FINANCIAL FORECASTING

FINANCIAL FORECASTING

 

                 Financial forecasting involves a systematic projection of expected actions of management in the form of financial statements, budget etc. Cash forecast or financial forecast is an estimation of in flows and out flows of the firm’s cash account over a particular future period of time.

   Methods of Forecasting

                The following are some of the important methods in use;

1.      Direct or Bottom up Method: -

             Under this method, various departments of an enterprise collect their own information or data and prepare their own forecasts. On the basis of these forecasts, the forecasts for the firm as a whole are then undertaken. Thus, the responsibility of successful forecasting lies directly with various departments and people in the organization.

2.      Indirect or Top down Method: -

              This method is just reverse of the direct or bottom up method. In this method, the forecasts for the industry or business as a whole is ascertained first and then the particular forecast for the various activities of the business are established. The process of forecasting is thus indirect and the responsibility for success in forecasting mainly lies with the top level of management.

3.      Historical Method: -

           This method refers to the projection of trends on the basis of past events. The historical sequence of events is analyzed as a basis for understanding the present and forecasting the future trends. The past recurring trends are associated with the corresponding cost and effect phenomenon in the future. The important advantage of this method is including;

a.   The past information or records can be easily obtained

b.      Present information is also not ignored

        However, the main limitation of this method is that the future trends may deviate drastically from the normal path indicated by the past events.

4.      Deductive Method: -

          Under this method, future trends are based on observation and investigation.  This method can be regarded as more dynamic in character as it takes into consideration not only the historical sequence of events but also the latest developments. However, the main draw back of this method is that it relies more on individual judgment and initiative appraisal than on actual record.

5.      Joint opinion method: -

                  As the name suggests this method utilizes the collective opinion, judgment and experience of various experts. A committee for business forecasting is formulated to take the joint view of various members. The main advantages of this method include;

1.It encourages co ordination and co-operation and also utilizes the services of various experts.

2.There is no need of detailed statistical analysis.

3.It is simple and easy to operate.

                However, the main disadvantage of this method is that, the joint responsibility that may ultimately result into nobody’s responsibility. The members of the committee may also not take active interest, as they know that their judgment may not be finally accepted. This may degenerate the entire forecasting process into a mere guess.

 

6.      Scientific business forecasting: -

                  Forecasting is done on scientific lines by making use of various statistical tools, such as business index or barometer, extrapolation or mathematical projections, regression and econometric models. Past statistical data modified in the light of changed present conditions provides the basic raw material for drawing more accurate conclusions for the future.

 

Purpose, use, importance and advantages of business forecasting

   The following are the specific advantages of business forecasting.

1.      Establishing a new business: - While setting up a new business, a number of business forecast are required. One has to forecast the demand for the product, capacity of competitors, expected share in the market, the amount and sources of raising finance.

2.      Formulating Plans: - Forecasting provides a logical basis for preparing plans. It plays a major role in managerial planning and supplies the necessary information. In fact, planning without forecasting is impossibility.

3.      Estimating Financial needs: - Every business needs adequate capital. In the absence of correct estimate of financial requirements, the business may suffer from inadequate or excess capital. Forecasting of sales and expenses helps in estimating future financial needs.

4.      Facilitating managerial decisions: - Forecasting helps management to take correct decision. By providing a logical basis for planning and determining in advance the nature of business operations, it facilitates correct managerial decisions about material, personnel, sales and other requirements.

5.      Quality of management: - It improves the quality of managerial personnel by compelling them to look in to the future and make provision for the same.

6.      Encourage co-operation and Co ordination: - Forecasting is not a one man’s or one department’s job. There should be a proper co-operation and co ordination among different departments for setting proper forecast for the business as a whole.

7.      Better Utilization of Resources: - Forecasting ensures better utilization of resources by revealing the areas of weakness and providing necessary information about the future.

8.      Success of Business: - Success in business to a great extend depend upon correct predictions about the future. Systematic forecasting ensures smooth and continuous working of the business.

 

  Disadvantages of Business forecasting

1.      The business forecast wastes time, money and energy.

2.      It is also felt that forecasting is influenced by the pessimistic or optimistic attitude of the        forecaster.

3.      It may not be possible to make forecast with a pinpoint accuracy.

4.      The forecast should be constantly monitored and revised with the changed circumstances.

 

                   Tools of Financial Forecasting (Techniques)

                        1. Preparation of Performa financial statement    2. Preparation of cash budget

 

1.     Preparation of Performa Financial Statement

                 Financial statements met to display the effect of future circumstances are described as performa statements. There is no rigid set of rules for constructing these performa financial statements because the purpose or objective of preparation is main determinant of format. Performa financial statements are prepared on the experience of past and present condition. There are two types of performa financial statements.

 

a. Projected Income Statement or P& L a/c

b. Projected Balance sheet or Position statement

 

A.    Projected Income Statement or P& L a/c

           The purpose of this statement is to have a fair and reasonable estimate of expected revenue, cost, profit, taxes, dividend and other figures of financial interest. All the projected figures (income and expenses) for a particular future period are recorded in the projected income statement. The preparation of the statement is an important step in the budgeting process.

Steps in preparation of Projected Income Statement

1. For the preparation of this statement the expected sales for the forecasted period is estimated    first.

2. All other figures or amounts (expenses or income) are calculated on the basis of the sales figure.

3. Profit or deficit can be calculated by comparing expected revenues and expenses.

            If there is any surplus, the investment plan can be prepared. If this statement shows a deficit, financial plan should be prepared for the procurement of additional fund needed.

 

B.     Projected Balance sheet or Position statement

             A projected balance sheet is essentially a forecast of expected fund flows. The construction of performa balance sheet is based upon the information in the performa income statements as well as other budgets and supportive statements. Four major steps are involved in projected balance sheet. They are;

1. Net investment should be calculated in each of the assets of the company on the target date.

2. Liabilities should be listed after proper analysis and study.

3. Net worth of the company should be calculated after adjusting the projected income of the company from the period of forecasting.

4. Projected assets are compared with total source of funds i.e. liabilities net worth.

               On the other hand, if the sources exceed the assets, the excess indicates the additional cash about the desired minimum level. This means there is excess cash in the organization. So the cash level or loans in advances should be reduced.

 

2.     Preparation of cash budgets 

              Finance manager prepares the cash budget generally. Since the cash budget based on numerous estimates organizing throughout the firm the finance manager should consult the executives of the firm while preparing the cash budget. A cash budget is an estimate of receipts and disbursements of cash during a future period of time. It is a forecast of expected cash inflows and outflows. It is a device to plan and control the use of cash. The cash budget pinpoints the period when there is likely to be excess or shortage of cash. The estimated cash collections for sales, debts, bills receivables, interests, dividends, and other incomes and sale of investments and other assets will be taken in to account. The amounts to be spent on purchase of materials, payments on creditors and meeting various other revenue and capital expenditure needs should be considered.

           Preparation of cash budget involves the following steps.

1. Estimating cash receipts

2. Estimating cash disbursement

3.Determining financial needs

 

                      Objectives of Cash Budget

         Cash budget in a firm is prepared to accomplish the following objectives.

1.To project firm’s cash position in future period.

2.To predict cash surplus or deficit in the future months.

3.To permit planning for financing needs in advance.

4.To help in selection of proper source of financing cash requirements of the firm.

5.To permit proper utilization of idle cash.

6.To maintain adequate balance between cash and working capital, sales, investments and loans

7.To exercise effective control over cash expenditure by limiting the spending of the various                          departments.

 

Investment

            Investment is the employment of excess funds in the expectation of positive return. The main Features of Investment are;

1. Liquidity

2. Safety

3. Return

4. Risk

5. Tax benefits

 

Risk

            Risk means possibility of loss or injury. In other words Risk is the difference between expected return and actual return.

 

Types of Risk

           Risk can be traditionally classified into two .They are;

1. Systematic risk and

2. Unsystematic risk

Systematic risk

                Systematic risk represents that portion of the total risk of an investment that cannot be eliminated or minimized through diversification. Systematic risk is also known as non-diversifiable risk or market risk e.g.:

1.The govt. changes the interest rate policy.

2.The corporate tax rate is increased.

3.Changes in inflation rate.

4.Changes in investor’s expectation.

5. Respective credit policy.

Unsystematic risk

               Unsystematic risk represents that portion of the total risk of an investment, which can be eliminated or minimized through diversification. Unsystematic risk is also known as diversifiable or unique risk. e.g.-

      1. Strikes.

      2. Availability of raw material.

      3. Management capabilities and decisions.

      4. Competition.