1. Methods of Forecasting :
Determining Future Need for Additional
Funds
November 20, 2014 Louisville
Irma Miller MBA, CPA
E-mail: info@irmamillercpa.com

2. 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.

3. Method of Forecasting
Process of attempting to estimate a future financing
requirements
Steps:
1. Project the sales revenue and expenses over the
planning period
2. Estimate the levels of investment in current and fixed
assets that are necessary to support the projected
sales (Working Capital and Capital Investment)
3. Determine the financing needs through out the
planning period

4. Method of Forecasting
Spontaneous Financing
• The trade credit and other account payable that arise
spontaneously in the day-to-day operations
• Normally vary directly with the level of sales
• Accounts Payable and Accrued Expenses
Discretionary Financing
• Require explicit decisions on the part of the management
every time funds are raised
• Do not normally vary directly with the level of sales
• Notes Payable, Long Term Debt, Common Stock, Paid
in Capital

5. Method of Forecasting
Percent of Sales Method
The percent of sales method assumes that as sales grow, many
income statement and balance sheet items will grow, remaining the
same percent of sales.
Yr. 1 % of Sales Forecast 10%
Increase
Sales $100,000 100% $ 110,000
COGS $ 75,000 75% $ 82,500
COGS Forecast calculation = 75% x 110% x $ 100,000 = $ 82,500
Percent of Sales Method
The percent of sales method assumes that as sales grow, many
income statement and balance sheet items will grow, remaining the
same percent of sales.
Yr. 1 % of Sales Forecast 10%
Increase
Sales $100,000 100% $ 110,000
COGS $ 75,000 75% $ 82,500
COGS Forecast calculation = 75% x 110% x $ 100,000 = $ 82,500

6. Method of Forecasting
Qualitative (Judgmental) vs. Quantitative
Qualitative (Judgmental)
This approach is based upon opinion and judgment from professionals. This
approach can also be subject to ‘political’ bias. This problem can be
eliminated by using a technique called Delphi. In the Delphi technique,
experts are quizzed independently to give their views about the forecast;
this then reduces the chance of a group bias effect.
Quantitative
This approach is based upon statistical analysis. The analysis is done
typically by looking at past data. Many companies using quantitative
technique will produce forecasts using Microsoft Excel.

7. Method of Forecasting
Naive Forecast
The simplest forecast is known as a naïve forecast. This is where you
simply take the last period’s figures and say that the forecast for the current
period will be the same.
Example: Actual Sales January – March
Month Sales Naïve Forecast
January 900
February 1,200 900
March 1,500 1,200
April (Forecast) 1,500

8. Method of Forecasting
Moving Averages
A moving average forecasts the current period based on the
average of a number of previous periods.
A variation on this is to assign different weights to the previous
periods.
Example: a three-month moving average
Forecast sales for April = ( 900 + 1,200 + 1,500 ) / 3 = 1,200

9. Method of Forecasting
Weighted Moving Averages
A weighted moving average assigns different weights to each period within
the calculation.
Example: a three-month weighted moving average
Month Sales A Weight B A x B
January 900 0.2 180
February 1,200 0.3 360
March 1,500 0.5 750
April (Forecast) 1,290

10. Method of Forecasting
Exponential Smoothing
Exponential Smoothing is a method that looks at how accurate a previous
forecast was against what actually happened. You take the difference and
take a proportion (known as the alpha, which is set between 0 and 1) of this
error and add it to the previous forecast to derive the current forecast.
Example: alpha= 0.3
Month Sales Forecast Difference from
actual
January 900
February 1,200 900 300
March 1,500 900 + (300 x 0.3) = 990 510
April (Forecast) 990 + (510 x 0.3) = 1,143

11. Method of Forecasting
Regression Analysis
Regression analysis uses one variable (the independent variable x)
to predict another (the dependent variable y). In the simplest form
of regression analysis there is a linear or straight line relationship,
described by the simple formula:
y = a + bx
Using a series of data for x and y we can see that there is likely to
be a relation between the two, and calculate the ‘best fit’ to estimate
a (the intercept) and b (the slope).

12. Method of Forecasting
y = a + bx
Apr
Jan
Feb
Mar
0
300
600
900
1200
1500
1800
2100
1 2 3 4
Month
Sales
Sales
Regression Analysis
Example
Month Period
(X)
Sales
(Y)
January 1 900
February 2 1,200
March 3 1,500
April
(Forecast)
4 Forecast =

13. Effective Techniques for Analyzing Data
Horizontal vs. Vertical
Horizontal Analysis looks at amounts on the financial statements
over the past years.
For example: the amount of cash reported on the balance sheet at
December 31 of 2012, 2011, 2009 and 2008 will be expressed as a
percentage of the December 31, 2008. Instead of dollar amounts
you might see 134, 125, 110, 103 and 100 (%).
Horizontal analysis is also referred to as trend analysis.

14. Effective Techniques for Analyzing Data
Horizontal vs. Vertical
Vertical analysis reports each amount on a financial statement as a
percentage of another item.
Vertical analysis of the balance sheet means every amount on the balance
sheet is restated to be a percentage of total assets.
Vertical analysis of an income statement results in every income statement
amount being presented as a percentage of sales.
The vertical analysis allows the comparison of your balance sheet and
income statement to another company’s or to the industry average.

15. Effective Techniques for Analyzing Data
Benchmarking
Benchmarking is the process through which an organization
captures specific data related to its costs and performance, and
then evaluates this cost and performance data against those from
other entities. It can be a critical tool for self-evaluation.
Benchmarking provides useful comparisons on key metrics. In this
way, benchmarking helps leaders define the right improvement
strategy for their organization, by enabling them to identify where
the organization leads, lags or operates at par with other
organizations. In addition, benchmarking provides the basis by
which an organization can articulate key issues, helping to identify
and address the areas that most urgently need improvement.

16. Effective Techniques for Analyzing Data
Comprehensive Benchmarking Tools Kit
• IBA Market Data
• IRS Corporate Ratios
• Pluris DLOM Database
• RMA Annual Statement Studies
• Ibbotson SBBI
• Bizcomps
Source:
NACVA – National Association of Certified Valuation and Analysis

17. Effective Techniques for Analyzing Data
Variance Analysis
Variance analysis is the process of reviewing and explaining the differences
between the original budget and actual performance.
Item Budget ($) Actual ($) Variance ($)
Sales Revenue 12,000 13,000 1,000 Favorable
Rent 2,000 2,500 500 Adverse
Labor 4,000 3,500 500 Favorable
Raw Materials 4,000 4,500 500 Adverse
Profit 2,000 2,500 500 Favorable

18. Effective Techniques for Analyzing Data
Variance Analysis continued …
Variance Analysis has many of the general problems associated
with budgets. The main issues are:
• Comparison are being made against an internally generated target.
• The variances are historical, encouraging a reactive approach.
It would be better to attempt to judge performance against external
measures. Then to try to make the analysis more forward-looking,
predicting problems ahead of time to come up with some early
solutions.

19. The Break Even Point (BEP)
is a point at which cost or expenses and revenue are equal.
BEP in unit Sales:
X = TFC
P-V
where:
TFC is Total Fixed Costs
P is Sale Price per unit
V is Variable Cost per unit

20. The Break Even Point (BEP)
Contribution Margin is the marginal profit per unit.
Contribution Margin
= Sale Price per unit – Variable Cost per unit
= P - V
BEP in Sales ($) = BEP in unit Sales x Sale Price per
unit
= TFC x P
P-V

21. Ratio Analysis
Key Financial Ratios may be classified as:
A. Liquidity Ratios: are measures of a firm’s short term
ability to pay maturing obligations.
B. Activity Ratios: are measures of how effectively an
enterprise is using its assets.
C. Profitability Ratios: are measures of the success or
failure of an enterprise for a given time period.
D. Investor Ratios: are measures that are of interest to
investors.
E. Leverage Ratios : are measures of company’s ability
to meet financial obligation.

22. Ratio Analysis
A. Liquidity Ratios
Working Capital = Current Assets - Current liabilities
Current ratio (working capital ratio) = Current assets
Current liabilities
Acid-test ratio
= Cash equivalents + Marketable securities + Net receivables
Current liabilities
Cash ratio = Cash equivalents + Marketable securities
Current liabilities

23. Ratio Analysis
B. Activity Ratios
Accounts receivable turnover = Net Credit Sales
Average Gross Receivables
Accounts receivable turnover in days
= Average gross receivables
Net credit sales/365
= 365 days / Accounts receivable Turnover
Inventory turnover = Cost of Goods Sold
Average Inventory*
* Average Inventory = (Beginning Inventory + Ending Inventory) / 2

24. Ratio Analysis
B. Activity Ratios (continued)
Inventory turnover in days
= Average inventory
Cost of goods sold/365
= 365 days / Inventory turnover
Operating cycle
= Account receivable turnover in days + Inventory turnover in days
Working capital turnover = Sales
Average working capital
Total asset turnover = Net sales
Average total assets

25. Ratio Analysis
C. Profitability Ratios
Gross Profit Margin = Gross Profit
Net Sales
Operation Profit Margin = EBIT *
Net Sales
*EBIT = Earning Before Interest and Taxes
Net Profit Margin = Net Income
Net Sales

26. Ratio Analysis
D. Investor Ratios
EPS* = Profit available to equity shareholders
number of shares issued
*EPS = Earning Per Share
DPS* = Dividends paid to equity shareholders
number of shares issued
*DPS = Dividends Per Share
P/E Ratio* = Current market share price
EPS
*P/E Ratio = Price Earning Ratio

27. Ratio Analysis
E. Leverage Ratio
Debt / Equity = Total Liabilities
Shareholders Equity
Debt Ratio = Total Liabilities
Total Assets
Time interest earned (TIE) = EBIT
Interest
Cash Flow to Debt Ratio = Operating Cash Flow
Total Debt

28. “Top-Down” or “Bottom-Up” ?
Should forecasts be produced “top-down” or “bottom-up” ?
(“Top-down” means that directives come from the top or board level
whereas “bottom-up” is more driven by departments.)
Top-down budgets are thought of as budgets which are imposed
from senior management within the organization (or the top). This
can feel very prescriptive but the top-down input does not
necessarily need to describe the budget in detail.
According to a study by the Hackett Group in 2011, the most
successful companies tend to start with a strong top-down
approach.

29. “Top-Down” or “Bottom-Up” ?
Continued …
It found that companies which used a predominantly top-down
approach were able to produce their budgets much more quickly.
Top-down budgets tend to start with the organization’s strategy and
objectives.
Top-down forecasts can be produced more quickly but may miss
some vital detail of changes happening within the business, and
ultimately figures need to come from the business not the finance
function.
Bottom-up budgets may be focused on operational detail and thus
become distracted from the bigger picture.
The best compromise may be to develop a co-ordinated forecast
that connects with key information from the business.

30. Three Different Approach of
Building Budgets
The three main recognized approaches to building a
budget are:
– Incremental budgeting
– Zero based budgeting (developed in the 1970s)
– Activity based budgeting (developed in the 1990s)
“According to a study by the Hackett Group in 2008,
73 percent of major companies take more than three
months to produce their budgets. This means the
budget is already three months out of date when the
year starts.”

31. Three Different Approach of
Building Budgets
Incremental Budgeting
Incremental budgeting is the simple approach to building a budget.
You start your budget with what you did last year and amend it for
the budget that you expect for this year.
Organization are often criticized for their rush to spend money at the
end of the year. The main factor driving this rush to utilize budgets
fully is that many managers believe their budget will be cut if they do
not spend them – “use it or lose it” is the message. This is more
likely to be true if the organization operates a system of incremental
budgeting.

32. Three Different Approach of
Building Budgets
Incremental Budgeting continued …
Incremental budget can promote “budget inertia”. This arises when
the budget justified expenditure, and people do not question how the
original budget was built.
Example:
Last year, a training manager spent $100,000 on external training
courses and consultants. This year, staff numbers are up by 10
percent so he puts forward a budget of $110,000. (This is the same
as last year plus an extra 10 percent to account for the extra
personnel.)

33. Three Different Approach of
Building Budgets
Incremental Budgeting continued …
Example continued … :
What he has not considered, is that last year the company was
faced with new legislation and software changes which mean a lot of
extra training was needed. This year there is not the same
requirement because most people are already trained. This year’s
budget should be based on a fully costed training plan that
considers actual needs.

34. Three Different Approach of
Building Budgets
Zero Based Budgeting
Zero based budgeting means starting the budget from
scratch. Every line and every cost has to be rejustified.
Building a budget from scratch means that all costs
should be reviewed and challenged.
A compromise may be to complete budgets on an
incremental basis (as in the previous examples) and
then to periodically review budgets on true zero cost
basis.

35. Three Different Approach of
Building Budgets
Activity Based Budgeting
Activity Based Costing (ABC) was developed and promoted by
Professor Robert Kaplan (of Harvard Business School) in the 1980s.
It is an approach that produces more systematic costings based on
costing activities.
This activity based approach was extended to budgeting in the
1990s (hence activity based budgeting) with budgets being based
on planned activity, which is then converted into a cost based
budget on an activity cost model. Few companies have adopted
activity based costing so only a small minority would have the data
to truly produce their budgets on this basis.

36. Three Different Approach of
Building Budgets
Activity Based Budgeting continued …
Despite the lack of data, the terminology and concepts of activity
based budgeting could still be used to help managers think
differently and promote the idea that budgets are not allocations of
funds but are actually plans for activities that are going to be
performed.
Managers can be encouraged to think about their budgets primarily
in terms of activities.
Alternatively, they could try to identify the activities that could be cut.
In order to cut activities they need to prioritize them and consider
which ones are least likely to affect the delivery of the organization’s
objectives.

37. Three Different Approach of
Building Budgets
Activity Based Budgeting continued …
Managers do not manage costs, they manage activities – cutting
costs means doing less activity or finding cheaper ways of doing the
activity This idea also helps us move away from thinking purely
about cost and inputs towards thinking more about activity,
output and outcomes (i.e. what our spending delivers).
Example:
The advantages of focusing on activities rather than on costs
When times are hard and savings need to be made, it can be very
tempting to slice a percentage off everyone’s budget.

38. Three Different Approach of
Building Budgets
Activity Based Budgeting continued …
Example continued … :
An example may be to say that all budgets will be cut by 5 percent,
or there might be a freeze on recruitment or a freeze on overtime.
All of these savings are arbitrary and while they might be appear to
be “fairer” they do not take into account the best interests of the
organization as a whole.
Cutting one department by 5 percent may affect the whole
organization very badly, whereas cutting another department by 10
percent may have comparatively little impact. Rather than cutting
budgets, organizations should seek savings by cutting activities.

39. Three Different Approach of
Building Budgets
Activity Based Budgeting continued …
Example continued … :
The activities which should be cut are those activities that contribute
the least to the organization’s achievement of its objectives.
If a budget is built based on a plan of prioritized activities it may be
easier to justify and to identify potential savings (should they be
required) by cutting activities.
Extended concept from Activity Based Budgeting:
• Balance Score Card
• Just In Time (JIT) Inventory
• Value Added Activity

40. Forecasting/Budgeting – Other
• Fixed vs. Flexible Budget
• Dynamic vs. Static Budget
• Rolling Forecast
• Beyond Budgeting
• Budgeting in QuickBooks
• Other Forecasting Tool – Host Analytics

41. Resources:
Berk, Jonathan, DeMarzo, Peter, Harford, Jarrad, “Fundamentals of
Corporate Finance”, Second Edition, 2012
Matias, Dr. Anthony J., MBA, CPA, “Budgeting and Forecasting, The
Quick Reference Handbook” 2012
Wyatt, Nigel, “Essential Guide to Budgeting and Forecasting, How to
Deliver Accurate Number” 2012
MacMorran, Jason, “Financial Modeling and Forecasting”
http://www.pncpa.com/admin/files/resources/financial_modeling_and_forecasting.pdf
CIMA, “Planning and Forecasting, Topic Gateway Series No. 17”
http://www.cimaglobal.com/Documents/ImportedDocuments/cig_tg__planning_and__forecasting_jun08.pdf

42. Resources:
Tysiac, Ken, “CPAs have opportunities in financial planning and
forecasting” Journal of Accountancy, August 20, 2014
http://www.journalofaccountancy.com/News/201410783
Waters, Richard, “Kodak’s inability to evolve led to its demise” The
Financial Times, January 20, 2012
http://www.ft.com/cms/s/2/032a15a2-4386-11e1-adda-00144feab49a.html#axzz3Fz8OpPw0
Hart, Alan, “Automated Budgeting, Forecasting and Business
Intelligence in a Manufacturing Environment”, Business Finance,
May 8, 2014
http://businessfinancemag.com/planning-budgeting-reporting/automated-budgeting-forecasting-and-business-intelligence-manufacturing
Wise, Chuck, “Benchmarking: A Critical Element in Finance
Transformation”, Business Finance, February 6, 2012
http://businessfinancemag.com/planning-budgeting-amp-reporting/benchmarking-critical-element-finance-transformation

43. Resources:
Hagel, Jack, “How to Better Connect – and Communicate - Planning,
Forecasting and Budgeting”, CGMA Magazine, February 10, 2014
http://www.cgma.org/magazine/features/pages/20138989.aspx?TestCookiesEnabled=redirect