A financial statement forecast or projection plays a central role in determining how a business’s value is determined. This guide provides a simplified overview of how one might prepare a forecast for use in a business valuation. Readers should gain a solid grasp on what information is needed and where time is best spent when preparing financial statement projections. We have included a free and fully functional workbook for reference or to build out your own forecast. In the model and related articles, we will walk through specific considerations and strategies for forecasting income statements and balance sheets, among many other topics.
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.
Why You Need a Financial Statement Forecast
You may be asking yourself, “Why is a financial statement forecast important?” or “Do I need to go through this process?” Yes, forecasts are critical inputs to most business valuations. The reason circles back to basic financial theory: the value of an asset can generally be explained by the future benefits it will provide to an investor. The concept is the same as when you pay for lunch so that you can satisfy your hunger. You buy a home to provide a stable and safe environment for your family. You buy a piece of manufacturing equipment to create products that will be sold to customers, thereby generating a return.
There are various ways to measure future benefits that a company will provide:
- Revenue
- Net income
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Dividends
- Free cash flow
In an ideal world, a business appraisal will incorporate existing financial forecasts that were prepared on or around the valuation date. However, if this information is not readily available, you may need to prepare a forecast specifically for the valuation.
Estimating the future benefits of a business can be challenging. The level of granularity required can vary from industry to industry. With so many variables to consider, you could potentially spend the rest of your career trying to predict all of the minute details that could impact a forecast. Fortunately, you don’t need to do that. Before we get into the nuances of what is needed, it is vital to understand the general framework of the financial metrics used to measure a business’s future benefits.
Appraisers Like to Use Free Cash Flow to Value Businesses
Free cash flow is widely considered the preferred financial metric to value businesses. This metric considers cash flow from operations, income tax liabilities, and reinvestment requirements in working capital and capital expenditures. Essentially, free cash flow represents the amount of cash flow available for distribution to a company’s stakeholders.
There are two variations of free cash flow:
- Free cash flow to invested capital represents the company’s cash flow available to both equity and debt holders. Interest expense and changes in debt balances are cash flow items related to debt holders and are excluded from the projected benefit stream. See below.
- Free cash flow to equity represents a company’s cash flow available to equity holders after subtracting expected interest expense and incorporating changes in debt balances. See below.
It is worth summarizing and reiterating the definitions above. By incorporating interest expense and changes in debt balances, we can measure the benefit stream that equity holders would expect to receive. Excluding these items from the calculations would allow us to measure the benefit stream available to both equity and debt holders. Your appraiser will ultimately determine which benefit stream he or she will use to value the company.
Pro Tip: Confirm what projected financial information your appraiser needs before you prepare your forecast.
An appraiser can choose from a variety of financial metrics to measure the future benefits of a business. Your appraiser will select the financial metric that best represents the future benefits to its investors. However, it is good to keep a practical mindset around what your appraiser needs for the valuation. The selection of the benefit stream should contemplate the purpose of the engagement and the facts and circumstances of the subject company.
For example, free cash flow to invested capital is one of the more commonly used financial metrics in financial reporting-related valuations. Most major audit firms and their internal valuation specialists expect to see free cash flow used in the valuation of a business. To avoid a potentially long and arduous review process with your auditors, it may be a good idea to use free cash flow to value the company.
In other cases, you may be preparing for a sale and using business valuation to help with your decision-making process. If net income is a central focal point for investors in your industry, you may want to concentrate your forecasting efforts on the income statement.
Bottom line, you should always ask about your appraiser’s needs at the beginning of the process.
Regardless of the definition of cash flow selected, the starting point for the calculations is an income statement metric (EBIT or pre-tax income). The free cash flow calculation also considers income tax expense and depreciation & amortization, which are income statement items. From the balance sheet, free cash flow contemplates capital expenditures and changes in net working capital and debt. Therefore, understanding how the income statement and balance sheet will behave in the future is usually necessary to perform a business valuation.
WHERE DID I PUT MY CRYSTAL BALL?
Feel like you need a crystal ball to project your company’s future? You’re not alone. Clients have often asked questions, such as:
- How do I prepare a forecast? I have no idea what will happen next month, let alone next year!
- How do I forecast the impacts of external factors on the business?
- What do I include/exclude in my projection?
- What do I need to forecast?
- How much detail does the forecast need to contain?
- How many years do I need to forecast?
We will answer all of these questions and more. Stick with us.
Forecasts can be as complicated or simplistic as you want them to be. At the end of the day, we are looking for accuracy, not precision. You need to be detailed enough to yield a realistic projected cash flow stream. We have assisted many clients with this process for valuation purposes. You’ll be relieved to know that the process of creating a forecast for valuation purposes is not nearly as painful and technical as you may be thinking.
FIVE STEPS TO FOLLOW WHEN FORECASTING FINANCIAL STATEMENT INFORMATION
Here is a quick reference infographic on the five steps for forecasting financial statement information.
1. Gathering and analyzing historical financial information
History is often an ideal point of reference for future performance. It provides tangible evidence of what your company has already achieved. It is also helpful to assess the level of risk in your forecasted financial information.
Just gathering the information, however, is not enough. Ideally, one would review, organize, and analyze the historical financial data before estimating the future. You should be adjusting historical financial information for non-recurring, extraordinary items. In addition, you need to understand what drove growth or declines in the business and how those factors will impact the future.
2. Developing a “story” for the company’s future
Figuring out the “story” for the future is arguably the most important (and, often, the most challenging) step in forecasting financial statements. The story should consider the information you gathered in step 1. Consider the following example.
Historical Facts:
- ABC Company halted operations last year to address quality-control issues.
- Revenues declined and the company hired additional employees to implement various quality improvement initiatives.
Potential Future Considerations:
- Future warranty claims or customer returns.
- Possible regulatory action, recalls, or lawsuits.
- Damage to the company’s reputation.
- Ongoing costs associated with process improvement efforts.
It is a good idea to jot down some notes as you create the “narrative” of the future. They will help you to maintain a consistent frame of reference as you proceed through the remaining steps. Think through the story before you ever touch a spreadsheet.
3. Translating the “story” into future financial information
Once you have crafted the story, it is time to put pen to paper. Start throwing some numbers into a spreadsheet to see your company become the next unicorn to IPO for billions – just kidding, of course! For your business valuation, you need to estimate what is reasonable for the company and (as much as possible) remove your personal biases from the numbers.
There are a variety of techniques available to project every line item of your financial statements. We will go into the procedural nuances of putting the forecast together in separate sections of the guide. For more information, see Forecasting Income Statements and Forecasting Balance Sheets sections of this guide.
4. Testing reasonableness
Once you’ve prepared your financial statement forecast, you’ll want to take a step back and double-check your numbers for reasonableness. For now, think of this part of the process as a gut check to your work thus far.
- Are your forecasted growth rates and profit margins in excess of historical figures?
- How do your assumed growth rates compare to industry peers?
- Are your projections consistent with general industry expectations, and is this reasonable?
- Are there any key risk factors that might hinder the achievement of the forecasted financial results? Are you able to build these factors into the forecast?
- Do the numbers match the story?
The list could go on forever. Now would be a good time to reference those notes from step 2. Have doubts as to your forecast’s reasonableness? Press on to step 5.
5. Making adjustments
Based on the results of step 4, you may need to make some adjustments to the items you projected. Once you’ve made the necessary adjustments, we highly suggest that you go back and repeat step 4. Keep revisiting the projection until you have numbers that match your story.
Pro Tip: Take the time to get the forecast right.
Steps 4 and 5 are essential processes because they can save you time and money on your business appraisal. More reliable projected financial information also yields a more accurate valuation conclusion. In general, the more back and forth you have around projections with your appraiser, the greater the chance for up-scoped fees.
A competent business appraiser will put your financial forecast through some scrutiny, which should be part of the valuation process. The more thought you have put into your projection, the less burdensome (and less expensive) the valuation process is likely to be.
The Most Important Step in Forecasting Financial Statements is the Story
We cannot stress this point enough.
Many people tend to focus the most heavily on the numbers when putting together a forecast. While the numbers are an undoubtedly significant element of a financial statement forecast, we believe the most critical factor to consider is the story behind the numbers. We always recommend thinking through expected business strategy, recent events, and industry expectations before touching a spreadsheet. Crafting a relatively detailed account of a company’s path to future success will help keep the projection “real.”
It is easy to throw numbers into a spreadsheet reflecting strong growth and margin improvement. Forecasts prepared without a story often incorporate unintended (or intentional) biases regarding your future financial performance. By developing the story first, you force yourself to think through some of the critical aspects of your forecast and the risks of achieving the company’s goals. This process tends to keep the numbers grounded via some level of personal skepticism.
Don’t get us wrong – you absolutely should buy into your company’s potential for future growth and profitability. However, a proper business valuation will include assessing the future return of your company (via your forecast) against the risks associated with achieving those projections. A good business appraiser will ask questions about your estimates to evaluate the risk profile of the business’s future cash flows. Remember that values are positively correlated with expected returns and negatively correlated with risk. For this reason, it is generally best practice to prepare your forecast on an “expected-case” basis, rather than with excessive conservatism or aggressiveness.
How to Translate Your Story into a Forecast – Frequently Asked Questions
Once you have crafted the story, it needs to come to life within your forecasted numbers. Most clients will use a spreadsheet to create their forecast. We have, however, received forecasted growth rates and margins written by a client on the back of a napkin at a lunch meeting. Before you get into the modeling, let’s address some of those frequently asked questions noted previously.
Do you have a question you want to see addressed here? Send us a message!
FAQ #1: How do I prepare a forecast?
A good starting point for estimating the future is your historical financial information. You have likely heard the phrase, “past performance is not a guarantee for future results,” which is relevant for any forecasting exercise. However, historical observations can provide valuable insight into how growth, margins, or capital-investment needs might behave going forward. Absent the expectation of significant future changes in the business, a company’s future performance might be similar to historical results. Historical results, however, can be rendered irrelevant by extraordinary events, including:
- The loss of a key executive
- A disaster that destroys a facility
- Winning a large contract in a historical year that will not recur in the future
- A natural disaster or pandemic
- Changing economic conditions (i.e., recession or recovery)
- Technological innovations and advancements
- Changes in the regulatory environment
Unfortunately, it is impossible to predict the timing and impact of many of these events on a company’s financial performance. The good news is that you generally do not need to unless they are already known or knowable as of your valuation date. We’ll dive deeper into this in a bit.
The unexpected factors will typically represent downside risks to the business that the appraiser can address subjectively. Your primary focus should be on what you would have known at the effective date of the valuation and the strategic plan for the company. If you can identify these risks and communicate them to the appraiser, you have already won half of the battle.
On the flip side, the company may be implementing growth initiatives intended to transform the company from a breakeven business into a money-making machine. These changes may mean that your historical financial information is less meaningful. In these cases, you will need to lean more heavily on the story you crafted for the company’s future.
In any case, the five steps for forecasting financial statements should provide a guideline for how you proceed. We would recommend using a spreadsheet program to keep your forecast organized. See our free, fully functional projection model that you can use as a basis for creating your projections.
FAQ #2: How do I forecast the impact of external factors on the business?
There is a concept called “known and knowable” in the appraisal world. The idea is to put yourself in the shoes of an investor at the valuation date and estimate the future based only on the information you would have known at the time.
The coronavirus pandemic provides a perfect example of what you likely would and would not consider if preparing a forecast for a date in early 2020. Below is a general timeline of the pandemic from January 2020 to March 2020 and ways to look at how it would have impacted a financial statement projection. It is not all-inclusive, nor does it cover the entire time frame of the pandemic. Still, it should give you some idea of how “known or knowable” factors can impact a forecast. Click or tap on the dates below for more information.
January 4, 2020
Event: World Health Organization announces pneumonia cases of unknown cause in Wuhan, China.
Impact on Forecast: Likely none as information related to these cases was limited.
January 9, 2020
Event: The Centers for Disease Control notes novel coronavirus in Wuhan, China and issues an interim travel health notice to people traveling to the city.
Impact on Forecast: Likely none as information related to these cases was limited.
January 30 & 31, 2020
Event: World Health Organization declares a “public health emergency of international concern” and the Secretary of Health and Human Services declares a public health emergency in the United States.
Impact on Forecast: Possibly some increased caution in projected growth rates and margins. However, at this time, it was too early to know the pandemic’s significance on economies around the world.
February 29, 2020
Event: First confirmed U.S.-based death from COVID-19 is announced in Washington.
Impact on Forecast: Possibly some increased caution in projected growth rates and margins. However, at this time, it was too early to know the pandemic’s significance on economies around the world.
March 11, 2020
Event: World Health Organization declares the COVID-19 outbreak a pandemic.
Impact on Forecast: Possibly some increased caution and possibly some reductions in projected growth rates and margins. However, at this time, it was too early to know the pandemic’s significance on economies around the world. The S&P 500 declined 7% on March 12, 2020, which was likely only a market reaction to this declaration rather than a broad shift in expectations for future economic growth.
March 13 - 16, 2020
Event: President Trump declares a national emergency, FOMC reduces the federal funds target rate to 0% to 0.25%, and Trump issues guidelines to the public: limit gatherings to fewer than 10 people; avoid unnecessary travel; avoid eating and drinking at bars, restaurants, and public food courts until March 30, 2020.
Impact on Forecast: Projecting at this time would have been very difficult given the significant uncertainties that existed around the pandemic’s impact on business conditions. However, at this point, a short-term economic impact would likely have been expected at a minimum. Forecasts likely would start incorporating adjustments related to the pandemic around this time.
March 31, 2020
Event: Through the end of March, several states issue shut-down mandates, insurance claims rise to historically high levels, several government-backed initiatives are underway (including the CARES Act), federal stay-at-home guidelines are extended by President Trump to April 30, 2020, and a number of other steps are taken by the Federal Reserve to maintain liquidity in the markets.
Impact on Forecast: Again, projecting would have been very difficult due to the uncertainties at this time. However, financial forecasts would have began to shift significantly at this point.
The extent to which you would include pandemic-related considerations in your forecast increases as you move further down the timeline. Once you have determined what external factors you can/should consider, you must estimate how it impacts the business.
Remember that every business is unique and can be impacted differently by events like pandemics. For example, the pandemic adversely affected the restaurant industry. Meanwhile, the pandemic helped fuel growth for cybersecurity consulting firms, given the broad shift from an in-office workforce to a largely work-from-home arrangement. We saw some clients forecast 50% declines (or more) in their sales during the pandemic. On the other hand, other clients achieved record growth rates and prepared for acquisitions at lucrative valuation multiples. It all boils down to industry.
See also: ValuInsights blog for more industry-centric valuation insights.
One strategy to forecasting amid a significant external event is to start simple. How would the company have performed absent the external event? Once you have a reasonable estimate, you can then adjust your forecast up or down to consider the event’s impact on the company. You will want to consider both the short-term implications and the long-term ramifications of the event on operations.
FAQ #3: What do I need to forecast?
Before we answer this question, let’s look again at how we calculate free cash flow.
As discussed earlier, the starting point for any free cash flow calculation is the income statement. At a bare minimum, management teams need to provide input into how the income statement would look going forward. Even if that input is limited to revenue growth and expected EBITDA margins, you need to give that to your appraiser. The income statement is influenced heavily by external market, economy, and industry conditions. The impact of these conditions can vary significantly between companies – even in the same general industry. It is difficult for an appraiser to reasonably estimate future financial performance without the management team’s perspective on the unique characteristics of the business. Ultimately, you know your business better than we do!
In some cases, you might have some thoughts around future growth and margins, but not around working capital reinvestment and capital expenditures. Passing the forecasting baton for these items is perfectly fine. Your appraiser should be able to work with you to make some high-level balance sheet estimations.
Remember that the reliability of any business valuation is directly tied to the dependability of the inputs. The old programming adage “GIGO”, or “garbage in, garbage out,” applies here. As a result, active collaboration between you and your appraiser may be necessary to ensure that all of the components of your forecast are reasonable.
FAQ #4: How much detail does the forecast need to contain?
A forecast for a business valuation can include as much or as little detail as you would like. The less granular you choose to be, the more “story” you may need to provide to support your forecast. This is especially true if your forecast assumptions are particularly conservative or aggressive. On the flip side, the more detail you provide, the more questions you may receive from your appraiser on individual assumptions. In either case, you probably won’t be able to avoid having a conversation with your appraiser to explain your projections. Worry not, as these discussions are a great way to perform a sanity check on your expectations for the business.
The level of detail required will depend on the facts and circumstances of your company. We usually advise clients to focus most of their attention on the line items with the most significant impact on future results. The question that should always be at the forefront of your mind when forecasting is: “will adding more detail to the assumptions materially change the results?” If the answer is no, then you’re probably better off keeping your forecast simplistic.
The key takeaway here is to be practical in your approach to forecasting. The “KISS” (keep it simple, stupid) rule is generally good to follow. Still, you want to include enough detail to create a financial projection that is grounded in reality and that you can explain. We will demonstrate these concepts in an example in the Forecasting Income Statements and Forecasting Balance Sheets sections later on in this guide.
FAQ #5: How many years do I need to forecast?
If your company has already reached a normalized level of growth and profitability, we have some good news! You likely do not need to forecast anything if you expect more of the same going forward. In these cases, an appraiser can work with you to estimate the business’s ongoing level of free cash flow based on your historical information. Your appraiser would then incorporate this metric in a valuation method known as an “income capitalization” (or “income cap,” for short).
For those companies that expect some variations in future growth, profitability, or capital reinvestment, the general goal is to forecast enough years to stabilize these items. Many appraisers (author included) will request a three- to five-year forecast by default. Three to five years of projected financial information usually gives an appraiser enough data to complete their analysis. Keep in mind that your appraiser may extrapolate additional years for the valuation if your forecast does not reflect stabilization in your company’s financial metrics. Regardless of the number of years you project, you will likely need to discuss your estimates with your appraiser, who may identify additional information requirements.
In any case, a good rule of thumb is to forecast for however many years you are comfortable. Management teams with a history of hitting or exceeding their targets will usually have more forecasting confidence than management teams in companies that have never prepared a forecast or have and never hit the mark. If you fall into the second or third category or somewhere in between, you may only feel comfortable with forecasting for the next year or two. This is perfectly fine. It is far more efficient to spend an hour talking through the company’s story and working collaboratively with your appraiser to construct a forecast for the valuation. While an appraiser can help prepare the projected financial information, collaboration is vital to ensure that the numbers tie back to the story.
Tying it All Together
Hopefully, you now have a good sense of what to think about as you build a forecast and the prospect of creating a financial projection is not as daunting as it may have seemed. You don’t need complex financial modeling to prepare a reasonable forecast. Now you’re ready to get into the nuts and bolts. Use the links below to navigate to other sections of this guide.
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!