Managing Financial Principles and

Techniques

Topic 2
Understanding Forecasting
Techniques

Fathimath Rasheed
MBA Batch 11
Principles of Forecasting
Many types of forecasting models that differ in complexity and amount
of data & way they generate forecasts:
1. Forecasts are rarely perfect
2. Forecasts are more accurate for grouped data than for individual
items
3. Forecast are more accurate for shorter than longer time periods
Types of Forecasting Methods
Decide what needs to be forecast
◦ Level of detail, units of analysis & time horizon required
Evaluate and analyze appropriate data
◦ Identify needed data & whether it’s available
Select and test the forecasting model
◦ Cost, ease of use & accuracy
Generate the forecast
Monitor forecast accuracy over time
Forecasting methods are classified into two groups:
Qualitative methods – judgmental methods
◦ Forecasts generated subjectively by the forecaster
◦ Educated guesses

Quantitative methods – based on mathematical

modeling:
◦ Forecasts generated through mathematical modeling
Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
Time Series Models:
◦ Assumes information needed to generate a forecast is
contained in a time series of data
◦ Assumes the future will follow same patterns as the past
Causal Models or Associative Models
◦ Explores cause-and-effect relationships
◦ Uses leading indicators to predict the future
◦ Housing starts and appliance sales
Time Series Models
Forecaster looks for data patterns as
◦ Data = historic pattern + random variation

Historic pattern to be forecasted:

◦ Level (long-term average) – data fluctuates around a constant mean
◦ Trend – data exhibits an increasing or decreasing pattern
◦ Seasonality – any pattern that regularly repeats itself and is of a
constant length
◦ Cycle – patterns created by economic fluctuations

Random Variation cannot be predicted

Time Series Patterns
Time Series Models
Naive: Ft +1 = At
◦ The forecast is equal to the actual value observed during the last
period – good for level patterns

Simple Mean: Ft +1 =  A t / n
◦ The average of all available data - good for level patterns

Moving Average: Ft +1 =  A t / n
◦ The average value over a set time period
(e.g.: the last four weeks)
◦ Each new forecast drops the oldest data point & adds a new
observation
◦ More responsive to a trend but still lags behind actual data
Forecasting Seasonality
Calculate the average demand per season
◦ E.g.: average quarterly demand
Calculate a seasonal index for each season of each
year:
◦ Divide the actual demand of each season by the average
demand per season for that year
Average the indexes by season
◦ E.g.: take the average of all Spring indexes, then of all
Summer indexes, ...
Forecast demand for the next year & divide by the
number of seasons
◦ Use regular forecasting method & divide by four for
average quarterly demand
Multiply next year’s average seasonal demand by
each average seasonal index
◦ Result is a forecast of demand for each season of next
year
Causal Models
Often, leading indicators can help to predict changes in
future demand e.g. housing starts
Causal models establish a cause-and-effect relationship
between independent and dependent variables
A common tool of causal modeling is linear regression:
Y = a + bx
Additional related variables may require multiple regression
modeling
Linear Regression
Identify dependent (y) and
independent (x) variables
Solve for the slope of the
line

b=
 XY − n XY

 X − nX2 2

Solve for the y intercept

a = Y − bX
Develop your equation for
the trend line
Y=a + bX
Selecting the Right Forecasting
Model
1. The amount & type of available data
▪ Some methods require more data than others
2. Degree of accuracy required
▪ Increasing accuracy means more data
3. Length of forecast horizon
▪ Different models for 3 month vs. 10 years
4. Presence of data patterns
▪ Lagging will occur when a forecasting model meant for a
level pattern is applied with a trend
Forecasting Software
Spreadsheets
◦ Microsoft Excel, Quattro Pro, Lotus 1-2-3
◦ Limited statistical analysis of forecast data
Statistical packages
◦ SPSS, SAS, NCSS, Minitab,
◦ Forecasting plus statistical and graphics
Specialty forecasting packages
◦ Forecast Master, Forecast Pro, Autobox, SCA
Guidelines for Selecting
Software
➢Does the package have the features you want?
➢What platform is the package available for?
➢How easy is the package to learn and use?
➢Is it possible to implement new methods?
➢Do you require interactive or repetitive forecasting?
➢Do you have any large data sets?
➢Is there local support and training available?
➢Does the package give the right answers?
Forecasts impact not only other business functions but all other
operations decisions. Operations managers make many forecasts, such
as the expected demand for a company’s products. These forecasts are
then used to determine:
▪product designs that are expected to sell,
▪the quantity of product to produce,
▪the amount of needed supplies and materials,
Also, a company uses forecasts to
▪determine future space requirements,
▪capacity and
▪location needs , and
▪the amount of labor needed
Forecasts drive strategic operations decisions, such as:
choice of competitive priorities, changes in processes, and
large technology purchases.
Forecast decisions serve as the basis for tactical planning;
developing worker schedules.
Virtually all operations management decisions are based on
a forecast of the future.
Forecasting is critical to management of all
organizational functional areas
◦ Marketing relies on forecasting to predict demand and
future sales
◦ Finance forecasts stock prices, financial performance,
capital investment needs..
◦ Information systems provides ability to share databases
and information
◦ Human resources forecasts future hiring requirements
Cost Functions
Refer to a regression equation that described the relationship
between a dependent variable and one or more independent
variable.
Normally estimated from past cost data and activity levels.
Cost estimation begins with measuring past relationships
between total costs and the potential drivers of those costs.
Any expected changes of circumstances in the future will require
past data to be adjusted in line with future expectations.
 Sources of funds
Finance is the lifeblood of business concern, because it is
interlinked with all activities performed by the business concern.
Arrangement of the required finance to each department of
business concern is a highly complex one and it needs careful
decision.
But, the requirement of finance may be broadly classified into
two parts:
1. Long-term Financial Requirements or Fixed Capital
Requirement
2. Short-term Financial Requirements or Working Capital
Requirement
1. Long-term Financial Requirements or Fixed Capital Requirement
The financial requirement of the business differs from firm to firm
and the nature of the requirements on the basis of terms or periods
of financial requirements, may be long-term and short-term financial
requirements.
Long-term financial requirement means the finance needed to
acquire land and buildings for business concerns, purchase of plant
and machinery, and other fixed expenditures.
Long-term financial requirement is also known as fixed capital
requirements.
Fixed capital is the capital, which is used to purchase the fixed assets
of firms such as land and building, furniture and fittings, plant and
machinery, etc. Hence, it is also called a capital expenditure.
2. Short-term Financial Requirements or Working Capital
Requirement
Apart from the capital expenditure of the firms, the firms should need
certain expenditure like procurement of raw materials, payment of
wages, day-to-day expenditures, etc.
This kind of expenditure is to meet with the help of short-term
financial requirements which will meet the operational expenditure of
the firms.
Short-term financial requirements are popularly known as working
capital.
SOURCES OF FINANCE
Sources of finance mean the ways of mobilizing various terms of finance to
the industrial concern.
Sources of finance may be classified under various categories according to
the following important headings:
1. Based on the Period
Sources of Finance may be classified under various categories based on the
period.
Long-term sources: Finance may be mobilized by long-term or short-term.
When the finance is mobilized with a large amount and the repayable over
the period will be more than five years, it may be considered a long-term
source.
Share capital, issues of debenture, long-term loans from financial
institutions, and commercial banks come under this kind of source of
finance.
Long-term source of finances are used to meet the capital
expenditure of the firms such as purchase of fixed assets, land and
buildings, etc.
Long-term sources of finance include:
● Equity Shares
● Preference Shares
● Debenture
● Long-term Loans
Short-term sources: Apart from the long-term sources of finance,
firms can generate finance with the help of short-term sources like
loans and advances from commercial banks, moneylenders, etc.
Short-term sources of finance are used to meet the operational
expenditure of the business concern.
Short-term sources of finance include:
● Bank Credit
● Customer Advances
● Trade Credit
● Money Market Instruments
2. Based on Ownership
Sources of Finance may be classified under various categories based
on the ownership:
An ownership source of finance include
● Shares capital, earnings
● Retained earnings
Borrowed capital include
● Debenture
● Bonds
● Loans from Bank and Financial Institutions.
3. Based on Sources of Generation
Sources of Finance may be classified into various categories based on
the sources.
Internal source of finance includes
● Retained earnings
● Surplus
External sources of finance may be include
● Share capital
● Debenture
● Loans from Banks and Financial institutions
4. Based in Mode of Finance
Security finance may include
● Shares capital
● Debenture
Retained earnings may include
● Retained earnings
● Reserves
Loan finance may include
● Long-term loans from Financial Institutions
● Short-term loans from Commercial banks.
The above classifications are based on the nature and how the
finance is mobilized from various sources.
But the above sources of finance can be divided into three major
classifications:
● Security Finance
● Internal Finance
● Loans Finance
Group 1. – Equity Shares
Group 2 – Preference shares
Group 3 – Creditorship Securities
Group 4 – Internal Financing and Loan Financing

- Features/ Characteristics
- Advantages
- Disadvantages
 SECURITY FINANCE
If the finance is mobilized through an issue of securities such as shares and
debenture, it is known as security finance. It is also known as corporate securities.
This type of finance plays a major role in deciding the capital structure of the
company.
Characters of Security Finance
Security finance consists of the following important characteristics:
1. Long-term sources of finance.
2. It is also known as corporate securities.
3. Security finance includes both shares and debentures.
4. It plays a major role in deciding the capital structure of the company.
5. Repayment of finance is very limited.
6. It is a major part of the company’s total capitalization.
Types of Security Finance
Security finance may be divided into two major types:
1. Ownership securities or capital stock.
Ownership Securities
The ownership securities, also known as capital stock, is commonly
known as shares.
Shares are the most Universal method of raising finance for a
business concern. Ownership capital consists of the following types
of securities.
● Equity Shares
● Preference Shares
EQUITY SHARES
Equity Shares are also known as ordinary shares and is different
from preference shares.
Equity shareholders are the real owners of the company.
They have control over the management of the company.
Equity shareholders are eligible to get dividends if the company
earns a profit.
Equity share capital cannot be redeemed during the lifetime of
the company.
The liability of the equity shareholders is the value of the unpaid
value of shares.
Features of Equity Shares
Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of
capital, which has no maturity period. It cannot be redeemed
during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to
get income left after paying fixed rate of dividend to preference
shareholder.
The earnings or the income available to the shareholders is equal
to the profit after tax minus preference dividend.
3. Residual claims on assets: If the company wound up, the
ordinary or equity shareholders have the right to get the claims on
assets.
These rights are only available to the equity shareholders.
4. Right to control: Equity shareholders are the real owners of the
company.
Hence, they have the power to control the management of the
company and they have the power to take any decision regarding the
business operation.
5. Voting rights: Equity shareholders have voting rights in the
meetings of the company with the help of voting right power; they
can change or remove any decision of the business concern.
6. Pre-emptive right: Equity shareholder pre-emptive rights.
The pre-emptive right is a legal right of the existing shareholders. It is
attested by the company so that the first opportunity to purchase
additional equity shares is given to them, in proportion to their
current holding capacity.
7. Limited liability: Equity shareholders have limited liability only to the
value of shares they have purchased. If the shareholders have fully paid
up shares, they have no liability.
Advantages of Equity Shares
1. Permanent source of finance: Equity share capital is a long-term
permanent source of finance, hence, it can be used for long-term or
fixed capital requirements of the business concern.
2. Voting rights: Equity shareholders are the real owners of the
company who have voting rights. This type of advantage is available
only to the equity shareholders.
3. No fixed dividend: Equity shares do not create any obligation to pay
a fixed rate of dividend. If the company earns profit, equity
shareholders are eligible for profit and can get dividend otherwise, they
cannot claim any dividend from the company.
4. Less cost of capital: Cost of capital is the major factor, which
affects the value of the company.
If the company wants to increase the value of the company, they
have to use more share capital because it consists of less cost of
capital (Ke) compared to other sources of finance.
5. Retained earnings: When the company has more share capital, it
probably would have more retained earnings which is a less costly
source of finance compared to other sources of finance.
Disadvantages of Equity Shares
1. Irredeemable: Equity shares cannot be redeemed during the
lifetime of the business concern. This may sometimes lead to over-
capitalization.
2. Obstacles in management: Equity shareholders can put obstacles
in management by manipulating and organizing themselves.
Because they have the power to veto any decision that is against the
wealth maximization goal of the shareholders.
3. Leads to speculation: Equity share dealings in the share market
lead to speculation during prosperous periods.
4. Limited income to the investor: Investors who desire to invest in
safe securities with a fixed income have no attraction for equity
shares.
5. No trading on equity: When the company raises capital only with
the help of equity, the company cannot take advantage of trading on
equity.
PREFERENCE SHARES
It is the shares, which have preferential rights which get dividend and
get back the initial investment at the time of winding up of the
company.
Preference shareholders are eligible to get a fixed rate of dividend and
they do not have voting rights.
Preference shares may be classified into the following major types:
1. Cumulative preference shares: Cumulative preference shares have
the right to claim dividends for those years that have no profits.
If the company is unable to earn profit in any one or more years, C.P.
Shares are unable to get any dividend but they have the right to get the
comparative dividend for the previous years if the company earned
profit.
2. Non-cumulative preference shares: Non-cumulative preference
shares have no right to enjoy the above benefits.
They are eligible to get a dividend only if the company earns profit
during the year. Otherwise, they cannot claim any dividend.
3. Redeemable preference shares: When the preference shares
have a fixed maturity period they become redeemable preference
shares.
It can be redeemable during the lifetime of the company. The
Company Act has provided certain restrictions on the return of
redeemable preference shares.
Irredeemable Preference Shares
Irredeemable preference shares can be redeemed only when the company goes
for liquidation. There is no fixed maturity period for such kind of preference
shares.
Participating Preference Shares
Participating preference shareholders have the right to participate in extra profits
after distributing the equity to shareholders.
Non-Participating Preference Shares
Non-participating preference shareholders do not have any right to participate in
extra profits after distributing to the equity shareholders. A Fixed rate of
dividend is payable to the type of shareholders.
Convertible Preference Shares
Convertible preference shareholders have the right to convert their holdings into
equity shares after a specific period. The articles of association must authorize
the right of conversion.
Non-convertible Preference Shares
Their shares, cannot be converted into equity shares from preference shares.
Features of Preference Shares
The following are the important features of the preference shares:
1. Maturity period: Normally preference shares have no fixed maturity
period except for redeemable preference shares. Preference shares can be
redeemable only at the time of the company liquidation.
2. Residual claims on income: Preferential shareholders have a residual
claim on income. The Fixed rate of dividend is payable to the preference
shareholders.
3. Residual claims on assets: The first preference is given to the preference
shareholders at the time of liquidation. If any extra Assets are available they
should be distributed to equity shareholders.
4. Control of Management: Preference shareholders do not have any voting
rights. Hence, they cannot have control over the management of the
company.
Advantages of Preference Shares
Preference shares have the following important advantages.
1. Fixed dividend: The dividend rate is fixed in the case of
preference shares.
It is also known as fixed-income security because it provides a
constant rate of income to investors.
2. Cumulative dividends: Preference shares have another advantage
which is called cumulative dividends.
If the company does not earn any profit in any previous years, it can
be cumulative with future period dividends.
3. Redemption: Preference Shares can be redeemed after a
specific period except for irredeemable preference shares. There
is a fixed maturity period for repayment of the initial investment.
4. Participation: Participative preference shareholders can
participate in the surplus profit after distribution to the equity
shareholders.
5. Convertibility: Convertible preference shares can be converted
into equity shares when the articles of association allow such
conversion.
Disadvantages of Preference Shares
1. Expensive sources of finance: Preference shares are an expensive
source of finance compared to equity shares.
2. No voting rights: Generally preference shareholders do not have any
voting rights. Hence they cannot have control over the management of
the company.
3. Fixed dividend only: Preference shares can get only a fixed rate of
dividend. They may not enjoy more profits from the company.
4. Permanent burden: Cumulative preference shares become a
permanent burden so far as the payment of dividend is concerned.
Because the company must pay the dividend for the unprofitable periods
also.
5. Taxation: From the taxation point of view, preference shares dividend
is not a deductible expense while calculating tax. But, interest is a
deductible expense. Hence, it has a disadvantage from the tax deduction
point of view.
CREDITORSHIP SECURITIES
Creditorship Securities also known as debt finance are mobilized from
the creditors.
Debenture and Bonds are the two major parts of the Creditorship
Securities.
Debentures
A Debenture is a document issued by the company. It is a certificate
issued by the company under its seal acknowledging a debt.
According to the Companies Act 1956, “debenture includes debenture
stock, bonds and any other securities of a company whether
constituting a charge of the assets of the company or not.”
Types of Debentures
Debentures may be divided into the following major types:
1. Unsecured debentures: Unsecured debentures are not given any
security on assets of the company. It is also known as simple or naked
debentures.
This type of debenture is treated as unsecured creditors at the time
of winding up of the company.
2. Secured debentures: Secured debentures are given security on
assets of the company.
It is also called a mortgaged debenture because these debentures are
given against any mortgage of the assets of the company.
3. Redeemable debentures: These debentures are to be redeemed
on the expiry of a certain period. The interest is paid periodically and
the initial investment is returned after the fixed maturity period.
4. Irredeemable debentures: This kind of debentures cannot be redeemed
during the lifetime of the business concern.
5. Convertible debentures: Convertible debentures are the debentures
whose holders have the option to get them converted wholly or partly into
shares.
These debentures are usually converted into equity shares. Conversion of
the debentures may be:
Non-convertible debentures
Fully convertible debentures
Partly convertible debentures
Features of Debentures
1. Maturity period: Debentures consist of a long-term fixed
maturity period.
Normally, debentures consist of 10–20 year maturity period and
are repayable with the principle investment at the end of the
maturity period.
2. Residual claims in income: Debenture holders are eligible to
get a fixed rate of interest at the end of every accounting period.
Debenture holders have priority of claim in income of the
company over equity and preference shareholders.
3. Residual claims on assets: Debenture holders have priority claims
on Assets of the company over equity and preference shareholders.
The Debenture holders may have either specific changes on the Assets
or floating changes to the assets of the company.
Specific change of Debenture holders are treated as secured creditors
and floating change of Debenture holders are treated as unsecured
creditors.
4. No voting rights: Debenture holders are considered as creditors of
the company.
Hence they have no voting rights. Debenture holders cannot have a
control over the performance of the business concern.
5. Fixed rate of interest: Debentures yield a fixed rate of interest till
the maturity period. Hence the business will not affect the yield of the
debenture.
Advantages of Debenture
1. Long-term sources: Debenture is one of the long-term sources of
finance for the company. Normally the maturity period is longer than the
other sources of finance.
2. Fixed rate of interest: Fixed rate of interest is payable to debenture
holders, hence it is most suitable for the companies that earn higher
profit. Generally, the rate of interest is lower than the other sources of
long-term finance.
3. Trade on equity: A company can trade on equity by mixing debentures
in its capital structure and thereby increase its earnings per share. When
the company applies the trade on equity concept, the cost of capital will
reduce and the value of the company will increase.
4. Income tax deduction: Interest payable to debentures can be deducted
from the total profit of the company. So it helps to reduce the tax burden
of the company.
5. Protection: Various provisions of the debenture trust deed and the
guidelines issued by the SEB1 protect the interest of debenture holders.
Disadvantages of Debenture
1. Fixed rate of interest: Debentures have a fixed rate of interest
payable to them.
Even though the company is unable to earn a profit, they have to
pay a fixed rate of interest to debenture holders, hence, it is not
suitable for those company earnings which fluctuate
considerably.
2. No voting rights: Debenture holders do not have any voting
rights. Hence, they cannot have control over the management of
the company.
3. Creditors of the company: Debenture holders are merely creditors
and not owners of the company. They do not have any claim in the
surplus profits of the company.
4. High risk: Every additional issue of debentures becomes more risky
and costly on account of the higher expectations of debenture holders.
This enhanced financial risk increases the cost of equity capital and the
cost of raising finance through debentures which is also high because of
high stamp duty.
5. Restrictions of further issues: The company cannot raise further
finance through debentures as the debentures are under the part of
the security of the assets already mortgaged to debenture holders.
INTERNAL FINANCE
A company can mobilize finance through external and internal
sources.
A new company may not be able to raise internal sources of finance
and they can raise finance only through external sources such as
shares, debentures and loans, But an existing company can raise
both internal and external sources of finance for their financial
requirements.
Internal finance is also one of the important sources of finance and
it consists of the cost of capital compared to other sources of
finance.
Retained Earnings
Retained earnings are another method of internal sources of finance.
It is not a method of raising finance, but it is known as the
accumulation of profits by a company for its expansion and
diversification activities.
Under the retained earnings sources of finance, a part of the total
profits are transferred to various reserves such as general reserves,
replacement funds, reserves for repairs and renewals, reserve funds
and secrete reserves, etc.
Advantages of Retained Earnings
1. Useful for expansion and diversification: Retained earnings are
most useful for the expansion and diversification of business activities.
2. Economical sources of finance: Retained earnings are one of the
least costly sources of finance since it does not involve any floatation
cost as in the case of raising funds by issuing different types of
securities.
3. No fixed obligation: If the companies use equity finance they have
to pay dividends and if the companies use debt finance, they have to
pay interest.
However, if the company uses retained earnings as a source of
finance, they do not need to pay any fixed obligation regarding the
payment of dividends or interest.
4. Flexible sources: Retained earnings allows the financial structure to
remain completely flexible. The company need not raise loans for
further requirements if it has retained earnings.
5. Increase the share value: When the company uses the retained
earnings as the source of finance for their financial requirements, the
cost of capital is cheaper than the other sources of finance; Hence the
value of the share will increase.
6. Increase earning capacity: Retained earnings have the least cost of
capital. They are most suited to those companies that go for
diversification and expansion.
Disadvantages of Retained Earnings
1. Misuses: The management can manipulate the value of shares in
the stock market by misusing the retained earnings.
2. Leads to monopolies: Excessive use of retained earnings leads to a
monopolistic attitude of the company.
3. Over-capitalization: Retained earnings lead to over-capitalization
because if the company uses more and more retained earnings, it
leads to an insufficient source of finance.
4. Dissatisfaction: If the company uses retained earnings as a source
of finance, the shareholder can’t get more dividends. So, the
shareholder does not like to use the retained earnings as a source of
finance in all situations.
LOAN FINANCING
Loan financing is one of the most important mode of finance raised by
the company. Loan finance may be divided into two types:
(a) Long-Term Sources
(b) Short-Term Sources
Financial institutions play a key role in the field of industrial
development and they are meeting the financial requirements of the
business concern.
Commercial Banks
Commercial Banks normally provide short-term finance which is
repayable within a year.
The major finance of commercial banks is as follows:
Short-term advance: Commercial banks provide advances to their
customers with or without securities.
It is one of the most common and widely used short-term sources of
finance, which is needed to meet the working capital requirement of
the company.
It is a cheap source of finance, which is in the form of a pledge,
mortgage, hypothecation etc.
Short-term Loans
Commercial banks also provide loans to business concerns to meet
short-term financial requirements. When a bank makes an advance in
a lump sum against some security it is termed a loan.
Loan may be in the following form:
(a) Cash credit: A cash credit is an arrangement by which a bank
allows its customer to borrow money up to a certain limit against the
security of the commodity.
(b) Overdraft: Overdraft is an arrangement with a bank by which a
current account holder is allowed to withdraw more than the balance
up to a certain limit without any securities.
Question and Answer Session

Q&A