Selected Articles on Financial Forecasting and Analysis

Long-term Financial Forecasting for Local Governments
By Christopher J. Swanson
Government Finance Review
Intro: Cities, counties, and other local government agencies are increasingly adopting long-term financial forecasting as a critical component of their financial management practices. Too many governments have found out the hard way what can happen in the absence of a realistic forecast model,one that projects and quantifies the impact of potential revenue shortfalls and increased liabilities well into the future.Forecasts can be used to create a strategic context for evaluating the annual budget, to establish a baseline for measuring the long-term effects of decisions, to test the economic effects of best-case and worst-case funding scenarios, and to establish a baseline projection of revenues, expenditures, and future cash flows and fund balances.

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The Value of Financial Forecasting
By Christopher J. Swanson
A financial forecast projects revenues and expenditures, usually five-plus years into the future. While an increasing number of public agencies use forecasts as an integral component of their financial planning and analysis process, many organizations do not, partly due to an unwillingness to move beyond the familiar annual budgeting process and partly due to misconceptions regarding the utility of multi-year forecasting in general.

Forecasting Issues
As any manager preparing a budget will tell you, it can be hard predicting what will happen tomorrow, let alone a year from now. Myriad factors ranging from the vagaries of the real estate market to local economic conditions impacting sales taxes, franchise fees and service charges can swing revenues by a wide margin. Shifting of political priorities in state capitols and Washington can present funding surprises in the middle of a fiscal year. And unexpected emergencies, man-made and natural, can throw off the most detailed expenditure plans.

Another oft-heard objection to development of long-range projections is that a forecast can become a self-fulfilling prophecy in itself, helping to maintain a less than optimal organizational status quo well into the future. For example, simple straight-line projections of department headcount and supporting costs can cause a public agency to postpone consideration of new and more effective processes and technologies for meeting the needs of its constituents.

In addition, many public officials naturally resist the idea of creating long-term financial benchmarks against which they may be held accountable, especially if they perceive their ability to influence outcomes as diminishing over time. The “compounding” effect of a series of probable forecasts over multiple years can yield a margin of error so wide as to render the projections meaningless.

Given all the potential variables that can impact even a single year’s budget, how valuable can a multi-year financial forecast be?

In fact, when developed and implemented properly, a long-range financial forecast can be an indispensable tool for managing an organization’s finances, promoting a more proactive decision-making process far superior to the shorter-term, reactionary mode within which most public agencies still operate.

Forecasting Advantages
Forecasts can be used for 1) creating a more strategic context for evaluating the annual budget, 2) establishing a baseline for measuring the long-term impact of decisions, 3) testing the economic impact of best case and worst case funding scenarios, and 4) establishing a baseline projection of revenues, expenditures and related future cash flows and fund balances, which are key metrics in evaluating the organization’s financial health.

Strategic Context
Organizations that rely only on an annual budget without the benefit of a longer range forecast are typically reactionary in nature, and improve their responsiveness to constituent demands on a very incremental basis, if at all. The organization will also be at a much higher risk of future financial hardships, especially when decisions are made that may not impose an immediate economic impact, but have the potential for incurring huge future financial liabilities, the most topical example being decisions relating to employee pension and healthcare benefits.

In addition, any organization intent on improving its effectiveness requires a vision of that potential state as well as a road map to get there. A financial forecast provides the foundation for that roadmap and tests the reasonableness of assumptions in attaining that vision.

Baseline for Measurement
It is impossible to analyze the potential positive or negative impacts of proposed changes to revenue sources, service levels or organization structure without first establishing a multi-year projection of baseline revenues and expenditures. Responsible policy makers know that meaningful cost-benefit analysis is a key component of the decision-making process.

Sensitivity Analysis
Financial forecasts allow officials to review what-if, sensitivity analysis that measures the financial impact of a range of best case and worst case economic scenarios. This is especially useful in measuring possible revenue sources that could be impaired by sudden economic downturns and shifts in intergovernmental assistance. Quantification of worst case scenarios also allows for the proactive development of contingency plans.

Tracking and Projecting Financial Condition
Because effective forecasting depends on detailed trend analysis, key metrics such as cash flow and fund balances can be traced over time and correlated with economic variables that can be used to project future cash flows.  Property values, local business cycles, new commercial and residential development, CPI and other measures are very useful for establishing a base for revenues and expenditure growth.

Forecasting Modeling and Techniques
There is a wide variety of forecasting techniques ranging from simple trend analysis to complex statistical analysis. In general though, forecasting techniques fall under three general categories of: 1) expert/judgmental analysis, 2) deterministic forecasting, and 3) econometric modeling.

Different techniques can be used to project different revenue and expenditure variables, based on the nature of the variable and historical data available to the forecaster. Where data is limited, “expert” analysis and judgment may be utilized, which is the least quantitative approach that typically relies on simple trend analysis and therefore requires that the projections be accompanied with best and worst case scenarios that test the broadest range of probable outcomes.

Deterministic and econometric forecasts are based on one or more underlying and correlative factors that directly impact revenues and to a lesser extent, expenditures. Changes in assessed property valuation will directly impact property tax revenues. Commercial and residential development, and local economic conditions, will impact permit and planning fees, franchise income and sales taxes.

It is also important that the forecast be developed in a model that allows for activation of what-if scenarios that depict a range of revenues, expenditures and corresponding cash flows, and their positive or negative impacts measured against an established baseline. A comprehensive forecast model will also allow for testing of proposed changes to revenues (eg. new or eliminated revenue sources, revised tax rates, fees, etc.), service levels, staffing and benefits, debt structure, introduction of new technologies, and changes to organizational structure.

Positioning the Forecast: Prediction vs. Projection
A forecast is not a budget and it is important to educate internal and external audiences to this fact. It is essential that the forecast be positioned as a projection of possible future outcomes based on a set of known variables and assumptions, rather than a “predictor” of what will happen. As with a weather forecast, a financial forecast is always subject to change based on new information, and an effective budgeting and planning process will provide for a consistent routine for updating the forecast. 

When used properly, a forecast can provide public officials with a means of better evaluating the financial impact of proposed initiatives and educating constituents as to an organization’s present and potential financial capabilities.