Reading: Financial Projections
A solid financial plan is the basis of every valuation exercise and every significant management decision. The financial plan allows us to identify the firm's capital needs as well as its ability to generate cash. It also unveils the various sources and uses of funds. This section shows how to set up a financial plan.
1. Introduction
By now, we have acquired the necessary knowledge to derive detailed information about the sources and uses of funds from the balance sheets and income statements of a firm.
In the real world, the available balance sheets and income statements typically provide an account of the firm's past. As we have discussed in the introduction to this course, the primary purpose of financial planning is to venture a glimpse into the financial future of a company.
The logical next step is to abandon the past and try to assess the firm's future ability to generate cash. On paper, this procedure is fairly simple:
- We project the firms balance sheets and income statements.
- Once we have these forecasts, we follow the steps from before to derive the firm's projected cash flow statements.
Clearly, the tricky part is step 1. To forecast the statements, we need to make a broad range of assumptions about the firm's future development. To do so, we need detailed knowledge of the firm's history, its product pipeline, the relevant trends in the market, as well as the overall business environment.
Very often, a substantial part of the necessary information is available inside the firm. By studying the firm's historical financial statements, reading its budgets, and talking to the relevant people inside the organization we can often obtain a fairly good picture of where the firm stands and where it is heading.
If we do not have access to specific inside-knowledge of the firm, sources such as industry reports, analyst reports, the financials of peer companies, or the firm's annual reports and website provide might a good starting point to make reasonable assumptions.
A detailed discussion of this fascinating and highly relevant topic goes beyond the scope of this course. Here, we focus on some technical aspects of forecasting financial statements. The course "Financial Analysis" provides some helpful information about how to read financial statements and extract information about the financial health of the company and its major trends.