Limitations of Financial Forecasting

By EssayTank | 20-Feb-2021 | 5 likes

You are now done analyzing your company’s past performance and are now looking forward. You want to project future performance. There are several reasons why financial forecasting is important. The first reason could be for operations planning and budgetary purposes. If you expect sales to grow, you may need to expand production capacity and hire extra staff. The reverse is 1 when a decline is imminent.

Another reason to perform financial forecasting is for credit worthiness assessment. Most creditors want to be sure that a business is able to generate sales before they inject any cash into it. Credit analysis also helps in valuation of businesses during mergers and acquisitions. 

1.      In cases where a business is planning an Initial Public Offering (IPO), then it is important to demonstrate to potential investors and the Securities Exchange Commission that the expected sales growth warrants the share valuation.

Challenges To Expect During Financial Forecasting

The following are potential pitfalls

·        Inaccuracy of Past Data

Virtually all forecasting relies on past performance to determine trends in performance. Analysts then use the discovered trend to project future performance. If past data is inaccurate, it automatically compromises the integrity of your forecast. As a finance student, ensure that you only collect and use official company data for listed companies or rely on data from credible financial analysis websites.

·        How Far into the Future are you Forecasting?

The further into the future you are trying to project, the more likely that your results will be inaccurate. A one-year projection is likely to be more accurate than a five year projection. The business operating environment is likely to change thus affecting your forecast. To reduce this problem, it is important to rely on as much historical data as possible.

·        Human Error and Incorrect Models

Forecasting relies on a model developed by analysts. Every business uses a key driver to forecast other balance sheet and income statement items. In most cases, a sales growth rate is determined from historical trends and a forecast is made. It is then assumed that the current relationship between sales and other items in the statement of comprehensive income will hold. This assumption is held and used to extrapolate the rest of the figures.

However, it is not always 1 that the relationship will hold. The cost of sales could grow faster or slower than sales. Other expenses such as administration and selling could also grow or decline faster than sales. As such, the accuracy of forecast data is always limited.

Most Business Owners and Managers Do Not Use Statistical Analysis

Despite the availability of powerful computing software, the use of statistical forecasting remains in the world of academia. In the real business world, it is quite difficult to apply and full rely on statistics purely.

There are managers who prefer to rely on their ‘gut feeling’ and make expansion decisions based on that. In other cases, it is hard to put the thoughts and views of every manager into a statistical model when there are conflicting views.

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