Monday, 29 May 2017

Forecasting Performance

Typically, forecasting involves making projections of cash flows to some point where the company has a steady state going forward  

The point when the Steady State going forward is reached

This steady state going forward is characterized by two properties

  • the company grows at a constant rate with a constant reinvestment ratio, and 
  • the company earns a constant rate of return on existing capital and new capital invested.

The Explicit Forecast Period

The horizon to the steady state, called the explicit forecast period, is usually 10 to 15 years.

This explicit forecast period should be divided into

  • a first forecast period of five to seven years, where the statements will include many details,and,
  • the remaining years' forecasts where the statements are simpler with less detail, which avoids the error of false precision.

Such forecasts require assumptions concerning a host of variables, including the return earned on invested capital and whether the company can stay competitive.

Steps in the Forecasting Process

There are six steps in the forecasting process.

  1. Prepare and analyze historical financial statements and data.
  2. Build the revenue forecast consistent with historical economy-wide evidence on growth.
  3. Forecast the income statement using the appropriate economic drivers.
  4. Forecast the balance sheet entries.
  5. Forecast the investor funds into the balance sheet.
  6. Calculate ROIC and FCF.

Additional issues include

  • determining the effect of inflation,
  • nonfinancial drivers, and 
  • which costs are fixed and which are variable.

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