Forecasting Methods

What Are Forecasting Methods?

The term Forecasting Methods in finance refers to techniques for analyzing business performance over time. Generally, Quantitative Financial Forecasting Methods are used over Qualitative methods.

Forecasting is a tool used by businesses to plan for future spending or to decide how best to allocate their budgets.

Using past data as input, forecasting is a process that produces well-informed estimations that can be used to predict future trends.

The main elements that are projected in forecasting are revenues, expenses, and capital expenditures for the businesses and the elements related to them.

The main four forecasting methods discussed in the articles are as follows:

1. Straight Line
2. Moving Average
3. Simple Linear Regression
4. Multiple Linear Regression

This article focuses on the popular Quantitative Methods. When using quantitative methodologies, forecasters base their predictions on historical data.

To get the most precise findings, a forecaster typically tries to control and analyze the current quantitative data using various quantitative and analytical data. 

Understanding the Forecasting Methods

Financial analysts can project a company's future sales, expenditures, and operating expenses using one of four primary forecasting techniques.

Although there are many commonly used quantitative budget forecasting methods, in this article, we concentrate on the top four techniques:

1. Straight-line
2. Moving average
3. Simple linear regression
4. Multiple linear regression

Straight Line

The straight-line approach assumes that a business's past growth rate will remain unchanged. A company's prior year's revenue is multiplied by its growth rate to estimate future revenue. 

Straight-line forecasting, for instance, assumes that if development were 12% last year, it would remain at that level in the upcoming year.

Despite being a fine place to begin, straight-line forecasting methods don't consider supply chain problems or market changes.

Moving Average

Using a flattening method called moving averages, one can forecast future values by analyzing the patterns in the data of a collection of information. The three-month and 5-month trend lines are the two most popular varieties.

Employ the following formula to determine a moving average: 

A1 + A2 + A3 … / N

• A = Periodic average
• N = The overall number of cycles.

Moving average forecasting can be more accurate by emphasizing recent periods with weighted averages.

Simple Linear Regression

To make predictions, regression analysis is a commonly utilized method. Depending on the connection between two variables—the dependent and independent variables—simple linear regression makes predictions about measurements. 

The independent variable is the element that affects the outcome, whereas the dependent variable reflects the quantity that is anticipated.

The simple linear regression equation is: 

y = bx + a

• y = The dependent variable
• b = The slope of a regression line
• x = an unrelated variable.
• a = Y-intercept 

Multiple Linear Regression

Business leaders may use multiple linear regression when two or more variables directly impact an organization's performance. This makes it possible to forecast performance more precisely because it considers several factors that eventually affect it.

A linear relationship between the dependent and independent variables is necessary for using multivariate linear regression methods. Furthermore, it must be possible to distinguish between the independent and dependent variables' effects without the aid of strong correlations between them.

Income Statement and Balance Sheet Projections

Forecasting income statement is one of the key steps in the creation and execution of a 3-Statment Financial Model. Since the balance sheet and the cash flow statement projections will be based upon the Income Statement projections

Projecting Income Statement

An income statement is projected or forecasted by projecting the business's future financial performance over a given time frame.

The income statement, sometimes referred to as the profit and loss statement, provides an overview of the earnings, costs, and revenues for a specific period of time for a business.

1. Gathering historical data: The first step in projections and forecasting is the gathering of historical data. This historical data can be easily collected through 10-K documents, which include all the financial information of the organization.
2. Identifying Business Drivers: It is important that analysts identify the key performance drivers. These drivers may include sales growth, cost of goods sold (COGS), OPEX, and taxes. Understanding these drivers will aid in setting the assumptions for forecasting.
3. Sales Forecast: Historical data, market trends, industrial analysis, and other relevant factors are used to better forecast the sales revenue of the firm.
4. COGS: The cost of goods sold is typically projected based on sales revenue. This item may include raw materials, work-in-progress, and final goods.
5. Gross Profit: Subtract the COGS from the anticipated sales to determine the gross profit. The gross profit as a percentage of sales is known as the gross profit margin.
6. OPEX: Expenses such as marketing, salaries, rent, utilities, and other overhead costs come under Operating Expenses. These are to be subtracted from the gross profit.
7. D&A: Depreciation and amortization are projected by preparing a supporting schedule named fixed Asset Schedule.
8. Interest and Taxes: Interest expenses are projected with the help of a supporting schedule named Debt Schedule, and Taxes are taken as the ongoing tax rate set by the government.
9. Net Income: The amount we get after deducting all the expenses from the revenues. 

Projecting Balance Sheet

Estimating a company's assets, liabilities, and equity at a future date is the process of projecting a balance sheet.

A company's assets, liabilities, and equity—the remaining ownership stake in the business—are all displayed on the balance sheet, which offers a quick overview of the company's financial situation.

1. Gathering Historical Data: Gather the last few years' worth of financial documents and historical balance sheets. Your projections are built on top of this data.
2. Understanding Business Drivers: Determine the main forces influencing the balance sheet. These consist of debt levels, capital expenditures, working capital management, and sales growth.
3. Accounts Receivable: Calculate the accounts receivable by taking the typical time for collection into consideration. This is how long it takes for bills to be paid by clients.
4. Inventory: Based on production needs and sales projections, project the inventory levels. The turnover ratio is a useful tool for estimating the speed at which inventory is sold.
5. Accounts Payable: Calculate accounts payable based on the terms of supplier payment. The cash conversion cycle is impacted by this.
6. Working Capital: Subtract current liabilities from current assets to get working capital. Liquidity depends on the effective management of working capital.
7. Fixed Assets and Depreciation: Apply depreciation and project additions to fixed assets (property, plant, and equipment). This affects the non-current assets on the balance sheet.
8. Long-Term Debt And Equity: Variations in long-term debt and equity for the project. Take into account any new loans, equity injections, or repayments.
9. Deferred Tax And Other Liabilities: Add other long-term obligations and deferred tax liabilities. Modifications to corporate plans or accounting standards may have an impact on these.
10. Retained Earnings: The total earnings that have not been paid out as dividends are known as retained earnings. Based on net income and dividend payments, the project is modified.

To understand these projections, check out our Financial Modeling Courses.

Are Forecast and Financial Forecasting Methods Different?

A forecast predicts what might transpire shortly based on a specific set of circumstances that could be related to historical or present insights. After a careful examination of various trends, it entails creating projections for the future. 

To put it another way, forecasting methods are the technique of making predictions regarding the future step by step. To predict future trends and obtain the most accurate data, finance managers employ various financial forecasting methods and approaches. 

Financial projections are the ensuing representations. A large portion of accounting entails assessing previous results. Both shareholders and the general public can see business success through economic outcomes. However, arranging and preparing for the future is equally crucial.

Investors must be satisfied that a company has been and will continue to succeed. Financial planning is necessary here. Here is a summary of the various techniques you can use to forecast the business's profitability.

Financial forecasting methods give information about a company's economic prospects by considering past evaluation results, such as revenue, cash flow, expenses, or sales. However, since so many unforeseeable elements might affect business productivity, this includes speculation and hypotheses.

Because it influences decisions about recruiting, financing, estimating earnings, and planning and implementation, financial forecasting methods are crucial to business operations. You can keep your mind on the future with its assistance.

The degree to which each financial prediction is considered affects how much attention is paid to specific spending categories. For general planning reasons, you can, for instance, estimate high-level trends by relying more on generalizations than on precise information. 

On the contrary, it's crucial to be precise if your prognosis pertains to a company's future, such as a potential merger or acquisition.

Relationship between Financial Forecasting and Forecasting Methods

The foundation for judgment in a company is financial forecasting. Around which plans are developed and activities are planned, it contains guidance about a company's future potential characteristics.

With the aid of statements like the projected income statement, launched cash flow statement, and so forth, forecasters inspire new estimations in financial forecasting. To ensure that its goals and priorities are internally consistent, a firm undertakes its financial projections to provide the tools for its expression.

Forecasts can also assist a business in determining which resources—such as debt or assets—are required to help it accomplish its objectives. A simple illustration of a financial prediction is predicting a business' sales.

Forecasting Methods sales can assist a business in making other financial decisions supporting accomplishing its objectives because most financial statement accounts are linked to or associated with sales. 

The costs to generate the increased sales would also rise if sales were to rise. Therefore, the company's total financial status is impacted by each prediction. A corporation develops its financial representation through the process of financial modeling.

Business decisions are made using the developed model. Financial models are mathematical constructs created by businesses that bring together many variables. An Excel spreadsheet that serves as an overview of a company's financial data is produced during the modeling phase. 

A managerial choice or a potential event's impact can be ascertained with the model. Additionally, the corporation can edit the variables in the spreadsheet to determine how the changes can impact the company's operations.

 Researched and authored by Drishti Kohli | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• 3 Statement Model

• Financial Forecasting

• Forecasting Balance Sheet Items in a Financial Model

• Forecasting Cash Flow

• Linear Regression