$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-1 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Chapter 6 Forecasting and Pro Forma Financial Statements

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-2 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Learning Objectives  Understand the basic steps used in selecting a forecasting model.  Know how to evaluate a forecasting model.  Given a business situation, choose the proper forecasting model.  Calculate a forecast using time series data.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-3 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Learning Objectives (continued)  Explain the role that the Mean Absolute Deviation (MAD) plays in selecting a forecasting model.  Understand the relationship among a business’s revenue base, sales forecast, assets, and need for financing.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-4 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Learning Objectives (continued)  Construct pro forma financial statements from available data on a proposed or existing business.  Apply the percentage of sales method in determining any required new financing needed for a business.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-5 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Forecasting  A forecast is a quantifiable estimate of future demand.  Forecasting in business is the process of estimating the future demand for our products and services.  Forecasting for the financial manager also requires estimates of future interest rates.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-6 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Forecasting Process  Determine the type of model to be used.  Determine the forecast horizon.  Select one or more forecasting models.  Evaluate the models.  Apply the chosen model.  Monitor and control the model.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-7 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Determine the Type of Model to be Used 1)Who will be using the forecast and what information do they require? 2)How relevant is historical data, and what is its availability? 3)How accurate does the forecast have to be? 4)What is the time period of the forecast? 5)How much time do we have to develop the forecast? 6)What is the cost or benefit (value) of this forecast to our company?

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-8 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Determine the Forecast Horizon  Inverse relationship between forecast accuracy and time horizon. › The longer the time horizon the more inaccurate the forecast will be.  Time horizon should be at least as long as time period of strategic plan.  Product life cycles influence length of forecasts. › Technological product sales would have a short forecast. › Milk sales would have a long forecast.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-9 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Select One or More Forecasting Models  Must consider the basic six questions. 1) Who will be using the forecast and what information do they require? 2) How relevant is historical data, and what is its availability? 3) How accurate does the forecast have to be? 4) What is the time period of the forecast? 5) How much time do we have to develop the forecast? 6) What is the cost or benefit (value) of this forecast to our company?  Some instances will require a combination of forecasting models.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-10 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Evaluate the Models  Compare the accuracy of forecasting models by use of Mean Absolute Deviation (MAD)  Remember the model assists the forecaster, it does not make the decision.  Changing market and economic conditions require us to constantly evaluate our forecasting models.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-11 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Apply the Chosen Model  Application in business is used to determine future requirement.  Application of the model and specific units of measurement used depends on the area of the business that uses the model: › Marketing wants demand of product. › Production requires units. › Finance requires dollars. › Personnel requires human resources.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-12 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Monitor and Control the Model  Model should allow us to develop controls in a three-step process: › Determine standard for measuring progress toward forecast. › Measure actual performance against this standard. › Take corrective action.  When the forecasting model no longer allows the manager to do this, then a new forecasting model must be developed.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-13 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Types of Forecasting Models  Judgmental models, which use qualitative methods  Time series models, which use quantitative methods  Causal models, which use cause-and-effect methods

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-14 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Judgmental Models  Judgmental models are qualitative and essentially use estimates based on expert opinion. › Survey of Sales Forces: most appropriate for manufacturing and wholesale firms. › Surveys of Customers: applicable to all firms. Customers express preference for new or modified products.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-15 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Judgmental Models (continued) › Historical Analogy most appropriate for firms that have several outlets. Introduction of new product which has characteristics similar to previous products. › Market Research can include surveys, tests, and observations. Results are statistically extrapolated to develop forecasts of demand for products.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-16 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Judgmental Models (continued)  Delphi Method uses a panel of experts to obtain a consensus of opinion. Used primarily for unique new products or processes for which no previous data exist.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-17 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Time Series Models  Time series forecasting models normally use historical records that are readily available within the firm or industry to predict future sales. › For this reason they are often referred to as internal or intrinsic models. › Assumption in time series forecasting is that past sales are a fairly accurate predictor of future sales.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-18 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Time Series Models (continued)  Moving average model  Weighted moving average model  Exponential smoothing model  Linear regression model

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-19 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Time Series Models (continued)  References for mathematics in forecasting: › A = Actual observation of the variable to be forecast. › F = Forecast of the variable.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-20 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Time Series Models (continued)  References for mathematics in forecasting (continued): › t = current time period. Time periods can be a measure of any time period (e.g., hour, day, month, year, decade, etc.). If time periods are measured in months and the current month is April, then t = April. › t-1 = one time period in the past. If time is being measured in months and t is April then one time period in the past is March. › t-2 = two time periods in the past, etc. If time is being measured in months and t is April then two time periods in the past is February. › t+1 = one time period in the future. If time is being measured in months and t is April then one time period in the future is May. › t+2 = two time periods in the future. If time is being measured in months and t is April then two time periods in the future is June.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-21 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Time Series Models (continued)  References for mathematics in forecasting (continued): ›  = the difference between two numbers. For example  AF would be actual observation of variable minus forecast. ›  = Sum of several numbers, normally in a column. › n = the number of observations used in a calculation. The n for months in a year equal 12 and n for years in a decade is 10.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-22 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Moving Average Model  Moving average model assumes that actual sales for some recent previous time periods are the best predictor of future sales.  It assumes that each time period taken in succession has an equal influence on the prediction of future sales.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-23 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Moving Average Model  The procedure is to obtain the arithmetic average of actual sales for several past time periods.  For a three-month forecast of year 1 data:

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-24 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-25 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Mean Absolute Deviation  Mean absolute deviation (MAD) is a tool used to measure the forecasting error of a model. › MAD is simple to calculate and provides us with a method of determining which weights, or alpha, to choose for our model and which model is most appropriate for predicting sales.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-26 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Mean Absolute Deviation (continued) › Absolute deviation is the absolute difference between forecasted sales and actual sales. › The absolute value of any number is positive and is represented mathematically by vertical lines drawn on either side of the number or formula.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-27 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Average Arithmetic Deviation vs. Average Absolute Deviation  The average arithmetic deviation is the actual difference between two numbers:  The average absolute deviation using the same numbers:

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-28 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Mean Absolute Deviation (continued)  Mean absolute deviation (MAD) is the measure of the overall forecast error. › MAD represents the average difference between our forecast and actual sales data.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-29 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-30 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Weighted Moving Average Model  Weighted moving average model assumes that the closest time period is a more accurate predictor of future sales than previous time periods. › Previous time periods do have some influence on future sales. › Forecaster will assign weights to the time periods based on his or her judgment.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-31 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Weighted Moving Average Model (continued)  The sum of the weights normally equal one. › If the forecaster does not want to use a sum of one, then we sum the weights and use this sum as the denominator in our equation. › The value of each weight is based on how much of an influence the forecaster believes the corresponding time period has on overall sales.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-32 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Weighted Moving Average Model (continued)  The formula for this method, using three months, is as follows: Using weights of 0.1, 0.3 & 0.6 with actual sales of 245,244, & 250 we solve as follows: Year 1 F t+1 = (W 1 )(A t22 ) + (W 2 )(A t21 ) + (W 3 )(A t ) F Apr = (0.1)(245) + (0.3)(244) + (0.6)(250) F Apr =

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-33 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-34 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Exponential Smoothing Model  Exponential smoothing model uses a smoothing constant, alpha (  ), as an adjustment in determining the forecast. › A smoothing constant is a value assigned by the forecaster to adjust the forecast based on the forecaster’s assumption of the relationship between sales in one time period and sales in the next time period. › Alpha can have any value between 0 and 1; however, alpha is normally 0.1, 0.2, or 0.3. › The higher the value of alpha, the greater the emphasis given to sales for the current time period.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-35 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Exponential Smoothing Model (continued)  With exponential smoothing we must begin with an assumed rather than an actual forecast.  The formula is or

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-36 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-37 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Linear Regression Model  Linear regression uses a statistical method known as least squared regression. › Four areas of variation: –Seasonal variation is caused by the predictable shopping habits of our customers. –Trend variation is variation caused by growth or decline in demand for our product or service over time. –Cyclical variation is caused by general economic factors that affect our industry. –Noise is random variation in our data that is not explained by the preceding factors.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-38 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Linear Regression Model (continued)  Linear regression is used to determine two factors: › The slope of the regression line › The intercept of the regression line  Basic formula for the regression line is:

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-39 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Regression line defined Where: y is the dependent variable. A dependent variable is one that relies on other variables for its value. x is the independent variable. An independent variable is one that does not depend on other variables for its value. In forecasting models, x is often a time period. a is the y intercept. The y intercept is the value of y when x equals 0. b is the slope of the regression line.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-40 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-41 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-42 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-43 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-44 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-45 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Causal Models  Causal models are also known as external or exogenous models. › Causal models take into account variables in the general economy that affect the revenue obtained by a company. › Causal models can be simple or very complex. › Most of them require multiple regression analysis, which is normally beyond the scope of a small business manager.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-46 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Practical Sales Forecasting for Startup Businesses  Steps to take for a sales forecast: › Listing what you know: –Expertise, experience, knowledge of charges and fees. –Previous revenue and cost information based on experience. › Research similar companies via EDGAR competing company annual reports, or industry-specific publications. › List three types of expenses: –Startup –Fixed –Variable › Develop a revenue forecast

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-47 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Forecast of Revenue for a Startup

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-48 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Pro Forma Financial Statements  A pro forma financial statement is a projected statement based on the forecast.  The three basic pro forma statements are: › Pro forma income statement › Pro forma cash budget › Pro forma balance sheet

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-49 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-50 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-51 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-52 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Pro Forma Balance Sheet Using Percentage of Sales  Percentage of sales method is based on the fact that assets and liabilities historically vary with sales. › Thus any increase in sales will cause a subsequent buildup in both assets and liabilities. › Both profit margins and dividend (owner) payout ratios determine the amount of internal financing that can be applied to support increased asset buildup.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-53 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Pro Forma Balance Sheet Using Percentage of Sales (continued) The basic formula for percentage of sales is:

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-54 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-55 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Using Percentage of Sales to Determine New Financing  The following is used based on pro forma balance sheet (Table 6-9):

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-56 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Monitoring and Controlling the Business  Monitoring in finance is normally accomplished by use of budgets and pro forma financial financial statements. › Most small businesses require only two budgets for monitoring and controlling purposes, the capital budget and the cash budget.  Controlling process requires three steps: › Establishing a standard › Comparing actual performance to the standard › Taking corrective action if necessary

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-57 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Startup Business Costs  Startup costs are those associated with getting the enterprise up and running prior to generating any sales.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-58 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ Gantt Chart  A Gantt chart, Figure 6-5, shows all tasks that have to be performed and the time that it takes to accomplish these tasks.

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks 6-59 Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458