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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. cas?) + cas? = Liabilities + Equity
90 + cas? = 40 + 60
cas? = 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)