Financial Forecasting

Question 1

Why is financial forecasting important? Name three reasons.

Answer 1

• All our investment decision rules require CF forecasts
• If we want to value a co (e.g for M&A) we need to be able to forecast co. FCFs to get accurate valuation
• By forecasting our company’s future performance, we can better plan for future possible cash shortages or surpluses

Question 2

What is a proforma?

Answer 2

• A prediction about co. future financial statements (I/S, B/S, etc.)

Question 3

What is the purpose of proforma statements?

Answer 3

• To estimate a company’s future need for external financing

- For valuation purposes (clearly, info about a company’s future CFs affects our valuation for it)

Question 4

What is the main approach we’ll use to forecast in this course?

Answer 4

Percent of sales forecasting

Question 5

What are the four main steps in percent of sales forecasting?

Answer 5

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

Question 6

Days’ Sales in Cash = …

Answer 6

Cash / Sales per day

Question 7

Collection period = …

Answer 7

Accounts receivable/ Credit sales per day

Question 8

Inventory turnover = …

Answer 8

COGS / Ending inventory

Question 9

Payables Period = …

Answer 9

Accounts payable / Credit purchases per day

Question 10

The higher the days’ sales in cash number, the less urgent need for what?

Answer 10

Cash

Question 11

A higher collection period number translates to what?

Answer 11

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

Question 12

A higher inventory turnover number translates to what?

Answer 12

• The higher the number, the less time inventory stays on the shelf
• E.g. inventory turnover = 12 means average shelf time is 1 month

Question 13

What does the payables period ratio measure?

Answer 13

• Average amount of time it takes a company to pay off its account payables

Question 14

If management isn’t comfortable with their days’ sales in cash and want to increase it, what can they do to increase their cash balance?

Answer 14

• Higher sales
• Increased profit margin
• Longer payables’ periods
• Shorter collection period
• Loan from a bank

Question 15

What are two complications that arise in financial forecasting (in general)?

Answer 15

(1) What if our debt level changes at the beginning of the year rather than at the end?
(2) What happens if the co. has a minimum cash balance, rather than just letting the cash balance fluctuate with sales?

Question 16

To understand why a company may be having liquidity problems, we can look at the following ratios:

Answer 16

• Days’ sales in cash (want higher)
• Collection period (want lower)
• Inventory turnover (want lower)
• Payables period (want lower)

Question 17

By looking at the gap b/w the forecasted assets and the forecasted equity + owner’s liability, we’ll get an estimate for what?

Answer 17

• the external funding required (how much external financing co. will need to obtain to achieve their objectives)

Question 18

A bigger bank loan means a company will have to pay more what?

Answer 18

Interest expense on the debt

Question 19

If a company needs more financing than a bank will grant, how can the co. change their strategy so they can meet their cash needs with the smaller loan amount the bank is willing to grant?

Answer 19

• Tighten up collection of AR so collection period drops
• Be more timely about paying back suppliers
• These changes will hurt sales though

Question 20

When forecasting, what do we use as the plug?

Answer 20

Bank loan

Question 21

Explain the problem of circularity in financial forecasting.

Answer 21

If our debt level changes at the beginning of the year rather than at the end…

• our addition to RE will depend on our interest payments
• but our interest payments depend our debt level
• and our debt level depends on our addition to RE

Question 22

What are the implications of debt level changing at the beginning of the year rather than at the end?

Answer 22

• Choice of debt in year t affects our interest payments in year t

Question 23

What is the non-iterative, non-spreadsheet approach to calculate the addition to RE?

Answer 23

= (EBIT - interest payments) (1 - T)

For example (10 - .06D) (1 - 0.3)

Question 24

What is the non-iterative, non-spreadsheet approach to calculate equity?

Answer 24

= Beginning equity + addition to RE

For example, 50 + (10 - .06D) (1 - 0.3)

Question 25

Suppose a company's cash policy is the following: - If cash balance isn't sufficiently high, take out a loan from bank so cash balance meets min. balance. - Otherwise, don't take out loan and let cash pile up. In this scenario, what do you forecast first? Last?

Answer 25

- Forecast all other variables first | - Forecast cash or the extra bank loan (overdraft) last

Question 26

How do you compute trial assets?

Answer 26

- Sum of all assets excluding cash

Question 27

How do you compute trial liabilities?

Answer 27

- Sum of all equity and liabilities excluding the overdraft

Question 28

If trial assets + min. cash balance > trial liabilities, then what must we set overdrafts to? Expand.

Answer 28

- To be greater than 0 - b/c company's CF from operations are not expected to be sufficient to meet the min. cash balance - hence additional external financing required - TAKEAWAY: set cash to min. balance, set overdraft equal to trial assets + min cash balance - trial liabilities

Question 29

If trial assets + min. cash balance < trial liabilities, then what must we set overdrafts to? Expand.

Answer 29

- No need to use overdrafts - Set overdrafts to 0 - Use cash as plug - Resulting cash balance will exceed min. balance - TAKEAWAY: set overdrafts to 0, set cash balance as difference b/w trial assets and trial liabilities

Question 30

If you're conducting a sensitivity analysis, you want to make sure you manually program the cells for cash and bank loan with what kind of statements?

Answer 30

"If" statements (only way to get cash balances and bank loan amounts to vary properly with underlying parameters)