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 fu ture 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.
Components
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For eg:
Source: Financial Forecasting (wallstreetmojo.com)
- 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 receivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more, short-term borrowing, long term debtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more, cash sales, and equity capital. Sources of cash outflow include payments of accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more, salaries, wages, capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more, repayment of loans, and debts. The cash budget does not include expenses like depreciation. The reflected surplus or deficit in the cash budgetCash BudgetCash budget refers to cash inflows and outflows estimations made by a company's management over a given period to evaluate whether the business has adequate cash & cash equivalents to meet its operational needs in the coming future.read more forms the base for investment and financing.
- Projected Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more – 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 statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more, balance sheet, initial balance sheet are the inputs required for its preparation. Projected sources of funds are cash flow from operationsCash Flow From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more, 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 modelingFinancial ModelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more 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 riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more 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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