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

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

3. Overview @

4. Learning Objectives @

5. Readings @

6. 1. Objectives

7. 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

8. 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

9. 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)

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

11. 2. Pro Forma Statements

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

13. 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.

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

16. 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

17. 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

18. 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

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

20. 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)

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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)

31. 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.

32. 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.

33. Bridges: Examples

34. Circularity Rather than a Bridge

35. Iterations
???

36. 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

37. 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)

38. Simplified Example: First Pass
Revenue % 125
COGS % 75
EBT
Taxes (50%)
NI (Ret Earn)
C Assets % 125
LT Assets % 125
T Assets
C Liab % 125
Equity
Liab & Eq

39. Simplified Example: Second Pass
Revenue % 125
COGS % 75
EBT
Taxes (50%)
NI (Ret Earn)
C Assets % 125
LT Assets % 125
T Assets
C Liab % 125
Equity
Liab & Eq

40. 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)

41. 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.

42. 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