WRITTEN REPORT ON FINANCIAL FORECASTING

I. INTRODUCTION

A. Definition of Financial Forecasting

Financial forecasting is a tool that enables managers to predict the future financial
position and performance of a company. Past financial statements are important for
forecasting, whose techniques combine information from financial statements with
external economic and industry data.

Forecasts validate the desirability of alternative decisions by management. Financial

forecasting is a task for the finance manager. A manager needs to know the likely
impact of his decision on the financial “bottom line” of his company. Inventory
decisions require a forecast of sales and inventory costs. Credit policy requires a
forecast of sales and of the costs of customer credit. Fixed asset investment decisions
require a long-term forecast of revenues and costs associated with the project.

Forecast financial statements are estimates of the overall impact of the management
strategy and program of action. Forecasts provide a comprehensive picture of a
company’s future financial status and performance and guide managerial decision
making. Forecasts are estimates of the organization. This makes for clarity in
communicating targets to stockholders. Similarly, it enables lower management to
determine the level of efforts it should exert to attain the forecast results.

B. Objective/s

This report aims to achieve the following:

1. To provide a definition of financial forecasting;

2. To identify how financial forecasting may be useful;
3. To discuss the different methods of forecasting financial accounts that will become
the basis for forecast financial statements;
4. To discuss on how forecasting is done in financial statements; and
 5. To recommend refinements in forecasting methods that will improve the
usefulness of financial forecasts to decision makers and analysts.

II. USEFULNESS OF FINANCIAL FORECASTING

Forecasts support plans, integrate the views of managers and communicate goals
throughout the company. Forecasts are useful to manger and analysts for several
reasons, as follows:

a. They support short- and long-term managerial financial plans. Investments and
financing take time and money to arrange.

Financial forecasts guide managers’ decisions in these two areas. A new plant is set
up based on forecast markets that will consume products produced by the new plant.
Without a reasonable assurance that the products can be sold, management should
not invest in the new plant. Management will take out a bank loan if its forecast of
cash position provides an assurance that the loan can be repaid on time.

b. They provide a comprehensive view of the intended results of the investment and
financing decisions of management.

A financial statement forecast shows how all the decisions of management affect the
bottom line. The net income, total financing, and total investments are examples of
the so-called “bottom line.” In proper planning procedures, all key strategies and plans
are approved by higher management only after looking at the integrated forecast of
the business performance.

c. They improve the planning process throughout the organization.

Forecasts require consultations among managers within the organization. Forecast

financial statements require coordination among different organizational units. As the
“front act” in the planning process, financial forecasting facilitates the coordination of
units within the business organization. They require managers to be explicit about
their forecasts.
 Forecasts yield information that are of value to managers. Forecast results are valuable
to a manager whose actions depend on the scenario that is likely to prevail in the future.
For each possible scenario, he could set up a corresponding policy. He could then plan
for inventory levels, customer credit terms, materials purchasing schedules, and
equipment acquisition depending on forecast scenarios.

Since forecasting takes time and is costly, a manger should decide how much information
to gather. Management can decide either to expend resources in forecasting or not to
plan at all and deal with unanticipated situations later. An analyst could gather historical
data and primary data to improve his forecast. Good forecasts enable a company to
make better business decisions. Forecasting efforts and costs pay off with future cost
savings and opportunities gained. There are two special cases when a company may
not find forecasting a justifiable investment, namely:

a. When the company does not incur substantial costs for being caught unprepared.

Some companies can react quickly to unexpected situations. These are companies
that can rapidly change their production and business setups.

b. When the company can insure itself against adverse situations.

These companies keep larger-than-usual cash balances or maintain ready lines of

bank credit as a precaution against contingencies. There are hidden costs, and
excess cash balances are nonearning assets. Banks charge higher interest rates to
a company that uses credit in emergency situations.

III. FINANCIAL FORECASTING TECHNIQUES

Various methods are used to prepare forecasts based on the available information.
Managers and analysts use three primary techniques:

a. Subjective or judgmental approach:

A subjective forecast, also called a judgmental forecast, predicts future values based
on the personal evaluation and experience of the manager. An expert gives an opinion
based on his perception of the external and internal operating conditions he faces.
The predictions form the basis for forecasts of profits, required investments and
sources of financing.

Judgmental forecasting is a method of forecasting that uses the forecaster’s

experience and opinion about the future business conditions and capability of the
company.

It may seem that the judgmental forecasting method’s weakness is its lack of a formal
quantitative basis. This impression is incorrect. Managerial judgment needs a
quantitative assessment of data. For example, a sales manager consults with his
salesmen to assess the sales potential of each territory. A factory manager has
access to cost records on which basis he forecasts factory cost. In fact, judgmental
technique is superior to other methods in the following ways:

 A manager assimilates his awareness of operating conditions into the forecast.

Judgmental forecasts are suitable for complex problems of forecasting. The
expertise of the forecaster determines the quality of the judgmental technique
 A manager is more committed to achieving the objectives of plans that are
based on his own forecasts. In contrast, forecasts prepared by analysts using
sophisticated quantitative techniques may not be acceptable to the
implementer.
 Subjective forecasts only require an expert. This is a decisive advantage in
many business situations that require quick response by management.
Examples of this situation are in pricing special customer orders, in competitive
bidding and in preparing project plans.

The disadvantages of judgmental forecasts are evident in other situations. When

managers realize that top management uses forecasts as standards of
performance, they might play games with top management.
 Quantitative analysis supplements managerial judgment. Managers tend to be
excessively pessimistic or optimistic about their own business prospects. Personal
styles and risk attitudes may affect the accuracy of judgmental forecasts.
Quantitative analysis objectively reveals patterns not evident to a manager. It also
checks the accuracy of judgmental forecasts.

b. Trend or time series analysis

Trend forecasts are prediction methods that derive patterns from past data.
Quantitative trend forecasts predict financial variables using past data. Examples are
sales forecast based on past sales data and factory overhead costs based on past
sales and cost data. Trends are patterns in past data. Examples of patterns are growth
trends and cycles. Many questions that managers seek to answer require an
understanding of patterns.

Trend forecasts use historical information about the financial variable. A common
approach is to extrapolate from past experience. There are three methods of using
patterns from past experience to predict the future. These three methods, illustrated
as sales prediction problem, are as follows:

 Prior year as indicator. Use the immediately preceding sales and adjust it for
“subjective” factors

There are cases when an analyst is at a loss on how to predict the future. For
example, suppose that sales varied widely in the past. Predicting that sales
will increase is as good as predicting that sales will decline in the next period.
Faced with this situation, the analyst’s best choice would be to use the prior
period’s sales as the predictor of the next period’s sales. A variation of this
approach is to adjust the forecast by considering the prior year’s growth rate.

The one-period forecast method disregards past data except the most recent.
The one-period method forecasts the next period’s value based only on the
last period’s value.
 The one-period forecasting method is useful when the variable is highly
random. For example, the daily prices of stocks in the stock exchange are
essentially random. If a specific stock’s price is sure to increase on the next
day, then investors would be buying now. The fact that at any given day, there
is no mad rush by the public to buy stocks is an indication that stock prices
behave randomly. The best forecast of the prices of stocks for the following
day in the Philippine Stock Exchange could be based on the previous day’s
prices.

The one-period method is also useful for very short forecast periods. While
chances that sales will increase next year are very good, tomorrow’s sales may
be more or may be less than yesterday’s. yesterday’s sales would be the best
predictor of tomorrow’s sales.

Finally, the one-period method is a default method. It works only because of

the absence of better forecasting methods. It is not a preferred forecasting
technique because it is all that can be done by a forecaster who could not find
any sound basis for his forecast.

 Simple or compound growth rates. Determine past average growth rate of

sales to forecast future sales.

The second trend forecasting approach is the use of historical average growth
rates. Growth rates are either simple or compound rates.

The simple growth rate formula relates the change in the variable over the
number of periods that have elapsed:

g = (Salest+n - Salest)
-----------------------
Sales1 x n

The forecast model based on the simple growth rate is in equation

Sales1+n = Sales1 + g x Sales1
Where g = simple growth rate

A financial analysis technique: Simple growth rate forecast method:

A forecast model using the simple growth rate method is:

Variablet+n = Variablet + g x Variablet

Where g = (variablet+n - Variablet)
----------------------------
(variablet) x n

The simple growth rate method is easy to calculate, and this is an advantage.
However, it is also deficient in that it depends on the reference base, n. For
example, using a one-year growth rate model (within n=1), the growth rate is
1.3 percent. The growth rate changed from 64.6 percent to 1.3 percent
because of the year chosen as reference point.

Average Compound Growth Rates

Average compound growth rates use the compounding formula in future value
analysis. The base period is the starting point of calculation of the compound
growth rate (also called the “true rate” in future value analysis). The formula
for the average compound growth rate comes from the compounding formula.

The average compound growth rate g is that which solves equation

Future value = Present value x (1+g)n
Solving for g:
g = (Future Value/Present Value)1/n – 1
the forecast model based on the simple growth rate is:
Salest+1 = Salest + (g x Salest)

A financial analysis technique: compound growth rate forecast:

A forecast formula that uses the compound growth rate is:
 Variablet+1 = Variablet + g x Variablet
Where g = [Variablet+1/ Variablet]1/n – 1

The compound growth rate is the average growth rate per period of sales for n
periods. The method uses only two points of the time period in deriving the
forecast. It ignores all other values of sales between years 1 and 14. A method
that does ignore other information in deriving the prediction model is not likely
to be a very powerful forecasting model.

 Time series regression. Derive a linear relationship between historical data and
time as a variable.

The statistical time series analysis method responds to limitations of the two
growth rate techniques. An example of the time series method is a regression
model with sales or inventory as dependent variable and time period as an
independent variable. Time series analysis assumes that the dependent
variable changes in a linear pattern over time. The method assumes that a
pattern is associated with the passage of time. The linear regression with time
as independent variable is only one of the many time series forecasting
models. There are other models like the nonlinear time series, the moving
average and the Box-Jenkins models.

A time-series model is a sound framework in cases when: (a) time is a

surrogate variable or substitute for an unknown underlying explanatory variable
and (b) data on the underlying explanatory variable are difficult to obtain.

Time-series forecast models reveal patterns from past data. An example of a

time series model is a linear regression with time as dependent variable.

Time series regression analysis:

A linear regression with time as dependent variable is a simple time series
model of the form:

Variable = a + b x t
Where t= (1,2,…,n) corresponds to n time periods, with t=1 representing Year
1

After calculating the regression equation from the given time series data, the
forecast values of these variables are plugged into the equation to forecast
sales. Graphically, the process involves extending the regression line and
evaluating sales at the y-axis given the future time period in the x-axis.

Statistical regression measures the reliability of its own estimate. The model
finds a regression line that has the minimum degree of deviation from the actual
data given, in this case, in time series. The minimum deviation, or “fit of the
regression line,” is achieved by minimizing the equated deviation of actual data
from the line. The summary measure of the degree of fit of the regression line
is the coefficient of determination, or R-squared. The higher the R-squared, the
higher is the degree of reliability of the regression equation as a forecasting
tool.

The maximum value for R-squared is one and the minimum is zero. When R-
squared is one, there is a perfect fit of the regression line with all time series
data. R-squared is the percentage of total variations that is accounted for by
the regression which, in the special case of R-squared equals 1, is 100 percent.
The financial analyst sets a level of R-squared for the forecast depending on
the minimum degree of reliability of the estimate that he desires. The higher
this minimum reliability and the smaller the set of historical data on which the
regression is based, the higher the required R-squared.

Forecasts Based on Relationships Among Variables: Correlation Forecasts

Trend forecasts assume that external conditions affecting the variable are
stable. This is not a sound assumption in many cases. Financial variables
depend on factors that do not behave as they had in the past. For example,
sales in the following year depend on economic factors. An economic
recession can upset the trend established in the past.
A technique that overcomes this limitation of trend analysis is the correlation
forecast. Two methods of forecasting that use correlation are the ratio
technique and the regression analysis.

Ratio Technique:
The regression technique calculates an average relationship between the
forecast variable and an economic variable that determines sales. The ratio
technique assumes that the forecast variable is determined by the independent
variable (e.g. inventory is a function of sales). Management controls inventory
by relating it to sales.

The basic principle of Ratio Technique in Forecasting assumes a constant

relationship between two variables. The relationship must be established from
past experience and management policy.

The fixed ratio assumed in the correlation forecast is external to the model.
Unlike trend analysis where the rates are set based on data, ratio analysis uses
a separated assumption. The ratio need not correspond to past experience.

When applied to the forecast of entire financial statements, the ratio method is
called the percentage of sales forecast.

For forecasting income, the percentage of sales method uses the historical
relationship between each cost item and sales. This is called vertical analysis
because the ratios relate the list of costs to the figure on sales. Given a
forecast of future sales, management forecasts costs using historical ratios or
a pre-set standard. Exceptions are for costs that do not vary with sales like
depreciation, interest expenses and rent.

For forecasting income, the percentage of sales method uses the historical
relationship between each cost item and sales. As sales change, this method
assumes that assets and liabilities will change in the same direction and by a
constant rate. The assumption is reasonable for assets that support sales,
such as working capital assets and fixed assets used in production and sales.
 Exceptions are assets that are not related to sales like investments and other
assets. Similarly, there are liabilities like accounts payable and accruals that
support sales. Other liabilities and capital accounts may not be supportive, and
they are excluded from the ratio method when making the forecast balance
sheet.

Regression Analysis

Regression analysis establishes the relationship between actual levels of

inventory and sales. Regression analysis provides sound forecasts only if
future operations re expected to remain similar to those in the past. Suppose
a company has undergone major changes in its line of businesses. Then its
past data are not a valid basis for deriving correlation. In that case, the
regression method is not relevant, and the analyst would be better off with ratio
and subjective methods.

IV. FORECAST FINANICAL STATEMENTS

A. Types and Uses of Forecast Financial Statements

Each financial variable is forecast in order to prepare forecast financial statements.

Forecast financial statements are comprehensive predictions of a company’s
overall financial status and performance. The three forecast financial statements
are the cash forecast, forecast balance sheet and forecast income statement.

1. Cash Flow Forecast