout the year. But a cash flow forecast is focused on how cash enters (cash inflows) and exits (cash outflows) the business.
If a business expected to get a loan for $10,000, that would be a cash inflow but not revenue. This means it would show up on the cash flow forecast, but not the profit forecast.
This also affects revenues and expenses if the business operates on the accrual basis. If you bill a client in December but they don’t pay until January, the revenue is recorded in December, but the cash inflow is recorded in January.
Both forecasts are immensely valuable to your financial planning. Even if a business is generating a profit, it may not be cash positive, which needs to be planned for.
