Evaluating how a business will perform in the future is crucial to many managers and external stakeholders. This differs from financial statements, which report historical financial performance. When evaluating strategic decisions, forward-looking estimates are critical. These decisions can be anything from debt and equity financing, capital improvement projects, shareholder buyouts, mergers, and reorganization plans. External accountants can prepare prospective financial reports grounded in realistic market-based assumptions. Because company insiders often see their business through rose-colored glasses, having a non-biased, realistic opinion when it comes to financial projections is important for accuracy and success.
Three Reporting Options
There are three types of reports to choose from when predicting future performance:
- Forecasts. These prospective statements present an entity’s expected financial position, results of operations, and cash flows. They’re based on assumptions about expected conditions and courses of action.
- Projections. These statements are based on assumptions about conditions expected to exist and the course of action expected to be taken, given one or more hypothetical assumptions. Financial projections may test investment proposals or demonstrate a best-case scenario.
- Budgets. Operating budgets are prepared in-house for internal purposes. They allocate money — usually revenue and expenses — for particular purposes over specified periods.
Although the terms “forecast” and “projection” are sometimes used interchangeably, there are important distinctions under the attestation standards set forth by the American Institute of CPAs (AICPA).
Leverage Your Financials
Historical financial statements are often used to generate forecasts, projections, and budgets. But accurate predictions usually require more work than simply multiplying last year’s operating results by a projected growth rate — especially over the long term.
For example, a start-up business may be growing 30% annually, but that rate is likely unsustainable over time. Plus, the business’ facilities and fixed assets may lack sufficient capacity to handle growth expectations. If so, management may need to add assets or fixed expenses to take the company to the next level.
Similarly, it may not make sense to assume that annual depreciation expense will reasonably approximate the need for future capital expenditures. Consider a tax-basis entity that has taken advantage of the expanded Section 179 and bonus depreciation deductions, which permit immediate expensing in the year qualifying fixed assets are purchased and placed in service. Because depreciation is so boosted by these tax incentives, this assumption may overstate depreciation and capital expenditures going forward.
Various external factors, such as changes in competition, product obsolescence, and economic conditions, can affect future operations. So can events within a company. For example, new or divested product lines, recent asset purchases, in-process research and development, and outstanding litigation could all materially affect future financial results.
We Can Help
When preparing prospective financial statements and reporting forward-looking estimates, the underlying assumptions must be realistic and well thought out. Contact us for objective insights based on industry and market trends, rather than simplistic formulas, gut instinct, and wishful thinking.
