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#12: Financial Forecasting
Financial Forecasting
• The Percentage of Sales Method - Part 1
• Overview
• Six Steps of the % of Sales Forecast
1. Decide Key Assumptions
2. Forecast the Income Statement
• The Percentage of Sales Method - Part 2
3. Forecast Working Capital
4. Forecast Balance Sheet
5. Forecast Statement of Cash Flows
6. Financial Ratios and Sensitivity Analysis
Overview
• Learn how financial managers create a forecast of the 3 financial statements using historical relationships
• Called the “ Percentage of Sales Method” because westart with a sales forecast then build other items as a “% of Sales”
• Booth, Cleary and Rakita (BCR) is confusing so we will stick with these slides (and Excel spreadsheet) to explain it.
• A financial forecast is great tool for understanding future financing needs
• Called External Financial Requirements (EFR)
• Generate proforma forecasts of Income Statement, Balance Sheet and Statement of Cash Flows
• Retained Earnings from Income Statement increases Common Equity on Balance Sheet
• Find out how much cash needed to run business
• Cash will be “ plug” that balances Balance Sheet
• Verify it using Statement of Cash Flows
Assets = Liabilities + Equity
(Assetsex. casℎ) + casℎ = Liabilities + Equity
90 + casℎ = 40 + 60
casℎ = 10
Six Steps of the % of Sales Forecast
1. Decide key assumptions
• For forecast, we need assumptions about:
• Sales growth and profit margins
• Cost of debt and quantity of debt => used to forecast interest expense
• Working Capital: A/R, Inventory, A/P
• Other Current Assets and Current Liabilities
• Tax rate and dividend payout ratio
• Depreciation and CAPEX
• Easiest way is to calculate historical ratios over the past 3 to 5 years and look at averages and trends.
• Common-size financial statements are helpful for identifying relationships and patterns.
• Examples of key assumptions:
• Sales growth declines steadily from 10% to 2%
• Margins and Working Capital ratios are unchanged.
• CAPEX declines overtime until equal to Depreciation.
|
YEAR FORECAST ASSUMPTIONS |
0 |
1 |
2 |
3 |
4 |
5 |
|
Sales growth and margins |
|
|
|
|
|
|
|
Sales growth (y-o-y) |
n.a. |
10.0% |
8.0% |
6.0% |
4.0% |
2.0% |
|
COGS % Sales |
70.0% |
70.0% |
70.0% |
70.0% |
70.0% |
70.0% |
|
SGA % Sales |
10.0% |
10.0% |
10.0% |
10.0% |
10.0% |
10.0% |
|
Depreciation % Sales |
5.0% |
5.0% |
5.0% |
5.0% |
5.0% |
5.0% |
|
Capital expenditures % Sales |
10.0% |
9.0% |
8.0% |
7.0% |
6.0% |
5.0% |
|
Interest expense, taxes and dividends |
|
|
|
|
|
|
|
Cost of debt (% per annum) |
6.0% |
6.0% |
6.0% |
6.0% |
6.0% |
6.0% |
|
Tax rate (%) |
20.0% |
20.0% |
20.0% |
20.0% |
20.0% |
20.0% |
|
Dividend payout ratio (%) |
10.0% |
10.0% |
10.0% |
10.0% |
10.0% |
10.0% |
|
Productivity (Working capital) |
|
|
|
|
|
|
|
Days of Receivables = AR / (Revenue/365) |
25 |
25 |
25 |
25 |
25 |
25 |
|
Days of Inventory = Inventory / (COGS/365) |
90 |
90 |
90 |
90 |
90 |
90 |
|
Days of Payables = AP / (COGS/365) |
45 |
45 |
45 |
45 |
45 |
45 |
|
Cash Conversion Cycle = Days AR + Days Inv - Days AP |
70 |
70 |
70 |
70 |
70 |
70 |
2. Forecast Income Statement
• Based on these assumptions, we forecast Income Statement down to Operating Income
• Called Earnings Before Interest and Taxes or “EBIT”
• We cannot forecast rest of Income Statement until we make an assumption about quantity of debt
• Used to calculate Interest Expense
• But we can forecast up to Earnings before Interest and Taxes (EBIT)