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CHAPTER SEVEN FINANCIAL FORECASTING Nelson Ogunseye Learning objectives By the end of the chapter, the student should be able to: · understand the meaning of financial forecasting; · know the importance of financial forecasting in business planning; · understand some of the major forecasts that are required for business; and · raise a simple forecast for his/her business. Financial forecasting Financial forecasting represents a major aspect of financial planning and it provides a major input into budgeting activities. In financial forecasting, the future of the business is predicted through the use of various forecasting tools. Financial forecasting attempts to estimate the future results of the organisation; it considers all areas of the organisation which may be new or existing. It is an important entry in drawing a business plan. Business dictionary defines financial forecast as predicting the future business condition that are likely to affect a company, organisation or country. Historical trends in respect of external and internal data that have effect on the company or organisation are identified and projected into the future towards providing vital information to decision-makers in the determination of the future financial status of the firm. In this exercise, the vision of the business is crystallised into quantitative terms and translated monetary units and values either as inputs or as outcomes. The inputs may be in the form of quantity and value of materials, the labour, the expenses and the overhead that will be required to produce the envisioned good or service. For the existing business, the forecast may be based on acquiring a particular capacity that increases the scale of operation of the business or determining the requirements of a successful business from the scratch. An example of the former situation may be to acquire a new machine which enhances the capacity of the business to meet up with increasing the number of product output towards taking advantage of demand opportunity or new markets. James C Van Horne notes that financial forecasting is an aspect of financial planning which involves the analysis of financial flows of the firm. A firm, in planning its finances, therefore, needs to be able to predict the consequences of the decisions taken by it on investments, financing and dividend decisions while at the same time putting into consideration the options available.
A typical forecast may cover such aspects as: · forecasted cash budget · forecasted performance statement · forecasted statement of financial position · forecasted cash flow statement · forecasted materials · production forecast · forecasted labour requirements · forecasted overhead · forecasted ratios · forecasted break-even point · assumptions of the forecasts In arriving at the estimated future results, there are issues that should be taken into consideration; they are:
Importance of financial forecasting The importance of forecasting the finance of a business cannot be over-emphasised as it serves many purposes.
The future is determined right from the present with the help of some forecasting tools which identify such vital factors as the demand, prices, demography, competitions, trend and other vital issues that affect business.
With financial forecasting, the identification of external financing requirement is simplified. This is made possible through the cash budget, the material budget, the labour budget, the direct expenses budget and the overhead budget. All these form the input into the forecasted income statement, the forecasted balance sheet and the forecasted cash flow statement all of which provide very important information to the external financier or investor in the business as the future of the firm is presented to the investor and financier.
The financial forecast provides insight into the assumptions on which the figures are based and thus the forecast can be reviewed in the light of changing circumstances.
Financial forecast also provides insight into the business strategy of the employed by the entrepreneur.
With the plans expressed in terms of the targeted figures, measuring accomplishments against the target and investigating variances becomes easier. Financial forecasts therefore, as standard, become a source of motivation to the entrepreneur and the enterprise. Necessary steps are therefore taken to ensure that positive results are consolidated while negative results are prevented. Tools of financial forecasting Various tools are engaged in forecasting the finance of a firm; the common ones are in the form of pro forma cash flow statement, pro forma balance sheet and pro forma income statement. The preparation of these statements in the pro forma format and the inclusion of risks ensure the measurement of the sensitivity of the plans to changes and how well the firm is positioned to cope with such changes or conditions prevalent. Forecast cash budget Firms prepare the projected future position of its receipts and disbursements to cover a period of time to define what should happen in respect of cash resources of the firm. This takes into cognizance the timing of occurrence of the flow of cash which typically consist of inflows and outflows together with the net position of the flows. CASH INFLOW – CASH OUTFLOW = NET CASH FLOW POSITION The arrival at the net position should therefore help the firm to determine future needs of cash by the firm otherwise it gives insight into the future cash surplus position which also requires the determination of the decision to gainfully engage such surplus. Cash flow volatility occurs when the swing or variations between cash surplus availability and cash deficit situation occurrence is frequent and short. This kind of situation requires frequent preparation of cash forecast in order to forestall a situation of negative surprises and stabilise the financial condition of the firm. For example, where the flow of cash is erratically volatile but shows or exhibits a predictable pattern, the preparation of budget at frequent intervals should provide a good help in predicting the high and low cash requirements and generation. However, in situations where business environment and demand is relatively stable, cash flow forecasting may be a more regular exercise at fairly defined intervals. Because cash flow budgeting is futuristic and its prediction is based on some factors which may be extraneous and internal to the firm, the accuracy and reliability is as good as the reliability of the conditions and assumptions underlying the preparation. A firm should therefore prepare buffer against periods of negative cash balances positions where its cash flows are vulnerable to high uncertainty. Preparing a cash forecast There are basically three segments to the cash forecast thus: 1. Receipts 2. Disbursements 3. Net cash flow Receipts Receipts typify the revenue in term of sales. Sales revenue has to be predicted in order to provide a view of the size of revenue that the firm can generate. The firm therefore conducts internal and external analysis using such tools as trend, regression or time series analysis in predicting the sales. This information is provided by the sales team through industry analysts, research reports and trade association publications. It is none-the-less important to ensure that sales prediction is as accurate as possible and the accuracy of the sales forecast will actually be accentuated by the rigorous internal and external analysis conducted in the prediction. With the accurate forecast of the sales attained, it is equally necessary to separate sales into its two major forms which are credit sales and cash sales. Sales forecast is therefore the starting point for preparing all other forecasts. Table 1.0 shows a typical example of a sales receipt schedule. Table 7.1.Schedule of sales projecting seven months’ sales receipts
The schedule above is a presentation of sales forecast and total sales for each of the months in the seven month period. The sales expected are both credit and cash components. The credit component is represented in the row next to total sale as credit sales and will not become cash until the lapse of two months following the month of sales. Cash collection in respect of such sales is the aggregate of the collections in months 1 and 2 (the total of which is given as total collections in the fifth row); the sixth row shows the cash collected immediately at the point of sale. From the hypothetical example, the firm in question has a policy of collecting 90% cash in respect of credit sales in the month following the month of sale and the remaining 10% cash in the month next to that. To break down the details of collections in respect of January sales, the following arithmetic would be done:
N Total sales 310,000 Cash collection broken down into: Collections in Month 1 (February) 243,000 Collections in Month 2 (March) 27,000 Cash collected in January 40,000 Total cash collected over three months 310,000 The situation then raises a question that where cash collection is lower like would be observed in January, what should be done? What to do would not be glaringly observed until the forecasts of expenses and expenditure are made and the net cash flow is projected. So we move on to consider cash disbursements or outflows. Cash outflows The structure of outflow planning is basically and usually tied to the level of sales and in a production environment, the determination of sales provides lead to how other elements of costs are satisfied or paid for. Therefore, the determination and identification of elements that make the inputs into production schedule should be done and should subsequently be quantified. Examples of such elements are materials (quantity and cost), labour, other direct expenses and overhead. Other items which include licenses, taxes, capital expenditure and so on should also be forecasted. It is important to stress that as the forecast looks into the distant future, it becomes less predictable particularly in the long term. Let us consider an example of cash outflows in Table 2 The cost of materials in this hypothetical example is expressed as 40% of the cost of sale. This means that material cost is about 40kobo in every N1 of sales while labour cost is about 20kobo of every naira sale, factory overhead is about 15kobo of a naira sale and selling and administrative overhead is about 8kobo. This is why we said at the beginning that sales quantity is very important when forecasting and sales forecasting have to be painstakingly done to achieve as much accuracy as could be achieved. It is also important to note that internal and external analysis should provide added advantage to the forecast as these two forecasts should actually converge to provide synergy to the sale forecast in terms of accuracy and reliability. So as could be seen above, a lot depends on sales forecast.
Net cash flow forecast Net cash flow represents the predicted net cash position of the summation of the predicted inflow and outflow of cash. The net position could end up net cash outflow or net cash inflow for a particular month but ultimately attaining positive cash balance at the end of a particular period under consideration. From our examples in Tables1 and 2 above, let us bring out the summary of the forecast inflow and outflow into another table to see what the net forecast balances will look like for each of the months projected as presented in Table 3. Table 3 shows that in January and February, the need for overdraft is exposed and the firm has to prepare for this. However in March the net cash flow position is positive and a short term investment has to be sought to avoid idleness, waste and loss of income. An overdraft of about N130,000 for three months should help in this case and the firm should therefore be prepared to negotiate it. Table 7.3. Net forecast balance
Accommodating contingencies in cash forecasting Forecasting is primarily based on assumptions that will result in the actual figure (either over or under forecast figure) depending on the assumptions upon which the forecast is based. As such, it is important to prepare the forecast by taking into cognizance, at least, two probable scenarios of best business conditions and worst business conditions. This incorporates uncertainty and it helps to avoid unpleasant surprises. We therefore consider the introduction of probability distribution of outcomes in expected cash positions and the flexibility of the firm about its expenses to variations in the expected sales or income. In doing this, pertinent questions have to be answered. Examples are: · With sales failing to attain a particular planned threshold, how adjustable are the expenses? · What expense items can be avoided or reduced? · What is the effect of eliminating such expense on the cash flow? Probabilities are therefore applied to the various outcomes to test and establish the margin of safety at various levels and the expected outcomes. Case study
Following up on our previous discussion that the production budget depends pretty much on the sales budget, production units which are based on sales and inventory forecasted will determine the quantity of units to be manufactured. So we shall perform some arithmetic calculations in situations where there is an opening inventory of products or goods for sale. This is quite foreseeable as one quarter leads to another. It should be noted that where there is zero opening balance, the closing balance of inventory in one quarter forms the opening balance of the following quarter.
Some of the key figures from the budget of Fundsfield’s Ltd for the first quarter of operations for 2016 are as shown below: Jan(N) Feb(N) March(N) Credit Sales 800,000 700,000 860,000 Credit Purchases 340,000 320,000 400,000 Cash Disbursement Wages & Salaries 40,000 35,000 42,000 Rent 15,000 15,000 15,000 Equipment Purchases 250,000 - 20,000 The company estimates that 10 percent of its credit sales will never be collected, 50percent will be collected in the following month. Purchases on account will all be paid for in the month following purchase. December sales were N900,000. Using the following information, complete the following cash budget. Jan(N) Feb(N) March(N) Opening Balance 100,000 ……………… ……………… Cash Receipts
Cash Disbursements Purchases Wages & Salaries Rent
6. ………………………………….and……………………………are methods of forecasting sales. 7. ………………………………….is the most essential forecast in financial foresting a. Selling and administrative budget b. Selling and distribution budget c. Cash budget d. Sales budget e. None of the above 8. In sales forecasting, the data gathered from one of the following sources is the most reliable: a. Salesmen of the firm b. External sources c. Combination of (a) and (b) above d. Non of the above e. All of the above 9. Production budget preparation is done based on: a. Cash budget b. Selling and administrative expense budget c. Sales budget d. None of the above e. Combination of (a) and (c) 10. Statistical forecast is made based on a. General business conditions b. Market conditions c. Product growth curves d. None of the above e. All of the above 11. budgets are a type of financial forecasting, the following are common budgets except: a. Cash budget b. Budgeted balance sheet c. Peoples budget d. Direct labour budget e. Sales budget 12. Financial forecasting is only important in new businesses and not in existing ones a. I agree b. I disagree c. I don’t know d. Financial forecasting is neither important in new or old businesses e. Financial forecasting is important to both old and new businesses. 13. Financial forecasting is important because a. It provides the route into the firm’s future b. It is a good exercise c. It helps to avoid conflict among staff of an organization d. It is prepared by the chief executive of the company e. It cannot just be done by anybody in the firm 14. Using the following information, what will the net cash flow be for the month: Opening balance N1,500 Sales N5,000 Debt Recovered N2,300 Rent N1,700 Purchases N4,200 a) N3,300 b) N2,900 c) N4,500 d) N2,000 e) N4,300
References 1. Joe, K. S.and Joel, U. S.. 1998. Financial management.2nd edition.Schaum’s Outlines McGrawHill. 2. Mukesh,B.a Business studies, Howwould you estimate the capital requirement of a new company? Internet Publication: TumatiPradeephttp://go4funding.com/Articles/Business-Funding/How-To-Raise-Capital-For-Your-Business.aspx 3. Ogunniyi, O.R. 2007. Fundamentals of financial management.3rd edition.Samfred Publications. 4. Richard, A. B. and Myers, C. 1996. Principles of corporate finance.5th edition.McGrawHill. 5. Thomas, W. Z., Normal, M. S. and Doug, W. 2008. Essentials of entrepreneurship and small business management. Fifth edition, Pearson Prentice Hall. Van, H. and James, C.2001.Financial management and policy.Seventh edition.Prentice Hall International Editions.
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