Financial Forecasting
By using the basis financial statements describes in other posts (Income Statement, Balance Sheet and Cash-Flow), managers can develop pro forma financial statements.
A. Forecast profitability, meaning to develop a pro-forma Income Statement. A firm’s net income depends mainly on 5 variables:
- Sales (price x quantity) -> it’s the main forecast driver, so be aware of your assumptions and make them explicit.
- Cost of Goods Sold (the cost of manufacturing or purchasing the firm’s product or services); can be fixed or variable costs; in general it’s a % of sales.
- Operating Expenses (marketing, distribution, administrative, depreciation and general costs); can also be fixed or variable.
- Interests
- Income Tax
B. Forecasting financial needs, requires to develop a pro-forma Balance Sheet.
- The first step in developing a pro-f0rma Balance Sheet is to determine the amount of assets that the company will require in order to produce its products and services. Most firms will require working capital (inventory, receivables and cash) and fixed-assets (building, machines, cars, computers, etc).
- The key to effectively forecasting is to understand the firm’s relationship between sales and assets. In general, the greater the firm’s sales, the greater the assets required and in turn, the greater need for financing. Be carefull in determining the working capital needed, it is usually underestimated (and don’t forget to add personal expenses and unexpected items). If the company has no reliable historical information, industry standard ratios or experts’ forecasting feedback can be the basis for determining the assets-to-sales ratio. In general, assets can be determined as a percentage of sales.
- In general, “cash” is a minimum level which is determined by the company policies. “Receivables” and “Inventory” are a % of sales. Finally, “Fixed Assets and Depreciation” are predictable expenses easy to estimate.
- The need to invest in assets will determine the amount of financing required. Whether it will be financed with debt or equity is another issue not to be analyzed at this stage. In general, you take into account the firm’s historical financial obligations. Note that “Payables”, are also a % of sales and come either from historical information or from industry averages.
C. Forecasting Cash-Flows, the pro-forma Income Statement and Balance Sheet do not provide with sufficient information about the company’s financial situation. Once the pro-forma Income Statement and Balance Sheet have been developed, we must develop the pro-forma cash-flow statement. This will allow the manager to understand the use and sources of funds; for example, it is possible that in the first year of operations the company can have negative cash flow from operations and its highest challenge is to get cash flows from financing.
Forecasting with INFLATION: inflation is an additional form of growth and at the same time increases the company costs. If your are expecting a growth in sales of 10% and inflation will be 5%, future sales will not be just 15% higher! Because of inflation sales in year 2 will be S2=(S1×1.1)x1.05. Furthermore, as not many companies are capable of passing suppliers increase in price to final customers, inflation will have an impact on cost of sales. Cost of Sales in year 2 will be COGS2= COGS1 x 1.05.
Notes
- Try making different scenarios (sensitivity forecasting).
- Determine and clearly understand what’s your brake-even point.
Understanding financial requirements flow...
Tags: financial forecasting, pro-forma balance sheet, pro-forma income statement