The Budget and Forecasting Process

1. Look at Apple’s recent financial statements, tell us based on 7-step processes whether the company is matured or something else like whether 7-step could be used in analyzing and forecasting APPL.

2. If company has forecasted growth in its earnings but its operating cashflow is declining. Provide 3 reasons for declining operating cashflow.

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Forecasting

Financial

Statements

Certain slides are modified for providing additional information

Forecasting Financial Statements

 A financial forecast is a fiscal management
tool that presents estimated information
based on past, current, and projected
financial conditions

 Forecasting

 Necessary step in process of valuation.

 Six-step Framework.

 Process “builds” pro forma financial statements

2

Forecasting Financial Statements (Contd.)

 Using Business and Strategic Factors in
Forecasting

 Shortcut Forecasting Techniques

 When and how to use

 Forecast Models

 Forecast is very critical and well thought-out
process because it tells the future
environment in which company will operate
and critical decision are made

3

General Forecasting Principles

• Produce reliable and realistic expectations.

– Unbiased and objective – neither conservative nor
optimistic.

• Forecasts should not manifest wishful thinking.

• Forecasts should be comprehensive.

– Include ALL expected future activities.

– All possible scenarios

– All Economic, market, political conditions

4

General Forecasting Principles (Contd.)

• Assumptions must be internally consistent.

• Good understanding of business

• Forecasts must rely on externally valid
assumptions with current business environment,
market research & data

– Assumptions should pass the test of common sense.

– Impose reality checks.

• Forecast must be collaborated and coordinated
amongst respective cross functional team

5

Why forecasting is critical

• Proper allocation and planning of resources

• To make proper business and policy

• Management will relay on making future business decision,
cashflow, growth and investments planning.

• Research analyst will use for forecasting future performance
and will impact share price

• Bankers will use to make proper credit decision for the
company prior to lending

• Individual will use as their investment tool

6

Seven-Step Forecasting Game Plan

1. Project revenues from sales and operating
activities.

2. Project operating expenses and derive
projected income.

3. Project operating assets and liabilities.

4. Project the financial leverage and capital
structure.

7

Seven-Step Forecasting Game Plan (Contd.)

5. Project nonrecurring gains or losses (if any).

6. Check whether the projected balance sheet
is in balance.

7. Derive the projected statement of cash
flows.

8

Seven-Step Forecasting Game Plan –
Coaching tips

• Steps are integrated and interdependent, not
necessarily sequential or linear.

• Forecasts must ARTICULATE between the 3
financial statements.(Income Statement,
Balance Sheet and Cash Flow Statement)

• Preparing financial forecasts is an iterative
and circular process.

– And requires at least one flexible financial
account.

9

Seven-Step Forecasting Game Plan –
Coaching tips (Contd.)

• Quality will depend on assumptions!

– Financial statements will be no better than these.

• Sweat the big stuff. Do not sweat the little
stuff.

• Analyst should perform sensitivity analysis
and reasonableness test on forecasts.

• Though excel is a good tool, analyst should
confirm all formulas, links etc.

10

FSAP (Financial Statements Analysis Package)
to Prepare Forecasted Financial Statements

• Contains a forecast spreadsheet to prepare
financial statement forecasts.

• Excel spreadsheets can provide a basis.

• Proper design of a spreadsheet and
preparation of forecasts can provide an
excellent learning experience.

11

FSAP to Prepare Forecasted Financial
Statements (Contd.)

• Helps solidify understanding of the
relationships between the various financial
statements.

• Provides a scratch pad to compute various
detailed forecast assumptions.

12

Step 1: Projecting Sales and Other Revenues

• Start with principal business activities.

• Sales – determined by price sales volume. Make it bottoms-up,
always; never tops-down. This means that you start with unit and
price details and build up to sales from specific, concrete
assumptions.

– Consider firm and its industry conditions.

• Life cycle

• Technological conditions

• Business cycle

• New product introduction/ramp up time vs market demand

• Nature of industry, sales return, discount, offerings

• Revenue recognition principle

13

Step 1: Projecting Sales and Other Revenues
(Contd.)

– Economic-wide conditions

– Exchange rates

– Segments

• Other revenues

• Product vs services offering, aggregate vs individual

• Keep in mind your sales goal

• Never get caught forecasting a market by assuming the total
market size and then projecting your market share.

14

Step 2: Projecting Operating Expenses

• Fixed vs. Variable components

– Does cost change proportionately to sales?

– Careful of the “relevant range”

– Industry knowledge important here

• Should forecast capital expenditures

• Projecting Cost of Goods Sold

– Analyze by segment

15

Step 2: Projecting Operating Expenses
(Contd.)

• Projecting Selling, General, and
Administrative expenses

• Projecting Other Operating Expenses

• Projecting Nonrecurring Operating Gains and
Losses

16

Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet

• Forecasting future operating assets and
liabilities from operating activities projected.

• To forecast individual operating assets and
liabilities, determine the underlying operating
activities that drive them.

• Utilize various ratio (DSO, DIO, DPO),
rollforward, scheduled payment, debt
requirement etc.

17

Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet (Contd.)

• Turnover-Based techniques:

– Used to forecast any operating asset and liability
accounts that vary reliably with sales.

– Should not be used if the firm experiences a
substantially different future growth rate or if the
relation between sales and forecast account varies
unpredictably.

18

Step 4: Project Financial Assets, Financial Leverage,
Common Equity Capital and Financial Income Items.

• Project Financial assets, Financial debt and Shareholders’ equity
capital necessary.

• Project effects of financing on net income, considering future
interest income interest expense and other elements of
financial income.

• To maintain a particular capital structure, Common-sized
balance sheet and projected amounts of total assets can be
used to project.

• Consider the financial leverage strategy of the firm.

19

Step 5: Projecting Nonrecurring Items, Other Expenses,
Provisions For Income Tax, and Changes in Retained

Earnings.
• Project Nonrecurring Items.

• Project Interest and Other Income/Expenses

• Project provisions for Income taxes.

• Calculate Net Income.

• Calculate changes in Retained Earnings.

20

Step 6: Balancing the Balance Sheet

• Projected assets less Projected liabilities and
shareholders’ equity = Amount of adjustment
(flexible financial account.)

• If Projected assets > Projected liabilities and
shareholders’ equity:

– Raise additional capital.

– Raise additional debt.

– Sell financial assets.

21

Step 6: Balancing the Balance Sheet
(Contd.)

• If Projected assets < Projected liabilities and shareholders’ equity: – Pay down debt. – Issue larger dividends. – Repurchase more shares. – Invest in financial assets.

• Evaluate the firm’s financial flexibility and
adjust the balance sheet.

22

Step 7: Projecting the Statement of Cash
Flows

• Characterize all changes in the Balance Sheet
in terms of impact on Cash.

• Derive the statement of Cash flows from
Projected Income Statement and Balance
Sheets.

23

Step 7: Projecting the Statement of Cash
Flows (Contd.)

– Tips for Forecasting Statement of Cash Flows:

• Do not use historical cash flows as they do not
provide good basis for projecting future cash flows.

• Use Implied Statement of Cash Flows computed from
projected Income Statements and Balance Sheets.

24

Shortcut Approaches to Forecasting

• Efficient only if firm is stable and mature in an
industry in steady-state equilibrium.

• Projected Sales and Income Approach

– Use recent sales growth rate.

– Use recent profit margin.

25

Shortcut Approaches to Forecasting
(Contd.)

• Projected Total Assets Approach
– Use historical asset growth rate in total assets.

– Also consider the link between sales growth and
asset growth.

– Alternative approach: use the total assets
turnover ratio, linking sales growth and asset
growth.

26

Analyzing Projected Financial Statements

• Test the reasonableness of forecast
assumptions and their internal consistency.

• Use ratios and other analytical tools for
testing.

• However, ratios cannot confirm whether our
forecast assumptions will turn out to be
reasonable.

27

Sensitivity Analysis and Reactions to
Announcements

• Can be used to assess the impact of new
announcements from the firm.

• Can be used to assess the sensitivity of firm’s
liquidity and leverage to key assumptions.

• Helps react quickly and efficiently to new
announcements.

28