FIN 422: Student Managed Investment Fund Topic 7: Financial Forecasting Larry Schrenk, Instructor

“Prediction is very difficult, especially if it's about the future.” Nils Bohr

Overview @

Learning Objectives @

Readings @

1. Objectives

Objectives of Financial Forecasting Short-term forecasts focus on cash budgeting and cash flow planning Long-term forecasts focus on planning for future growth in sales and assets and for financing of this growth

Short-Term Forecasts and Cash Budgeting General procedure results in dynamic short-term financial planning and cash budgeting system: Develop sales forecast for upcoming year Develop estimates of next year’s expected profitability Develop forecasted (pro forma) income statement for upcoming year Estimate cash payment and collection lags Develop detailed cash collection and payments forecast Construct cash budget Develop forecasted (pro forma) balance sheet for end of next year

Long-Term Financial Planning Long-term financial planning: concerns future sales growth and devising plans to finance this growth Percentage of sales technique As future sales grow, assets will also have to increase to support sales increases Increased assets will be financed by reinvested earnings and increases in so-called spontaneous liabilities (i.e. accounts payable) Any shortages of financing sources will have to be provided for from external financing sources (i.e. long-term debt, additional equity)

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. Assumptions must be internally consistent. Forecasts must rely on externally valid assumptions. Assumptions should pass the test of common sense. Impose reality checks.

2. Pro Forma Statements

Forecasting and Pro Forma Analysis Timing of financial needs Amount of financial needs Flow of funds Check the covenants

Steps in Financial Forecasting 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. Project non recurring gains or losses (if any). Check whether the projected balance sheet is in balance. Derive the projected statement of cash flows.

1. Sales and Other Revenues Start with principal business activities Sales Price Sales volume.

1. Sales and Other Revenues (cont’d) Market factors Seasonal changes Business cycle Recession/Expansion Inflation Exchange rates Industry factors Technological conditions Firm factors Life cycle

1. Sales and Other Revenues (cont’d) Regression can be used to estimate future sales. Collect five years of quarterly sales Use dummy variables for seasons There are also more advanced methods

Step 2: 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

Step 2: Operating Expenses (cont’d) Projecting Selling, General, and Administrative expenses Projecting Other Operating Expenses Projecting Nonrecurring Operating Gains and Losses

Step 2: Operating Expenses (cont’d) Regression can be used to estimate the variable/fixed components of costs as a function of sales y = fixed portion + variable portion (sales)

Step 3: Operating Assets and Liabilities 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

Step 3: Projecting Operating Assets and Liabilities (cont’d) 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

Step 4: Financial 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

Step 5: Nonrecurring Items, Provisions For Income Tax, etc. Project Nonrecurring Items Project provisions for Income taxes Calculate Net Income Calculate changes in Retained Earnings

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

Step 6: Balancing the Balance Sheet (cont’d) 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

Step 7: 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

Step 7: Statement of Cash Flows (cont’d) 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

Key Assumptions Operating at full capacity? Each type of asset grows proportionally with sales Payables and accruals grow proportionally with sales Profit margin and payout ratio will be maintained? Specific sales increase

Pro Forma Statements Sales change based on growth rate in sales Some items change directly as percent of sales Cash Accounts receivable Some items change indirectly as percent of sales Inventories Net fixed assets Accounts payable and accruals Some items change independently Depreciation Taxes Some items change by firm choice Payout ratio Capital structure (plug)

Bridges: General Clearly we can’t hope to get anywhere if we develop separate forecasts of the different statements. The income statement records the effect of a given year while the balance sheets show the situation at the beginning of and after that year. Furthermore the balance sheet must balance. The two statements must therefore be intimately linked. There must be “bridges” between them.

Bridges: Examples Retained Earnings: Interest: Net Income – Dividends = Change in Retained Earnings An income statement amount less dividends equals a balance sheet amount. Interest: Interest Expense = Interest Rate  Interest Bearing Debt An income statement amount equals a balance sheet amount times a cost figure.

Bridges: Examples

Circularity Rather than a Bridge

Iterations ???

Simplified Example Revenue 100 COGS 60 EBT 40 Taxes (50%) 20 NI (Ret Earn) 20 C Assets 100 LT Assets 100 T Assets 200 C Liab 100 Equity 100 Liab & Eq 200

Simplified Example Assumptions Sales will increase by 25% Some items change directly as percent of sales COGS, CA, LTA, and CL will increase with sales Some items change indirectly as percent of sales Some items change independently Tax rate will remain constant Some items change by firm choice Payout ratio will remain zero Any additional capital will be raised through equity (plug)

Simplified Example: First Pass Revenue 100 25% 125 COGS 60 25% 75 EBT 40 50 Taxes (50%) 20 25 NI (Ret Earn) 20 25 C Assets 100 25% 125 LT Assets 100 25% 125 T Assets 200 250 C Liab 100 25% 125 Equity 100 120 Liab & Eq 200 245

Simplified Example: Second Pass Revenue 100 25% 125 COGS 60 25% 75 EBT 40 50 Taxes (50%) 20 25 NI (Ret Earn) 20 25 C Assets 100 25% 125 LT Assets 100 25% 125 T Assets 200 250 C Liab 100 25% 125 Equity 100 125 Liab & Eq 200 250

Ratios Current Pro Forma Current Ratio 1.0 (100/100) 1.0 (125/125) ROA 10% (20/200) 10% (25/250) ROE 20% (20/100) 20% (25/125)

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.

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