Funds are required at each stage of a business. Be it a small enterprise or large; all need funds for the smooth functioning of their operations. In such a scenario, financial forecasting becomes extremely important. The right financial forecasting techniques ensure the accuracy of forecasts, so there will be no hindrance as far as the funds are concerned.
Meaning of a Forecast?
A forecast is the prediction of the future based on a certain set of circumstances that could be related to the past or present data. It involves developing future estimates after a thorough analysis of different trends. In other words, forecasting is a step-by-step process of predicting the future. In finance, managers use different financial forecasting techniques to foresee future trends and get the most accurate figures. The resulting statements are known as financial forecasts.
- Meaning of a Forecast?
- What is Financial Forecasting?
- Qualitative Financial Forecasting Methods
- Quantitative Financial Forecasting Methods
- Causal Methods
- Simple Linear Regression Method
- Multiple Regression Method
- Days Sales Financial Forecasting Technique
- Percentage of Sales Financial Forecasting Technique
- Time-series methods
- Financial Statements for Financial Forecasting
- Projected Funds Flow Statement and Projected Cash Flow Statement
- Projected Income Statement and Balance Sheet
What is Financial Forecasting?
Financial forecasting forms the basis of decision-making in an organization. It provides information regarding future aspects of a business, around which strategies are formulated, and planning is done.
Under financial forecasting, the forecasters develop future estimates with the help of statements such as the projected income statement, projected cash flow statement, etc.
A company estimates/predicts two main things in a financial forecast:
- Future Income
- Future Expenses
With the financial forecasts, one can understand the level of production, the funds required, the need for working capital, and the overall long-term operational efficiency of the business. Expected growth in sales can be ascertained to know the profitability. Eventually, it helps make crucial investment decisions and control the uncertain events and associated risks thereon.
Qualitative and Quantitative Methods of Financial Forecasting
There are two ways of developing financial forecasting using either a qualitative or a quantitative method.
Qualitative Financial Forecasting Methods
The qualitative methods use non-quantifiable or non-measurable data for forecasting purposes. Herein, the manager gives due importance to the consumer’s opinion or expert judgment for arriving at suitable results.
These methods are widely in use when past data is not available. For example, it would be wise to research consumers’ preferences while launching a new product in the market.
Some of the qualitative methods are:
The opinions of the key staff hold great value. For example, the sales team comes in contact with the customers, and thus, they know their needs and requirements better.
Under the executive opinion method, the opinions of experts of different departments such as production, sales, purchasing, and operations are taken to envision and predict the future.
Revisions are made in the forecasts beforehand to fulfill customer expectations.
The management team can undertake complete market research wherein a sample of current, and future customers will be selected to discuss and predict a good or service.
With market research, the forecaster can figure out the demand for a particular good or service. Whether the customers would like to buy a new product or a new variant of the existing product or not? However, this forecasting method is a bit expensive and hence may not always be used.
The Delphi technique revolves around a structured method. A facilitator is there to ease this whole process of deriving the forecasts from a set of experts.
The first step of this method includes gathering data through the medium of questionnaires. Multiple rounds are there. The analysis of data is done at every stage. So, the result of the preceding rounds forms the basis of the next round. The process of collecting and analyzing iterations continues until they reach a consensus.
Consequently, the managers prefer the Delphi method for long-term forecasts only, given the amount of time and effort required in this technique.
Reference Class Forecasting
The reference class forecasting is based upon human judgment. Under this method, the forecaster predicts the future according to similar scenarios in other places or times.
The manager/forecaster makes the judgment on the expected outcome of a planned action in the future.
Here, the team generates the most likely scenarios in line with various other scenarios. First, the forecaster calculates the outcomes of different scenarios and then develops the most likely scenarios.
This method uses in-depth knowledge of the sales force about customer behavior. The insights help improve the product/service as per the consumer’s expectations. The forecaster calculates the average of salesforce polling to derive future estimates.
Quantitative Financial Forecasting Methods
In quantitative methods, the forecasters use past observations to generate forecasts. Usually, a forecaster manipulates and analyzes the existing quantitative data through various quantitative and statistical tools to arrive at the most accurate results.
Some of the quantitative methods are:
In the causal method or, cause and effect method, the forecaster studies the relationship of one variable with another relevant variable. Consequently, a change in one item causes the same change in another.
Regression analysis is a widely used causal method. It can further be divided into:
Simple Linear Regression Method
The simple linear regression focuses on the distribution of two variables. Here, the forecaster studies the bivariate distributions and calculates the estimated values of the dependent variable according to the values of the independent variable.
Multiple Regression Method
Multiple regression analysis or multiple discriminant analysis is an extension of the simple regression method where a variable is dependent on more than one variable/factor.
For instance, sales could depend on more than just one variable. The analysis of one or more of those factors determines the sales forecasts.
Some other examples of the causal financial forecasting techniques are:
Days Sales Financial Forecasting Technique
This is a popular technique wherein the forecaster first, calculates the day’s sales and then studies how it relates to other items on the balance sheet. It helps in arriving at the balance sheet forecast. Therefore, one can know the requirement of funds and take measures accordingly.
Percentage of Sales Financial Forecasting Technique
The sales forecast paves the way for getting a clear picture of the expected future sales with which a manager can forecast the firm’s financial requirements. Any change in the sales will have much effect on other variables of the balance sheet, particularly the assets and liabilities.
Thus, it’s crucial to make the sales forecast and establish its relationship with other variables as accurately as possible.
This is another popular quantitative method. It involves the gathering of data over different periods to identify trends. Then, the forecaster analyzes the trends to derive the forecasts mainly for the short term.
For example, simple averaging and exponential smoothing are popular time-series techniques.
Financial Statements for Financial Forecasting
The financial statement is another important tool in the hands of a manager, especially when there is an acquisition/ merger or at the time of the formation of a new company.
Therefore, investors need these statements before providing the required capital to a firm. These statements cover the costs and sales figures of the previous two to three years after excluding some one-time costs.
Projected Funds Flow Statement and Projected Cash Flow Statement
The projected funds flow statement represents the data about further procurement of funds from various sources and their application in assets or repaying debts, etc., whichever the case be. It helps in understanding the impact on working capital by establishing a relationship between sources and the application of funds.
On the other hand, the projected cash flow statement primarily focuses on the inflow and outflow of cash. It covers the items which result in the realization of cash or expenditure in cash. It is a detailed statement of the projected cash flows generated from the operating activities, investing activities, and financing activities. Therefore, it proves to be a useful tool for forecasting the company’s financial requirements.
Projected Income Statement and Balance Sheet
With the help of the sales forecast and anticipated expenses for a particular period under forecasting estimation, the firm projects the income statement.
After that, the forecaster draws a projected balance sheet considering the expected future increase or decrease of the long-term funds, further acquisition or disposal of fixed assets, the estimated working capital items, and the reference of sales forecasts.
In conclusion, financial forecasting is crucial for undermining business risks. Similarly, selecting an appropriate financial forecasting method is equally important for deriving successful results.
Also, read Rolling Forecasts.