To avoid confusion, it is important to define clearly what is meant by the term forecasting. It is also important to distinguish forecasting from activities such as planning and modeling, which are related to forecasting but nevertheless are separate managerial functions.
A forecast is a prediction about a condition or situation at some future time. Much of human activity is based on forecasts. We routinely listen to weather forecasts on the radio to help us plan future activities. Forecasting is an important part of our lives.
Business decisions, and especially financially related business decisions, depend heavily on forecasts of future events. Decisions to lend money or borrow money depend on forecasts of future cash flow and future expected returns. For example, when John agrees to lend Mary some money, it is assumed that John expects to be repaid. This document is about the techniques financial managers use to predict the likely future values of financial variables such as revenues, expenses, and cash balances.
Some managers use the terms forecasting, planning, and modeling interchangeably to describe a large, involved process by which the firm decides what it wants to accomplish and how it intends to accomplish it. Other managers have much more specific, detailed processes in mind when they use these same terms.
As has been noted, forecasting is a process by which predictions are made about some future condition. Planning is a process by which a firm develops a scheme to accomplish something. A plan can be very broad in nature and may have nothing to do with forecasting. Suppose, for example, management has already decided to modernize one of the company’s plants and wants to establish a planning group to plan the modernization. The group’s job will be not to forecast the effect of the decision but to implement the modernization program.
The planning process frequently depends on forecasts. If the planning group had been charged with the review of the basic plant modernization decision, then it would have had to rely heavily on forecasting. The group would need to evaluate estimates (forecasts) of the cost of modernization, estimates of the increased productivity (lower operating expenses) it would make possible, and so forth. Planning usually involves forecasting.
When the planning process is complex, it is common to reduce the plan to a financial model, a simplified representation of a complex process. Because financial issues usually involve numbers, it is common for financial planning to be reduced to structured numerical models that are given such names as budgets, pro forma balance sheets, and income statements.