Forecasting in financial statements
Once we've gone through and built out our financial assumptions based on the historical figures, it's time to move on to the forward-looking portion of those assumptions. I'm in the 02_06_Begin excel file. Now, we've gone through and computed various historical metrics for the firm, revenue growth, cogs as a percentage of revenue, SG&A as a percentage of revenue, etc. The point of doing that on a historical basis was not because it was fun, maybe it is, maybe it's not right, but instead, because it sets the ground rules for what we think will happen going forward. Now there's a few different ways that we could estimate what might happen in the future to this firm. Let's just look at revenue growth for example. The approach we've taken as a starting point is just to say, let's use the average revenue growth over the last four years. In that case, it's 6.3%. An alternative approach would be to say, alright, well let's see what we think will happen to say, we're rolling out and what we think will happen to the market as a whole, and then we could try to tie our revenue growth to the sum of these two values, and that's okay in practice, but the problem becomes that there's a lot of error that's going to go on in measuring or estimating what our share growth will be and what the overall market growth will be. Similarly if we were to simply use the average of the growth over the last four years, we're still going to get a relatively inaccurate picture of what this year's growth is going to be. Finally we can just pull a number out of thin air, we could say well based on the data from our salespeople and how we're feeling about things, maybe we think we're going to get an 8% growth rate.
The point is there's a variety of different ways we can get this projection, we're going to have to pick one. Now in our particular case the easiest thing to do is going to be to use average figures over time. This has the virtue of being clearly defendable if we should be asked about it by other people and we can do this across most of our different metrics, SG&A, cogs, interest, etc. Now certainly, some of these figures will be more forecast-able than others. We think about what our interest expense is going to look like. This will probably be tied directly to the Fed funds rate and the level of depth that we have maturing. So we might very well be able to accurately plug in some sort of an estimate there, where it might be much harder to estimate our depreciation or our cogs cost. When we get done, whatever method we choose, we're going to need to extend this across the entire time period and all of our forward-looking projections. The reason for this, is that these assumptions that we're setting now are going to be the basis for our income statement, our balance sheet, and our cash flow statement on a forward-looking basis. Given that, it's impossible to be too careful when it comes to establishing the assumptions on a forward-looking basis. Keep this in mind as you're building up your financial models. If you're interested in learning more about basic financial forecasting and some of the more advanced methodologies, I recommend you check out my financial forecasting with excel course.