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Using Financial Forecasts to Advise Business - Method of Forecasting - Revised

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Using Financial Forecasts to Advise Business - Method of Forecasting - Revised

  1. 1. Methods of Forecasting : Determining Future Need for Additional Funds November 20, 2014 Louisville Irma Miller MBA, CPA E-mail: info@irmamillercpa.com
  2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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 ($) Sales Revenue 12,000 13,000 1,000 Favorable Rent 2,000 2,500 500 Adverse Labor 4,000 3,500 500 Favorable Raw Materials 4,000 4,500 500 Adverse Profit 2,000 2,500 500 Favorable
  18. 18. Effective Techniques for Analyzing Data Variance Analysis continued … Variance Analysis has many of the general problems associated with budgets. The main issues are: • Comparison are being made against an internally generated target. • The variances are historical, encouraging a reactive approach. It would be better to attempt to judge performance against external measures. Then to try to make the analysis more forward-looking, predicting problems ahead of time to come up with some early solutions.
  19. 19. The Break Even Point (BEP) is a point at which cost or expenses and revenue are equal. BEP in unit Sales: X = TFC P-V where: TFC is Total Fixed Costs P is Sale Price per unit V is Variable Cost per unit
  20. 20. The Break Even Point (BEP) Contribution Margin is the marginal profit per unit. Contribution Margin = Sale Price per unit – Variable Cost per unit = P - V BEP in Sales ($) = BEP in unit Sales x Sale Price per unit = TFC x P P-V
  21. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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

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