Academic journal article Business Education & Accreditation

Forecasting Financial Statements Using Risk Management Associates Industry Data

Academic journal article Business Education & Accreditation

Forecasting Financial Statements Using Risk Management Associates Industry Data

Article excerpt

ABSTRACT

Finance professionals must frequently forecast financial statements. The common practice for forecasting financial statements is to apply the percentage of sales method. In this paper, we develop a new method for forecasting financial statements based data available from The Risk Management Association. This method offers three advantages over the percentage of sales method. First, it specifies the appropriate percentages for each account using industry average data. Second, it allows the developer to use any figure in the income statement or balance sheet as a starting point. For example, an investor who knows only that they have $100,000 available to start a company can forecast a balance sheet and income statement. Third, the percentage of sales method applies only to the income statement, while the method developed here allows estimation of both the income statement and balance sheet. Statements produced using the technique presented here are easily defendable to skeptical bankers.

JEL: A22, A23, C52, C53, C58

KEYWORDS: Forecasting, Banking, Entrepreneurship

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

This paper presents a new method to forecast financial statements. The approach relies on industry financial data available from Risk Management Associates (RMA), Annual Statement Studies. RMA Annual Statement Studies provide historical financial statements for some 760 industries based on the statements of firms that operate within each industry. The approach requires the user to provide a single estimate of sales or owner's equity contribution. From this estimate, a full balance sheet and income statement are prepared. This methodology is founded in scientific principles and derived from industry average data. As such, the resulting statements are more credible than percentage of sales or ad-hoc estimates. This added credibility should lead to better funding opportunities and lower capital costs. The method also allows financial analysts to make better recommendations and entrepreneurs to make better project selection decisions.

The remainder of the paper is organized as follows: In the next section, we discuss the related literature. The following section discussed the RMA data. Next, financial statement forecasts based on an estimate of firm sales and an estimate of owner's equity contribution combined with RMA data are provided. The paper closes with some concluding comments and precautionary notes.

LITERATURE REVIEW

Many sources provide guidance for forecasting financiáis and preparing pro forma statements. The guidance suggests two basic approaches: percent of sales and comparable methods. The percent of sales approach uses history to forecast income statement and balance sheet accounts as a percent of projected sales. The judgmental approach improves on the strict percent of sales method by allowing for incorporation of additional information such as financial ratios to determine forecast levels of certain accounts that do not vary directly with sales volume. These accounts include capital expenditures and debt levels. Both methods require a sales forecast as a starting point.

Corporate Finance texts concentrate on forecasting required new funds or external sources of financing for large established firms with a history of operating results (Block, Hirt and Danielson, 2009)? (Gitman, 2009), (Brealey, Myers and Marcus, 2009) and (Ross, Westerfield and Jordan, 2010). Both approaches are well-suited for the analysis of long-term capital requirements of established firms. Financial Statement Analysis texts suggest preparing pro forma financial statements for prospective and credit analysis of established firms using a judgmental approach (Penman, 2010), (Subramayam and Wild, 2009), and (Revsine, Collins, Johnson and Mittelstaedt, 2009). The percent of sales and judgmental methods work well for companies that have past data to draw on but are not useful for a proposed or startup company that needs to present a viable business plan to a lending institution. …

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