Chapter 10

Copyright © 2011 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 10Chapter 10Forecasting Forecasting

Financial Financial StatementsStatements

Chapter: 10 2

Forecasting Financial StatementsForecasting

Necessary step in process of valuation.Six-step Framework.

Process “builds” pro forma financial statements

Chapter: 10 3

Forecasting Financial Statements (Contd.)Using Business and Strategic Factors in

Forecasting.Shortcut Forecasting Techniques.

When and how to use.Forecast Models.

Chapter: 10 4

General Forecasting PrinciplesProduce reliable and realistic

expectations.Unbiased - neither conservative nor

optimistic.Forecasts should not manifest wishful

thinking.Forecasts should be comprehensive.

Include ALL expected future activities.

Chapter: 10 5

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 6

Seven-Step Forecasting Game Plan1. Project revenues from sales and

operating activities.2. Project operating expenses and derive

projected income.3. Project operating assets and liabilities.4. Project the financial leverage and capital

structure.

Chapter: 10 7

Seven-Step Forecasting Game Plan (Contd.)5. Project non recurring gains or losses (if

any).6. Check whether the projected balance

sheet is in balance.7. Derive the projected statement of cash

flows.

Chapter: 10 8

Chapter: 10 9

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.

Seven-Step Forecasting Game Plan - Practical tips

Chapter: 10 10

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.

Seven-Step Forecasting Game Plan - Practical tips (Contd.)

Chapter: 10 11

FSAP to Prepare Forecasted Financial StatementsContains 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 12

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 13

Step 1: Projecting Sales and Other RevenuesStart with principal business activities.Sales – determined by price AND volume.

Consider firm and its industry conditions.Life cycle.Technological conditions.Business cycle.

Chapter: 10 14

Step 1: Projecting Sales and Other Revenues (Contd.)

Economic-wide conditions.Exchange rates.Segments.

Other revenues

Chapter: 10 15

Step 2: Projecting Operating ExpensesFixed 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 16

Step 2: Projecting Operating Expenses (Contd.)Projecting Selling, General, and

Administrative expenses.Projecting Other Operating Expenses.Projecting Nonrecurring Operating Gains

and Losses.

Chapter: 10 17

Step 3: Projecting Operating Assets and Liabilities on the Balance SheetForecasting 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 18

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 19

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 20

• Project Nonrecurring Items.• Project provisions for Income taxes.• Calculate Net Income.• Calculate changes in Retained Earnings.

Step 5: Projecting Nonrecurring Items, Provisions For Income Tax, and Changes in Retained Earnings.

Chapter: 10 21

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

Chapter: 10 22

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 6: Balancing the Balance Sheet(Contd.)

Chapter: 10 23

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: Projecting the Statement of Cash Flows

Chapter: 10 24

Tips for Forecasting Statement of Cash Flows:Ensure that the Balance Sheet is in balance.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.

Step 7: Projecting the Statement of Cash Flows (Contd.)

Chapter: 10 25

Shortcut Approaches to ForecastingEfficient 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 26

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 27

Analyzing Projected Financial StatementsTest 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 correct.

Chapter: 10 28

Sensitivity Analysis and Reactions to AnnouncementsCan 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.