Applications of Budgeting and Financial Forecasting
Financial forecast refers to preparation of detailed projections of expected revenue that quantifies future expectations of a company’s micro and macroeconomic business environment.
Organizations have the practice of using the financial forecast carried out by the in-house teams or external consultants, because they need to plan for an uncertain future. The critical questions that a management needs to answer before planning for financial forecasting are as follows:
- Estimating Accuracy of a Forecast:
Accuracy of the forecast is crucial for decision making and allocating resources for a particular project. Different types of forecasting methods provide different level of confidence interval and the management needs to ascertain whether the use of forecasting method is appropriate for that particular outcome.
- Cost Benefit Analysis:
In general, if more effort and resources are put in, the forecast will be more accurate. However the cost involved in going for a sophisticated forecast needs to be approved given the constraint of resources.
- Timelines of Forecasting:
Timelines for forecast (decision to make a 5-year forecast or a 10-year forecast) is a crucial factor in arriving at the accuracy of forecast. However, there is a tradeoff of amount of data involved and increasing timelines, which needs to be deiced before starting the forecasting process.
Role of Assumptions in Forecasting:
Making assumptions about the future is the first step of forecasting. A good forecasting should have all relevant assumptions listed beforehand to begin with the process of forecasting. The assumptions should also be internally consistent and should flow directly from the assumptions made about the future.
Clearly listed assumptions are also crucial for carrying out sensitivity analysis, which involve changing the critical assumptions to study the impact of projections and financial parameters, such as Debt Service Coverage Ratio, Internal Rate of Return, profitability margins, gearing levels and so on.
Budgeting refers to making a detailed financial plan that quantifies future expectations and actions relative to using existing resources and acquiring new resources. Budgeting can take various forms and can provide the basis for setting up detailed sales targets, staffing plans, inventory production, cash management, borrowings, capital expenditure etc. Budgeting provides benchmark to compare actual results and to accordingly develop corrective measures.
Different types of Budgeting that is undertaken in an organization are as follows:
- Financial Budgeting for an organization refers to forecasting income statement, balance sheet and cash flow statement for future years.
- Corporate Budgeting refers to planning of financial budgets by a company and implanting the same in its operations.
- Capital Budgeting refers to the planning process in which a company takes a decision for its long-term investments, such as investment in plant and machinery, investment in fixed assets, investment in new projects and more.
- Sales budget refers to forecasted sales volumes and is influenced by previous sales patterns, current and expected economic conditions, activities of competitors and more.
- Productions Budget (which has direct correlation to sales budget) refers to setting up production targets in line with the forecasted sales keeping in view the existing inventory levels.
- Cash budget refers to forecasting all the future cash receipts and cash payments of a business for a specified period.
- Marketing Budget refers to planning different forms/mode of marketing that is required for a specific product/entire organization.
- Project Budget refers to planning the budgeting activity for a specific project, such as forecasting project related revenues, project related expenditures, capital investments in the project and so on.
The basic methods of forecast include Qualitative forecast, time series forecast and causal forecast.
- Qualitative Forecast:
- The inputs to forecasting model are obtained from various departments and various personnel of the organization based on their judgment.
- It follows an outlined technique to obtain the forecasts of knowledgeable personnel/executives without any bias.
- Time Series Forecast:
- It involves tracking a particular variable over time and building models for forecasting based on expected movement of the variable in the future period.
- The method is useful for studying variables with recurring patterns and with/without seasonality.
- Causal Forecast:
- In this model, the factors causing movement in variable are studied over time.
- The method is used to check whether the causal relationship between factors is stable and whether the relationship is predictable.
- Regression analysis is the best-suited model for undertaking causal forecasting.
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