Prospective analysis: Guidelines for forecasting financial statements

Abstract

In this chapter, we discuss some ideas that might be useful in forecasting financial statements based on historical data.1 The approaches and suggestions presented in this chapter assume that the analyst has access to some company information that is not usually found in publicly available financial statements. In forecasting financial statements, we start with the historical financial statements and from them we identify the patterns and relationships of different items, the implicit policies, growth rates, and so on. The usual practice is to examine historical financial statements to derive information from them that can be used to forecast financial statements. As all information needed cannot be obtained from historical statements, we assume that the information is available from the company's management. We show how we can find information not found in the statements. Finally, we develop a detailed example of a hypothetical firm to explain the procedure to forecast financial statements. We also critically examine the usual practice of using plugs in forecasting financial statements. The chapter is organized as follows: first, we present comments in a general form about the relevance of prospective analysis to nontraded firms. Specifically, we highlight the importance for these firms of having a financial model with which they can assess the value creation in the firm. In the second section, we review concepts in accounting and economics that are used in forecasting financial statements. We stress upon a financial statement that shows the detailed inflows and outflows of cash in the firm: the cash budget (CB). This is an important tool for managing a firm. We also review topics like Pareto law and Fisher equation. Fisher equation is the key to forecasting variables linked to inflation rate. We also review the indexes used to measure inflation. The chapter uses the Fisher equation to forecast interest rates and increases in prices. Special mention is devoted to a usual practice when forecasting: the plug. This is a practice that we do not recommend and show an alternate approach. The approach we propose in this chapter follows an accounting principle that is the basis of any accounting procedure: the Double Entry Principle. This principle guarantees consistent and error-free financial statements. We show with a simple example how the plug works and its limitations. Next, the reader will find what information is needed for forecasting financial statements and where and how to find it. We identify the procedure to identify policies that govern the working of a firm such as accounts receivable and payable (AR and AP), inventories, dividend payout, payments in advance, and the like. We also deal with the real-life problem of a firm with multiple products and/or services. Finally, we show some tools to perform sensitivity analysis for financial management and analysis. We also use this tool to check the consistency of the financial model. In the next two sections, we deal with the relevance of several accounting concepts. In particular, we briefly describe the CB. © 2009 Springer-Verlag Berlin Heidelberg.