Finance is a game about future after all. It is more important to know how a company will do next year than how it is doing now. How do we proceed in forecasting a company’s future performance? What kind of a perspective should we stand from in a forecast? Today we will talk about the general idea of financial forecasting before we delve into the details of doing it.
The forecasting process starts with a retrospective analysis of a company’s past financial statements. First thing we need to do is adjust the past financial statements so that they reflect a company’s performance truthfully. The reason is we need to know a company’s real productivity behind the numbers so that we can make accurate estimations for the future. The authenticity and value of information is crucial in forecasts, so we want to get our resources straight before we attempt a prediction.
Forecasts are based on assumptions. We must make assumptions about the revenue growth and other assumptions about how expenses will change in relation to chances in revenues. Therefore, it is important that when we make forecasts, we must understand and agree on the assumptions we use to make these forecasts. That is to say, we need to be in consensus of what kind of information we are basing the prediction on. The accuracy and value of the prediction is only as good as the information. In making forecasts, we have to always keep in mind the idiom “garbage-in, garbage out.”
Because of the law of diminishing marginal utility, people always are overly conservative in making financial decisions. They would give up good opportunities just to avoid the chance of losing money. Even though it is true that being conservative will reduce the chance of catastrophic losses, it will let go many profitable opportunities, which once compounded, is also very costly. It is important to find a good balance in the “war of conservatism vs optimism.” It’s important to keep in mind that, in the end, the goal of a forecast is accuracy.
Another thing that should be noted is the “level of precision” of a prediction. Computing each item of next year’s financial statements to 10 decimal places would certainly make the forecast look more professional, but not necessarily more accurate. The forecasts of many items in the financial statements are closely linked to each other, so a little bit of fluctuation of estimation of one item could affect all other predictions by less or more. Multiple decimal places isn’t really meaningful unless our assumptions can be as precise.
After the forecasting process, we must make sure that the prediction passes the smell test. A smell test means we check if these forecasts make economic sense. There are so many factors about the market that cannot be directly reflected by financial statements, like the competitiveness of the industry, the target customers, the environmental awareness of the society, and so on. Thus, we have to consider, for example, is it really true that if we raise the price of the product in a competitive industry, the revenue will increase accordingly. Smell test is a process where we step back, pull our heads out of the numbers, and let our instincts take over.
We also have to make sure that the forecasts are internally consistent. It is just like what the math teachers always say, “check your work before you hand in the test.” In financial forecasts, we have to make sure that the balance sheet, income statement, and statement of cash flows matches each other. It is not just a formality that you should go through, but also an opportunity to check the math in your forecasts, because any discrepancy will be shown on the spread sheets.
In conclusion, in financial forecasts one should be comprehensive and not overly-conservative in making assumptions. Ideally, a forecast should consider competitive advantage, trends in manufacturing costs, logistical requirements, necessary marketing support, after-sale customer service, and many more aspects of a business. Then, we formulate forecast assumptions that are reasonable and consistent with the economic realities defining that company.
P1 – https://knowlium.com/revenue-forecasting/