Prospective Analysis Guidelines for Forecasting Financial Statements

Ignacio Velez-Pareja and Joseph Tham

8.1 Chapter Introduction and Objectives

Having performed an accounting and financial analysis, an analyst has to forecast financial statements into the future. This is a precursor to valuation. Many methods of forecasting like percent sales method are available. In this chapter, we provide a comprehensive overview of prospective analysis. Although parts of the chapter are written from the perspective of a company's manager, they are still valid for an analyst. After all, the analyst's perspective mirrors that of the manager. This chapter has the following objectives:

• Highlight what data are required for forecasting

• Discuss elements of forecasting balance sheet and income statement

• Discuss the derivation of cash flows from the forecast

• Highlight implementation issues in a real-life setting

8.2 Introduction

In this chapter, we discuss some ideas that might be useful in forecasting financial statements based on historical data.1

The approaches and suggestions presented in this chapter assume that the analyst has access to some company information that is not usually found in publicly available financial statements.

Universidad Tecnológica de Bolivar, School of Finance and International Business, Ave. Miramar #18-93 Apto 6 A, Manga, Cartagena, Colombia

1 Many ideas presented in this chapter are the result of advising undergraduate and graduate students in the course cash flow valuation (CFV): A basic introduction to an integrated market-based approach at Duke University during the Fall of 2005 and my experience in teaching the subject at Universidad Tecnológica de Bolívar in Cartagena, Politecnico Grancolombiano in Bogota, and other universities in Colombia.

S.R. Vishwanath, C. Krishnamurti (eds.), Investment Management: A Modern Guide 155

to Security Analysis and Stock Selection, DOI: 10.1007/978-3-540-88802-4.8, © 2009 Springer-Verlag Berlin Heidelberg

In forecasting financial statements, we start with the historical financial statements and from them we identify the patterns and relationships of different items, the implicit policies, growth rates, and so on. The usual practice is to examine historical financial statements to derive information from them that can be used to forecast financial statements. As all information needed cannot be obtained from historical statements, we assume that the information is available from the company's management. We show how we can find information not found in the statements. Finally, we develop a detailed example of a hypothetical firm to explain the procedure to forecast financial statements. We also critically examine the usual practice of using plugs in forecasting financial statements.

The chapter is organized as follows: first, we present comments in a general form about the relevance of prospective analysis to nontraded firms. Specifically, we highlight the importance for these firms of having a financial model with which they can assess the value creation in the firm.

In the second section, we review concepts in accounting and economics that are used in forecasting financial statements. We stress upon a financial statement that shows the detailed inflows and outflows of cash in the firm: the cash budget (CB). This is an important tool for managing a firm. We also review topics like Pareto law and Fisher equation. Fisher equation is the key to forecasting variables linked to inflation rate. We also review the indexes used to measure inflation. The chapter uses the Fisher equation to forecast interest rates and increases in prices.

Special mention is devoted to a usual practice when forecasting: the plug. This is a practice that we do not recommend and show an alternate approach. The approach we propose in this chapter follows an accounting principle that is the basis of any accounting procedure: the Double Entry Principle. This principle guarantees consistent and error-free financial statements. We show with a simple example how the plug works and its limitations.

Next, the reader will find what information is needed for forecasting financial statements and where and how to find it. We identify the procedure to identify policies that govern the working of a firm such as accounts receivable and payable (AR and AP), inventories, dividend payout, payments in advance, and the like. We also deal with the real-life problem of a firm with multiple products and/or services.

Finally, we show some tools to perform sensitivity analysis for financial management and analysis. We also use this tool to check the consistency of the financial model.

In the next two sections, we deal with the relevance of several accounting concepts. In particular, we briefly describe the CB.

8.3 General Comment on Financial Statement Forecasting

Forecasting financial statements is imperative for the management because it can provide a rough guide to the future performance of the firm. It is very important to do some prospective analysis for the long-term (LT) to develop strategies for meeting the challenges that may arise. Moreover, for most firms, it is vital to have a financial model that allows management to control value creation. This can be done by constructing cash flows from the financial statements and estimating the firm value. We propose to construct three financial statements: balance sheet (BS), income statement (IS), and CB without plugs and without circularity.2

Much of the economic activity in the world takes place inside nontraded firms. Even in a developed country like the United States, traded firms account for less than 0.5% of the total firms. In emerging markets the proportion is much less.

The financial model would be useful to examine and anticipate the economic effect of a decision. This can be done through the use of sensitivity analysis, scenario analysis, and Monte Carlo simulation. In addition, the financial model can be used to time capital market issues or in planning capital expenditure.

8.3.1 The Cash Budget

The cash budget (CB) or cash forecast (other names are cash flow or fund flow) shows the liquidity of the firm. In other words, the CB shows the amount of cash available at each point in time. In the CB, we record all the inflows and outflows of the firm. We can think of the CB as a financial statement that records all the checkbook transactions in the firm. The CB shows all the cash transactions of the firm. It shows how much cash goes into the firm bank account and how much cash goes out. The cumulative cash remaining is what the firm has as cash in hand at the end of any period. It should be identical to the amount of cash that is listed in the BS. Moreover, the CB is very powerful tool for the financial management of any firm.

Perhaps the CB is the most important financial statement in the firm for financial management purposes. With it we can estimate the financing needs and the cash surplus in each period. Some typical items in the CB statement are shown in the Table 8.1.

The CB can help us answer questions such as when do we need funds? How much money do we need? Can we obtain it by speeding up the repayment of sales sold to customers? Is there a limit in the amount of sales? Can we postpone some payments? Can we renegotiate the debt terms with the bank? Can we increase sales with the available resources? For how long can we increase the sales with the actual available resources? If we increase sales, how much funds do we need to support the increase? How can we negotiate a debt schedule profile with the bank? Which is the maximum debt capacity of the firm in a given planning horizon? When and how much liquidity will we have?

For convenience, we can organize the CB in modules according to the type of transactions we record. The CB we present is similar, in some way, to the cash flow statement according to generally accepted accounting principles. However, the CB is more detailed and of course is prospective, not an ex-post analysis.

2 The uselessness and distractions of plugs and circularity will be apparent later in the chapter.

Inflows

Outflows

Sales on cash

Accounts receivables recovery Loans received Equity invested

Repayments of loans lent to third parties

Interest received from loans to third parties

Sale of inventories

Sale of fixed assets

Sale of other assets

Interest on marketable securities

Redemption of marketable securities

Customers ' in advance payments

Value added tax (VAT) collected

Accounts payable payments for purchases

Salaries and fringe benefits

Interest payments

Principal payments

Rent

Overhead expenses

Promotion and advertising

Asset acquisition

Social security payments

Earnings distributed or dividends paid

Taxes paid (income, capital gains, VAT)

Investment in marketable securities

Repurchase of equity

Loans lent to third parties

Taken and adapted from Tham and Vélez-Pareja (2004)

This approach is integral and allows the management to conduct sensitivity analysis from the input data. When we say integral we mean that everything in the model is linked to some input data (input variables) in such a way that a change in one of them will give a specific result.

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  • Tommy
    What is prospective analysis in accounting?
    2 days ago

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