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Principles of Finance

18.4 Generating the Complete Forecast

Principles of Finance18.4 Generating the Complete Forecast

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Generate a forecasted income statement that incorporates pertinent sales, functional, and policy variables.
  • Generate a forecasted balance sheet.
  • Connect the balance sheet and income statement forecasts with appropriate feedback linkages.

In this section of the chapter, we will tie together what we have learned so far about forecasting sales, common-size analysis, and using what we know about the company and its environment to create a full set of pro forma (forward-looking or forecasted) financial statements.

Forecast the Income Statement

To arrive at a fully forecasted income statement, we use historical income statements, common-size income statements, and any additional information we have about future sales and costs, such as the effects of the economy and competition. As we saw earlier in the chapter, we begin with forecasted sales because they are the basis for many of the forecasted costs.

Let’s begin with the sales forecast for Clear Lake Sporting Goods that we saw earlier in the chapter, in Figure 18.9, and use it along with the prior year income statement by month shown in Figure 18.12. We will consider other data we have about the business to begin creating a full income statement (see Figure 18.13).

Prior year monthly income statement by month. It shows the gross monthly sales from January to December, and calculates the net income for all of the previous twelve months.
Figure 18.12 Prior Year Monthly Income Statement by Month

The first two key points regarding product lines have already been built into the sales forecast. Notice that the cost of goods sold was 50% in the prior year. However, based on possible future legislation, to be conservative, we should increase the cost of goods sold by 2% in the last quarter of the year. Thus, we will forecast cost of goods sold at 50% of sales in the first nine months and increase it to 52% in the last three months of the year.

Rent is a fixed cost that historically amounts to $458 per month. However, we know that the landlord is increasing rent by $50 starting on July 1. Thus, we will forecast rent at the same fixed cost of $458 per month for the first six months and increase it to $508 per month for the second half of the year.

Depreciation, also a fixed cost, was historically $300 per month. However, we know that depreciation expense will go down by $25 beginning in April. Thus, we forecast depreciation at $300 for the first three months and at $275 for the last 9 months.

Salaries expense has historically been $450 per month. However, we know that the company is implementing a new compensation program on January 1 that will increase salaries expense by 4% ($18). Thus, we will forecast salaries for the whole year at $468.

Utilities expense seems to vary somewhat by sales from month to month, as shops are open longer hours during their busy season. However, the total utilities expense is not expected to change for the coming year. Thus, the forecast for utilities expense remains at $2,500, broken down by month as a percentage of sales.

Interest expense is a fixed cost and isn’t anticipated to change. Thus, the same $167 interest expense per month is forecast for the coming year.

Finally, income tax expense is forecasted as a percentage of operating income because tax liability is incurred as a direct result of operating income. Figure 18.13 shows the next 12 months’ forecast for Clear Lake Sporting Goods using all of this data.

The forecasted monthly income statement for Clear Lake Sporting Goods shows the gross monthly sales forecasts from January to December, as well as the forecasted monthly expenses. The monthly net income is calculated by subtracting the expenses from the net sales. The annual gross sales, net sales, expenses, and net income are calculated as well.
Figure 18.13 Forecasted Income Statement

Forecast the Balance Sheet

Now that we have a reasonable income statement forecast, we can move on to the balance sheet. The balance sheet, however, is entirely different from the income statement. It requires a bit more research and additional assumptions. Just like the income statement, it’s often a work in progress. A first draft is a good starting point, but adjustments must be made once it is created, and all the interrelationships between the statements, cash flow in particular, are taken into consideration.

The balance sheet is a bit more difficult to forecast because the statement reflects balances at just a given point in time. Account balances change daily, so forecasting just one snapshot in time for each month can be a challenge. A good starting point is to assess general company financial policies or rules of thumb. For example, assume that Clear Lake pays most of its vendors on net 30-day terms. A good way to forecast accounts payable on the balance sheet might be to add up the cost of goods sold from the forecasted income statement for the prior month. For example, in Figure 18.14, we see that Clear Lake has forecasted its accounts payable for March as the cost of goods sold in March from its forecasted income statement.

For accounts receivable, Clear Lake generally receives payment from customers within net 90-day terms. Thus, it uses the sum of the current and prior two months’ forecasted sales to estimate its accounts receivable balance.

Inventory will vary throughout the year. For the first six months, the company tries to build inventory for four months of sales. Once the busy season hits, inventory goes down to three months’ worth of future sales, then finally drops to only two months of sales in December. Thus, managers use their sales forecast by month to estimate their inventory ending balance each month.

The equipment balance is forecasted by reducing the prior month’s balance by the forecasted depreciation expense on the forecasted income statement.

Unearned revenue is historically around 50% of the current month’s sales. Thus, Clear Lake estimates its unearned revenue balance each month by taking the current month’s net sales from the forecasted income statement and multiplying it by 50%.

Short-term investments, notes payable, and common stock are not anticipated to change, so the current balance is forecasted to remain the same for the next 12 months.

To forecast the ending balance for retained earnings for each month, managers add the monthly net income from the forecasted balance sheet to the prior balance and subtract a quarterly $10,000 dividend.

Once all of these accounts are completed, the balance sheet is out of balance. Given that all of these events are somewhat related but are not tied together dollar for dollar, it’s not surprising when the forecasted balance sheet is finished and does not balance. To complete the first draft (see Figure 18.14), the cash account is used as a variable and plugged in to make the balance sheet balance. Notice that by the end of the year, the company has $59,905 in cash. However, look at what happens midyear—the cash account falls to only $8,782. In the next section, we will generate a cash flow forecast, which will allow Clear Lake to update its balance sheet forecast once it estimates what it will do to cover the cash flow gaps.

The Forecasted monthly balance sheet for Clear Lake Sporting Goods shows the addition of a cash account under current assets. This amount ranges from a high of $60,834 in November to a low of $8,782 in June.
Figure 18.14 Forecasted Balance Sheet Draft

Linkages between the Forecasted Balance Sheet and the Income Statement

Notice that in the discussion in the prior section on the balance sheet forecast, a lot of the information in the forecasted income statement was used to generate the forecasted balance sheet. The balance sheet accounts generally depend on activity reported in the income statement. For example, for many firms, the balance in their accounts receivable account is tied to their sales. Looking at historical balances in the accounts receivable account and how those relate to historical sales will help determine how to use the forecasted future sales to estimate the future balance of accounts receivable.

The same is true of accounts payable. Looking at past balances, past expenses (normally cost of goods sold), and the firm’s payment terms for its vendors allows managers to use forecasted cost of goods sold or other expenses to estimate the balance in the accounts payable account.

We learned in Financial Statements that net income flows into retained earnings. Thus, the net income from the forecasted income statement can be used to help estimate the ending balance in retained earnings. If the firm intends to issue any dividends in the coming year, managers should also estimate that reduction in their forecast.

It’s also common to find other general policies or procedures that help drive performance and aid in forecasting balances. For example, if the company has a goal of maintaining a certain level of inventory or a minimum balance in its cash account, that information can be used to guide the estimate for those accounts.

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