FINANCIAL FORECASTING

Forecasting financials is an important part of accounting skills and is used by managers, financial analysts, and investors to predict future potential revenue streams, expenses, and cash flow. While creating financial reports for future periods involves a great deal of uncertainty, it is still very useful for businesses to make their best predictions based on the information they have.

Forecasts can be used at a project level, for example, to help make a decision as to whether to undertake a particular project or at a company level, for example, to decide whether to invest in a certain company or whether financing is needed.

Pro-forma financial statements are one of the most common types of financial forecasts. The percent of sales forecasting method is used when creating proformas internally; it involves determining future expected sales and finding trends among various accounts in the financial statements.

Businesses also use other assumptions and methodologies when the percent of sales method is not ideal. For example, some line items, such as cost of goods sold, can often be forecasted by assuming that they will continue to grow proportionally with sales.

Other line items may be more accurately forecasted using assumptions based on information other than sales, such as other information in the annual report or in industry reports. For example, in forecasting PPE and depreciation, while longer-term planned capital expenses may roughly mirror sales, we will often use more detailed descriptions about planned purchases in the notes sections of financial statements as the basis of our forecast.

Another account that typically does not vary directly with sales is income tax expense. Instead, if the business is stable, income tax expense generally can be estimated as a certain percentage of income before taxes.?

To forecast liabilities and equity, the current portion of long-term debt is determined based on the part of a long-term loan that becomes current or is to be repaid within one year. Since they are linked, interest expense and borrowings can be tricky to forecast and may take some trial and error. For example, a company that may need additional funding, meaning an increase in borrowings, will have increased interest expenses.

In some cases, borrowings will be a plug to make the balance sheet balance. In other cases, another account such as cash or equity may be used as a plug to make the balance sheet balance. Retained earnings are calculated by adding net income to the retained earnings account balance of the prior year. Any dividends to be paid need to be subtracted from retained earnings.

Another important component in planning and evaluating the future of a business is to look at the expected cash flows that the company will generate. These provide an indication of how much actual cash is generated, and hence available, to be paid out to investors in the business or invest in new projects. The equation is: FCF = (1?t) × EBIT + DEP ? CAPX ? Δ NWC

With free cash flows determined, stakeholders consider the valuation of various projects. In order to fully consider the valuation of a project, however, stakeholders must consider the concept time value of money because a dollar received today is worth more than one that would be received a year from now due to opportunity costs of how else the dollar could be spent, inflation, and the certainty of payments. In order to fairly compare different projects, the value of the cash flows has to be considered at the same time period.

Present Value of Infinite Cash Flows = Cash Flows in the Final Year of Our Projection / Discount Rate ? Growth Rate

For simplicity, we often translate all cash flows to the value that they would be worth today, the “present value.” In order to make the calculation, you need a discount rate, which is the rate that would otherwise be available in the market or the rate that best captures the risk inherent in the project being evaluated.?

With all cash flows determined, the value of the project can be calculated by using the net present value, or NPV, of the cash flows. The NPV nets out the present values of all the cash inflows and outflows of the project. The result is a single number that gives a good indication of what a business or a particular investment is worth today. It is important that the NPV uses only relevant cash flows in the analysis.?

If the business has already paid for something that will be used at no additional cost by the new project, those costs are omitted because they are sunk costs and shouldn’t factor into the decision of whether or not the project should be undertaken. Likewise, costs that will be incurred whether we go ahead with the project or not are also irrelevant to this decision.

The valuation of a project will change as the assumptions that go into the NPV model, such as the cash flows and discount rate, change. This sensitivity analysis is an important part of the overall analysis.

Valuation measures introduced in the module include the internal rate of return, or IRR, and the Payback Period. The IRR is the discount rate that sets the NPV of a project equal to zero. The IRR allows us to see the percentage rate that would be earned for a given set of cash flows. This method incorporates the time value of money as the NPV does.

This metric is often used when there is a lack of clarity or a lack of consensus within the company as to what discount rate should be used in an NPV calculation.

The payback period tells us how fast investors can expect to have their money returned. This metric is more useful for someone who is concerned about limiting the downside potential rather than evaluating the whole project. It ignores the time value of money and the cash flows that occur after the payback period. Lease accounting is the process by which an organization records the financial impacts of its leasing activities in its accounting calculations and reports. According to the latest lease accounting standards, lessees are required to recognize ROU assets and lease liabilities for all leases with terms longer than 12 months. Under US GAAP, two types of long-term leases are operating leases and finance (previously capital) leases. In contrast, under IFRS, all long-term leases are treated as finance leases.??