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Analyzing Forecasts

Analyzing Forecasts

Author: Sophia Media

Identify questions to ask about operational inputs when analyzing forecasts.

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[MUSIC PLAYING] Hi. This is Dr. Bob Nolley with a summary lesson on financial forecasting. As I talked about in the earlier lessons, business planning and financial forecasting refers to the set of activities where business operations are planned for advancing the business strategy and what results may occur from executing those strategies in the next year. Firms need to take great care in this process because these statements are reviewed by many stakeholders, including creditors, vendors, and regulatory agencies.

We learned that forecasting financial statements starts with an estimate of several values, the first of these being sales, and then the cost of goods sold and anticipated expenses. Since actual business activities are planned in relation to these estimates, it's very important that realistic expectations and estimates are used. With this in mind, it's important to remember to address some specific points.

Will the company have sufficient cash on hand to meet its regular bills and any non-regular cost or investment opportunities that become available? Will the financial position of the firm remain sound after this growth is achieved? This is what the balance sheet shows us.

Is there a logical balance between debt and the amount contributed by the owner when the business is raising funds through operations in its own right? Are short- and long-term obligations matched properly with appropriate funding? That is, is short-term borrowing funding short-term asset needs? And finally, do key business ratios remain within sensible bounds?

Businesses often manage and address these key issues by closely measuring the impacts of modifying the inputs to operations. Let's look at these. Accounts receivable is the money owed to a business by its customers, and it's shown on the balance sheet as an asset.

So to forecast this, a business not only has to anticipate the level of sales that will be made on credit, but it also has to anticipate when payments on these accounts will occur and account for the fact that some of these credit accounts will default and become bad debt. Accounts receivable also has a great impact on the firm's expected cash flows. So modifying this in the forecast will affect how much cash the company decides to have on hand.

Inventory is another key input. It primarily deals with the goods on hand that are required at different locations. The issues of inventory management concern the fine line of lead time for replenishment, the current cost of keeping inventory on hand, inventory forecasting, valuation visibility, and what future prices might be like.

Balancing all of these leads to an optimal inventory level. And this is an ongoing process as the business needs shift and reacts to change in strategy and goals. Companies that rely on the sale of physical goods and have to carry inventory have to manage it in such a way as to decrease expenses as much as possible. Since inventory is such a prevalent expense, accurate forecasting is of the utmost importance.

Accounts payable is the money owed by a business to its suppliers and is shown on the balance sheet as a liability. Usually, a supplier will ship a product, bill the company, and collect payment later. This is all part of the cash conversion cycle. This is the period of time when the supplier has already paid for the materials but hasn't been paid in turn by the customer yet. These accounts payable influence the current liabilities of the business, which in turn impacts liquidity of the business.

Now, to summarize, it's important for management to go through a financial sanity check on its business forecast statements to make sure that it has sufficient cash on hand and that its inputs are managed appropriately. These include accounts receivable, inventory, and accounts payable.

This is Dr. Bob Nolley. And I'll see you in the next lesson.