Financial Forecasting is the process by which businesses plan for the future such as expected revenue growth and profitability. This financial forecasting process critically provides the avenue for a business to articulate its financial goals and it is used by both internal managers, planners and outside investors. The process helps businesses to identifying their asset requirements while provide leaders with data on any need for external financing. The five articles provided accurate description of what financial forecasting is and show examples of current approaches to providing credible financial forecasts.
Based on one financial forecasting article; “The the principal driver of the forecasting process is generally the sales forecast” (Business Finance Online). Business Finance Online articulated that the majority of Balance Sheet and Income Statement accounts are directly tied to sales and so the financial forecasting process can assist businesses to assess the expected increase in Current and Fixed Assets that is needed to support forecasted sales. The articles all agree that financial forecasting in necessary if firms need to get external financing.
Banks and other investors want to know that the business will remain profitable. The general agreement in the articles relates to fact that businesses often need to plan their Capital Structure; a mix of debt and equity used to finance the business assets, working capital and dividend Policy. Business Finance Online also articulated that identifying funds to be raised in order to support the forecasted sales is a key output of financial forecasting. This amount is called Additional Funds Needed (AFN) or External Financing Needed (EFN).
This vital financial forecasting provides the business with the relevant information to decide if its forecasted sales growth rate will support profitability goals, expected capital Structure and dividend policy. A common theme in all the articles surrounds the vital thought that financial analysts and other leaders within businesses need to present their respective organization with financial forecasts that are credible and supportive of first-class decision-making while inspiring confidence in the business to continue to grow profitably.
We will examine a financial forecasting method presented in the articles and this is the Percentage of Sales method. The percentage of Sales method serves to predict a future period Income Statement and Balance Sheet by an assumption that most accounts will remain a fixed proportion of Sales. The articles describes this type of financial forecasting approach, as fairly simple, but emblematic and highly illustrative of the many issues related to forecasting and posits that it can readily be extended to allow for a more flexible technique, such as forecasting items on an individual basis (Business Finance Online).
Percentage of Sales Method The Percentage of Sales Method is a financial forecasting process that is based on the theory that in general, most Balance Sheet and Income Statement accounts changes proportionately with sales. Sales forecast is therefore vital in preparing the Pro Forma Financial Statements and any need for external financing can then be readily identified. The articles were all in agreement that this percentage of sales method in financial forecasting was often used by businesses to provide fairly accurate prediction of future earnings.
The Balance Sheet and Income Statement shown below is an example of forecasted sales growth. The growth in sales in the example is set at 25%. Firstly, the Balance Sheet and Income Statement accounts are expressed as percentages of Sales since they will vary directly with Sales. This is done by dividing the balance for these accounts for the current year (2009) by sales revenue for the current year. The Balance Sheet accounts that usually change closely with Sales are Accounts Receivable, Cash, Inventory and Accounts Payable and these vary accordingly.
Normally, fixed Assets are tied closely to Sales figures unless there is excess capacity however, in the example shown below, the assumption is that Fixed Assets are currently at full capacity and therefore will change directly with a change in sales. Notably, Notes Payable, Long-Term Debt, and Common Stock do not vary in direct relation with Sales but depend on how the business seeks to raise funds to support the forecasted sales growth. The retained earnings on the Balance Sheet shows the cumulative total of the company’s profits that have been reinvested in the business.
The change in retained earnings is linked to Sales and the link comes from relationship between Sales growth and Earnings. Costs on the Income Statement are shown as a percentage of Sales and the assumption is that all costs remain at a fixed percentage of Sales. Net Income is also expressed as a percentage of Sales. Taxes are expressed as a percentage of Taxable Income and this depends on the tax rate. Finally, expected payout in dividends and the addition to Retained Earnings are expressed as a percentage of Net Income in order to determine the Payout and Retention Ratios respectively.
Please see the calculations below that are used to prepare the Balance Sheet and Income statement. After doing the calculations, the Partial Pro-forma Financial Statements are prepared. The forecasted sales figure is first decided on and this is done my multiplying Sales for the current year (2009) by one plus the forecasted growth rate in Sales. S1= S0 (1 + g) = $1200(1 + . 25) = $1500 Where: S1 = the forecasted Sales level, S0 = the current Sales level, and g = the forecasted growth rate in Sales.
Once the forecasted Sales level has been determined, the Balance Sheet and Income Statement accounts which vary directly with Sales can be determined by multiplying the percentages by the sales forecast. The accounts which do not vary directly with sales are simply transferred to the Partial Pro-Forma Financial Statements at their current levels. Retained Earnings on the Balance Sheet is the one item whose amount is determined using a slightly different procedure.
The Partial Pro-Forma balance for Retained Earnings equals Retained Earnings in the current year plus the forecasted Addition to Retained Earnings from the Partial Pro-Forma Income Statement. The balances for summary accounts, such as Total Current Assets and Total Current Liabilities, are determined by summing their constituent accounts (Business Finance Online). One article also points to the fact that when preparing a financial forecast, analysts often consider only a few important factors, such as recent sales growth (Associated Content).
This should not be the only data on which to predicate future sales growth and leaders need to seek to avoid using such basic forecasting as this could lead to overinvestment, over hiring, and missed investor expectations. Another article further advocated that financial analysts need to: Offer renewed rigor in their forecasting process. The triangulated forecasting approach (TFA) provides a framework that analysts can use to build forecasts that management can believe in. Management can rely on triangulated forecasts to make proactive strategic and operating decisions (Microsoft Dynamics).
The Triangulated forecasting focuses on the three core forecasting elements: Capture the right information, Utilize information aggregation: by looking at potential customer orders and market data, and use detailed information analysis. By focusing on these three elements and the issues surrounding them, financial analysts can build a strong and trustworthy forecast. The common the theme of all the articles surrounds the importance of providing a credible forecast that accurately predicts the company future financial health.
Leaders and financial analysts need to base their assumption on data that supports their forecasts otherwise all projections will remain wishful thinking and companies may not be able to raise capital that is need for growth or predict future events (Associated Contents). ? References Associated Content. 2009. Forecasting Sales: The importance of forecasting in business planning. Retrieved April 9, 2009 from http://www. associatedcontent. com/article/1315275/forecasting_sales_the_importance_of_pg2. html? cat=3 Business Finance Online. 2007. Percentage of Sales method. Retrieved April 9, 2009 from http://www. zenwealth.
com/BusinessFinanceOnline/FF/PercentageOfSales. html Business link. 2009. Forecast and Plan your Sales. Retrieved April 9, 2009 from http://www. businesslink. gov. uk/bdotg/action/layer? topicId=1073901350&r. l1=1073858805&r. l3=1073869162&r. lc=en&r. t=RESOURCES&r. i=1073791235&r. l2=1073859137&r. s=e Central Administration IT. 2009. Financial Forecasting. Retrieved April 9, 2009 from http://www. uis. harvard. edu/staff/policies/financial_forecasting. php Microsoft Dynamics. 2009. Article: Conducting Financial Forecasting. Retrieved April 9, 2009 from http://community. dynamics. com/blogs/articles/comments/45. aspx