Unit Three

Financial forecasting
Contents:
1. Overview of financial forecasting
2. Forecasting growth rates and outside financing
3. Forecasting external financing needs
4. Financial statement forecasting; percentage of sales method
Overview of financial forecasting
• Financial forecasting is a process by which financial analysts estimate and project a
business’s future outlook (financially).
• A financial forecast predicts any given business’s future income and expenses, usually
over the next year.
• Financial forecasting refers to that process by which a business estimates or predicts how
it is likely to perform in the future.
• A forecast is the prediction of the future based on a certain set of circumstances that
could be related to the past or present data.
• It involves developing future estimates after a thorough analysis of different trends. In
other words, forecasting is a step-by-step process of predicting the future.
Three basic principles of forecasting are:
 Forecasts are rarely perfect,
 Forecasts are more accurate for groups than individual items,
 Forecasts are more accurate in the shorter term than longer time horizons.
The forecasting process involves five steps:
 Decide what to forecast
 Evaluate and analyze appropriate data
 Select and test model
 Generate forecast
 Monitor accuracy.
Advantage of financial forecasting
• It can be used as a control device in evaluating the results. It helps you to make a
blueprint for your business.
• It helps to explain the requirement of funds for the firm.
• It helps in recognizing the risks and financial crunches in the business.
• It also helps to explain the proper requirements of cash and their optimum utilization
• It gives an assessment of the future need for cash and enables you to take a decision
about whether money should be borrowed or not, It assists to secure a bank loan
• Allows comparison of strategic alternatives
• To understand the strengths and weaknesses of the business
• Represents a benchmark for assessing project development
Approaches of financial forecasting
• There are two ways of developing financial forecasting:
 Qualitative approach of Financial Forecasting: Qualitative methods – judgmental methods,
Forecasts generated subjectively by the forecaster
 Executive opinion  Delphi method
 Market research  Sales force polling
 Quantitative approach of Financial Forecasting
• Quantitative methods – based on mathematical modeling: Forecasts generated through
mathematical modeling
 Cause and effect method  Percentage of sales method
 Days sales financial forecasting  Time series method
The three financial statements most commonly used in financial forecasting are:
• Income Statement
• Balance Sheet
• Cash Flow Statement
External financing need forecasting
Instead of preparing a set of forecasted financial statements, you can also calculate your external
financing needs (EFN) by using a formula that looks at three changes:
1. Required increases to assets given a change in sales. Formula = (A/S) x (Δ Sales).
2. Required increases to liabilities given a change in sales. = (Ap/S)* (Δ sales) Note: Long term
debt does not increase with a change in sales and is typically excluded.
3. Profit Margin on Sales; i.e. net income / sales. = NI/Sales
4. Required increases to retained earnings as a result of income less any distributions. FS(1-d)
• The complete formula (EFN) is expressed as:
EFN = (A/S) x (Δ Sales) - (Ap/S) x (Δ Sales) - (PM x FS x (1-d))
• A / S: Assets that change given a change in sales, expressed as a percentage of sales.
• Δ = Symbol for Change
• Δ Sales: Change in sales between the last reporting period and the forecasted sales.
• Ap / S: Liabilities that change given a change in sales, expressed as a percentage of sales.
• PM: Profit Margin on Sales; i.e. net income / sales.
• FS: Forecasted Sales
• d: dividend payout percent
• (1 - d): Percent of earnings retained after paying out dividends; d is the dividend payout
ratio.
Example of financial forecasting
Assume ABC corporate business needs to forecast financial statement of an organization for the
year 2016 based on 2015 performance using percentage of sales growth forecasting method.
Given:
 Sales growth will be by 25%
 All income statement accounts will increase with relation to sales growth, except interest
expenses(based on long term notes payables)
 Current fixed asset utilization are 100%
 All asset accounts and account payable will be increase with relation to sales growth
 External financing will be:
EFN = (A/S) x (Δ Sales) - (L/S) x (Δ Sales) - (PM x FS x (1-d))
= ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0270($2,500)(1 - 0.4) = $184.5 million.
 Tax rate constant at 40%
 Dividend payout ratio constant at 40%
 Stockholders equity accounts have no relation with sales growth
 Approximation to nearest number: the forecasted financial statements are as follows
 Forecasting Income statement
2015 Percentage to sales 2016
Sales 2000 2500
Cost of sales 1200 0.6 1500
Gross profit 800 0.4 1000
Operating expenses 700 0.35 875
EBIT 100 125
Interest (10%) 10 20
EBT 90 105
Tax 40% 36 42
Net income 54 63
Dividend 40% 21.6 25.2
Retained earning 32.4 37.8

Forecasting Statement of Balance sheet

Percentage to Liabilities and Percentage
Assets
2015 sales 2016 equity 2015 to sales 2016
Cash 20 0.01 25 Account payable 100 0.05 125
Account receivable 240 0.12 300 Short –term N/P 100 100
Total current
Inventory
240 0.12 300 liabilities 200 225
Total current asset 500 625 Long- term N/P 100 284.5
Fixed asset net 500 0.25 625 Common stock 500 500
Total asset 1000 1250 Retained earning 200 237.8
Total claim 1000 1250