Forecasting Financial Statements in Corporate Accounting By Siddhant Sir

Financial Forecasting: Financial statements are vital tools, akin to a company's horoscope, providing insights into past, present, and future financial health. Analyzing the Balance Sheet, Profit and Loss (P&L) Statement, and Cash Flow Statement helps identify early warning signals and predict performance. This forecasting process is essential for interpreting financial situations and anticipating future developments, offering significant benefits.

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Key Terminology for Financial Forecasting

Before delving into the process, understanding these key terms is essential:

• Forecast: A prediction of a probable event or an estimation of where the business is likely headed based on current trends. For example, projecting a future profit or loss level.

• Budget: A future financial target or goal expressed in numerical terms. It outlines the financial plan for an upcoming period and may or may not equal the forecast.

• Projection: A "what-if" scenario analysis. It is a blueprint outlining what would happen if specific conditions or assumptions materialized.

• Proforma: A presentation of how a financial statement would appear as a result of a hypothetical future transaction.

Financial Forecasting Meaning 

Financial forecasting is the process of estimating or predicting a company's financial future by linking it to its historical and current performance. Key performance indicators such as revenue, cash flow, expenses, and sales are analyzed to project future outcomes. This is a critical activity for driving business performance and building stakeholder confidence.

The core concept is "today's commitment for tomorrow's action." The process involves a comprehensive analysis of:

• Past business performance

• Current business trends

• Other relevant factors, such as future market opportunities

Comparative Structures in Financial Planning

It is important to differentiate between key planning concepts, a common area for theoretical questions.

Financial Forecasting vs. Financial Projection

• Financial Forecast: A statement of management's expectations based on what they reasonably expect will happen. This information is typically published for stakeholders and the general public, representing the most likely scenario.

• Financial Projection: Projects the likely outcome of one or more hypothetical scenarios or assumptions. It is a detailed "what-if" analysis showing how financial statements would change under different conditions.

Forecasting the Profit & Loss (P&L) Statement

The typical starting point for any P&L forecast is the sales revenue. Sales and production are closely interrelated and should be estimated together.

Key Considerations for Projecting Profitability

• Capacity Utilization: Assume low in initial years, rising gradually to maximum.

• Sales and Production: Can assume they are equal (no finished goods stock adjustment).

• Revenue: Consider net of excise duties or similar taxes.

• Cost of Production: Account for material requirements per unit and their prices.

• External Factors: Always account for the inflation factor and any seasonal fluctuations.

Structure of a Projected P&L Statement

1. Sales

2. Less: Variable Costs

3. = Contribution

4. Less: Fixed Costs (e.g., Depreciation, Other Fixed Costs)

5. = Earnings Before Interest & Tax (EBIT)

6. Less: Interest

7. = Earnings Before Tax (EBT)

8. Less: Tax

9. = Net Profit After Tax (PAT) / Earnings After Tax (EAT)

Worked Example: P&L Projection with Two Scenarios

Base Data (in Crores): Sales: 200; Variable Cost: 120; Fixed Cost (Other): 25; Depreciation: 20; Tax: 10.

Scenario 1: Good Condition (Optimistic)

• Assumptions: Sales +37.5%; Variable cost 56% of sales; Other Fixed Costs 15 Cr; Depreciation unchanged; Tax rate 28.57%.

Scenario 2: Worst Situation (Pessimistic)

• Assumptions: Sales -25%; Variable cost 65% of sales; Other Fixed Costs 25 Cr; Depreciation unchanged; Tax rate 28.57%.

Forecasting the Cash Flow Statement

The Cash Flow Statement tracks changes in cash and cash equivalents over a period, covering three primary activities:

1. Net Cash Flow from Operating Activities

2. Net Cash Flow from Investing Activities

3. Net Cash Flow from Financing Activities

1. Operating Activities

These are the principal revenue-producing activities and are linked to net profit or loss. A high surplus from operations indicates a healthy business.

• Net Profit vs. Cash Flow: Net Profit includes non-operating and non-cash items (like depreciation), while Cash Flow from Operating Activities considers only operating activities and excludes non-cash items.

• Verbal Emphasis: "It's not profit that repays a loan; it is the cash that repays the loan."

• Examples of Non-Cash Items adjusted: Depreciation, amortization, issuance of shares/debentures for non-cash consideration.

2. Investing Activities

This section details cash flows from acquiring and disposing of non-current assets (tangible/intangible) and other investments. It also includes non-operating investment income (interest, dividends, rent received).

• Investing in Capex (Capital Expenditure): Indicates capacity building for future growth.

• Investing in Financial Assets (Shares, Debentures): May suggest less focus on business expansion.

3. Financing Activities

This section demonstrates the entity's capital structure. It reflects cash flows related to financing policies, such as raising funds from owners/lenders, repaying borrowed funds, and paying dividends.

Key Information for 2023 Forecast (in Crores): PBIT: 80; Depreciation: 20; Tax paid: 30; Purchase of Fixed Assets: 30; New secured loan: 20; Repay old loan: 5; Increase in Unsecured Loan: 10; Increase in Inventory: 10; Increase in Receivables: 15; Interest paid: 20; Dividend paid: 10; Opening Cash Balance (2022): 20.

Projected Cash Flow Statement for 2023 (in Crores):

A. Cash Flow from Operating Activities

• PBIT: 80

• Add: Depreciation (non-cash): 20

• Operating Profit before WC Changes: 100

• Less: Increase in Inventory: (10)

• Less: Increase in Receivables: (15)

• Cash Generated from Operations: 75

• Less: Tax Paid: (30)

• Net Cash Flow from Operating Activities (A): 45

B. Cash Flow from Investing Activities

• Less: Purchase of Fixed Assets: (30)

• Net Cash Used in Investing Activities (B): (30)

C. Cash Flow from Financing Activities

• Increase in Secured Loan (20 raise - 5 repay): 15

• Increase in Unsecured Loan: 10

• Less: Interest Paid: (20)

• Less: Dividend Paid: (10)

• Net Cash Used in Financing Activities (C): (5)

Summary:

• Net Increase in Cash (A + B + C): 45 - 30 - 5 = 10

• Opening Cash Balance: 20

• Closing Cash Balance: 30

Forecasting the Balance Sheet

Projecting the Balance Sheet involves updating each asset and liability account based on the operational, investment, and financing forecasts for the upcoming period. A key validation step is to ensure that the final balancing figure for cash in the projected Balance Sheet matches the closing cash balance calculated in the Cash Flow forecast.

Worked Example: Balance Sheet Forecast

Projected Balance Sheet as at 2023 (in Crores):

• Result: The total projected liabilities (405 Cr) equals the total assets (405 Cr), with the cash balance of 30 Cr matching the closing cash balance from the Cash Flow Statement forecast, confirming consistency.

Practice Problems: P&L Projections

Problem 1

Base Year Data: Sales: 700, Net Income: 96, Dividend Paid: 32.

Forecast: Sales to increase by 25%. Operating cost is 70% of sales. Interest, Tax Rate, and Dividend Payout Ratio remain constant.

1. Projected Sales: 875

2. Operating Cost: 612.5

3. EBIT: 262.5

4. Interest: 40

5. EBT: 222.5

6. Tax Rate: 40% (calculated from Base Data: (96+32)/(700-40))

7. Projected Net Income: 133.5

8. Projected Dividend: 44.5 (Payout Ratio = 32/96 = 33.33%; 33.33% of 133.5)

9. Addition to Retained Earnings: 89

10. Dividend Growth Rate: 39.06%

Problem 2

Base Year Data: Sales: 3000, Operating Cost: 2300, Depreciation: 250, Interest: 125, Tax Rate: 40%.

Forecast: Sales to increase by 10%. Operating cost is 80% of sales. Depreciation to increase at the same rate as sales (10%). Interest and Tax Rate are constant.

1. Projected Sales: 3300

2. Operating Cost: 2640

3. Profit before Dep.: 660

4. Depreciation: 275

5. EBIT: 385

6. Interest: 125

7. EBT: 260

8. Tax: 104

9. Projected Net Income: 156