Financial Reporting and Statement Analysis

Unit 7
Forecasting Techniques and Methods
Unit 7 - Forecasting Techniques and Methods

Introduction
This unit is designed to explain some of the most important forecasting techniques used in the financial analysis of business entities. The
unit further discusses the forecasting methods and their inherent limitations.

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Unit 7 - Forecasting Techniques and Methods

Learning Objectives

At the completion of this unit, you will be able to:

• Explain the features of forecasting techniques
• Classify the various forecasting techniques adopted by businesses
• Analyze the forecasting methods using examples
• List the limitations of forecasting methods

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Unit 7 - Forecasting Techniques and Methods

Table of contents

S.No Details Page No.

1. Introduction to Forecasting Techniques and Methods 6
2. Features of Forecasting 8
3. Importance of Forecasting Techniques 8
4. Types of Forecasting Techniques 9
4.1 Qualitative Methods 11
4.1.1 - Delphi Technique 12
4.1.2 - Panel Consensus 14
4.1.3 – Market Research 14
4.1.3.1 - Salesforce Polling 15
4.1.3.2 - Consumer Survey 15
4.2 - Quantitative Methods 16
4.2.1 - Time Series 16
4.2.1.1 - Moving Average (MA) 17

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Unit 7 - Forecasting Techniques and Methods

Table of contents

S.No Details Page No.

4.2.1.1.1 Simple Moving Average (SMA) 17
4. Summary 21
5. Reference and Further Readings 22

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Unit 7 - Forecasting Techniques and Methods

1. Introduction to Forecasting Techniques and Methods

Forecasting has become an indispensable part of our daily lives. From critical commercial decisions to decisions about our daily lives, we
intentionally or unintentionally use forecasting techniques to get the best out of a situation.
For a business firm, though, forecasting is a make-or-break decision.
It helps businesses see what is waiting ahead of them and bring into line the actions based on the observations. A simple example is:
What number of products to be stored in a departmental store and how quickly the shop owner will be able to clear the stock. The shop
owner can decide this using forecasting method.

Business Forecasting
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Unit 7 - Forecasting Techniques and Methods

In the corporate world, every decision taken by the business firms backed by some type of prediction or forecast. A sound forecast is the
need of an hour in the fast-paced business world. Every day managers deal with a series of challenges, faces competition and encounter
unexpected failures. For example, sudden changes in the level of sales, unexpected competition, fall in the level of margins, changes in
macroeconomic aspects, raising the cost of raw materials, declining bottom-line, etc. Each of these factors can crush the business into
pieces. Therefore, forecasting techniques are of immense help in understanding the in and out of business.
Several forecasting techniques have been developed to help the manager in predicting the impact of various factors on the business.
Every method has its advantages and inherent limitations. The management of a company has the privilege to select suitably. However,
the selection of a suitable forecasting technique is a critical task since there is no standard set equation to choose a method. Many
factors impact the selection of forecasting technique. For example, availability of time series data, level of accuracy desired, level of
research conducted, time available for the study etc.
The primary purpose is to bring together an unbiased, systematic and logical information and
judgements which relate to the factors being estimated. Such techniques are frequently used in new-
technology areas, where the development of a product idea may require several “inventions’”.
Hence, R&D demands are difficult to estimate where market acceptance and penetration rates are
highly uncertain. Forecasting techniques make extensive use of statistical tools. Hence, it is also
known as statistical analysis.

Statistical Analysis

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Unit 7 - Forecasting Techniques and Methods

2. Features of Forecasting
Most important features of forecasting are:
1. It is concerned with future

2. It shows the probability of events

3. It analyses past data to predict future

4. It uses statistical tools

5. It uses some personal observations

Features of Forecasting
3. Importance of Forecasting Techniques
Forecasting techniques:
• Deliver appropriate and dependable information about the past and present actions and the anticipated future events. This is
essential for comprehensive planning.
• Give confidence to managers in taking complex business decisions under pressure.
• Keep managers active and alert so that they can face an unexpected crisis with a strong preparation.
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4. Types of Forecasting Techniques

Forecasting techniques can be broadly classified into two categories:
i. Qualitative Methods
ii. Quantitative Methods

Forecasting
Techniques

Qualitative Quantitative
Methods Methods

Types of Forecasting Techniques

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Unit 7 - Forecasting Techniques and Methods

These methods are further classified as follows:

Delphi

Qualitative Panel Consensus

Market Research

Forecasting Techniques Simple Moving Average

Moving Average
Weighted Moving
Average
Exponential Smoothing
Time Series
ARIMA

X11
Quantitative

Regression

Causal Economic model

Leading Indicators

Types of Forecasting Methods

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Unit 7 - Forecasting Techniques and Methods

4.1 Qualitative Methods

Qualitative methods consider the knowledge of a product, market and customers to make a judgement on the future trends. There are
several qualitative methods available for forecasting. Personal views and opinions are the basic building blocks for qualitative forecasting
methods. These methods are used when enough historical data is not available.
Qualitative methods are judgmental in nature. The predictions, forecasts and judgements made are heavily dependent on the personal
views of experts and managers. The experience, knowledge and skills possessed by experts will have a more significant bearing on the
results of qualitative forecasting methods. There are several forecasting methods available in this category. However, the most reliable
qualitative methods are discussed in the sub-sections.

Qualitative
Methods

Delphi Panel Market

Technique Consensus Research

Types of Qualitative Methods

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Unit 7 - Forecasting Techniques and Methods

4.1.1 Delphi Technique

Delphi technique is one of the most popular and commonly used forecasting techniques. A group of field experts from the RAND
Corporation developed Delphi method between 1950s and 60s.
The Delphi method is a forecasting outline based on the outcomes of multiple rounds of questionnaires shown to a panel of experts.
Numerous rounds of surveys are sent out, and unidentified replies are combined and shared with the group after every round. The
experts can adjust their responses in the following rounds. Subsequently, several rounds of questions are asked, and the panel is told
what the group reflects. This method pursues to reach the precise answer, which means the responses of experts, shifts as and when the
rounds are completed based on the views of remaining experts in the panel.
In this method, the group facilitator identifies and select a panel of experts on the topic chosen. As soon as the panel of experts
confirmed, a well-defined and well a structured questionnaire along with clear instructions are shared with the experts. The responses are
collected from all the experts separately.
In this stage, the facilitator will compile all the responses in a single document and send the compiled document to all the experts in the
panel. Another chance will be given to every panel member to change or modify their response. This process will be repeated until the
entire panel of experts reaches the common conclusion.
Advantages and Disadvantages of the Delphi Method.

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Unit 7 - Forecasting Techniques and Methods
Some of the advantages and disadvantages of the Delphi Method are:
S. No. Advantages
1 Easy to understand and perform
2 Easy to conduct and collect responses
3 Saves time and cost
4 Focus on the idea instead on individual
5 Relatively accurate
6 High level of accuracy
7 Widely acceptable
8 Opportunity to correct their views
Responses are weighted equally. Therefore, a single
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answer may not shift the direction of views.
Since the response are collected on feedback forms,
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the noise will be reduced during the discussions.
Advantages and Disadvantages of Delphi Method
Disadvantages
Lack of clear and standard methodology
Participants don’t have a chance to elaborate on their views
Highly time-consuming to collect multiple rounds of responses.
The Consensus on a view doesn’t mean the correct answer
Experts may be biased since they have their styles of researching to
form their opinions.
The complexity of data analysis is more
Difficult to keep the statement value free
Experts attempt to take the middle path which is often an inaccurate
way of reaching the conclusion
There is a tendency to ignore unique responses even if it is a correct
response.
The organiser needs to struggle in order to ensure the same level of
motivation and enthusiasm through the process.
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Nominal group method and brainstorming methods are similar techniques with the added advantage of allowing participants to
incorporate their personal views. However, the Delphi method is more appropriate when there is a lack of extensive research, lack of
clarity and consensus on a topic.
4.1.2 Panel Consensus
In this method, the experts from all the levels of an organisation come together to have an open discussion. Each member can express
his/her opinion. The meeting will be concluded on the common consensus. The experts will have their views and opinions about the
topic. Each member will share their experiences, views and comments about the topic. The discussion will continue until they arrive at a
conclusion. Finally, the group takes the best decision.
4.1.3 Market Research
Market research is the most effective, systematic and formal method of analysing the hypothesis about the real market. This is a most
commonly used technique. This is a formal method of market analysis based on various types of hypothesis.
The market research can be conducted in two ways:
Salesforce
Polling
Market
Research
Consumer
Survey
Types of Market Research
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4.1.3.1 Salesforce Polling

Few business firms conduct sales force survey since the sales executives will be in regular touch with
the customers and consumers. It is a fact that the salespeople will have a better understanding of the
perception and expectations of customers from a product.
Many companies use this method since the cost involved in conducting sales force polling will be less.
This type of surveys creates seriousness among salespeople in the generation of revenue for the
organisation. However, it is not a scientific approach to rely on sales force for market predictions.
Biased behaviour of salesforce may give incorrect predictions about the market.

Salesforce Polling

4.1.3.2 Consumer Survey

Consumer survey may involve a personal interview, questionnaires method etc. The
data collected using this method is validated using extensive statistical analysis.
Generally, companies conduct consumer survey and salesforce polling to
understand the market size, demographics, scope, consumer spending pattern and
many other aspects related to the market.

Consumer Survey
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4.2 Quantitative Methods

Quantitative forecasting techniques are statistical tools that are used to make
projections and predictions of the business. This method uses prior experiences Time Series
and historical facts and figures to conclude the future. Quantitative
Methods
Qualitative methods are objective in nature. They rely heavily on statistical analysis Causal
and mathematical computations. There are two major categories of quantitative
methods used for forecasting. Types of Quantitative Methods

4.2.1 Time Series

As the name suggests, it usually is analysing the time series data (hourly, daily, weekly, monthly, fortnightly, quarterly, half-yearly, yearly
etc). Time series method analyses historical data to extract meaningful characteristics of the data. This method relies on statistical
models to predict future values based on previously observed values.
This method is extensively used for non-stationary data. For example, weather predictions, stock price analysis, economic data analysis,
sales forecast etc. This method assumes that historical data will have hidden and significant insights about the business which will help to
understand the future trends in business.
One of the important assumptions made for time series forecasting technique is that components like seasonality and cycles will repeat
themselves. Lines charts are generally used to understand time series forecast. Time series methods are used in most of the business
operations including sales, finance and operations. Time series analysis help businesses in identifying trends and cyclical patterns in the
normal course of business.
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Unit 7 - Forecasting Techniques and Methods

A well-ordered sequence of observations of a captured object (known as variables) at an equally distributed time interval is known as
time series. Time series is anything which is observed in sequence over a specified period at regular interval. Time series data is of vital
importance when we predict something which is altering over the time using past data. In time series analysis the goal is to guess the
future value using the historical data.
Some of the most commonly used time series methods are briefly discussed in the following sections.
4.2.1.1 Moving Average (MA)
An average is nothing but the middle value of the set of numbers. Moving average is precisely the same. It is one of the traditional
methods for time series decomposition designed during the 1920s. Until the 1950s, the method was extensively used by the individuals
and business firms. This is one of the simplest methods of time series analysis. This is also known as the simple moving average.
This method is used to calculate the average of ‘n’ periods. The average value calculated considered as the forecasted value for the
subsequent periods. Generally, business firms can use this method to understand the direction of sales. A moving average helps us in
understanding whether the sale is uptrend or downtrend.
4.2.1.1.1 Simple Moving Average (SMA)
Simple moving average (SMA) smooth out irregularities such as peaks and valleys in order to recognise the trends with clear signals. Let
us assume that there are 12 observations of prices with an equal interval of time. After plotting our data, it is clearly shown that there is
an uptrend with a series of peaks and valleys.
Let us understand simple moving average with an example.

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Unit 7 - Forecasting Techniques and Methods

Example 7.1: Calculate the moving average for the following data.

Year Loan amount (Rs. Crores)

2007 15
2008 18
2009 19
2010 22
2011 19
2012 24
2013 25
2014 28
2015 26
2016 30
2017 26

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Unit 7 - Forecasting Techniques and Methods

Solution:
Year Loan Amount (Rs. Crores) SMA (3 years) SMA (5 years)
2007 15
2008 18
2009 19 17.33
2010 22 19.67 18.5
2011 19 20.00 19.5
2012 24 21.67 21
2013 25 22.67 22.5
2014 28 25.67 24
2015 26 26.33 25.75
2016 30 28.00 27.25
2017 26 27.33 27.5

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Explanation:
Step 1: Determine the sum of the first three years sales values.
Step 2: Divide the sum by three if it is three years moving average.
Step 3: The value will indicate the predicted value for sales in the third year.
Step 4: Repeat the steps for the remaining years.
Note: Determining the moving average for the first 2 years (In case of 3 years moving average) is not possible, as data for 1st and 2nd
year is not provided.
Moving Average The larger the interval, the
35 more the peaks and valleys
30 are smoothed out and vice
25 versa.
SALES

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15
The SMA essentially deals with
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historical data having more
5
and more peak and valleys.
0
1 2 3 4 5 6 7 8 9 10 11 The given an example might
TIME
be a stock data or retail data
Actual Forecast etc.
Moving Average - Graphical Representation of the Data in Table

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4 – Summary
Here are the key points what we learnt in this unit.
• Economics is the study of scarcity, and economic analysis begins with the assumption that people are rational. Our needs are
unlimited, but material resources, human resources, and other resources are finite.
• The banker has to manage scarcity and ensure optimal allocation while deciding between various courses of action.
• While aiming for scientific precision is desirable, it is not practical, and most situations call for action within a limited time frame and
with limited information. The practice of economics is thus art to some extent, as its application depends on the practitioner’s
execution skill.
• It is a science to the extent that it calls for precision and the use of scientific methods in assessing economic phenomena.
• Microeconomics deals with the study of individual choices, group behaviour, and the firm's behaviour in individual markets, while
macroeconomics studies the performance of national economies.
• Bankers can use economic tools such as the opportunity cost principle, Incremental principle, the principle of time perspective,
Discounting principle and the equi-marginal principle to make better decisions.

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Unit 7 - Forecasting Techniques and Methods

5 – Reference and Further Readings

1. Paul Samuelson and William Nordhaus, “Economics”, July 2010

2. P N Chopra, “Business Economics”, 2015, Kalyani publishers
3. Robert Frank and Ben S Bernanke, “Principles of Economics”, Nov 2000.
4. This animated cartoon explains how to calculate opportunity cost
https://www.youtube.com/watch?v=whZORVxPaLE
5. The following video explains the principles of managerial economics.
https://www.youtube.com/watch?v=97a5zAaQ3dA

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