Chapter 2 -
Using the Basic Forecasting Model
Learning Objectives
The purpose of this chapter is to introduce you to the basic forecasting model. After completing
this chapter you should be able to
• Understand the importance of assumptions;
• Determine what “basic” assumptions are necessary in preparing the first pass forecast;
• Compute the EFN requirements for a company using the percent of sales method to
prepare a sources and uses of cash equation;
• Determine when an asset or liability is spontaneous; and
• Prepare the first-pass pro forma balance sheet.
Making Assumptions
Assumptions are a necessary part of the forecasting process. Through them, we make the
forecast workable, and through them, we begin to develop an understanding of how things
interrelate in our company.
When we prepare our first-pass forecast we generally make very basic assumptions. The most
common basic assumption is that we want the current or existing financial relationships to be
maintained. (Remember, this is just our starting point. We can and should reevaluate these
assumptions in later forecasting passes during our planning process.)
The most common way to operationalize these basic assumptions is to link various values to
sales. This should make some sense to you because the company’s sales level is probably one of
the biggest, if not the biggest, determinant of its future.
The basic model we use is called the
percent of sales method. To prepare our first pass forecast
we determine how each asset, liability, and expense should behave as sales change. Sometimes
the changes in the assets, liabilities, and expenses occur on their own. For others, we must make
the changes occur if the company is to be successful. Whether the changes occur on their own or
whether we must force the change, before forecasting we must determine these relations.
Generally, as a starting point in our first pass forecast, we assume that we want the past
relationships between sales and the other accounts to remain as they are now.
As stated before, we can later change the assumptions. If, for example, we have been
mismanaging our inventory, the basic assumption builds this mismanagement into the forecast.
As we plan for the future, correcting this mismanagement would be a good idea. We build the
correction into a second-pass forecast. By observing the first pass and the second pass, we can
see the impact of continued mismanagement and the impact of the correction.
Percent of Sales and Sales Forecasts
Sales Forecast and Forecasting
To use the percent of sales model requires a sales forecast. This is the one area where a
prediction is important. If your company has “no idea” where its sales are headed in the future,
then this model should not be used. If you have no idea where your company’s sales are headed,
there probably is not a planning model that will work for you.
The Sales Forecast
The sales forecast can be a simple number or it can be a range. In the model, we prepare a
forecast with one sales prediction at a time. We can then recompute the model with other
alternate sales predictions. We can then see the likely impact of the possible range of sales
increases.
Who Prepares the Sales Forecast?
The answer to this question varies. The accountants and financial analysts (us) are generally not
in the best position to forecast sales. After all, we tend to have less of a relationship with our
customers and markets than others in the company. We therefore often must rely on sales
forecasts generated by others.
Sometimes we must become involved in sales forecasting. This could occur if there is no one
else in the company willing or able to generate the forecast. Or, it could occur if we believe the
forecast we have been given is, in some way, flawed or unrealistic.
For much of the seminar, we will assume that the sales forecast is provided to us from others in
the company. In a later chapter, we will return to the idea of sales forecasting for those instances
where we need to become involved in it.
1 All organization names used in this course are purely fictitious as are the individuals depicted therein. Any
similarity to real organizations or persons is purely coincidental.
732962