Management Essays – Financial Forecasting

Financial Forecasting

Role of Financial Statements Forecasting

The role of financial statement forecasting at Strident Marks is to provide expected future financial statements based on conditions that management expects to exist and the action it expects to take. These statements offer financial managers insight into the prospective future financial condition and performance of the company. Financial statement includes income statement and balance sheet. (Horne, Wachowicz & Bhaduri, 2008)

Development of Income Statement Forecast

The income statement forecast is a summary of a Strident Marks expected revenues and expenses over some future period, ending with the net income for the period. The sales forecast is the key to scheduling production and estimating production costs. The detailed analysis of purchases, production based wages and overhead costs helps to produce the most accurate forecasts. The costs of good sold are forecasted on the basis of past ratios of cost of goods sold to sales.

Following this the selling, general and administrative expenses are forecasted. The estimates of these expenses are fairly accurate because they are generally calculated in advance. Usually, these expenses are not sensitive to the changes in sale, specifically to the reduction in sales in the very short run. After this other income and expenses along with interest expenses are estimated to obtain the net income before taxes. Next to this income taxes are computed based on the applicable tax rate, which is then deducted to arrive at estimated net income after taxes. All of these are then combined into an income statement. Anticipated dividends are deducted from profit after taxes to give the expected increase in retained earnings. This anticipated increase need to agree with the balance sheet forecast figures that are developed next.

Development of Balance Sheet Forecast

To prepare balance sheet forecast for a particular period say for June 30, Strident Marks utilizes the balance sheet of the previous December 31. Receivables at June 30 can be estimated by adding to the receivable balance at December 31, the total projected credit sales from January through June (for which the estimation is done) and deducting the total projected credit collection for the particular period.

Forecasting Assets: In the absence of cash budget, the receivable balance can be estimated on the basis of a receivable turnover ratio. This ratio, which depicts the relationship between credit sales and receivables, should be based on past experience. To obtain the estimated level of receivables, projected credit sales are simply divided by the turnover ratio. If the sales forecast and turnover ratio are realistic, the method will produce a reasonable approximation of receivable balance.

The estimated investment in the inventories for a particular period may be based on the production schedule, which in turn is based on the sales forecast. This schedule should represent expected purchases, the expected use of inventory in the production and the expected level of finished goods. On the basis of this information along with the beginning inventory level, an inventory forecast can be made (Horne, Wachowicz & Bhaduri, 2008)

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Estimates of future inventory can be based on an inventory turnover ratio, instead of the use of production schedule,. This ratio is applied in the similar manner as for the receivables, except that now we solve for the ending inventory position.

Inventory Turnover Ratio = cost of goods sold (Ending) Inventory

Future net fixed asset are estimated by adding planned expenditures to existing net fixed assets and subtracting from this sum the book value of any fixed assets sold along with depreciation during the period. Fixed assets are fairly easy to forecast because capital expenditure are planned in advance.

Forecasting Liabilities and Shareholder Equity: for instance if the company wants to estimate the liabilities for June 30, the accounts payable are estimated by adding the projected purchases for January through June and deducting total projected cash payments for purchases for the period to the balance of December 31.

The calculation of the accrued wages and expenses is based on the production schedule and the historical relationship between these accruals and production. The shareholders equity at June 30 will be equity at December 31 plus profits after taxes for the period minus the amount of dividends paid. Generally cash and notes payable (short term bank borrowings) serve as balancing factors in the preparation of forecast balance sheets, whereby assets and liabilities plus shareholders’ equity are brought into balance.

Once all the components of the balance sheet are estimated, they are combined into a balance sheet format. (Horne, Wachowicz & Bhaduri, 2008)

Importance of Financial Statement Forecast

The information that goes into a cash budgets can be used to prepare forecast financial statements. Financial mangers can make direct estimates of all the items on the balance sheet by projecting financial ratios into the future and then making estimates on the basis of these ratios. Receivables, inventories, accounts payable and accrued wages and expenses are frequently based on historical relationships to sales and production when a cash budget is not available.

Forecast statements allow us to study the composition of expected future balance sheets and income statements. Financial ratios are computed for analysis of the statements; these ratios and the raw figures may be compared with those for present and past financial statements. Using this information, the financial manager can analyze the direction of change in the financial condition and performance of the company over the past, the present and the future. If the firm is accustomed to making accurate estimates, the preparation of a cash budget, forecast statements or both forces it to plan ahead and to coordinate policy in the various areas of operation.

Continual revision of these forecasts keeps the company alert to changing conditions in its environment and in its internal operations. In addition, forecast statements can even be constructed with selected items taking on a range of probable values rather than single point estimates. (Horne, Wachowicz & Bhaduri, 2008)

Comparison between financial statement forecasting process and budgeting process

The budgeting process starts with forecasting of future income statements. These statements are made on monthly or weekly basis and may stretch for twelve months in the future.

Both budgeting and forecasting are important management tools that we use to anticipate needs and avoid crisis. (Laura, 2000)

Budgeting process gives us information about only the prospective future cash position of the company, whereas forecast statements embody expected estimates of all assets and liabilities as well as of the income statement items.

The key differences between budgeting process and forecasting are as follows:

• The budget obtained by budgeting process is generally more detailed than a forecast.
• Expenditures are more specifically matched to sources of income in a budget than in a forecast.
• Budgeting is a tool for management to achieve the objectives, whereas, forecasting is a used by management to formulate the budget.
• Budgeting is related to future definite period only, whereas, forecasting is related to past, present and future for pure estimation.
• Budgeting is dependent on forecasting but forecasting is not dependent on the budgeting.
• The preparation of budgets ids essential to achieve the production targets but the forecasting is essential to prepare a business budget.
• Budgets are quantitative, whereas, forecasting is qualitative in nature.
• Budgeting is a business process for management whereas forecasting is a mental process for management.
• The success of budgeting is dependent on sound forecasting whereas, success of forecasting is dependent on proper use and analysis of scientific and statistical methods.
• Budgeting process starts after forecasting while the forecasting is a pre process of budgeting.
• Budgeting is a standard itself whereas forecasting helps in preparing budget as a standard.
• Budgeting highlights the whole business while the forecasting helps the budget to highlight the business. (Khan, & Jain, 2002)

References

• Horne, J.C., Wachowicz, J.M. & Bhaduri, S.N. (2008). Fundamentals of Financial Management. Delhi: Dorling Kindersley (India) Pvt. Ltd.
• Khan, M.Y. & Jain, P.K. (2002). Financial Management. New Delhi: Tata McGraw-Hill Publishing Company Ltd.
• Laura, E. (2000). Budgeting for the Future: Why Firms Need to Forecast and Budget Their Cash Flows. Retrieved June 2, 2008, from http://www.allbusiness.com/accounting-reporting/budget-budget-forecasting/622015-1.html