The Budget and Forecasting Process

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Forecasting

Financial

Statements

Certain slides are modified for providing additional information

Forecasting Financial Statements

 A financial forecast is a fiscal management tool that presents estimated information based on past, current, and projected financial conditions

 Forecasting

 Necessary step in process of valuation.

 Six-step Framework.

 Process “builds” pro forma financial statements

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Forecasting Financial Statements (Contd.)

 Using Business and Strategic Factors in Forecasting

 Shortcut Forecasting Techniques

 When and how to use

 Forecast Models

 Forecast is very critical and well thought-out process because it tells the future environment in which company will operate and critical decision are made

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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.

– All possible scenarios

– All Economic, market, political conditions

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General Forecasting Principles (Contd.)

• Assumptions must be internally consistent.

• Good understanding of business

• Forecasts must rely on externally valid assumptions with current business environment, market research & data

– Assumptions should pass the test of common sense.

– Impose reality checks.

• Forecast must be collaborated and coordinated amongst respective cross functional team

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Why forecasting is critical

• Proper allocation and planning of resources

• To make proper business and policy

• Management will relay on making future business decision, cashflow, growth and investments planning.

• Research analyst will use for forecasting future performance and will impact share price

• Bankers will use to make proper credit decision for the company prior to lending

• Individual will use as their investment tool

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Seven-Step Forecasting Game Plan

1. 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.

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Seven-Step Forecasting Game Plan (Contd.)

5. Project nonrecurring gains or losses (if any).

6. Check whether the projected balance sheet is in balance.

7. Derive the projected statement of cash flows.

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Seven-Step Forecasting Game Plan – Coaching tips

• Steps are integrated and interdependent, not necessarily sequential or linear.

• Forecasts must ARTICULATE between the 3 financial statements.(Income Statement, Balance Sheet and Cash Flow Statement)

• Preparing financial forecasts is an iterative and circular process.

– And requires at least one flexible financial account.

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Seven-Step Forecasting Game Plan – Coaching 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 and reasonableness test on forecasts.

• Though excel is a good tool, analyst should confirm all formulas, links etc.

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FSAP (Financial Statements Analysis Package) 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.

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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.

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Step 1: Projecting Sales and Other Revenues

• Start with principal business activities.

• Sales – determined by price sales volume. Make it bottoms-up, always; never tops-down. This means that you start with unit and price details and build up to sales from specific, concrete assumptions.

– Consider firm and its industry conditions.

• Life cycle

• Technological conditions

• Business cycle

• New product introduction/ramp up time vs market demand

• Nature of industry, sales return, discount, offerings

• Revenue recognition principle

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

– Economic-wide conditions

– Exchange rates

– Segments

• Other revenues

• Product vs services offering, aggregate vs individual

• Keep in mind your sales goal

• Never get caught forecasting a market by assuming the total market size and then projecting your market share.

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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

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Step 2: Projecting Operating Expenses (Contd.)

• Projecting Selling, General, and Administrative expenses

• Projecting Other Operating Expenses

• Projecting Nonrecurring Operating Gains and Losses

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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.

• Utilize various ratio (DSO, DIO, DPO), rollforward, scheduled payment, debt requirement etc.

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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.

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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.

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Step 5: Projecting Nonrecurring Items, Other Expenses, Provisions For Income Tax, and Changes in Retained

Earnings. • Project Nonrecurring Items.

• Project Interest and Other Income/Expenses

• Project provisions for Income taxes.

• Calculate Net Income.

• Calculate changes in Retained Earnings.

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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.

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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 firm’s financial flexibility and adjust the balance sheet.

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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.

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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.

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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.

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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.

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Analyzing Projected Financial Statements

• Test the reasonableness of forecast assumptions and their internal consistency.

• Use ratios and other analytical tools for testing.

• However, ratios cannot confirm whether our forecast assumptions will turn out to be reasonable.

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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.

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