Financial Forecasting Flashcards
Why is financial forecasting important? Name three reasons.
- All our investment decision rules require CF forecasts
- If we want to value a co (e.g for M&A) we need to be able to forecast co. FCFs to get accurate valuation
- By forecasting our company’s future performance, we can better plan for future possible cash shortages or surpluses
What is a proforma?
- A prediction about co. future financial statements (I/S, B/S, etc.)
What is the purpose of proforma statements?
- To estimate a company’s future need for external financing
- For valuation purposes (clearly, info about a company’s future CFs affects our valuation for it)
What is the main approach we’ll use to forecast in this course?
Percent of sales forecasting
What are the four main steps in percent of sales forecasting?
(1) Look at historical data to find which items (e.g. COGS) tend to vary in proportion to sales
(2) Forecast sales
(3) Based on sales forecast and percentage estimates from step #1, compute forecasts for the other variables that are tied to sales
(4) Conduct a sensitivity analysis or scenario analysis with different assumptions about the variables
Days’ Sales in Cash = …
Cash / Sales per day
Collection period = …
Accounts receivable/ Credit sales per day
Inventory turnover = …
COGS / Ending inventory
Payables Period = …
Accounts payable / Credit purchases per day
The higher the days’ sales in cash number, the less urgent need for what?
Cash
A higher collection period number translates to what?
- The higher the number, the longer it takes (on average) for the company to receive payment for their sales on credit
A higher inventory turnover number translates to what?
- The higher the number, the less time inventory stays on the shelf
- E.g. inventory turnover = 12 means average shelf time is 1 month
What does the payables period ratio measure?
- Average amount of time it takes a company to pay off its account payables
If management isn’t comfortable with their days’ sales in cash and want to increase it, what can they do to increase their cash balance?
- Higher sales
- Increased profit margin
- Longer payables’ periods
- Shorter collection period
- Loan from a bank
What are two complications that arise in financial forecasting (in general)?
(1) What if our debt level changes at the beginning of the year rather than at the end?
(2) What happens if the co. has a minimum cash balance, rather than just letting the cash balance fluctuate with sales?
To understand why a company may be having liquidity problems, we can look at the following ratios:
- Days’ sales in cash (want higher)
- Collection period (want lower)
- Inventory turnover (want lower)
- Payables period (want lower)
By looking at the gap b/w the forecasted assets and the forecasted equity + owner’s liability, we’ll get an estimate for what?
- the external funding required (how much external financing co. will need to obtain to achieve their objectives)
A bigger bank loan means a company will have to pay more what?
Interest expense on the debt
If a company needs more financing than a bank will grant, how can the co. change their strategy so they can meet their cash needs with the smaller loan amount the bank is willing to grant?
- Tighten up collection of AR so collection period drops
- Be more timely about paying back suppliers
- These changes will hurt sales though
When forecasting, what do we use as the plug?
Bank loan
Explain the problem of circularity in financial forecasting.
If our debt level changes at the beginning of the year rather than at the end…
- our addition to RE will depend on our interest payments
- but our interest payments depend our debt level
- and our debt level depends on our addition to RE
What are the implications of debt level changing at the beginning of the year rather than at the end?
- Choice of debt in year t affects our interest payments in year t
What is the non-iterative, non-spreadsheet approach to calculate the addition to RE?
= (EBIT - interest payments) (1 - T)
For example (10 - .06D) (1 - 0.3)
What is the non-iterative, non-spreadsheet approach to calculate equity?
= Beginning equity + addition to RE
For example, 50 + (10 - .06D) (1 - 0.3)
Suppose a company’s cash policy is the following:
- If cash balance isn’t sufficiently high, take out a loan from bank so cash balance meets min. balance.
- Otherwise, don’t take out loan and let cash pile up.
In this scenario, what do you forecast first? Last?
- Forecast all other variables first
- Forecast cash or the extra bank loan (overdraft) last
How do you compute trial assets?
- Sum of all assets excluding cash
How do you compute trial liabilities?
- Sum of all equity and liabilities excluding the overdraft
If trial assets + min. cash balance > trial liabilities, then what must we set overdrafts to? Expand.
- To be greater than 0
- b/c company’s CF from operations are not expected to be sufficient to meet the min. cash balance
- hence additional external financing required
- TAKEAWAY: set cash to min. balance, set overdraft equal to trial assets + min cash balance - trial liabilities
If trial assets + min. cash balance < trial liabilities, then what must we set overdrafts to? Expand.
- No need to use overdrafts
- Set overdrafts to 0
- Use cash as plug
- Resulting cash balance will exceed min. balance
- TAKEAWAY: set overdrafts to 0, set cash balance as difference b/w trial assets and trial liabilities
If you’re conducting a sensitivity analysis, you want to make sure you manually program the cells for cash and bank loan with what kind of statements?
“If” statements (only way to get cash balances and bank loan amounts to vary properly with underlying parameters)