Forecasting Financial Performance 3rd Ed.

Unit 3

The Open University

Publisher: The Open University, 2000, 107 pages

ISBN: 0-7492-9727-1

Keywords: Finance, MBA

Last modified: Jan. 25, 2014, 7:08 p.m.

We now have the ratios based on the annual report of some company. The next step would be to try to guess what the future might look like. Who else might be interested in the future performance of a company? Investors, lenders, managers (internal and external), employees, debt providers, …. All of them need to know the decision they want to take to be able to ask the right questions about the future.

For your forecast, scenarios, remember:

  • strategic change is only possible to push through by powerful stakeholders, meaning that most will have to forecast based on existing strategies
  • sometimes only the likelyhood of the worst outcome is needed
  • the timeperiod depends on your goal, e.g. repayment of a 5 year bond needs 5 year forecast
  • which cash flows should you include relate to which are available to you

Forecasting is an imprecise art, with lots of assumptions, which need to be checked if the real outcomes differ from your assumptions. Most of your assumptions will turn out to have been wrong.

Sales and profitability

You should look at the continuing core-activities, where the potentials reflect the economic situation in general and in the sector. The actual performance comes more from inside the company. You actually start your forecast from the top to bottom of the income statement.

Sales

In large comglomerates you need to break things down into small, easy to understand, homogeneous, appropriate groups. The division here can be regional, devisional, or any other logical one.
Take into account that some things might have been integrated or sold in the middle of the year.
Also take into account the general economic environment (GNP = gross national product; GDP = gross domestic product). Normally, a company can only grow faster than the economy by capturing market share. You can actually use that to see what growth in relation to the sector has been in the past, to get clues as to the future.

[In general I deviate from the course here a little because I do believe that Fisher and Buffet have it right when they say that you need to understand the business. Understanding the numbers is not enough. ]

If the company changed the strategy, whether or not a competitor response is likely, if capacity will limit growth in sales, can sales be physically produced, … are the limits on scarce resources … all this need to be considered.

To get more information on the sector you can do a porter analysis.

To forecast profits, you need the profit margin and adjust it for any changes you think are likely. This includes effects of the economic cycle, especially in industries with high fixed costs. Competitors strategies are also important. Samsung for example really wanted to get into the mobile phones space and it hurt Nokia's volumes.

Asset investment

Next you need to forecast operating cash, NOP, fixed assets and investments.

NOP: NOP/Sales will likely be constant without strategy change. Otherwise forecast underlying assets and liabilities. Also think whether the ratio will improve or fall based on management capabilities. Pay attention that you do not work with working capital as this includes several non-operating items (e.g. marketable securities, short term portion of long term dept, …) which have no real relation to sales.

Cash: A company might need it for production or strategic reasons. Find the transactionally needed cash balance. This is also what makes ratios hard to use as it mixes transactional and investment cash balances. You can as always use the sector ratios as guidance.

Fixed assets: Take historic paterns and peer comparison into account. Net fixed assets turnover ratio is good as it allows you to find out what kind of investment in fixed assets is needed to support forecasted sales. Pay attention to depreciation though to be sure that you are comparing current sales to current fixed assets value.

Financial Structure

Here you take a look at debt, provisions, new funding needed and equity. New funding can come from new debt, equity or retained profits/losses. In the short term, you will take your profitability assumptions, mixing them with your assumption that new funds will be in the form of debt. In the long term, analysts normally presume a fixed debt/equity ratio.

Retained profit (loss) = (NOP - Old debt x interest - New debt x interest) ( 1-Taxes) - Minority interests - Dividends.

You may need to find out about seasonabel borrowings which might be hinted at via a historic interest expense to average debt ratio above what the market gives as interest rates. Dividends can be seen as something that a company has to pay when looking at the short term, taking a growth rate into account, while longer term analysis can take a percentage of profit earned as a more appropriate measurement.

In the long term, new funding needed will also include new equity.

Assessing Trading Partners

To assess trading partners you will likely take a look at a short period of between 30 and 90 days. There are some challenges here:

  • Quick decisions needed
  • Monitoring costs might be too high for benefit
  • Financial information is often only available several months after balance sheet date
  • No information for privately owned companies

Often you use a credit reference agency or credit rating agencies (Moody's, S&P, …) for longer time horizons. In addition to financial information and ratios, credit reports often have peer comparisons and also include single measures based on several factors, like Experian, who publish a rating of 1 to 100 based on 20 factors. Experian does that by also collecting information from different companies on how they are paid by their partners, resulting in a DBT (days beyond term) number. It is important to distinguish between willingness and ability to pay here, as cash management is an important part and might result in later payments if the bargaining power is on the paying end.

Forecasting debt capacity

Banks will look at the longer term to find out if the company has the capacity to take on (more) debt. For this to be possible the company needs to be able to meet all obligations ranking with the same importance as the new debt. Direct lenders will do their own credit assessment, while credit rating agencies help in terms of bond sales and other vehicles.

Banks lend money based a market rate (Base Rate, LIBOR [London interbank offered rate], EURIBOR [Euro interbank offered rate]) plus a spread known as the credit risk premium. The different between what the bank pays for funds and what it gets can be very low (e.g. 0.125%) up to something like 3% (rarely above). To be sure that payments are made, the bank will make conservative forecasts.

NOP + Depreciation - Tax - CAPEX +/- Change in noa +/- change in minimum cash balances - after-tax interest on seasonable debt - dividends = cash available to service debt

Seasonable debt and dividends are optional here. Also take into account the NPV of those cash flows. The discount rate to use is the companies borrowing rate. You can also substract current portion of long term debt as well as after-tax interest on existing debt to be even more sure.

Company Valuations

Here the book looks at DCF valuation methods. You will normally calculate the value of a company over two time periods. One being the present values of cash flows in your forecast period and the other being the cash flows following that period as a whole. The second part is called continuing or residual value. Small shareholders cannot influence the strategy of the company should hence take the current strategy for their forecasts. You should also calculate the worst case, most likely case and best case. You can then look at a probability of each of those outcomes. As a potential shareholder you work backwards in the sense that you know what you would pay and then calculate what kind of assumptions you would need to make to get to that value, or you simply find out that the current price is too high or low.

Ensure that the discount factor is consistent with the cash flows to be discounted. Normally the nominal values re used. Take into account that debt might have tax benefits. The present value of nominal free cash flows during the forecast period plus the terminal/residual value will be the enterprise value. Adding investment and substracting debt from that (both at market value) you get the total equity value.

EBITDA = NOP + Depreciation
Free cash flow = EBITDA - Taxes - CAPEX +/- change in noa +/- change in op. cash +/- other

The present value of free cash flows can be calculated with the WACC which reflects the debt/equity ratio.

Value drivers are those relationships or ratios that largely determine the free cash flow. Operating margins are one. Taxes paid another. Remember here that the taxes mentioned here are those payable as if the company had no debt. The savings due to the tax shelter in relation to debt are included in the discount rate calculated via the WACC.

This synopsis is licensed under a Creative Commons License from the OUBS Blog.

  1. Introduction
    • Outline of Unit 3
    • Objectives of the unit
  2. Introducing Forecasting
    • 2.1 The Purpose of the Forecast
    • 2.2 Which Scenarios?
    • 2.3 Which Horizon?
    • 2.4 Which Cash Flow?
    • 2.5 The Approach to Forecasting
  3. Sales and Profitability
    • 3.1 Forecasting Sales
    • 3.2 Porter Revisited
    • 3.3 Forecasting Profits
  4. Asset Investment
    • 4.1 Net Operating Assets
    • 4.2 Cash
    • 4.3 Fixed Assets
    • 4.4 Other Asets
  5. The Financial Structure
    • 5.1 The Implied Financial Structure
    • 5.2 The Target Financial Structure
    • 5.3 The Change in the Profit and Loss Reserve
      • An implied financial structure
      • The change in the profit and loss reserve — a target financial structure
  6. Assessing Trade Partners
    • 6.1 The Credit Report — Financial Ratios
    • 6.2 The Credit Report — Ratings
    • 6.3 The Credit Report — Additional Information
  7. Forecasting Debt Capacity
    • 7.1 The Lenders’ Perspective
    • 7.2 Total Debt Capacity Forecasts
    • 7.3 Additional Debt Capacity Forecasts
    • 7.4 Credit Rating Agencies
  8. Company Valuations
    • 8.1 The Investors’ Perspective
    • 8.2 Consistent Assumptions
    • 8.3 Which Cash Flows?
    • 8.4 Value Drivers
    • 8.5 Brokers’ Reports
  • Appendix 1: OUFS The Boots Company plc
  • Appendix 2: Extract from the Annual Report 1997, The Boots Company plc
  • Appendix 3: Experian Rating of Blue Circle
  • Appendix 4: Credit Rating Agency Rating Definitions
    • Standards & Poors Issue Credit Ratings Definitions
    • Long-Term Issue Credit Ratings
      • AAA
      • AA
      • A
      • BBB
      • BB
      • B
      • CCC
      • CC
      • C
      • D
    • Moody's Long-Term Ratings
      • Debt ratings — Taxable debt and deposits globally
        • Aaa
        • Aa
        • A
        • Baa
        • Ba
        • B
        • Caa
        • Ca
        • C
  • Appendix 5: Broker’s Report on Blue Circle Industries plc

Reviews

Forecasting Financial Performance

Reviewed by Roland Buresund

Decent ****** (6 out of 10)

Last modified: May 21, 2007, 3:04 a.m.

MBA material, what do you expect?

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