Chapter 10
Forecasting
Financial
Statements
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Forecasting Financial Statements
 Forecasting
 Necessary step in process of valuation.
 Six-step Framework.
 Process “builds” pro forma financial
statements
Forecasting Financial Statements
(Contd.)
 Using Business and Strategic Factors in
Forecasting.
 Shortcut Forecasting Techniques.
 When and how to use.
 Forecast Models.
General Forecasting Principles
 Produce reliable and realistic
expectations.
 Unbiased - neither conservative nor optimistic.
 Forecasts should not manifest wishful
thinking.
 Forecasts should be comprehensive.
 Include ALL expected future activities.
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.
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.
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.
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.
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.
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.
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.
Step 1: Projecting Sales and Other
Revenues
 Start with principal business activities.
 Sales – determined by price AND volume.
 Consider firm and its industry conditions.
 Life cycle.
 Technological conditions.
 Business cycle.
Step 1: Projecting Sales and Other
Revenues (Contd.)
 Economic-wide conditions.
 Exchange rates.
 Segments.
 Other revenues
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.
Step 2: Projecting Operating Expenses
(Contd.)
 Projecting Selling, General, and
Administrative expenses.
 Projecting Other Operating Expenses.
 Projecting Nonrecurring Operating Gains
and Losses.
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.
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.
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.
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.
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
(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.
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.
Step 7: Projecting the Statement of
Cash Flows (Contd.)
 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.
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.
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.
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
correct.
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.