Using Financial Forecasts to Advise Business - Financial Forecasting 101 - Revised

Financial Forecasting 101:
Become a Key Player in Strategic
Business Decisions
November 20, 2014 Louisville
Irma Miller MBA, CPA
E-mail: info@irmamillercpa.com

Disclaimer
• The views expressed in this presentation are my own
and not necessarily those of the Kentucky Society of
Certified Public Accountants, the American Institute
Certified Public Accountants and the Internal Revenue
Service.
• The information is not a substitute for consultation with
an expert and the creator is not liable for problems
arising from following the advice on the site.
• The laws and regulations are subject to change over
time and recent changes after the date of this
representation may not be reflected on this presentation
• We do not necessarily endorse any companies’ names
that we may mention on the case studies. We may not
disclose the real name on the case studies.

Real Life Example of Successful
Forecasting and the Positive Results
ABC Company – a small professional service, husband
and wife shareholders with 10-15 part-time and full-time
employees - has a first year of being an S-Corporation
and running payroll for their employees from self-
employed in Schedule C Form 1040. The CPA firm in
charge with ABC Company has been working on
communicating and informing the importance of
separating personal and business expenses, having a
separate business bank account and having an
understanding in calculating employer and employee
portion of payroll tax withholding.

Real Life Example of Successful
Forecasting and the Positive Results
The CPA Firm explains that there are 3 reports for ABC
Company that should not include any personal expenses
and shareholder personal transactions to accurately
show company financial performances and for planning,
budgeting and forecasting :
• Balance Sheet
• Profit and Loss
• Cash Flow Statement
The CPA Firm explains to the ABC Company to be
aware of the existence of the “hidden” employer portion
of payroll tax liabilities to all employees for better
planning the cash flow availability when the payroll tax is
due.

Real Life Example of Poor Forecasting and
the Negative Results
XYZ retail company has grown its business activities and
decided to expand their accounting software by using
several third party integrations.
QuickBooks is the accounting software that is used.
They decide to use Bill.com for extended Accounts
Payable and Accounts Receivable, TSheets for the
employee time sheets and Fishbowl for the inventory.
The management decision making depends on the
cumulative report from QuickBooks after all the
information from all the third party integration is properly
synced to QuickBooks.

Real Life Example of Poor Forecasting and
the Negative Results
SYNC SYNC
S
Y
N
C

Conventional/Traditional Business Model
Business
ABC Company
Accounting
A/R A/P
Finance
Human
Resources
Payroll
Legal
Sales
Marketing
Advertising
Warehouse
Manufacturing
Operations

Growing Small Business Model
A
Small Biz
B
Small Biz
C
Small Biz
Accounting
A/R A/P
Finance
Human
Resources
Payroll
Legal
Business
Consultant
Warehouse
Manufacturing
Sales
Marketing
Advertising

Planning, Budgeting and Forecasting:
How They’re Related and How They’re Different
Planning:
Planning is the act or process of making or carrying out plans; specifically : the
establishment of goals, policies, and procedures for a social or economic unit.
Merriam-Webster Dictionary
Planning is usually interpreted as a process to develop a strategy to achieve desired
objectives, to solve problems, and to facilitate action.
Mitchell 2002, 6
Short-term planning – 3 months, 1-year
Long-term planning – 3-5 years

Budgeting:
The budget is the bane of corporate America. It never should have existed. But the
budgeting process at most companies has to be the most ineffective practice in
management. It sucks the energy, time, fun and big dreams out of an organization …
And yet … companies sink countless hours into writing budgets. What a waste.
Jack Welch, former CEO General Electric
Budget is a quantitative plan for acquiring and using resources over a specific time
period. Budgets are thus used for two distinct purposes: planning – which involves
developing goals and resources to achieve them; and control – a process
implemented by management, in order to ensure that goals are attained.
Nigel Wyatt

Budgeting:
The completed budget, also called the Master Budget,
is composed of separate but interdependent elements
that are essential for the creation of a successful budget:
• Income forecasting (sales budget)
• Expense budget
• Cash flow projections (cash budget)

Role of Budgeting:
1. Meeting the
organization’s objectives
2. Planning
3. Monitoring and
controlling
4. Co-ordinating
5. Evaluating performance
6. Improving performance
7. Motivating managers
8. A management contract
9. Communicating
10.Providing basis for
authorizing expenditure
and delegating
responsibility
11.Identifying scarce
resources
12.Allocating resources
13.Demonstrating and
delivering good
corporate governance

Forecasting:
Forecasting – presents an entity’s expected financial
position, results of operations, and cash flows, based on
responsible party’s assumptions reflecting conditions it
expects to exist and actions it expects to take.
Forecasting – the prediction of outcomes, trends, or
expected future behavior of a business, industry sector,
or the economy through the use of statistics. Forecasting
is an operational research technique used as a basis for
management planning and decision making.

Tips for Explaining Forecasting to Non-Financial
Management Executives
Uses of Forecasting
• Financing (debt or
equity)
• Buy vs. Lease
• Valuation
• Business Plans
• Strategic Plans
• Expansion
• Merger/Acquisition
• Lost Profits
• Business Interruption
• Litigation Support
• Start-Ups

Tips for Explaining Forecasting to Non-
Financial Management Executives
The forecasts may be for sales, profit or cash. Profit and cash forecasts
require us to model the income statement (or profit and loss account); the
cash flow requires us to model the cash flow statement. The third primary
financial statement is balance sheet.
Factors to consider in Sales Forecasting:
• New product sales volumes are very difficult to forecast. New products in
many industries tend to have a very high failure rate (Apple, Google)
• Short term: competitor action: supply shortages: commodity prices change
• Longer term: product life-cycle; competitor action; substitutes; changing
technological (Kodak), economic and social environments (global
international, internet and social networking changes consumer shopping
habits and attitudes ); supply shortages

Other budgeting tips:
• Purchase Budgeting: Cheaper is not always better. What is the
relationship between Cost, Value, Cash and Risk? Our purchase
should not be based on the cheapest option, but the “best value for
money” option: the option that gives us the most for our money. To
define what good “value for money” is we not only need to know the
costs, we also need to be able to make a judgment about the value
of what we are purchasing. We should make our choices based on
what meets our needs most cost effectively.
• External firm accountants (outsource, yearly engagement) vs. ‘in-
house’ accountants (full-time position)
• Difference in cash vs. profits (accrual based). Income is recorded as
it is earned. Costs are recorded when benefits of the costs are
received.

Other budgeting tips: Continued …
• Profit is a measure of performance and in many “for-profit”
organizations it is the only measure of performance. Profits are
accounted for on an accrual basis; this means there will be a “time”
difference between the budget for profit and the budget for cash. It
also means that a business can be profitable and run out of cash (or
go bankrupt) and yet a loss-making business can still generate cash
and stay in business.
• To give a better picture of performance and maintain an accrual
basis rather than cash, the quarterly or yearly payment of expenses
should be prorated on the month or period it belongs to (seasonal,
business cycle) such as: rent, insurance.

Other budgeting tips: Continued …
• Capital Expenditure vs. Revenue Expenditure. Capital Expenditure
is capitalized in the Balance Sheet financial statement and written
off over its useful life (usually more than a year). For example: fixed
asset. This cost is not charged directly to Profit and Loss financial
statement. Revenue expenditures are charged directly to the
branches Profit and Loss financial statement.
• Working capital is made up of debtors (Accounts Receivable), stock
(Inventory) and creditors (Accounts Payable). Stock or Inventory is
made up of raw materials, work in process (partially finished goods)
and finished goods.

Estimating the Accuracy of the Forecast
Improving forecasting can have a big impact on improving
efficiency and effectiveness. To improve our forecasting we need
to start by measuring the accuracy of forecasts. Improving the
accuracy of a forecast will also improve forecasting confidence.
Forecasts are our best estimate of the future.
Measuring and Improving Forecasts Accuracy
Two simple numerical measures of forecast accuracy are:
1. Mean squared error (MSE). The MSE is the average of the
square of the ‘errors’ (the difference between the forecast and
actual result) – the lower the MSE figure the better.
Continued …

Measuring and Improving Forecasts Accuracy continued …
2. Mean absolute percentage error (MAPE). The MAPE is the
average of percentage ‘absolute’ differences between the
forecast and the actual result:
• The absolute figures are the differences between actual and
forecast – but making all the negative figures positive.
• These differences are then expressed as a percentage of the
‘actual’ figure for each period.
• The percentages for each period are then ‘averaged’.
Generally the lower the MAPE the better the forecast
Continued …

Example: Calculation of MSE and MAPE
Monthly forecast vs. actual sales (expressed in units)
Period Forecast Actual Error Error
squared
Absolute
error
Absolute
percentage
error
1 100 110 (10) 100.0 10 9.09%
2 110 121 (11) 121.0 11 9.09%
3 121 112 9 81.0 9 8.04%
4 112 115 (3) 9.0 3 2.61%
5 115 116 (1) 1.0 1 0.86%
6 116 118 (2) 4.0 2 1.69%
Sum 316.0 31.38%
MSE MAPE
Average 52.7 5.23%

Cost vs. Benefit
The first step in decision making is to identify the costs and benefits
of a decision.
Any decision in which the value of the benefits exceeds the costs
will increase the value of the business. To evaluate the costs and
benefits of a decision, we must value the options in the same terms
– cash today.
Simple example:
Suppose a jewelry manufacturer has the opportunity to trade 200
ounces of silver for 10 ounces of gold today. Continued …

Simple example continued …
An ounce of silver differs in value from an ounce of gold.
Consequently, it is incorrect to compare 200 ounces to 10 ounces
and conclude that the larger quantity is better. Instead, to compare
the cost of silver and the benefit of the gold, we first need to quantify
their values in equivalent terms – cash today.
Consider the silver. What is its cash value today ? Suppose silver
can be bought and sold for a current market price of $10 per ounce.
Then the 200 ounces of silver we would give up has a cash value of:
(200 ounces of silver) x ($10/ounce of silver = $2,000
If the current market price for gold is $500 per ounce,
the 10 ounces of gold we would receive has a cash

Simple example continued …
value of:
(10 ounces of gold) X ($500/ounce of gold) = $5,000
We have now quantified the decision. The jeweler’s opportunity has
a benefit of $5,000 and a cost of $2,000. The net benefit of the
decision is $5,000 - $2,000 = $3,000 today. The net value of the
decision is positive, so by accepting the trade, the jewelry firm will
be richer by $3,000.
Berk, Jonathan, DeMarzo, Peter, Harford, Jarrad, “Fundamentals of Corporate Finance”, Second Edition, 2012 p 64-
65.
Extended concept for cash today:
– Market Prices
– The Valuation Principles
– The Time Value of Money (NPV, DCF, IRR)

Considering Timelines
Timeline: a linear representation of the timing of the expected cash
flows.
Timelines are an important first step in organizing and then solving a
financial problem.
Constructing a time line:
Assume a friend owes you money. He has agreed to repay the loan
by making two payments of $10,000 at the end of each of the next
two years.

Continued …
Year 1 Year 2
0 1 2Date
Cash Flow $0 $10,000 $10,000
Today End Year 1 Begin Year 2

Continued …
Distinguishing Cash Inflows from Outflows
Inflows (cash flows received) are positive cash flows, whereas
outflows (cash flow paid out) are negative cash flows.
To illustrate, suppose you have agreed to lend your brother $10,000
today. Your brother has agreed to repay this loan with interest by
making payments of $6,000 at the end of the next two years.

Considering Timelines continued …
Notice that the first cash flow at date 0 (today) is represented as -
$10,000 because it is an outflow. The subsequent cash flows of
$6,000 are positive because they are inflows.
Year 1 Year 2
0 1 2Date
Cash Flow -$10,000 $6,000 $6,000

Simplifying Assumptions: Their Critical Role
in Financial Forecasting
80/20 Rule
80% of the dollar amount of the budget is made up of just 20% of
the budget lines/items or accounts. (The budget lines/items are the
cost or income or headings in the budget)
Managing these large budget lines carefully will normally have the
biggest impact overall.
Managers often make the mistake of focusing on costs where they
feel they have the most discretion.
We may have lots of choice and a lot of chances to reduce
expenditure on stationery but normally it is not meant to have much
impact on our overall performance.

In many departments, the largest budget is the payroll cost. Often
people imagine they have no control over these costs and that they
may as well ignore them. If most of your cost in your budget is
payroll, this means that most of your time should be spent making
sure that you get the most out of your staff. An hour of time spent on
cost control on a petty cost may be better spent on managing your
staff and getting them to deliver more.
Labor is not always the main cost. A European manager in a
Chinese factory was surprised at the high level of staff employed to
inspects for defects. He wanted to reduce the headcount, but the
savings in staff costs were relatively low in comparison to the
savings on materials from quality improvement. In many Chinese
businesses, even with rising pay rates, material is the key cost to
control.

Sensitivity Analysis
Sensitivity analysis breaks the Net Present Value (NPV) Calculation
into its component assumptions and shows how the NPV varies as
the underlying assumptions change.
By conducting a sensitivity analysis, we learn which assumptions
are the most important; we can then invest further resources and
effort to refine these assumptions.
Example:
The Linksys’s managers believe that the HomeNet project has risk
similar to its existing projects. There is likely to be significant
uncertainty. In addition to the base case assumptions, Linksys’s
managers would also identify best and worst case scenario for
each.

Sensitivity Analysis
Continued …
Initial
Assumption
Worst
Case
Best
Case
Parameter
Units Sold (thousands) 50 35 65
Sale Price ($/unit) 260 240 280
Cost of Goods ($/unit) 110 120 100
NWC ($ thousands) 1125 1525 725
Cost of Capital 12% 15% 10%
NPV ( $ millions) 2.862 -1.13 6.85

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