In: Finance
What are the key assumptions and principles used in forecasting? What are the primary drivers of gaps between the financial forecast and actual results? How can financial forecasting benefit an organization?
Key assumptions and principles used in forecasting
1. Forecasts are more accurate for groups or families of items rather than for individual items: When items are grouped together, their individual high and low values can cancel each other out. The data for a group of items can be stable even when individual items in the group are very unstable. Consequently, one can obtain a higher degree of accuracy when forecasting for a group of items rather than for individual items.
2. Forecasts are more accurate for shorter than longer time horizons: The shorter the time horizon of the forecast, the lower the degree of uncertainty. Data do not change very much in the short run.
3. All trends will eventually end: Many factors will affect the pattern you’re trying to forecast. It doesn’t matter how accurately you predict the trend, in the future the variables will change and the forecast will be wrong.
Primary drivers of gaps between the financial forecast and actual results
1. It is impossible to guess the future: Forecasts are frequently mere projections of the current situation extrapolated into a future period. They assume that the future is only a slight variation of the present. That methodology is good enough for stable times but proves entirely useless when things turn out wrong.
2 Opinions are often biased: Too often experts and forecasters are affected by the event they are trying to analyse which makes it more difficult for them to draw objective conclusions.
3. Inaccurate research: Experts forecasts are mostly based on surveys, and when these investigations fail, all the ensuing reasoning is invalidated.
Benefits of Financial forecasting to an organization
1. Provides better control over cash flow: Since cash is the first thing that a company wants to manage, a financial forecast becomes extremely useful for businesses. It allows you to allocate money to different tasks in a more efficient manner and helps you channel your cash in the right direction.
2. Measures financial performance: One crucial aspect of financial forecasting is that it allows you to measure your future financial performance against set standards. It acts as a benchmark against which you can match your performance, identify loopholes, and take necessary corrective actions.
3. Lowers financial risks: Financial forecasting helps you identify processes that are the most money-consuming. You can lower your financial risks by pumping money from such processes and channeling it towards more profitable ones. It gives you a clear picture of potential risks and helps you devise necessary avoidance strategies.