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Corporate Finance:Forecasting

Professor Scott Hoover

Business Administration 221

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What is financial forecasting? Financial forecasting is the development of pro

forma financial statements for subsequent analysis. …a picture of what the company might look like in the

future.

Why is financial forecasting important? Banks (and perhaps other investors) often require

it. Allows the firm to identify problem areas. Allows the firm to determine financing needs.

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Long-Term Forecasting Objectives

Identify strengths and weaknesses Determine External Funding Required

Percent-of-Sales Forecasting (typical methodology) 1. Examine historical evidence to determine which items tend

to vary with sales and which do not. 2. Develop reasonable assumptions about the ratio of X to

Sales (where X is the given item). 3. Forecast sales 4. Create financial statements based on the forecasts. 5. Interpret the pro forma financial statements. 6. Conduct sensitivity analysis. 7. Revise assumptions and repeat until plan is satisfactory.

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Long-Term Forecasting Example Thoughts on assumptions

Income Statement Cost of Goods Sold should vary with sales SG&A costs may or may not vary with sales Depreciation and Interest depend on the levels of Fixed

Assets and Debt on the balance sheet. Balance Sheet

Current assets and liabilities typically vary with sales Fixed assets vary with sales over the long term, but not

necessarily in the short term. Long-term debt and equity are, to a certain extent, choice

variables.

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Short-Term Forecasting (Cash Budget) Objectives

Identify potential shortages and/or excesses in short-term accounts

Develop short plan for financing, production of inventory, credit terms, etc.

Percent of Sales Forecasting (typical methodology) 1. Forecast Sales 2. Project current assets and liabilities based on current

plan 3. Revise plan and repeat until projections are

satisfactory.

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Cash Budget (Short-Term Forecasting) Example

Note: The most confusing element of the cash budget is that inventory is recorded at cost, not retail price. example: Suppose COGS/Sales = 40%. If we have $500

in sales, inventory is reduced by $200. Important Elements of Cash Budgeting

Sales projections Credit Standards (…receivables) Credit availability (…payables) Inventory

current level and projected levels Cash Use of short-term debt Other