Financial Forecasting

The science and art of forecasting

The Principles
The beginning
• Before forecasting individual line items, one must determine how many years to
forecast and how detailed the forecast should be.
• The explicit forecast period must be long enough for the company to reach a
steady state.
• Normally, in practice, the explicit forecast period (not applicable for startups)
could be 10-15 years. It may be even longer for cyclical companies or those
experiencing rapid growth.
• Split the forecast period:
• Detailed 5-7 year forecast, with complete financial statements with as many links to real
variables as possible (e.g., unit volume, cost per unit, price per unit etc.)
• A simplified forecast for the remaining years, focusing on a few key variables, such as
revenue growth, margins, and capital turnover.
The preparation for forecasting
• Collect raw historical data
• Financial statements, notes to accounts, audit report
• Integrate financial statements
• As a general rule, operating and nonoperating items should not be aggregated within the
same line item.
• The P&L should be linked with the Balance Sheet through retained earnings. Similarly link
Cash flow statement with P&L and Balance Sheet.
• Build historical financial ratios
• This step will help forecast future ratios to prepare forward financial statements
• Reorganize financial statements
• Reorganise the financial statements to key line items to forecast the long-end of the
forecast horizon and calculate important indicators (e.g., NOPLAT, Invested capital)
The nuts and Bolts
• Build Revenue Forecast
• Estimate future revenues by using either a top-down (market-based) or a bottom-up
(customer-based) approach. Bottom-up approach may also include product-wise /region-wise
forecast
• One may use predictive analytics for this purpose
• Past trend
• Correlation approach
• Determinants approach
• Geographical diversification
• Product mix
• Give extra emphasis to revenue forecast.
• Forecast the income statement
• Use appropriate economic drivers to forecast operating expenses, depreciation, S,G&A. For example, COGS
(as % of revenue)
The nuts and Bolts
• Forecast the Balance Sheet
• Forecast operating working capital, PPE, Intangible assets, and nonoperating assets
• Reconcile the balance sheet with investor funds
• Complete the balance sheet by computing retained earnings and forecasting other
equity items.
• Use excess cash and/or net debt to balance the balance sheet
• Calculate ROIC and FCF
• Calculate ROIC to ensure forecasts are consistent with economic principles, industry
dynamics, and the company’s ability to compete.
• To complete the forecast, calculate free cash flow (FCF) as the basis for valuation.
Future FCF should be calculated the same way as historical FCF.