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 ResultsThe 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

SYNC

Conventional/Traditional Business Model

BusinessABC Company

AccountingA/R A/PFinance

Human Resources

Payroll

LegalSales

MarketingAdvertising

WarehouseManufacturing

Operations

Growing Small Business Model

ASmall Biz

BSmall Biz

CSmall Biz

AccountingA/R A/PFinance

Human Resources

Payroll

Legal

Business Consultant

WarehouseManufacturing

SalesMarketing

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

Planning, Budgeting and Forecasting: How They’re Related and How They’re Different

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

Planning, Budgeting and Forecasting: How They’re Related and How They’re Different

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)

Planning, Budgeting and Forecasting: How They’re Related and How They’re Different

Role of Budgeting:1. Meeting the

organization’s objectives2. Planning3. Monitoring and

controlling4. Co-ordinating5. Evaluating performance6. Improving performance7. Motivating managers8. A management contract

9. Communicating10.Providing basis for

authorizing expenditure and delegating responsibility

11. Identifying scarce resources

12.Allocating resources13.Demonstrating and

delivering good corporate governance

Planning, Budgeting and Forecasting: How They’re Related and How They’re Different

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

Tips for Explaining Forecasting to Non-Financial Management Executives

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.

Tips for Explaining Forecasting to Non-Financial Management Executives

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.

Tips for Explaining Forecasting to Non-Financial Management Executives

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.

Tips for Explaining Forecasting to Non-Financial Management Executives

Estimating the Accuracy of the ForecastImproving 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 AccuracyTwo 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 …

Tips for Explaining Forecasting to Non-Financial Management Executives

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 MAPEMonthly 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%

Tips for Explaining Forecasting to Non-Financial Management Executives

Cost vs. BenefitThe 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 …

Tips for Explaining Forecasting to Non-Financial Management Executives

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

Tips for Explaining Forecasting to Non-Financial Management Executives

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)

Tips for Explaining Forecasting to Non-Financial Management Executives

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.

Tips for Explaining Forecasting to Non-Financial Management Executives

Considering Timelines

Continued …

Year 1 Year 2

0 1 2Date

Cash Flow $0 $10,000 $10,000

Today End Year 1 Begin Year 2

Tips for Explaining Forecasting to Non-Financial Management Executives

Considering Timelines

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.

Tips for Explaining Forecasting to Non-Financial Management Executives

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.

Simplifying Assumptions: Their Critical Role in Financial Forecasting

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.

Simplifying Assumptions: Their Critical Role in Financial Forecasting

Sensitivity AnalysisSensitivity 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.

Simplifying Assumptions: Their Critical Role in Financial Forecasting

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