Financial Planning

Learning Objectives:

At the end of the chapter, the learners are expected to:

1. Explain the basic concepts on financial forecasting.
2. Determine the different users of financial forecasting..
3. Differentiate the different approaches of forecasting.
4. Use the different techniques in their forecasting.

Financial Forecasting

Everyone doing business dreams to be somebody in the future such as the lead
distributor of product X for example. However, we cannot just attain the dream without
doing something. One has to exert efforts and should be guided with its VGMO and be
forward looking. . One of the greatest challenges facing owners and managers is how
to improve profitability and generate growth. A crucial business process for meeting
such challenge is financial forecasting.

Financial forecasting is an essential part of business planning that uses past

financial performance and current conditions or trends to predict future company
performance. In short, financial forecasts are tools by which businesses can set and
meet goals. It is the starting point of business planning, making it as one of the most
important functions to be applied in business. Forecasting is the projection of future
sales, revenues, earnings, costs and other possible variables that are helpful in the
firm’s operation. It is the basis for budgeting activities and estimating future financing
needs. Financial forecasts begin with forecasting sales and their related expenses.

Users of Forecast

Forecast can be used by individuals within and outside the company for various
reasons or purposes. Some of the are as follows;

1. Top Management
Forecast is used as a tool for long-range planning. It serves as basis for
making targets and implementing long range strategic decisions and making
capital budgeting decisions.

2. Production Manager
Makes use of forecast to determine the amount of raw materials that will
be needed in the production, the budget, schedule of production activities,
inventory levels to maintain to avoid disruption in the production process, labor
hours, and the schedule of shipments.
 3. Purchasing Manager
Makes use of the forecast to ascertain the volume of materials that should
be purchased for a certain period.

4. Marketing Manager
The forecast is used to estimate how much sales should be made for a
particular period and to plan promotional and advertising activities for the
products.

5. Finance Manager
He makes use of the forecast to anticipate the funding requirements of the
firm. He must establish the firm’s cash inflows and outflow, and indicate the
exact moment when the firm will be needing additional funding.
6. Human resource Manager
He utilizes the forecast to supply the human resources needed in
achieving the firm’s objectives.

7. Colleges and Universities

It utilizes the forecast to identify possible enrollees in a school year. The
figures on hand can help determine the revenues to be obtained from the tuition
fees, the faculty to be hired, planning of room assignments, and building of
facilities.

Approaches in Forecasting

In general, there are two approaches in forecasting namely (1) qualitative and
quantitative. (Shim et. al, 2006)

Qualitative Forecasts

These types of forecasting methods are based on judgments, opinions, intuition,

emotions, or personal experiences and are subjective in nature. They do not rely on any
rigorous mathematical computations. In practice, the combination of both qualitative
and quantitative methods is usually the most effective.

Methods of Qualitative Forecasting

1. Expert opinion
The views of the managers or a group with a high level of expertise, often
in combination with statistical models, are synthesized to generate a consensual
forecast. The forecasting method is simple and easy to implement. The opinion
of the experts become the basis of forecasting, thus no statistical tools being
employed.

2. Delphi Method
 This is similar to the expert opinion, as it is also done by a group of
experts. However, under this method, members are asked individually through a
questionnaire about their forecast of future events.
The participants in this method are the decision-makers, staff assistants,
and respondents where the decision-makers usually consist of experts who make
the actual forecast. Staff assistants aid decision-makers by preparing,
distributing and collecting the questionnaire, and analyzing and summarizing the
survey results. The respondents are people from different places who provide
inputs to the decision-makers before the forecast is made.

3. Sales Force Polling

The sales force is used by companies to arrive at their sales forecast. The
sales people having direct contact with the consumers, envision the condition of
the future market. Under this approach, every sales person estimates the sale in
his region or territory. The forecasts are then reviewed to ensure that the data
are realistic. Then they are combined at the district or national levels to arrive at
a general forecasts.

4. Consumer Market Survey

Firms conduct their own consumer or potential consumer surveys to
accumulate information regarding future purchasing plans. Surveys may be
conducted through telephones, inquiries, questionnaires and interviews. Surveys
can help not only in preparing a forecast but also in improving product design,
planning for new products, and determining consumer behavior.

In summary, a table is presented.

ll. Quantitative Forecasts

 These types of forecasting methods are based on mathematical (quantitative)
models, and are objective in nature. They rely heavily on mathematical computations.
Illustrations:

1. Naïve Method

Compute for the demand forecast for year 6.

Year Actual demand Forecast Note

1 350 - No data to use
2 380 350 Uses last period’s actual
3 400 380 Value as forecast
4 425 400
5 500 425
6 ?
(answer 500)

2. Simple Moving Average Method

 Simple moving average method: The forecast for next period (period t+1)
will be equal to the average of a specified number of the most recent observations,
with each observation receiving the same emphasis (weight).

In this illustration we assume that a 2-year simple moving average is being used. We
will also assume that, in the absence of data at startup, we made a guess for the year 1
forecast (300). Then, after year 1 elapsed, we made a forecast for year 2 using a naïve
method (310). Beyond that point we had sufficient data to let our 2-year simple moving
average forecasts unfold throughout the years.

Year Actual demand Forecast Note/solutions

1 310
2 365
3 395
300 Guess forecast at the beginning
310 Forecast for year 2 – Naïve
Method was used
337.50 From this point forward, these
forecasts were made on a year-
by-year basis using a 2-yr moving
average approach (310 + 365 =
675/2)

4 415 380 395 + 365 = 760/2

5 450 405 415 +395 = 810/2
6 465 432.50 450 + 415 = 865/2
7 457.50 465 + 450 = 915/2

3. Weighted Moving Average Method

Weighted moving average method: The forecast for next period (period
t+1) will be equal to a weighted average of a specified number of the most recent
observations.
In this illustration we assume that a 3-year weighted moving average is
being used. We will also assume that, in the absence of data at startup, we made
a guess for the year 1 forecast (300). Then, after year 1 elapsed, we used a
naïve method to make a forecast for year 2 (310) and year 3 (365). Beyond that
point we had sufficient data to let our 3-year weighted moving average forecasts
unfold throughout the years. The weights that were to be used are as follows:
Most recent year, .5; year prior to that, .3; year prior to that, .2.

Year Actual Forecast Note/solutions

demand
1 310 300 Guess forecast at the beginning
2 365 310 Forecast for year 2 – Naïve Method was
used
3 395 365 This forecast was made using a naïve
 approach.

4 415 369 From this point forward, these forecasts

were made on a year-by-year basis
using a 3-yr weighted. moving average
approach .
(395 x.5 + 365 x.3 + 310 x.2)

5 450 399 (415 x .50 + 395 x .3 + 365 x .2)

6 465 428.50 (450 x .5 + 415 x .3 + 395 x .2)
7 450.50 (465 x .5 + 450 x .3 + 415 x .2)

4. Trend Projections

Trend projection method: This method is a version of the linear

regression technique. It attempts to draw a straight line through the historical
data points in a fashion that comes as close to the points as possible.
(Technically, the approach attempts to reduce the vertical deviations of the points
from the trend line, and does this by minimizing the squared values of the
deviations of the points from the line). Ultimately, the statistical formulas compute
a slope for the trend line (b) and the point where the line crosses the y-axis (a).
This results in the straight line equation
Y = a + bX

Where X represents the values on the horizontal axis (time), and Y represents
the values on the vertical axis (demand).

For the demonstration data, computations for b and a reveal the following
(NOTE: I will not require you to make the statistical calculations for b and
a; these would be given to you. However, you do need to know what to do
with these values when given to you.)

b = 30
a = 295
Y = 295 + 30X

This equation can be used to forecast for any year into the future. For
example:
Year 7: Forecast = 295 + 30(7) = 505
Year 8: Forecast = 295 + 30(8) = 535
Year 9: Forecast = 295 + 30(9) = 565
Year 10: Forecast = 295 + 30(10) = 595