Forecasting of Financial Statements

Forecasting is more of an art than science. We will look at some of the methods of forecasting
the financial statements of a firm. These forecasted financial statements summarize the expected
performance of the firm for the near future. There are different methods used in forecasting
financial statements, and we will discuss two of those methods in this chapter.
Percentage Sales Forecasting
In this method we assume that sales is the key variable that drives all other variables in the
income statement and balance sheet, except for the long-term debt and equity capital. In other
words, if the sales changes by one percent, all other variables except the two mentioned will
also change by one percent. The following example will show us how we can forecast using this
method.
Example 1
The following are the Income statements and Balance Sheets of a firm for the year 2001. The
sales for 2002 are expected to go up by 3%.
Income Statement
Sales
Cost of goods sold
EBIT
Interest 1
EBT
Income tax @30%
Net income
Balance Sheet
Assets
Current assets
Net fixed assets
Total Assets
Liabilities & Equity
Current liabilities
Long term debt
Common equity
Retained earnings
Total liabilities and equity

_2001
1,000
800
200
100
100
30
70
===
2001
500
3,500
4,000

=====

300
1,000
2,500
200
4,000
====

Interest is calculated by multiplying the long term debt by the rate of interest:
1,000 x 0.10 = 100

Since the assumption in this model is that all variables in the financial statements, except long
term debt and equity will increase or decrease at the same rate as sales, the forecasting can be
done by simply multiplying each of the variables by one plus the rate of change. We will call
this the first pass.
Forecasted Financial Statements - First Pass
Income Statement
Sales
Cost of goods sold
EBIT
Interest
EBT
Income tax @30%
Net income

2001
1,000 x 1.03
800 x 1.03
200
100
100
30
70
===

Balance sheet
Assets
Current assets
Net fixed assets
Total Assets

2001

Liabilities & Eau

Current liabilities
Long term debt
Common equity
Retained earnings
Total liabilities and equity
Difference in balance sheet totals

500 x 1.03
3, 500 x 1.03
4,000

=====

_2002
1,030.00
824.00
206.00
100.002
106.00
31.80
74.20
====

515.00
3,605.00
4,120.00

=======

300 x 1.03
1,000

309.00
1,000.00

2,500
200 + 74.20
4,000
====

2,500.00
274.203
4,083.20
========
36.80

The reason for this difference in balance sheet totals is due to the fact that the long-term debt
and the common equity were kept constant. Before we answer the question why the long-term
debt and equity was not forecasted, let us take a look at the forecasted Cash flow statement of
the firm for the year 2002.

2
3

Since the long-term debt amount is the same, the interest for the year 2002 also remains the same.
Retained earnings for the year 2002 is the total of previous years balance plus the net income for the year 2002.

Forecasted Cash flow Statement- First Pass

Cash flaw from operations
Net income for 2002
Increase in Current assets
Increase in Current liabilities
Net operating cash flow

2002
74.20
- 15.00
9.00
68.20

Cash flow from investing

Increase in Fixed assets

- 105.00

Cash flow from investing

Change in long-term debt
Change in common equity
Cash flow from investing

0.00
0.00
0.00

Net cash flow for the year

- 36.80

As we can see the net cash flow for the year is exactly the same as the difference in balance
sheet. In the year 2002, the operations resulted in a net positive cash inflow of 68.20, while the
investments showed a cash outflow of 105. What happened here was that in order to attain a
growth of 3% in sales, the firm has to invest additional amounts in working capital and fixed
assets. Only part of the investment was covered by the internal source of capital, namely the
retained earnings. The difference has to be covered by additional capital, either in the form of
long-term debt, common equity or a combination of both. Please remember that these are
forecasted statements and once the firm identifies the additional capital required, it can look for
sources from where it can be procured.
Let us assume that this particular firm is going to raise the additional capital in the form of
long-term debt. For this the firm issues additional long-term debt to the tune of $36.80 at an
annual interest rate of 10%. The revised income statement and balance sheet will look like this:
Forecasted Financial Statements - Second Pass
Income statement
Sales
Cost of goods sold
EBIT
Interest
EBT
Income tax @30%
Net income

2001
1,000 x 1.03
800 x l.03
200
100
100
30
70
===

2002
1,030.00
824.00
206.00
103.68 4
102.32
30.70
71.62
======

The amount of long-term debt is now 1,000 + 36.80 = 1,036.80 and the interest is 1,036.80 x 0.10 = 103.68

Balance sheet
Assets
Current assets
Net fixed assets
Total Assets
Liabilities & Equity
Current liabilities
Long term debt
Common equity
Retained earnings
Total liabilities and equity

_2001
500 x 1.03
3,500 x 1.03
4,000

======

515.00
3,605.00
4,120.00
=======

300 x 1.03
1,000 + 36.80

309.00
1,036.80

2,500
200 +71.62
4,000
======

2,500.00
271.625
4,117.42
========

Difference in balance sheet totals

2.58

Again we have a small difference in the balance sheet and it can be eliminated by
repeating the passes several times till the balance sheet balances.
Problems with the percentage sales forecasting method
The main problem with this method is the assumption that all variables, except the long term
debt and equity changes at the same rate as the sales. Even though changes in sales may affect
almost all aspects of the firm, it is hard to imagine that the correlation between the changes will
be one. The following are some of the reasons why the changes in the financial statement items
and sales may not be perfectly correlated.
Variable vs. Fixed Cost
In order for the costs to change in direct proportion to the sales, we have to assume that all
costs are variable. If some of the costs are fixed, then the change in the sales will not
proportionately increase or decrease the costs.
Example 2
A firm that produces Widgets gave you the following information. What will be the percentage
change if total costs if the unit sales are expected to go up by 5% in the year 2002?
Units sold in 2001
Price per unit
Variable cost per unit
Fixed cost per year

10,000
$1.50
$1.00
$2,000

We can calculate the changes in the following tabular form.

5

Retained earnings for the year 2002 is the total of previous year's balance plus the revised net income
for the year 2002.

Units sales
Sales in dollars (Unit sales x 1.50)
Variable cost (Unit sales x 1.00)
Fixed cost
Total cost

2001
10,000 x 1.05
$15,000
$10,000
$ 2,000
$12,000

2002
10,500
$15,750
$10,500
$ 2,000
$12,500

Percentage change in total cost = 12,500-12,000= 4.17%

12,000
As you can see the cost did not go up by 5% as with the sales, but it increased only by
4.17%. The lower increase in total costs is due to the fixed costs remaining the same.
Lumpiness of assets
Real assets used in generating the sales are not infinitely divisible and this is called the
"lumpiness" of assets. We will use the following example to illustrate this point.
Example 3
Let us continue with the data from example 2. This firm has one Widget producing machine
that can produce 15,000 widgets a year. The cost of a new Widget making machine is $20,000.
Since the firm in 2001 produced only 10,000 Widgets, we can say that the firm is operating its
machinery at two-third capacity. In other words, the firm can produce additional 5,000 Widgets
a year without buying a new machine. But once the annual production/sales increases over
15,000, the firm will have to buy a new machine and in that year it will have to find additional
capital of $20,000 to buy the new machine.
Even though percentage sales forecasting is seldomly used as the final model, we can use
parts of percentage forecasting model in developing a reasonably sound forecast of financial
statements.
Time Series Forecasting
Another way of forecasting using only the past information is time series forecasting or trend
forecasting. While in the percentage sales forecasting we assumed that all the variables except
for the capital items are perfectly correlated with sales, in this model there is no a priori
assumption of perfect correlation. In other words we assume that each variable follows a certain
predictable path, and that path is determined by how the variable behaved in the past.
In time series analysis we look at the past trends in a variable and extrapolate it into the future.
The most commonly used method is the regression technique. For this we have to calculate
both the intercept and slope of each of the income statement and balance sheet against a time
variable.

Example 4
The flowing are the sales figures of a firm for the past five years (all figures are in
millions.).
Year
1997
1998
1999
2000
2001
We will set up this information in a spreadsheet as follows and estimate the slope
and intercept of this variable as follows:
1. Create a year dummy by putting 1 for the first year and then
continuing with the same for each year.
2. Go to Tools on the Excel menu and click on Data analysis. Click on
Regression in the dialog box. Enter the range of Y-variable (sales)
and X-variable (year dummy). Press OK. You will get the following
output.
Year

Sales
Year

dummy
1997

458
1
511
2
575
3
580
4
601
5

1998
1999
2000
2001

Summary Output
Regression Statistics
Multiple R
0.9492522
R Square
0.9010797
Adjusted R Square 0.8681062
Standard Error
21.474791
Observations
5

ANOVA
df
Regression
Residual
Total

1
3
4

SS
12602.5
1383.5
13986

MS
12602.5
461.16667

F
27.32743

Significance F
0.0136184

Coefficients Standard Error

Intercept
X Variable

438.5
35.5

22.52295126
6.790925317

t Stat

P-value

19.4691129 0.000296
5.2275645 0.0136184

Lower95% Upper 95%Lower 95.0% Upper950%

366.82185 510.17815
13.888225 57.111775

366.82185
13.888225

The intercept from this regression is 438.5 and the slope (X-variable) is 35.5. We can
forecast the sales for the next year, which is 2002 as follows:
Sales2002 = Intercept + Year dummy x slope = 438.5 + 6 x 35.5 = 651.50
Few other output variables of interest are the Adjusted R 2 of this regression, which in this case
is 0.8681 and the Significance of F, which is 0.0136. Adjusted R 2 explains how much of the
change in dependent variable is attributable to the independent variable. In this regression
86.81% of the changes in dependent variable is caused by independent variable, which of
course is a very high number. Similarly the significance of F is 98.64%, which means that this
regression is significant at 1.36% confidence level.
Again the problem with time series forecasting is that it depends only on the past
information. In the following sections I will try to combine the above two methods to
create a model that is an improvement.
Combined Percentage Sales and Time Series Forecasting Model
I will use the AMD Income statement and Balance sheet to illustrate this model. The first step
is to check the correlation between the variables in the income statement and balance sheet and
sales.
Step 1: Calculate the correlation between sales and other items in the income statement and
balance sheet. The calculations for AMD are in the attached spreadsheet called: ADVANCED
MICRO DEVC-Correlation Analysis.
Step 2: Estimate the slope and intercept of each of the variables in the income statement and
balance sheet. See spreadsheet titled: ADVANCED MICRO DEVC - Slope and Intercept.
.Step 3: Combine the above two spreadsheets. If the correlation of a particular variable with
sales is greater than 0.8, keep it and delete the cells corresponding to the intercept and slope
coefficients of that variable. If the correlation is less than 0.8 then delete the cell that contains
correlation and keep the cells containing intercept and slope. The purpose of this exercise is to
identify those variables that can be forecasted using percentage sales method and those that can
be forecasted using the time series model. See the spreadsheet titled: ADVANCED MICRO
DEVC - Forecast Model.
Step 4: Forecast the growth in sales using available information from Valueline and similar
sources. Forecast the growth of those variables that are highly correlated with sales using the
same growth rate as the sales. Those variables that are not correlated with sales should be
forecasted using the time series model. For this please refer to the cell formula. Keep the net
interest payment the same as the previous year. Same treatment is applicable to long-term debt
and capital items. This will be the first pass. Find the pre-tax income and use the appropriate tax
rate (from Valueline) to find the after-tax income. Add this to the retained earnings from the

510.17815
51.111775

previous year to find the current years retained earnings. Take the totals of the balance sheet
and find the additional capital needed. Use the second pass to provide for the additional capital
needed in the form of long-term debt and/or equity. Make sure that you make necessary
adjustments in the interest and dividend payments. The three passes I have for the model are in
three separate worksheets.
A practical approach to Forecasting
The above methods that were discussed have serious drawback- all are based on historic
data. Because the conditions change quite rapidly in real world it is not correct to assume
that the past information is the only information that is needed to forecast the future
financial statements of a firm. The following are the steps in creating a realistic forecasting
model for the firm.

Firm Analysis: Find what is happening with the firm. For this you may look at the latest
quarterly report to the SEC (10-Q). Refer to the latest copy of the Valueline for the firm.
You can also gather current information by looking at the recent reports about the firm by
Wall Street analysts (available in Yahoo!). When you go through these reports look for
major events that may alter the future of the firm (mergers, divestitures, law suits, new
product introductions, Government regulations, etc.).
Industry Analysis: Identify the industry where the largest segment of the firm's operations
is concentrated. There are changes within a particular industry that can affect the future
performance of the firm. Information about a particular industry is available in Valueline
and Yahoo!
Macro Economic Analysis: Finally you should look at the overall forecast for the
economy, which can have a significant impact on the future performance of the firm. For
example if there is dramatic increase in crude oil prices due to a potential war in MiddleEast, it might affect the firm you are analyzing. It is important to note that some firms are
more susceptible to macroeconomic changes than others.
The starting point of your forecasting model is the Combined Percentage Sales and Time
Series Forecasting Model. The following are the suggestions for altering this model to
make it a realistic model.
Suggestion 1: Forecast the sales for the three-year period using various source like
Valueline, analysts reports, 10-Q, etc. Each of these sources may have different opinion
about the sales forecast, but you can either choose the one that you think is the most
realistic or otherwise simply find the average as the consensus estimate.
Suggestion 2: Look at each variable in the income statement and balance sheet more
critically. If you have specific information about a specific variable, then you should use that
information to change the variable. For example if the firm has announced a plan to cut the
cost by reducing the number of workers, plant closing, etc. incorporate the effect of that on
cost of goods sold. This type of analysis is the most crucial part of the forecasting.
Suggestion 3: Look for specific information about the changes in the capital structure. For
example if the firm has a stock repurchase plan, it will affect the treasury stock. Similarly if
there are any changes in the dividend policy6, it should be reflected in the forecast.

You can change the individual variables if needed, but make sure that you will provide written
explanation for the reasons for changing the variable.

In the case of AMD, there were no dividend payments. But if the firm you are analyzing pays dividend, you

should prepare a Statement of Retained earnings and transfer only the retained earning portion to the balance
sheet.