Business Performance

Evaluation:
Approaches for Thoughtful
Forecasting
Why?
the uncertainty surrounding business
performance
unanticipated events have a way of making
certain that specific forecasts are never
exactly correct
however, thoughtful forecasts provide
managers with an understanding of the
opportunities for business success
Principles in the art and science of thoughtful
financial forecasting for the business manager.
understanding the financial relationships of a
business enterprise
grounding business forecasts in the reality of
the industry and macroenvironment
modeling a forecast that embeds the
implications of business strategy
recognizing the potential for cognitive bias in
the forecasting process
Understanding the financial relationships of a
business enterprise

Interpreting Financial Ratios

a useful way to identify and compare
relationships across financial statement line
items. Trends in the relationships captured by
financial ratios are particularly helpful in
modeling a financial forecast.
Growth rates
For example, if total revenue for a business increases from $1.8 million to $2.0 million, the total
revenue growth for the business is said to be 11.1% [(2.0 − 1.8)/1.8].
Total revenue growth can be further decomposed into two other growth measures:
 unit growth (the growth in revenue due to an increase in units sold)
 and price growth (the growth in revenue due to an increase in the price of each unit).
In the above example, if unit growth for the business is 5.0%, the remaining 6.1% of total growth
can be attributed to increases in prices or price growth.
Margins
Margin ratios capture the percentage of revenue that flows into profit or, alternatively, the
percentage of revenue not consumed by business costs.
Gross margin = Gross profit/Total revenue
Operating margin = Operating profit/Total revenue
NOPAT margin = Net operating profit after tax (NOPAT)/Total revenue
Net profit margin = Net income/Total revenue
Turnover
Turnover ratios measure the productivity, or efficiency, of business assets.

Accounts receivable turnover = Total revenue/Accounts receivable

Inventory turnover = Cost of goods sold/Inventory
PPE turnover = Total revenue/Net PPE
Asset turnover = Total revenue/Total assets
Total capital turnover = Total revenue/Total capital
Accounts payable turnover = Cost of goods sold/Accounts payable
Accounts receivable days = Accounts receivable/Total revenue × 365 days
Inventory days = Inventory/Cost of goods sold × 365 days
Accounts payable days = Accounts payable/Cost of goods sold × 365 days
Return on investment
Return on investment captures the profit generated per dollar of investment.
Return on equity (ROE) = Net income/Shareholders’ equity
Return on assets (ROA) = NOPAT/Total assets
Return on assets (ROA) = Net income/Total assets
Return on capital (ROC) = NOPAT/Total capital
ROC = NOPAT margin X Total capital turnover
ROC = Net profit margin X Total capital turnover X Total capital leverage
Nestle (the world's largest food & beverage
company)
(in billions of Swiss francs)
Nestle (Financial Ratio)
Using Financial Ratios in Financial
Models

Financial ratios provide the foundation for

forecasting financial statements because financial
ratios capture relationships across financial
statement line items that tend to be preserved
over time.
Nestle (Financial Forecasting) (in billions of Swiss francs)
Grounding business forecasts in the reality of
the industry and macroenvironment

 Business performance tends to be correlated across the economy, information

regarding macroeconomic business trends should be incorporated into a
business’s financial forecast. If the economy is in a recession, then the
forecast should be consistent with that economic reality.
 Business prospects are dependent on the structure of the industry in which
the business operates. Some industries tend to be more profitable than
others.
Modeling a forecast that embeds the
implications of business strategy
One helpful way of tempering the modeling of business strategy’s effects is to complement the
traditional bottom-up approach to financial forecasting with a top-down approach. The top-down
approach starts with a forecast of industry sales and then works back to the particular business of
interest. The forecaster models firm sales by modeling market share within the industry. Such a
forecast makes more explicit the challenge that sales growth must come from either overall
industry growth or market share gain.
Nestle (Thoughtful Financial Forecasting)
In early 2014, Nestle was engaged in important efforts to expand the company product line in foods
with all-natural ingredients as well the company presence in the Pacific Asian region.
These initiatives required investment in new facilities. It was hoped that the initiatives would make
up for ongoing declines in some of Nestle’s important product offerings, particularly prepared
dishes.
Nestle was made up of seven major business units: powdered and liquid beverages (22% of total
sales), water (8%), milk products and ice cream (18%), nutrition and health science (14%), prepared
dishes and cooking aids (15%), confectionary (11%), and pet care (12%).
The food processing industry had recently seen a substantial decline in demand for its products in
the developing world. Important macroeconomic factors had led to sizable declines in demand from
this part of the world. The softening of growth had led to increased competitive pressures within
the industry that included such food giants as Mondelez, Tyson, and Unilever.
Nestle (Thoughtful Financial Forecasting) (in billions of Swiss francs)
Recognizing the potential for cognitive bias in
the forecasting process
Two elements of cognitive bias that play a role in financial
forecasting are optimism bias and overconfidence bias.
This note Rate defines optimism bias as a systematic
positive error in the expected value of an unknown
quantity, and defines the overconfidence bias as a
systematic negative error in the expected variance of an
unknown quantity.
Nestle (Thoughtful Financial Forecasting vs actual) (in billions of Swiss francs)
“In business, the idea of measuring what you are doing, picking the
measurements that count like customer satisfaction and
performance...you thrive on that.“

-Bill Gates-

Thank you...