From the course: Financial Modeling and Forecasting Financial Statements

Evaluate how banks use a financial forecast to make loans

From the course: Financial Modeling and Forecasting Financial Statements

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Evaluate how banks use a financial forecast to make loans

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Banks and other lenders are interested in one thing, being repaid with interest, and those payments will be made out of future cash flows, so success in the banking business is all about making accurate forecasts of a borrower's future cash flows. When a business approaches a bank for a large loan, the bank starts the evaluation process by asking for the company's standard financial statements, a balance sheet, an income statement, and a statement of cash flows. These financial statements are useful because they help the lender predict the future ability of the borrower to repay the loan. By the way, many small and medium-sized businesses do not routinely prepare a statement of cash flows. Now, in a later module, we'll see how to create a statement of cash flows, including a forecasted statement of cash flows, using data from the balance sheet and the income statement. Okay, so how do these historical financial statements help the bank look into the company's future? Well, first, historical financial statements reveal historical trends. For example, total sales for Walmart during fiscal 2024 were $642 billion. This amount represented a 6% sales growth rate over the prior year. Now, sales for fiscal 2025 were $675 billion, a 5% increase over 2024. So, it's not too much of a stretch to forecast that sales for Walmart in 2026 will be about 5% higher than sales in 2025, or our forecast will be about $709 billion. Now, this forecasting through linear extrapolation works fine for a relatively stable company such as Walmart, and over a relatively short time period. For example, back in the early 1990s, Walmart sales were growing at about 24% per year. Now a linear extrapolation at 24% per year over the following 25 years would suggest 2026 Walmart sales of almost $15 trillion. This is over 20 times what the actual value is likely to be. So long-term linear extrapolations are unwise because they ignore the many changes in economic circumstances and the competitive environment. For example, back in 1995, no one knew how difficult it would be for Walmart to continue its growth in countries outside the United States. And no one had any idea that Walmart's most dangerous competitor would be Amazon, competing in the online sales space. So banks need to be careful about just blindly extending past long-term trends when making forecasts of a company's ability to generate cash flows in the future. Plans evolve, macroeconomic factors change, and new markets pop into existence and old ones disappear. In addition, creating financial models and forecasts for a small company with a short track record is much more difficult than is creating forecasts for a large and stable company such as Walmart. For example, a few years ago my brother Kay and I created an online tutoring service for university accounting students. We established a website, no I'm not going to tell you what it is, populated the website with learning material and sat back to wait for the cash flows to roll in. Fortunately we didn't have to borrow any money to launch this venture. But if we had been forced to look for bank financing, we could have gone to the bank with a beautiful forecasting spreadsheet showing sales, profits, and cash flows rising beautifully into the future. But this was a startup business in an immature market, so our forecast would have been very uncertain. Banks have to be cautious, ultra-cautious, when building financial models for startup companies. So how did Kay and I do in our little venture? Well, I think in our best month so far, we've generated a profit of about $250 to be split between the two of us, not quite enough to retire to a private island in the South Pacific. A key success factor for any lender is the ability to reliably model a borrower's ability to generate cash flows in the future, cash flows that can be used to repay the loan with its interest.

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