Financial Forecasting: Meaning, Elements and Applications

After reading this article you will learn about the Financial Forecasting:- 1. Meaning of Financial Forecasting 2. Elements of Financial Forecasting 3. Other Applications.

Meaning of 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.

It is needless to mention that such forecasting needs past records, cash flow and fund-flow behaviour, the applications of financial ratios etc. along with the industrial economic condition. It is a kind of plan which will be formulated at a future date for a specified period.

The merits of the financial forecasting are noted below:

(i) It can be used as a control device in order to fix the standard of performances and evaluating the results thereof

(ii) It helps to explain the requirement of funds for the firm together with the funds of the suppliers

(iii) It also helps to explain the proper requirements of cash and their optimum utilisation is possible and so surplus/excess cash, if any, invested otherwise.

Financial planning, on the other hand, is nothing but one part of a larger planning process within an organisation.

“A complete planning system begins at the highest level of policy with the firm’s basic goals or purpose, usually stated in qualitative, mission-oriented, terms. From this it is derived the firm’s commercial strategy, defining the product or services it will produce and the markets it will serve. Supporting policies are developed in production, marketing, research and development, accounting and finance. The extent to which the system formalized with detailed planning and budgeting system in each area depends in part on the firm’s size and the complexity of its operation.” — E. Solomon and J. S. Pringle

Thus, in a broader sense, financial planning can be viewed as the representation of an overall plan for the firms in terms of finance and, similarly, in a narrower sense, it may refer to the process of determining the financial requirements which is needed in order to support a given set of plans in other areas.

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. The sales may be estimated on the basis of market research and economic surveys.

On the contrary, production schedule can be formulated and estimates may be made for the cost of production. The most accurate forecast may be made available with the help of a detailed analysis of purchases, productive wages and overhead costs. Sometimes, cost of goods sold is estimated on the basis of past ratios of cost of goods sold to sales.

Next estimate is made for administrative and selling expenses. Since both of them are generally budgeted in advance, their estimates are seldom accurate. 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.

A typical form of pro-forma income statement is presented below (with imaginary figures):

Therefore, this proforma income statement helps us to analyse the composition of expected future income statement and Balance Sheet with the help of different financial ratios. These ratios along with the raw figures may be compared with the present and past Balance Sheets.

The financial manager, with the help of this information, realizes the changes in the financial position together with the performances of the firm over the past, present and future.

If estimates are made accurately, the preparation of proforma income statement and cash budget force it to plan ahead. Continuous reversion of the estimates helps the firm to tackle the changed circumstances of the business.

B. 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.

Interpretation of Pro-forma Balance Sheet items Assets:

(a) Fixed Assets:

In order to acquire, replace or disposal of fixed assets over a number of years, capital budget plan is to be drawn up and adjustments have to be done accordingly. Depreciation on assets should also be considered before arriving at the values of fixed assets for preparing the projected Balance Sheet. Other assets will remain as they are unless it is specially mentioned.

(b) Current Assets:

(i) Sundry Debtors:

It depends on the number of days’ credit allowed to customers which can be ascertained either under:

(i) Credit Sales/Average Debtors

Or

(ii) (Debtors/ Credit Sales) X 365

(ii) Inventories:

The inventory level in relation to production programme which is to be maintained is an important item in this regard. As soon as the level is fixed by the management, the same will be an item of the proforma Balance sheet.

These are ascertained as under:

Stock Turnover ration = Cost of goods sold/Average inventories

Or, Sales/Average inventories

(iii) Cash:

A minimum amount of cash is to be maintained in hand for different purposes. But where the flexible bank borrowing is available, the cash balance will represent the difference between the assets and the liabilities. In case of assets, viz. Goodwill, Patent, Pre-paid Expenses etc., they are to be valued at the existing figures until and unless there are some special information about them.

Liabilities:

(a) Shareholder’s fund Net Worth:

It represents the amount of Share Capital and Reserves and Surplus (fixed assets plus current assets minus current and long term liabilities). But for this purpose, fresh issue of shares, redemption of preference shares, a retained earnings from profit should also be taken into consider­ation.

(b) Creditors:

It depends on the number of days credit allowed by suppliers.

This can be ascertained for the purpose of proforma Balance Sheet either under:

(i) Credit purchase/ Average Creditors

Or (ii) (Creditors/Credit Purchase) X 365

(c) Outstanding Liabilities:

These are ascertained on the basis of the pattern of wages payment, tax payment etc. For this purpose past and future data relating to them are also to be taken into consideration while preparing a proforma Balance Sheet.

(d) Provision for Tax and Dividends:

Proper provisions for taxes and dividends should also be made for the proforma Balance Sheet. They also depend on past and future data the rate of tax and dividend etc. Once we estimate/ascertain all the components of proforma Balance Sheet, they are combined and presented in a Balance Sheet. Moreover, all the Balance Sheet items can be estimated by projecting financial ratios for the future.

A cash budget method is an available way for preparing a proforma statement. Where such budget is not available, Bills (Receivables and Payable) Debtors and Creditors, accrued wages and expenses are based on historical relationship between production and sales.

Illustration:

The following is the Balance Sheet of X Co. Ltd on 31.3.1987:

The management estimates the purchases and sales for the year ended 31.3.1988 as under:

It was decided to invest Rs. 1,00,000 in purchase of fixed assets which are depreciated at 10% on cost. The time-lag for payment to trade creditors for purchases and receipts from sales is one month. The business earns a gross profit of 30% on turnover. The sundry expenses are 10% of the turnover. The amount of depreciation is not included in these expenses.

Draft a Proforma Balance Sheet including a proforma Income Statement for the period 31.3.1988 assuming that Creditors are all trade creditors for purchases and Debtors for sales and there is no other item of current assets and liabilities apart from Stock and Cash and Bank Balances.

Solution:

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.

In reality, information is available from this budget about the sources of expected cash that will be required by the business as and when necessary. At the same, if the synchronization of cash between receipts and disbursement is not possible, it is impossible to earn expected profit which is shown in Budgeted Profit and Loss Account and, hence, performances of all other functional budgets will become useless.

Advantages of Preparing Cash Budget:

The following advantages may be derived from the Cash Budget:

1. The preparation of the Cash Budget gives us a clear idea of how much cash is required at what time and necessary arrangements may be made for the purpose.

2. It informs how much additional cash is required during the peak period and the possible ways in which the said cash may be collected, e.g., loan or overdraft taken from bank or outsiders.

3. Since the surplus amount of cash can be known by its preparation, benefits of Cash Discount may be derived by making payments before due date.

4. Cash Budget expresses either the deficit or the surplus of cash, therefore, surplus of cash, if any, should be invested properly, otherwise it will remain idle which will increase the cost.

A Cash Budget is prepared by any one of the following methods:

(a) Receipts and Payments Method;

(b) The Adjusted Profit and Loss Method;

(c) The Balance Sheet Method.

The first method (viz., Receipts and Payments Method) is very useful for the short-period Cash Budget. The inflow and outflow, of cash can be estimated by a proper analysis under
this method. But the second method (viz., The Adjusted Profit and Loss Method) and the third method (viz., The Balance Sheet Method) are, however, useful for long-period budgets, say for 2 to 5 years.

Of course, it is possible to prepare the Cash Budget under the later methods if weekly or monthly Projected Profit and Loss Account and Projected Balance Sheet are prepared.

(a) Receipts and Payments Method:

It has already been stated that this method is useful for a short-period budget. Here, all anticipated cash receipts and payments which are expected during the budget period are taken into consideration. But accrued incomes and expenses are not to be considered at all in this budget.

The detailed information about the inflow and outflow of cash for sales, cost of production etc., is collected from this budget. Under this method, the budget is divided into two parts, viz., Receipts and Payments.

Since the primary sources of cash are from sales, the receipts part of the budget is prepared according to the Sales Budget. On the other hand, the payments part of the budget is prepared according to other functional budgets.

This method contains the following information:

(i) It provides information as to how much of sales are being made for cash and also about the time-lag in case of credit sales.

(ii) Information about the raw materials to be purchased from Purchase Budget is also furnished.

(iii) How much should be paid on account of wages can be known from Labour Budget and the lag in payment of wages should also be considered.

(iv) Similarly, it can also be known how much is to be paid for different overheads, and the lag in payment of overhead should also be taken into consideration.

(v) Information is also available for Capital Expenditure Budget about the cost to be incurred for acquiring fixed assets.

All other information about the receipts (viz., issue of shares, overdrafts taken from Bank etc.) and the payments (viz., payment for dividend and taxation, repayment of loans etc.) is also available.

Illustration:

From the following information prepare a monthly Cash Budget for the four months ending 31st December:

Other relevant information is:

(a) Wages to be paid to workers Rs. 6,000 each month.

(b) Dividend from Investments amounting to Rs. 1,000 is expected on 31st December.

(c) Income-tax to be paid (in advance) in December Rs. 2,000.

(d) Preference share dividend of Rs. 5,000 is to be paid on 30th November. Balance at Bank on 1st September is expected to be Rs. 6,000.

Solution:

(b) Adjusted Profit and Loss Method:

This method is based on the assumption that profit is equivalent to cash and both cash and non-cash transactions are taken into consideration. It is practically useful for long- term forecasting.

Under this method, various non-cash charges (e.g., depreciation) are added back with budgeted net profit and deducting non-cash credit and, thereafter, adding or deducting the changes of assets or liabilities, as the case may be, which ultimately affect cash.

Since it is started by taking the balance from Budgeted Profit and Loss Account, it is called Adjusted Profit and Loss Method. It is also called Budgeted Cash Flow Statement as the receipts and payments of cash are shown during the budget period. The adjusted profit implies the estimated cash available.

However, this method depends on the following:

(i) Budgeted Profit and Loss Account is to be prepared for the budget period.

(ii) Budgeted Balance Sheet, both for the current and previous periods, are also to be prepared:

The only difference between Receipts and Payment Method and Adjusted Profit and Loss Method is that the latter takes non-cash transactions into consideration and at the same time considers profit equivalent to cash.

Illustration:

The Balance Sheet of Sumana Ltd. as at 31st December 1984, is as follows:

Depreciation is to be charged @ 10% on Plant and Machinery (on Straight-Line Method).

Stock is expected to be valued at Rs. 70,000 at the end of the year.

Future Taxation to be reserved for the following year amounted to Rs. 20,000.

Transfer Rs. 20,000 for General Reserve.

You are required to prepare a Cash Flow Statement under Adjusted Profit and Loss Method assuming that last year’s tax and dividend are to be paid. Prepare also the Forecast Balance Sheet

Solution:

(c) Balance Sheet Method:

It has already been stated that this method is useful for long-term forecasting. Under this method, a Budgeted Balance Sheet is prepared by incorporating all expected assets and expected liabilities except cash. The excess of two sides (liabilities or assets) will represent either cash balance or overdraft as the case may be.

In other words, if the assets side is greater than the liabilities side, the difference will represent Bank Overdraft or vice-versa.

Illustration:

 

Other information:

(a) Credit allowed to customers for 2 months and from creditors 1 month.

(b) Lag in payment of Wages and Expenses ¼ a month.

(c) Advance Tax is to be paid in November Rs. 25,000.

(d) Insurance @ Rs. 5,000 payable in every month which is not included in the above ‘Wages and Expenses’.

(e) Machinery purchased in December amounted to Rs. 1, 50,000.

(f) 10% of Sales and Purchases are made for cash.

(g) Selling commission is payable @ 5% on sales payable in the month following the month of collection

(h) The Bank Balance on 1st October is Rs. 1, 00,000.

Problem 2:

The following is the operation budget of your company phased by quarters for a calendar year. From this and the additional information given prepare a Cash Flow Forecast by quarters.

Problem 3:

A manufacturing company has been experiencing difficulties in its operation due to various reasons. It has, however, planned its operations for the year ended 30th June 1985. From the following relevant particulars prepare a Cash Budget for the months of July, August, September and October 1984 Estimated variable production cost per unit:

Fixed overheads estimated to be Rs. 36,000 p a. is expected to be incurred in equal amounts each month during the budget period Estimated sales for the first five months are:

Other information:

(i) Finished Goods Stock:

75% of each month’s involves sales units to be produced in the month of sales and 25% in the previous month.

(ii) Raw Material Stock:

50% of direct materials required for each month production to be purchased in the previous month.

(iii) Terms of payment:

(a) Direct materials:

To be paid in the month following the month of purchase.

(b) Direct wages:

To be paid 75% in the month used and 25% in the following month.

(c) Expenses:

To be paid within the month due.

(iv) Estimated payments from customers (Stiles):

Problem 4:

From the following data prepare a Cash Budget for the quarter October-December. Draft a note from the Management Accountant and Financial Controller to accompany this statement:

All the sales are on credit. Half of the dues are collected in the month of sale, on which a cash discount of 20% is allowed and the other half are realised in the next month.

(b) Materials are purchased for cash on which a rebate of 5% is offered by the supplier. If the company buys on credit, payment can be deferred by one month forgoing the rebate.

The purchase budget for the next quarter is:

The above estimates include the quarter’s provision for depreciation amounting to Rs. 900 for Department A and Rs. 750 for Department B.

(e) The General Overheads Budget for the quarter is Rs. 3,500 (out of which Rs. 200 is for Depreciation Reserves, Rs 300 for Bad Debts reserve).

(f) An old machine is to be replaced with an additional outlay of Rs. 7,000 in the month of December.

(g) The Cash Balance on 1st October may be taken at Rs. 15,000.

Other Applications of Financial Forecasting:

The elements of financial forecasting with the help of pro-forma financial statements (viz., Pro-forma Income Statement and Pro-forma Balance Sheet) and Cash Budget. Here, we will highlight some other methods of financial forecasting required by a firm.

They are:

(i) Per cent of Sales Method;

(ii) Scatter Diagram and/or Simple Regression Method

(i) Per-cent of Sales Method:

We know that certain variables of Balance Sheet are directly affected with sales, e.g.. Accounts Receivables, Inventories. Cash, Accounts Payable etc. and naturally, these accounts vary directly with the variation of sales value. That is why sales to Balance Sheet items are to be ascertained which exhibit a clear picture of financial position of a firm and helps to make financial forecasting.

Under this method, each component of Balance Sheet item is expressed in terms of percentage of sales. The same can be explained with the help of the following hypothetical Balance Sheet of Prafulla Ltd for the year ended 31st Dec. 1995.

Additional Information:

(i) Amount of sales was Rs. 20,00,000.

(ii) Net profit after tax was @ 5%.

(iii) During the year 1995. the company earned Rs 90,000 (after tax) and paid Rs. 45,000 as dividend The company wants to declare @ 50% of net profit by way of dividend and the company expects to expand it sales to Rs 30,00.000. You are asked to ascertain how much additional funds the company should need in order to operate the said conditions.

The answer is presented in the following manner:

We are to ascertain the percentage of sales to various items of Balance Sheet, which directly vary with the variation of sales figure.

We also know that in order to increase the amount of sales more account receivables, more cash and inventories are to be correspondingly increased but not the fixed assets (as they do not have any direct bearing on sales) and accounts payable including provisions on the liabilities side of the Balance Sheet Needless to mention here that other items viz., Share Capital, Reserves and Surplus, long-term debts will not make any change.

But the retained earnings will naturally go up if the company does not pay 100% of its earnings by way of dividend.

Thus, the percentage of sales on affected the Balance sheet items and calculation showing the per cent of sale on each additional rupee which must be financed is computed as under:

From the above, it is quite clear that for every rupee one increase in sales, corresponding assets be increased by Rs. 0.60 which must be financed otherwise. The other two items of liabilities, viz., Accounts Payable and Provisions, will also increase with sales and they must supply Rs. 0.20 of additional funds for each rupee one increase in sales simultaneously.

Now if 20% spontaneously general funds are subtracted from the current assets, the balance left only 40% (i.e., Rs. 0.24 for each rupee one increase in sales) which must be taken either from external sources (long-term debt) or retained earnings (reserves and surplus)

Now the amount of sales is estimated to be increased from Rs. 20,00,000 to Rs. 30,00,000 i.e., an additional Rs. 10,00,000 for which the company requires an additional fund of Rs. 4,00,000 (after applying 40% increase in sales), which may easily be taken from retained earnings.

Now, the impact of additional sales is presented below:

This method is very useful for short-term financial forecasting and not long-term forecasting. This method is also not simple and in actual practice, however, an experience is absolutely needed for its application. Before applying this method one must know the basic relation between assets and affected assets and liabilities of the Balance Sheet and also the technology of the particular firm.

(ii) Scatter Diagram:

We can explain one more method by which one can estimate the financial forecasting in a more logical way, that is, Scatter Diagram and/or Simple Regression Method. We know that Scatter Diagram is a method of graphical representation which requires some practical experience. It is, no doubt, superior than the earlier method, i.e., Per cent of Sales Method, particularly for long-range forecasting financial requirements.

Since sales forecasting is the most significant aspect of financial forecasting, it becomes necessary, particularly for the sales manager, to draw a line (on the basis of past data) which fits the scatter of points, known as the line of best fit. Needless to mention that the said line may either be linear or curved and which is quite different from the earlier method basically.