Chapter 10 Forecasting Financial Statements

Forecasting Financial Statements Necessary step in process of valuation. Six-step Framework. Process “builds” pro forma financial statements Chapter: 10

Forecasting Financial Statements (Contd.) Using Business and Strategic Factors in Forecasting. Shortcut Forecasting Techniques. When and how to use. Forecast Models. Chapter: 10

General Forecasting Principles Produce reliable and realistic expectations. Unbiased and objective - neither conservative nor optimistic. Forecasts should not manifest wishful thinking. Forecasts should be comprehensive. Include ALL expected future activities. Chapter: 10

General Forecasting Principles (Contd.) Assumptions must be internally consistent. Forecasts must rely on externally valid assumptions. Assumptions should pass the test of common sense. Impose reality checks. Chapter: 10

Seven-Step Forecasting Game Plan Project revenues from sales and operating activities. Project operating expenses and derive projected income. Project operating assets and liabilities. Project the financial leverage and capital structure. Chapter: 10

Seven-Step Forecasting Game Plan (Contd.) Project non recurring gains or losses (if any). Check whether the projected balance sheet is in balance. Derive the projected statement of cash flows. Chapter: 10

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Seven-Step Forecasting Game Plan - Practical tips Steps are integrated and interdependent, not necessarily sequential or linear. Forecasts must ARTICULATE between the 3 financial statements. Preparing financial forecasts is an iterative and circular process. And requires at least one flexible financial account. Chapter: 10

Seven-Step Forecasting Game Plan - Practical tips (Contd.) Quality will depend on assumptions! Financial statements will be no better than these. Sweat the big stuff. Do not sweat the little stuff. Analyst should perform sensitivity analysis on forecasts. Chapter: 10

FSAP to Prepare Forecasted Financial Statements Contains a forecast spreadsheet to prepare financial statement forecasts. Excel spreadsheets can provide a basis. Proper design of a spreadsheet and preparation of forecasts can provide an excellent learning experience. Chapter: 10

FSAP to Prepare Forecasted Financial Statements (Contd.) Helps solidify understanding of the relationships between the various financial statements. Provides a scratch pad to compute various detailed forecast assumptions. Chapter: 10

Step 1: Projecting Sales and Other Revenues Start with principal business activities. Sales – determined by price AND sales volume. Consider firm and its industry conditions. Life cycle. Technological conditions. Business cycle. Chapter: 10

Step 1: Projecting Sales and Other Revenues (Contd.) Economic-wide conditions. Exchange rates. Segments. Other revenues Chapter: 10

Step 2: Projecting Operating Expenses Fixed vs. Variable components Does cost change proportionately to sales? Careful of the “relevant range”. Industry knowledge important here. Should forecast capital expenditures. Projecting Cost of Goods Sold. Analyze by segment. Chapter: 10

Step 2: Projecting Operating Expenses (Contd.) Projecting Selling, General, and Administrative expenses. Projecting Other Operating Expenses. Projecting Nonrecurring Operating Gains and Losses. Chapter: 10

Step 3: Projecting Operating Assets and Liabilities on the Balance Sheet Forecasting future operating assets and liabilities from operating activities projected. To forecast individual operating assets and liabilities, determine the underlying operating activities that drive them. Chapter: 10

Step 3: Projecting Operating Assets and Liabilities on the Balance Sheet (Contd.) Turnover Based techniques: Used to forecast any operating asset and liability accounts that vary reliably with sales. Should not be used if the firm experiences a substantially different future growth rate or if the relation between sales and forecast account varies unpredictably. Chapter: 10

Step 4: Project Financial Assets, Financial Leverage, Common Equity Capital and Financial Income Items. Project Financial assets, Financial debt and Shareholders' equity capital necessary. Project effects of financing on net income, considering future interest income interest expense and other elements of financial income. To maintain a particular capital structure, Common sized balance sheet and projected amounts of total assets can be used to project. Consider the financial leverage strategy of the firm. Chapter: 10

Step 5: Projecting Nonrecurring Items, Provisions For Income Tax, and Changes in Retained Earnings. Project Nonrecurring Items. Project provisions for Income taxes. Calculate Net Income. Calculate changes in Retained Earnings. Chapter: 10

Step 6: Balancing the Balance Sheet Projected assets less Projected liabilities and shareholders’ equity = Amount of adjustment (flexible financial account.) If Projected assets > Projected liabilities and shareholders’ equity: Raise additional capital. Raise additional debt. Sell financial assets. Chapter: 10

Step 6: Balancing the Balance Sheet (Contd.) If Projected assets < Projected liabilities and shareholders’ equity: Pay down debt. Issue larger dividends. Repurchase more shares. Invest in financial assets. Evaluate the firms financial flexibility and adjust the balance sheet. Chapter: 10

Step 7: Projecting the Statement of Cash Flows Characterize all changes in the Balance Sheet in terms of impact on Cash. Derive the statement of Cash flows from Projected Income Statement and Balance Sheets. Chapter: 10

Step 7: Projecting the Statement of Cash Flows (Contd.) Tips for Forecasting Statement of Cash Flows: Do not use historical cash flows as they do not provide good basis for projecting future cash flows. Use Implied Statement of Cash Flows computed from projected Income Statements and Balance Sheets. Chapter: 10

Shortcut Approaches to Forecasting Efficient only if firm is stable and mature in an industry in steady-state equilibrium. Projected Sales and Income Approach Use recent sales growth rate. Use recent profit margin. Chapter: 10

Shortcut Approaches to Forecasting (Contd.) Projected Total Assets Approach Use historical asset growth rate in total assets. Also consider the link between sales growth and asset growth. Alternative approach: use the total assets turnover ratio, linking sales growth and asset growth. Chapter: 10

Analyzing Projected Financial Statements Test the reasonableness of forecast assumptions and their internal consistency. Use ratios and other analytical tools for testing. But, ratios cannot confirm whether our forecast assumptions will turn out to be reasonable. Chapter: 10

Sensitivity Analysis and Reactions to Announcements Can be used to assess the impact of new announcements from the firm. Can be used to assess the sensitivity of firm’s liquidity and leverage to key assumptions. Helps react quickly and efficiently to new announcements. Chapter: 10