Magazine article Journal of Commercial Lending

The Art of Making Financial Statement Projections: A Six-Step Visual Model

Magazine article Journal of Commercial Lending

The Art of Making Financial Statement Projections: A Six-Step Visual Model

Article excerpt

Financial statement projections are perhaps the most important, but least understood, element of commercial lending. For the banker, it is not the business' track record and historical cash flow that determine loan repayment but future events and future cash flow. For the borrower, a well-designed financial forecast is critical to maximizing returns. Despite these Compatible goals, many bankers and borrowers do not make full and frequent use of financial forecasting. Because of the complexity and the potential to become lost in the scientific allure of computerized projections, many bankers and borrowers have lost touch with how simple the projection process can be.

One common argument against financial forecasting is that volatile markets and rapid changes in the economy make forecasts imprecise and inaccurate. Another problem is that computer models make it possible to explore unlimited deviations in countless variables. In addition, what-if scenarios can result in tedious and complex output that becomes a time-consuming mathematical exercise instead of a practical planning tool. In other words, science (or at least technology) has overcome the art of making forecasts.

The inherent margin of possible error in financial projections is not a reason to avoid them. Nor should the many variables and possible outcomes be intimidating. In fact, the greater the chance for error, the more important it is to investigate, at least at an elementary level, the future financial position of the borrower.

The Six-Step Visual Model

This article describes a simple model using visual representation of financial statements as a basis for making projections. Visual representation is the key element of the model, and it focuses attention on important relationships and the interactive nature of financial statements.

The model is constructed with a minimal number of inputs and can be sketched on a single piece of paper. The result is a picture of the financial statements that both the banker and the borrower can use to visualize the effect of key operating strategies and financing structures. The model can also target areas for further investigation by more sophisticated methods. Computer-based analysis can then be used as an enhancement, justified on a cost basis or the size of a proposed lending transaction or relationship.

The six-step process involves information that in most cases, should be provided by the borrower, but the model can also be built using loan officer assumptions. A worksheet for assembling the needed data is shown in Figure 1.

Step No. 1 - Sales Forecast

The first step of the model is to estimate sales for the first period being projected, usually the coming fiscal year. Tempered by historical sales patterns, the sales forecast can involve such factors as the influence of price levels, quantities sold, demand from customers, competitors' actions, technology, seasonality, and the economic cycle. Projected sales is an important element of the forecast because most other pieces of the projected financial statements will be derived from it.

Step No. 2 - Sales into Costs, Expenses, and Profit

The second step is to break down total sales into the major components of the income statement: cost of goods sold, operating expenses, interest, taxes, and net income. Other elements also should be considered if they are material to the borrower's business.

In the model, the income statement is shown as a stacked bar and the individual elements are shown in blocks proportional in size to their percentage value. For instance, most firms have at least 65-75% of sales absorbed by the cost of goods sold, so this is usually the largest section of the stacked bar.

A stacked bar is used, rather than a pie chart, because the bar replicates the vertical format and sequence of the income statement. Although proportions do not need to be exact, they do need to highlight key relationships and management strategies. …

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