Financial forecasting methods
/Types of Financial Forecasting Methods
There are a number of methods that can be used to develop a financial forecast. These methods fall into two general categories, which are quantitative and qualitative. A quantitative approach relies upon quantifiable data, which can then be statistically manipulated. A qualitative approach relies upon information that cannot actually be measured. The following are quantitative forecasting methods.
Causal Forecasting Methods
Causal methods assume that the item being forecasted has a cause-and-effect relationship with one or more other variables. For example, the existence of a movie theater can drive sales at a nearby restaurant, so the presence of a blockbuster movie can be expected to increase sales in the restaurant. The main types of causal forecasting methods are as follows:
Regression analysis. This method examines the relationship between a dependent variable (the item being forecasted) and one or more independent variables that influence it. Simple regression involves one independent variable, while multiple regression includes several factors to improve accuracy. By analyzing historical data, regression models can estimate future values based on changes in influencing factors.
Econometric models. These are advanced statistical models that combine multiple equations to analyze the economic relationships between variables. They are commonly used in macroeconomic forecasting, such as predicting GDP, inflation, or industry trends. By incorporating economic theories and real-world data, econometric models help businesses and policymakers make informed decisions.
Input-output models. This method analyzes the interdependencies between different sectors of an economy or business operation. It examines how inputs (such as raw materials, labor, or capital) flow through a system and impact outputs. By mapping these relationships, input-output models help predict how changes in one area will affect overall performance.
Leading indicators method. This approach uses key economic or business indicators that tend to change before the variable being forecasted. Examples include stock market trends, interest rates, and consumer confidence indexes, which can signal future economic activity. Businesses use this method to anticipate demand shifts and adjust their strategies accordingly.
Simulation models. These models use mathematical and computational techniques to create scenarios based on different assumptions and input variables. They help forecast outcomes by simulating real-world processes, such as market demand fluctuations or supply chain disruptions. Organizations use simulation models for strategic planning and risk assessment.
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Time Series Forecasting Methods
These methods derive forecasts based on historical patterns in the data that are observed over equally spaced time intervals. The assumption is that there is a recurring pattern in the data that will repeat in the future. Three examples of time series methods are:
Rule of thumb. The rule of thumb approach is based on a simplified analysis rule, such as copying forward the historical data without alteration. For example, sales for the current month are expected to be the same as the sales generated in the immediately preceding month.
Smoothing. The smoothing approach uses averages of past results, possibly including weightings for more recent data, thereby smoothing out irregularities in the historical data.
Decomposition. A decomposition analysis breaks down the historical data into its trend, seasonal, and cyclical components, and forecasts each one.
Qualitative Forecasting Methods
There are several types of qualitative forecasting methods, which are as follows:
Market research. This approach is based on discussions with current and potential customers regarding their need for goods and services. Information must be gathered and analyzed in a systematic manner in order to minimize biases caused by small data sets, inconsistent customer questioning, excessive summarization of data, and so forth. This is an expensive and time-consuming research method. It can be useful for detecting changes in consumer sentiment, which will later be reflected in their buying habits.
The opinions of knowledgeable personnel. This approach is based on the opinions of those having the greatest and most in-depth knowledge of the information being forecasted. For example, the senior management team may derive forecasts based on their knowledge of the industry. Or, the sales staff may prepare sales forecasts that are based on their knowledge of specific customers. An advantage of using the sales staff for forecasting is that they can provide detailed forecasts, possibly at the level of the individual customer. There is a tendency for the sales staff to create overly optimistic forecasts.
The Delphi method. This approach is a structured methodology for deriving a forecast from a group of experts, using a facilitator and multiple iterations of analysis to arrive at a consensus opinion. The results from each successive questionnaire are used as the basis for the next questionnaire in each iteration; doing so spreads information among the group if certain information was initially not available to everyone. Given the significant time and effort required, this method is best used for the derivation of longer-term forecasts.
Qualitative methods are especially necessary during the early stages of a company or product, where there is little historical information that can be used as the basis for a quantitative analysis.