Financial Forecasting

Question 1

Why is forecasting important?

Answer 1

All investment decision rules (IRR, NPV, payback period, profitability index) require cash flow forecasts; those forecasts have to come from somewhere

If we want to value a company, we need to be able to forecast the company’s free cash flows to get accurate valuation

Allows for better planning for future possible cash shortages and surpluses

Question 2

What is a pro forma?

Answer 2

Prediction about the company’s future financial statements

Question 3

What are the purposes of Pro Forma Statements?

Answer 3

Estimate a company’s future need for external financing
(Will firm have enough cash to make it through next year, or does the firm need to obtain external financing?)

Valuation- information about companuy’s future cash flows affects valuation for it

Question 4

What is the percent of sales forecasting?

Answer 4

Approach to forecasting that computes many variables/accounts as a function (in particular) of future sales projections

Question 5

What are the steps to Sales Forecasting?

Answer 5

1. ) Look at historical data to find which items tend to vary in proportion to sales
2. ) Forecast sales
3. ) Based on sales forecasts and percentage estimates from step 1, compute forecasts for the other variables that are tied to sales
4. ) Conduct sensitivity analysis or scenario analysis with different assumptions about the variables

Question 6

Days’ Sales in Cash (B/S)

Answer 6

Cash / Sales per day

• The higher the number, less urgent the need for cash; median value for non-financial S&P 500 companies: 29.7 days

Question 7

Collection Period (B/S)

Answer 7

Accounts Receivable / Credit Sales per Day

• The higher the number, the longer it takes (on average) for the company to receive payment for their sales on credit

Question 8

Inventory Turnover (B/S)

Answer 8

COGS / Ending Inventory

• The higher the number, the less time inventory stays on shelf
• 12 implies avg shelf time = 1 month

Question 9

Payables Period (B/S)

Answer 9

Accounts payable / Credit purchases per day

• Average amount of time it takes a company to pay off its AP’s; simply collection period applied to AP

Question 10

How do you get an estimate for the external funding required?

Answer 10

By looking at the gap between the forecasted assets and the forecasted equity + owner’s liability

Question 11

How can a company change strategy to meet cash needs with smaller loan?

Answer 11

Tighten up collection of AR so that collection period drops

Longer payable period

Question 12

What are two complications with forming pro forma statements?

Answer 12

1. ) Debt level changes at the beginning of the year rather than at the end
   - cannot ignore interest expense

2.) Company has minimum cash balance rather than just letting cash balance fluctuate with sales

Question 13

Calculate Retained Earnings (RE) amount for pro forma

Answer 13

RE(current year) = RE(last year) + NI(current year) - DIV PAID

NI = earnings after tax

Question 14

What are the 4 ways to improve a company’s cash situation (liquidity)?

Answer 14

1. increase sales drastically (or margins)
2. decrease collections period*
3. increase payables period*
4. take out a bank loan

*try to improve cash cycle

Question 15

How do you solve the circularity issue that arises with pro forma statements when interest is paid at the BEGINNING of the year?

Answer 15

continue to recalculate the plug and interest expense until you arrive at the right answer, iterations will correct

OR

know that DEBT = ASSETS - EQUITY

DEBT = ASSETS - [BEG EQUITY + (EBIT - DEBT * r)(t)]