From the course: Financial Modeling and Forecasting Financial Statements

Monitor financial statements to keep forecasts accurate

From the course: Financial Modeling and Forecasting Financial Statements

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Monitor financial statements to keep forecasts accurate

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Using the historical financial statements as a starting point, we can systematically create a forecast of next year's financial statements. First, let's consider the balance sheet. Not all balance sheet accounts change according to the same process. Some items increase naturally as sales volume increases. Others increase only in response to specific long-term expansion plans. and other balance sheet items change only in response to specific financing choices made by management. Let's first talk about those items that increase naturally with an increase in sales volume. By the way, this highlights the importance of starting the whole forecasting process with a reliable sales forecast. For year two, a careful analysis of historical trends, economic conditions, and company plans has led the financial planners of Darrold Company to agree that sales are expected to increase a whopping 50% in year two. Here are the balance sheet assets for Darrold Company for last year, year one. If Darrold Company plans to increase its sales volume by 50% in year two, it seems logical to assume that Darrold will need about 50% more cash with which to handle the increased volume of business. In other words, the increased level of activity itself will just create the need for more cash. The same is true of accounts receivable and inventory. In short, a planned 50% increase in the volume of Daryl's business means that in the absence of plans to significantly change its method of operation, Daryl will also experience a 50% increase in the levels of its accounts receivable and its inventory. These forecasted natural increases are reflected in this forecasted balance sheet asset listing for year two. Now note that we don't yet have a forecast for the amount of property plant and equipment needed in year two. The amount of property plant and equipment doesn't naturally rise as sales increase. Instead, a specific plan is necessary based on existing capacity, expected sales in year two, and expected developments beyond year two. The planned acquisition of property, plant, and equipment is discussed in a subsequent module. Now, let's talk about the income statement. Darold Company's income statement for year one, up through the computation of operating profits, looks like this. The amount of sum expenses is directly tied to the amount of sales for the year. Darold Company's sales are forecasted to increase by 50% in year two from $1,000 to $1,500. So it is reasonable to predict that cost of goods sold will increase by the same 50%. Another way to perform this calculation is to assume that the ratio of cost of goods sold to sales remains constant from year to year. Thus, because cost of goods sold was 70% of sales in year one, cost of goods sold should increase to $1,050 in year two. Similarly, other operating expenses such as wages and shipping costs are also likely to maintain a constant relationship with the level of sales. So if operating expenses were 18.5% of sales of $1,000 in year one, as a forecasting starting point, we can assume that those operating expenses will be 18.5% of forecasted sales of $1,500 in year two, or $278. By the way, we'll talk about the expected change in operating expenses in more detail later when we discuss the impact of fixed costs and variable costs. In this simple example, we're assuming that all our operating expenses are variable costs. Now, forecasted items from Derald Company's income statement for year two appear like this. Note that we don't yet have a forecast for depreciation expense in Year 2, because the amount of depreciation is driven not by sales, but by the level of property, plant, and equipment. We will consider this in another module. Now, some balance sheet and income statement items can be expected to change roughly in proportion to the change in sales. We can use this insight in constructing forecasted financial statements.

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