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The Concept of Financial Forecasting

Akash Dubey

| Updated: Sep 24, 2019 | Category: Finance

Financial Forecasting

The concept of forecasting makes utilization of past data to predict future outcomes. Forecasting is a vital mechanism widely used to make financial and management decisions. Financial forecasting is used to make future projections about the expenses and revenue of the business and thus predict the profit potential of the company. The screening comprises profit and loss statements, cash flow, balance sheets, etc.

The process of financial forecasting involves using historical data of sales, revenue, and factors of influence to make future projections. It is then studied by experts to conclude how the enterprise will perform in the target period.

The Need for Financial Forecasting

Business operations take place in an environment of uncertainty. Thus any cure to reduce the uncertainty of business outcomes is highly productive for organizational growth. Such information is not only a valued asset for the entity but also a necessity of the business. Additionally, it also helps to stay ahead of competitors by having a better idea of future risks and opportunities.

A forecast is monitored on a regular basis and updated on regular intervals in order to cover up any deviation. This routine scrutiny of forecast projections helps to analyze the predictions with actual results.

Benefits of Financial Forecasting

  • It helps to set the standard of performances and act as a base to evaluate real-time results.
  • It helps in the timely arrangement of funds as a result of the financial projection of funds needs and revenue potential.
  • It helps in the optimum utilization of resources and reduces the non-performing resources of the organization.

Process of Financial Forecasting

Process of Forecasting

1. Gather Financial Information

The first and foremost step to start the forecasting procedure is to gather historical records of the business. The method of forecasting helps to makes projections on the basis of past records and performance of the entity. Projecting without taking historical data into records is mere expectation without any concrete evidence.

An organization needs financial statements bookkeeping[1] transactions with updated records. Once the records are gathered, then the organization can proceed to the process of forecasting.

2. Historical Data based Vs. Research-Based Projections

Once the necessary data is available, the next is to determine the type of forecast to proceed. There are two approaches to make a forecast. The kind of forecast largely depends upon the need of the organization. Even though every forecast has elements of historical data and market research. However, the choice of approach should not undermine the purpose of making the forecast. Let us now read about the two in detail.

Historical Data-Based Forecast

Historical data based forecast uses financial statements of previous years to make future projections. The experts take financial statements and balance sheet of past years to make projections about the future performance of the entity

  • Pros

The benefits of this approach to the forecast are that it can be conducted in a short time without taking a hefty toll on time, costs, and resources. Additionally, it helps to make a rough estimate of business growth.

  • Cons

The disadvantage is that it ignores the external factors that impact the growth of the organization, such as market trends and factors. Additionally, it cannot be used for making a presentation for investors.

Research-Based Forecast

The forecast that is based on the research-based premises is called a research-based forecast. This approach to financial forecast takes broad factors into consideration that are potential influences on business growth.

  • Pro

The advantage of a research-based forecast is that it provides an in-depth and extensive view. This is the kind of forecast that can be presented to investors and stakeholders as it is considered the most realistic forecast among the two.

  • Cons

The disadvantages are that the research-based forecasting is time-consuming and expensive. Moreover, it is costly as you may need the help of experts to conduct the forecast.

Preparation of Pro Forma Statements

Pro forma statements are the statements that are prepared using the forecast process. They are the presumptive income statements and balance sheets.

Preparation of Pro Forma Income Statements

Preparation of Pro Forma Income Statements

The pro forma income statements are prepared with the help of historical data blended with market research. The process involves making reasonable estimates about the possible earnings and expenses of the company. The estimation of the sales figure for the coming period helps to shape the complete statement. The sales figures are estimated on the basis of numbers from previous years, along with market research and economic factors.

Estimates about production expenses are next to being taken into account. The production expenses comprise production cost, wage rates, overhaul expenses, etc. Projections for the cost of production are made using the previous year’s cost of production in comparison to sales made in that period.

The next element of estimates for this statement is administrative expenses, selling expenses and interest and taxes. Administrative expenses and selling expenses are not highly elastic in nature, and hence they can be predicted accurately.

The income after administrative and selling expenses deductions is income before interest and taxation. The amount of interest and taxation can be predicted with a low risk of deviation.

Pro Forma Balance Sheet 

Pro Forma Balance Sheet

The pro forma balance sheet is prepared using the information from the pro forma income statements. However, the information is not sufficient to make satisfactory projections. Balances of previous years are also included to drive the changes from the old balance sheet to the pro forma balance sheet.

The pro forma balance sheet contains the forecasted value of fixed assets after infusing the amount of depreciation for the coming year. Current assets will be charged based on the period of credit allowed to creditors.
The amount of inventory will be forecasted based on the production plan of the entity for the following year. Here, the amount of cash place an important and diverse role. The cash balance will be shown at the lowest. Interestingly any difference between the assets and liabilities side of the Pro forma balance sheet will be balanced from the cash in hand.

For the liabilities side, preplanned redemption of the debenture and fresh issue of shares and debentures should be taken in to account. Additionally, past and future data of liabilities should be taken into account to account for outstanding liabilities for the pro forma balance sheet. Provisions for tax and dividends are prepared by taking the figures of the previous year balance sheet and pro forma income statements.

Projected Cash Flow

The projected cash flow statement depicts the assumed amount of cash that will change hands in the coming year. The statement shows light on the cash requirements of the following year. It helps to decide how much additional funds from equity or debt a business has to raise to meet the cash requirements. The amount of cash requirement is proportionally dependent on the production and expansion plan of the business enterprise.

Read our article:Cash Flow Forecasting in Financial Model

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Akash Dubey

Akash Dubey is a Law Graduate and works as an Advisor at Enterslice. He is proficient in Legal and Financial Advisory. His expertise in the skills of Legal and Financial Research is an aid to his strengths as an Advisor.

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