Projection of a company’s financial performance into the future is useful both for credit analysis (in assessing whether a company would be able to meet its debt covenants), and equity analysis.
Data needed for preparing forecasted financial statements include previous financial statements, industry structure (competition, barriers to entry, etc.) and outlook, and macroeconomic trends. Forecasting is often based on past data, which forms a valid basis in case of mature companies with a stable track record, but not in case of startups or companies undergoing restructuring or divestitures, etc.
There are two ways in which forecasted financial information is useful for analysis: forecasting performance metrics over near future and over long-term
Financial performance metrics such as earnings, cash flow, etc. are forecasted for the near future and used as an input into market valuation approaches. This process involves the following steps:
- Forecast the industry-wide sales using historical industry sale and macroeconomic growth forecasts (which are itself derived from the past relationship between growth rates and other macroeconomic variables).
- Work out the historical market share of the company and adjust it for the future outlook of each company giving its strategic position.
- Forecast expenses (either function-wise or nature-wise) based on their proportion to revenues in the common-size financial statements. For stable companies, an analyst may assume a stable gross or net profit margin, but not for high-growth companies, companies in volatile industries such as commodities, etc. Care must be taken to exclude any non-recurring items.
Multiple period projections
This approach is used in discounted cash flow analysis in which future cash flows are projected and discounted to determine the value of a company and/or its equity and in credit analysis, in which sufficiency of future cash flows is assessed to evaluate a company’s debt-paying capacity.
An analysis may use different definitions of cash flows, such as free cash flow to firm (FCFF) and free cash flow to equity (FCFE), etc.
The multi-year forecasts also use the same process as outlined above, but each step is more detailed and considers a range of data sources. It is also important to carry out sensitivity and scenario analysis to identify how the output would change in response to a change in different assumptions.
The key point in both methods is to create correct and consistent relationships between different items in financial statements. For example, increased sales may require increased capital expenditure and additional working capital which may result in greater depreciation which in turn can have an impact on taxable income and taxes. An analyst needs to follow through on all material and important linkages and relationships.