Course Objectives

2

Evaluate forecasting methods to maximize company profitability.

Knowledge, Skills, and Abilities

Determine the amount of new funds required based upon forecasted financial statements.

Apply various forecasting methods to create projected financial statements.

3

Create a master budgeting system that supports a company's goals and objectives.

Knowledge, Skills, and Abilities

Prepare a master budget along with supporting schedules.

Develop a pro forma Income Statement, Balance Sheet, and Cash Budget from a series of forecasted budgets.

Four Approaches to Forecasting

Approach 1: Ratios

Lets say the Sales dept expects the following revenues over the next 2 years, and you know that historically, your companys Profit Margin has stayed around 5% even when sales levels fluctuate. How could you use a ratio to forecast Net Income?

Expected Sales in 1 year	Expected Sales in 2 years
$3,500,000	$4,500,000

Last week we learned that Profit Margin = Net Income / Sales, so we can use that ratio to determine what Net Income is likely to be in the future, based on the Sales estimates we have.

So, if Profit Margin = Net Income / Sales = 5%, or 0.05, we can rearrange the formula to this:

Net Income = Sales x 0.05

Substituting in our expected sales levels, we see that Net Income one year from now is expected to be $3,500,000 x 0.05 = $175,000, and Net Income two years from now is expected to be $4,500,000 x 0.05 = $225,000.

Other ratios can be used to forecast other variables as well, such as the Inventory Turnover ratio. Using the same expected sales levels from above, if your inventory turnover ratio is historically 7.0, you can predict your expected level of inventory for the next two years.

Inventory Turnover = Sales / Inventory. Rearranging this formula, Inventory = Sales / Inventory Turnover.

So, Inventory for Year 1 = $3,500,000 / 7.0 = $500,000 worth of inventory, and Year 2 would be $4,500,000 / 7.0 = $642,857 in inventory.

It is important to understand that basing a prediction upon a variable that is itself an estimate (sales, in our examples) can lead to errors throughout the forecast. For this reason, it is wise to use more than one method of forecasting and compare the results to determine what may be the best estimate.

Approach 2: Percent-of-Sales Method

The Percent-of-Sales method is presented beautifully in your text (Chapter 4) so we will not duplicate that in this lesson. Essentially, the Percent-of-Sales method is similar to using ratios to forecast a variable as we did above, with the caveat that every forecasted variable is divided by the expected sales forecast.

Lets say, for example, sales are currently $100,000 and accounts payable are $10,000. Then, mathematically, accounts payable / sales = 10%. If sales are forecasted to increase to $150,000 in the next year, then using the percent-of-sales method, accounts payable will stay as 10% of the new sales amount, increasing to $15,000.

See your text for more comprehensive examples!

Approach 3: Time Series Models

Time series models were briefly discussed in our Week 1 Lesson as quantitative models for short-term, and sometimes intermediate, forecasting. Time series models are often used by the Sales Department to forecast expected sales levels. So although other methods of forecasting are often used to forecast the other variables, the process of forecasting will usually start with a time series model to forecast sales.

As mentioned in Week 1, time series models use mathematical formulas and very specific assumptions about the relationship of past sales to future sales. The best forecasting model will be one that has a strong correlation between the model and the actual performance of your company. The primary time series models are (1) moving average, (2) weighted moving average, and (3) exponential smoothing.

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Moving Average

Weighted Moving Average

Exponential Smoothing Model

Approach 4: Pro Forma Financial Statements