Financial Forecasting

‘Forecast’ means to form an opinion beforehand i.e. to make a prediction.

Thus financial forecasting means a systematic projection of the expected
action of finance through financial statements.

A financial forecast is an estimate of future financial outcomes for a company

or country (for futures and current markets). ... Unlike a financial plan or a
budget a financial forecast doesn't have to be used as a planning
document.
A financial forecast identifies trends in external and internal historical data,
and projects those trends in order to provide decision-makers with
information about what the financial status of the company is likely to be
at some point in the future.
 Characteristics of financial forecasting
• Features of Forecasting:
Peculiarities, characteristics or features of forecasting are as follows:-
• Forecasting in concerned with future events.
• It shows the probability of happening of future events.
• It analysis past and present data.
• It uses statistical tools and techniques.
• It uses personal observations.
Importance of Forecasting
• Forecasting provides relevant and reliable information about the past and
present events and the likely future events. This is necessary for sound planning.
• It gives confidence to the managers for making important decisions.
• It is the basis for making planning premises.
• It keeps managers active and alert to face the challenges of future events and
the changes in the environment.
 Steps in Forecasting
Steps in Forecasting
Procedure, stages or general steps involved in forecasting are given below:-
• Analyzing and understanding the problem : The manager must first identify the real
problem for which the forecast is to be made. This will help the manager to fix the scope of
forecasting.
• Developing sound foundation : The management can develop a sound foundation, for the
future after considering available information, experience, type of business, and the rate of
development.
• Collecting and analyzing data : Data collection is time consuming. Only relevant data must
be kept. Many statistical tools can be used to analyze the data.
• Estimating future events : The future events are estimated by using trend analysis. Trend
analysis makes provision for some errors.
• Comparing results : The actual results are compared with the estimated results. If the actual
results tally with the estimated results, there is nothing to worry. In case of any major
difference between the actual and the estimates, it is necessary to find out the reasons for
poor performance.
• Follow up action : The forecasting process can be continuously improved and refined on the
basis of past experience. Areas of weaknesses can be improved for the future forecasting.
There must be regular feedback on past forecasting.
 Elements of Financial Forecasting:
Financial forecasting involves preparation of proforma financial statements and also
the preparation of Cash Budget.
Therefore, it includes the preparation of:
• A. Pro-forma Income Statement;
• B. Pro-forma Balance Sheet; and
• C. Cash Budget.
• A. Pro-forma Income Statement; This statement is a projection of income for a
period of time in future which, in other words, is to furnish a fair and reasonable
estimate of expected revenue, cost, profits, taxes, dividends and other financial
items. It is prepared around the estimate of the expected sales for the forecast
period. Production schedule can be formulated and estimates may be made for
the cost of production. Next estimate is made for administrative and selling
expenses. Further estimates are made for other income and expenses along with
interest in order to ascertain the net income before taxes.
• Income-taxes are to be deducted at the prescribed rate for ascertaining the net
estimated income after taxes. At last, dividend payments have to be pre-
determined at the appropriate level which is also to be deducted from the
estimated net income/profit-after tax.
.Pro-forma Income Statement;
 Pro-Forma Balance Sheet:
Pro-Forma Balance Sheet:
• This Balance Sheet depends on the information available in the
proforma Income Statement together with different schedules and
budgets.
• In other words, preparation of a proforma Balance Sheet is based on:
• (a) The Net Worth of the company — calculated after adjusting the
projected income;
• (b) The comparison of the projected assets with the total sources of
fund — i.e., if assets exceed the total expected liabilities, the difference
will represent additional sources which must be accounted for and in
the opposite case, the excess will indicate the additional cash;
• (c) The liabilities which are based on past indications;
• (d) The net investment in each component of the assets of the
company in order to achieve the planned levels of production.
Proforma of Balance sheet
 Cash Budget
C. Cash Budget:
• A Cash Budget is a forecast of how much cash will be required during a
specific period in future. Therefore, expected cash receipts and expected
cash payments are estimated by preparing this budget. However, the
estimates are prepared for weeks or months depending upon the
requirement of cash. This budget is prepared after the preparation of all
functional budgets.
• This budget is intended:
• (i) To see that adequate amounts of cash are available for capital as well
as revenue expenditures.
• (ii) To make an arrangement of cash in advance if there is any expected
shortage of cash.
• (iii) To see that the surplus amount of cash, if any, is employed in any
profitable investment outside the business.
Cash Budget
 Financial Forecasting
Limitations of Forecasting
Demerits, criticism or limitations of forecasting involves following points:-
• The collection and analysis of data about the past, present and future involves a lot
of time and money. Therefore, managers have to balance the cost of forecasting
with its benefits. Many small firms don't do forecasting because of the high cost.
• Forecasting can only estimate the future events. It cannot guarantee that these
events will take place in the future. Long-term forecasts will be less accurate as
compared to short-term forecast.
• Forecasting is based on certain assumptions. If these assumptions are wrong, the
forecasting will be wrong. Forecasting is based on past events. However, history
may not repeat itself at all times.
• Forecasting requires proper judgment and skills on the part of managers. Forecasts
may go wrong due to bad judgment and skills on the part of some of the
managers. Therefore, forecasts are subject to human error.
• 100% accuracy is not possible.
 Precautions in Financial Forecasting
• Flexibility and should be based on reliable data/information.
• Regular monitoring and revision.
• Evaluation should be made by experienced ,skilled and professionals.
• Assumptions should give better sense of understanding .
• If firms operating under a high degree of risk or uncertainty should
maintain a larger amount of cash.
 Tools and Techniques of Financial Forecasting
A. Qualitative Techniques of Financial Forecasting
Executive Opinions: In this method, the expert opinions of key personnel of
various departments, such as production, sales, purchasing and operations,
are gathered to arrive at future predictions. The management team makes
revisions in the resulting forecast, based on their expectations.
Reference Class Forecasting: This method involves predicting the outcome of a
planned action based on similar scenarios in other times or places. This is
used to predictions that are arrived at based only on human judgment.
Delphi Technique: Here, a series of questionnaires are prepared and answered
by a group of experts, who are kept separate from each other. Once the
results of the first questionnaire are compiled, a second questionnaire is
prepared based on the results of the first. This second document is again
presented to the experts, who are then asked to reevaluate their responses
to the first questionnaire. This process continues until the researchers have
a narrow shortlist of opinions.
 Tools of Financial Forecasting
Sales Force Polling: Some companies believe that salespersons have
close contact with the consumers and could provide significant
insights regarding customer behavior. In this method of forecasting,
the estimates are derived based on the average of sales force
polling.
Consumer Surveys: Businesses often conduct market surveys of
consumers. The data is collected via telephonic conversations,
personal interviews or survey questionnaires, and extensive
statistical analysis is conducted to generate forecasts.
Scenario Writing: In this method, the forecaster generates different
outcomes based on diverse starting criteria. The management team
decides on the most likely outcome from the numerous scenarios
presented.
 Tools and techniques of forecasting
B. Quantitative Techniques of Financial Forecasting
• Percentage of sales method or Proforma Financial Statements: Proforma statements use
sales figures and costs from the previous two to three years after excluding certain one-
time costs. This method is mainly used in mergers and acquisitions, as well as in cases
where a new company is forming and statements are needed to request capital from
investors.
• Time-Series Forecasting: Time-series forecasting is a popular quantitative forecasting
technique, in which data is gathered over a period of time to identify trends. Time-series
methods are one of the simplest methods to deploy and can be quite accurate, particularly
over the short term. Some techniques that fall within this method are simple averaging and
exponential smoothing.
• Regression or Cause-Effect Method: Here, the forecaster examines the cause-and-effect
relationships of the variable with other relevant variables such as changes in consumers’
disposable incomes, the interest rate, the level of consumer confidence, and
unemployment levels. This method uses past time series on many relevant variables to
produce the forecast for the variable of interest.
• Projected balance sheet
• Projected fund flow statement
• Projected cash flow statement
 Financial Planning
Financial Planning is the process of estimating the capital required and determining
it’s competition. It is the process of framing financial policies in relation to
procurement, investment and administration of funds of an enterprise.
• Financial Planning is process of framing objectives, policies, procedures,
programmes and budgets regarding the financial activities of a concern. This
ensures effective and adequate financial and investment policies.

Financial planning involves deciding what investments and activities would be mos
t appropriate under both personal and broader economic circumstances.
All things being equal, short-term financial planning involves less uncertainty
than long-term financial planning because, generally speaking, market
trends are more easily predictable in the short term Likewise, short-
term financial plans are more easily amendable in case something goes wrong as a
result of the short time frame.
 Objectives of Financial Planning

• Adequate finance
• Balancing of costs and risks
• Flexibility
• Simplicity of financial structure
• Long term view
• Liquidity management
• Optimum use of resources
• Economical.
• Framing financial policies with regards to cash control, lending,
borrowings, etc.
• Framing financial programs like budget, credit policies,
 Importance of Financial Planning

The importance can be outlined as-

• Adequate funds have to be ensured.
• Financial Planning helps in ensuring a reasonable balance between outflow
and inflow of funds so that stability is maintained.
• Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning.
• Financial Planning helps in making growth and expansion programmes
which helps in long-run survival of the company.
• Financial Planning reduces uncertainties with regards to changing market
trends which can be faced easily through enough funds.
• Financial Planning helps in reducing the uncertainties which can be a
hindrance to growth of the company. This helps in ensuring stability an d
profitability in concern.
 Characteristics and principles of sound financial plan

• Easy to understood and it should be simple

• Should be based on clear cut objectives
• Less dependence on external funds
• It should be flexible
• Solvency and liquidity (long term as well as short term requirement)
• Minimize the costs burden and risk
• Portfolio should diverse risk and ensure better profitability
Limitations of financial Planning:
• Difficulties in forecasting
• Difficulties in changes
• Problems of coordination's
• Rapid changes.
 Capitalization
Capitalization is refers to total amount of capital employed in a business.
Capitalization refers to the process of determining the plan of financing . In
includes not only the determination of the quantity of finance required for a
company but also the decision about the quality of financing.
It includes:
• Estimation total amount of capital to be raised.
• Determining the types of securities to be issued and,
• Determining the composition or proportion of the securities;
Since capitalization includes:
• Share capital
• Long term debt
• Reserves and surplus
• Short term debts
• creditors
 Need of capitalization

• At the time of promotion/incorporation of a

company
• At the time of expansion of an existing
company
• At the time of
amalgamation/mergers/acquisition of
companies
• At the time of reorganization of capital of a
company
 Overcapitalization
• Meaning of Over-capitalization:
• It is the capitalization under which the actual profits of the company are not sufficient to pay
interest on debentures and borrowings and a fair rate of dividend to shareholders over a
period of time. In other words, a company is said to be over-capitalised when it is not able to
pay interest on debentures and loans and ensure a fair return to the shareholders.
• We can illustrate over-capitalisation with the help of an example. Suppose a company earns
a profit of Rs. 3 lakhs. With the expected earnings of 15%, the capitalisation of the company
should be Rs. 20 lakhs. But if the actual capitalisation of the company is Rs. 30 lakhs, it will
be over-capitalised to the extent of Rs. 10 lakhs. The actual rate of return in this case will go
down to 10%. Since the rate of interest on debentures is fixed, the equity shareholders will
get lower dividend in the long-run.
• There are three indicators of over-capitalisation, namely:
• (a) The amount of capital invested in the company’s business is much more than the real
value of its assets.
• (b) Earnings do not represent a fair return on capital employed.
• (c) A part of the capital is either idle or invested in assets which are not fully utilised.
Causes of Over-Capitalisation:
• Over issue of capital
• Promotion and formation during inflation
• Inadequate demand
• Payment of high rate of interest
• Acquisition of Assets at Higher Prices: Assets might have been acquired at inflated prices
or at a time when the prices were at their peak.
• Higher Promotional Expenses: The company might incur heavy preliminary expenses such
as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission,
brokerage, etc.
• Underutilization: The directors of the company may over-estimate the earnings of the
company and raise capital accordingly.
• Insufficient Provision for Depreciation: Depreciation may be charged at a lower rate than
warranted by the life and use of the assets, and the company may not make sufficient
provisions for replacement of assets. This will reduce the earning capacity of the company.
(v) Liberal Dividend Policy: The company may follow a liberal dividend policy and may not
retain sufficient funds for self-financing. This may lead to over-capitalisation in the long-run.
(vi) Inefficient Management:
 Effects of Over-capitaliztion on Company:
• Loss of goodwill
• The shares of the company may not be easily marketable.
• The company may not be able to raise fresh capital from the market.
• Reduced earnings may force the management to follow unfair practices. It may
manipulate the accounts to show higher profits.
• Management may cut down expenditure on maintenance and replacement of assets.
Proper amount of depreciation of assets may not be provided for.
• Because of low earnings, reputation of the company would be lowered.
Effects of Over-capitalisation on Shareholders:
• (i) Over-capitalisation results in reduced earnings for the company. This means the
shareholders will get lesser dividend.
• (ii) Market value of shares will go down because of lower profitability.
• (iii) There may be no certainty of income to the shareholders in the future.
• (iv) The reputation of the company will go down. Because of this, the shares of the
company may not be easily marketable.
• (v) In case of reorganisation, the face value of the equity share might be brought down.
 Continued
• Effects of Over-capitalization on Society:
• (i) The profits of an over-capitalized company would show a declining trend. Such a company
may resort to tactics like increase in product price or lowering of product quality.
• (ii) Return on capital employed is very low. This means that financial resources of the public
are not being utilized properly.
• (iii) An over-capitalised company may not be able to pay interest to the creditors regularly.
• (iv) The company may not be able to provide better working conditions and adequate wages
to the workers.
Remedies for Over-capitalization:
(i) The earning capacity of the company should be increased by raising the efficiency of human
and non-human resources of the company.
(ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing
resources.
(iii) The par value and/or number of equity shares may be reduced.
(iv) Management should follow a conservative policy in declaring dividend and should take all
measures to cut down unnecessary expenses on administration.
(v) Reorganization of equity share capital
 Under capitalization
A company be under-capitalized when the rate of profits it is making on the total capital is
exceptionally high in relation to the return enjoyed by similarly situated companies in the
same industry.
Under-utilization is the reverse phenomenon of over-capitalization and occurs when company's
actual capitalization is lower than its proper capitalization warranted by earning capacity.
For instance, the capitalisation of a company is Rs. 20 lakhs and the average rate of return of the
industry is 15%. But if the company is earning 30% on the capital investment, it is a case of
under-capitalisation.
Causes:
1. Under estimation of capital requirements
2. Under estimation of future earnings
3. Promotion during depression
4. Conservative dividend policy
5. Efficient managerial policies
6. Desire for control and trading on equity.
 Effects of Under-Capitalization
Effects of Under-capitalization on Shareholders:
• (i) The profitability of the company may be very high. As a result, the rate of earnings per
share will go up.
• (ii) The value of its equity share in the market will go up.
• (iii) The financial reputation of the company will increase in the market.
• (iv) The shareholders can expect higher dividends regularly.
Effects of Under-capitalization on Company:
• (i) Because of higher profitability, the market value of company’s shares would go up. This
would also increase the reputation of the company.
• (ii) The management may be tempted to build up secret reserves.
• (iii) Higher rate of earnings will attract competition in the market.
• (iv) The workers of the company may be tempted to demand higher wages, bonus and other
benefits.
• (v) If a company is earning higher profits, the customers may feel that they are being over­
charged by the company.
• (vi) The government may increase tax rates on companies earning exceptional profits.
Effects of Under-capitalization on Society:
• (i) Under-capitalisation may lead to higher profits and higher prices of shares on the stock
exchange. This may encourage unhealthy speculation in its shares.
• (ii) Because of higher profits, the consumers feel exploited. They link higher profits with
higher prices of the products.
• (iii) The management of the company may build up secret reserves and pay lower taxes to the
Government.
Remedies for Under-capitalization:
• (i) Under-capitalisation may be remedied by increasing the par value and/or number of equity
shares by revising upward the value of assets. This will lead to decrease in the rate of
earnings per share.
• (ii) Management may capitalise the earnings by issuing bonus shares to the equity
shareholders. This will also reduce the rate of earnings per share without reducing the total
earnings of the company.
• (iii) Where under-capitalisation is due to insufficiency of capital, more shares and debentures
may be issued to the public.
 Factors Affecting the Financial Plan

• Nature of the industries

• Standing of the concern (goodwill, credit
worthiness, performance and attitude of
management
• Future plans(expansion, restructuring,
diversification and modifications)
• Availability of resources
• General economic conditions
• Government conditions.
 Steps in Financial Plan

• Setting of the financial objectives

• Formulating financial policies
• Formulating financial procedure
• Assigning the duties
• Control on plans
• ensure the flexibility
 Scenario Analysis
What is Scenario Analysis?
Scenario analysis is a process of examining and determining
possible events that can take place in the future by considering
various feasible results or outcomes. In financial modeling, this
process is typically used to estimate changes in the value of a
business, especially when there are potentially favorable and
unfavorable events that could impact the company.
Most business managers also use scenario analysis during their
decision-making process to find out the best-case scenario as well
as worst-case scenario while anticipating profits or potential
losses. Individuals can use this process when they have a big
investment coming up like purchasing a house or setting up a
business.
What are the 3 common cases used in Scenario Analysis?
Base case scenario – this is the average scenario based on
management assumptions. An example – when calculating the
net present value, the rates most likely to be used are the
discount rate, cash flow growth rate, or tax rate.
Worst case scenario – considers the most serious or severe
outcome that may happen in a given situation. An example –
when calculating the net present value, one would take the
highest possible discount rate and subtract the possible cash
flow growth rate or the highest expected tax rate.
Best case scenario – this is the ideal projected scenario and is
almost always put into action by management to achieve their
objectives. An example – when calculating the net present
value, use the least possible discount rate, highest possible
growth rate, or lowest possible tax rate.
 Steps to Performing Scenario Analysis in
Financial Modeling

Steps to performing Scenario Analysis in financial modeling

Building scenarios into a financial model is an important exercise to
help cater for uncertainty.
The steps to performing this analysis are:
• List the assumptions you want to create scenarios for
• Copy and paste the list of assumptions by the number of scenarios
you wish to have
• Fill in all details of each scenario
• Ensure the layout of all three scenarios is identical
• Create a new section called “Live Scenario”
• Use Excel’s CHOOSE function to switch between selected scenarios
• Link the “Live Scenario” numbers directly into the financial model
 Example

Maria wants to create a budget, but she is unsure of her

income. By using scenario analysis, she will be able to
determine different possible income values and then,
perform probability analysis. The worst-case scenario for
Maria is a gross income of Rs70,000 and a cost of goods sold
amounting to Rs35,200. This leaves Maria with a gross profit
of Rs34,800.
The best-case scenario for Maria is a gross income of Rs120,000
and a cost of goods sold amounting to Rs28,000. This would
leave Maria with a gross profit of Rs92,000.In order to
compare the two scenarios, Maria creates a scenario report,
which summarizes the two options.
 Benefits of Performing Scenario Analysis?
What are the benefits of performing Scenario Analysis?
• Future planning – gives investors a peek into the expected returns and risks
involved when planning for future investments. The goal of any business venture is
to increase revenue over time, and it is best to use informed calculations when
deciding to include the investment in the portfolio.
• Proactive – Companies can avoid or decrease potential losses that result from
uncontrollable factors by being aggressively preventive during worst-case scenarios
by analyzing events and situations that may lead to unfavorable outcomes. As the
saying goes, it is better to be proactive than reactive when a problem arises.
• Avoiding risk and failure – to avoid poor investment decisions, scenario analysis
allows businesses or investors to assess investment prospects. It takes the best and
worst probabilities into account so that investors can make an informed decision.
• Projecting investment returns or losses – the analysis makes use of tools to
calculate the values or figures of potential gains or losses of an investment. This
gives concrete, measurable data that investors can base the approaches they take
for a better outcome.
 Drawbacks of Scenario Analysis
What are the drawbacks of Scenario Analysis?
Scenario analysis tends to be a demanding and time-consuming process that
requires high-level skills and expertise. Due to the difficulty in forecasting
exactly what takes place in the future, the actual outcome may be fully
unexpected and not foreseen in the financial modeling.
It may be very difficult to envision all possible scenarios and assign
probabilities to them. Investors must understand that there are risk factors
associated with the outcomes and they must consider certain risk
tolerance to be able to pursue a goal.