From the course: Financial Modeling and Forecasting Financial Statements

Create processes for dynamic modeling

From the course: Financial Modeling and Forecasting Financial Statements

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Create processes for dynamic modeling

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Remember, at the end of 1985, Home Depot was in dire straits. To try to fix Home Depot, we've looked at the impact on Home Depot's forecasted cash flow of various changes in operating, investing, and financing activities. Now although we did these changes that might help, at least in the short term, we didn't find the magic bullet to completely fix Home Depot's operating cash flow problems to to put the company on solid footing for future growth. When we do this exercise in class, we pause and say, well, I guess it's hopeless. Home Depot can't be fixed, hopeless. In fact, you know that slide I have where I have the word hopeless and it twirls around on the screen. That is so clever. But people know it can't be hopeless. They've seen Home Depot. Surely the company must have figured out something. And after a pause, a few students in the class will call out, we'll do everything at once. Don't just change one thing at a time, change everything. And of course, that's exactly what Home Depot did. They changed everything in 1986. Based on the modeling exercises we did before, here's a forecast of Home Depot's operating cash flows for 1986 through 1990, assuming that the company continues operating in the same way as it had in 1985. Now, if you're a visual person, here's a time series graph of the forecasted operating cash flows. Ugly. A company with forecasted operating cash flows like this has no future except death. Okay, then let's change everything. We will manage our inventory more efficiently, reducing the number of days sales and inventory from the existing 108 days to an achievable industry benchmark of 66 days. We will squeeze our accounts receivable, reducing the collection time from the existing 14 days down to nine days. We'll stretch out the time we wait to pay our suppliers from 48 days to 50 days. Not a big change, but everything helps. Let's manage our purchasing costs from our suppliers and our pricing to our customers to increase our gross profit percentage a little bit, from 26% up to 28%. And finally, let's reduce our overhead expenses, wages, rent, and so forth, from 22% of sales to 20% of sales. All of these changes are reasonable, benchmarked against best practices in the industry. Take a look at these forecasted operating cash flows, which reflect these changes. And here's the time series graph. That's awesome. That's astounding, a complete transformation. With these operating cash flows, Home Depot can easily keep growing, paying for its expansion with internally generated cash flows, as well as the proceeds of loans, which cashflow-hungry bankers will now be eager to supply. So it's as easy as that. Just a few changes in the spreadsheet and Home Depot's future is secure. Well, not so fast, my friend. It's not as easy as that. Behind each one of those spreadsheet parameters is a person, an inventory management person, an accounts payable person, a wage compensation person. The marvelous transformation in the spreadsheet is only possible if those people can make it happen in the real world. That's a good point. Financial modeling and financial statement forecasting is a great starting point, a tool to explore various options. But in the end, the real work is done by real people in the real world who can make the financial model come to life.

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