From the course: Financial Modeling and Forecasting Financial Statements

Deduce the connection between past and future business performance

From the course: Financial Modeling and Forecasting Financial Statements

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Deduce the connection between past and future business performance

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A common criticism I hear about accounting is that it's too focused on the past. Managers, bankers, and investors, they don't want to know about the past, they want to know about the future. People say that looking at financial statements is like trying to drive your car by looking in the rearview mirror to see where you've been. Well, I'm going to go with Winston Churchill on this topic. He said, the farther back you can look, the further forward you are likely to see. Churchill, a student of history, understood that studying the past allows one an educated glimpse into an uncertain future. Studying and analyzing the historical performance of a company allows financial statement users to project the future performance of that company. We can make some reasonable assumptions about a company's future performance, and it is then fairly straightforward to see what future financial statements might look like. To illustrate, let's discuss forecasting a company's income statement. Now the same general concepts apply if we're looking at the balance sheet. To begin, we recognize that the amounts of some expenses are directly tied to the amount of sales for the year. For example, if we do nothing differently in the future, it seems reasonable to predict that cost of sales will increase at the same rate as sales increases. For example, year after year, Wal-Mart's cost of sales is approximately 75% of Wal-Mart's sales amount. In other words, if Wal-Mart sells you something for $100, that thing costs Wal-Mart about $75 to purchase from its suppliers. So if Wal-Mart's sales are forecasted to increase next year to $1 trillion, then cost of sales will probably be about $750 billion. By the way, Walmart's actual sales are not $1 trillion, they're about two-thirds of that amount, $674 billion. But hey, when you're doing a what-if calculation, why not try to be optimistic? Similarly, other operating expenses, such as wages, are also likely to maintain a constant relationship with the level of sales. Some expenses don't necessarily vary with sales. For example, depreciation expense will vary with the amount of a company's buildings and equipment. If the amount of buildings and equipment increases, it's reasonable to expect that depreciation expense will also increase. Now consider interest expense. The amount of interest expense is not tied to the level of sales. Instead, you pay more interest if you have more loans. If the amount of a company's loans goes up, it's reasonable to forecast that interest expense will also go up. Okay, well, let's not forget about income tax expense. Income tax expense is not a function of sales. It's a function of income. Hence the name. If you tell me forecasted income for next year, I can then apply the expected income tax rate to generate an estimate of next year's income tax expense. By the way, self-employed individuals in the United States do this simple forecast all the time, as they sent estimated income tax payments into the U.S. Internal Revenue Service. Now, a major point is this. In creating forecasted financial statements, we just systematically think about what causes financial statement numbers to change, what events or activities drive those changes, and then we forecast the future based on our expectations about those changing activities. historical information and making some reasonable assumptions, we can get a look at what the future might look like. And as we put more investigative effort into our assumptions, we can get an even more accurate picture of what the future might look like. And it's not hard. It's kind of fun. And the nice thing about getting a glimpse of what the future looks like is if you don't like it, you can change the assumptions associated with your forecast. Yeah, sure. You can change the the assumptions to get a different forecast, you just then need to make sure that those changed assumptions are associated with reasonable and achievable actions in the real world. If they are, you can create a different financial future.

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