In this article we will discuss about:- 1. Meaning of Forecast 2. Financial Forecasting Techniques 3. Benefits.
Meaning of Forecast:
A forecast is a prediction of what is going to happen as a result of a given set of circumstances. The dictionary meaning of ‘forecast’ is ‘prediction, provision against future, calculation of probable events, foresight, prevision’. In business sense it is defined as ‘the calculation of probable events’.
When estimates of future conditions are made on a systematic basis the process is referred to as forecasting and the figure or statement obtained is known as forecast. Forecast is a prediction of what is going to happen as a result of a given set of circumstances. The growing competition, rapid change in circumstances and the trend towards automation etc. demand that decisions in business are not to be based purely on guess work, rather on careful analysis of data concerning the future course of events.
Forecasting aims at reducing the areas of uncertainty that surround management decision-making with respect to costs, profit, sales, production, pricing, capital investment and so forth. In forecasting, both macro and micro- economic factors like price levels, inflationary trends, monsoons, international industry trends, governmental changes, cost of finance, competition, company’s strategies and plans, consumer preferences, technological innovation etc. will be considered.
A forecast is a mere assessment of future events. A forecast includes projection of variables both controllable and non-controllable that are used in development of budgets. A budget is a plan, whereas a forecast is a prediction of future events and conditions. Forecasts are needed in order to prepare budgets. In forecasting events that will occur in the future, a forecaster must rely on information concerning events that have occurred in the past.
In order to prepare a forecast, the forecaster must analyze past data and must base the forecast on the result of the analysis. The object of business forecasting is not only to determine the trend of figures that will tell exactly what will happen in future, but also to make analysis based on definite statistical data, which will enable the firm to take advantage of future conditions to a greater extent than it could do without them. There always must be some range of error allowed for in the forecast.
While forecasting one should note that it is impossible to forecast the future precisely. Forecasting is an initial step in financial planning process. It starts with predicting the future events that will have significant impact on the firm’s business and its success or failure. It is an estimation of future events in advance and forecasts the future funds requirements and its utilization.
The forecasts will be converted into, plans for action and presentation of plans in the form of financial statements and put them for action. In other words, forecasts will lead to setting up of goals of firm and translating the goals into operational plans for action. The finance function involves the both in setting up of goals and to see that goals are achieved through financial planning, decision-making and control.
Financial Forecasting Techniques:
Financial forecasting provides the basic information on which systematic planning is based on. Sometimes the financial forecasting is used as a control device to set the way for firm’s future course of action. For strategic planning, financial forecasting is a prerequisite.
In financial forecasting, the future estimates are made through preparation of statements like projected income statement, projected balance sheet, projected cash flow and funds flow statements, cash budget, preparation of projected financial statements with the help of ratios etc.
Financial forecasting helps making decisions like capital investment, annual production level, operational efficiency required, requirement of working capital, assessment of cash flow, raising of long-term funds, estimation of funds requirement of business, estimated growth in sales etc.
Some of the important techniques that are employed in financial forecasting is given below:
1. Days Sales Method:
It is a traditional technique used to forecast the sales by calculating the number of days sales and establishing its relation with the balance sheet items to arrive at the forecasted balance sheet. This technique is useful for forecasting funds requirement of a firm.
2. Percentage of Sales Method:
It is another commonly used method in estimating financial requirements of the firm basing on forecast of sales. Any change in sales is likely to have impact on various individual items of assets and liabilities of the balance sheet of a firm.
This will help in forecasting financial needs of the firm by establishing its relation with the changes in levels of activity. Proper understanding of the relationship of sales level changes with the balance sheet items is necessary before any financial forecast is made.
3. Simple Linear Regression Method:
Simple linear regression is concerned with bivariate distributions, that is distributions of two variables. Simple regression analysis provides estimates of values of the dependent variable from values of independent variable. The device used to accomplish this estimation procedure is the regression line.
For financial forecasting purpose, sales is taken as an independent variable and then values of each item of asset (dependent on sales) are forecasted. Under this method, every time only one item of asset level can be determined. Then all forecasted figures are then put into the projected balance sheet to know the financial needs of the firm in future.
4. Multiple Regression Method:
Multiple regression analysis is further application and extension of the simple regression method for multiple variables. This method is applied when behaviour of one variable is dependent on more than one factor. In this method of financial forecasting it is assumed that sales are a function of several variables.
But in case of simple regression method only one variable can be considered each time, with the increase in the number of independent variables. Computations may be easily made with the help of computer. The method used in financial forecasting depend on the requirements and accuracy needed in forecasting.
5. Projected Funds Flow Statement:
The funds flow statement presents the details of financial resources that are available during the accounting period and the ways in which those resources are applied in the business. It is a statement of sources and application of funds analyzing the changes taking place between two balance sheet dates.
A projected funds flow statement will present the data relating to procurement of further funds from various sources and their possible application in fixed assets or repayment of debts or increase in current assets or decrease in current liabilities etc. The funds flow statement establish relationship between sources and application of funds and its impact on working capital. It is a powerful tool extensively used in financial forecasting.
6. Projected Cash Flow Statement:
It is a detailed projected statement of income realized in cash and cash expenditure incorporating both revenue and capital items. Projected cash flow statement focus on the cash inflow and outflow of various items represented in the Income statement and Balance sheet. The projected cash flow statement shows the cash flows arising from the operating activities, investing activities and financing activities. A projected cash flow statement is used in forecasting the financial requirements of the firm.
7. Projected Income Statement and Balance Sheet:
The projected income statement is prepared on the basis of forecast of sales and anticipated expenses for the period under estimation. The projected balance sheet is also drawn based on the future estimation of raising or repayment long-term funds and acquisition or disposal of fixed assets and estimation working capital items with reference to the estimated sales.
Benefits of Financial Forecasting:
The financial forecasts help the Finance manager in the following ways:
a. It provides basic and necessary information for setting up of objectives of firm and for preparation of its financial plans.
b. It acts as a control device for firm’s financial discipline.
c. It provides necessary information for decision-making of all functions in an organization.
d. It monitors the optimum utilization of firm’s resources.
e. It projects the funds requirement and utilization of funds in advance.
f. It alarms the management when the events of the concern going out of control.
g. It enables the preparation and updation of financial plans according to the changes in economic environment and business situations.
h. It provides the information needed for expansion plans of business and future growth needs of the organization.