Financial Forecasting Meaning
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.
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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.
Components
- Projected Income Statement – This is an anticipated income statement that depicts the expected expenses and revenues for the future financial period, i.e., usually one year.
- Cash Budget – This depicts 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, cash sales, and equity capital. 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 financing.
- 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.
- 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.
Difference Between Financial Forecasting and Financial Modeling
Financial forecasting is a method of prediction that a company makes and prepares for the future. It involves a possible outcome of the future by determining its current financial statements and performance, whereas financial modeling is the action taken on financial forecasting. Once the forecast assumptions are developed, and numbers are calculated using a financial statement, financial modeling comes into the picture. Financial modeling builds a predictive operating model to help a company in making sound business decisions. These financial models are mathematical models where different variables are linked together. The process involves preparing the company’s future balance sheet.
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– 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.
- Archive 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.
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