Ave Maria College

SENIOR HIGH SCHOOL DEPARTMENT

School ID No. 402686 Gov’t Permit No. 0059 s. 2015

LESSON 10: FINANCIAL FORECASTING

A. The Importance of Forecasting

Forecasting holds immense importance across various domains and industries due to its ability to provide
valuable insights into future trends, events, and outcomes. Here are several key reasons why forecasting is
important:

1. Strategic Planning: Forecasting enables organizations to make informed decisions and formulate long-
term strategies. By predicting future demand, market trends, and competitive dynamics, businesses can
allocate resources effectively, set realistic goals, and stay ahead of the competition.
2. Resource Allocation: Forecasting helps optimize resource allocation by anticipating future needs and
demands. Whether it's raw materials, labor, or capital investments, accurate forecasts enable
organizations to allocate resources efficiently, minimize waste, and maximize productivity.
3. Risk Management: By identifying potential risks and uncertainties, forecasting allows organizations to
develop risk mitigation strategies and contingency plans. Whether it's fluctuations in demand, economic
downturns, or supply chain disruptions, accurate forecasts enable businesses to proactively address
potential threats and minimize their impact.
4. Financial Planning and Budgeting: Forecasting plays a crucial role in financial planning and
budgeting processes. By projecting future revenues, expenses, and cash flows, organizations can develop
realistic budgets, set financial targets, and ensure financial stability and sustainability.
5. Inventory Management: Forecasting helps optimize inventory levels by predicting future demand for
products and services. By maintaining the right balance between supply and demand, organizations can
minimize inventory costs, prevent stockouts, and enhance customer satisfaction.
6. Performance Evaluation: Forecasting provides a benchmark for evaluating performance and tracking
progress towards organizational goals. By comparing actual outcomes with forecasted projections,
businesses can identify variances, analyze performance drivers, and take corrective actions as needed.
7. Market Analysis and Customer Insights: Forecasting provides valuable insights into market
dynamics, consumer behavior, and emerging trends. By analyzing historical data and external factors,
organizations can anticipate changes in customer preferences, identify growth opportunities, and tailor
their offerings to meet evolving market demands.
8. Product Development and Innovation: Forecasting informs product development and innovation
efforts by identifying emerging market needs and preferences. By understanding future demand trends
and customer expectations, businesses can innovate and introduce new products and services that
address unmet needs and create value for customers.
9. Government Policy and Regulation: Forecasting informs government policy and regulatory decisions
by providing insights into economic trends, employment patterns, and societal changes. Policymakers
rely on forecasts to design effective policies, stimulate economic growth, and address social challenges.
10. Long-Term Sustainability: Forecasting contributes to the long-term sustainability of organizations by
promoting forward-thinking and proactive decision-making. By anticipating future opportunities and
 challenges, businesses can adapt to changing market conditions, foster innovation, and ensure their
continued success and relevance.
B. Forecasting Sales

A sales forecast is a prediction of future sales revenue. Just like a weather forecast, your team should
view your sales forecast as a plan to work from, not a firm prediction.

What is a sales forecast based on?

Sales forecasts are usually based on historical data, industry trends, and the status of the current sales pipeline.

What are sales forecasts used for?

Businesses use the sales forecast to estimate weekly, monthly, quarterly, and annual sales totals.

What you need for accurate sales forecasts

1. Get reliable data

Good data is the most important requirement for a good sales forecast. That means that getting hold of good
data is crucial.

Is your company fairly established? Use your historical data to model future performance.

If your company is fairly new and you don’t have historical data yet, look at the industry averages to set
benchmarks.

Before you begin to think about how to forecast sales, here’s what you need to do, step by step:

2. Document your sales process

Without a clearly documented sales process describing the actions and steps it takes to close a deal, you’ll have
difficulty predicting whether any single deal will close.

3. Set your quotas

While your forecast may be different from your goals, you won’t know if your forecast is good or bad unless
you first have a target.

Make sure each rep has an individual quota, as does the entire sales team. Read more about setting sales goals
or quotas here.

4. Set a benchmark or a current average of some basic sales metrics

Having easily accessible measures of the following basic sales metrics will make forecasting much easier:

The time it takes the customer to express interest

How long it takes to close a deal

The average price of a deal

The duration of the customer on-boarding process

Average renewal or rates, or how frequently you get repeat business

Conversion rates at each stage of the sales process

Essentially, you want to define the average duration and performance of your sales process.

5. Understand your current sales pipeline

Make sure you understand what’s in your current pipeline, and that your CRM is accurate and up-to-date. If you
don’t have a CRM, forecasting is more difficult, but not impossible.

C. Pro Forma Financials

What Is Pro Forma? Pro forma means “for the sake of form” or “as a matter of form." When it appears in
financial statements, it indicates that a method of calculating financial results using certain projections or
presumptions has been used.
Pro forma financials are not computed using generally accepted accounting principles (GAAP) and usually
leave out one-time expenses that are not part of normal company operations, such as restructuring costs
following a merger.

Essentially, a pro forma financial statement can exclude anything a company believes obscures the accuracy of
its financial outlook and can be a useful piece of information to help assess a company's future prospects.

Types of Pro Forma Financial Statements

1. Pro Forma Budget Documents

A budget anticipates the inflow of projected revenues and the outflow of funds for a defined future
period, usually a fiscal year. A budget is based on certain assumptions about future expenses and
revenues. It takes into account past expenses and revenues and factors in the costs of the company's
plans for the fiscal year.

2. Pro Forma Company Income Statements

A pro forma income statement uses the pro forma calculation method, mainly to draw the attention of
potential investors to specific numbers when a company issues its quarterly earnings announcement.

For example, a company will report its actual sales and expenses for the quarter that just passed and, in
the same chart, will list its projections of these numbers for the current quarter.

In this case, the company is projecting the future, based on its knowledge of past sales and expenses
and factoring in expected changes.

3. Pro Forma Earnings Projections

A company may present a pro forma statement to inform investors about their internal assessment of
the financial outcome of a proposed change in the business.

For example, if a company is considering an acquisition or a merger, it may publish a pro format
statement of the expected impact of the move on its future earnings and expenses.

4. Pro Forma Financial Accounting

 In financial accounting, a pro forma earnings report excludes unusual or nonrecurring transactions.

These excluded expenses could include declining investment values, restructuring costs, and
adjustments made on the company’s balance sheet that fix accounting errors from prior years.

5. Pro Forma Managerial Accounting

Accountants prepare financial statements in the pro forma method ahead of a proposed transaction such
as an acquisition, merger, a change in a company's capital structure, or new capital investment.

These are models that forecast the expected result of the proposed transaction. They focus on estimated
net revenues, cash flows, and taxes.

The statements are presented to the company's management to help it make a decision on a proposed
action based on its potential benefits and costs.

Limitations of Pro Forma Statements

Investors should be aware that a company’s pro forma financial statements can hold figures or
calculations that do not comply with generally accepted accounting principles (GAAP), the set of standards
followed by public companies for their financial statements. In fact, they can differ vastly. Pro forma results
may contain adjustments to GAAP numbers in order to highlight important aspects of the company's operating
performance.

What Is a Pro Forma Financial Statement?

Pro forma financial statements incorporate hypothetical numbers or estimates. They are built into the data to
give a picture of a company's profits if certain nonrecurring items are excluded.

These are often intended to be preliminary or illustrative financials that do not follow standard accounting
practices. Companies use their own discretion in calculating pro forma earnings, including or excluding items
depending on what they feel reflects the company's true performance or future performance.

D. Generating the Complete Forecasts

Forecast the Income Statement

To arrive at a fully forecasted income statement, we use historical income statements, common-size income
statements, and any additional information we have about future sales and costs, such as the effects of the
economy and competition. As we saw earlier in the chapter, we begin with forecasted sales because they are the
basis for many of the forecasted costs.
The first two key points regarding product lines have already been built into the sales forecast. Notice that the
cost of goods sold was 50% in the prior year. However, based on possible future legislation, to be conservative,
we should increase the cost of goods sold by 2% in the last quarter of the year. Thus, we will forecast cost of
goods sold at 50% of sales in the first nine months and increase it to 52% in the last three months of the year.

Rent is a fixed cost that historically amounts to 458 per month. However, we know that the landlord is
increasing rent by 50 starting on July 1. Thus, we will forecast rent at the same fixed cost of 458 per month for
the first six months and increase it to $508 per month for the second half of the year.

Depreciation, also a fixed cost, was historically 300 per month. However, we know that depreciation expense
will go down by 25 beginning in April. Thus, we forecast depreciation at 300 for the first three months and at
275 for the last 9 months.

Salaries expense has historically been 450 per month. However, we know that the company is implementing a
new compensation program on January 1 that will increase salaries expense by 4% (18). Thus, we will forecast
salaries for the whole year at 468.

Utilities expense seems to vary somewhat by sales from month to month, as shops are open longer hours during
their busy season. However, the total utilities expense is not expected to change for the coming year. Thus, the
forecast for utilities expense remains at 2,500, broken down by month as a percentage of sales.

Interest expense is a fixed cost and isn’t anticipated to change. Thus, the same $167 interest expense per month
is forecast for the coming year.
Forecast the Balance Sheet

Now that we have a reasonable income statement forecast, we can move on to the balance sheet. The balance
sheet, however, is entirely different from the income statement. It requires a bit more research and additional
assumptions. Just like the income statement, it’s often a work in progress. A first draft is a good starting point,
but adjustments must be made once it is created, and all the interrelationships between the statements, cash flow
in particular, are taken into consideration.

The balance sheet is a bit more difficult to forecast because the statement reflects balances at just a given point
in time. Account balances change daily, so forecasting just one snapshot in time for each month can be a
challenge. A good starting point is to assess general company financial policies or rules of thumb. For example,
assume that Clear Lake pays most of its vendors on net 30-day terms. A good way to forecast accounts payable
on the balance sheet might be to add up the cost of goods sold from the forecasted income statement for the
prior month. For example, in Figure 18.14, we see that Clear Lake has forecasted its accounts payable for
March as the cost of goods sold in March from its forecasted income statement.

For accounts receivable, Clear Lake generally receives payment from customers within net 90-day terms. Thus,
it uses the sum of the current and prior two months’ forecasted sales to estimate its accounts receivable balance.

Inventory will vary throughout the year. For the first six months, the company tries to build inventory for four
months of sales. Once the busy season hits, inventory goes down to three months’ worth of future sales, then
finally drops to only two months of sales in December. Thus, managers use their sales forecast by month to
estimate their inventory ending balance each month.

The equipment balance is forecasted by reducing the prior month’s balance by the forecasted depreciation
expense on the forecasted income statement.

Unearned revenue is historically around 50% of the current month’s sales. Thus, Clear Lake estimates its
unearned revenue balance each month by taking the current month’s net sales from the forecasted income
statement and multiplying it by 50%.

Short-term investments, notes payable, and common stock are not anticipated to change, so the current balance
is forecasted to remain the same for the next 12 months.

To forecast the ending balance for retained earnings for each month, managers add the monthly net income
from the forecasted balance sheet to the prior balance and subtract a quarterly 10,000 dividend.

E. Forecasting Cash Flow and Assessing the Value of Growth

Create a Cash Flow Forecast

A cash flow forecast isn’t overly complex, yet it is not easy to assemble because it requires making many
assumptions about the future. A cash forecast begins with the beginning cash balance, adds anticipated cash
inflows, and deducts anticipated cash outflows. This identifies cash surpluses and shortages.
Next, Clear Lake identifies cash outflows, which include accounts payable, salaries, rent, utilities, dividends,
and interest payments. Accounts payable are normally paid within 30 days, so the forecast for cost of goods sold
for the prior month is used as an estimate of amount paid for payables.

Salaries are paid monthly and thus represent the same recurring monthly cash outflow, as does rent. Utilities,
like accounts payable, are assumed to be paid within 30 days. Thus, the cash outflow for utilities is the utilities
expense for the prior month from the forecasted income statement.

Assessing the Value of Growth

It’s a fairly common assumption that most, if not all, businesses want to grow. While it certainly can be good as
a firm to grow in size, growth just for the sake of growth isn’t necessarily a good goal. A firm can grow in size
based on customers, employees, locations, or simply sales. However, that doesn’t mean that the growth will
increase profits. Growth may increase profits, but this is not a safe assumption. Scaling up operations takes
careful planning, which includes monitoring the profitability of the sales and, of course, the cash flow it would
require. Growing a business can require more inventory, more locations, more equipment, and more manpower,
all of which cost money. Even if the forecasted growth is profitable, it may pose problems from a cash flow
perspective. It’s important that the firm review not only its forecasted income statement and balance sheet but
also its cash forecast, as this can reveal some serious gaps in funding depending on the extent, timing, and
nature of the planned growth.

For example, assume that Clear Lake Sporting Goods intends to run a large-scale ad campaign to boost sales in
its busy season. Historically, the store relied primarily on its prime location for high volumes of retail foot
traffic. Managers felt, however, that given the increase in competition, they could boost sales significantly by
running the ad campaign in the first quarter. The campaign would cost $30,000. Forecasts already reflect a cash
deficit at the end of the first quarter of $13,000, so the additional $30,000 ad campaign, which would require
payment up front, would create a much larger need for funding. It’s also important that managers look at the
increased cost of doing business along with the increased cost in advertising to ensure that the move would be
profitable. Fortunately, Excel or other forecasting software can be used to create a forecast with formulas that
tie together, making scenario analysis such as this a much easier process.