Financial Forecasting

In addition to knowing what happened in the past, managers/management of an organization would like to anticipate the future. So they need to understand how to prepare pro-forma or projected financial statements. These statements help to:

Assess whether the firm’s anticipated performance is in line with its own targets and with the expectations of investors.

Estimate the effect of proposed changes as they can be used to do “What if” analysis.

Determine the future financing needs of the firm.

Strategic Plan

In the liberalized business environment, characterized by expanding opportunities and swiftly changing market conditions, strategic planning has assumed greater significance not only for growth but for survival as well.

The strategic plan of a firm spells out its corporate purpose, corporate scope corporate objectives and corporate strategies. The corporate purpose defines the mission of the firm. Put differently, it states the raisond’etre of the firm. For example, a pharmaceutical company has expressed its purpose as “To provide quality health care for the masses”. The corporate scope delineates the lines of business in which the firm wishes to engage in and the geographic spread of its operation. For example, Nucor Corporation, a firm listed on the New York Stick Exchange has defined its scope as follows: ‘We are a manufacturing company, producing primarily steel products’. While the corporate purpose and scope reflect the broad philosophy and nature of the firm’s activities, corporate objectives spell out the specific goals sought by the firm. Some goals are stated in quantitative terms such as achieving a market share of 30 percent, a growth rate of 25 percent, and a return on equity of 20 percent. Other goals are stated in qualitative terms such as “attaining a measure of stability”. Corporate strategies or policies are the instruments for achieving corporate objectives. A firm may, for example, follow the policy of vertical integration to achieve growth and stability.

Components of a Financial Plan:

Pro forma statements are part of a financial plan. While there is considerable variation in the scope, degree of formality, and level of sophistication in financial planning across firms, most of the financial plans have certain common elements. These are:

Economic assumptions: The financial plan is based on certain assumptions about the economic environment (interest rate, inflation rate, growth rate, exchange rate, and so on).

Sales forecast: the sales forecast is typically the starting point of the financial forecasting exercise. Most financial variables are related to the sales figure.

Pro-forma statements: The heart of a financial plan is the pro-forma (forecast) profit and loss accounts and balance sheets.

Asset requirements: Firms need to invest in plant and equipment and working capital. The financial plan spells out the projected capital investments and working capital requirements over time.

Financing plan: Suitable sources of financing have to be thought of for supporting the investment in capital expenditure ad working capital. The financing plan delineates the proposed means of financing.

Cash budget: The cash budget shows the cash inflows and outflows expected in the budget period.

Sales Forecast:

The sales forecast is typically the starting point of the financial forecasting exercise. Most of the financial variables are projected in relation to the estimated level of sales. Hence, the accuracy of the financial forecast depends critically on the accuracy of the sales forecast.

Although the financial manager may participate in the process of developing the sales forecast, the primary responsibility for it typically vests with the marketing department or the planning group.

Sales forecasts may be prepared for varying planning horizons to serve different purposes. A sales forecast for a period of 3-5 years, or even longer durations may be developed mainly to aid investment planning. A sales forecast for a period of one year (and in some cases two years) is the primary basis for the financial forecasting exercise discussed. Sales forecast for shorter duration (six months, three months, one month) may be prepared for facilitating working planning and cash budgeting.

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