Business Forecasting Financial Statements

Whether you're currently in business or thinking of starting a business this section is a must.  In this section, existing business owners will learn about financial planning for the future, while aspiring entrepreneurs will learn how to develop forecasted financial statements for their business plan. 

Business Forecasting is the process of predicting future activities of an existing or proposed business venture. As part of your business plan or expansion plan, you will be required to forecast various financial statements and financial analysis, namely, the forecasted cash flow statement, forecasted income statement, forecasted balance sheet, forecasted break-even analysis, forecasted sensitivity analysis, forecasted ratios, and notes to the forecasted financial statements.

The purpose of forecasting financial statements is twofold. Firstly, the business forecasting & analysis assist the ENTREPRENEUR in determining whether or not their proposed business venture or planned expansion is feasible. Secondly, the business forecasting assist a potential INVESTOR in determining whether or not they will or should invest into the business.

Generally speaking, investors (banks, government organizations, individuals, etc) request the entrepreneur develop three (3) years of forecasted financial statements and financial analysis. That is, a forecasted cash flow statement, a forecasted income statement, a forecasted balance sheet, a forecasted break-even analysis, a forecasted sensitivity analysis, and forecasted ratios for years 1, 2, and 3 into the future. Remember to always complete the forecasted financial statements and financial analysis one year at a time. In other words, NEVER begin forecasting year two's financial statements until all year one's forecasted financial statements are completed.

Many business owners and aspiring entrepreneurs will call on an accountant to construct their forecasted financial statements and financial analysis. This section, however, has been written to enable you to conduct your own business forecasting and create your financial statements and analysis; thus, saving possibily thousands of dollars.

Be sure to read the Introduction below.  It provides basic information on an example (case study) that we'll be using throughout this entire section on business forecasting. 

Please Note:  when forecasting financial statements and financial analysis , be sure to complete the STEPS in the order they appear below!   Good luck and have fun forecasting your financial satetments and financial analysis.

INTRO         Case Study Example on Business Forecasting
STEP 1        Creating Financial Budgets
STEP 2        Creating a Cash Flow Statement
STEP 3        Creating an Income Statement
STEP 4        Creating a Balance Sheet
STEP 5        Creating a Ratio Analysis
STEP 6        Creating a Break-even Point
STEP 7        Creating a Sensitivity Analysis
STEP 8        Creating Notes to Financial Statements

As with other main menu categories at Business Plan Hut, below provides a narrative on the topics addressed under the Business Forecasting section.  Furthermore, our discussion on Business Forecasting consists of the following main topics.

INTRO         Case Study Example on Business Forecasting
STEP 1        Creating Financial Budgets
STEP 2        Creating a Cash Flow Statement
STEP 3        Creating an Income Statement
STEP 4        Creating a Balance Sheet
STEP 5        Creating a Ratio Analysis
STEP 6        Creating a Break-even Point
STEP 7        Creating a Sensitivity Analysis
STEP 8        Creating Notes to Financial Statements

When you are conducting your business forecasting, be sure to complete each STEP in the order in which they appear above.  This cannot be stressed enough.

Each step is briefly discussed below.  Please Note: You may follow the link on each topic below to be transferred to a more in depth conversation regarding that subject term.  Alternatively, you may continue to read along here and learn about all the sections covered under business forecasting.  Let’s get started by introducing you to a case study which will be used throughout our entire discussion on business forecasting.

Intro - Case Study Example on Business Forecasting

We get started by introducing you to Mr. Murray Wilson and his aspiration to start a new business called Scholarship Information Services.  We offer some background information on Mr. Wilson and provide you with some data important for our business forecasting example.  Be sure to read this introduction since it is the basis for creating and forecasting each of the business financial statements and projection analysis. Let’s now start with the first step in business forecasting which is creating financial budgets.

STEP 1 - Financial Budgets

The first step in business forecasting involves creating a variety of financial budgets.  After creating the financial budgets, you will have the necessary information to prepare financial statement projections and financial analysis projections including the income statement, balance sheet, cash flow statement, break-even analysis, sensitivity analysis and ratio analysis.

There are fourteen financial budgets in total that should be developed in the order in which each appear below. The financial budgets include:

Budget 1 - Selling Price and Product Cost (per unit) Budgets
Budget 2 - Sales Budget
Budget 3 - Purchase Budget
Budget 4 - Direct Manufacturing Labor Budget
Budget 5 - Manufacturing Factory Overhead Budget
Budget 6 - Ending Inventory Budget
Budget 7 - Cost of Goods Sold Budget
Budget 8 - Fixed Asset Budget
Budget 9 - Operating Expenses Budget
Budget 10 - Drawings or Dividend Budget
Budget 11 - Cash Investments Budget
Budget 12 - Opening Balance Sheet
Budget 13 - Interest Expense Budget
Budget 14 - Income Tax Rate and Budget

Let’s begin our discussion with the first financial budget, entitled “Determining Your Selling Price & Product Cost (per unit)”.

Budget 1 - Selling Price and Product Cost (per unit) Budget

The starting point of business forecasting begins with determining the selling price and product cost on a per unit basis. Recall from previous discussions, the term product and service are interchangeable.  So if you have a plumbing service, your selling price per unit is considered your billable rate per hour.  In addition, the direct service cost per unit or per billable hour is zero.

Please Note: most businesses sell more than one product or offer more than one service.  Should you fall into this category, you will need to develop a weighted average selling price and weighted average cost.  The process of weighted averages reduces your total number of selling prices down into one single selling price known as a weighted average selling price.  Obviously, one selling price is much easier to work with than 20 selling prices, for example.

Similarly, you can put all your direct product costs though the same process in order to acquire one single direct product cost known as the weighted average cost. The section on weighted averages fully explains the process and provides you with a step by step approach.  Let’s now move onto the second financial budget and define the sales budget.

 
Budget 2 - Sales Budget

The second financial budget is the Sales Budget.  Again, each of the budgets must be prepared in the order in which they appear above.  The sales budget consists of six main components.  Below defines the sales budget and provides a brief summary of what you’ll discover when reading the full version of the Sales Budget.  

The first step in the sales budget is to predict the number of units (or billable hours as we’ve seen in the previous financial budget) you anticipate selling in each forecasted year. After calculating the number of units you anticipate to sell each year, simply multiply that number by the selling price to arrive at an annual dollar sales projection. 

The next part of the sales budget involves estimating when sales will materialize.   You do this from a percentage standpoint opposed to a unit or dollar amount.  In other words, you need to distribute 100% among each of the twelve months of your forecasted year.  Since sales in certain months will be higher than in other months, the sales percentages in each month will not be the same. 

The next step involves multiplying the monthly percentages by the total annual forecasted dollar sales calculated above.  Now you have your monthly sales projections.  Follow the same process for each of the forecasted years. If you don’t fully understand how to do sales projections, not to worry since we have created several examples of sales projections throughout the sales budget discussion.

Now you have to ask yourself… when will customers actually pay you for the sale.  Businesses offering 30 day credit terms will collect the cash from the sale in 30 days.  Alternatively, businesses offering no credit terms will collect the cash from the sale immediately.   If you offer 30 days credit terms or plan to offer it, you will have an account receivable at the end of the forecasted year.  In other words, your sales projections in month 12 will not be collected until month 13 (IE the first month of the second forecasted year).  As a result, the outstanding amount becomes an account receivable on the first year projected balance sheet.

All topics addressed here are important when creating the sales budget.  As you will discover later on, the answers to the above questions are needed when preparing financial statements and preparing financial projections.  This concludes the topics addressed under the Sales Budget.  The next budget to be completed is the Purchase Budget.     

Budget 3 - Purchase Budget

The next financial budget to prepare is the Purchase Budget.  The purpose of the purchase budget is to ensure you have enough inventory of goods relative to your sales projections.  If you are predicting unit sales of 1,000 in month 3 and only 750 units are available, then an opportunity cost of 250 units results.  Customers will go elsewhere to make the purchase in which you could have financially enjoyed.  The purchase budget does not apply to those of you who do not sell physical products.

Our discussion on the purchase budget consists of 4 sections.  The first section calculates the number of units to be purchased per month based on sales projections.  After you calculate the inventory requirements, you’ll need to determine the cost of inventory purchases on a monthly basis. 

Similar to the above Sales Budget, the final two components of the Purchase Budget rely on your supplier’s credit granting policy.  In other words, when do you have to pay for inventory and how much will appear in accounts payable at the year of each projected year, if any.  Should a supplier grant a 60 days credit term, then the last two months of purchases, in each forecasted year, will appear on the balance sheet as an accounts payable. If payment is due immediately upon the purchase, then a zero balance appears in the accounts payable section of the balance sheet.

Purchasing the right amount of inventory based on your sales assumptions is crucial in any business carrying merchandise or any product for resale.  After reading the discussion on the Purchase Budget, you will have a great understanding of when to buy and in what quantities.

Budget 4 – Direct Manufacturing Labor Budget

The fourth financial budget relates directly to manufacturers.  Retailers and service providers can skip or omit the direct manufacturing labor budget.  

The direct manufacturing labor budgets require two calculations. The first calculation deals with the total cost of direct manufacturing labor. These costs consist of the laborers who work directly in the manufacturing process.  In other words, these laborers fabricate raw materials into finished units.  Clerical workers, a sales staff, or marketing managers, for example, are not directly related to the manufacturing process and therefore are not considered when calculating the Direct Manufacturing Labor Budget.

The calculation of Direct Manufacturing Labor considers the number of units produced multiply by the number of direct labor hours needed to produce one finished unit of product. This equals the number of required direct labor hours per year.  Then multiply the number of required direct labor hours per year by the wage rate per hour.  Be sure to consider employee benefits or mandatory employer related costs.  The resulting figure is the total cost of direct manufacturing labor per year.

The second and final calculation of for the Direct Manufacturing Labor Budget is the cost of direct labor per unit.  To obtain this number, simply divide the total cost of direct labor hours per year (from above) by the number of finished units you anticipate to produce.  By having this number, you can apply it to your sales projections each month to calculate the total direct manufacturing labor cost each month.  As you will see later on under the business forecasting process, the direct manufacturing labor cost will appear on the monthly cash flow statement.  

Budget 5 - Manufacturing Factory Overhead Budget

Similar to the above Direct Manufacturing Labor Budget, retailers and service providers need not prepare the manufacturing factory overhead budget.  It only relates to manufacturing and processing companies. 

Factory overhead costs are expenditures which relate directly to the operation of a factory, processing company or manufacturing plant.  Note: Labor costs and raw materials are not included in the budget.   Below explains why the direct manufacturing labor costs and raw materials are exceptions to the Manufacturing Factory Overhead budget. 

Recall in the financial budget 4 above, entitled, Direct Manufacturing Labor Budget, we already calculated the direct manufacturing labor cost.  And under the financial budget number 7 seven (below), we will be calculating the cost of raw materials and cost of goods sold.  Not to worry, you’ll understand this concept when we discuss this topic below.

Examples of factory overhead costs include expenses relating only to the factory or production plant such as electricity expense on factory, heating costs, utilities, repairs, general factory supplies, and insurance on production plant, to name a few.  The thing to remember here is the Factory Overhead Budget deals strictly with costs directly associated with the production facility, manufacturing plant or factory.  Furthermore, repairs and maintenance to an office area is an operating expense, while a repair and maintenance on an area within the manufacturing plant is considered a factory overhead cost.

For a more in depth discussion on this topic, please refer to our complete discussion relating to Manufacturing Factory Overhead Budget.

Budget 6 - Ending Inventory Budget

The next financial budget to be developed is Ending Inventory.  Ending inventory is the amount of merchandise or product you plan to have on hand at the end of each fiscal period.  In this section, you’ll discover ending inventory can be calculated at any time throughout the year.  Ending Inventory at the end of the fiscal period is the result of the beginning inventory in units, plus the purchases throughout the year, less the units sold during the year, multiplied by the per unit cost.

Ending inventory formula is the same for a retailer as it is for the ending inventory formula for a manufacturer. That said, however, a greater number of calculations need to be made when determining the ending inventory for a manufacturing or processing company.  As you will discover, these topics and additional calculations are also addressed in our discussion on the ending inventory budget.

Retailers often refer to ending inventory as ending merchandise inventory. Sellers of services only do not have ending inventory nor do they have beginning inventory for that matter.  For further information on ending inventory, please refer to the complete discussion entitled, Ending Inventory Budget.

Budget 7 - Cost of Goods Sold Budget

In this budget entitled, Cost of Goods Sold, we begin by defining the term cost of goods sold (also referred to as COGS or cost of sales).  Since the cost of goods sold for a retailer is much different than the calculation for a manufacturer, we divide this section into two main parts.  Part 1 is called Calculating Cost of Goods Sold Budget for a Retailer and Part 2 is called Calculating Cost of Goods Sold Budget for a Manufacturer.

Retailers will learn the cost of goods sold formula is Beginning Inventory + Purchases Made during the period = Total Goods Available for Sale - Ending Inventory = Cost of Goods Sold.

With the assistance of an example, you will learn how to create a cost of goods sold budget for a two year period. 

Manufacturers will learn the cost of goods sold formula calculation is Beginning Inventory + Purchases of Raw Materials during the period + Direct Labor Costs + Factory Overhead = Total Goods Available for Sale - Ending Inventory = Cost of Goods Sold.  Again, an example is used to show you how to calculate cost of goods for a manufacturer.

What you must remember about cost of goods sold  or cost of merchandise sold is that they appear on the income statement and not on the balance sheet.  The unsold goods at any given point, however, appear on the balance sheet in the form of inventory; finished inventory, goods in progress (unfinished inventory) and raw materials.  Unlike a retailer, manufacturers will have a “finished goods inventory” and a work in progress or unfinished goods inventory. 

In conclusion, budget 7 will help you better understand the cogs formula as well as other important areas about inventories and cost of goods sold.

Budget 8 - Fixed Asset Budget

Fixed Assets are assets having a useful life of over one year.  Examples of fixed assets include computers, land, buildings, automobiles, office furniture, and office equipment, just to name a few.

There are many components of the fixed asset budget and, therefore, we have organized this topic into the following sections.

Part 1 Determine the Fixed Assets You Plan to Invest into the Business
Part 2 Determine the Fixed Assets Required for the Business
Part 3 Estimate each Fixed Asset's Deprecation Expense for each Forecasted Year
Part 4 Determine the Accumulated Depreciation of each Fixed Asset
Part 5 Determine the Forecasted Current Market Value of each Fixed Asset

The fixed assets you intend to invest into the business are necessary when creating the opening balance sheet.  In addition, you will need the fixed asset budget to calculate the year end depreciation expense calculation and the accumulated depreciation expense calculation. 

Part two of the fixed asset budget, involves determining the fixed assets you need to purchase for each forecasted year.  Similarly, you need these values in order to arrange the fixed asset section of the balance sheet.  In addition, the values are necessary for calculating depreciation expense and accumulated depreciation expense.

The third part of this budget asks you to estimate the useful life of the fixed assets discussed above. You will use these figures to calculate deprecation expense using the straight line method of depreciation, for instance.

The remaining narrative on Business Forecasting will be completed shortly.

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