Financial Analytics Toolkit: Financial Statement Forecasting

Managers need to be comfortable with financial statement forecasting. Forecasts allow managers to plan properly by weighing consequences and preparing for outcomes. A less$-$recognized but equally important benefit is that the act of forecasting forces managers to make explicit the many links that exist between decisions, possibly drawing attention to constraints that otherwise might have been overlooked. This is particularly important since financial statements integrate the financial and operating decisions of a firm.

While this note focuses on financial statements, the forecasting techniques described herein are readily transferred to related contexts, such as building cash$-$flow forecasts and using ratios to evaluate financial performance. Furthermore, while forecasts can be generated for many reasons, this note will focus on the use of forecasting in the context of decision$-$making. Thus the two most important criteria for forecasts are that they be unbiased $($neither optimistic nor pessimistic$)$ and consistent $($rationally constructed from all the available information$).$ The need to be unbiased follows directly from the role of financial statements in decision$-$making: biased forecasts lead to biased decisions. Consistency is the ultimate measure of forecast quality.

Growth Estimates and Consistency

Virtually all financial statement forecasts begin with a forecast of revenues or an estimate of revenue growth. In some contexts, revenue is broken down into unit sales and selling prices. The revenue forecast establishes the scale of operations, and most decisions follow from this starting point. This note will not explore the difficulties in generating growth estimates, but will focus on constructing financial statements built from those estimates.

Consistency can be expected along many dimensions and constitutes the ways in which a forecast is evaluated. In general, a forecast should:

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Reflect current macroeconomic conditions

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Reflect the current level of competition and evolving conditions in the industry

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Acknowledge the actual capabilities of the firm

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Assume asset investments that can support operating forecasts

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Reflect the firm$$s stated policies and goals

Perhaps most important of all, the forecast must be internally consistent with respect to the rules of double$-$entry accounting: first, assets must equal the sum of liabilities and owner$$s equity; and second, the balance in any account must be equal to its starting balance, plus additions, and less reductions. For example, the assumed

This technical note was prepared by Marc L$.$ Lipson, Robert F$.$ Vandell Professor of Business Administration. Copyright $2019$ by the University of Virginia Darden School Foundation, Charlottesville, VA$.$ All rights reserved. To order copies, send an email to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means$$electronic$,$ mechanical, photocopying, recording, or otherwise$$without the permission of the Darden School Foundation. Our goal is to publish materials of the highest quality, so please submit any errata to

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ending balance in owner$$s equity should equal the starting balance, plus net income, less any dividend, adjusted for any equity transactions.

Forecasts are built from the assumed scale of future operations, but they also require many assumptions regarding the future relations among decision variables. These relations reflect, in essence, the way a business operates$$they are assumptions about behaviors and policies. When a relation changes, this implies a change in those behaviors and policies. Consistency ensures that the assumed changes are rational, feasible, and optimal.

A great source of information upon which to base assumptions for the future is what has been observed in the past. Absent any other information that would indicate a stated target, one of the key judgments in forecasting is how to build future expectations from past data. The easiest$$and often most defensible$$ assumption is that the future will look like the immediate past. That said, one should keep in mind the following:

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The immediate past will likely reflect prevailing conditions, but it is only a single point estimate.

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If all past data are useful, then averaging those data provides a statistically better estimate.

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One should always watch for outliers.

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One should identify any trends and be clear as to whether they are likely to continue.

The assumptions that build a forecast are rarely assumptions about individual line items in a financial statement. Most often they are about the relation between a line item and the ultimate driver of that line item: in most cases