Financial forecasting is the process of predicting a company’s future financial performance, based on its past and present financial data. This involves using a variety of techniques, such as analyzing historical financial data, creating financial models, and considering external factors that may impact the company’s performance.
1. Steps in Financial Forecasting
The systematic and logical method of forecasting involves the following steps:
1. Forecast of Economic and Business Conditions for the Nation and the Market Area to be Served:
Attempts have to be made to visualise the future climate for business and analyse the currents and cross-currents affecting the character and magnitude of business in the foreseeable future.
Prediction of trends of economic changes, business fluctuations is the primary step in the forecasting process. General economic forecast unfolds an overall setting within which forecasts about the prospects of the firm’s business can be projected.
2. Forecasts of Conditions and Course of Changes within the Particular Industry:
In the light of general economic forecasts, the position and prospects of the industry are appraised.
Forecast of Sales of the Output of the Firm is the Critical Aspect of the Forecasting Process:
What would be the firm’s probable share in the turnover expected for the whole industry is to be projected Moreover, expected sales turnover will be the basis for future production planning.
Thus forecasting predicts the total demand and its probable stability or certainty in future and on the basis of such predictions the future sales levels are estimated.
2. Financial Forecasting Techniques
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 requirements of a firm.
2. Percentage of Sales Method:
It is another commonly used method in estimating financial requirements of the firm based 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.
3. Simple Linear Regression Method:
Simple linear regression is concerned with bivariate distributions that are distributions of two variables. Simple regression analysis provides estimates of values of the dependent variable from values of independent variables. For financial forecasting purposes, sales is taken as an independent variable and then values of each item of asset (dependent on sales) are forecasted.
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.
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.
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.
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.
3. Advantages of Financial Forecasting
The financial forecasts help the Finance manager in the following ways:
1. It provides necessary information for setting up of objectives and for preparation of financial plans.
2. It acts as a control device for a firm’s financial discipline.
3. It provides necessary information for decision making of all functions in an organization.
4. It monitors the optimum utilization of firm’s resources.
5. It projects the funds requirement and utilization of funds in advance.
6. It alarms the management when the events of the concern go out of control.
7. It enables the preparation and updation of financial plans according to the changes in economic environment and business situations.8. It provides the information needed for expansion plans of business and future growth needs of the organization.