2.3 Forecasting and Financial Statements
Forecasting is an important aspect of operating a business. It is essential for a company’s strategic planning, management, and organization. A financial forecast is an estimate of future financial outcomes of a company. Businesses use forecasts to predict how much they will need to spend on expenses, such as materials, or how much income will be generated. Forecasting can be simple for items that remain consistent in value and quantity. For example, rent is consistent over the short-term and grows moderately in the long term. However, when the values can change significantly, forecasting can be an arduous task. As a general rule, forecasting becomes more complicated as variability increases and more elements have to be accounted for.
Using historical internal accounting and sales data, in addition to external market and economic indicators, a financial forecast is created to reflect a company’s possible financial outcomes over a specific time period—which is usually one year. Generally, the main goal of a financial forecast is to predict revenue. Once a company’s revenue is estimated, future costs are then predicted. Fixed costs generally remain constant or are subject to little change. Variable costs are usually estimated based on expected sales. After sales and expenses are predicted, the company can then estimate net income for the period.
Unlike a financial plan or a budget, a financial forecast doesn’t have to be used as a planning document. It is usually done in order to give company’s management and investors an idea of a company’s possible performance, upon which the management can decide on the course of actions for the company. Moreover, when forecasting, companies usually estimate several scenarios. This way if certain trends do not continue into the future (for example, due to competitor actions, or unexpected economic changes), a company is less likely to be caught by surprise and can navigate its operations more successfully.
Companies approach forecasting in many different ways. Some companies pay marketing agencies that study industry trends to obtain the recent trend data. Many organizations hire market research consultants to obtain and review industry data to predict consumer demand. Many companies employ economists to develop financial models to project sales. While financial modeling is typically used by big companies, smaller companies with a simpler revenue and expense structure often base their estimates of possible future sales on past trends and customer demand expectations.
Examples 2.5 Forecasting Ice Cream Sales and Expenses
Suppose a local ice cream company wants to forecast their ice cream sales for summer. In spring, their sales totaled $26,000 (the company sold 5200 ice cream cones for $5 each). From previous years, the management has noticed a pattern in sales increasing on average by 40% in summer. So, if the sales in spring were $26,000, the management expects to make approximately $26,000*1.4=$36,400, or 7280 ice cream cones for $5 each.
Having an estimate of sales for the summer, a company now can forecast its expenses. Fixed expenses, such as rent, will remain the same. Variable costs, such as ingredients and labour to produce ice cream, will have to increase proportionally to the amount of ice cream cones that are expected to be sold in summer. After calculating the expenses, the company can forecast its income by deducting all the estimated expenses from the estimated sales revenue.
Note that forecasting depends not only on the size of the company and its revenues and expenses structure, but also on the type of goods sold. For example, if a company sells ice cream, previous data on company’s sales is the main determinant of consumer’s demand. If, on the other hand, the company sells luxury cars, to forecast the demand for the products on top of it sales data the company needs to take into account the economic situation in the country, household’s income levels, competitor’s strategies, industry trends and so on.
In example 2.5, management expects a 40% increase in sales in summer after studying the local demand for ice cream cones. Without knowing the demand, it would be impossible to project the company’s sales. The better and the more accurate the demand forecast is, the more precise the sales and, correspondingly expenses forecast will be. Without an accurate demand estimate, a company may find itself with an excess of unused products and services if the demand was overstated or unable to serve the customers and lose on potential revenues if the demand was understated. Producing excess products and services is costly, since they could be employed in different ways to produce revenues. For example, they could be invested. On the other hand, when a company’s set production targets are too low, the company faces missed opportunities for profit. Moreover, not being able to meet the demand for products and services is likely to discourage potential customers form using the company’s products or services in the future.
To a limited extent, a company may be able to alter future demand to be more in line with its capacity because it has control over some determinants of demand, like pricing, promotion, and location. If the business is surprised by demand levels that are higher or lower than expected, these market strategy elements can be adjusted to either stimulate or diminish demand to conform to its production capabilities. For example, if a company that manufactures clothing has overestimated its demand, it can increase its sales by decreasing prices on clothing, or having big sale events. However, even if the company will manage to sell the clothing they initially planned to based on their forecasting, this was done by losing part of their revenues, since they had to decrease their prices to increase the demand. Furthermore, companies can alter demand only to a certain extent, as most businesses have limited ability to affect it.
Forecasts are made in advance. This enables the companies to have an adequately sized operation, sufficient staff in terms of size and training, and obtain any necessary resources for production. These capabilities are usually not possible to achieve overnight. For some goods, production is a process that takes significant time from initiation to completion, such as constructing apartments or office space that will be leased to customers. Even businesses that provide products or services “made to order,” where most of the direct organization or production activities occur after a purchase is made, usually need to have supplies, trained labor, and management structures in place in advance of the order to be in a position to negotiate a sale.
2.3.1 Pro Forma Financial Statements
After using forecasting tools to predict sales, expenses and income for a period, companies often create financial statements with this information to study forecasted scenarios in more detail. These statements are called pro forma financial statements.
Pro forma statements summarize the projected future status of a company based on the current financial statements and company’s forecast. These statements can be done annually to represent forecasting results for the future periods, or whenever the need arises. For example, if a company decides to build a new factory, pro forma statement may be created to reflect the changes to company’s profitability, cash flows and financial position as a result of undertaking this project.
Pro forma financial statements are used internally by the business and they are not required to be released to public or to shareholders. They are used to aid managers in making decisions regarding company’s operations and financing, as well as to determine areas that need to be analyzed and resolved for the company to continue running smoothly. For example, management may use pro forma financial statements to determine the effect of decreasing the company’s inventory to decrease storage costs. The money from the excess inventory will then be invested. On the pro forma balance sheet, the financial position of the company will remain unchanged: the decrease in inventories will be offset by an increase in long-term investments. However, when analyzing the financial ratios, company’s management may notice that cutting inventory will result in current assets being too low to finance company’s current liabilities. So, the management will have to decide on the course of action to deal with this issue, which would not have been apparent had the pro forma balance sheet not been prepared and analyzed.
Example 2.6 Pro Froma Statement for Absolute Tire Inc.
Absolute Tire Inc. is a company that manufactures tires. For the year 2016, its income statement was:
| Absolute Tire Inc. | ||
| Income Statement | ||
| For the Period Ending January 2nd, 2017 | ||
| Revenues | ||
| Sales Revenue | $2,670,000 | |
| Expenses | ||
| COGS | $1,134,750 | |
| Selling, general and administrative expense | $368,000 | |
| Income before Taxes | $1,167,250 | |
| Income Tax | $291,812 | |
| Net Income | $875,438 |
The company’s sales depend on the orders from the auto retailer company Street Cars Ltd. in the city, and sales in the local store. The sales in the local store have been constant for the past 5 years, averaging 2000 tires sold per year. In 2016, the company sold 11350 tires to Street Cars Ltd. as per company’s orders. The company sells tires for $200 each and will keep the same price in 2017. For 2017, Street Cars Ltd. is expecting to host an auto event and the management of the company has increased their order to 18500 tires for 2017. Due to the event, Absolute Tire Inc. expects an increase in demand for their tires sold in the local store to go up by 30%. Production costs per item remain the same. Due to an increase in company’s operations, selling, general and administrative expenses are expected to increase by 20%. The company pays 25% in federal and provincial taxes.
What is the pro forma income statement for Absolute Tire Inc. for 2017?
Solution
To construct the pro forma income statement, we need to determine sales and expenses for 2017.
We begin by projecting the sales. In 2016, company’s sales where $2,670,000. To generate these sales, Absolute Tire Inc. sold 13,350 tires (2000 in the local store and 11,350 to Street Cars Ltd.), each retailing for $200. We know that in 2017, company’s sales are expected to increase. Street Cars Ltd. has ordered 18,500 tires, which will generate $3,700,000 in sales. Moreover, the sales in the local store are also expected to increase (by 30%). If on average the company sells 2000 tires per year in the local store, then in 2017 the company can expect to sell 2000 tires * 130% = 2,600 tires, earning Absolute Tire $520,000 in sales. So, for 2017, the forecasted sales are:
$3,700,000 + $520,000 = $4,220,000
The number of tires sold to generate these sales is 18,500+2,600= 21,100.
In 2016, the company’s COGS were $1,134,750. These are expenses the company incurred to manufacture 13,350 tires. This means, that the production cost per tire was $1,134,750/13,350 tires= $85/tire. The company expects the production costs per tire to be the same in 2017. So, to produce 21,100 tires in 2017, the company will have
COGS = 21,100 tires* $85/tire = $1,793,500 in production expenses.
Selling, general and administrative expense is expected to increase by 20% in 2017 compared to 2016. So, in 2017, these will be:
$368,000*120% = $441,600
Now that we have expected revenues for the period and expenses, we can calculate Absolute Tire’s income before tax:
Income before tax = Sales revenue – COGS – Selling, general and administrative expense = $4,220,000-$1,793,500-$441,600 = $1,984,900.
Since company pays 25% in taxes, the income tax for 2017 is estimated to be:
Income tax = Income before taxes * Income tax rate = $1,984,900 * 25% = $496,225
Now that we have the income before taxes and the income tax amount, we can calculate Absolute Tire’s net income as follows:
Net income = Income before tax – Income tax = $1,984,900 – $496,225 = $1,488,675.
So, the pro forma income statement for 2017 is:
| Absolute Tire Inc. | ||
| Pro Forma Income Statement | ||
| For the Period Ending January 2nd, 2018 | ||
| Revenues | ||
| Sales Revenue | $4,220,000 | |
| Expenses | ||
| COGS | $1,793,500 | |
| Selling, general and administrative expense | $441,600 | |
| Income before Taxes | $1,984,900 | |
| Income Tax | $496,225 | |
| Net Income | $1,488,675 |
So, as we see form the pro forma income statement, the projected net income for 2017 is expected to be higher than the net income in 2016 by 70% ($1,488,675/$875,438 = 170%).