Methods of Forecasting :

Determining Future Need for Additional Funds

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.

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

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 ExpensesDiscretionary 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

Method of Forecasting

Percent of Sales MethodThe 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 MethodThe 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

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.

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

Method of Forecasting

Moving AveragesA 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

Method of Forecasting

Weighted Moving AveragesA 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

Method of Forecasting

Exponential SmoothingExponential 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

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).

Method of Forecasting

y = a + bx

Apr

Jan

Feb

Mar

0

300

600

900

1200

1500

1800

2100

1 2 3 4

Month

Sal

es Sales

Regression Analysis

Example

Month Period

(X)

Sales

(Y)

January 1 900

February 2 1,200

March 3 1,500

April(Forecast)

4 Forecast =

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.

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.

Effective Techniques for Analyzing Data

BenchmarkingBenchmarking 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.

Effective Techniques for Analyzing Data

Comprehensive Benchmarking Tools Kit• IBA Market Data• IRS Corporate Ratios• Pluris DLOM Database• RMA Annual Statement Studies• Ibbotson SBBI• BizcompsSource:

NACVA – National Association of Certified Valuation and Analysis

Effective Techniques for Analyzing Data

Variance AnalysisVariance 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

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.

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

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

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.

Ratio AnalysisA. Liquidity Ratios

Working Capital = Current Assets - Current liabilities

Current ratio (working capital ratio) = Current assetsCurrent liabilities

Acid-test ratio= Cash equivalents + Marketable securities + Net receivables

Current liabilities

Cash ratio = Cash equivalents + Marketable securitiesCurrent liabilities

Ratio AnalysisB. Activity RatiosAccounts 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

Ratio AnalysisB. 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 = SalesAverage working capital

Total asset turnover = Net salesAverage total assets

Ratio AnalysisC. 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

Ratio AnalysisD. Investor Ratios

EPS* = Profit available to equity shareholdersnumber 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

Ratio AnalysisE. Leverage RatioDebt / Equity = Total Liabilities

Shareholders Equity

Debt Ratio = Total Liabilities

Total Assets

Time interest earned (TIE) = EBITInterest

Cash Flow to Debt Ratio = Operating Cash Flow Total Debt

“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.

“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.

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.”

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.

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.)

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.

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.

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.

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.

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.

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.

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

Forecasting/Budgeting – Other

• Fixed vs. Flexible Budget

• Dynamic vs. Static Budget

• Rolling Forecast

• Beyond Budgeting

• Budgeting in QuickBooks

• Other Forecasting Tool – Host Analytics

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

Resources:

Tysiac, Ken, “CPAs have opportunities in financial planning and forecasting” Journal of Accountancy, August 20, 2014http://www.journalofaccountancy.com/News/201410783

Waters, Richard, “Kodak’s inability to evolve led to its demise” The Financial Times, January 20, 2012http://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, 2014http://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, 2012http://businessfinancemag.com/planning-budgeting-amp-reporting/benchmarking-critical-element-finance-transformation

Resources:

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