FINANCIAL MANAGEMENT II

CHAPTER THREE
FINANCIAL FORECASTING
What is forecasting?
• Forecasting refers to the practice of predicting
what will happen in the future by taking into
consideration events in the past and present.
• Basically, it is a decision-making tool that helps
businesses cope with the impact of the future’s
uncertainty by examining historical data and
trends.
• It is a planning tool that enables businesses to
chart their next moves and create budgets that
will hopefully cover whatever uncertainties may
occur.
Budgeting vs. Forecasting
• Budgeting and forecasting are both tools that help
businesses plan for their future.
• However, the two are distinctly different in many
ways:
• Budgeting involves creating financial statements
for a specific period, such as projected revenue,
expenses, cash flow, and investments.
• It is usually conducted with input from many
different departments, because it requires input
from multiple departments in order to come up
with a holistic and detailed report.
• Therefore, the budgeting process takes time to
complete.
• The company uses the budget to guide it in its
financial activities.
• In other words, a budget is a plan for a
company’s future.
• While budgets are usually made for an entire
year, forecasts are usually updated monthly or
quarterly.
• Through forecasting, a company can project
where it’s going, and it may adjust its budget and
allocate more or less funds to an activity,
depending on the forecast.
• In summary, budgets depend on the forecast.
• While related, budgets and forecasts are separate
concepts: a budget is a plan for a company’s
future, whereas a forecast is a sign of where the
company is going.
• Based on the forecast, a budget may be altered to
better reflect reality.
• Both qualitative and quantitative methods are
used when developing a forecast.
Forecasting Methods
 Businesses choose between two basic methods
when they want to predict what can possibly
happen in the future:
 Qualitative and Quantitative Methods.
1. Qualitative method
• Otherwise known as the judgmental method,
qualitative forecasting offers subjective results, as
it is comprised of personal judgments by experts
or forecasters.
• Forecasts are often biased because they are based
on the expert’s knowledge, intuition
(perception) and experience, making the process
non-mathematical.
• Without the use of conscious rational processes.
2. Quantitative method
• The quantitative method of forecasting is a
mathematical process, making it consistent and
objective.
• It steers away from basing the results on opinion
and intuition, instead utilizing large amounts of
data and figures that are interpreted.
Features of Forecasting

Here are some of the features of making a forecast:

1. Involves future events

 Forecasts are created to predict the future, making
them important for planning.

2. Based on past and present events

• Forecasts are based on opinions, intuition, guesses,
as well as on facts, figures, and other relevant data.
• All of the factors that go into creating a forecast
reflect some extent what happened with the
business in the past and what is considered likely
to occur in the future.
3. Uses forecasting techniques
Most businesses use the quantitative method,
particularly in planning and budgeting.
The Process of forecasting
• Forecasters need to follow a careful process in
order to yield accurate results.
• Here are some steps in the process:

1. Develop the basis of forecasting

The first step in the process is investigating the
company’s condition and identifying where the
business is currently positioned in the market.
2. Estimate the future operations of the business

Based on the investigation conducted during the

first step, the second part of forecasting involves
estimating the future conditions of the industry
where the business operates and projecting and
analyzing how the company will fare in the future.
3. Regulate the forecast
• This involves looking at different forecasts in the past and
comparing them with what actually happened with the
business.
• The differences in previous results and current forecasts are
analyzed, and the reasons for the deviations are considered.

4. Review the process

Every step is checked, and refinements and modifications are

made.
Sources of data for forecasting

1. Primary sources
• Information from primary sources takes time to
gather because it is first-hand information, also
considered the most reliable and trustworthy sort of
information.
• The forecaster does the collection, and may do so
through things such as interviews, questionnaires,
and focus groups.
2. Secondary sources
• Secondary sources supply information that has
been collected and published by other entities.
• An example of this type of information might be
industry reports. (similar industries)
• As this information has already been compiled
and analyzed, it makes the process quicker.
Forecasting Methods
 There are four main types of forecasting methods
that financial analysts use to predict
future revenues, expenses, and capital costs for a
business.
 While there are wide ranges of frequently used

quantitative budget forecasting tools, in this

section we focus on four main methods:

(1) Straight-line,

(2) Moving average,

(3) Simple linear regression and

(4) Multiple linear regressions.

Technique Use Math involved Data needed
1. Constant growth rate Minimum level Historical data
Straight
line
2. Moving Repeated forecasts Minimum level Historical data
average
3. Simple Compare one Statistical A sample of
linear independent with one knowledge relevant
regression dependent variable required observations

4. Compare more than Statistical A sample of

Multiple one independent knowledge relevant
linear variable with one required observations
regression dependent variable
• Four of the main forecast methodologies are: the
straight-line method, using moving averages, simple
linear regression and multiple linear regressions.
• Both the straight-line and moving average methods
assume the company’s historical results will
generally be consistent with future results.
• The regression methodologies forecast results based
on the relationship between two or more variables.
Other thoughts forecasting methods says:
 Forecasting is estimating the magnitude of uncertain

future events and providing different results with

different assumptions.
 Top forecasting methods include Qualitative
Forecasting (Delphi Method, Market Survey,
Executive Opinion, and Sales Force Composite) and
Quantitative Forecasting (Time Series and Associative
Models).
 Not all methods would necessarily serve the

purpose of forecasting, the decision-makers

should understand what type is best suited for the
business.
Top 6 Methods of Forecasting

1. Qualitative Methods –
 These methods are based on emotions, intuitions, judgments,
personal experiences, and opinions.
 This means that there is no math involved in qualitative
forecasting methods.
Delphi Method,
• Market survey,

• Executive opinion,

• Sales force composite are part of this type of forecasting.

2. Quantitative Methods:
• These methods depend wholly on mathematical or
quantitative models.
• The outcome of this method relies entirely on
mathematical calculations.
 Time Series and Associative Models are a part of
this type of forecasting.
Qualitative Methods

1 – Delphi Method
• The agreement of a group of experts in consensus
is required to conclude in the Delphi method.
• This method involves a discussion between
experts on a given problem or situation.
• An argument or brainstorming is done to complete
that everyone involved in the debate agrees to.
2 – Market Survey
• In a market survey, interviews and surveys of
customers are made to understand the task of the
customer and tap the trend well in advance to
deliver the right product or service according to
the changing needs of the customer.
3 – Executive Opinion
• As the name suggests, the executives or managers are
involved in such forecasting.
• This method is very similar to the Delphi method;
however, the only difference here is that the
executives may or may not be experts of the matter in
question, albeit they have the experience to understand
the problem or situation and formulate a forecasting
method that would bring out the best possible result.
4 – Sales Force Composite
• The information and intuition of the salesperson
determine the needs of the customer and estimate the
sales in the particular region or area assigned to the
salesperson.
• This information is vital in forecasting the needs of
the customer, which can be used to make necessary
changes in the business to meet the needs of the
customer and identify the sales volumes beforehand.
Quantitative Methods
5 – Time Series Models
• Time series models look at historical data and
identify patterns in the past data to arrive at a point
in the future based on these historical values.
• Since the historical data has a pattern, it becomes
evident that the data in the future should also have
a pattern, and this method looks at cracking the
pattern in the future so that there is very little
deviance from the actual calculations and the
outcomes in the real world.
Example – Straight Line Method
• One of the simplest methods in forecasting is
the Straight Line Method; this uses historical data
and trends to predict future revenue.
• ABC Ltd. looks to achieve a YoY growth of 6% for
the next three years. In a straight-line method, the first
step is to find the growth rate of sales used in our
calculation.
• For 2019, the growth rate is 6%, as per historical data.
Historical Year Sales growth Revenue
rate %

2018 6% 100,000
2019 6% 106,000
Forecastin 2020 6% 112,360
g 2021 6% 119,101.6

2022 6% 126,247.7
Example – Moving Averages Method
 This allows the number of past periods to be
added. For a 3 year moving average, the
collection of 3 years ( 20,000 25,000 and 30,000)
will be added and the total will be divided by 3
 Moving averages are averages that move with the
underlying data, thereby providing accurate
information relevant to the current scenario.
Example, from the following data, forecast the
revenue and growth rate of a local govt unit per
month using moving average method for the three
months of the second quarter.
Month 2020 Actual 3-month moving Growth
revenue average (Birr) rate
(Birr)
1 34,500
2 35,580
3 36,620 35,567

34,500+35,5
80+36,620/3
=35,567
• Actual revenue Birr 34,770, 35,790, and 37,220
respectively for the 4th, 5th, and 6th month
respectively
• Answers 35,656, 35,726, and 35,927

• Growth rate = -5%, 3%, and 4%

• 4th month = 35,580+36,620+34,770/3= 35656

• 5th month = 36,620+34,770+35,790/3= 35,726

• 6th month =34,770+35,790+37,220/3 = 35,927

4th month =(34,770-36,620)/36,620 = -5%
5th month = (35,790 -34,770)/34,770 = 3%
6th month = (37,220 – 35,790)/35,790 = 4%
6 – Associative Models
• Associative models look at the variable that is
being forecasted as being related to other
variables in the system, which means each
variable is associated with the other variable in
the system.
• The forecast projections are made based on these
associations.
Conclusion

• Forecasting enables a business to take the necessary steps

to achieve a particular goal by providing vital information
regarding future events and its occurrence and magnitude.

• Forecasting can be either qualitative or quantitative,

depending on the information gathered and its nature,
usually subjective or objective, and as a result, is based on
mathematical calculations or no mathematical
calculations at all.
• The management decides on the best forecasting
method to be used according to the business.
• It is based on internal and external factors and
whether the external factors are controllable or
uncontrollable.
• Uncontrollable factors can be government
policies, competitors’ strategies, natural
calamities, and so on.
• Quantitative forecasting uses mathematical
models to arrive at the forecasting results, and it
also relies on historical data to back the findings.
• Qualitative forecasting uses emotions, intuition,
(perception) past experiences, and values.
• It is an essential procedure in business that
enhances business operations and ensures the
functions can be performed smoothly in the ever-
changing business environment.
• Financial Forecasting is the process of predicting

or estimating future stats of an organization i.e.

how business will perform in the future based on

historical data like by analyzing:

• The income statement,

• Position statement,
• Current conditions,

• Past trends of the financial,

• Future internal and external environment which is

usually undertaken with the objective of

preparing and developing budget and allocating

available resources to ensure best possible

utilization.
Example
Orange Inc. has collected the following data for the
future 5 years. You are requested to draw a
comparative financial statement for the next 5 years
and determine the company’s growth potential.
Out of the above figures, cash sales are 80%, and
cash expenses are 75% of the total figure. Assume
opening cash as 50,000 and comment on the cash
position of the company.
Solution
Comparative Financial Statement
Comment – Company has good growth potential
as profits are increasing at a good rate.
Cash Position
Comment:
 Since the company has a higher percentage of
cash sales than cash expenses, the cash position
is becoming stronger with the increasing sales
year by year.
 Therefore it can be said that the overall company
has good growth potentials.
1. Projected Income Statement:

This is an anticipated income statement that

depicts (shows) the expected expenses and
revenues for the future financial period, i.e.,
usually one year.
2. Cash Budget:
 This depicts (show) total cash inflow and
outflow expected in the future.
 Sources of cash inflow include cash sales,
collection from accounts receivable, short-
term borrowing, long term debt, and equity
capital (issue share).
• Sources of cash outflow include payments of
accounts payable, salaries, wages,
capital expenditure, repayment of loans, and
debts.
• The cash budget does not include expenses like
depreciation.
• The reflected surplus or deficit in the
cash budget forms the base for investment and
3. Projected Balance Sheet:
 This sheet reflects the expected assets, liabilities,
and owner’s equity at a particular date.
 To prepare this, inputs like initial balance sheet,
capital expenditure budget, profit plan,
investment, and financial plan are required.
4. Projected Sources and Uses of Fund:
 Sources of funds and its uses in the planning period are
shown in this statement.
 The projected income statement, balance sheet, initial
balance sheet are the inputs required for its preparation.
 Projected sources of funds are
cash flow from operations, a decrease in fixed assets,
an increase in long-term liabilities, and the issuance of
share capital.
Importance of Financial Forecasting
New Business Promotion:

 Financial forecasting helps businesses utilize its

funds to promote new business ventures and
initiatives.
 It also helps in determining the success rate of
the business they are promoting.
Seamless Functioning:

• Without interruption, coherent

• Accurate and effective forecasting of the
finances like current revenue, revenue potential,
and other expenses helps in the organization’s
smooth running.
• The forecast also helps in anticipating future
roadblocks.
Estimating Financial Requirements:

• It helps determine sales and cost of customer

acquisition, capital for a specific project, and
other expenses required for further management
of the business.
• This preemptive forecast helps in making sound
business decisions.
Control Cash Flow:

 It helps in controlling the cash flows of a

business.
 Organizations with a good amount of cash (bank
balance) are more financially organized and
better control their business operations.
Achieve Overall Success:

 Financial forecast is important in achieving

overall success for the business as it forms a
strong foundation for the complete budgeting
of departments across the organizations
Benefits:
• The financial forecast allows businesses to predict
future financial performance against set standards.
• It provides a benchmark against which
performance, loopholes, and corrective actions of
an organization are monitored.
• It helps in identifying the processes that are most
capital consuming.
• Financial risk can be lowered by pumping out
money from such processes and channelizing
them towards the profitable ones.
• It helps in predicting the financial viability of
new business ventures.
• It helps prepare the best model for figuring out
how a business will perform when specific
plans and strategies are worked out.
Disadvantages
• Even if we have forecasting experts and a great
process in place, predicting the future accurately is
impossible.
• Markets have a high volatility level, and the number of
factors influencing demand keeps changing with time.
• Data gathering, data organizing, and coordination are
required for this process, which is very time-
consuming.
• Also, substantial input from the marketing and
sales team is required, making it a resource-
intensive process.
• Hiring a team of advanced planners is a
significant investment.
• Adding good quality tools, high-quality talent,
and software might prove a costly affair for the
forecasting process.
3.2 Forecasting Sales Growth Rate
• The sales growth rate measures the rate at which a
business is able to increase revenue from sales
during a fixed period of time.
• Understanding the sales growth rate is a critical
metric that empowers companies to make data-
informed decisions.
• If this rate decreases compared to prior periods
that can be an indication that the sales team
needs to take a different approach to drive
revenue growth.
• Conversely, a high sales growth rate is often
seen as a good sign for company stakeholders.
Now that we understand what sales growth rate tells us, let’s
review how to calculate it.

Sales Growth Rate Formula

• To calculate the sales growth rate for your business you’ll
need to know the net sales value of the initial period and the
net sales value of the current period.
• These values should be easy to find on an income statement.

• Once you have these values, you can use the following
formula:
Sales Growth Rate =

(Current Period Sales — Prior Period Sales) / Prior

Period Sales *100
• Let’s walk through an example of how to apply
the sales growth rate formula.
• Serial Juice Co. is a startup that delivers custom
pressed fruit and vegetable juices to its
customers.
• The Serial Juice Co. sales team wanted to
measure their sales growth rate from their fiscal
year that ended April 30, 2019, to their fiscal
year that ended on April 30, 2020.
• During the fiscal year that ended on April 30,
2019, the company reported bringing in
$750,000 in sales. The following year, they
reported bringing in $1,000,000 in sales.
• Let’s use the sales growth rate formula with
these figures.
• Sales Growth Rate = ($1,000,000 —
$750,000) / $750,000 * 100 = 33%
• That means Serial Juice Co. had a sales growth
rate of 33% during this time period.
Average annual sales growth rate

• When assessing sales growth rate many

companies choose to measure how much their
sales have grown over a number of years, which
is known as the average annual sales growth rate.
• To measure your company’s sales growth
performance over a number of years, begin by
using the previous formula to calculate the sales
growth rate of each year you would like to
assess.
• Once you have those values, you can use the
following formula:
Average Annual Sales Growth Rate =
(Sales Growth Rate A + Sales Growth Rate B +
Sales Growth Rate C + [Any other periods you
would like to measure]) / Total Number of
Periods
Let’s apply this to an example.
The company in question let’s call it GSD
Company would like to measure their average
annual sales growth rate over the past four years.
Here are the annual sales values and growth rate
year over year for GSD Company:
YEAR REVENUE GROWTH RATE

2015 $950,000

2016 $1,000,000 5.26%

2017 $1,125,000 12.5%
2018 $1,200,000 6.67%
2019 $1,400,000 16.7%
• Now let’s apply these values to the average
annual sales growth formula:
• Average Annual Sales Growth Rate =

(5.26% + 12.5% + 6.67% + 16.7%) / 4 Years =

10.28%
• From 2015 to 2019, GSD Company had an
annual sales growth rate of 10.28%.
What is a good sales growth rate?
• There are no hard and fast values that indicate a
“good” or “bad” sales growth rate because the
rate of growth is relative for each company. Here
are a few factors that can impact how much a
company can expect to see sales growth from
year to year.
 Company size:

A small business may experience a higher sales

growth rate than a larger business because a small
business is working with smaller dollar values,
therefore it takes fewer sales to influence a change.
• For example, a small company that pulls in $500,000
revenue one year and $750,000 of revenue the next
year will experience a sales growth rate of 50%. A
large company that brings in $10 million in sales one
year, and $12 million in sales the next year has a sales
growth rate of 20%.
• Though the actual sales growth rate for the larger
company is lower, this company had to bring in
significantly more money than the smaller company.
 Competitive landscape:

• A successful sales growth rate can also depend on

how well a company’s competitors are performing
and the overall growth of its industry.
• In 2019, U.S. ecommerce sales grew by
14.9% from the prior year and retail sales grew
by 3.8%. With these figures in mind, companies
that sell products and services online likely saw
higher individual sales growth rates than retail
companies because at an industry level, there
were more opportunities for growth for
ecommerce companies.
 Sales goals:

• Lastly, a successful sales growth rate will largely

depend on the unique sales goals of the company.
• Each company has its own set of goals and
strategies that are highly influenced by the factors
above, as well as the company’s leadership,
stakeholders, and sales team bandwidth.
• Understanding sales growth rate can
provide valuable insight into the current
and future performance of your company.
3.3 Forecasting External Financing Needed
• External financing in business refers to the money
borrowed from banks or investors.
• It is essentially external because it is not generated
from within the business but instead comes from an
outside source.
• When it comes to the overall finances of a company,
external financing is important as it can help a
company grow.
Differences between Internal and External Financing

• To perpetuate, a business needs funding.

• It can be from its resources, or it can be sourced

from somewhere else.
• When a company sources the funding from its
sources, i.e., its assets, from its profits, we would
call it an internal source of financing.
• On the other hand, when a company needs
enormous money, and only internal sources
are not enough, they take loans from banks
or other financial institutions.
• The external financing needed (EFN) is the
amount of financing the business requires
from outside sources to remain profitable.
• EFN is important to understand since it
depicts (shows) the exact amount the
company needs to borrow from lenders and
other outside sources.
How to Define External Financing Needs
• Understanding how to determine a company's
external financing needs is important.
• This amount is not an estimate but rather a
calculated amount based on the company's current
financial standing.
• Determining how much external financing a
business needs is based on several factors, with
two major factors being the internal growth rate
and the sustainable growth rate
1. Internal growth rate:
• Refers to the expected growth of a business without
external borrowing.
• This means the business can invest its profits and
grow with its earnings.
• The internal growth rate is calculated based on the
return on assets (ROA) which measures a business's
profitability and is calculated as follows:
Return on assets = Net Income / Total Assets
A business will need to reference its financial
statements to determine these amounts.
For example, the income statement shows a net
income of $100,000 on the bottom line, and the
balance sheet shows total assets, on the bottom of the
left side of the statement, at $700,000. Therefore, the
ROA ratio would then equal to about 14% since:
• 14.3% = $100,000 / $700,000
2. Sustainable growth rate:
• Refers to the maximum growth possible for a
business without raising leverage or the debt
ratio.
• This means the company can sustain its finances
at a certain level without receiving funds from
outside sources or incurring debt.
• The sustainable growth rate is calculated as:
Sustainable growth rate = Return on Equity x
Retention Rate
• Return on equity is equal to net income divided
by equity. (Net income/equity)
• The retention rate is the amount of earnings a
company invests back into itself, which is equal
to 1 minus the dividend payout ratio. (1- dividend
paid ratio)
External Financing Needed Formula
• The business must calculate the external financing
needed to understand exactly how much money is
needed from external sources.
• External financing needed can be calculated using
the formula:
• External Financing Needed = Increase in Assets
- Increase in Liabilities - Retained Earnings
• For example, if a business is looking to expand its
physical property, it will need to consider the
amount of external financing needed. If it is
expanding the property by about 25%, it may also
calculate the expenses by this amount. So, if its
assets are $200,000 and liabilities at $100,000, the
increase of 25% would be $50,000 and $25,000
respectively.
• If, for example, the retained earnings are
projected at $15,000, then the formula would be
written as:

• $10,000 (External Financing Needed) = $50,000

(Increase in Assets) - $25,000 (Increase in
Liabilities) - $15,000 (Retained Earnings)
3.4. Financial Statement Forecasting:

The Percentage of Sales Method:

The percentage of sales method allows you to

forecast financial changes based on previous sales
and spending accounts. Here's how to work
through it.
• Most businesses think they have a good sense of
whether sales are up or down, but how are they
gauging accuracy?
• With shifting budgets and different departments
needing more or less from the company every
month, having a precise account of every expense
and how it relates to future sales is a must.
• That’s where the percentage of sales method
comes in handy.
• The percentage of sales method allows
businesses to make accurate assessments of their
previous sales so they can comfortably project
into the future.
What is the percentage of sales method?
• The percentage of sales method is a forecasting
tool that makes financial predictions based on
previous and current sales data.
• This data encompasses sales and all business
expenses related to sales, including inventory and
cost of goods.
The benefits of percentage forecasting
• Business forecasting may not perfectly predict
your company’s financial future, but it can give
you a strong sense of where your company is
headed and any changes you may need to make.
• Here are just some of the benefits of business
forecasting:
I. Developing structured plans:
With an idea of how much revenue you
stand to gain or lose in the coming period,
you can create a detailed plan for how to
increase or achieve that revenue.
II. Creating accurate budgets:
 Knowing the exact accounts your money is
leaving from and coming into allows you to
create a more accurate budget.
 Having a budget at the beginning of the month is
a great start, but knowing whether or not you
have stuck to that budget by the end of the month
is far more important.
III. Analyzing expenses and revenue:
 When you know your revenue is exceeding your
expenses, you can start planning for business
improvements, employee raises, and other
additional expenses that might benefit the
company and further increase revenue down the
line.
IV. Evaluating market trends:
Insight into how customers are paying for
products and what products they are
buying allows you to reconfigure your
sales strategy and make sure you are
putting your best foot forward.
V. Percentage of sales method formula:
 There are five basic steps to the percentage of
sales method formula.
 We’ll go through each step and then walk through
an example to see the formula in action.
How to calculate step by step
1. Locate and determine your current
numbers:
 Before doing any calculating, you need to have
your current finances ready and available.
 These numbers will serve as a baseline for future
budget comparisons and will give you a sense of
what your business is looking like financially.
2. Choose what you want to forecast:
 Not every business expense or account is
influenced by sales.
 Of course, if you are seeing high expenses in
areas that are not backed up by revenue return,
those are worth looking into through a budget
analysis; they’re just not applicable to this
formula.
 Some accounts you may want to forecast
include:
• Cash

• Accounts receivable

• Accounts payable

• Fixed assets

• Cost of goods sold

• Net income
3. Write out the balances of each account and their
percentage in relation to revenue:
• Depending on the size of your business, this can take
some time.
• The hope in this step is that you will end up with
positive percentages in every account.
• If not, it means you have a negative net income.
We’ll go into this further in the walk-through
example.
4. Calculate the forecasted sales:
• Your Company should have an ideal increase
forecast based on current sales and realistic goals.
• Let’s say you expect sales to increase 20 percent.
• Using the following formula, you can determine
the approximate value of your forecasted sales:
• If your current sales are at $75,000 and you
expect a 20-percent increase, your formula would
look like this:
• 75,000 (1+20/100) = 75,000 (1.2) = $90,000

• If your sales increase by 20 percent, you can

expect your total sales value in the upcoming
quarter or year to be $90,000.
5. Apply your new sales value to the percentages
calculated in step 3:
 By taking the percentage of revenue relevant to
each account and applying it to your forecast
number, you’ll be able to see approximately how
much money will be gained or lost in each
account.
End of chapter 3