What Is Forecasting? (With Definition and Different Methods)

Today, many companies use forecasting to plan for their financial future. Professionals working as managers, financial planners, financial analysts, and client experience specialists frequently rely on forecasting to do their jobs successfully. If you are considering entering a field that uses forecasting, it's helpful to learn more about it to prepare for the role. In this article, we answer "What is forecasting?" explain why it's important, provide steps to follow, share some forecasting methods and helpful skills to consider.

Related: A Guide to Finance Careers

What is forecasting?

If you've ever asked yourself "what is forecasting," it is the practice of using historical data and past trends to make informed predictions about future trends. It is a decision-making and planning tool that companies use for various purposes, like planning for their financial future and determining how to allocate their budget. The data that forecasters use may come from a variety of sources. The two types of sources include:

Primary sources

When a forecaster directly collects information from a source, you can consider it a primary source. As there are no other sources that the data is passing between, information gathered from primary sources is often the most reliable. Due to the methods of collection and the organization of information, collecting data from primary sources may take some additional time. Some primary sources include interviews, focus groups, and questionnaires.

Secondary sources

Secondary sources are when another source has already collected and prepared information, such as a different company or individual. Retrieving information from a secondary source often takes less time than gathering and organizing information from a primary source. An example of a secondary source is an industry report.

Why is forecasting important?

Forecasting has many important uses that can lead to a company's future success, including:

Estimating the success of a startup business

If you're considering a new business venture, forecasting can reveal important information that may indicate whether the business may succeed. When you forecast, assess potential risks and uncertainties that most new businesses encounter and determine whether you have the resources to overcome these obstacles. Some information that you may try to uncover includes:

• competitors strengths

• potential demand for product development

• future industry developments

Estimating financial necessities

Estimating a company's future financial necessities is a primary objective. By forecasting, you aim to determine future sales, capital needed for product development, costs of future expansions, and various other expenses. Having this knowledge can give you a better idea of the financial future of the company.

Assisting managers in making smart decisions

Companies frequently rely on forecasting when making management decisions. Businesses often face uncertainties, like seasonal sales fluctuations and changes in material prices. Forecasting enables managers to make informed decisions concerning the company's future. For example, if a manager notices that sales decrease during the summer, they may make an informed decision to reduce costs in other areas, such as personnel or inventory.

Increasing the likelihood of success

A business' success is often reliant on correct fund allocation and fine margins. Forecasting can reveal more information about crucial metrics, such as the number of raw materials required, the correct budget for each department, and the number of upcoming sales. Management can use this information to allocate funds and resources and prioritize products and services.

Promoting cooperation

Analyzing data can be a collaborative effort that promotes cooperation between different managers and their departments. Working together to plan for the future and a common goal can improve relationships and strengthen morale. Consider meeting with your team and reviewing a financial forecast together so you can invite everyone to speak and share their input on the report. Consider all feedback, as it can help improve the company.

How to forecast

If you're new to forecasting, follow these steps to achieve effective results:

1. Understand the market and establish a basis

Perform research on the current market and establish the basis of the investigation. First, gain a good understanding of the company's position within the market. To achieve this, research the market and your competitors and look back twice as far as you look forward. For example, if you're forecasting for the next year, you can gain sufficient insight from looking over financial reports from the past two years. Next, establish a basis. You may choose to base your forecasting on opinions and intuition or facts, figures, and data.

2. Estimate the future industry and the company's place in it

Use your findings from the research you've conducted to estimate the future conditions of the industry. Consider any trends or patterns that you may have found. Then project and analyze how the company may fare. For example, if you notice that the company has lost money in January for seven consecutive years, then you can project that it's likely this trend may continue in the future.

3. Adjust the forecast

Examine forecasts from past years and compare them to the final financial reports. Take note of any differences that occurred and look for trends or patterns in the deviations. Consider the possible reasons for these deviations and adjust your current forecast accordingly.

4. Review the forecasting process

Once you've created a forecast, review the process. Make sure to check each step carefully to improve the chances of having an accurate report. If you discover new information, be flexible and open to making changes.

Forecasting methods

There are two primary methods of forecasting that companies use to predict and plan for their financial future, including:

1. Qualitative method

This method, also called the judgmental method, bases on forecasters' personal judgments. Forecasts that use the qualitative method may have bias. This bias is because of the forecaster's knowledge, intuition, and experience influencing the data. As this method does not rely on math and data, it can be inaccurate. An example of forecasting using the qualitative method is when a person forecasts the outcome of a final game in a hockey league. It's essential for a forecaster to omit personal interest or bias, like having a favourite team, when preparing their forecast.

Some examples of qualitative methods include:

• Informed opinion or judgements: an informed choice based on relevant information

• Delphi method: surveying a panel of experts to come to a group opinion

• Market research: gathering information about consumers' preferences and needs

Related: How To Do Market Research With 6 Guided Steps (With Types)

2. Quantitative method

The quantitative method of forecasting relies on math, which makes it an objective method. When forecasters use this method, they avoid basing results on opinions or intuitions. Instead, they use statistical data and figures to create forecasts. Some examples of quantitative methods include:

• Discounting: determines the current value of a future payment

• Econometric modelling: determines the statistical relationship between various economic quantities

• Time-series methods: analyze data points collected over time

• Analysis of leading indicators: indicates value in statistics based on a lesser variable

• Analysis of lagging indicators: indicates value in statistics based on a greater variable

Related: What is Quantitative Analysis?

Skills that are helpful for forecasters

Improving the following skills may help you find success when forecasting:

Business skills

When working with finances, understanding general business and the specific market is a valuable tool. Regardless of investment type, an investor often relies on their understanding of how the business works. Having strong business skills can determine how you use forecasting and which method you use for a specific situation.

Technical skills

Technical skills are a person's abilities to perform practical tasks, such as data analysis. Data analysis can help a forecaster extract the right information from their sources and research. They then organize the information and draw conclusions from it. This is a pivotal step in forecasting, and having strong technical skills can help lead to an accurate forecast.

Data management skills

As data is the base of all forecasts, it's helpful to have excellent data management skills. People with strong data management skills can manage and use information as needed. For example, it's helpful for an investor to be skilled at identifying, sorting, and managing relevant data. This includes ensuring that the data used is reliable and is useful in creating models for the future.

Communication skills

Having strong communication and interpersonal skills can help investors find success. Communication is crucial throughout the forecasting process. Whether you're gathering data in the early stages of forecasting or are sharing the final forecast with the company managers, interacting with others effectively can help make your job easier and help increase your chances of success.