Financial Statement Forecasting

Financial Statement Forecasting

Financial Statement Forecasting

The financial statement forecasting begins with  the forecasting of the future estimates that are made through preparation of statement like projected income statement, projected balance sheet, projected cash flow and fund flow statements, cash budget, preparation of projected financial statements with the help of ratios etc. Financial statement forecasting is useful in making various financial decisions like capital investment, annual production level, operational efficiency required, requirement of working capital, assessment of cash flow, raising of long term funds, estimation of funds requirement of business, estimated growth in sales etc.

When we forecast the financial statement we forecast the Profit and Loss and Cash Flows. From these financial statements, we get the forecasted Balance Sheet. When we prepare the Profit and Loss, we start from the sales figures. For forecasting the sales figures, we can use the trend analysis or we can use the factor analysis. The trend analysis is created for each product so that we can forecast the sales as per the requirement. In the case of factor analysis, we forecast the factors contributing to the sales of the company’s product. Then we use these factors to predict the sales. Besides the market survey is also carried out to predict the sales. Market surveys are carried out by the internal people as well as by the external people.

After forecasting the sales figure, we shall be forecasting the cost figures. Generally cost figures are segregated in to the following heads:

• Consumption
• Power and fuel
• Salary and wages
• Other manufacturing expenses
• Selling and distribution expenses

Financial Projections

Each of the above head is then segregated into fixed cost and variable cost. Then we project the cost in terms of capacity utilisation of the firm. While making the projections of sales as well cost, we start with the physical projections. In the physical projections we project the physical quantity would be produced or sold (for example in the case of sales projections, we shall be projecting the number of units sold or quantity of units sold). Once the physical projections are made, we shall get the price by multiplying the physical quantity with the price per unit of physical quantity. While projecting the price of the physical quantity, the market trend is to be captured.

While making the projections of sales and cost, we have to project the fixed asset and current assets requirement. The same would be found out from the asset turnover ratio of the company.

For example the firm is operating in an industry where the FA/Sales ratio is 0.5 and the firm is already operating at FA/Sales ratio of 0.48. Now the firm wants to increase the sales from $200 million to $250 million and this has been projected in the sales projections. This would mean that the firm would require at least $24 million addition of fixed asset to maintain the same FA/Sales ratio.

Once we project the fixed asset addition, the funding would also determine the liability i.e. how much would be funded with the help of debt and how much would be equity. Similarly the same projections would be made for Current Asset also. The Current Asset projections is made in terms of holding level (which we have discussed in the Module 1) . These four items i.e. Fixed Asset Addition, Current Asset Addition, Debt Addition and Equity Addition would be put in the cash flow statement.

Now we have to project the liability payment which would be estimated based on the actual repayment schedule as well the projected repayment schedule of the new liability. This liability payment would be made in the cash flow statement.

Now in the P&L statement, the depreciation, interest and taxes are not projected. We can now project the depreciation as we have already projected the fixed asset amount. Once we project the depreciation, now we have to project the interest and taxes.

Before we project the interest, we have to project the average balance of debt and interest rate. For finding out the average amount of debt, we have already calculated the repayment schedule in the cash flow. So from these we calculate the interest amount by multiplying the average balance with the interest rate. The interest rate is projected based on the Macro Economic expectation of the market. Once we project the interest rate the taxes are projected by way of multiplying the tax rate with the Profit Before Tax amount. Once we get the profit after tax we can transfer this to the cash flows and also to the reserves in the balance sheet.

Now the balance sheet is tallied. The entire sequence is shown in the form of a flow chart: Some of the important techniques that are employed in financial forecasting are as follows:

Step 1: Projections of quantity of sales and then price per unit and then sales amount.

Step 2: Projections of quantity of input factors and then price per unit and then cost amount.

Step 3: Actual FA/Sales ratio and then determining the Fixed Asset (FA) requirement . Incorporating the same in the cash flow.

Step 4: Project the holding level of appropriate expenses and then arrive at the current asset level by multiplying expenses with the holding level. This would also be incorporated in the cash flow.

Step 5: Project the level of debt and equity in the cash flow by taking into consideration the repayment commitment.

Step 6: Calculate Depreciation in P&L ; Project Interest in P&L and Project Tax in P&L.

Step 7 : Now transfer the Retained Profit from Step 5 and Depreciation from Step 5 to cash flow.

Step 8 : Cash and bank balance amount from cash flow would be carried to Balance sheet.

Step 9 : Balance sheet is tallied without any changes .

Also read: Techniques of financial statement forecasting