Financial budgets, financial forecasts, financial projections and pro forma financial statements are terms that are often used interchangeably, but they are not the same thing.
The confusion arises as they all follow a similar format usually taking the form of a set of the three main financial statements, balance sheet, income statement, and cash flow statement, shown over a number of periods, and a list of significant assumptions and accounting policies, the differences, however, lie in the reasoning and assumptions behind them.
A financial budget is a statement of intent, it shows the financial outcome for the business based on managements current intentions and objectives. Think of the budget as a planned route to a chosen target destination, it is an aspirational goal for the business to aim for.
Where you want to go…
For example, if the business says that it is aiming for 5% sales growth, this is a target, it is a statement of fact. The business can produce the financial budget based on this target and it does not necessarily have to assess the uncertainties that might prevent it from achieving the target.
The budget is usually prepared on an annual basis at the start of each financial year, and is normally kept as an internal document, used by management as a tool to monitor and control the business.
Operating a business without a financial budget is similar to setting out on a journey without any understanding of the intended route or destination. The business is aimless.
A financial forecast shows the financial outcome based on assumptions which reflect the conditions that the management expects to exist and the course of action it expects to take.
Unlike the financial budget, the forecast is not setting a target, it is showing the route management believe the business is expected to travel on not the planned route.
Where you are going …
For example, based on the expectation that the business will recruit a new sales manager, it forecasts that sales will increase by five percent this year. This is not a hypothetical assumption it is the managements “best guess” as to what will happen if it follows the expected course of action and among other things recruits a new sales manager. The business needs to assess the uncertainties that might prevent it from achieving the forecast and take these into account.
The financial forecast is a statement about the future of the business (sometimes referred to as prospective financial information), and is used by management to indicate the most likely financial outcome.
The forecast is normally prepared annually and often updated monthly with actual results, providing a rolling forecast to continually update management as to where the business is heading. By comparing the forecast to the budget, management can decide whether the business is following the planned route and heading for the targeted destination or whether action is needed to correct the situation.
Financial forecasts often have a more general audience than a budget or projection, and can be used by people not directly connected to the business, for example investors might be provided with a forecast as part of an offering statement when a business is raising equity finance.
Operating a business without a financial forecast is similar to setting out on a journey with a planned route and destination (budget), and not bothering to look where you are going or what obstacles lie ahead.
Budget vs Forecast
To summarize the difference between budgeting and forecasting, although they may look the same the budget and the forecast are two different things, the budget is simply a target which management aims for, the forecast is what the business expects to happen. The business might aim (budget) for a sales growth of ten percent, and target all its managers to achieve that aim, however, based on the assumptions about the expected conditions, if might be forecasting only a five percent increase in sales.
A financial projection shows the financial outcome based on hypothetical assumptions. A hypothetical assumption is one that is consistent with the purpose of the financial projection but is not necessarily expected to happen.
Hypothetical “What would happen if …”
Another way of looking at a financial projection is to view it is as answering a “What would happen if …” type question. For example, a business might want to know what would happen if it doubled the size of its production facility, no one is suggesting that this is expected to happen, it is purely hypothetical. This is just one of many hypothetical assumptions which go to make up the financial projection.
A financial projection is also a statement about the future of the business, and is used for various reasons including raising finance. When used outside the business, it is normally intended for people who are in direct contact with the business who can ask appropriate questions about its construction and purpose. Financial projections are often used to supplement financial forecasts to give answers to a series of “what if” type questions not answered by the forecast.
To continue the journey analogy, think of a financial projection as simply answering a “what would happen if we took a different route and aimed for a different destination” type question.
A financial projection is a useful addition to the business planning process, the budget gives it a planned route, the forecast shows it where it is going, and the financial projection allows management to look at alternatives.
Pro Forma Financial Statement
Pro forma financial statements simply refer to a set of financial statements (balance sheet, income statement, and cash flow statement), which have been prepared in order to show the effects of a specific transaction on the historical financial statements of a business prior to the transaction actually taking place.
Historical statements adjusted for the effects of a future transaction …
For example, a business might be considering the acquisition of another business and is seeking finance. It will issue proforma financial statements to show what the significant effects on the historical financial information might have been had the acquisition occurred at an earlier date. Although the transaction is in the future and uncertain, the pro forma financial statements are essentially restated historical information and are not considered to be projections.
This type of financial statement is more fully covered in our pro forma financial statements article.
Using the Financial Projections Template
The formats of the financial budget, forecast, projection or pro forma statements are very similar, only the purpose and assumptions change, for this reason our financial projection template can be used in each of these situations.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.