Financial Forecasts in Predicting Future Performance - Essay Example

 Financial Forecasts in Predicting Future Performance INTRODUCTION Our world today is beset with financial crisis of insurmountable coverage. A multitude of corporations declare bankruptcy and render thousands of employees jobless. The inevitable nature of factors which interplay and caused this financial turmoil on a global scale proves that financial planning and forecasting are worthless. However, there are still enumerable enterprises which rely on financial forecasts to predict future performance. The objective of this essay is to validate the hypothesis that corporations are better-off eliminating financial forecasts as a tool to predict financial performance. To arrive at a conclusive argument, the following issues would be discussed: (1) uses of financial forecasts; (2) importance of forecasts; (3) kinds and approaches to financial forecasting; (3) factors that increase their reliability; and (5) find out if corporations still utilize this tool in their decision-making process. FINANCIAL FORECASTS Definition of Terms Financial forecasts “are estimates of financial results based on the information that you have today” (Sponsored Research Funding). In a study conducted by Terner (2006), financial forecasts are simply defined as “an estimate or projection of costs or revenues”. From these two sources, it can be deduced that financial forecasts are merely estimates of financial components in a corporations’ financial statements. Forecasting utilizes historical data to predict future financial patterns. Financial Forecasts 3 Financial dictionary (2008) defines financial forecasts as a financial plan “that describes your current financial status, your financial goals and when you want to achieve them and strategies to meet those goals”. Uses of Financial Forecasts Financial forecasts are used in a variety of business endeavors, among which are: (1) as a guide for the accomplishment of corporate objectives; (2) as a warning mechanism to apply corrective measures in situations that warrant them; (3) as an evaluating tool for the performance of the company’s personnel; (4) to provide investors with useful information; and (5) to design the appropriate strategies in formulating plans and policy changes. Importance of Forecasts Bushman (2007) enumerated several rationales for the importance of financial forecasts, to wit: (1) Financial forecasts provides management with ample time to change strategies that affect the corporations’ operations and thereby enable them to maximize benefits. (2) With the use of relevant information provided by financial forecasts, losses could be prevented. (3) Forecasts aid decision makers in new product development. (4) Financial forecasts are closely examined by investors for publicly traded stocks of corporations and give them relevant information prior to decision making. Financial Forecasts 4 Kinds and Approaches to Financial Forecasting There are different kinds of financial forecasts depending on the scale of the business, products offered or manufactured, funds requirements, and future business plans (expansion, diversification, etc.). According to Lane (2007), “the principal driver of the forecasting process is generally the sales forecast”. The rationale for this is that most items contained in the Balance Sheet and Income Statements are derived from the sales figures. Percentage of Sales Method is a “financial forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts vary with sales” (Lane 2007). The assumption here is that most items in those two financial statements have a direct percentage to sales, therefore, future financial performance are projected using the forecasted sales level. Another method to forecast financial requirements is the External Financing Needed (EFN) Method. This method determines the amount of funds needed when the projected sales figure is determined. There are actually two (2) equations which are utilized in order to arrive at the EFN: the full capacity equation and the excess capacity equation. There are other financial statements that need to be forecasted to assist management in their decision making process. Aside from the sales forecast, cash flow statements and operating budgets assist in predicting future financial performance. If any internal or external factors immediately affect the prepared forecasts, due diligence and patience should be applied in finding out how these factors would affect different Financial Forecasts 5 financial components in the projected financial statements. By doing so, corrective measures could immediately be reviewed, evaluated and implemented. Factors that Increase the Reliability of Forecasts A study conducted Economist Intelligence Unit for KPMG International entitled Forecasting with Confidence, reveal that of the 544 senior executives involved in the forecasting process, almost 78% find these financial forecasts as unreliable, with a 5% margin of errors. However, for those companies who were able to produce accurate forecasts, the respondents of the study revealed the factors that increase their reliability. These factors are summarized below: 1. The process of doing financial forecasting should be taken more seriously. This is made possible by making the managers accountable for the forecasts that they conformed. At the same token, managers who are able to project or estimate an accurate forecast are given incentives. 2. Financial forecasts are seen as tools that enhance quality rather than just complying with basic requirements. Those firms who were able to estimate accurately “are more interested in further scenario planning and sensitivity analysis” (domain-b.com). In addition, due to their innate focus as financial managers, they perceived a lesser need for training their staff to delve on the forecasting process. 3. The accuracy and availability of information are given utmost importance. Data are solicited from external sources and market reports. In addition, emphasis is given to the operations managers who should be active in the preparation of the Financial Forecasts 6 forecasts since they directly oversee in day-to-day operations of the company. Further, company data are given priority as to their reliability and timeliness 4. More effort and focus is accorded to financial forecasts. Knowing that forecasts are mere tools which guide financial managers in their decision making process, any changes in the internal or external environment warrants immediate review of these forecasts. Updating and monitoring are frequently undertaken to ensure their effectiveness and reliability. 5. Realization that financial forecasts benefits shareholders contribute to their reliability. Shareholders often require financial forecasts to guide them in their decision for further investment in the company. The availability of financial forecasts increase the confidence of shareholders and have a direct effect in share prices of the company. Do Corporations Still Use Financial Forecasts? In this age of computerized systems, the more appropriate question is: do companies still use the traditional approach to financial forecasting? A proliferation of software programs make financial forecasting easier with one flick of the hand. IBS Pro! (2008) is one of the many software companies who offers a software package which would enable a “consolidation, forecasting, budgeting and reporting” of financial statements “in a one single solution”. One of the many reasons why corporations shy from preparing financial forecasts is the tedious manual work associated in making one. With the availability of computer softwares, forecasting is easier, more accurate, flexible, simple and more organized. Financial Forecasts 7 Business Plan Software and Guide present Exl-Plan which is a comprehensive financial forecasting software package for enterprises requiring the preparation of financial statements with the aid of the computer. In detail, “Exl-Plan runs with Excel for Windows (5, 7, 8, 95, 97, 2000 and XP). Sixteen variants are available to cover different sizes of businesses and accounting formats. Typically, Exl-Plan produces fully-integrated 1-3-5-7 year financial projections - monthly for the first year, quarterly for second-third, and annual for fourth-fifth. Based on a user's assumptions, it generates income statements, cash flows, balance sheets, ratios and graphs for each period (month, quarter & year).” Due to the ease and availability of means to prepare financial forecasts, corporations utilize computerized systems to assist them in this endeavor. Apprehensions in utilizing this tool were due primarily to the following factors: (1) the tedious methods of preparing financial forecasts using manual means; (2) the need for frequent updating and revision; (3) management’s attitude towards using financial forecasts as a tool for decision making; and (4) lack of qualified personnel to prepare this. ANALYSIS Financial forecasts are a compilation of estimates based on historical data. Viscione (1977) averred that “many events can occur that will cause actual results to differ from those projected. Consequently, one must recognize this important fact when interpreting financial forecasts; because of the inherent uncertainty involved, it is necessary to continuously revise and update forecasts’. Financial Forecasts 8 Since this tool is designed as a guide for future financial performance, forecasting cannot assume that the factors which had an effect on the company’s operations for one particular year would still be the same factors that the company would encounter in the future. The uncertain external market and competitive forces which interplay in the economic environment all affects the reliability of the financial forecasts. However, one should not immediately discard the usefulness and benefits that forecasting accords. The benefits to forecasting far outweigh the costs associated with its preparation and use. As indicated in the uses of forecasts as well as its importance to business enterprises, the time element that these forecasts provide enable decision makers to make appropriate actions to ensure accomplishment of objectives. The technological advancement eliminated the tedious work normally undertaken with forecasting preparation. A lot of software providers mastered the craft of incorporating forecasting in the computer systems of corporations. These would lessen the time previously allocated for the preparation of forecasts, thereby saving costs. Shareholders and investors require financial forecasts to aid them in future investments. Companies which regularly provide projected financial statements are proven to result in stable share prices (Bushman 2007). A guide, map or plan on hand is always better than nothing. Finally, forecasts are very important inputs needed for managerial functions like planning and control. With the mission and vision statements clearly defined, forecasts provide the direction to develop strategies, outline tasks and responsibilities, and structure schedules to achieve these goals. Control measures could only be instituted if Financial Forecasts 9 there is a basis that significant deviations from financial plans occur. Causes for the deviations are easier to identify with the availability of financial forecasts. Therefore, immediate and appropriate corrective measures are undertaken to align the direction to its original course. CONCLUSION All business decisions rely on financial tools to enable management to formulate the necessary plans and policies for changes that are necessary for future operations. With the global financial crisis being experienced, forecasting should be taken more seriously now. “Forecasts are kept accurate by updating the data of key metrics, which include sales volume, expenses, average sale price, customer combination, and many other ratios that identify performance. The forecast is updated once a month, but the figures that are used to update the forecast are taken daily. The predictions evolve constantly.” (Cellars 2007) The hypothesis that corporations are better-off eliminating financial forecasts as a tool to predict financial performance is negated. Despite the costs, effort and dedication involved in the task of financial forecasting, corporations are still better off utilizing this tool as a guide for future strategic decisions. References Bushman, M. Why is Forecasting Important to an Organization? Associated Content: Business and Finance. Retrieved on February 26, 2009 from Business Plan Software. Financial Projection Software. BRS Inc. Retrieved on February 26, 2009 from Cellars, T. (2007). Financial Forecasting. Associated Content: Business and Finance. Retrieved on February 26, 2007 from < http://www.associatedcontent.com/article/219309/financial_forecasting_pg2.html?cat=3> Dictionary of Financial Terms. Copyright © 2008 Lightbulb Press, Inc. Retrieved on February 26, 2009 from Financial plan Domaind.com (2007). Most corporate financial forecasts unreliable: KPMG. Retrieved on February 26, 2009 from Viscione, J. A. (1977). Financial Analysis: Principles and Procedures. Boston: Houghton Mifflin Company Read More