chapter 5

• Financial forecasting


  A disciplined means of evaluating the cash need of a venture
• Financial forecasting


  • Aids in determining whether a proposed venture deserves the entrepreneur's investment of capital and effort
  • Allows comparison of strategic alternatives
  • Helps the entrepreneur and investors understand the strengths and weaknesses of the venture
  • Represents a benchmark for assessing project development
• Components of financial modeling

  • Revenue forecast
  • Income statement forecast
  • Balance sheet forecast
  • Integration and cash flow forecast
• Approaches to revenue forecasting

  • Naïve
  • Yardsticks
  • Fundamental
• Information sources for revenue forecasting

  • Forecasting uncertainty
  • Scenarios
  • Sensitivity
  • Simulation
• Principles of financial forecasting

  • Build and support a schedule of assumptions
  • Begin with a forecast of revenue
  • Decide whether to forecast in real or nominal terms
  • Choose an appropriate time span and forecasting interval
  • Integrate the financial statements
  • Assess the reasonableness of the model
• Forecasting revenue of an established business

  1. Extrapolate the nominal historical average

  2. Extrapolate the real historical average

  3. Weight more recent periods more heavily

  4. Exponential smoothing

  5. Tie to related variables that are forecasted
• Naïve forecasting methods


  • Extrapolate the nominal historical average
  • Extrapolate the real historical average
  • Weight more recent periods more heavily
  • Exponential smoothing
  • Tie to related variables that are forecasted

  
• Large variance in the historical annual growth rates
• May be more accurate if product prices follow inflation
• Less than the simple average due to the small weight on Year -5
• Implicitly reflects data from before Year T
• Expected real GDP growth Year 0 = 1.5%
• Forecasted real growth rate Year 0 = 1.5% x 5.0 = 7.5%
• Yardsticks


  Established firms comparable to the new venture on some dimensions important to forecasting revenue
• Yardsticks


  • Product/customer attributes
  • Distribution channels
  • Adoption rates
  • Technology
• IPO prospectuses contain data on recently-private/newly-public ventures
• Fundamental analysis


  • Market size and market share
  • Engineering cost estimates
  • Demand-side approach
  • Supply-side approach
  • Credibility and support for assumptions
  • Mixed approach
• Yardsticks for a new coffee shop venture

  • Other coffee shop locations
  • Direct observation
  • Communication with other coffee shop owners, real estate professionals, trade associations
• Yardsticks for a new general aviation navigation system

  • Navteq Corporation
  • Garmin Ltd.
  • GPS Industries, Inc.
• Selling price of $2,500
• Demand-side considerations


  • Geographic market
  • Number of potential customers
  • Market growth rate
  • Typical customer purchase amount
  • Expected average price
  • Product quality compared to competitors
  • Promotional effectiveness compared to competitors
  • Competitor reactions
  • Potential new market entrants
  • Expected market share
• Supply-side considerations

  • Existing production, marketing, and distribution capacity
  • Ability to add and integrate resources for expansion
• Estimating uncertainty


  • Assessing risk using historical data
  • Sensitivity analysis
  • Developing alternative scenarios
  • Incorporating uncertainty with simulation
• Forecast error = 9.71%
• Forecast for Year 0: μ = 8.06%, σ = 9.71%
• Sensitivity analysis

  • Vary model assumptions and see the impact on the forecast
  • Shortcomings: developing estimates for uncertainty of assumptions, ignoring interdependencies among variables
• Scenario analysis


  • Allows several assumptions to vary at the same time and can incorporate correlations
  • Data required are available for many ventures
  • For some ventures, only a small number of realistic scenarios are possible
• Simulation


  • Assign probability distributions to key variables
  • Estimate correlations among variables
  • Based on historical data, yardsticks, or fundamental analysis
• Development will require 18 months, during which period no sales will be made
• Initial monthly sales of 100 units at a price of $200 beginning in Month 19
• Unit sales will grow 8 percent per month for three years and then remain constant
• The sales price will increase each month at the inflation rate
• Inflation at 6 percent per year (modeled as 0.5 percent per month)
• me time


  and can incorporate correlations
• data required to develop scenarios are available for many ventures
• for some ventures, only a small number of realistic scenarios are possible
• Estimating Uncertainty


  Incorporating uncertainty with simulation
• Incorporating uncertainty with simulation

  1. Assign probability distributions to key variables

  2. Estimate correlations among variables

  3. Based on historical data, yardsticks, or fundamental analysis
• NewCompany


  A medical device start-up