Understanding the key differences between a financial plan vs. budget vs. forecast

Planning, budgeting, and forecasting is a three-step process for determining and mapping out an organization's short- and long-term financial goals. While these terms are often used interchangeably, they aren’t the same, it’s important to understand how they differ. 

A budget is a high-level financial outline, typically covering a 12-month period, developed collaboratively with inputs from different teams. It is, in most cases, static. The budget sets out expected revenues and expenses to meet the company's strategic objectives. 

A financial plan then breaks down the budget into further, finer detail. Think of it as explaining the ‘why’ and ‘how’ behind the budget allocations. 

Finally, forecasting is an ongoing process, conducted monthly or quarterly, that predicts future financial outcomes based on past performance and anticipated market conditions. 

To put it simply, a budget serves as an overall roadmap for resource allocation, planning lays the groundwork for executing that roadmap, and a forecast provides a glimpse into the company's financial horizon based on the performance of the previous month,  quarter, or year. 

While the three activities are certainly interrelated, it is important to recognize the differences between them. This article will provide clarity to help you understand each process and how they work together. 

What is financial planning?

Business financial planning is all about getting into the nitty-gritty of allocating resources and how to best use them to achieve the strategic objectives and goals of the company. 

It involves translating high-level strategies into actionable operational plans, typically created on an annual basis. This is called an annual operating plan (AOP), also known as an annual plan or operating plan. Creating an AOP provides a roadmap for the company's financial activities over the next 12 months.

The primary question that the financial planning exercise seeks to answer is, ‘How will we align our resources with our strategy, and how will we measure our progress?’ The AOP and budget are closely intertwined, with the plan providing the context and rationale for the budget requests. 

During the planning process, the finance team digs deep into the budgets of individual departments to understand their assumptions and drivers. 

For example, when analyzing revenue funnels, the finance team might examine different markets, regions, and products to determine the required investments in headcount, marketing activities, and business operations (travel, benefits, etc.).

How to create a financial plan

The first step in creating a business financial plan is to establish high-level revenue targets based on the company's strategic objectives. For SaaS businesses, this top-line planning begins with forecasting the number of customers and the average contract value (ACV) to determine the target annual recurring revenue (ARR).

Once the revenue goals are set, the planning process then goes down to the level of individual departments. Each team has to assess the resources and initiatives required to achieve the overall targets. 

These individual departmental plans are finally consolidated and reviewed to ensure alignment with the company's overall objectives. Mind you, this isn’t a simple process; it is highly iterative and involves close collaboration between finance, leadership, and operational teams to refine assumptions, identify dependencies, and optimize resource allocation.

To summarize, the key steps in the financial planning process are: 

1. Establish strategic objectives and revenue targets
2. Develop department plans and budgets
3. Consolidate and align plans across the organization
4. Review and refine assumptions and resource allocation
5. Finalize and communicate the annual operating plan
6. Monitor and adjust the plan based on actual performance

Many organizations leverage advanced financial planning and analysis (FP&A) software  to streamline and enhance the planning process. These tools facilitate collaboration, provide real-time data and insights and enable scenario modeling and sensitivity analysis, ultimately leading to more accurate, agile, and effective financial planning.

Components of SaaS Financial Planning

The AOP for a SaaS business includes several key components that work together to provide a comprehensive view of the company's financial strategy and performance: 

• Sales forecasting: Projects future revenue based on historical sales data, market trends, customer acquisition and retention rates, and pricing strategies. Sales forecasting is crucial for setting realistic growth targets and aligning resources accordingly.
• Expense planning: Details anticipated expenses across various categories, such as headcount costs, sales and marketing expenses, research and development, and general administrative costs. Proper expense planning helps ensure that the company allocates resources efficiently.
• KPIs and metrics: Identifies and tracks key performance indicators (KPIs) and metrics that indicate the company's financial health and progress towards set goals. For SaaS businesses, important metrics include monthly and annual recurring revenue (MRR and ARR), customer acquisition cost (CAC), customer lifetime value (LTV), and churn rate.
• Cash runway: Forecasts the company's cash position over time, considering factors such as revenue growth, expense management, and funding requirements. This component helps SaaS businesses ensure they have the required liquidity to support operations. 
• Headcount planning: Determines the new hiring and skill sets required to support the company's planned growth objectives. It also includes planning for employee development and retention and aligning headcount expenses with revenue targets.
• Scenario planning: Helps develop alternative financial scenarios based on different assumptions about market conditions, competitive landscapes, and internal factors. With scenario planning, you can come up with best-case, worst-case and base-case scenarios for various risks and opportunities, and develop contingency plans accordingly.

Challenges of planning

Financial planning in SaaS businesses can be complex and challenging due to the unique nature of the subscription-based model. Some of the key challenges include:

• Collaboration and stakeholder engagement: Effective financial planning requires close collaboration between finance teams and various business units. However, ensuring the full investment of stakeholders can be a challenge. These stakeholders must provide the necessary information for the exercise to succeed. In most cases, finance professionals are highly engaged, while others may be less forthcoming or may not prioritize it as much. 
• Lack of data or information: The management team may not have established robust budgeting or planning processes in early-stage or rapidly growing SaaS companies. This can lead to a lack of historical data upon which to base financial plans. 
• Financial literacy among stakeholders: For financial planning to be effective, all stakeholders must have a basic understanding of financial concepts and be able to support their assumptions and projections with data. Ad-hoc or intuition-based planning can lead to highly unrealistic targets and, in turn, misaligned resource allocation. 

What is business budgeting?

Budgeting is a critical financial exercise that involves creating a detailed plan for an organization's expected income and expenditures over a specific period, usually a financial (fiscal) year. 

A budget can be thought of as a quantitative roadmap that outlines how the company intends to allocate its financial resources to achieve its strategic objectives while maintaining financial stability.

In essence, a budget is a more controlled and precise way of planning for the upcoming financial year. It translates the broader goals and strategies outlined in the financial plan into specific, measurable financial targets and constraints. A budget sets clear limits for each department or function so that the organization can ensure that its spending aligns with its priorities and available resources.

How to create a budget for your business

The budgeting process involves the following key steps:

1. Define the company's financial goals and priorities based on its strategic plan and stakeholder expectations
2. Forecast revenue based on factors such as sales projections, pricing strategies, and market conditions
3. Determine expenses and estimate costs across different areas of the business
4. Allocate resources to different areas of the business based on their expected contribution to the company's objectives
5. Finalize the budget and ensure buy-in from all stakeholders
6. Monitor performance regularly, comparing actuals with the budget and  analyzing variances

There are four common methods of strategic budgeting in SaaS:

• Zero-based budgeting: Starts from a "zero base" and justifies every expense, rather than basing the budget on historical data.
• Activity-based budgeting: Allocates resources based on the costs of specific activities or processes that drive the most value.
• Value proposition-based budgeting: Prioritizes investments that enhance the company's value proposition and competitive advantage.
• Driver-based budgeting: Identifies key business drivers and creates a budget that reflects their expected impact on financial performance.
  

To streamline the budgeting process and improve accuracy, many organizations use budgeting software tools. These solutions automate data collection, facilitate collaboration, and provide real-time insights into financial performance.

Once the budget is established and actual results start coming in, companies can perform variance analyses to identify discrepancies between planned and actual performance. These insights can then be used to update the budget assumptions and projections for the remainder of the year, providing a more accurate picture of the company's financial trajectory.

For additional context, variances can be positive or negative, favorable or unfavorable. These terms are often used interchangeably and as such, can create confusion not clearly defined.

Positive and negative variances simply refer to the result of your variance calculation. Is it a positive number or a negative number? In contrast, favorable vs unfavorable refers to the impact of that variance on the business, regardless of whether the number is positive or negative. 

For example, if your cloud cost for a given quarter came in much lower than expected, the variance would be negative. However, lower costs are generally thought of as positive. On the flip side, let’s say you have a positive variance in your churn rate. That might explain the lower cloud hosting fees, but it’s certainly not a favorable variance.    

Understanding and using these terms correctly is key to clearly communicating variance to your stakeholders. Another point to be made here is that any variance – favorable or unfavorable – may be important to look into. Ideally, you would investigate every variance but that’s not always feasible. A good rule of thumb is to prioritize those line items in your budget that can have the biggest impact on your business.  

If you can determine the reason for variance in these line items, you can create a more accurate budget the following year. 

What are the common challenges associated with the budgeting process?

The budgeting process can present challenges, particularly for growing SaaS businesses:

• Ensuring accuracy and realism: One common issue is the tendency for departments to be conservative with their targets so that they can consistently meet them. This practice can lead to ‘false euphoria’. While everything seems hunky dory, you are really underachieving because if you had an accurate budget and goals, you would have pushed to do better with the existing resources. To mitigate this, finance teams must ask probing questions and request the data behind each department's projections to verify their accuracy and whether they are realistic.‍
• Predictive ability: A deep understanding of growth levers, value propositions, and the market is crucial to predict future performance accurately. Achieving this in the first few instances could be a task for early-stage companies. Think of it as a work in progress and regularly refine them based on actual results.‍
• Resource allocation: Finance teams must work closely with department heads to understand their resource requirements and assess the potential return on investment (ROI) for each expense category. This involves carefully analyzing the costs and benefits of each investment and prioritizing initiatives that align with the company's strategic objectives and financial constraints.‍
• Balancing short-term needs with long-term goals: Budgeting often involves making trade-offs between immediate operational requirements and longer-term strategic investments. Companies must find a way to strike a balance. For example, should you build smaller but important features instead of new product development, should you stick to the existing strategy or try out new market expansion? This requires a deep understanding of the company's cash flows and risk tolerance.

What is financial forecasting?

Financial forecasting is a process that predicts an organization's future financial performance based on historical data, current trends, and anticipated events. Forecasting is an extension of the planning process, and utilizes many of the same components, but incorporates actual performance data to refine and update the projections.

A forecast represents the most up-to-date expectations for the current year's financial performance. Forecasts are typically updated on a monthly or quarterly basis, allowing organizations to adapt to changing circumstances and make informed decisions.

How to create a financial forecast

The following steps are involved in creating a financial forecast:

1. Gather historical financial data and analyze underlying trends
2. Identify key business drivers and assumptions
3. Project revenue based on sales pipeline and market conditions
4. Estimate expenses across various departments
5. Incorporate actual performance data and adjust projections accordingly
6. Review and refine the forecast based on stakeholder input and changing circumstances
7. Monitor actual results against the forecast and update it regularly

To streamline this process and improve accuracy, many organizations leverage financial forecasting software. With these platforms, one can automate data collection, facilitate scenario modeling, and provide real-time insights into financial performance.

Components of Forecasting

• P&L (Income statement) forecasting: The P&L forecast is the first and the most critical component of financial forecasting, as it projects the company's revenue, expenses, and profitability (if any) over a given period. With this in place, you can make informed business decisions. P&L forecast is a prerequisite for balance sheet and cash flow forecasting.
• Balance sheet forecasting: Balance sheet forecasting projects the company's assets, liabilities, and equity at specific future points in time. It is typically more relevant for mature companies and helps assess the organization's financial health and stability.
• Cash flow forecasting: This involves predicting the inflows and outflows of cash over a specific period, helping companies manage their cash liquidity and working capital. The cash flow forecast can be done using the direct or indirect method, with a focus on operating cash flow. Just to explain the methods briefly, the direct method is when one lists all major operating cash receipts and payments to provide a detailed view of the actual cash inflows and outflows from operating activities. The indirect method, on the other hand, starts with net income and adjusts for non-cash items (depreciation, amortization) and changes in working capital (accounts receivable, accounts payable, inventory) to arrive at the operating cash flow. 
• Headcount planning: Forecasting headcount needs and associated costs is essential for ensuring that the organization has the right talent in place to support its growth ambitions while managing its financial resources effectively.

Challenges and limitations with forecasting

• Reliance on assumptions: Forecasting is inherently all about making assumptions about future events and trends, which can, as you can imagine, introduce bias or error. Making assumptions that are too optimistic can lead to problems. As an example, let’s say that your ACV is $10,000, but you forecast that your ACV will become $13,000 without any other downstream changes like headcount increase or pricing change; you will certainly not achieve it. To mitigate this risk, organizations must calibrate their assumptions with data to the extent possible and ensure they are realistic and achievable.
• Reduced accuracy over longer time horizons: The accuracy of financial forecasts decreases as the time horizon extends further into the future. One really can’t accurately predict more than 12-18 months in advance. Anything far into the future is more of an aspiration rather than a projection or forecast. There are just too many variables and moving parts that are out of your control. 

To overcome these challenges, organizations must continuously pressure-test their assumptions, incorporate the latest data and insights, and regularly update their forecasts to reflect changing circumstances. 

In the following sections, we will delve deeper into the practical aspects of developing effective budgets, plans, and forecasts, exploring best practices and strategies for overcoming common challenges and maximizing the value of these processes.

Connecting the dots for a better business strategy

Financial budgeting, planning, and forecasting are the three pillars that shape a SaaS company's overall business strategy. With these processes, you can align an organization's financial resources with its strategic objectives, ensuring that the investments are made in areas that drive long-term growth and profitability.

Tracking budgets, plans, and forecasts, along with any variances and their causes, is essential for SaaS businesses for these reasons:

• Alignment with strategic plan: Budgeting for your business is essential. You are bound to have variances, but without a budget to guide you, it’s impossible to reliably plan or create realistic forecasts. Regularly tracking your budget helps you adjust your financial projections, helping to ensure the company stays on track to achieve the strategic goals. 
• Agility and adaptability: By comparing actual results to budgets and forecasts, SaaS companies can quickly identify areas of underperformance or overperformance and adjust their plans accordingly. When variances occur, they present an opportunity for the company to take corrective action to realign its financial performance with its overall strategy. 
• Informed decision-making: Accurate financial projections and variance analyses provide valuable insights into the company's financial health and trajectory. This information enables management to make data-driven decisions about resource allocation, investments, and risk management.

The insights gleaned from budgeting, planning, and forecasting processes also feed into the next cycle of financial planning, enabling the organization to refine its strategies and allocate resources more effectively over time.

Best practices for financial budgeting, planning and forecasting

Tips for successful financial planning

• Align financial plans with strategic objectives: The financial plans must be closely tied to the company's overall strategy. The plan must reflect the resources and investments needed to achieve the set long-term goals.
• Foster cross-functional collaboration: Every department must actively participate in the planning process to ensure a comprehensive and realistic view of the organization's financial needs and opportunities.
• Leverage data and analytics: Historical data, market trends, and predictive analytics can help inform the financial planning decisions and improve the accuracy of projections.
• Regularly review and adjust plans: It is a healthy practice to continuously monitor actual performance against the plan so that you can make necessary adjustments to stay on track or adapt to changing circumstances.

Tips for accurate budgeting

• Use a bottom-up approach: Every department head must be involved in the budgeting process to ensure that budgets reflect realistic resource requirements and constraints. Ultimately, the final numbers will be decided by senior leadership. However, to the extent they are informed by individual teams and the realities they experience in their day-to-day work, the final budget will be more accurate and effective. 
• Align budgets with key performance indicators (KPIs): It is important to tie budget allocations to specific KPIs and objectives to ensure that resources are directed towards activities that drive the most value.
• Implement a flexible budgeting approach: It’s important to remember that an annual budget is a plan. While it’s generally pretty static, it’s always good to set aside some resources that can help you accommodate unexpected challenges or opportunities. 
• Regularly monitor and control spending: Implement processes to track actual spending against the budget, identify variances (both positive and negative), and take corrective action as and when needed.

Tips for precise financial forecasting

• Choose the right drivers: Identifying the key business drivers that impact financial performance is a good place to start the forecast process. Once you identify all the most important drivers, you can build more accurate forecasts. 
• Incorporate multiple scenarios: Use scenario planning to develop best-case, worst-case, and base-case scenarios to better understand the range of potential outcomes and prepare for different eventualities. This way you can maximize business outcomes, whatever the situation is.  ‍
• Continuously update forecasts: Regularly review and update forecasts based on the latest data and insights, ensuring that projections remain accurate and showcase the best possible view into the near future. 

Unlock the power of connected financial planning 

In today's ever-changing business environment, having the right tools and technologies in place is essential for effective financial budgeting, planning, and forecasting. 

While spreadsheets have for long been the de facto solution for business financial planning, they come with significant limitations:

• Lack of real-time visibility: Unless updated manually, spreadsheets do not provide access to the latest data and insights, thereby hindering agile decision-making.
• Prone to human error: Manual data entry and formula errors can heavily compromise the accuracy and reliability of financial projections.
• Difficult to collaborate on: Sharing and updating spreadsheets across teams is a real pain and can result in version control issues.
• Time-consuming: Finance teams spend significant time on building and maintaining these bulky and complex spreadsheet models, taking their focus away from bigger problems that need their urgent attention. 

To overcome these challenges and unlock the full potential of financial planning, SaaS businesses are turning to cutting-edge FP&A platforms like Drivetrain. 

Drivetrain enables organizations to seamlessly connect data from various sources, automate workflows, and generate real-time insights.

Drivetrain’s powerful, built-for-B2B strategic financial planning platform's scenario modeling and what-if analysis features allow finance teams to quickly assess the impact of different assumptions and decisions, enabling more informed and agile decision-making.

By adopting a connected planning approach and leveraging tools like Drivetrain, SaaS businesses can streamline their budgeting, planning, and forecasting processes, saving time and improving accuracy. Explore Drivetrain to see how easy connected planning can be.