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Forecasting Financial Requirements

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)
      

Forecasting is a statistical technique that has wide applicability in business activities.  Forecasting involves making judgments about future events based on an analysis of part events and factors that might affect those events in the future.

The role of forecasting in business is simple.  Accurate forecasts of future events can assist managers make better decisions in the present.  For example, forecasting is important for marketing, production and financial matters, among others.

The simplest method to forecast is to extrapolate in to the future based on information from the past.  Fitting a trend line is one method to do this, and is perhaps the most common quantitative method used in corporations.  More sophisticated empirical techniques are available and involve what is known as time series analysis.  Basically, time series analysis attempts to decompose historical data on the event to be forecast into secular, seasonal, cyclical and irregular components.  Once these components are known, and assuming that the economic environment in the future is similar to what it has been in the past, accurate projections can be made.

Working capital is the basis for forecasting financial requirements.  A percentage of sales approach, using financial ratios, can be used to forecast financial requirements.

To illustrate forecasting financial requirements, assume that the financial statement data appended is available.  The company wants to known what amount of additional financing is required if sales are expected to reach the $600,000 level (a 20 percent increase).  The percentage of sales approach will be used to provide the answer.

For each $1.00 of sales, assets will increase $1.00.  This increase must be financed. Accounts payable are assumed to be financed by suppliers who make credit available and so provide 10 percent of new funds.  The firm must find additional financing from internal or external sources for 90 percent of each sales dollar.

If sales are to increase from $500,000 to $600,000, then $90,000 (=$100,000 increase in sales x 90%) in new funds are required.

Step 3.  How much of the financing required ($90,000) can be financed internally from operations?

Since the sales revenue will be $600,000 and the profit margin is 10 percent, profit will be $60,000.  Of this amount, $15,000 is required for dividends ($60,000.  Of this amount, $15,000 is required for dividends ($60,000 x 25% dividend payout).  This leaves $45,000 of net income available to finance some of the additional sales.

Step 4.  How much of the financing requirement must be financed externally?

If $45,000 of the $90,000 total requirement is provided internally, then $45,000 must be obtained from external sources.

The relationships reflected in this illustration can be summarized in the following formula:

External funds needed = (A/TR)(S)-(B/TR)(S-bm(Q)

where

A/TR

=

assets that increase spontaneously with total revenues or sales as a percentage of total revenues or sales

B/TR

=

those liabilities that increase spontaneously with total revenues or sales as a percent of total revenue or sales

S

=

change in total revenue or sales

m

=

profit margin on sales

b

=

earnings retention ratio

Q

=

total revenues projected for the year

External funds required

=

($500,000) (-$100,000)

($500,000

($50,000) (-$100,000)

(75%)(10%)($600,000)


=


$45,000 (same as computed in the discussion)

To summarize, the relationship between sales and assets is the key question in forecasting financing requirements.  The formula used in this illustration can be used in different ways by changing the assumptions.

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