The Four Key Steps of Financial Forecasting - Essay Sample

Financial forecasting is the process through which a company comes up with a plan that estimates "its future level of receivables inventory, payables, and other corporate accounts as well as its anticipated profits and borrowing requirements" by creating projected statements (Block, Hirt, & Danielsen, 2017, p. 97).

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Forecasting comprises four primary steps, which include (1) creating of a projected income statement, (2) deriving a cash budget from the income statement, (3) integrating the income statement and the cash budget into a projected balance sheet, and (4) determining the level of financing the firm requires to pay for its activities for the period in context (Block et al., 2017).

Formulating a projected income statement involves establishing the level of unit sales that the management anticipates and multiplying it by unit selling price results in the sales revenue (Block et al., 2017). The management then derives a production schedule by adding the projected units of sales to the level of inventory it desires to be available at the end of the period in question, minus the amount of inventory in stock at the beginning of this period (Block et al., 2017). The schedule shows the units that the firm needs to manufacture, which the manager multiplies by the cost of producing one unit to get the cost of goods sold (COGS) (Block et al., 2017). The difference between revenue and COGS gives the projected gross profit Block et al., 2017). The next step comprises estimating the amount of general and administrative cost and deducting them from gross profit to arrive at earnings before taxes. Subtracting taxes returns after-tax income, and deducting dividends produce retained earnings (Block et al., 2017). A compilation of all these items amounts to the pro forma income statement (Block et al., 2017).

Deriving a cash budget involves converting the anticipated sales and costs figures one estimates in the income statement projections into smaller and detailed periods to predict the recurrent and regular (or monthly) cash inflows and outflows summaries (Block et al., 2017). The financial manager breaks down the level of sales and costs in the income statement into monthly cash receipts (revenue) and cash payments (manufacturing cost as well as funds used to acquire assets like new equipment) (Block et al., 2017). The combination of monthly cash receipts and payment culminates into a cash flow statement (Block et al., 2017). The manager gets the monthly net cash flow by calculating the difference between the cash receipts the cash payments for each month (Block et al., 2017).

Formulating the pro forma balance sheet involves integrating the figures obtained from the income statement and the cash flow statement into a balance sheet (Block et al., 2017). Since balance sheets show the cumulative changes in a corporation, the process starts with an assessment into the previous period's balance sheet and transforming the items in the two pro forma statements above through the period to create a company's standing in the following period (Block et al., 2017).

Determining the funds needed to finance the firm's activities involves making a comparison between the prior period's balance sheet and the preceding period's pro forma balance sheet to establish the changes in a firm's assets, liabilities, and stockholder equity accounts (Block et al., 2017). These changes represent the levels of funds the firm needs for the period in question and from where it obtains them (Block et al., 2017).

Reference

Block, S. B., Hirt, G. A., & Danielsen, B. R. (2017). Foundations of financial management (Sixteenth edition). New York, NY: McGraw-Hill Education.