FINANCIAL FORECASTING

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This is where the real work of financial management begins inasmuch as it deals with forecasting future events in an effort to anticipate asset needs and associated financing strategies. Looking at the past via financial analysis is always more pleasurable since you are dealing with known data and most of the effort is mechanical in nature. Now, however, you have to deal with future events which by nature are uncertain and prone to change. Most firms adopt a flexible approach to financial forecasting by looking at different time periods and recognizing that a great deal of attention might be paid to the details of a short term forecast whereas a longer time frame contains so many uncertainties that the focus shifts to broader areas of interest with less concern that the details will be "exactly right". Financial planning in the modern corporation is largely a matter of looking at a range of possible outcomes and trying to anticipate how management will adapt as events unfold. This is not to say that sloppy thinking or methods in developing the estimated future financial statements are acceptable, but it is critical to recognize that having the financial plan come to fruition in all of its detail is highly unlikely.

The planning process involves five basic steps:

  1. Project financial statements with special attention to expected cash flows and relevant ratios
  2. Examine asset needs over the projection period including fixed and current assets
  3. Estimate forecasted internal sources of funds and indicated needs for new external funding
  4. Develop explicit processes for adjusting the plan as economic and competitive events unfold
  5. Provide a review of the plan versus actual results and a management incentive system consistent with results

Relatively few analysts forecast without the use of a financial spreadsheet since the mechanical work is onerous and the time required to do them by hand tends to reduce the number of alternatives considered in the forecasting process. The logic, however, is relatively straightforward and the spreadsheet serves only as "dumb calculator" that has the advantage of being both fast and patient! The results of a spreadsheet generated forecast are no better than the effort put into validating the logic of the relationships between items on the balance sheet and income statement. "Garbage In-Garbage Out" is still the operative rule regardless of how many pages of output are generated or the level of arithmetic accuracy employed.

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ProForma Statements

The forecasting process must begin with an estimate of sales or gross revenue for the firm and this is where possible errors in the financial plan originate. If the sales forecast is either high or low; the consequences can be significant since the firm will either have insufficient assets to meet a sales volume greater than expected or it will have an excessive investment in fixed and current assets when revenue does not meet expectations. Most analysts initially look to the marketing department or person when seeking a sales forecast, but be forewarned that marketers tend to be optimists! It is a challenging occupation and the majority of them succeed only when well endowed with high levels of positivism and energy. The financial forecaster certainly does not want to inject discouragement into their proposed selling activity, but should be aware that prudence dictates a 'haircut' before using the initial estimate!

A simplistic but useful approach is to begin with a percent of sales forecast where an initial assumption is made that the future will be similar to the past. Historical relationships between various balance sheet items and past sales are determined by dividing, for example, last year's accounts receivable balance by last year's sales. (The same observation could be made in forecasting as was made in the analysis material regarding the use of average asset levels rather than the ending balance.) The resulting percentage of historical accounts receivable to sales is then applied to the expected sales level for the upcoming period and the result is a dollar amount of expected accounts receivable. For example, assume sales last period were $1,275,000 and the average accounts receivable balance was $117,000. The historical percentage of accounts receivable to sales would be 9.18% (multiply this by 365 and you can see the average collection period of 33.5 days or divide it into 1 and observe the accounts receivable turnover is 10.9 times per year). You are forecasting an increase in sales for the coming period to a level of $1,450,000. Multiplying by the 9.18% results in an estimated level of accounts receivable amounting to $133,059 which is an increase of $16,059 from last year. The increase from $117,000 to $133,059 can also be seen by multiplying the 9.18% times the change in sales ( $175,000 ) = $16,059. The critical assumption, of course, is that the accounts receivable and sales will maintain their historical relationship during the coming period. If the $175,000 increase in sales level had been obtained through easing credit terms, the forecast would obviously be in error and would need to use the higher percentage that would accompany easier credit.

It is easy to criticize the percent of sales method of forecasting, but it is commonly used as a starting point for estimating proforma financial statements since it is relatively simple to implement and begins to focus attention on the specific nature of various balance sheet accounts. For example, blindly doing a percentage of sales forecast for new fixed assets such as equipment or buildings is nonsensical since it implies that the dollar investment shown in the forecast matches the reality of the cost of the fixed assets. It is impractical to purchase part of a new machine or only build part of the new building this year! Fixed assets tend to be "lumpy" and have an all-in cost which is either invested or not depending on need and available funds. Doing the percent of sales forecast as a starting position, however, quickly shows the need for a supplemental forecast regarding new capital investments needed by the firm. The level of investment shown on the supplemental schedule would then be put into the proforma balance sheet.

The basic concept is to forecast as much of the balance sheet as possible with an emphasis on estimating the level of total assets required to support the sales for the forecast period. Then, forecast the spontaneous liabilities that change with sales levels and the amount of funding available from the income for the time period being analyzed. Most debt, whether in the form of bank loans or longer term bonds/mortgages is not considered spontaneous and would not change with sales levels. There is always the possibility of asset based financing where a lender has offered to lend a specified percentage of accounts receivable or inventory with some upper limit being set on the total funding provided. In that instance, a limited amount of new debt might be considered "quasi-spontaneous" and could be incorporated using the lending agreement percentages of the forecasted appropriate assets. In most forecasts, total assets exceed the amount of spontaneous financing, the carried forward portion of negotiated credit and the available equity. The difference, in order to force the balance sheet to balance, is typically shown as Additional Funds Needed (AFN) or External Funds Needed (EFN). The forecaster is indicating the amount of new financing required to support the forecasted assets and leaving the determination of where those funds will be found as another set of management decisions. There are instances where the available financing exceeds the forecasted assets in which case the solution is to put the difference (again, forcing the balance sheet to balance) into a special "cash or excess funds" account so that a determination can be made regarding the use of these excess funds. It is tempting to use excess funds to reduce outstanding loan obligations, but that makes the decision as to their disposition and it is best to leave that as a separate consideration from the forecasting activity.

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AFN Equation

An alternative approach to estimate the level of funding requirements for an upcoming period is to work with the formula shown below which seeks to estimate the AFN or "Additional Funds Needed":

Note that this will result in similar results to doing the percentage of sales forecast above since it uses the same logic that the future is like the past. You are looking at assets relative to sales at time zero which are expected to increase with the additional sales being forecast for the next period. The same is true of the liabilities; they would be the spontaneous sources of funds such as accounts payable that you expect to rise proportionately with sales. The last part of the equation simply multiplies the profit margin times total sales expected for the next period times the percentage of income normally retained in the business (income net of dividends paid if any) to obtain the level of equity funding provided by profit on sales. If no dividends are paid, the retention percentage is 100% which means you will reinvest the after tax income back into the business. Additional Funds Needed (AFN) can come from negotiated sources of debt or from sales of new equity, but it would not be spontaneous with changes in sales levels. If the firm employs a revolving line of credit backed by current assets such as inventory or accounts receivable, it would be a spontaneous source of funds and show in the second part of the above equation up to the limits imposed by the lender.

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Cash Budgeting

Cash budgeting is an another forecasting tool that may be useful in some situations. It typically is done for shorter time periods such as monthly or quarterly for the upcoming year and involves the receipt and expenditure of actual cash funds for those time periods. Its primary usage occurs where the firm wants shorter term goals for performance measurement purposes or in the instance of strong seasonality. The process is to identify the timing and amounts of actual cash flows into and out of a department, division or the overall firm. The cash budget is usually done with two major groupings; cash inflows and cash outflows. The forecast is made estimating the actual cash movements into and out of the firm. Collections on accounts receivable, for example, would be shown in the time period during which they are actually collected rather than at the point of sale when they are created. Accounts payable, similarly, would be shown when the actual payment is made rather than at the point of purchasing the items from a supplier. Depreciation is a non-cash charge so would not be part of a cash budget, but its effect on taxes occurs on the date when the taxes are actually paid to the appropriate governmental body.

The emphasis on shorter time frames may provide insights regarding the ebb and flow of seasonal investments in current assets and accompanying funds needs that would be lost in the annualized format of typical proforma financial statements. This could prove useful to the highly seasonal firm which runs the risk of under-estimating financing needs due to seasonal increases in inventory and accounts receivable. If sales are relatively stable across the year, however, there is little to be gained from doing quarterly or even semi-annual cash budgets since the results will look strikingly similar to the annual proforma financial statements. As firms diversify their product lines for cash flow stability throughout the year, the cash budget becomes less critical in terms of estimating additional funding needs and more of a short term monitoring device to encourage managers to 'remain on track' during the forecast period.

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