Session 3

Financial Forecasting

Financial forecasts are prepared to provide the management team with a guide for

making their managerial decisions. Forecasting is essentially a pro-active exercise. It is

done in order to increase the chances of success by preparing way ahead for the impact of

anticipated events, whether these impacts are positive or negative. As the management

team probes the future, trying to discern what may be in store for the organization and

what they intend to do about it, they will also need to know what the possible results will

be of the actions that they intend to take. This iterative review process enables the

management team to improve the plan and implement with confidence. As the plan is

prepared, reviewed and implemented it goes through the organizational elements that are

key to its preparation, review and implementation and as this process goes on these

various elements communicate with each other. Consequently, relationships are cemented

and strengthened.

Financial forecasting techniques fall under three classifications: subjective or

judgmental, trend or time series, and correlation or causal relationship.

Subjective or judgmental forecasting pertains to predicting values based on the

personal evaluation and experience of the manager. It is a method of forecasting that

uses the forecaster’s opinion of the condition and the capability of the company based

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed
approval of the author

on his perceptions of the external and internal operating conditions he faces.

There is a tendency by some to belittle the forecasts that are arrived at using the

judgmental approach, mainly because of its perceived lack of quantitative, therefore,

scientific basis. This is not quite a fair assessment of the usefulness of this methodology

and not truly reflective of actual practice. In reality, a lot of practitioners rely on

judgmental forecasts because it brings into the decision process the manager's awareness

of operating conditions that he has assimilated while doing his job. A judgmental forecast

is almost always accompanied by the manager's commitment to attain a corporate

objective that is anchored on his own forecast. Thus, attaining buy-in of operating people

to corporate goals is facilitated. Of course, it does have its downside. A glaring

shortcoming would be the “agency problem”issue whereby the operating manager, aware

that the corporate goal will be based on his judgmental estimate, deliberately forecasts a

low target that is easily attainable in order to look good with minimal effort on his part,

but, in which case, the stockholders' interests are not fully promoted. To correct this,

some companies use systemic solutions by aligning the rewards and compensation

system with forecasting accuracy, such as providing incentives for forecasting accuracy

and penalties for unexplained forecasting inaccuracies. Others give their managers stock

options so that, as stockholders, they can better identify their personal interests with that

of the company.

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

Trend forecasting involves making predictions based on patterns derived from

past data such as seasonal and cyclical cycles as well as growth trends. There are three

forecasting methods popularly associated with trend forecasting: prior year as indicator,

simple or compound growth rates and time-series regression.

The prior year as an indicator is a popular choice in cases where the analyst is at a

loss as to how to predict the future. This is why it is referred to as the default method. For

example, if a variable, say, sales, can go either way, the best choice as the basis for

making a prediction of the next period is the actual result of the current period. Hence,

the actual result of the current period is the forecast for the next period. Some analysts

take the percent change of the current period over the immediately preceding period and

use this as a multiplier to forecast the next period.

Illustration:

Actual sales of the current period, Year 14 = P532 million

Forecast for Year 15 = P532 million

Or,

Actual sales of the immediately preceding period, Year 13 = P525 million

Percent change, Year 13 to Year 14 = 1.3%

Forecast for Year 15 = 532 * 1.013 = P539 million

The simple growth rate is arrived at by calculating the average percentage change

of the variable between the current period and the base period by dividing the percentage

over the number of periods. This becomes the multiplier applied against the current

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

period to arrive at the forecast for the next period.

. Illustration:

Actual sales of the base period, Year 1 = P53 million

Actual sales of the current period, Year 15 = P532 million

Percent change, Year 1 to Year 14 = (532-53)/53 = 903.8%

Average percent change, Year 1 to 14 = 903.8/14 = 64.6%

Forecast for Year 15 = 532*1.646 = P875 million

The compound growth rate is calculated by solving for the rate of change which,

when applied to the base period as many times as the periods, results in the current value

of the variable. Mathematically, this is the (n-l)th root of the ratio of the value of the

current period over the base period, less one. This becomes the multiplier applied against

the current period to arrive at the forecast for the next period.

Illustration:

Actual sales of the base period, Year 1 = P 53 million

Actual sales of the current period, Year 14 = P532 million

Compound growth rate, Year 1 to Year 14 = (532/53)1/13-1 = 19.40/6

Forecast for Year 15 = 532 * 1.194 = P635 million

The time-series regression forecast is based on the equation of the regression line,

the line that displays the best goodness-of-fit with the actual data on the variable (also

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

known as the b.l.u.e. line, acronym for “best linear unbiased estimate”). This is

represented by the equation, y = a+bx. Doing the time-series regression forecast by hand

is a rather tedious exercise. However, built-in programs in most scientific calculators and

personal computers can now greatly facilitate the process.

The limitation inherent in trend forecasting is the assumption that the conditions

affecting the variable are stable. This, of course, is not quite a sound assumption in many

cases. Sales, for example, may be influenced to a significant extent by dynamic

environmental forces such as changing economic conditions. Correlation or causal

relationship forecasting seeks to remedy this shortcoming by basing the forecast on the

relationship of two variables. There are two correlation forecast techniques that are

popular: ratio technique and regression analysis. The ratio technique assumes a

relationship between two variables based on observed historical experience or by

management policy. For example, if the Cost of Goods Sold of ABC Company has

historically been 53.5% of Sales and management feels that a 55% Cost-as-a-%-of-Sales

target for next year is realistic, then the Cost of Goods Sold for next year will be

forecasted as 55% of whatever is the sales target for next year. Regression analysis works

in the same manner as the time-series regression estimate discussed earlier, the only

difference being that some other variable substitutes for time as the independent variable.

For example, if the company’s historical experience shows that the sales-inventory

regression line is defined by the equation Inventory = 11.2M + .134 Sales, then the

company’s projection for inventory next ,year will simply be what comes out from the
________________________________________________________________________

This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

application of the regression formula to the sales projection.

Financial projections, which, for all intents and purposes, really embody the

financial plans of the company, are articulated in the projected financial statements. The

three basic statements usually compose the “heart” of the financial plan package. These

are the Projected Income Statement, the Projected Balance Sheet and the Cash Flow

Forecast. The Projected Income Statement shows the company’s profitability

expectations; the Projected Balance Sheet indicates the planned levels of asset and the

corresponding financing; while the Cash Flow Forecast summarizes the planned cash

receipts and disbursements. The manner of preparing the projected financial statements is

done systematically by projecting each account one at a time. Commonly, the first

projected financial statement to be prepared is the Projected Income Statement and the

first account to be projected is usually Sales. This becomes the starting point. Next would

be the projections for cost, expense and the tax accounts. To illustrate, let us try to go

through the Projected Financial Statement of ABC Company (on page 5 of your handout

for Session 2). The company has determined that Sales is going to increase by +50% over

this year because the new factory, reflected as Construction-in-Progress in the Balance

Sheet this year (refer to the Balance Sheet on page 6) is expected to be already on-stream,

i.e., fully operational, by next year. Thus, since Sales this year (19X2) is P 530M, sales

next year (19X3) is expected to be (530)(1.5) = P 195M. The Cost of Goods Sold

excluding depreciation next year is expected to be 55% of Sales. Since Sales is projected
to be P 195M, 55% of this or P 437M, is going to be Cost of Goods Sold excluding

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

depreciation of next year. Note that our depreciation rate is P 127M per year without the

new factory (refer to page 14 of your handout on Session 1). The new factory will be

depreciated over 10 years. Since it has a book value of P 680M, the equivalent annual

depreciation is then P 68M. Hence, our total projected Cost of Goods Sold is P 437M plus

the depreciation of the old machineries of P 121M plus the depreciation of the new

factory of P 68M for a total of P 632M. Deducting projected Cost of Goods Sold from

projected Sales results in the projected Gross Profit of P 163M. Selling and General

Expenses are expected to increase by 5% next year over this year. Since S&G expenses

this year is P 32M, 105% of this, or P 34M, is the projected S&G expense next year.

Deducting projected S&G expenses from projected Gross Profit results in a projected

Operating Profit of P 129M. The company does not intend to incur additional borrowings

next year, thus, interest expense is expected to stay at the same level. Deducting interest

expense from projected Operating Profit results in Profit Before Income Tax. Since the

tax rate assumed is 35%, then the projected Income Tax is calculated as 35% of the

projected Profit Before Tax of P 12M or P 25M. Deducting projected Income Tax from

projected Profit Before Tax results in the projected Net Income of P 47M.

Preparing the Projected Income Statement is pretty much straightforward and

intuitively understandable. Preparing the Projected Balance Sheet is a little more

challenging. However, the process is the same. In preparing the Projected Balance Sheet,

we also do it systematically by forecasting the balances of the various accounts one at a

time. We are advised to project the asset accounts first. Next, we project the liability

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approval of the author

accounts except the Bank Loans. Then, we project the equity accounts, taking into

consideration the projected Net Income and planned dividend declarations, if any. Finally,

we deduct the sum of projected liabilities and equity from the sum of projected assets. If

the result is positive, the differential becomes the projected Bank Loan. If the result is

negative, the differential becomes the projected investment in Marketable Securities. In

this manner, we are able to satisfy the accounting equality of Assets = the sum of

Liabilities and Equity.

As in the Projected Income Statement, we shall try to illustrate this by going

through the Projected Balance Sheet of ABC Company as shown in page 5 of your

handout.

The first account to be projected is the cash account. Ideally, the projected cash

balance should be consistent with the target cash level of the company. In our example,

the company has set a target cash level equivalent to two months worth of purchase

requirements plus S&G expenses and Interest. Since most purchases will eventually find

themselves in costs of production, to simplify the calculation, we will make use of the

projected non-depreciation component of Cost of Goods Sold as the surrogate for

purchases. Thus, the total base for the cash level target is P 528M; made up of P 437M for

Purchases, (this is the non-depreciation component of Cost of Goods Sold), P 34M for

S&G expense, and P 57M for interest. 1/6 of P 528M (2 months worth) is P 88M. This is

the projected Cash Balance.

 The company is targeting a 50-day collection period. Based on this and the sales

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

projection of P 195M, the company can expect an Accounts Receivable balance of P

110M by the end of the next year.

Similarly, Inventory in Days is targeted to be 75 days worth by the end of the

year. Based on this and the projected Cost of Goods Sold of P 632 M, the company

expects to have Inventories worth P 132~ by the end of the year.

There are no changes expected in the Prepaid Expense accounts so the Prepaid

Expense balance of P 20M as of year-end is projected to be the same balance for next

year. The same is true for Investment in Other Companies.

There are no other capital asset acquisitions planned. Thus, the Property, Plant and

Equipment account of 781M is simply made up of the account's beginning balance (P

296M) plus the amount converted from the Construction-in-Progress account (P680M)

less 1he depreciation charges forecasted for 1he year, made up of depreciation due to the

old capital assets (P 127M) and the depreciation due to the new factory (P 68M).

The sum total of all the projected asset accounts is P1, 158M.

The company targets to keep its payables at the equivalent of 50 days purchase,

approximately the same as its collection period. This enables it to match the level of a

current asset account with that of a corresponding current liability account. Since its

purchases is estimated to be P 437M (the non-depreciation component of the Cost of

Goods Sold account), then the equivalent Accounts Payable balance would be P 61M by

the end of the year. Since income tax is paid quarterly, we can expect the company to
have 25% of its income taxes still remaining in payables by the end of the year. The

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This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author

estimated income tax for the next year is P 25M. 25% of this (about P 6M) is the

projected Income Tax Payable. The current portion of 1he long-term debt, Capital Stock

and Capital in Excess of Par win remain the same. However, Long-Term Debt win be

reduced by P 20M due to the amount transferred to the current portion (P 20M). Retained

Earnings will increase by P 47M, the amount of the Net Income projected for the year,

thus a projected ending balance of P 13~. The sum total of the liabilities and the equity

accounts is P 1,148M. Deducting the total liabilities and equity of P 1,148M from the

total assets of P 1,158M results in appositive P 10M. This means that financing will have

a shortfall of P 10M which the company is expected to meet via a Bank Loan of the same

amount. Reflecting the amount of the projected Bank Loan in the Projected Balance

Sheet completes the final version of this projected statement.

The Cash Flow Forecast is easy to do once the first two projected statements, the

Projected Income Statement and the Projected Balance Sheet, are done. The first step

towards the preparation of a Cash Flow Forecast is to calculate the changes in the balance

sheet accounts between this year and nest year. Then, these changes are analyzed:

increases in liabilities and equity and decreases in assets are sources of cash. Converse]y,

decreases in liabilities and equity and increases in assets are uses of cash. The difference

between total Sources and total Uses results in the Net Cash Flow which is articulated in

the projected Balance Sheet as a change in the Cash balance. Adding the Net Cash Flow

to the Cash balance of the current year results in the Cash Balance projected for next
year.

________________________________________________________________________

This paper is the personal property of Prof. Mike Soledad of Davao Doctors College and may not be reproduced without the expressed

approval of the author