Financial Modeling and Forecasting Financial
StatementsFinancial Statements
INTRODUCTION
Projecting the financial future
In this course we provide an introduction to and practice with financial modelling and financial
statement forecasting.
Many people mistakenly believe that financial accounting reports are simply dry, historical
summaries of the past.
Now there's nothing wrong with history. A historical summary of a company's past
performance allows you to evaluate management performance, especially if you compare that past
performance to what was planned.
However, most financial statement users are not as interested in the past as they are in the future.
For example, when deciding whether to loan money to a company, a banker wants to know what the
company's cash flows will be in the future. After all, it's out of future cash flows generated by the
company that the loan will be repaid.
In a similar fashion, potential investors are interested in future profits, and future cash flows. When
you buy a company, you're buying its future, not its past.
Now, in this course, we will show you how to use the historical financial statements as a platform for
forecasting a company's future.
We will consider each of the important financial statement numbers, such as cost of goods sold,
depreciation expense, and the levels of inventory and fixed assets. And we'll ask the question what
will cause this number to change in the future.
We will see the forecasting power of the simple account equation assets equal liabilities plus equity.
We will work through some practice exercises in constructing forecasted financial statements. These
are also called pro forma financial statements.
And we will illustrate the insights that financial statement forecasting provides by using our favorite
teaching case, the near-death experience of Home Depot back in 1985.
What you should know
Before taking this Financial Modeling and Forecasting Financial Statements course, you should
consider taking our other courses, Accounting Foundations, and Running a Profitable
Business: Understanding Financial Ratios. Among other things, those courses introduce you to the
basics of the financial statements and the importance of the numerical relations among the different
items in the financial statements.
In other words, you really should have a working knowledge of the basics of the financial
statements before you launch into this course on financial modeling. The advice provided in this
course is general advice only. It has been prepared without taking into account your objectives, your
financial situation, and your risk tolerance. The course is not intended to give investment advice, but
instead to communicate basic information to help viewers understand the basics of the topic
presented. For investment advice, you should seek advice from your own trusted, independent
financial advisor.
1
,1 - WHO USES FORECASTED FINANCIAL STATEMENTS?
Use the past to understand the future
Now a common criticism I hear about accounting is that it's too focused on the past.
Managers, bankers, and investors don't want to know about the past. They want to know about the
future.
People say that looking at financial statements is like tryin' to drive your car by looking in the rear-
view mirror to see where you have been.
Well, I'm going to go with Winston Churchill on this topic. He said, "The further 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 the uncertain future.
Studying and analyzing the historical performance of a company allows financial statement users to
project the future performance of a company.
We can make some reasonable assumptions about a company's future performance, and it is then
fairly straight-forward 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 a balance sheet. So, to begin, we
recognize that the amounts of some expenses are tied directly 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-to-
sales will increase at the same rate as sales increases.
For example, year after year, Walmart's cost-of-sales is approximately 75% of Walmart's sales
amount. In other words, if Walmart sells you something for $100, that thing costs Walmart about $75
to purchase from its suppliers.
So, if Walmart sales are forecasted to increase next year to $1 trillion, then cost-to-sales would
probably be about $750 billion.
By the way, Walmart's actually sales are about half that level, 'about $500 billion, but hey, we're
doin' a 'what-if' calculation. Why not try out an optimistic scenario?
Exactly, similarly, other operating expense, 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
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 is reasonable to forecast that interest expense will go up as well.
Now, 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.
Now, by the way, self-employed individuals in the United States do this simple forecast all the
time as they send 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.
Using historical information and making some reasonable assumptions, we can get a look at what
the future might look like.
1
, 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.
It's not hard, and it's kind of fund, and the nice thing about getting a glimpse of what the future looks
like, is that if you don't like it, you can change the assumptions associated with your forecast.
Yeah, you can change the assumptions to get a different forecast.
You just 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.
Keys to running a business
Running an organization without the benefit of any financial forecasts is a very exciting
exercise. From one day to the next, you have no idea what's coming.
Every morning, you wake up to a whole new collection of surprises. Now, that's one way to run an
organization. A different way is to spend some time carefully constructing a numerical plan, a
financial model, a forecast. Yes, there'll still be surprises, but you'll have the model, the plan, the
forecast within which to adapt to those surprises.
A careful financial model is simply a numerical plan of a business's activities made in advance that
helps a business identify and solve problems before those problems ever actually arise in the real
world.
Now, think about a company that's been around for a long time. Let's use General Electric as an
example. They've been around since 1878, when Thomas Edison started the Edison Electric Light
Company.
Now let's compare this old company, General Electric, to a brand-new company, a startup
company, a company that involves just two partners, 10 employees, and lots of exciting
ideas. Which one of these two companies, the old one or the new one, is likely to have a more
comprehensive, sophisticated internal financial modeling and forecasting process to aid in both
short-term and long-term planning? Well, the old company, of course.
General Electric, for example, has a very elaborate internal financial modeling and forecasting
process. In contrast, a startup company, they probably haven't taken the time to make any kind of
financial plan at all.
Now think about which of these two companies really needs a financial plan, the old company,
General Electric, or the new startup company.
Of course they both can benefit from financial planning and forecasting, but which one can benefit
more? Let me put it this way.
If General Electric decided not to do any detailed financial forecasting this year, would the General
Electric employees still know what to do? Well, sure. The company's been around for so long that
everyone knows what to do. You pretty much do what you did last year, plus a little more. At least
for a year or two, General Electric could probably continue forward in good shape without a financial
plan just by operating on organizational inertia.
Now, how about that startup company? In a startup company, no one knows what they're
doing because it's never happened before. It's their first year. They're creating the business as they
go, so it would be extremely useful for the partners in this startup company to spend a little time
planning out on paper how things are going to go before launching into the unknown.
For example, our startup company has 10 employees now, but is that enough to handle the
necessary workload next month, or is it too many?
Well, if you haven't even tried to forecast your level of activity next month, along with the output
capacity of your employees, then you have no idea whether 10 employees is too many, too few, or
just right.
Consider another example. Let's say that your startup company is developing green technology and
needs the rare earth element terbium in its production process.
2
StatementsFinancial Statements
INTRODUCTION
Projecting the financial future
In this course we provide an introduction to and practice with financial modelling and financial
statement forecasting.
Many people mistakenly believe that financial accounting reports are simply dry, historical
summaries of the past.
Now there's nothing wrong with history. A historical summary of a company's past
performance allows you to evaluate management performance, especially if you compare that past
performance to what was planned.
However, most financial statement users are not as interested in the past as they are in the future.
For example, when deciding whether to loan money to a company, a banker wants to know what the
company's cash flows will be in the future. After all, it's out of future cash flows generated by the
company that the loan will be repaid.
In a similar fashion, potential investors are interested in future profits, and future cash flows. When
you buy a company, you're buying its future, not its past.
Now, in this course, we will show you how to use the historical financial statements as a platform for
forecasting a company's future.
We will consider each of the important financial statement numbers, such as cost of goods sold,
depreciation expense, and the levels of inventory and fixed assets. And we'll ask the question what
will cause this number to change in the future.
We will see the forecasting power of the simple account equation assets equal liabilities plus equity.
We will work through some practice exercises in constructing forecasted financial statements. These
are also called pro forma financial statements.
And we will illustrate the insights that financial statement forecasting provides by using our favorite
teaching case, the near-death experience of Home Depot back in 1985.
What you should know
Before taking this Financial Modeling and Forecasting Financial Statements course, you should
consider taking our other courses, Accounting Foundations, and Running a Profitable
Business: Understanding Financial Ratios. Among other things, those courses introduce you to the
basics of the financial statements and the importance of the numerical relations among the different
items in the financial statements.
In other words, you really should have a working knowledge of the basics of the financial
statements before you launch into this course on financial modeling. The advice provided in this
course is general advice only. It has been prepared without taking into account your objectives, your
financial situation, and your risk tolerance. The course is not intended to give investment advice, but
instead to communicate basic information to help viewers understand the basics of the topic
presented. For investment advice, you should seek advice from your own trusted, independent
financial advisor.
1
,1 - WHO USES FORECASTED FINANCIAL STATEMENTS?
Use the past to understand the future
Now a common criticism I hear about accounting is that it's too focused on the past.
Managers, bankers, and investors don't want to know about the past. They want to know about the
future.
People say that looking at financial statements is like tryin' to drive your car by looking in the rear-
view mirror to see where you have been.
Well, I'm going to go with Winston Churchill on this topic. He said, "The further 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 the uncertain future.
Studying and analyzing the historical performance of a company allows financial statement users to
project the future performance of a company.
We can make some reasonable assumptions about a company's future performance, and it is then
fairly straight-forward 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 a balance sheet. So, to begin, we
recognize that the amounts of some expenses are tied directly 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-to-
sales will increase at the same rate as sales increases.
For example, year after year, Walmart's cost-of-sales is approximately 75% of Walmart's sales
amount. In other words, if Walmart sells you something for $100, that thing costs Walmart about $75
to purchase from its suppliers.
So, if Walmart sales are forecasted to increase next year to $1 trillion, then cost-to-sales would
probably be about $750 billion.
By the way, Walmart's actually sales are about half that level, 'about $500 billion, but hey, we're
doin' a 'what-if' calculation. Why not try out an optimistic scenario?
Exactly, similarly, other operating expense, 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
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 is reasonable to forecast that interest expense will go up as well.
Now, 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.
Now, by the way, self-employed individuals in the United States do this simple forecast all the
time as they send 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.
Using historical information and making some reasonable assumptions, we can get a look at what
the future might look like.
1
, 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.
It's not hard, and it's kind of fund, and the nice thing about getting a glimpse of what the future looks
like, is that if you don't like it, you can change the assumptions associated with your forecast.
Yeah, you can change the assumptions to get a different forecast.
You just 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.
Keys to running a business
Running an organization without the benefit of any financial forecasts is a very exciting
exercise. From one day to the next, you have no idea what's coming.
Every morning, you wake up to a whole new collection of surprises. Now, that's one way to run an
organization. A different way is to spend some time carefully constructing a numerical plan, a
financial model, a forecast. Yes, there'll still be surprises, but you'll have the model, the plan, the
forecast within which to adapt to those surprises.
A careful financial model is simply a numerical plan of a business's activities made in advance that
helps a business identify and solve problems before those problems ever actually arise in the real
world.
Now, think about a company that's been around for a long time. Let's use General Electric as an
example. They've been around since 1878, when Thomas Edison started the Edison Electric Light
Company.
Now let's compare this old company, General Electric, to a brand-new company, a startup
company, a company that involves just two partners, 10 employees, and lots of exciting
ideas. Which one of these two companies, the old one or the new one, is likely to have a more
comprehensive, sophisticated internal financial modeling and forecasting process to aid in both
short-term and long-term planning? Well, the old company, of course.
General Electric, for example, has a very elaborate internal financial modeling and forecasting
process. In contrast, a startup company, they probably haven't taken the time to make any kind of
financial plan at all.
Now think about which of these two companies really needs a financial plan, the old company,
General Electric, or the new startup company.
Of course they both can benefit from financial planning and forecasting, but which one can benefit
more? Let me put it this way.
If General Electric decided not to do any detailed financial forecasting this year, would the General
Electric employees still know what to do? Well, sure. The company's been around for so long that
everyone knows what to do. You pretty much do what you did last year, plus a little more. At least
for a year or two, General Electric could probably continue forward in good shape without a financial
plan just by operating on organizational inertia.
Now, how about that startup company? In a startup company, no one knows what they're
doing because it's never happened before. It's their first year. They're creating the business as they
go, so it would be extremely useful for the partners in this startup company to spend a little time
planning out on paper how things are going to go before launching into the unknown.
For example, our startup company has 10 employees now, but is that enough to handle the
necessary workload next month, or is it too many?
Well, if you haven't even tried to forecast your level of activity next month, along with the output
capacity of your employees, then you have no idea whether 10 employees is too many, too few, or
just right.
Consider another example. Let's say that your startup company is developing green technology and
needs the rare earth element terbium in its production process.
2
