[MUSIC PLAYING] Hello. This is Dr. Bob Nolley, back with you for the lesson on forecasting and strategy. One of the most important actions the company takes is the development of its strategic plan. It defines what direction it will take. It generates decisions that have to be made about the resources that are available. All of the available alternatives need to be evaluated.
The biggest part of this is the financial forecast. This is done using the accounting and sales data and evaluating the externalities and what the market might look like. This financial forecast should be the best possible estimate of what will happen to the company financially over the next year.
Every financial forecast starts with the most difficult aspect, and that is predicting revenue, coming up with a sales forecast. After this, future costs can be estimated, starting by using earlier accounting data.
Once you have the sales forecast, the next step is financial modeling. The modeling is a building of a representation of what the impact of financial decisions will be. It's a mathematical model. It represents a very simple version of the performance of a business or portfolio or project.
It uses information from accounting and financial systems. In small and medium-sized businesses, spreadsheet software can be used. The main goal of building the financial forecast is to project the additional funds needed, or the AFM.
Since the strategy of most companies is focused on growth in sales, a business needs to figure out how much in additional resources will be required to support that new sales level, and how it will finance the acquisition of those resources. AFM is a way of calculating just how much new funding will be needed.
A firm can then realistically look at whether or not they're going to be able to generate the AFM required to reach the new goals. Figuring out the amount of external funding needed is a key part of calculating AFM. And there are some detailed mathematical formulas.
But basically, the AFM simplified formula is this-- AFM equals projected increase in assets minus the spontaneous increase in liabilities that happens, and minus increase in retained earnings that they don't pay back to the shareholders. This is AFM.
The second important concept that a business must address is the issue of capacity. Capacity is the maximum level of output that can be produced by a firm, capacity planning ensures that a firm will keep from growing too fast in sales and make sure it's using its financial resources in the most efficient way possible.
Capacity is central to planning. And it's the process of determining the production capacity level that's needed by an organization to meet its new sales forecast.
In finance and economics, you often hear the term capacity utilization. This refers to the extent to which the business actually uses its installed productive capacity. And it talks about the relationship between the actual output that gets produced with the equipment that is on site already, and any potential output that could be produced.
A problem that is frequently seen in large corporations is that companies suffer from chronic excess capacity. Business production is not often as efficient as it should be.
Now let's review these key points. Using historical, internal, accounting, data and a sales forecast, and looking at the external market and economic indicators, a financial forecast is the best estimate of what will happen to a company in financial terms over the next period. Financial forecasting is held by financial modeling, which can be as simple as spreadsheet software. Assumptions can play a key role in the financial forecast.
One necessary result of financial forecasting is the calculation of the AFM, or the Additional Funds Needed. This helps a firm realistically examine what additional funding will be needed to generate the assets to support the projected sales level.
The second issue that must be examined is capacity planning. This is the process of looking at the production capacity that the firm needs to meet its new sales goals. Capacity utilization is the extent to which a company is using its capacity to create production efficiently.
This is Dr. Bob Nolley. And I'll see you in the next lesson.