The Concept of Financial Forecasting - Enterslice Fintech (2024)

Finance

The concept of forecasting makes utilization of past data to predict future outcomes. Forecasting is a vital mechanism widely used to make financial and management decisions. Financial forecasting is used to make future projections about the expenses and revenue of the business and thus predict the profit potential of the company. The screening comprises profit and loss statements, cash flow, balance sheets, etc.

The process of financial forecasting involves usinghistorical data of sales, revenue, and factors of influence to make futureprojections. It is then studied by experts to conclude how the enterprise willperform in the target period.

The Need for Financial Forecasting

Business operations take place in an environment of uncertainty. Thus any cure to reduce the uncertainty of business outcomes is highly productive for organizational growth. Such information is not only a valued asset for the entity but also a necessity of the business. Additionally, it also helps to stay ahead of competitors by having a better idea of future risks and opportunities.

A forecast is monitored on a regular basis and updated onregular intervals in order to cover up any deviation. This routine scrutiny offorecast projections helps to analyze the predictions with actual results.

Benefits of FinancialForecasting

• It helps to set the standard ofperformances and act as a base to evaluate real-time results.
• It helps in the timelyarrangement of funds as a result of the financial projection of funds needs andrevenue potential.

• It helps in the optimumutilization of resources and reduces the non-performing resources of theorganization.

Process of Financial Forecasting

1. Gather Financial Information

Thefirst and foremost step to start the forecasting procedure is to gatherhistorical records of the business. The method of forecasting helps to makesprojections on the basis of past records and performance of the entity.Projecting without taking historical data into records is mere expectationwithout any concrete evidence.

An organization needs financial statements bookkeeping^[1] transactions with updated records. Once the records are gathered, then the organization can proceed to the process of forecasting.

2. Historical Data based Vs. Research-Based Projections

Oncethe necessary data is available, the next is to determine the type of forecastto proceed. There are two approaches to make a forecast. The kind of forecastlargely depends upon the need of the organization. Even though every forecasthas elements of historical data and market research. However, the choice ofapproach should not undermine the purpose of making the forecast. Let us nowread about the two in detail.

Historical Data-Based Forecast

Historicaldata based forecast uses financial statements of previous years to make futureprojections. The experts take financial statements and balance sheet of pastyears to make projections about the future performance of the entity

• Pros

Thebenefits of this approach to the forecast are that it can be conducted in ashort time without taking a hefty toll on time, costs, and resources.Additionally, it helps to make a rough estimate of business growth.

• Cons

Thedisadvantage is that it ignores the external factors that impact the growth ofthe organization, such as market trends and factors. Additionally, it cannot beused for making a presentation for investors.

Research-Based Forecast

Theforecast that is based on the research-based premises is called aresearch-based forecast. This approach to financial forecast takes broadfactors into consideration that are potential influences on business growth.

• Pro

Theadvantage of a research-based forecast is that it provides an in-depth andextensive view. This is the kind of forecast that can be presented to investorsand stakeholders as it is considered the most realistic forecast among the two.

• Cons

Thedisadvantages are that the research-based forecasting is time-consuming andexpensive. Moreover, it is costly as you may need the help of experts toconduct the forecast.

Preparation of Pro Forma Statements

Proforma statements are the statements that are prepared using the forecastprocess. They are the presumptive income statements and balance sheets.

Preparation of Pro Forma Income Statements

Thepro forma income statements are prepared with the help of historical datablended with market research. The process involves making reasonable estimatesabout the possible earnings and expenses of the company. The estimation of thesales figure for the coming period helps to shape the complete statement. Thesales figures are estimated on the basis of numbers from previous years, alongwith market research and economic factors.

Estimatesabout production expenses are next to being taken into account. The production expensescomprise production cost, wage rates, overhaul expenses, etc. Projections forthe cost of production are made using the previous year’s cost of production incomparison to sales made in that period.

Thenext element of estimates for this statement is administrative expenses,selling expenses and interest and taxes. Administrative expenses and sellingexpenses are not highly elastic in nature, and hence they can be predictedaccurately.

Theincome after administrative and selling expenses deductions is income before interestand taxation. The amount of interest and taxation can be predicted with a lowrisk of deviation.

Pro Forma Balance Sheet

The pro forma balance sheet is prepared using the information from the pro forma income statements.However, the information is not sufficient to make satisfactory projections. Balances of previous years are also included to drive the changes from the old balance sheet to the pro forma balance sheet.

The pro forma balance sheet contains the forecasted value of fixed assets after infusing the amount of depreciation for the coming year. Current assets will be charged based on the period of credit allowed to creditors.
The amount of inventory will be forecasted based on the production plan of the entity for the following year. Here, the amount of cash place an important and diverse role. The cash balance will be shown at the lowest. Interestingly any difference between the assets and liabilities side of the Pro forma balance sheet will be balanced from the cash in hand.

For the liabilities side, preplanned redemption of the debenture and fresh issue of shares and debentures should be taken in to account. Additionally, past and future data of liabilities should be taken into account to account for outstanding liabilities for the pro forma balance sheet. Provisions for tax and dividends are prepared by taking the figures of the previous year balance sheet and pro forma income statements.

Projected Cash Flow

The projected cash flow statement depicts the assumed amount of cash that will change hands in the coming year. The statement shows light on the cash requirements of the following year. It helps to decide how much additional funds from equity or debt a business has to raise to meet the cash requirements. The amount of cash requirement is proportionally dependent on the production and expansion plan of the business enterprise.

Read our article:Cash Flow Forecasting in Financial Model

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