Finance for Business Professionals Workshop

SessionSession- 5 Brief Overview of Financial Forecasting

- September 24, 2010

Instructor: Saif Rahman

What is Financial Forecasting?

y

It is a Part of Planning process. y They are inferences as to what the future may be. y Extends over a time horizon. y Based on: i. Economic assumptions (interest rate, inflation rate, growth rate and so on). ii. Sales forecast. iii. Pro forma statements of Income account and Balance sheet. iv. Asset requirements. v. Financing plan. vi. Cash Budget
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Financial Forecasting
Purpose
Financial managers must produce forecasts for the financial results of corporate plans to:
Determine whether the corporate plans will require additional external financing Determine whether the corporate plans will produce surplus cash resources that could be distributed to shareholders as dividends Assess the financial forecasts to determine the financial feasibility of corporate plans if poor financial results are forecast, this gives management the opportunity to reexamine and amend corporate plans to produce better results before resources and people are committed.

Financial Forecasting Process

The basis for all financial forecasts is the sales forecast. The most recent balance sheet values are the starting point. Pro forma (forecast) balance sheets are projected assuming some relationship with projected sales (constant percentage of sales) Current liabilities are usually assumed to rise and fall in a constant percentage with sales we call them spontaneous liabilities because they change without liabilities negotiation with creditors.

Preparing Comprehensive Pro Forma Financial Statements

Sales Forecast Production Forecast

Cash Flow Forecast

Pro Forma Income Statement Pro Forma Balance Sheet Sales, production and cash flow forecasts are usually done on a monthly basis whereas pro forma income and balance sheets 5 are done an annual basis

Financial Forecasting
The Percentage of Sales Method
The percentage of sales method involves the following steps: 1. Determine which financial policy variables you are interested in 2. Set all the non-financial policy variables as a percentage of nonsales 3. Extrapolate the balance sheet based on a percentage of sales 4. Estimate future retained earnings 5. Modify and re-iterate until the forecast makes sense. reThis process most often results in a balance sheet that does not balance a plug (balancing) amount is the external funds required (or surplus funds forecast)

Percent of Sales Method

   

Suppose this years sales will total $32 million. Next year, we forecast sales of $40 million. Net income should be 5% of sales. Dividends should be 50% of earnings.

This year Assets Current Assets Fixed Assets Total Assets Liab. Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab & Equity $8m $16m $24m $4m $4m $1m $6m $15m $7m $2m $9m $24m

% of $32m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Predicting Retained Earnings:



Next years projected retained earnings = last years $2 million, plus: million,

projected sales

net income x sales

(1
x

cash dividends - net income )

$40 million x

.05

(1 - .50)
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= $2 million + $1 million = $3million

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

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Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m $10m $27m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

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Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m $10m $27m

% of $40m 25% 50%

12.5% How much 12.5% Discretionary n/a Financing n/a

will we n/a Need?

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Predicting Discretionary Financing Needs

Discretionary Financing Needed = projected total assets $30 million projected total liabilities projected owners equity

$17 million - $10 million

= $3 million in discretionary financing

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Sustainable Rate of Growth

g* = ROE (1 - b)
where

b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or net income sales ROE = sales x assets common equity x assets
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Forecasting Price


Forecasted price must be consistent with that upon which any research into demand, including surveys, was based.

For companies with various product offerings, it is useful to capture differences in the prices of these offerings. For example, if you are forecasting sales for a car wash, it is important that you capture the prices of the different grades of washes. Rather than applying a blended price of a typical car wash, this is better done by explicitly forecasting the price and number of each type of wash and computing revenues for each
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Drivers of Economic Growth

Expansion of Consumer Goods/Service Sectors

Monetary Conditions

Consumer Confidence

Consumer Spending

Fiscal Policy

Business Confidence

Business Investment

Other Factors Global Growth Technological Innovations

Expansion of Industrial Goods/Service Sectors

Increased Commercial Borrowing/ Fewer Defaults

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Forecasting Sales of Established Firm



   

For a firm with a history of sales or where there exists a comparable firm with a history of sales, one can extrapolate trends nominal growth rate real growth rate (net out pricing changes and examine quantity of items sold) could weight period of history more reflective of firms expected performance growth rate of sales should be adjusted for relevant expected changes in economic and industry factors

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Forecasting Sales of Established Firm:

Use of Quarterly Information and adjustment for seasonality
 

Make use of quarterly information in forecasting sales Consider case of Le Chateau (Cdn store sales in Millions) Forecasting Q3 and Q4 sales
Year Ended Jan 2003 Jan 2002 % Change Q1 40.9 35.5 15% Q2 49.1 39.7 24% 48.7 52.4 176.3 Q3 Q4 Total

Method #1: If one assumes that Q3 and Q4 will experience the same quarter growth as did Q1 and Q2, then sales should increase by 20%. This means Q3 Canadian sales will rise to $58.3 and Q4 Canadian sales will rise to $62.9. Estimate of total annual sales is $211.2.
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Forecasting Sales of Established Firm:

Use of Quarterly Information


Refinement #1: If same stores sales growth was 15% in Q1 and Q2, but number of stores is 2% higher in Q3 and Q4, growth of sales for these quarters should be 17%. Refinement #2: Use updated figures. Le Chateau stated that first 6 weeks of Q3, Canadian store sales increased 16%. Forecast growth at 16%.
0

Refinement #3: Use information from other firms in industry. Recent information from another Canadian apparel retailer, La Senza, for its Q3 results indicated no growth in comparable store sales. Its Q1 and Q2 2002 same store figures had been 6.5% ahead of 2001. One could cut forecast Q3 and Q4 growth from 16% to 9%.

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Forecasting Gross Margins of Established Firm Use of Quarterly Information



Analysts often assume for retailers, that cost of goods sold is a variable cost and selling, general and administrative costs are fixed As shown below, gross margins tend to decrease in weak sales periods (when there is very keen competition) ; as an offsetting effect, SGA is lower in low sales periods
Le Chateau Sales Gross Margin as % of Sales SGA as % of Sales EBITDA as % of Sales Q1 43.0 34.6% 29.1% 5.5% Q2 51.6 37.0% $13.4 26.0% 11.0% Q3 60.4 36.6% $15.3 25.4% 11.2%
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Selling, General and Administrative Costs $12.5