A Practical Guide to Financial Statement Forecasts for Business Valuations – Forecasting Income Statements

For a going concern business, projected income statements provide crucial insight into its future economic benefits. Because of this, a reliable income statement forecast is often necessary for performing a business valuation. This article will discuss considerations for developing an income statement projection for valuation purposes and specific techniques to do so. We have included a free, fully functional forecasting model with examples that we will be referencing in this article. Feel free to use it as needed for your own forecasting needs.

This article is a continuation of A Practical Guide to Financial Statement Forecasts for Business Valuations. We highly recommend that you read this article first as it provides essential conceptual background for forecasting financial statements.

Disclaimer: This article provides general guidance related to forecasting financial statement information for a business appraisal. The discussion provided herein solely reflects the opinions of the author. It is not exhaustive and all-inclusive, and the concepts discussed herein may not be applicable in all situations. Business valuations should consider the facts and circumstances pertinent to the subject company. No guide can predict all potential scenarios.

For CPAs: “Forecast”, “estimations”, “projections”, and other variations of these words will be used interchangeably and without specific reference to the American Institute of Certified Public Accountants’ (AICPA) attestation standards or definitions of these terms. In addition, this guide was not prepared to address the preparation of prospective financial information for an examination engagement under AT-C Section 305. The AICPA differentiates between financial forecasts and projections as follows:

Financial Forecast – Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, an entity’s expected financial position, results of operations, and cash flows. (AT-C Section 305.09)
Financial Projection – Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions, an entity’s expected financial position, results of operations, and cash flows. (AT-C Section 305.09)

Although many of the concepts will inevitably carry over, the intent of this guide is not to conform to either of the definitions noted above.

Six Core Considerations You Should Ponder as You Build Out Your Income Statement Forecast

The preparation of an income statement forecast is subject to much judgment. Therefore, an individual creating a forecast needs to think through a plethora of concepts, including, but not limited to, the following:

The broad narrative around the company’s future growth and profitability.
Considerations of the local market and economic conditions, competitive landscape, and industry expectations.
The level of detail to include around income statement line items.
The intended use of the income statement forecast (and, in turn, the level of scrutiny it will receive).
How easy is the forecast to explain to an interested party (i.e., business appraiser, independent auditor, investor, the IRS, or a judge)?
Is your forecast representative of a base-case, expected-case, or best-case scenario?

1. Develop the “Story” for the Company’s Future First

As discussed in the first section of this guide, the most critical component of a financial statement projection is the “story” of the company’s future successes and challenges. All of the numbers that you estimate within the forecast should align with the story.

2. Consider Market, Economic, and Industry Conditions

While company-specific factors are essential considerations, external market, economic, and industry conditions also play a significant role in a business’s future financial performance. For instance, a family-owned fast-casual burger restaurant in a great location might not perform well if an In-N-Out recently opened next door (by the way, I love In-N-Out).

3. Assess How Much Detail You Need to Include in the Income Statement Forecast

An income statement projection can include a few summarized income and expense categories or many individual line items. The level of detail required will ultimately depend on the nature of the company and the significance of various income and expense items on its cash flow. Every business is unique and, unfortunately, there is no clearly defined line around how much detail you need to incorporate in a forecast.

4. Think About the Intended Use of the Forecast (and Valuation)

The forecast and valuation’s intended use will significantly influence the importance of detail in the forecast. A forecast used in contentious litigation may be subject to significant scrutiny, possibly necessitating greater detail within individual line items. On the other hand, an informal calculation of value for a business’s internal corporate planning needs may not require much detail at all.

5. Can You Explain Your Forecast?

At some point, you likely will need to explain the forecast to somebody. The more complicated the projected financial information, the more difficult it will be to explain to another party. You may have invested a ton of time and effort into developing your story and numbers. However, that effort might be for naught if regulators, investors, or auditors do not understand (or worse yet, misunderstand) the story or model.

The key is to be detailed enough to have a relatively high degree of confidence in the forecasted figures. If a model is too simplistic, it will not be easy to assess the reasonableness of the projected numbers. On the other hand, a model that is too complicated may be challenging to explain (and prone to inconsistencies in various assumptions).

6. Consider the Likelihood of Hitting Your Projected Figures

Last on this list, but certainly not least, you will need to consider the likelihood associated with the company’s ability to achieve the forecasted financial results. For example, are your estimates conservative and reflective of base-case thinking prepared for lending purposes? Or, do your projections include aggressive sales goals that provide a best-case look for the company? In most cases, you’ll want to give an “expected-case” forecast to your appraiser for the business valuation.

Where to Start

Historical financial information is the typical starting point to any reliable forecast. Therefore, the presentation and reliability of this information are essential to consider. Projecting from unreliable historical financial information is like firing a cannon from a canoe. Without a solid foundation, your forecast might be meaningless.

Consider a real-world example:

ABC Company’s bookkeeping was performed by the owner/CEO and his wife, neither of whom had much accounting experience. The husband/wife team were planning to sell their company and wanted an idea of the business’s value. Therefore, they were looking for an appraiser to perform some limited-scope business valuation calculations (or what we would call a “calculation of value”).

Understanding that there were some likely irregularities in the company’s historical financial information, We took some time to review the data. We asked about its profitability, which we observed was higher than its peers in the public markets. The owner and his wife indicated strong relationships with their customers and recognition in the local market, which allowed them to set prices a bit higher than the competition. We had some doubts and they were insistent, so we made normalizing adjustments as we could and provided caveats to the client. We let them know that we would assume that the information provided was correct, but the analysis was subject to change if we later found the historical financial results to be unreliable.

We helped the client prepare some basic financial projections using the owner’s insight into future growth and changes in profitability. We based the projections on the historical financial statement information and the client felt comfortable with the forecast. All was well. We issued a draft of the analysis (again with caveats). Unfortunately, after our draft was issued, the client informed me that they had forgotten about certain ongoing business expenses that had been paid with their personal credit cards and were never recorded in the Company’s books (yikes!). After adding in those expenses, the company’s profitability moved considerably lower. The change in future profitability essentially cut the company’s valuation by more than 25%.

The silver lining in this situation was that the owners recognized the importance of having their books in order prior to sale. They hired a consultant shortly after we issued our draft to help them with straightening out their financial statements in preparation for a sale.

For a business with established operations, the historical financial results are often the best starting point for estimating the future. However, as the client learned in the case study above, the reliability of that information was critical to the end result.

Another important consideration when forecasting financial statement information is whether your historical financial information is presented on a cash or accrual basis. Business valuations are typically performed with accrual financial statements in mind because publicly-traded companies report their financial information on an accrual basis. Business appraisers will frequently perform benchmarking, analyze valuation multiples, and choose rates of return based on information derived from public markets. Cash basis financial information will not be comparable to public companies or much of the available financial benchmarking resources out there.

Be sure to communicate to your appraiser that your financial statements are prepared on a cash basis.

Time to Forecast

There are countless ways to forecast your income statement. To save you from an immensely technical read, We will not reiterate here what is already available through a Google search. A great article was published in the July 1971 edition of the Harvard Business Review on selecting the correct forecasting technique. While certain business models may not have existed at the time of publication (think Software-as-a-Service, or SaaS), and certain examples in the article are somewhat outdated, many of the concepts continue to be relevant. The method you should select will depend on the type of business and level of detail needed for your valuation requirement.

This section of the guide will provide some simplistic examples for projecting the various components of an income statement. This article will not be nearly as technical and detailed as the Harvard Business Review article – hopefully, that is an incentive to read on.

As you forecast the various components of an income statement, you should always think about what your appraiser needs for the valuation. Income statements need to be projected because they are direct inputs in calculating free cash flow. Free cash flow definitions are presented below for reference (income statement inputs are in bold and orange):

Side-by-side formulas for calculating free cash flow to invested capital and equity with emphasis on income statement items

A “top-down” approach often works well for forecasting EBIT or pre-tax income. Therefore, we will begin our discussion with revenue and work our way down the income statement to net income.

How to Forecast Revenue

Revenue growth is arguably one of the most critical data points forecasted and is frequently considered a barometer for success. Higher revenues often can be accompanied by increases in profitability, access to greater capital resources, and a higher caliber of management and workforce. In a business valuation, revenue increases often translate into higher value.

We will demonstrate how to forecast individual line items with examples that are presented In our free, fully functional projection model.

The examples presented in this section are simplified versions of some of the methods we have used to help clients prepare an income statement forecast. You will notice that methodologies can differ by business and industry. There are many options available to forecast revenue, and no method will be best suited to all situations.

A Simplistic Approach

The most simplistic method for forecasting revenue is the application of a simple growth rate, as shown in Figure 1 below (yellow cells and blue font indicate inputs):

Example simplified revenue growth forecast

We have had many clients present forecasts to us in this manner. A simple growth rate is probably the most commonly presented method for forecasting revenue that we have come across. The benefit of the simplistic model is that it is easy to understand. However, alone, it does not provide any insight into the various factors that impact future revenue. We will dive into some of the more detailed forecasting methods next.

Volume and Price

One intuitive and straightforward way to forecast revenue is to break it down into two major components: volume and price. Depending on the type of business, volume might take the form of unit counts, billable hours, or customer counts. The price could be represented by the price per unit, an average hourly rate, or revenue per customer. The following example assumes unit volume and price per unit for two products.

In Figure 2, we have two products (A and B) with volume and price inputs. Total growth rates and projected total revenue metrics in Figure 2 reconcile to the projected numbers in Figure 1. You can think of Figure 2 as providing some “narrative” to the total revenue growth rates that were shown in Figure 1. In particular, we can see that volume continues to grow with occasional price increases that further contribute to the forecasted growth rates on total revenue.

Seeing the detail in the numbers allows the appraiser (and forecaster) to initiate dialog around the projected growth rates. Discussion points might include:

How will the company generate 10% increases in Product B unit sales in 2021 following two years of limited growth?
Discuss the impact of the price increase in Product B units forecasted in 2022 and how this increase might impact unit sales. The historical results show us that Product B unit sales declined in 2019 when the company instituted an increase in pricing.
What challenges and risks are associated with implementing the forecasted pricing increase for Product A in 2023?

The addition of just two variables introduces several questions that can help fine-tune the assumptions and better explain the company’s expected financial performance. The Q&A process between client and appraiser should lead to more reliability in the projected financial information, translating into a more reliable valuation conclusion.

The “Retail” Model

Another way to forecast revenue is to estimate income by individual profit centers, such as a retail or franchised restaurant business with numerous locations. Take a look at Figure 3 for an example of this type of modeling.

The model presented in Figure 3 applies in cases where management tracks financial performance at individual profit centers, such as franchised restaurants and retail chains. Some of the other factors that would make this model applicable are:

Individual locations may be subject to different growth patterns due to local market conditions, such as demographics, competitors, foot traffic patterns, and street frontage.
Individual locations have varying levels of capacity and are at different stages of development.
The business expects to open new stores or close underperforming stores.

The detail provided in this type of revenue forecast often leads to many questions to understand your expectations. It also allows for a more accurate estimation of future capital expenditures, working capital needs, and financing requirements.

Subscription Model

For companies that operate on a subscription model, the simple example in Figure 4 can help project future revenue. Many subscription-based businesses (Software-as-a-Service, or SaaS, companies, for instance) assess future revenue growth via annualized recurring revenue (ARR) or monthly recurring revenue (MRR) rates. These metrics provide a measurement of the ongoing annual revenue potential that a company can provide.

While ARR and MRR are essential metrics for analyzing SaaS companies, your financial projections still need to reflect 12-month revenue estimates. In other words, we need to consider the true measure of revenue collected in each year in the future.

There are many ways to estimate annual revenue. The example below provides a more simplistic approach to forecasting revenue. In this example, revenues are generated based on the average number of expected subscribers per year x the average fee charged per subscriber.

This model has two core inputs: average number of customers and average revenue per customer.

The average customer count is based on the number of customers at the beginning and end of each year. To estimate end-of-period customer count, we include estimates for lost customers and the addition of new customers.
Similarly, the average revenue per customer, or the subscription rate, are also be calculated as the average beginning and ending subscription rate within each period.

The example calculations in Figure 4 are simplified and assume that changes in customer count occur evenly over the year. This assumption will not hold true in all cases. Take, for example:

Company A generates the heaviest volume of new customer acquisitions at the beginning of the year.
Company B acquires new customers primarily at the end of the year.

Company A would generate greater revenue due to the more favorable timing of new customer acquisition. Therefore, your forecast model should be structured to best reflect the timing of when revenue is generated and recognized by the company.

Clearly, this model can quickly become much more complex if you build in other factors, including:

Contract timing
Varying levels of subscriptions and fees
Customer promotions
Incremental revenues from add-on services

The list can go on. How you build your model will depend on your business, the impact of incorporating additional complexities, your forecasting ability, and the purpose of the forecast.

So what is the best method to forecast revenue?

It truly depends on the circumstances. You should cater your forecasting model to the facts and state of your specific business. In this section of the guide, we have presented four simplistic examples. Your model could be considerably more detailed or driven by entirely different factors.

How to Forecast Cost of Revenue

There are several ways to forecast the cost of revenue. Most methodologies revolve around the idea that these expenses will vary with revenue. For this reason, the cost of revenue is typically considered a “variable expense.” However, certain factors can impact how this line item behaves relative to revenue, including:

Product/service mix
Location of customers and freight costs, tariffs, or lost inventory
Increasing/decreasing pricing power with suppliers
Improvements in operational efficiency and automation

Figure 5 presents a simplistic approach to estimating the cost of revenue.

In Figure 5, projected gross margins increase gradually over the next five years as the cost of revenue declines as a percentage of revenue. This simple way of estimating cost of revenue is perfectly acceptable and might be necessary if you took a simplified approach to estimate future revenue. Suppose your revenue forecast incorporated simple growth rates (refer back to Figure 1). After all, without explicitly forecasting revenue based on the future product mix, it would be difficult to break down the cost of revenue by product.

Figure 6 represents a continuation of the example provided in Figure 2 and breaks down the projected cost of revenue between Product A and Product B.

With the additional detail provided in Figure 6, the changes in gross margin are more transparent. We can see that improvements in gross margin result from pricing increases to customers and fluctuations in the cost associated with producing Product A and Product B each year. Notice that we get to the same figures as was presented in Figure 5, but with greater clarity.

How to Forecast Operating Expenses

To help us forecast operating expenses, let’s categorize them in four broad categories:

“Fixed” costs – grow at a fixed rate; do not move proportionately with revenue (i.e., rent expense, property taxes, telephone and internet expenses, accounting fees, government fees, and subscriptions).
“Variable” expenses – grow at variable rates; move proportionately with revenue (i.e., commission payments, travel and entertainment, and freight).
“Semi-fixed” expenses – may or may not move proportionately with revenue (i.e., salaries and wages, payroll taxes, utilities, and marketing).
One-time expenses – includes one-off items that do not necessarily tie to how the operations are doing (i.e., litigation costs, charitable contributions, or consultants). These costs may or may not appear historically and will almost always require input from company management.

The best starting point for forecasting operating expenses is to first categorize your highest ongoing historical operating costs within the categories listed above. Doing this upfront allows you to assess whether a simplistic approach is feasible for your financial projection. As you review your historical expenses, you want to should focus on the ongoing costs and exclude any one-time expenses that are not expected to recur in the future.

Here are the potential scenarios you may run into:

For companies with mostly fixed costs, you can likely get away with applying a growth rate to total operating expenses each year (simplistic).
For companies with mostly variable expenses, you may want to estimate future expenses using percentages of revenue (simplistic).
Companies with a mixed bag of major fixed, semi-fixed, and variable costs may need a more complex approach to forecast operating expenses accurately.

Pro Tip: Start simple if possible and build in complexities as you think through assumptions.

In our experience, differentiating nominal costs between fixed and variable may not yield materially different projected results. Therefore, it makes sense to rule out the simplistic approaches first before proceeding with a more complicated modeling exercise.

Let’s look at our example before moving on.

The focus of this section will be on the operating expense line items in Figure 7. We will first analyze the historical figures to ascertain whether they are fixed, semi-fixed, or variable expenses. Based on this analysis, we will then present how to forecast these costs to arrive at the projected figures in Figure 7.

How to Identify Fixed vs. Semi-Fixed vs. Variable Expenses

There are two primary ways to assist you with categorizing your operating costs: percentage of revenue and growth rates. We will illustrate both in this section. A sample of historical operating expenses is presented as a percentage of revenue in Figure 8 below.

From Figure 8, it is pretty easy to spot fixed vs. variable vs. semi-fixed expenses. See below for how these analytics might look.

Rent: As revenues grow, rent expense consistently declines as a percentage of revenue, which is typically observed for a fixed cost.
Salaries and Wages: As a percentage of revenue, salaries and wages fluctuated over the period analyzed as the company added additional employees in 2019 to support growth. In this case, salaries and wages are a semi-fixed expense.
Utilities: Utilities expense is a consistent 2.5% of revenue. Since this expense remains a constant percentage of revenue, it would likely be classified as a variable expense.

The second method is to analyze the historical growth of costs. See Figure 9 below for the growth rates associated with the same three expenses shown in Figures 7 and 8.

Again, the differences between fixed, semi-fixed, and variable are easy to point out.

Rent: A consistent growth rate tends to suggest a fixed expense, which is the case for rent expense in this example.
Salaries and Wages: Variations in growth rates that are not consistent with revenue growth can indicate a semi-fixed expense, as appears to be the case for salaries and wages.
Utilities: Expenses that grow consistently with revenue (i.e., utilities in this instance) would qualify as a variable expense.

We would suggest analyzing expenses using a percentage of revenue and growth rates to categorize the costs. Then, once you have classified the major expenses, you can make a determination as to whether or not a simplified approach makes sense.

The Simplified Approach to Projecting Operating Expenses

We like to keep things simple whenever possible (and supportable). If operating expenses primarily comprise fixed costs, you may be able to apply an overall growth rate to total operating expenses. If expenses are mostly variable, you may want to use a percentage of revenue to estimate operating expenses. We find that these methods are often preferable to clients due to their simplicity. In addition, a simplified approach might be necessary where historical information is limited.

The free, fully functional forecasting model included with this guide allows you to estimate operating expenses based on simplified approaches or to use fixed, semi-fixed, or variable forecasting methods.

The Fixed vs. Variable Approach to Projecting Operating Expenses

If you have ruled out the simplified approaches, you need to forecast the major operating expenses individually. We summarize in Figure 10 each cost and its category, forecasting method, and the relevant assumptions.

The narrative around the assumptions in Figure 10 could be as follows:

Rent expense is forecasted using the escalators included in our lease agreements, or approximately 2.0% per year.
Salaries and wages are generally stable year-over-year. However, we occasionally need to add to our team to support growth. We expect to add a fourth manager at $65,000 per year in 2022, which is why salaries and wages increase significantly in that year. Subsequent amounts reflect ongoing annual increases in compensation.
Utilities generally increase with production activity and, therefore, were projected at 2.5% of revenue.

Notice that there is a story to go with the forecasting assumptions, which also supports how we classified the expenses. It is good practice to jot some notes down now, as you will probably need them later to answer questions from your appraiser.

You are likely to have more than three expenses and many of your costs may be somewhat nominal in magnitude. You do not need to project each expense individually (unless you want to)! We generally recommend aggregating minor ongoing expenses and forecasting based on how they behaved historically. Chances are, you will not end up with a materially different forecast when simplifying the smaller line items.

The free model included with this guide allows you to change the expense category and forecast method as needed.

The simplistic examples in this guide provide obvious examples of how operating expenses can be classified. Unfortunately, you are unlikely to see trends this clear in the real world. The assessment of fixed vs. variable can be tricky in some instances, and the historical financial information may not give you a straightforward trend. In these cases, apply common sense to make the appropriate assessment. It’s more of an art than a science!

How to Forecast Interest Expense

Forecasting interest expense will usually involve projecting future interest-bearing debt and estimating future interest rates. We will discuss the forecast of interest-bearing debt in the Forecasting Balance Sheets section of this guide.

Forecasting future interest rates can, unfortunately, require a relatively significant amount of guesswork. Market conditions, historical financial performance, and general creditworthiness can all influence a company’s interest rates. While it is challenging to predict a company’s future financial performance and creditworthiness, it is impossible to forecast future interest rates with any precision. Ask your appraiser a few questions upfront before you go through the headache of estimating future interest rates.

What is the purpose of the valuation and what does your appraiser need? First off, there are cases where you are unlikely to need projected interest expense. For instance, valuations for financial reporting exercise (i.e., to support a financial statement audit) are typically completed on an invested capital basis. Free cash flows to invested capital do not incorporate future changes in debt balances or interest expense. We would recommend that you confirm with your appraiser what is needed to complete the valuation.

How significant is interest expense to the business’s free cash flow? For minimally-leveraged companies, interest expense may not significantly impact free cash flow. The impact of interest expense is mitigated to a certain degree by the tax shield it provides to a company. In some cases, it may not matter if you assume a constant interest rate or incorporate future fluctuations to reflect a changing interest rate environment. No need to punish yourself with a complex interest expense and debt forecasting exercise.

Understand that we’re trying to give you a few paths to avoid additional financial modeling, if at all possible. As you will see, the calculations can be simple, but making assumptions around future debt requirements and interest rates can be complicated.

There are two primary elements needed: future interest-bearing debt and estimated future interest expense. You can typically calculate interest expense by multiplying the average debt balance (the average beginning and ending balances) in each period by the projected interest rate. The average balance is usually appropriate in cases where debt balances tend to fluctuate throughout the year (i.e., working capital lines of credit). However, the use of an average is not a hard and fast rule. It may be more appropriate to use the beginning or ending balance if those amounts provide a better indication of the debt balance owed most of the year.

Please see the Forecasting Balance Sheets section of this guide for more information on projecting future debt balances.

Now, the fun part: estimating interest rates. As with everything else we have discussed in this guide, you have some options.

Option 1: Let’s tackle the easy one first. If a company has existing debt, you will want to use the associated interest rates as a reference point. Estimating future interest expense is straightforward for a company with existing debt at fixed interest rates. You can use the current interest rates to forecast the annual cost of debt.

Option 2: For companies with debt and variable interest rates, you may want to forecast using your current rates. There are several reasons for this simplistic approach. First and foremost, it is very challenging to estimate future interest rates with any degree of certainty. How do you consider the following?

- Regular fluctuations in interbank borrowing rates;
- Actions by central banks that influence interest rates;
- The market’s appetite for corporate debt throughout the credit rating scale;
- Geopolitical risk factors that impact national credit ratings;
- Changes in bank lending standards.

Second, we have to ask ourselves whether adjustments to the current interest rates will yield a materially different valuation result. Remember that the ultimate goal for the forecast is to calculate a reasonable estimate of a company’s future free cash flow. Incremental changes to the assumed interest rates may not significantly impact overall cash flow. In these cases, it can be difficult to justify the investment of time and effort to forecast changes in future interest rates.

Still Need to Forecast Future Interest Rates?

If you must go through projecting changes in interest rates, the task requires a bit of research. Several quantitative methods have been developed to predict future interest rates. These methods are beyond the scope of this guide. We are not making investment decisions with our forecasted interest rates, so we will not suggest one of these complicated models.

Here is a more “simplified” and intuitive approach.

The first step in estimating the future is establishing a solid starting point (i.e., your current interest rates). If you have a current rate, you can use that as a reference point and incorporate adjustments to reflect future changes expected in the company’s financial situation and the market. We will provide some resources to help with assessing future changes in interest rates.

If you don’t have a current interest rate, you will need to estimate it. Here are a few ideas:

You can look at the effective cost of debt of comparable companies in the public markets and add a premium to that based on differences in credit risk.
You can look at published private company debt rates. There are a number of free and paid resources available, including GF Data (paid publication) or the Pepperdine Private Capital Markets Report (free publication).
Another method would be to estimate your company’s credit rating and then match it to corporate bond yields with a corresponding rating. Standard & Poor’s has a great document with high-level discussion on how credit ratings are determined. Using a company-specific credit rating, you can then dig up the associated corporate debt rates observed in the market.

So far, we have estimated the company’s current cost of debt. Now we can try to project out future adjustments over time. If you have access to a Bloomberg Professional Services terminal, you can obtain an interpolated forecast of interest rates. Bloomberg forecasts these rates based on data from current debt rates and interest rate futures, forward rate agreements, and interest rate swaps. Sounds complicated, right? It’s also expensive.

There are some limited free resources available online for those of you without access to a Bloomberg terminal. Google is your friend here. Some of these resources include:

The Federal Open Market Committee (FOMC) provides periodic estimates for changes in the federal funds rate, which provides a general feel for where interest rates could be headed. Look for the links to the “Projection Materials.” Importantly, keep in mind that changes in the federal funds rate do not necessarily correlate with corporate bond yields.
Various major investment advisory firms provide fixed income reports that provide insight from their top investment analysts. These insights are typically centered around short-term changes in corporate bond rates.
Moody’s Analytics provides a free, weekly market outlook report with short-term insight into how yields may change in the short term.

Have other resources? Shoot us an email and we would be happy to add it to this guide.

Once you have some idea of how interest rates might change in the future, you can make some broad strokes to estimate how your company’s interest costs will change in the future. Remember that you won’t have the ability to forecast with too much precision here. If your research indicated that interest rates would rise, you could include increases within your interest expense estimates. The magnitude and timing of interest rate fluctuations are up to you.

You may be asking, “How do I do that?” Unfortunately, there is no great answer here. It is a challenging exercise and difficult to explain to an auditor, the IRS, and your appraiser. Now you better understand why we usually advocate for the simplistic approach noted earlier.

How to Forecast Depreciation and Amortization Expense

Depreciation and amortization expense are non-cash items and are tax-deductible. In calculating free cash flow, these non-cash expenses are first subtracted from operating income to calculate the income taxes. We then add back depreciation and amortization to calculate cash flow. For businesses with significant fixed asset requirements, depreciation can substantially impact the magnitude of income tax expense. We will address tax depreciation from the perspective of a taxpayer in the United States.

There are two general conventions for projecting depreciation expense:

Book depreciation: This convention is what we would call “economic” depreciation. Typically, book depreciation is calculated over the asset’s useful life and represents the ongoing loss of value in the asset due to its usage.
Tax depreciation: This convention strives to estimate the deduction that a company would report to the IRS or other taxation authority to calculate its income tax liability. There are several methods available to taxpayers for depreciating fixed assets – see IRS Publication 946. You can find guidance around the life that should be associated with various types of assets. Appendix A (page 70) provides the tables related to the available depreciation methods, including Modified Accelerated Cost Recovery System (MACRS). Exciting stuff!

Many business appraisers will focus on tax depreciation when calculating free cash flow because it provides a better avenue to estimating future income taxes.

Further complicating the calculation is “bonus” depreciation, made available to taxpayers by the Tax Cuts and Jobs Act of 2017. You can read more about what these rules allow in this 137-page IRS publication. In a nutshell, taxpayers may immediately depreciate 100% of the cost of certain purchases of fixed assets through December 31, 2022 as if they were normal expenses. The percentage declines to 80%, 60%, 40%, and 20% in each year through the end of 2026. After 2026, life returns to normal and fixed assets are depreciated using the standard tax depreciation methods previously accepted by the IRS.

Confused yet? Let’s look at an example.

Figure 12 looks a lot more complicated than it really is. Let’s break the schedule down into its major components.

The top portion of the example provides a projection of existing fixed assets. We are using a 5-year MACRS depreciation schedule for these assets. The schedule you use will depend on the remaining depreciable life of the fixed assets on the books.
In the middle portion of Figure 12, we present capital expenditures and bonus depreciation. You can see that the capital expenditures in 2021 and 2022 are fully expensed in those years. Bonus depreciation gradually declines through 2026.
At the bottom of the example, the remaining MACRS-based depreciation is calculated for the portion of capital expenditures not subject to bonus depreciation. Since 100% of capital expenditures in 2021 and 2022 are eligible for bonus depreciation, there is no ongoing depreciation of these assets.
The total projected depreciation expense is equal to the depreciation on existing fixed assets plus bonus depreciation plus ongoing depreciation for assets not eligible for bonus depreciation.

The general idea is to estimate the depreciation expense related to each year’s capital expenditures. Importantly, the depreciation schedule provided as a part of our sample forecast workbook is not intended to be tax advice. It does not incorporate all of the nuances related to depreciation expense as stipulated in the Internal Revenue Code.

To be honest, it is rare that a client will have gone through a modeling exercise to calculate tax depreciation. Many clients will prepare projections to the EBITDA level and leave these calculations to the appraiser to complete (most appraisers will have the type of model shown in Figure 12).

Pro Tip: Use this simple sanity check to confirm the reasonableness of your projected depreciation expense.

Projected depreciation expense should never result in a negative net fixed assets balance. You can perform this sanity easy check by adding capital expenditures to the existing net fixed assets value in each period and subtracting projected depreciation. If net fixed assets decline or increase by too much in any year, you may want to revisit the capital expenditures and depreciation assumptions.

Income Taxes

The last component of the income statement that impacts the calculation of free cash flow is income taxes. If you pay taxes at the corporate level, incorporating income taxes in free cash flow makes sense. Many privately-owned businesses are legally set up as pass-through entities (i.e., S corporations, limited partnerships, limited liability companies). These legal entities don’t pay income taxes at the company level. Instead, income passes through to the owners, who pay income tax at the individual level.

In a business valuation, appraisers will often start by valuing a company as a publicly-traded C corporation and separately adjust for tax structure and privately-owned status. All of the rate of return information used in a discounted cash flow analysis is drawn from the public equity markets. Publicly-traded companies are broadly structured as C corporations. Therefore, to reflect cash flows on the same basis as publicly-traded companies, we will incorporate C corporation income taxes within the projected free cash flow stream.

There are several ways to estimate income taxes. Here are some commonly used ways we see it done.

If you have a tax department or consultant to turn to, they probably can provide the best indication of your company’s effective income tax rate.

If you do not have an internal tax team, no problem. For valuation purposes, you can usually take a simplistic approach to estimate your income taxes. For U.S.-based companies, you can use the applicable state income tax rate and federal income tax rate (today, that rate is 21%). State corporate income taxes are deductible for federal tax purposes. Therefore, the effective tax rate would be calculated as follows (using California corporate tax rate as an example):

The primary resource we like to reference for state corporate income tax rates is The Tax Foundation, State Corporate Income Tax Rates and Brackets for 2021.

For international companies, you can estimate corporate income tax rates in much the same way. A good centralized data source for income tax rates by country is KPMG’s Corporate Tax Rates Table. We would also recommend looking at PwC’s Worldwide Tax Summaries Online database, which provides summarized information for corporate and individual tax rules for over 150 countries worldwide. This is a great way to identify if there are other local tax rates to consider in your income tax calculation.

The third method is to sit back, relax, and let your appraiser do some calculations on your behalf. It is typical for the appraiser to calculate an estimated income tax rate for the client. How’s that for easy?

Are we there yet?

Almost. We have not crossed the finish line just yet. Before you close your laptop, you should review your forecast assumptions again for reasonableness. There are several ways to do this. Here are some of the standard tests that appraisers will perform:

Historical comparisons – How does forecasted performance compare to historical financial results? Compare historical trends in growth and profitability, and investigate any irregularities. Reassess your assumptions as appropriate.
Revisiting the story of the company’s future – Do the forecasted numbers intuitively make sense when compared against your story for the company’s future? Consider the likelihood of clearing hurdles to reach the expected growth rates and margins. You have to buy into the projected financial information and sell it to someone else.
Market/Industry comparisons – How do the forecasted revenue growth rates and profit margins compare to industry expectations or those of your publicly-traded comparable companies? Benchmarking your company’s growth rates and profit margins against publicly-traded peers provides a quantitative way to assess the reasonableness of your assumptions. ValuAnalytics can provide you with the information and analytics needed to complete these benchmarking assessments. Contact us or click here to request our services.

Here are some examples of some reasonableness test and related questions using Figure 7 as an example:

Historical comparison –historical EBITDA margins range between 27.5% and 32.2% from 2016 through 2020. In contrast, forecasted EBITDA margins range between 31.4% and 34.4%, with the stabilized margins coming in at around 33.2%. Many of the margins in the forecasted years are higher than observed historically. Is this reasonable?
Revisiting the story of the company’s future – The cost of materials and labor has increased in recent years. You expect this trend to continue going forward. At the same time, additional competition from manufacturers in China has increased pricing pressures across the entire industry. These factors would both suggest a decline in gross margins. In contrast, gross profit margins are projected to grow from 52.7% in 2021 to 54.7% by 2024. Is it reasonable to assume that gross margins will continue to increase in the future?
Market/Industry comparisons – Industry analysts expect the EBITDA margins of the company’s publicly-traded industry peers to decline over the next two years. The forecasted margins appear to be increasing. Is the projected increase in margins reasonable?

You don’t need to be an appraiser to think through these types of questions. Chances are, many of the questions regarding your forecast may be typical of what you already consider when managing the company’s day-to-day operations. Nobody knows your business as well as you do, so it is essential to ask questions, have discussions about the reasonableness of the forecast, and make adjustments as necessary. Remember, the more realistic your projections, the less subjectivity needed to value the company. More realism and less subjectivity typically result in a more reliable valuation.

Koji Bratcher is an accredited senior appraiser with the American Society of Appraisers with approximately 15 years of experience serving clientele in the middle-market space. He is the founder of ValuAnalytics, LLC and a director and principal in Helios Consulting, Inc.

ValuAnalytics provides clients with the ability to quickly and affordably benchmark companies against publicly-traded companies to support internal valuation processes and financial analyses. ValuAnalytics can benchmark your company’s historical and forecasted financial results against your publicly-traded competitors.

Need a valuation performed for your company or its assets? Helios Consulting, Inc. is a full-service valuation firm located in Los Angeles, CA and can assist you with your valuation requirements. We service clients worldwide for a variety of purposes. If you require assistance with preparing a financial statement forecast, give us a call!