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Financial-modeling-and-forecasting - Notes

Bachelor of commerce (Mount Kenya University)

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JOMO KENYATTA UNIVERSITY

OF
AGRICULTURE & TECHNOLOGY
SCHOOL OF OPEN, DISTANCE &
eLEARNING
IN COLLABORATION WITH

DEPARTMENT OF COMMERCE

HBF 2403: FINANCIAL MODELING AND FORECASTING

LAST REVISION ON February 25, 2015

E.A.NONDI
([email protected])

P.O. Box 62000, 00200

Nairobi, Kenya

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HBF 2403: FINANCIAL MODELING AND FORECASTING

Course description
Financial time series analysis in forecasting; Financial regression analysis for fore-
casting; other forecasting statistical tools; Building blocks of financial forecasting.
Vertical and horizontal relationships among parameters of financial statements. Sta-
tistical and graphical analysis of past budget patterns. Setting parameters for future
growth and/or changes on financial budgets. Pro forma financial statements. Cash
flow projections. Application of computer packages in financial forecasting

Prerequisite: Prerequisites – HBC 2104 Introduction to Accounting II and

HBC 2121: Introduction to Business Statistics

Course aims
Provide the students with the many tools and analytical techniques, necessary for
financial forecasting in a dynamic economic environment

Learning outcomes
By the end of this course the learners should be able to:

1. Develop financial forecasting models.

2. Forecast future profitability, cash flows and growth in wealth, given the ap-
propriate financial statements.

3. Use univariate and multivariate forecasting models for financial forecasting

Instruction methodology
• Lectures and tutorials ·

• Case studies ·

• Group discussions

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Assessment information
The module will be assessed as follows;

• 30% of marks from CAT .

• 70% of marks from written Examination to be administered at JKUAT .

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Contents

1 Introduction to financial modeling and forecasting 1

1.1 Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Financial Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.3 Why do we create financial models . . . . . . . . . . . . . . . . . . 1
1.4 How far out is it reasonable to forecast . . . . . . . . . . . . . . . . 2
1.5 What unit of time should be used in the forecast . . . . . . . . . . . 2
1.5.1 What key metrics are predicted . . . . . . . . . . . . . . . . 2
1.6 What are the key steps in building a financial model . . . . . . . . . 2

2 Accounting assumptions, principles, procedures and policies 5

2.1 Model drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1.1 Assumptions: . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Modeling Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 Cyclical Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.3.1 What causes this cycle . . . . . . . . . . . . . . . . . . . . 10
2.4 Secular Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.5 Modeling Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

3 Financial time series analysis 17

3.1 introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.2 Definition of a Time Series . . . . . . . . . . . . . . . . . . . . . . 18
3.2.1 Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.2.2 Seasonal Variation . . . . . . . . . . . . . . . . . . . . . . 18
3.2.3 Irregular Fluctuations . . . . . . . . . . . . . . . . . . . . . 19
3.2.4 Motivation for FTSA . . . . . . . . . . . . . . . . . . . . . 19
3.2.5 Objective of the Course . . . . . . . . . . . . . . . . . . . 19

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CONTENTS CONTENTS

4 Financial time series and their characteristics 22

4.1 Asset Returns Simple definition: . . . . . . . . . . . . . . . . . . . 22
4.2 Why returns in FTSA? . . . . . . . . . . . . . . . . . . . . . . . . 22
4.3 Types of Returns in Financial Analysis . . . . . . . . . . . . . . . 23
4.3.1 Annualized (Average) Return . . . . . . . . . . . . . . . . 24
4.3.2 Continuous Compounding & Present Value . . . . . . . . . 24
4.3.3 Dividend Payments . . . . . . . . . . . . . . . . . . . . . . 25

5 Financial time series ;distributional properties of returns 29

5.1 Chapter objectives: . . . . . . . . . . . . . . . . . . . . . . . . . . 29
5.2 introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
5.3 moment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
5.4 Distribution of Returns . . . . . . . . . . . . . . . . . . . . . . . . 31
5.4.1 Log-Normal Distribution . . . . . . . . . . . . . . . . . . . 32
5.4.2 Realistic: . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5.4.3 Unrealistic: . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5.4.4 Stable Distribution . . . . . . . . . . . . . . . . . . . . . . 32
5.4.5 Scale Mixture of Normal Distributions . . . . . . . . . . . . 33

6 Regression analysis 36
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
6.2 Classical assumptions for regression analysis include: . . . . . . . . 36
6.3 Linear Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
6.4 Regression Equation . . . . . . . . . . . . . . . . . . . . . . . . . 37
6.5 Linear Regression . . . . . . . . . . . . . . . . . . . . . . . . . . 38
6.6 Regression Coefficients . . . . . . . . . . . . . . . . . . . . . . . . 40
6.7 Hypothesis testing and Regression . . . . . . . . . . . . . . . . . . 41
6.7.1 F-Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
6.8 Limitations of Regression Analysis Focus on three main limitations: 43

7 Other forecasting methods 45

7.1 Chapter objectives: . . . . . . . . . . . . . . . . . . . . . . . . . . 45
7.2 introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
7.3 There are several assumptions about forecasting: . . . . . . . . . . . 45
7.4 Genius forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . 46

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CONTENTS CONTENTS

7.5 Trend extrapolation . . . . . . . . . . . . . . . . . . . . . . . . . . 46

7.6 Consensus methods . . . . . . . . . . . . . . . . . . . . . . . . . . 47
7.7 Simulation methods . . . . . . . . . . . . . . . . . . . . . . . . . . 48
7.8 Cross-impact matrix method . . . . . . . . . . . . . . . . . . . . . 49
7.9 Scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
7.10 Decision trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
7.11 Combining Forecasts . . . . . . . . . . . . . . . . . . . . . . . . . 51
7.12 Difficulties in Forecasting Technology . . . . . . . . . . . . . . . . 51
7.13 Defining a Useful Forecast . . . . . . . . . . . . . . . . . . . . . . 52
7.14 Do Forecasts Create the Future . . . . . . . . . . . . . . . . . . . . 54
7.15 The Ethics of Forecasting . . . . . . . . . . . . . . . . . . . . . . 56

8 Financial statement analysis 60

8.1 Financial Statement Overview . . . . . . . . . . . . . . . . . . . . 60
8.2 Locating Financial Statements . . . . . . . . . . . . . . . . . . . . 61
8.3 Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
8.4 Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
8.5 Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . 65
8.6 How Financial Statements . . . . . . . . . . . . . . . . . . . . . . . 67

9 Three statement financial modeling 71

9.1 Three-Statement Financial Modeling . . . . . . . . . . . . . . . . . 71
9.2 Building from the Basic Model . . . . . . . . . . . . . . . . . . . . 71
9.3 Model Design & Layouts . . . . . . . . . . . . . . . . . . . . . . . 72
9.3.1 Laying out Assumptions . . . . . . . . . . . . . . . . . . . 73
9.3.2 Numeric Display . . . . . . . . . . . . . . . . . . . . . . . 73
9.4 Six Steps to Simple Financial Modeling . . . . . . . . . . . . . . . 73

10 Forecasting cash flows 79

10.1 Cash Flow Forecast . . . . . . . . . . . . . . . . . . . . . . . . . . 79
10.2 What can you use it for? . . . . . . . . . . . . . . . . . . . . . . . 79
10.3 Change in Working . . . . . . . . . . . . . . . . . . . . . . . . . . 81

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HBF 2403: Financial Modeling and Forecasting

LESSON 1
Introduction to financial modeling and forecasting

1.1. Chapter objectives

Chapter objectives: By the end of this chapter, the learners should;

1. Give an overview of Financial Modeling

2. Explain whether it is reasonable to forecast

3. Outline reasons why we create models

4. Outline What key metrics are predicted?

5. Discuss What are the key steps in building a financial model?

1.2. Financial Modeling

Overview Remember, there are three main Financial Statements commonly used to
analyze a company: the Income Statement, the Balance Sheet, and the Statement
of Cash Flows. In this module, will dissect financial modeling primarily through
the Income Statement. A financial analyst must understand how to evaluate the
historical Income Statement line items and make key, rational forward-looking as-
sumptions of the company’s business performance.

1.3. Why do we create financial models

A financial model is built to study a company’s financial history and to use the in-
formation available (both past and present) to predict the company’s performance
in the future. Although companies change to some degree every year, you can
still learn a lot about a company’s revenue growth profile, cost structure, margins,
and earnings growth by analyzing its past performance. Likewise, sometimes cur-
rent information is available that supersedes the past (such as a new acquisition or
changed cost structure). These are all essential factors in determining how much a
company is worth.

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1.4. How far out is it reasonable to forecast

The further out a forecast is made, the less confidence one can have in the accuracy
of predictions in it. For this reason, most investment banking models are forecast
out only five years, while equity research models are more short-term: they usu-
ally only go out two years. Any prediction beyond this horizon is, typically, too
uncertain so many things can change in that time frame.

1.5. What unit of time should be used in the forecast

Most models are built quarterly or yearly, but in certain circumstances it may make
sense to model a business on a monthly basis. For example, if a company is very
cash-constrained it may make sense to understand monthly cash flows, as they may
not last a quarter. Additionally, some businesses are highly seasonal, and therefore
some months of the year look much different from others. In general, you should
build your model on an annual or quarterly basis unless instructed otherwise.

1.5.1. What key metrics are predicted

Generally, a financial model is used to predict several key metrics of a company’s
financial performance, with the later items being key metrics in valuing a business:

• Revenue growth

• Gross Profit

• EBIT and EBITDA

• Net Income

• Free Cash Flow

1.6. What are the key steps in building a financial model

In this module we will take a deeper look at each step in the process but first, as
a review, here are the primary steps involved in building a spreadsheet financial
model for a company:

1. Input historical Financial Statements (Income Statement, Balance Sheet).

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HBF 2403: Financial Modeling and Forecasting

2. Calculate key ratios on historical financials (e.g., Gross Margin, Net Income
Margin, Accounts Receivable/Payable Days, etc.).

3. Make forward-looking assumptions for projecting the Income Statement and

Balance Sheet based on these historical ratios and any additional considera-
tions.

4. Build a Statement of Cash Flows (tying together Net Income from the Income
Statement and Cash from the Balance Sheet).

5. Tie Ending Cash Balance from the Statement of Cash Flows into the Balance
Sheet, and Balance the Balance Sheet.

6. Calculate Interest Expense and tie this into the Income Statement.

It is important to leave the Interest Expense item for last. The main reason for this
is that Interest Expense is a function of Debt balances and Cash balances. How-
ever, Interest Expense also affects Net Income, which is used to project Cash (and
often Debt balances as well). As you can see, there is usually a circular relation-
ship between Interest Expense and Cash/Debt, spanning across the three projected
Financial Statements that you’ve built. Once the circular component of the model
has been built, it is very easy to make a mistake that flows through the entire model,
and involves a fair amount of work to correct. Therefore, build everything else first,
make sure that it is built properly, save the file, and only then tie the Interest Ex-
pense piece into the model as a final step. to avoid common errors and help ensure
that the outputs of your model will be reasonable:

• Confirm historical financials for accuracy.

• Validate key assumptions for projections.

• Sensitize variables driving projections to build a valuation range.

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Review questions

Example . Give an overview of Financial Modeling

Solution: A financial model is built to study a company’s financial history and to
use the information available (both past and present) to predict the company’s per-
formance in the future. Although companies change to some degree every year, you
can still learn a lot about a company’s revenue growth profile, cost structure, mar-
gins, and earnings growth by analyzing its past performance. Likewise, sometimes
current information is available that supersedes the past (such as a new acquisition
or changed cost structure). 

Assignments

E XERCISE 1.  Explain whether it is reasonable to forecast

E XERCISE 2.  Outline reasons why we create models
E XERCISE 3.  Outline What key metrics are predicted?
E XERCISE 4. 
Discuss what are the key steps in building a financial model?

References
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 2
Accounting assumptions, principles, procedures and policies

Chapter objectives:
By the end of this chapter, the learners should;

1. Describe model drivers

2. Discuss the modeling of revenue trends

3. Explain the modeling of expense line items

2.1. Model drivers

When building a model, you will generally be faced with a number of considera-
tions about how exactly to build it. One such consideration is how detailed to make
the model should projecting the Income Statement be done in a relatively simple,
straightforward way, or should a number of different assumptions (model drivers)
be driving it? The general rule is this: more data inputs do not necessarily mean
better data output, but the more thought you have put into your assumptions, the
more accurate the model is likely to be. Thus “more drivers” (more assumptions)
does not always translate into “better model”, but the modeler should put a fair
amount of thought into what parameters drive the results of the business. The most
important ones should be broken out as separate assumptions that can be modified.
First, let’s start with the top line of the Income Statement: Revenue.
The two main drivers of revenue are Price and Volume. Price × Volume = Revenue
Price, in turn, is driven by both a company’s pricing strategy and inflationary con-
siderations. Volume drivers include industry growth, product demand, and market
share, among potentially others. So to what level of detail should you dive into this
hierarchy of drivers? It depends on the task. In some cases, more detail is better; in
others, only a brief overview is required.
Usually, models start off relatively simple (a fewer number of drivers) and get more
complex as a deal process proceeds (more drivers are added to make the model more
sophisticated and more responsive to additional areas of uncertainty). Continuing
with our discussion of revenue drivers, we can look at modeling revenue in one of
two primary ways. Revenue can be modeled either top down or bottom up.

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Top Down Modeling Modeling using a top-down approach starts with the address-
able market. This is the entire market to which a company could potentially sell its
goods or services. The addressable market is then broken down into sub-components.
Most companies will identify the size of their market in their annual 10K filing.
You can the calculate the company’s market share by dividing its sales by the total
sales for the industry. Here is an example. Top-Down Approach To Modeling Unit
Sales: Hypothetical Example XYZ Corp. operates in California, Texas and Florida
and sells college textbooks. Using a top-down approach, we start by studying the
percentage of people within each state who attend college:

This provides us with the upper bounds of our addressable market. If XYZ Corp
only sells to college students in these states, we know they cannot sell books to
more than 13.5 million potential customers. Next, we need to understand XYZ’s
market share and how many books each student buys:

Out of a population of 83 million people, we compute that 13.5 million are college
students. If we assume that each college student buys an average of two books per
year, there are 27 million (13.5 million × 2 books per student) college textbooks
sold annually in these states. Of that, we compute that XYZ Corp has approxi-
mately 11% market share (XYZ Books Sold of 2.85 million ÷ Total of Books Sold
of 27 million). Note that this share is different in different states—this may become
important, especially if we find that expected growth rates differ by state. We es-
timate this in the next step. Once we understand the addressable market, we can
now forecast the growth rate of the population, the percentage of people that are in
college, the total number of textbooks each person in college buys, and the market
share XYZ Corp has:

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2.1.1. Assumptions:
1. California’s population grows by 3%, 4% and 5% over the next 3 years.

2. Texas’s population grows by 2%, 3%, and 4%.

3. Florida’s population grows by 4%, 5%, and 6%.

4. The percentage of college students in each state stays the same as the previous
year.

5. XYZ maintains the same market share each year in each state.

If we estimate that each person continues to buy two books per year, then we project
that XYZ Corp will sell almost 3 million books next year, and more than that in
Years 2 and 3:

Math Example: In Year 1, California grows population 3%, to 39.1 million × 15.8%
college students × XYZ market share of 10% = 618,000 college students. These
college students each buy two books per year, so 2 books × 618,000 = 1,236,000
books sold in California in Year 1. Conclusion: In this example, volume growth
was mainly a function of population growth within XYZ Corp’s markets. In order
to project revenue, we would then need to make assumptions about projected per-
book price increases (or decreases) in each year. Bottom-Up Modeling By contrast,
modeling using a bottom-up approach is based on the unit economic approach of a
single customer or selling unit, regardless of the segmentation. Bottom-up analyses
generally rely heavily on historical data from actual sales in the past, and go from
there. Because bottom-up analyses build directly from recent historical results, a
bottom-up analysis is typically more accurate in the short-term, and is therefore

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HBF 2403: Financial Modeling and Forecasting

generally used when estimating short-term trends. Bottom-Up Approach To Mod-

eling Unit Sales: Hypothetical Example XYZ Corp sells books to college students,
mainly through college bookstores. Thus in our bottom-up approach, unit growth
will be mainly a function of store growth and books sold per store:

This analysis disregards the big picture view of population growth, but it does focus
on the unit economics of the business, which can be just as accurate (and sometimes,
in the short-term, it can be even more accurate). Now, we need to make assumptions
about how this existing market will grow. When forecasting, there are two ways to
determine what growth rate to use: historical data and research-based assumptions.
Using historical data is as simple as looking at the historical growth rates, identify-
ing a pattern, and then applying a reasonable assumption for future periods based
on this pattern. If XYZ Corp has consistently grown revenues by 5% every year, it
seems reasonable to assume that revenue would continue to grow at a similar pace:

It should be noted that this same logic would apply when modeling segments of
the addressable market in the top-down approach. In order to increase the level
of accuracy of your estimate, you should also conduct research. Research can in-
volve reading the company’s historical filings to look for clues of what management
thinks growth could be. You can also study macro factors or sector-specific factors
that may influence the company’s revenue growth rate. For example, since XYZ
Corp sells books to college students, college enrollment patterns will likely influ-
ence total number of college textbooks sold. Additionally, if XYZ is expanding
to new college bookstores, it would be reasonable to make assumptions about how
many new stores the company will sell to, and how quickly book sales will accumu-
late in these new stores. Conclusion: In this example, volume growth was mainly
a function of the number of college bookstores that XYZ Corp sells through. We
had the option to grow volume based upon the number of bookstores that the com-
pany sells through, and assumptions about growth in book sales per store. We also
had the option of modeling new store growth and making assumptions about how
many sales these stores will garner for the company. In order to project revenue, we
would then need to make assumptions about projected per-book price increases (or

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HBF 2403: Financial Modeling and Forecasting

decreases) in each year. Instead, we made the simplifying assumption that revenue
growth continues at a 5% rate, similar to the company’s recent past revenue growth
rate.

2.2. Modeling Revenue

Trends Generally speaking, established companies tend to grow revenues over time
at an approximate rate—one that can be difficult to measure precisely, but often a
range can often be found. However, this long-term underlying growth trend can
be obscured by short-term developments caused by specific patterns. There are
three main types of revenue patterns, or trends, to look for: seasonal, cyclical, and
secular. When modeling business performance, it is critical to make sure that your
assumptions coincide with the economic reality of the company you are modeling.
Seasonal Trends A seasonal business is one with revenue patterns that increase and
decrease with a regular pattern during specific periods of the year.
The pattern does not have to be based around seasons, but oftentimes it is (such as
housing or road construction in the Northern US). Here are some concrete exam-
ples:

• A company that sells snowplows is likely to do a lot of business in the winter

and late fall, but little business in the summer. In this case, the strong sales
period lasts about 3-6 months.

• A flower shop will likely see a huge increase in sales in the days leading up to
Valentine’s Day and Mother’s Day. These two holidays may represent 75%
of the company’s full-year business, with the strong sales period only lasting
a couple of days.

• Retail companies tend to have strong sales performance around the end of the
year, with people buying gifts for holidays such as Christmas and Hanukkah.
As you can see in the graphic below, a majority of each year’s revenue occurs
in the 3rd and 4th quarters.

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HBF 2403: Financial Modeling and Forecasting

2.3. Cyclical Trends

A cyclical business is similar to a seasonal business, in that business tends to be
strong in certain periods but weaker in others. For cyclical businesses, however,
the trend usually lasts for a time period longer than one year (sometimes as long
as a decade), and is generally unrelated to the calendar. Cyclical companies often
have long periods of sustained growth followed by a sharp drop off when the cycle
changes.

2.3.1. What causes this cycle

It depends, but usually the cycle is tied to the strength of some economic indicator,
such as gold prices, GDP growth, or new housing starts. For example, the housing
market had a long growth period through the early and mid 2000’s, and collapsed
in 2007 and 2008. Oil refining business revenues and earnings are closely tied
to the price per barrel of oil. Retail companies experience cyclical growth trends
around overall GDP growth and/or consumer spending growth. As you can see in
the graphic below, the hypothetical company experienced a major decline in its rev-
enue path in Years 8 and 9. This could be due to internal problems specific to the
company (such as a major lawsuit or a product safety scare), or due to macroeco-
nomic effects such as a credit crisis or a global growth slowdown. (Depending on
the situation, it is also possible that revenue growth in Years 3-7 was exaggerated
due to the same cyclical indicator that lead to the downturn in Years 8-9.)

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2.4. Secular Trends

A secular trend typically lasts longer than a cyclical trend. It typically involves the
advent of a new technology or consumer behavior that is here for good, or at least
for a long time. The reserve is also true: some business are involved in secular
declines due to technological obsolescence, or shifts away from them in consumer
behavior. For example, the Internet is a new technology that has revolutionized
many industries, and has been consistently growing for the past 20 years and will
likely continue to for some time. By contrast, outdated technologies such as CDs
and DVDs are in decline after being replaced by online media and Blu-Ray tech-
nology. Another industry in secular decline is milk production, as adults shift to
other sources of calcium and protein, partly due to available substitutes and partly
due to health concerns. In the graphic below, the blue line represents the revenue
of a company that is experiencing secular growth while the pink line represents a
company that operates in a secular decline.

Modeling Expense
Line Items The cost structure of a business’s operations can be divided into two
components: fixed costs and variable costs. Fixed costs tend not to change as a
company’s revenue grows or declines, while variable costs are directly related to
how much revenue a company is earning. Costs can also be divided into production-
related expenses (often called Cost of Goods Sold, or COGS), and non-production-
related expenses (often called Other Operating Expenses or just Operating Ex-
penses). Fixed Costs Fixed costs typically stay constant year over year, unless

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the company puts a cost savings program into place, such as by firing corporate
headquarters employees. Examples of fixed costs are rent payments, management
salaries, and insurance premiums.
Variable Costs
Variable costs are usually directly related to the production and supply of goods or
services available for sale, and are typically modeled as a percentage of revenue.
Examples include labor, material, and utility costs. As a company grows revenue
and keeps fixed costs in place, a company is able to increase its profitability. This
arises from a phenomenon known as operating leverage. Operating leverage mea-
sures the degree to which profit as a percentage of revenue grows as revenue grows.
Companies with a high fixed cost structure tend to exhibit the most operating lever-
age. Here’s an example: a company may be utilizing half of its current manu-
facturing facility. As new orders come in for its products, the company is able to
produce more products without utilizing an additional facility. Thus, the percent-
age of revenue that can be saved as gross profit increases as the number of units
produced increases. As you can see in the graphic below, the hypothetical company
has increased its revenue and its gross margin simultaneously.

It is important to note that Variable Costs are not synonymous with COGS, and
likewise, Fixed Costs are not synonymous with Other Operating Expenses. True,
many COGS expenditures tend to be variable—but not all of them are. Likewise,
some non-production-related Operating Expenses, such as Sales & Marketing, tend
to vary proportionally with revenue. SG&A: Head Count, Marketing, and Corpo-
rate Expenses Selling, general and administrative expenses are typically modeled
as a percentage of revenue. Investment bankers typically evaluate the SG&A as
a percentage of revenue over the last few historical years and make assumptions
(e.g., by taking the average of the last three years). It is important to note, however,
that typically, at least some component of SG&A is actually fixed expenses. Costs
like insurance premiums, legal counsel, and corporate employee salaries tend to be
mostly fixed, at least in the short-term. EBIT and EBITDA
After COGS and Other Operating Expenses are subtracted out, the result is EBIT.
EBIT is short for Earnings Before Interest and Taxes, and EBITDA is EBIT plus

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Depreciation and Amortization Expenses. EBIT is also called Operating Profit,

because it is the money produced by the operations of the company before Taxes
and Interest are taken out. EBITDA takes this one step further by removing the non-
cash expenses, Depreciation and Amortization. EBITDA is a proxy for the cash
flow of the operations of a business, assuming that no new Capital Expenditures
are necessary. This is usually not the case, however, because ongoing operations
usually need more capital expenditure to grow the company and to maintain the
business infrastructure in place. It is important to understand that EBITDA and
EBIT are not drivers of a financial model.
They are among the primary outputs of the model. They are key metrics that invest-
ment bankers use to evaluate the worth of a business.

2.5. Modeling Interest

Expense and Interest Income Interest Expense and Income are based directly off
the outstanding Debt and Cash balances, respectively, that a company shows on its
Balance Sheet. To model these on a going forward basis:

• Divide Interest Expense by total Debt amount to calculated the average Cost
of Debt (prior to any adjustments for the Tax Shield of Debt

• Check to see if the company has any swaps outstanding, or anything else that
may change the implied average Cost of Debt.

• Model future Interest Expense as the average Cost of Debt multiplied by the
average amount of Debt on the Balance Sheet in each year.

This is usually calculated as:

(Beginning Debt Balance + Ending Debt Balance) ÷ 2.
For Interest Income, try to determine how much of the Cash balances have his-
torically been invested in interest-bearing assets; use previous Interest Income fig-
ures to determine the average interest rate earned on these balances. Then, make
assumptions about this rate in the future, and multiply this assumed rate by the
average amount of Cash on the Balance Sheet in each year.
As with Debt, this is usually calculated as: (Beginning Cash Balance + Ending Cash
Balance) ÷ 2.

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Taxes Once Net Interest Expense has been computed, subtract it from EBIT to arrive
at EBT (Earnings before Tax). In order to estimate future tax rates on EBT, look
at historical effective tax rates (different from marginal tax rates, in that effective
tax rates measure the total percent of EBT that is paid as taxes, while marginal tax
rates measure the amount of tax liability generated from a $1 additional increase in
EBT). In addition, read annual and quarterly filings to see if there are any reasons
why effective taxes may be higher or lower than historical rates (e.g., because of
R&D tax credits,
Net Operating Losses (NOLs), changes in statutory corporate tax rates, or changes
in exposure to foreign countries). Take out one-time expenses or non-recurring
items that may have impacted the tax rate in previous years. If the company has
a NOL carryforward, which may act as a tax shield protecting future profits from
taxation, use a normalized tax rate in projecting future tax rates. The NOL carryfor-
ward can be valued separately as a tax shield, assuming that the company remains
profitable in the future.
Net Income Once taxes have been subtracted from EBT, we have Earnings, or Net
Income. Like EBIT and EBITDA, Net Income can be used in some models as a ba-
sis for valuation – particularly if we are valuing the equity component of a business
(Market Capitalization) separately from the business as a whole (Enterprise Value).
Calculate Earnings Per Share Net, we can estimate Earnings Per Share (EPS). EPS
is simply the ratio of Net Income to Number of Outstanding Shares. EPS comes in
two varieties: Basic EPS and Fully Diluted EPS.
Basic EPS: Net Income ÷ Weighted-Average Shares Outstanding—(Beginning SO
+ Ending SO) ÷ 2.
Fully Diluted EPS: Net Income ÷ Average Fully-Diluted Shares Outstanding—(Beginning
FDSO + Ending FDSO) ÷ 2.
In the Fully-Diluted Shares Outstanding calculation, be sure to include all options,
warrants, convertible bonds, and convertible preferred shares as though they were
converted today into outstanding shares. This makes the denominator of the EPS
calculation as large as it can reasonably be, and is thus an ultra-conservative mea-
sure of a firm’s earning power. You may need to adjust your outstanding share as-
sumptions if new equity shares are being issued or if shares are being repurchased
through a share buyback plan. If a share buyback plan is operational, read the fi-
nancial statements and company filings to try to understand how many more shares

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are remaining to be repurchased on the existing share buyback authorization.

Assume that the company will use a certain percentage of cash flow to buy back
stock, and model out the future outstanding share amounts using this assumption.
Other Notes
Calculate Debt/EBITDA: The Debt/EBITDA ratio is a measure of the financial
leverage of a company. This metric is an indicator of how much wiggle-room
the company has to pursue different corporate actions, including share buybacks.
When doing share buyback modeling, understand how much leverage the company
can reasonably take on if you are assuming that the company is using cash flow to
buy back stock rather than pay down debt.
Calculate EBITDA/Interest Expense: The EBITDA/Interest Expense ratio is a mea-
sure of a company’s ability to service its debt i.e., how much of the cash flow from
its operations is being used to compensate the holders of the company’s debt. If this
ratio begins approaching 1 (or worse, is at or below 1!), then the company is spend-
ing most or nearly all of its EBITDA to pay for its existing Debt—a potentially
dangerous sign. Likewise, if EBITDA is declining, watch this metric to understand
if company will have any issues servicing its existing Debt obligations

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Review questions

Example . Describe model drivers

Solution: When building a model, you will generally be faced with a number of
considerations about how exactly to build it. One such consideration is how detailed
to make the model—should projecting the Income Statement be done in a relatively
simple, straightforward way, or should a number of different assumptions (model
drivers) be driving it?


E XERCISE 5.  Discuss the modeling of revenue trends

E XERCISE 6.  Explain the modeling of expense line items
E XERCISE 7.  What is top-down modeling
E XERCISE 8.  Describe the seasonal trend

References
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 3
Financial time series analysis

Chapter objectives:
By the end of this chapter, the learners should;

1. Give a brief history of time series analysis

2. Define a time series

3. Discuss the components of a time series

4. Explain the motivation behind the use of financial time series analysis

5. Outline the objectives of financial time series

3.1. introduction
Brief History of Time Series Analysis

• Statistical analysis of time series data (Yule, 1927) v/s forecasting (even
longer).

• Forecasting is often the goal of a time series analysis.

• In business and economics:

1. To study dynamic structures of a process

2. To investigate the dynamic relationship between variables

3. To perform seasonal adjustment of economic data (eg: GNP)

4. To improve regression analysis when errors are serially correlated

5. To produce point and interval forecasts for both level and volatility series

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3.2. Definition of a Time Series

A time series is a chronological sequence of observations on a particular variable.
Components of a Time Series

• Trend

• Cycle

• Seasonal Variations

• Irregular Fluctuations Trend

Trend refers to the upward or downward movement that characterizes a time series
over a period of time. That is, a long-run growth or decline in the time series. Some
factors that affect trend are:

• Technological change in the industry

• Changes in consumer tastes

• Market growth

• Inflation or deflation, etc.

3.2.1. Cycle
Cycle refers to recurring up and down movements around the trend levels. These
fluctuations can have a duration of anywhere from 2 to 10 years or even longer
when measured from peak to peak or trough to trough. Extremely long time series
data are required to be able to detect cycles.

3.2.2. Seasonal Variation

Seasonal Variations are periodic patterns in a time series that complete themselves
with the period of a calendar year. These generally repeat every year and are most
often caused by weather and customs. Generally, monthly or quarterly data over a
few years is needed to be able to detect seasonality in time series.

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3.2.3. Irregular Fluctuations

Irregular fluctuations are erratic movements in a time series that follow no recog-
nizable or regular pattern. Such movements represent what is “left over” in a time
series after trend, cycle, and seasonal variations have been accounted for. Most are
caused by events one cannot forecast such as: earthquakes, accidents, hurricanes,
etc.

3.2.4. Motivation for FTSA

Financial time series analysis is defined as the, "theory and practice of asset valua-
tion over time”.
What make FTSA different?

• Highly empirical

• Uncertainty – concept of volatility

• Dependent more on statistical theory and methods for development of robust

models.

3.2.5. Objective of the Course

• Provide some basic knowledge of financial time series

• To introduce some statistical tools and econometric models useful for analyz-
ing

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• FTS

• To gain empirical experience in analyzing FTS

• Provide a flavor of current research in the field

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Review questions

Example . Give a brief history of time series analysis

Solution: Brief History of Time Series Analysis • Statistical analysis of time series
data (Yule, 1927) v/s forecasting (even longer). • Forecasting is often the goal of
a time series analysis. • In business and economics: To study dynamic structures
of a process To investigate the dynamic relationship between variables To perform
seasonal adjustment of economic data (eg: GNP) 

Assignments

E XERCISE 9.  Define a time series

E XERCISE 10.  Discuss the components of a time series
E XERCISE 11.  Explain the motivation behind the use of financial time series
analysis
E XERCISE 12.  Outline the objectives of financial time series

References and Additional Reading Materials

1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial statements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 4
Financial time series and their characteristics

Chapter objectives:
By the end of this chapter, the learners should;

1. Define asset returns

2. Outline the reasons for returns in financial time series analysis

3. Discuss why returns in financial time series

4. Outline the type of returns in financial time series

4.1. Asset Returns Simple definition:

The profit realized on a base product.

4.2. Why returns in FTSA?

• For most investors return of an asset is a complete and scale-free summary of
the investment opportunity.

• Return series are easier to handle normalizing effect compared to the price
series of the underlying investment.

• They have more attractive and widely studied statistical properties.

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4.3. Types of Returns in Financial Analysis

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4.3.1. Annualized (Average) Return

When the investment horizon is longer than a year (k > 1) it is customary to report
the returns as annualized (average) returns as follows:

4.3.2. Continuous Compounding & Present Value

The concept is important in finance since most investors invest an initial amount
(C) in the market for an extended period. When interest r is paid n times a year the
principal on which the interest is computed changes and thus the net asset value (A)
is different than that derived using a simple return computation. Thus,

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• Multi period return is simply the sum of continuously compounded single

period returns

• Statistical properties of log returns are easier to study and well-developed in

the literature.

4.3.3. Dividend Payments

When the investment instrument has dividends they are simply added into the price
components as follows:

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The excess return is considered to be a payoff for an arbitrage portfolio that goes
long
in an asset and short in the reference asset without an initial investment.
Long Position: When an investor purchases shares in the market.
Short Position: When an investor sells shares in the market that he/she does not
own. Essentially, he/she has borrowed the shares from another investor that has
purchased the shares. The borrowed shares must be paid back along with any ac-
crued dividend. The hope of the short seller is that a decline in price in the market
on the shares will allow him/her to profit.

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Review questions

Example . Outline the reasons for returns in financial time series analysis
Solution: Why returns in FTSA? • For most investors return of an asset is a com-
plete and scale-free summary of the investment opportunity. • Return series are
easier to handle – normalizing effect compared to the price series of the underlying
investment. • They have more attractive and widely studied statistical properties


Assignments

E XERCISE 13.  Define asset returns

E XERCISE 14.  Discuss why returns in financial time series
E XERCISE 15.  Outline the type of returns in financial time series
E XERCISE 16.  What is annualized return

References
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 5
Financial time series ;distributional properties of returns

5.1. Chapter objectives:

By the end of this chapter, the learners should;

1. Understand the behavior of asset returns : a. Across assets — allows for

diversification of portfolio b. Across time – allows for long range planning

2. Describe moments

3. Describe the test for tail thickness

4. Explain the Test for symmetry

5.2. introduction
Recall: A return of an asset is a random variable. Therefore, to compute the distri-
bution properties one needs to only compute the moments of the random variable.
For our discussion we will compute the first four moments of rit

5.3. moment

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Test for tail thickness

5.4. Distribution of Returns

An assets return is treated as a continuous random variable. Therefore, when N
assets are studied over T time-periods we have a joint distribution of all asset re-
turns. The CAPM (Capital Asset Pricing Model) assumes such a joint-distribution.
Additionally, we are also interested in the distribution of a set of returns for N as-
sets given the distribution of the ith asset – or the conditional distribution. For this
course, we will focus only on the joint distribution, more specifically the marginal
distributions, as they will form the basis of the univariate time-series analysis.
In this regard several distributions have been proposed as discussed next. Normal
Distribution Assumption: Simple returns are iid and N(m,sv2). Unrealistic and false:

• Lower bound of a simple return is -1. However, a normal distribution is not

bounded.

• Multi-period return is a product of one-period returns and thus is not normally

distributed even if the one-period return is

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• Empirically, it has been shown that returns have fat-tails, or excess kurtosis

5.4.1. Log-Normal Distribution

Assumption: Log returns are and N(m,sv2).

5.4.2. Realistic:
• There is no lower bound of a log return.

• Multi-period log returns is a sum of one-period log returns and thus is nor-
mally distributed.

5.4.3. Unrealistic:
Empirically, it has been shown that log returns have fat-tails, or excess kurtosis.

5.4.4. Stable Distribution

An extension of the normal distributions – in that they are stable under addition.
They solve the problem of capturing excess kurtosis but most stable distributions
do not have a finite variance which is in conflict with most finance theories. An ex-
ample of a stable distribution is a Cauchy distribution – which is symmetric around
the median but has an infinite variance.

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5.4.5. Scale Mixture of Normal Distributions

New distributions being studied in literature. Basically they attempt to overcome
the limitations of the normal distribution.
Empirical Properties of Returns
<< WinORSe-ai – bring in the returns and plot both simple returns and log returns
>> Point: Both simple return and log-return will have a similar scatter plot. Thus
for computation purposes use log-returns. Other Processes Considered

• Volatility – useful in the study of option pricing and risk management. New
studies focus on realized volatility, and conditional variance.

• Continuous Time Processes – or high-frequency data analysis.

• Extreme Events –somewhere the size, frequency, and impact of an extreme

event will be studied

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Review questions

Example . Define a stable distribution

Solution: An extension of the normal distributions – in that they are stable under
addition. They solve the problem of capturing excess kurtosis but most stable distri-
butions do not have a finite variance which is in conflict with most finance theories.
An example of a stable distribution is a Cauchy distribution – which is symmetric
around the median but has an infinite variance. 

Assignments

E XERCISE 17.  Describe the behavior of asset returns a. Across assets — allows
for diversification of portfolio b. Across time – allows for long range planning
E XERCISE 18.  Describe moments
E XERCISE 19.  Describe the test for tail thickness
E XERCISE 20.  Explain the Test for symmetry

Reference
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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7. Ross, S., Westerfield, J. and Jordan, F. (2008). Corporate Finance, 8th Edition
McGraw-Hill,

8. Irwin. Apte, P.G (2008), “Financial Institutions and Markets”, 14th Edition,
McGraw Hill.

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LESSON 6
Regression analysis

Chapter objectives:
By the end of this chapter, the learners should;
1. Define regression analysis

2. Outline the assumptions of regression analysis

3. Describe linear regression

4. Discuss the assumptions of linear regression

5. Explain Hypothesis testing and Regression Coefficients

6.1. Introduction
Regression Analysis is a causal / econometric forecasting method. Some forecast-
ing methods are based on the assumption that it is possible to identify underlying
factors that might influence a variable that is being forecast. For example, including
information about weather conditions might improve the ability of a model to pre-
dict umbrella sales. This is a model of seasonality that shows a regular pattern of
up and down fluctuations. In addition to weather, seasonality can also result from
holidays and customs such as predicting that sales in college football apparel will
be higher during football season as opposed to the off season. Regression analy-
sis includes a large group of methods that can be used to predict future values of
a variable using information about other variables. These methods include both
parametric (linear or non-linear) and non-parametric techniques.

6.2. Classical assumptions for regression analysis include:

• The sample is representative of the population for the inference prediction.

• The error is a random variable with a mean of zero conditional on the ex-
planatory variables.

• The independent variables are measured with no error. (Note: If this is not
so, modeling may be performed instead, using errors-in-variables model tech-
niques).

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• The predictors are linearly independent, i.e. it is not possible to express any
predictor as a linear combination of the others.

• The errors are uncorrelated, that is, the variance– co-variance matrix of the
errors is diagonal, and each non-zero element is the variance of the error.

• The variance of the error is constant across observations (homoscedasticity).

(Note: If not, weighted least squares or other methods might instead be used).

6.3. Linear Regression

A linear regression is constructed by fitting a line through a scatter plot of paired
observations between two variables. The sketch below illustrates an example of a
linear regression line drawn through a series of (X, Y) observations:

A linear regression line is usually determined quantitatively by a best-fit procedure

such as least squares (i.e. the distance between the regression line and every obser-
vation is minimized). In linear regression, one variable is plotted on the X axis and
the other on the Y. The X variable is said to be the independent variable, and the
Y is said to be the dependent variable. When analyzing two random variables, you
must choose which variable is independent and which is dependent. The choice
of independent and dependent follows from the hypothesis - for many examples,
this distinction should be intuitive. The most popular use of regression analysis is
on investment returns, where the market index is independent while the individual
security or mutual fund is dependent on the market. In essence, regression analy-
sis formulates a hypothesis that the movement in one variable (Y) depends on the
movement in the other (X).

6.4. Regression Equation

The regression equation describes the relationship between two variables and is
given by the general format:

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In this format, given that Y is dependent on X, the slope b indicates the unit changes
in Y for every unit change in X. If b = 0.66, it means that every time X increases (or
decreases) by a certain amount, Y increases (or decreases) by 0.66*that amount.
The intercept a indicates the value of Y at the point where X = 0. Thus if X
indicated market returns, the intercept would show how the dependent variable
performs when the market has a flat quarter where returns are 0. In investment
parlance, a manager has a positive alpha because a linear regression between the
manager’s performance and the performance of the market has an intercept number
a greater than 0.

6.5. Linear Regression

Assumptions Drawing conclusions about the dependent variable requires that we
make six assumptions, the classic assumptions in relation to the linear regression
model:

1. The relationship between the dependent variable Y and the independent vari-
able X is linear in the slope and intercept parameters a and b. This require-
ment means that neither regression parameter can be multiplied or divided by
another regression parameter (e.g. a/b), and that both parameters are raised to
the first power only. In other words, we can’t construct a linear model where
the equation was Y = a + b2X + e, as unit changes in X would then have a b2
effect on a, and the relation would be nonlinear.

2. The independent variable X is not random.

3. The expected value of the error term "e" is 0. Assumptions #2 and #3 allow
the linear regression model to produce estimates for slope b and intercept a.

4. The variance of the error term is constant for all observations. Assumption
#4 is known as the "homoskedasticity assumption". When a linear regression
is heteroskedastic its error terms vary and the model may not be useful in
predicting values of the dependent variable.

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5. The error term e is uncorrelated across observations; in other words, the co-
variance between the error term of one observation and the error term of the
other is assumed to be 0. This assumption is necessary to estimate the vari-
ances of the parameters.

6. The distribution of the error terms is normal. Assumption #6 allows hypothesis-

testing methods to be applied to linear-regression models.

Standard Error of Estimate Abbreviated SEE, this measure gives an indication of

how well a linear regression model is working. It compares actual values in the de-
pendent variable Y to the predicted values that would have resulted had Y followed
exactly from the linear regression. For example, take a case where a company’s
financial analyst has developed a regression model relating annual GDP growth to
company sales growth by the equation Y = 1.4 + 0.8X.
Assume the following experience (on the next page) over a five-year period; pre-
dicted data is a function of the model and GDP, and "actual" data indicates what
happened at the company:

To find the standard error of the estimate, we take the sum of all squared residual
terms and divide by (n - 2), and then take the square root of the result. In this case,
the sum of the squared residuals is 0.09+0.16+0.64+2.25+0.04 = 3.18. With five
observations, n - 2 = 3, and SEE = (3.18/3)1/2 = 1.03%.
The computation for standard error is relatively similar to that of standard deviation
for a sample (n - 2 is used instead of n - 1). It gives some indication of the predictive
quality of a regression model, with lower SEE numbers indicating that more accu-
rate predictions are possible. However, the standard-error measure doesn’t indicate
the extent to which the independent variable explains variations in the dependent
model. Coefficient of Determination Like the standard error, this statistic gives an
indication of how well a linear-regression model serves as an estimator of values for
the dependent variable. It works by measuring the fraction of total variation in the

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dependent variable that can be explained by variation in the independent variable.

In this context, total variation is made up of two fractions:
Total variation = explained variation + unexplained variation total variation total
variation
The coefficient of determination, or explained variation as a percentage of total vari-
ation, is the first of these two terms. It is sometimes expressed as 1 - (unexplained
variation / total variation). For a simple linear regression with one independent vari-
able, the simple method for computing the coefficient of determination is squaring
the correlation coefficient between the dependent and independent variables. Since
the correlation coefficient is given by r, the coefficient of determination is popularly
known as "R2, or R-squared". For example, if the correlation coefficient is 0.76,
the R-squared is (0.76)2 = 0.578.
R-squared terms are usually expressed as percentages; thus 0.578 would be 57.8%.
A second method of computing this number would be to find the total variation
in the dependent variable Y as the sum of the squared deviations from the sample
mean. Next, calculate the standard error of the estimate following the process out-
lined in the previous section. The coefficient of determination is then computed by
(total variation in Y - unexplained variation in Y) / total variation in Y. This second
method is necessary for multiple regressions, where there is more than one indepen-
dent variable, but for our context we will be provided the r (correlation coefficient)
to calculate an R-squared.
What R2 tells us is the changes in the dependent variable Y that are explained by
changes in the independent variable X. R2 of 57.8 tells us that 57.8% of the changes
in Y result from X; it also means that 1 - 57.8% or 42.2% of the changes in Y are
unexplained by X and are the result of other factors. So the higher the R-squared,
the better the predictive nature of the linear-regression model.

6.6. Regression Coefficients

For either regression coefficient (intercept a, or slope b), a confidence interval can
be determined with the following information:

1. An estimated parameter value from a sample

2. Standard error of the estimate (SEE)

3. Significance level for the t-distribution

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4. Degrees of freedom (which is sample size - 2) For a slope coefficient, the

formula for confidence interval is given by b ± tc*SEE, where tc is the critical
t value at our chosen significant level.
To illustrate, take a linear regression with a mutual fund’s returns as the dependent
variable and the S&P 500 index as the independent variable. For five years of
quarterly returns, the slope coefficient b is found to be 1.18, with a standard error
of the estimate of 0.147. Student’s t-distribution for 18 degrees of freedom (20
quarters - 2) at a 0.05 significance level is 2.101. This data gives us a confidence
interval of 1.18 ± (0.147)*(2.101), or a range of 0.87 to 1.49. Our interpretation
is that there is only a 5% chance that the slope of the population is either less than
0.87 or greater than 1.49 - we are 95% confident that this fund is at least 87% as
volatile as the S&P 500, but no more than 149% as volatile, based on our five-year
sample.

6.7. Hypothesis testing and Regression

Coefficients Regression coefficients are frequently tested using the hypothesis-testing
procedure. Depending on what the analyst is intending to prove, we can test a slope
coefficient to determine whether it explains chances in the dependent variable, and
the extent to which it explains changes. Betas (slope coefficients) can be determined
to be either above or below 1 (more volatile or less volatile than the market). Alphas
(the intercept coefficient) can be tested on a regression between a mutual fund and
the relevant market index to determine whether there is evidence of a sufficiently
positive alpha (suggesting value added by the fund manager).
The mechanics of hypothesis testing are similar to the examples we have used pre-
viously. A null hypothesis is chosen based on a not-equal-to, greater-than or less-
than-case, with the alternative satisfying all values not covered in the null case.
Suppose in our previous example where we regressed a mutual fund’s returns on
the S&P 500 for 20 quarters our hypothesis is that this mutual fund is more volatile
than the market.
A fund equal in volatility to the market will have slope b of 1.0, so for this hy-
pothesis test, we state the null hypothesis (H0)as the case where slope is less than
or greater to 1.0 (i.e. H0: b < 1.0). The alternative hypothesis Ha has b > 1.0.
We know that this is a greater-than case (i.e. one-tailed) - if we assume a 0.05
significance level, t is equal to 1.734 at degrees of freedom = n - 2 = 18.

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Example: Interpreting a Hypothesis Test From our sample, we had estimated b of

1.18 and standard error of 0.147. Our test statistic is computed with this formula: t
= estimated coefficient - hypothesized coeff. / standard error = (1.18 - 1.0)/0.147 =
0.18/0.147, or t = 1.224.
For this example, our calculated test statistic is below the rejection level of 1.734,
so we are not able to reject the null hypothesis that the fund is more volatile than
the market.
Interpretation: the hypothesis that b > 1 for this fund probably needs more observa-
tions (degrees of freedom) to be proven with statistical significance. Also, with 1.18
only slightly above 1.0, it is quite possible that this fund is actually not as volatile
as the market, and we were correct to not reject the null hypothesis.
Example: Interpreting a regression coefficient The CFA exam is likely to give the
summary statistics of a linear regression and ask for interpretation. To illustrate,
assume the following statistics for a regression between a small-cap growth fund
and the Russell 2000 index:

6.7.1. F-Test
The formula for F-statistic in a regression with one independent variable is given
by the following: Formula 2.41 F = mean regression sum of squares / mean squared
error = (RSS/1) / [SSE/(n - 2)]
The two abbreviations to understand are RSS and SSE: 1. RSS, or the regression
sum of squares, is the amount of total variation in the dependent variable Y that
is explained in the regression equation. The RSS is calculated by computing each
deviation between a predicted Y value and the mean Y value, squaring the deviation
and adding up all terms. If an independent variable explains none of the variations
in a dependent variable, then the predicted values of Y are equal to the average
value, and RSS = 0. 2. SSE, or the sum of squared error of residuals, is calculated
by finding the deviation between a predicted Y and an actual Y, squaring the result
and adding up all terms. TSS, or total variation, is the sum of RSS and SSE. In other
words, this ANOVA process breaks variance into two parts: one that is explained
by the model and one that is not. Essentially, for a regression equation to have high
predictive quality, we need to see a high RSS and a low SSE, which will make the
ratio (RSS/1)/[SSE/(n - 2)] high and (based on a comparison with a critical F-value)
statistically meaningful. The critical value is taken from the F-distribution and is

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based on degrees of freedom.

For example, with 20 observations, degrees of freedom would be n - 2, or 18, re-
sulting in a critical value (from the table) of 2.19. If RSS were 2.5 and SSE were
1.8, then the computed test statistic would be F = (2.5/(1.8/18) = 25, which is above
the critical value, which indicates that the regression equation has predictive quality
(b is different from 0)
Estimating Economic Statistics with Regression Models Regression models are fre-
quently used to estimate economic statistics such as inflation and GDP growth. As-
sume the following regression is made between estimated annual inflation (X, or
independent variable) and the actual number (Y, or dependent variable):
Y = 0.154 + 0.917X

6.8. Limitations of Regression Analysis Focus on three main limitations:

1. Parameter Instability - This is the tendency for relationships between vari-
ables to change over time due to changes in the economy or the markets,
among other uncertainties. If a mutual fund produced a return history in a
market where technology was a leadership sector, the model may not work
when foreign and small-cap markets are leaders.

2. Public Dissemination of the Relationship - In an efficient market, this can

limit the effectiveness of that relationship in future periods. For example, the
discovery that low price-to-book value stocks outperform high price-to-book
value means that these stocks can be bid higher, and value-based investment
approaches will not retain the same relationship as in the past.

3. Violation of Regression Relationships - Earlier we summarized the six classic

assumptions of a linear regression. In the real world these assumptions are
often unrealistic - e.g. assuming the independent variable X is not random.

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Review questions

Example . Define regression analysis

Solution: Regression Analysis is a causal / econometric forecasting method. Some
forecasting methods are based on the assumption that it is possible to identify un-
derlying factors that might influence a variable that is being forecast. For exam-
ple, including information about weather conditions might improve the ability of a
model to predict umbrella sales. This is a model of seasonality that shows a regular
pattern of up and down fluctuations. In addition to weather, seasonality can also
result from holidays and customs such as predicting that sales in college football
apparel will be higher during football season as opposed to the off season. 

Assignments

E XERCISE 21.  Outline the assumptions of regression analysis

E XERCISE 22.  Describe linear regression
E XERCISE 23.  Discuss the assumptions of linear regression
E XERCISE 24.  Explain Hypothesis testing and Regression Coefficients

Reference
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 7
Other forecasting methods

7.1. Chapter objectives:

By the end of this chapter, the learners should;

1. Outline various assumptions about forecasting

2. Explain genius forecasting method

3. Describe Consensus methods.

4. Explain the use of Simulation methods in forecasting

5. Describe Cross-impact matrix method of forecasting

6. What is Scenario forecasting

7. Explain the use of Decision trees in forecasting

8. Explain the Combining Forecasts

9. Explain how to Define a useful forecasting

10. Explain the Ethics of forecasting

7.2. introduction
Most people view the world as consisting of a large number of alternatives. Futures
research evolved as a way of examining the alternative futures and identifying the
most probable. Forecasting is designed to help decision making and planning in the
present. Forecasts empower people because their use implies that we can modify
variables now to alter (or be prepared for) the future. A prediction is an invitation
to introduce change into a system.

7.3. There are several assumptions about forecasting:

1. There is no way to state what the future will be with complete certainty. Re-
gardless of the methods that we use there will always be an element of uncer-
tainty until the forecast horizon has come to pass.

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2. There will always be blind spots in forecasts. We cannot, for example, fore-
cast completely new technologies for which there are no existing paradigms.

3. Providing forecasts to policy-makers will help them formulate social policy.

The new social policy, in turn, will affect the future, thus changing the ac-
curacy of the forecast. Many scholars have proposed a variety of ways to
categorize forecasting methodologies.

The following classification is a modification of the schema developed by Gordon

over two decades ago:

7.4. Genius forecasting

This method is based on a combination of intuition, insight, and luck. Psychics and
crystal ball readers are the most extreme case of genius forecasting. Their forecasts
are based exclusively on intuition. Science fiction writers have sometimes described
new technologies with uncanny accuracy. There are many examples where men
and women have been remarkable successful at predicting the future. There are
also many examples of wrong forecasts. The weakness in genius forecasting is
that its impossible to recognize a good forecast until the forecast has come to pass.
Some psychic individuals are capable of producing consistently accurate forecasts.
Mainstream science generally ignores this fact because the implications are simply
to difficult to accept. Our current understanding of reality is not adequate to explain
this phenomena.

7.5. Trend extrapolation

These methods examine trends and cycles in historical data, and then use mathemat-
ical techniques to extrapolate to the future. The assumption of all these techniques
is that the forces responsible for creating the past, will continue to operate in the
future. This is often a valid assumption when forecasting short term horizons, but
it falls short when creating medium and long term forecasts. The further out we
attempt to forecast, the less certain we become of the forecast. The stability of the
environment is the key factor in determining whether trend extrapolation is an ap-
propriate forecasting model. The concept of "developmental inertia" embodies the
idea that some items are more easily changed than others.

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Clothing styles is an example of an area that contains little inertia. It is difficult

to produce reliable mathematical forecasts for clothing. Energy consumption, on
the other hand, contains substantial inertia and mathematical techniques work well.
The developmental inertia of new industries or new technology cannot be deter-
mined because there is not yet a history of data to draw from. There are many
mathematical models for forecasting trends and cycles. Choosing an appropriate
model for a particular forecasting application depends on the historical data. The
study of the historical data is called exploratory data analysis. Its purpose is to iden-
tify the trends and cycles in the data so that appropriate model can be chosen. The
most common mathematical models involve various forms of weighted smoothing
methods. Another type of model is known as decomposition.
This technique mathematically separates the historical data into trend, seasonal and
random components. A process known as a "turning point analysis" is used to pro-
duce forecasts. ARIMA models such as adaptive filtering and Box-Jenkins analysis
constitute a third class of mathematical model, while simple linear regression and
curve fitting is a fourth. The common feature of these mathematical models is that
historical data is the only criteria for producing a forecast. One might think then,
that if two people use the same model on the same data that the forecasts will also be
the same, but this is not necessarily the case. Mathematical models involve smooth-
ing constants, coefficients and other parameters that must decided by the forecaster.
To a large degree, the choice of these parameters determines the forecast. It is vogue
today to diminish the value of mathematical extrapolation. Makridakis (one of the
gurus of quantitative forecasting) correctly points out that judgmental forecasting is
superior to mathematical models, however, there are many forecasting applications
where computer generated forecasts are more feasible. For example, large man-
ufacturing companies often forecast inventory levels for thousands of items each
month. It would simply not be feasible to use judgmental forecasting in this kind
of application.

7.6. Consensus methods

Forecasting complex systems often involves seeking expert opinions from more
than one person. Each is an expert in his own discipline, and it is through the syn-
thesis of these opinions that a final forecast is obtained. One method of arriving at
a consensus forecast would be to put all the experts in a room and let them "argue it

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out". This method falls short because the situation is often controlled by those indi-
viduals that have the best group interaction and persuasion skills. A better method
is known as the Delphi technique. This method seeks to rectify the problems of
face-to-face confrontation in the group, so the responses and respondents remain
anonymous. The classical technique proceeds in well-defined sequence. In the first
round, the participants are asked to write their predictions. Their responses are col-
lated and a copy is given to each of the participants. The participants are asked to
comment on extreme views and to defend or modify their original opinion based on
what the other participants have written. Again, the answers are collated and fed
back to the participants. In the final round, participants are asked to reassess their
original opinion in view of those presented by other participants.
The Delphi method general produces a rapid narrowing of opinions. It provides
more accurate forecasts than group discussions. Furthermore, a face-to-face discus-
sion following the application of the Delphi method generally degrades accuracy.

7.7. Simulation methods

Simulation methods involve using analogs to model complex systems. These analogs
can take on several forms. A mechanical analog might be a wind tunnel for mod-
eling aircraft performance. An equation to predict an economic measure would be
a mathematical analog. A metaphorical analog could involve using the growth of
a bacteria colony to describe human population growth. Game analogs are used
where the interactions of the players are symbolic of social interactions. Mathe-
matical analogs are of particular importance to futures research. They have been
extremely successful in many forecasting applications, especially in the physical
sciences. In the social sciences however, their accuracy is somewhat diminished.
The extraordinary complexity of social systems makes it difficult to include all the
relevant factors in any model.
Clarke reminds us of a potential danger in our reliance on mathematical models.
As he points out, these techniques often begin with an initial set of assumptions,
and if these are incorrect, then the forecasts will reflect and amplify these errors.
One of the most common mathematical analogs in societal growth is the S-curve.
The model is based on the concept of the logistic or normal probability distribution.
All processes experience exponential growth and reach an upper asymptopic limit.
Modis has hypothesized that chaos like states exist at the beginning and end of the

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S-curve. The disadvantage of this S-curve model is that it is difficult to know at

any point in time where you currently are on the curve, or how close you are to the
asymtopic limit. The advantage of the model is that it forces planners to take a long-
term look at the future. Another common mathematical analog involves the use of
multivariate statistical techniques. These techniques are used to model complex
systems involving relationships between two or more variables.
Multiple regression analysis is the most common technique. Unlike trend extrapo-
lation models, which only look at the history of the variable being forecast, multiple
regression models look at the relationship between the variable being forecast and
two or more other variables. Multiple regression is the mathematical analog of a
systems approach, and it has become the primary forecasting tool of economists
and social scientists. The object of multiple regression is to be able to understand
how a group of variables (working in unison) affect another variable. The multi-
ple regression problem of collinearity mirrors the practical problems of a systems
approach. Paradoxically, strong correlations between predictor variables create un-
stable forecasts, where a slight change in one variable can have dramatic impact
on another variable. In a multiple regression (and systems) approach, as the rela-
tionships between the components of the system increase, our ability to predict any
given component decreases. Gaming analogs are also important to futures research.
Gaming involves the creation of an artificial environment or situation. Players (ei-
ther real people or computer players) are asked to act out an assigned role. The
"role" is essentially a set of rules that is used during interactions with other players.
While gaming has not yet been proven as a forecasting technique, it does serve two
important functions. First, by the act of designing the game, researchers learn to de-
fine the parameters of the system they are studying. Second, it teaches researchers
about the relationships between the components of the system.

7.8. Cross-impact matrix method

Relationships often exist between events and developments that are not revealed
by univariate forecasting techniques. The cross-impact matrix method recognizes
that the occurrence of an event can, in turn, effect the likelihoods of other events.
Probabilities are assigned to reflect the likelihood of an event in the presence and
absence of other events. The resultant inter-correlational structure can be used to
examine the relationships of the components to each other, and within the overall

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system. The advantage of this technique is that it forces forecasters and policy-
makers to look at the relationships between system components, rather than viewing
any variable as working independently of the others.

7.9. Scenario
The scenario is a narrative forecast that describes a potential course of events. Like
the cross-impact matrix method, it recognizes the interrelationships of system com-
ponents. The scenario describes the impact on the other components and the sys-
tem as a whole. It is a "script" for defining the particulars of an uncertain future.
Scenarios consider events such as new technology, population shifts, and changing
consumer preferences. Scenarios are written as long-term predictions of the future.
A most likely scenario is usually written, along with at least one optimistic and
one pessimistic scenario. The primary purpose of a scenario is to provoke think-
ing of decision makers who can then posture themselves for the fulfillment of the
scenario(s). The three scenarios force decision makers to ask:

1. Can we survive the pessimistic scenario,

2. Are we happy with the most likely scenario, and

3. Are we ready to take advantage of the optimistic scenario?

7.10. Decision trees

- Decision trees originally evolved as graphical devices to help illustrate the struc-
tural relationships between alternative choices. These trees were originally pre-
sented as a series of yes/no (dichotomous) choices. As our understanding of feed-
back loops improved, decision trees became more complex. Their structure became
the foundation of computer flow charts. Computer technology has made it possible
create very complex decision trees consisting of many subsystems and feedback
loops.
Decisions are no longer limited to dichotomies; they now involve assigning prob-
abilities to the likelihood of any particular path. Decision theory is based on the
concept that an expected value of a discrete variable can be calculated as the av-
erage value for that variable. The expected value is especially useful for decision
makers because it represents the most likely value based on the probabilities of

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the distribution function. The application of Bayes’ theorem enables the modifi-
cation of initial probability estimates, so the decision tree becomes refined as new
evidence is introduced. Utility theory is often used in conjunction with decision
theory to improve the decision making process. It recognizes that dollar amounts
are not the only consideration in the decision process. Other factors, such as risk,
are also considered.

7.11. Combining Forecasts

It seems clear that no forecasting technique is appropriate for all situations. There
is substantial evidence to demonstrate that combining individual forecasts produces
gains in forecasting accuracy. There is also evidence that adding quantitative fore-
casts to qualitative forecasts reduces accuracy. Research has not yet revealed the
conditions or methods for the optimal combinations of forecasts. Judgmental fore-
casting usually involves combining forecasts from more than one source. Informed
forecasting begins with a set of key assumptions and then uses a combination of
historical data and expert opinions. Involved forecasting seeks the opinions of all
those directly affected by the forecast (e.g., the sales force would be included in
the forecasting process). These techniques generally produce higher quality fore-
casts than can be attained from a single source. Combining forecasts provides us
with a way to compensate for deficiencies in a forecasting technique. By selecting
complementary methods, the shortcomings of one technique can be offset by the
advantages of another.

7.12. Difficulties in Forecasting Technology

Clarke describes our inability to forecast technological futures as a failure of nerve.
When a major technological breakthrough does occur, it takes conviction and courage
to accept the implications of the finding. Even when the truth is starring us in the
face, we often have difficulty accepting its implications. Clark refers to this resis-
tance to change as cowardice, however, it may be much deeper. Cognitive disso-
nance theory in psychology has helped us understand that resistance to change is
a natural human characteristic. It is extremely difficult to venture beyond our lati-
tudes of acceptance in forecasting new technologies. Clarke states that knowledge
can sometimes clog the wheels of imagination. He embodied this belief in his self-
proclaimed law: "When a distinguished but elderly scientist states that something

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is possible, he is almost certainly right.

When he states that something is impossible, he is very probably wrong." Nearly all
futurists describe the past as unchangeable, consisting as a collection of knowable
facts. We generally perceive the existence of only one past. When two people give
conflicting stories of the past, we tend to believe that one of them must be lying or
mistaken. This widely accepted view of the past might not be correct. Historians
often interject their own beliefs and biases when they write about the past. Facts
become distorted and altered over time. It may be that past is a reflection of our
current conceptual reference. In the most extreme viewpoint, the concept of time
itself comes into question. The future, on the other hand, is filled will uncertainty.
Facts give way to opinions. As de Jouvenel points out, the facts of the past provide
the raw materials from which the mind makes estimates of the future. All forecasts
are opinions of the future (some more carefully formulated than others). The act
of making a forecast is the expression of an opinion. The future, as described by
de Jouvenel, consists of a range of possible future phenomena or events. These
futuribles are those things that might happen.

7.13. Defining a Useful Forecast

Science fiction novelist Frederik Pohl has suggested that the "only time a forecast
has any real utility is when it is not totally reliable". He proposes a thought experi-
ment where a Gypsy fortune teller predicts that we will be run over and killed when
we leave the tea room. If we know that the Gypsy’s predictions are one hundred
percent accurate, then Pohl states that the fortune is useless, because we would be
unable to alter the forecast. In other words, predictions only become useful when
they are not completely reliable.
The apparent paradox created by Pohl’s thought experiment is only a function of
the particular situation. The paradox exists only when

1. we want the future to be different than the prediction, and

2. when we believe that there is no way for us to adapt to or affect the forth-
coming changes. Pohl’s thought experiment actually doesn’t even meet that
criteria, since one could present a convincing argument that it is more desir-
able to spend the rest of our lives confined to the comfort of a tea room than
to leave and meet certain death.

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Obviously, our new life would be difficult to accept and adapt to, but it could be
done. Prisoners do it all the time. A forecast can be one hundred percent accurate
and still be useful. For example, suppose our Gypsy had told us that after leaving
her tea room we would safely return home. Again, since we know that her forecasts
are completely accurate, we would receive emotional comfort from her predictions.
In a more tangible example, suppose the prediction is that our manufacturing com-
pany will receive twice as many orders for widgets as we had anticipated. Since the
forecast is one hundred percent accurate, we would be wise to order more raw mate-
rials and increase our production staff to meet the coming demand. Pohl is wrong.
The goal of forecasting is to be as accurate as possible. In the case of business
demand forecasting, it is naive to suggest that an accurate forecast is useless.
On the contrary, a more accurate forecast enables us to plan the use our resources in
a more ecological fashion. We can minimize waste by adapting to our expectations
of the future. It is sometimes useful in thought experiments to look at the situation
from the opposite perspective. Suppose we know that our Gypsy is always wrong
in her predictions. Her accuracy is guaranteed to be zero. Note that this is different
than random forecasts, where she might hit the mark once in a while. The Gypsy
sighs with relief and says that there is no fatal accident in store for us today.
According to Pohl’s reasoning, this should provide the most useful forecast because
it has the least accuracy. It’s obvious, though, that this fortune is as useless as
the one where she is completely accurate. Leaving the Gypsy’s tea-room is not
something we would want to do. If we view accuracy as a continuum, it may be
that the antonym of accuracy is randomness (instead of inaccuracy).
In this case, Pohl’s theory would suggest that random forecasts are more useful
than accurate forecasts. In demand forecasting, the degree of over- and under-
utilization of our resources is proportional to the difference between the observed
and predicted values. Random forecasts are entirely unacceptable for this type of
application. Pohl’s thought experiment is very important because it forces us to
look at the theoretical foundations of forecasting. First, Pohl’s experiment may not
be valid because it violates a basic assumption of forecasting (i.e., we cannot predict
the future with one hundred percent accuracy). Second, the usefulness of a forecast
does not always seem to be related to its accuracy.
Both extremes (completely accurate and completely inaccurate) can produce use-
ful or useless forecasts. The usefulness of a forecast is not something that lends

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itself readily to quantification along any specific dimension (such as accuracy). It

involves complex relationships between many things, including the type of infor-
mation being forecast, our confidence in the accuracy of the forecast, the magnitude
of our dissatisfaction with the forecast, and the versatility of ways that we can adapt
to or modify the forecast. In other words, the usefulness of a forecast is an applica-
tion sensitive construct. Each forecasting situation must be evaluated individually
regarding its usefulness. One of the first rules of doing research is to consider how
the results will be used. It is important to consider who the readers of the final re-
port will be during the initial planning stages of a project. It is wasteful to expend
resources on research that has little or no use. The same rule applies to forecasting.
We must strive to develop forecasts that are of maximum usefulness to planners.
This means that each situation must be evaluated individually as to the methodol-
ogy and type of forecasts that are most appropriate to the particular application.

7.14. Do Forecasts Create the Future

A paradox exists in preparing a forecast. If a forecast results in an adaptive change,
then the accuracy of the forecast might be modified by that change. Suppose the
forecast is that our business will experience a ten percent drop in sales next month.
We adapt by increasing our promotion effort to compensate for the predicted loss.
This action, in turn, could affect our sales, thus changing the accuracy of the origi-
nal forecast. Many futurists (de Jouvenel, Dublin, Pohl, and others) have expressed
the idea that the way we contemplate the future is an expression of our desire to
create that future. Physicist Dennis Gabor, discoverer of holography, claimed that
the future is invented, not predicted. The implication is that the future is an expres-
sion of our present thoughts. The idea that we create our own reality is not a new
concept. It is easy to imagine how thoughts might translate into actions that affect
the future.
Biblical records speak of faith as the force that could move mountains. Recent re-
search in quantum mechanics suggests that this may be more than just a philosoph-
ical concept. At a quantum level, matter itself might simply be a manifestation of
thought. Electrons and other subatomic particles seem to exist only when physicists
are looking for them, otherwise, they exist only as energy. An incredible discovery
was made at the University of Paris in 1982. A team of researchers lead by Alain
Aspect found that under certain conditions, electrons could instantaneously com-

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municate with each other across long distances. The results of this experiment have
been confirmed by many other researchers, although the implications are exceed-
ingly hard to accept. Three explanations are possible:
1. information can be transferred at speeds exceeding the speed of light,

2. the passage of time is an illusion,

3. the distance between the electrons is an illusion.

All three explanations rock our perception of reality. David Bohm has explained
Aspect’s experiment by hypothesizing a holographic universe in which reality is
essentially a projection of some deeper dimension that we are not able to compre-
hend. Instantaneous communication is possible because the distance between the
particles is an illusion. Neurophysiologist Karl Pribram has also theorized about
the holographic nature of reality. His theory is based on a study of the way that
the brain recalls memory patterns, but the implications are the same. Reality is a
phantasm. If reality is an illusion, then the future is also an illusion. The phenom-
ena of being able to see the future is known as precognition. Most people believe
that (to some degree) they can predict the future. Fortune-tellers, however, believe
they can view the future. There is a major difference. We predict the future based
on knowledge, intuition and logic. Precognitive persons claim to "see" the future.
Knowledge and logic are not involved.
Throughout history, there have been many reports of gifted psychics with precog-
nitive powers. Through some unknown mechanism, these people are able predict
things that will happen in the future. If we admit that even a single person in history
has possessed this capability, then we must accept the fact that our concept of real-
ity needs dramatic alteration. Time itself may not exist as we currently perceive it.
Forecasting may be a method of creating illusions. Forecasting can, and often does,
contribute to the creation of the future, but it is clear that other factors are also op-
erating. A holographic theory would stress the interconnectedness of all elements
in the system. At some level, everything contributes to the creation of the future.
The degree to which a forecast can shape the future (or our perception of the future)
has yet to be determined experimentally and experientially. Sometimes forecasts
become part of a creative process, and sometimes they don’t. When two people
make mutually exclusive forecasts, both of them cannot be true. At least one fore-
cast is wrong. Does one person’s forecast create the future, and the other does not?

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The mechanisms involved in the construction of the future are not well understood
on an individual or social level. Modis believes that the media provides the mecha-
nism by which social forecasts take on a creative context. In this theory, extensive
media coverage acts as a resonating cavity for public opinion, and creates a "cul-
tural epidemic" that modifies social behavior. Dublin points out that the "future has
become so integral to the fabric of modern consciousness that few people feel com-
pelled to question it...". Because of the power of a prediction to affect the future, he
goes on to state that prophesy is usually a self-interest quest for power.

7.15. The Ethics of Forecasting

Are predictions of the future a form of propaganda, designed to evoke a particular
set of behaviors? Dublin states that the desire for control is implicit in all forecasts.
Decisions made today are based on forecasts, which may or may not come to pass.
The forecast is a way to control today’s decisions. Dublin is correct. The purpose of
forecasting is to control the present. In fact, one of the assumptions of forecasting
is that the forecasts will be used by policy-makers to make decisions. It is therefore
important to discuss the ethics of forecasting. Since forecasts can and often do
take on a creative role, what right do we have to make forecasts that involve other
peoples futures? Nearly everyone would agree that we have the right to create our
own future. Goal setting is a form of personal forecasting. It is one way to organize
and invent our personal future. Each person has the right to create their own future.
On the other hand, a social forecast might alter the course of an entire society.
Such power can only be accompanied by equivalent responsibility. There are no
clear rules involving the ethics of forecasting. In Future Shock, Toffler discussed
the importance of value impact forecasting, the idea that social forecasting must
involve physical, cultural and societal values. It is doubtful that forecasters can
leave their own personal biases out of the forecasting process.
Even the most mathematically rigorous techniques involve judgmental inputs that
can dramatically alter the forecast. Many futurists have pointed out our obligation
to create socially desirable futures. Unfortunately, a socially desirable future for
one person might be another person’s nightmare. For example, modern ecological
theory says that we should think of our planet in terms of sustainable futures. The
finite supply of natural resources forces us to reconsider the desirability of unlim-
ited growth. An optimistic forecast is that we achieve and maintain an ecologically

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balanced future. That same forecast, the idea of zero growth, is a catastrophic
nightmare for the corporate and financial institutions of the free world. Our Keyne-
sian system of profit depends on continual growth for the well-being of individuals,
groups, and institutions. Desirable futures is a subjective concept. It can only be un-
derstood relative to other information. The ethics of forecasting certainly involves
the obligation to create desirable futures for the person(s) that might be affected by
the forecast. If a goal of forecasting is to create desirable futures, then the fore-
caster must ask the ethical question of "desirable for whom?". To embrace the idea
of liberty is to recognize that each person has the right to create their own future.
Forecasters can promote libertarian beliefs by empowering people that might be af-
fected by the forecast. Involving these people in the forecasting process, gives them
the power to become co-creators in their futures.

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Review questions

Example . Outline various assumptions about forecasting

Solution: 1. There is no way to state what the future will be with complete certainty.
Regardless of the methods that we use there will always be an element of uncer-
tainty until the forecast horizon has come to pass. 2. There will always be blind
spots in forecasts. We cannot, for example, forecast completely new technologies
for which there are no existing paradigms. 3. Providing forecasts to policy-makers
will help them formulate social policy. The new social policy, in turn, will affect
the future, thus changing the accuracy of the forecast. 

Assignments

E XERCISE 25.  Explain genius forecasting method

E XERCISE 26.  Describe Consensus methods.
E XERCISE 27.  Explain the use of Simulation methods in forecasting e
E XERCISE 28.  Describe Cross-impact matrix method of forecasting
E XERCISE 29.  What is Scenario forecasting -
E XERCISE 30.  Explain the use of Decision trees in forecasting
E XERCISE 31.  Explain the Combining Forecasts
E XERCISE 32.  Explain how to Define a useful forecasting .

References
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

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5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 8
Financial statement analysis

Chapter objectives:
By the end of this chapter, the learners should;

1. Give an overview on Financial Statement analysis

2. Describe Income Statement

3. Explain Balance Sheet Statement

4. Describe the Cash Flow Statement

5. Explain How Financial Statements Tie Together

8.1. Financial Statement Overview

What are Financial Statements, why are they important, and why do financial ana-
lysts use them? Financial statements are formal records of the financial activities of
a business. For a corporation with publicly traded securities, there are three primary
financial statements that must be reported quarterly (4 times per year):

• Income Statement: Reports a snapshot of a company’s business performance

over a period of time. This statement indicates how much revenue (sales) is
generated by a business, and also accounts for direct product costs, general
expenses, Interest on Debt, Taxes, and other expense items. The purpose of
this statement is to show the company’s level of profitability, which is equal
to a company’s Revenue net of its expenses.

• Balance Sheet Statement: Reports a snapshot of a company’s outstanding

balances in various accounts at a specific point in time. The purpose of this
statement is to demonstrate a business’s financial heath at any given time,
by enumerating it assets as well as the claims against them (liabilities and
equity).

• Statement of Cash Flows: Reports on all of the company’s activities that af-
fect its cash position over a period of time. These activities are broken down

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into three primary categories: Operating, Investing, and Financing. The pur-
pose of this statement is to give a detailed reconciliation of how the com-
pany’s Cash is being used (and how much Cash is being generated). These
financial statements all aim to provide an overview of a business’s perfor-
mance and position, either over time, or at a given point in time. They are
highly interrelated and must tie together perfectly. For example, in the State-
ment of Cash Flows, a detailed account of the change in a company’s Cash
balances is given.
This change must exactly match the change in Cash balances listed on the beginning
and ending Balance Sheets for the Company. Similarly, many items in the Income
Statement directly reflect changes in Balance Sheet accounts over time, and must
match the changes there. More discussion of this concept can be found at the end
of this chapter. Financial statements are issued by companies and reviewed by the
Securities & Exchange Commission (SEC). The SEC requires publicly-traded com-
panies to file quarterly and annual results of operations. These are the summarized
financial results of the company, and they are the backbone of financial modeling,
company profiles and pitch book presentations. Without financial statements, most
valuation work would be difficult or nearly impossible.

8.2. Locating Financial Statements

All publicly-traded companies are required by the SEC to file quarterly and an-
nual reports. Private companies are not required to file financial reports, although
some may have to if they have publicly traded debt. Company filings are found on
the SEC’s EDGAR website. Primary Information Found in Financial Statements
(Forms 10-K & 10-Q)
• Management Discussion & Analysis

• Income Statement

• Balance Sheet Statement

• Statement of Cash Flows

• Notes and Exhibits to Financial Statements Annual reports are filed as 10-Ks
with the SEC and must be filed within 60 days of the company’s fiscal year
end.

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10-Ks are much more detailed than quarterly reports (10-Qs, discussed below), and
contain information such as the company’s Business Overview, Risk Factors, Fi-
nancial Data (Income Statement, Balance Sheet, and Statement of Cash Flows),
Management Discussion & Analysis, and other important disclosures. Quarterly
reports are filed as 10-Qs with the SEC and have to be filed within 40 days of the
end of the fiscal quarter. 10-Qs are less detailed than annual form 10-Ks but do pro-
vide helpful detail around the quarterly Financial Data (Income Statement, Balance
Sheet, and Cash Flow), Management Discussion & Analysis, and other Company
disclosures.

8.3. Income Statement

The Income Statement shows how much Revenue (i.e., sales) is being generated by
a business, and also accounts for Costs, Expenses, Interest, Taxes and other items.
The main purpose of this statement is to show the company’s level of profitability.
The Income Statement represents items over a period of time, usually over a quar-
ter (3 months) or a year. This statement is also referred to as the Profit and Loss
Statement (P&L).
Income Statement: Key Line Items
Revenue represents the sales brought in from selling a product or performing a
service.
Cost of Goods Sold (COGS) represents direct costs of producing goods and services
that the business has sold, such as material costs and direct labor.
Selling, General, & Administrative Expense (SG&A) represents expenses associ-
ated with selling products and managing the business. This will include salaries,
shipping, insurance, utilities, rent, compensation for executives, etc.
Depreciation & Amortization (D&A) represents the expenses associated with fixed
assets and intangible assets that have been capitalized on the Balance Sheet. D&A
that is directly related to production will generally be included in COGS and will
be separated out on the Statement of Cash Flows (more on this later).
Net Interest Expense represents the total Interest paid on Debt liabilities, net of the
total Interest received on Cash assets.
Tax Expense represents the amount of taxes paid.
Net Income represents the company’s profit, which is Revenue minus all of the
aforementioned costs and expenses. Calculating Earnings Per Share (EPS)

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EPS equals Net Income (after dividends on preferred stock) divided by the com-
pany’s Weighted Average Shares Outstanding. Shares Outstanding will typically
be found either on the Income Statement, below Net Income, or on the first page
of the most recent 10-Q or 10-K. It can also be calculated as the average of the
number of common shares outstanding at the beginning of the period and end of the
period (from the company’s Balance Sheet). EPS is an extremely important metric
of a company’s value: it represents the profit generated by the company for each
shareholder. It will be used extensively when working through valuation techniques
such as Comparable Company Analysis and Precedent Transaction Analysis. Here
is an example of an Income Statement, showing all of the discussed line items, from
Amazon at the end of 2010 (Ticker AMZN):

8.4. Balance Sheet

The Balance Sheet provides a snapshot of a company’s financial position at the end
of a period (either quarterly or annually). The balance sheet lists company Assets,
Liabilities, and Shareholders’ Equity as of a specific point in time. An important
rule is that the Balance Sheet for a company must balance.
In other words: Balance Sheet Golden Rule: Assets = Liabilities + Shareholders’
Equity This may seem like an obvious statement, but in producing financial models
it is easy to make an error wherein the balance sheet does not properly balance,
which will lead to serious problems with financial projection. Always make sure
your balance sheet balances! As demonstrated above, the difference between Assets
and Liabilities is Shareholders’ Equity. In other words, the value of a company’s

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equity is equal to the value of its assets net of the outstanding obligations it has
to other entities. This is, from an accounting (or “book”) perspective, what the
value of a company’s shareholders positions “should be.” As we have seen, there
are many reasons why a company’s equity will trade at a different valuation in the
market than that derived from the Balance Sheet (usually, and hopefully, at a higher
valuation than Book Value).
From the perspective of a financial analyst, the most important Balance Sheet line
items fall into the following categories:
Cash (Asset): Money owned by the company. For accounting purposes, Cash gen-
erally includes currency and coins on hand, checking account balances, and unde-
posited customer checks.
Current Assets: Assets whose value is expected to translate into Cash in the near
future (generally within one year). Cash is a Current Asset. Most Current Assets
besides Cash are classified as “Operating Assets,” or Assets generated by the com-
pany as part of the functioning of its business operations.
Other or Long-term Assets: Assets whose value will not translate into Cash in the
near future (outside of one year). Most Long-term Assets are classified as “Oper-
ating Assets,” or Assets required by the company as part of the functioning of its
business operations.
Debt (Liability): An obligation (almost always interest-bearing) that represents bor-
rowed money that the company must repay. Debt is usually part of Long-Term Li-
abilities (see below), although any portion of Debt which must be repaid within the
next year will be classified as a Current Liability.
Current Liabilities: Liabilities that a company must meet (via payment) in the near
future (generally within one year). Most Current Liabilities (other than Debt) are
classified as “Operating Liabilities,” or Liabilities generated by the company as part
of the functioning of its business operations.
Other or Long-term Liabilities: Liabilities that do not need to be met (via payment)
in the near future (outside of one year). Most Long-term Liabilities are classified as
Debt, although some qualify as “Operating Liabilities,” or Liabilities generated by
the company as part of the functioning of its business operations.
Shareholders’ Equity: The difference between Assets and Liabilities. This repre-
sents the value of the company’s assets after all outstanding obligations have been
paid off. This value accrues directly to the company’s owners, or Shareholders.

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Note that the difference between Current Assets and Current Liabilities is referred
to as “Working Capital” or “Net Working Capital,” while the difference between
Operating Assets and Operating Liabilities is referred to as “Operating Working
Capital.” Working Capital is an important consideration in financial modeling—this
is particularly true of Operating Working Capital. This concept will be discussed in
further detail later in this training course. Here is an example of a Balance Sheet,
showing all of the discussed line items, from Amazon at the end of 2010 (Ticker
AMZN):

8.5. Statement of Cash Flows

The Statement of Cash Flows, or Cash Flow Statement (CFS), provides an account-
ing of the Cash being generated by a business, and the uses of that Cash, over a
period of time. The CFS shows how Net Income (from the Income Statement) and
changes in Balance Sheet items affect a company’s Cash balance. Generally speak-
ing the CFS will provide a clear view of the short-term viability of a business and
its ability to pay its debts. If the business is not generating enough Cash from its
operations to service its obligations, it should be evident from its CFS. The bottom
line, therefore, is that the CFS reflects a company’s liquidity, solvency, and ongoing
viability.
Three Parts of a Cash Flow Statement All Cash flows can be broken down into one
of the important categories:

• Operating Activities: The Cash generated/used by a company’s business op-

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erations. This includes earnings delivered by the company as well as pay-

ments collected from its customers. In its simplest form, Cash Flow from
Operating Activities (CFO) will equal Net Income + Depreciation & Amor-
tization – changes in Operating Working Capital.

• Investing Activities: The cash generated/used by a company’s investment in

assets. Cash Flow from Investing Activities (CFI) includes the purchases of
Fixed (long-term) Assets and maintenance of those Assets (Capital Expendi-
tures), payments made for M&A activities (usually acquisitions of other com-
panies), or Cash generated by Marketable Securities or other non-operating
uses of Cash.

• Financing Activities: The Cash generated/used by a company’s financing of

its operations. Cash Flow from Financing Activities (CFF) includes the Cash
inflows from shareholders and lenders as well as the outflows of dividends
or sales of stock. Items found in this line item will include: Dividends Paid,
Cash raised via the sale of Common Stock, Cash proceeds from Borrowings
(Debt), and repayment of Debt obligations.

The SCF is greatly affected by the change in Balance Sheet line items. When Assets
on the Balance Sheet fall, Cash typically rises. For example: if “Accounts Receiv-
able” (an Operating Current Asset on the Balance Sheet) falls, this is because a
customer had paid its bill and hence Cash increases. Simultaneously, the Accounts
Receivable line item decreases by the same amount. By contrast, when Liabilities
and Equity rise, typically so does Cash. For example, if a company issues Debt (a
Liability on the Balance Sheet), Cash will rise by the same amount as the value of
the loan taken out. Similarly, if a Company repurchases common shares outstand-
ing, Cash will decrease by the same amount as the value of the Equity being retired
in the transaction. In summary, Assets are uses of Cash while Liabilities and Equity
are sources of Cash. This important concept will come into play directly in building
financial models that help determine a company’s value. Here is an example of a
Statement of Cash Flows, showing all of the discussed line items, from Amazon at
the end of 2010 (Ticker AMZN):

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8.6. How Financial Statements

Tie Together Now that you are familiar with the three main Financial Statements,
we can ascertain how they all tie together. In short, the Financial Statements are
interconnected in many places. In particular, practically every line item on the
SCF is connected to one of the two other statements. Connected Line Items on the
Financial Statements While this list is not exhaustive, it covers most of the basic
interconnections across a company’s Financial Statements:
Income Statement: o Depreciation: Fixed Long-term Assets (Balance Sheet) are
depreciated over a period of time; this is expensed on the Income Statement. o
Amortization: Some other Long-term Assets (Balance Sheet) are amortized (sim-
ilar to being depreciated) over a period of time; this is expensed on the Income
Statement.
Balance Sheet: o Cash: Ending Cash on the Cash Flow Statement flows into Cash
within Current Assets on the Balance Sheet. Shareholder’s Equity: Net Income
(Earnings from the Income Statement) after Dividends Paid flow into Retained
Earnings in Shareholder’s Equity.
Cash Flow Statement: o Beginning Cash: This is equal to the previous period’s
ending Cash balance on the Company’s Balance Sheet. Net Income (CFO): Equals
Net Income found on the Income Statement. Depreciation (CFO): Depreciation is a
(generally unlisted) component of COGS and other expense items found on the In-
come Statement; it is added back because it is a non-Cash expense. In other words,

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the company did not actually spend the money being represented by Depreciation
during the period—that Cash expense was recorded as a Capital Expenditure in a
prior period. That value is allocated over a long time horizon, and Depreciation
in any given year represents that year’s ascribed value of the Assets being used. o
Amortization (CFO): Amortization is a (generally unlisted) component of COGS
and other expense items found on the Income Statement; like Depreciation, it is
added back because it is a non-Cash expense.
The Cash was generally spent in a prior period, usually as part of an acquisition.
Capital Expenditures (CFI): This is money spent on Long-term (Fixed) Assets on
the Balance Sheet. The change in these Assets should equal Capital Expenditures
minus the year’s Depreciation on these Assets. o Repayments of and Proceeds
from Long-term Debt (CFF): This is money raised from, or used to repay, Long-
term Debt obligations (Liabilities) on the Balance Sheet. (Note that mandatory
Debt repayments coming due in the near future are moved from Long-Term Lia-
bilities to Current Liabilities on the Balance Sheet as their repayment dates draw
near.) Ending Cash: This is equal to the current period’s ending Cash balance on
the Company’s Balance Sheet. How Does Depreciation Affect the Financial State-
ments? Depreciation is an especially tricky line item because it affects all three
Financial Statements, but is often not broken out directly in the Income Statement
even though it is an annual expense. Here is a summary of how Depreciation affects
all three Statements (a similar description also applies to Amortization):
Income Statement: Depreciation is an expense on the Income Statement (often
buried inside displayed line items such as COGS). Increasing Depreciation will
increase expenses, thereby decreasing Net Income.
Cash Flow Statement: Because Depreciation is incorporated into Net Income, it
must be added back in the SCF, because it is a non-cash expense and therefore does
not decrease Cash when it is expensed.
Balance Sheet: Net Fixed Assets (generally Plant, Property, and Equipment) is
reduced by the amount of the Depreciation. This reduces Fixed Assets. It also re-
duces Net Income and therefore Retained Earnings (Shareholders’ Equity) as well.
As discussed previously, Depreciation is a non-Cash expense. Therefore, increases
or decreases to Depreciation will not impact Cash directly.

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Review questions

Example . Give an overview on Financial Statement analysis

Solution: Financial statements are formal records of the financial activities of a
business. For a corporation with publicly traded securities, there are three primary
financial statements that must be reported quarterly (4 times per year): • Income
Statement: Reports a snapshot of a company’s business performance over a pe-
riod of time. This statement indicates how much revenue (sales) is generated by a
business, and also accounts for direct product costs, general expenses, Interest on
Debt, Taxes, and other expense items. The purpose of this statement is to show
the company’s level of profitability, which is equal to a company’s Revenue net of
its expenses. • Balance Sheet Statement: Reports a snapshot of a company’s out-
standing balances in various accounts at a specific point in time. The purpose of
this statement is to demonstrate a business’s financial heath at any given time, by
enumerating it assets as well as the claims against them (liabilities and equity). •
Statement of Cash Flows: Reports on all of the company’s activities that affect its
cash position over a period of time. These activities are broken down into three
primary categories: Operating, Investing, and Financing. The purpose of this state-
ment is to give a detailed reconciliation of how the company’s Cash is being used
(and how much Cash is being generated). 

Assignments

E XERCISE 33.  Describe Income Statement

E XERCISE 34.  Explain Balance Sheet Statement
E XERCISE 35.  Describe the Cash Flow Statement
E XERCISE 36.  Explain How Financial Statements Tie Together

References
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

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3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 9
Three statement financial modeling

Chapter objectives:
By the end of this chapter, the learners should;

1. Describe the Three-Statement Financial Modeling

2. Explain the Model Design & Layouts

3. Outline the Six Steps to Simple Financial Modeling

9.1. Three-Statement Financial Modeling

Overview Investment banking analysts and associates are expected to be able to
build three-statement operating models as part of their day-to-day responsibilities.
In fact, in most cases, analysts and associates will spend as much time performing
this task as any other. Therefore, it is extremely important that any investment
banking professional or candidate be well versed in how to build a three-statement
operating model to completion.

9.2. Building from the Basic Model

In the previous chapter, Financial Modeling, we discussed the basics behind mod-
eling the future financial performance for the company you, as an analyst, are eval-
uating. However, that chapter only covers the beginning portion: how to model
assumptions and build calculations for the Income Statement. While it is important
to understand all of the considerations in building that prediction as accurately as
possible, it is also important to note that building a complete financial model for a
company does not end there.
The projected Balance Sheet and Statement of Cash Flows must also be built, and
the three statements must be integrated correctly. Now that we have an under-
standing of how to model Revenue and Expenses, this chapter will build on that
understanding. We will walk through each key step in building and forecasting a
three-statement operating model for a company. The model will begin by using his-
torical data and ratios, and forecasted ratios and projections—topics that we have
already begun to discuss previously—and will tie in the building of the rest of the

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complete operating model. A Quick Review Building from the previous chapter,
we saw that the basic financial model revolved around the Income Statement, and
the Model Drivers (which we can call Assumptions) that are used to project future
figures on the Income Statement. We start off with historical financials (typically,
around 3 years worth), calculate key ratios based on those financials, and use them
as part of a process to determine which drivers (assumptions) to use in projecting
those financials going forward:

In short, historical financial raw data, and ratios calculated from them, are used
as an integral part of the process to derive forward-looking assumptions that drive
financial data projections. We should start by building a model designed to reflect
that. Also, as a reminder from the Discounted Cash Flow chapter (as well as the
previous chapter), use the mnemonic “C.V.S.” to avoid common errors and help
ensure that the outputs of your model will be reasonable:

• Confirm historical financials for accuracy.

• Validate key assumptions for projections.

• Sensitize variables driving projections to build a valuation range.

9.3. Model Design & Layouts

Three-statement financial models can be built in a variety of different layouts and
designs. For example, the Income Statement, Balance Sheet, and Statement of Cash
Flows can be combined on one excel tab, or each of the three financial statements
can occur on separate tabs (i.e., worksheets within a single workbook). The As-
sumptions can be listed on a separate worksheet, or they can be listed below or be-
side the Income Statement. Conceptual vs. Physical Layout Importantly, however,
the analyst must keep in mind the conceptual design of the model. Assumptions are
derived from historical financial data as well as logic and external analysis; these

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assumptions drive the values projected in the Financial Statements (primarily the
Income Statement, but as we shall see, the other statements as well). Thus they can
be physically on the same worksheet as the statements, but they are always logically
separate:

9.3.1. Laying out Assumptions

Likewise, the Assumptions themselves can be built in a variety of layouts. In-
come Statement drivers and assumptions can be built on a separate tab or as part of
the same tab as the Income Statement. If combined on the Income Statement tab,
drivers and assumptions can be integrated into the Income Statement or directly
underneath the statement line items:

9.3.2. Numeric Display

The presentation of the financial statements can be in either a positive-only, or pos-
itive/negative, perspective. In other words, numbers that subtract from others (such
as Expense items, which subtract from Revenue on the path to calculating Net In-
come) can be displayed either as positive numbers that are subtracted, or negative
numbers that are added. Mathematically, they are equivalent.

9.4. Six Steps to Simple Financial Modeling

. In Financial Modeling, we outlined the key steps in building a complete financial
model, and began discussing those steps. Here, we will complete discussing those

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steps:
• Input historical Financial Statements (Income Statement, Balance Sheet).

• Calculate key ratios on historical financials (e.g., Gross Margin, Net Income
Margin, Accounts Receivable/Payable Days, etc.).

• Make forward-looking assumptions for projecting the Income Statement and

Balance Sheet based on these historical ratios and any additional considera-
tions.

• Build a Statement of Cash Flows (tying together Net Income from the Income
Statement and Cash from the Balance Sheet).

• Tie Ending Cash Balance from the Statement of Cash Flows into the Balance
Sheet, and Balance the Balance Sheet.

• Calculate Interest Expense and tie this into the Income Statement. For more
detail on Steps 1-3, please revisit that chapter on the Introduction to Financial
Modeling. Step 1: Input Historical Financial Data The first step in building
a financial operating model is to input the historical Financial Statements
(Income Statement and Balance Sheet).

Here are some notes to make this process easier:

Color code your cells so that formulas are a different color from directly input
data. Standard practice is to make the text color blue for input data and black for
formulas.
Put any comments about the line items to the side of each item; standard practice is
to make comments italic.
Use the “Alt + =” shortcut to subtotal the income statement sections. For example,
once you input the Operating Expenses items, type “Alt + =” in the cell directly
underneath to calculate the subtotal for 2003 of $23,500.

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Double-check that the input data correctly matches the source, and that you end up
with the same net income each year as the historical input source. You can code
this as a “Balance Check” formula directly in the spreadsheet.
Follow the same steps for the Balance Sheet by making sure that the input data
and formulas match the source. Also, run a “balance check” to make sure the data
your input Balance Sheets actually balance. For the Balance Sheet, remember the
all-important Accounting Identity: Total Assets = Total Liabilities + Shareholders’
Equity

Step 2: Calculate Ratios Once you’ve finished inputting the historical data on the
Income Statement and Balance Sheet, you can calculate key historical financial
ratios. Make sure to use the relevant ratio when calculating each assumption, which
will be used to drive future projections. Here is a list of ratios typically required,
at minimum, to build out Income Statement financial projections: Year-over-Year
Growth Rates: Income Statement

• Revenue: (Year 2 Revenue ÷ Year 1 Revenue) – 1

• Gross Profit: (Year 2 Gross Profit ÷ Year 1 Gross Profit) – 1

• EBIT: (Year 2 EBIT ÷ Year 1 EBIT) – 1

• Net Income: (Year 2 Net Income ÷ Year 1 Net Income) – 1 Margin and Ratio
Analysis: Income Statement

• Cost of Goods Sold (COGS): (Year 1 COGS ÷ Year 1 Revenue)

• Gross Margin: (Year 1 Gross Profit ÷ Year 1 Revenue)

• Selling, General & Administrative (SG&A): (Year 1 SG&A ÷ Year 1 Rev-

enue)

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• Depreciation & Amortization (D&A): (Year 1 D&A ÷ Year 1 Revenue)

• Effective Tax Rate: (Tax Expense ÷ Earnings Before Tax, a.k.a. EBT) Com-
pute these for all years in the historical financial data range, noting that
growth rate calculations can only begin in Year 2, not Year 1:

Ratio Analysis: Balance Sheet Next, we must compute ratios on key Balance Sheet
line items for each year. Many Balance Sheet ratios are expressed either in terms of
units of time (Days), or frequency per unit of time (Turns). Here, we have expressed
these ratios as units of time (Days):

• Accounts Receivable Days: 365 days × (Year 1 Accounts Receivable ÷ Year

1 Revenue)

• Inventory Days: 365 days × (Year 1 Inventory ÷ Year 1 COGS)

• Prepaid Expenses: (Year 1 Prepaid Expenses ÷ Year 1 Revenue)

• Accounts Payable Days: 365 days × (Year 1 Accounts Payable ÷ Year 1

COGS)

• Accrued Expenses: (Year 1 Accrued Expenses ÷ Year 1 Revenue)

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Review questions

Example . Outline the Six Steps to Simple Financial Modeling

Solution: 1. Input historical Financial Statements (Income Statement, Balance
Sheet). 2. Calculate key ratios on historical financials (e.g., Gross Margin, Net In-
come Margin, Accounts Receivable/Payable Days, etc.). 3. Make forward-looking
assumptions for projecting the Income Statement and Balance Sheet based on these
historical ratios and any additional considerations. 4. Build a Statement of Cash
Flows (tying together Net Income from the Income Statement and Cash from the
Balance Sheet). 5. Tie Ending Cash Balance from the Statement of Cash Flows into
the Balance Sheet, and Balance the Balance Sheet. 6. Calculate Interest Expense
and tie this into the Income Statement 

Assignments

E XERCISE 37.  Discuss the financial statements modeling steps

Example. 2. Describe the Three-Statement Financial Modeling

Exercise. 3. Explain the Model Design & Layouts

Exercise. 4. Explain how to link the balance sheet, income statement and profit
and loss

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References
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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LESSON 10
Forecasting cash flows

Chapter objectives:
By the end of this chapter, the learners should;

1. Explain the meaning of cash flow forecast

2. Discuss the use of cash flow forecast

3. Define free cash flows

4. Explain how to calculate free cashflows

10.1. Cash Flow Forecast

What is a cashflow forecast? A cash flow forecast indicates the likely future move-
ment of cash in and out of the business. It’s an estimate of the amount of money
you expect to flow in (receipts) and out (payments) of your business and includes all
your projected income and expenses. A forecast usually covers the next 12 months,
however it can also cover a short-term period such as a week or month. The concept
of cash flow is quite easy: Net Cash Position = Receipts - Payments

10.2. What can you use it for?

Cash flow forecasts can help predict upcoming cash surpluses or shortages and
help you to make the right decisions. It can help in tax preparation, planning new
equipment purchases or identifying if you need to secure a small business loan. By
including every case scenario in your cash flow forecast you will see how your busi-
ness will cope if your business hits tough times or does better than expected. Prior
warning allows you to work out solutions to anticipated temporary cash shortfalls
or arrange short-term investments for temporary cash flow surpluses.
Free cash flow is the cash that flows through a company in the course of a quarter
or a year once all cash expenses have been taken out. Free cash flow represents
the actual amount of cash that a company has left from its operations that could
be used to pursue opportunities that enhance shareholder value - for example, de-
veloping new products, paying dividends to investors or doing share buybacks. (

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10.3 Calculating Free Cash Flow We work out free cash flow by looking at what’s
left over from revenues after deducting operating costs, taxes, net investment and
the working capital requirements . Depreciation and amortization are not included
since they are non-cash charges. (For more information, see Understanding The
Income Statement.)
In the previous chapter, we forecasted The Widget Company’s revenues over the
next five years. Here we show you how to project the other items in our calculation
over that period.
Future Operating Costs When doing business, a company incurs expenses - such
as salaries, cost of goods sold (CoGS), selling and general administrative expenses
(SGA), and research and development (R&D). These are the company’s operating
costs. If current operating costs are not explicitly stated on a company’s income
statement, you can calculate them by subtracting net operating profits - or earn-
ings before interest and taxation (EBIT) - from total revenues. A good place to
start when forecasting operating costs is to look at the company’s historic operating
cost margins. The operating margin is operating costs expressed as a proportion of
revenues.
For three years running, The Widget Company has generated an average operating
cost margin of 70%. In other words, for every $1 of revenue, the company incurs
$0.70 in operating costs. Management says that its cost cutting program will push
those margins down to 60% of revenues over the next five years.
However, as analysts and investors, we should be concerned that competing widget
factories might be built, thus squeezing The Widget Company’s profitability. There-
fore, as we did when forecasting revenues, we will err on the side of conservatism
and assume that operating costs will show an increase as a percentage of revenues
as the company is forced to lower its prices to stay competitive over time. Let’s say
operating costs will hold at 65% of revenues over the first three projected years, but
will increase to 70% in Year 4 and Year 5 .
Taxation Many companies do not actually pay the official corporate tax rate on their
operating profits. For instance, companies with high capital expenditures receive
tax breaks. So, it makes sense to calculate the tax rate by taking the average annual
income tax paid over the past few years divided by profits before income tax. This
information is available on the company’s historic income statements.
Let’s assume that for each of the past three years, The Widget Company paid 30%

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income tax. We will project that the company will continue to pay that 30% tax rate
over the next five years.
Net Investment To underpin growth, companies need to keep investing in capital
items such as property, plants and equipment. You can calculate net investment by
taking capital expenditure, disclosed in a company’s statement of cash flows, and
subtracting non-cash depreciation charges, found on the income statement.
Let’s say The Widget Company spent $10 million last year on capital expenditures,
with depreciation of $3 million, giving net investment of $7 million, or 7% of total
revenues . But in the two prior years, the company’s net investment was much
higher: 10% of revenues.
If competition does intensify in the widget industry, The Widget Company will
almost certainly have to boost capital investment to stay ahead. So, we will assume
that net investment will steadily return to its normal level of 10% of sales over the
next five years, as seen in Figure 2: 7.6% of sales in Year 1, 8.2% in Year 2, 8.8%
in Year 3, 9.4% in Year 4 and 10% in Year 5.

10.3. Change in Working

Capital Working capital refers to the cash a business requires for day-to-day opera-
tions, or, more specifically, short-term financing to maintain current assets such as
inventory. The faster a business expands, the more cash it will need for working
capital and investment.
Working capital is calculated as current assets minus current liabilities. These items
are found on the company’s balance sheet, published in its quarterly and annual fi-
nancial statements. At year end, The Widget Company’s balance sheet showed cur-
rent assets of $25 million and current liabilities of $16 million, giving net working
capital of $9 million.
Net change in working capital is the difference in working capital levels from one

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year to the next. When more cash is tied up in working capital than the previous
year, the increase in working capital is treated as a cost against free cash flow.
Working capital typically increases as sales revenues grow, so a bigger investment
of inventory and receivables will be needed to match The Widget Company’s rev-
enue growth. In our forecast, we will assume that changes in working capital are
proportional to revenue growth. In other words, if revenues grow by 20% in the
first year, working capital requirements will grow by 20% in the first year, from $9
million to $10.8 million . Meanwhile, we will keep a close watch for any signs of a
changing trend.
As you can see in Figure 3, we’ve determined our estimated free cash flow for our
forecast period. Now we are one step closer to finding a value for the company. In
the next section of the tutorial, we will estimate the value at which we will discount
the free cash flows.

Review questions

Example . Discuss the use of cash flow forecast

Solution: A cash flow forecast indicates the likely future movement of cash in and
out of the business. It’s an estimate of the amount of money you expect to flow
in (receipts) and out (payments) of your business and includes all your projected
income and expenses. A forecast usually covers the next 12 months, however it can
also cover a short-term period such as a week or month. The concept of cash flow
is quite easy: 

Assignments

E XERCISE 38.  Explain the meaning of cash flow forecast

Example. 2. Define free cash flows

Exercise. 3. Explain how to calculate free cash flows

Exercise. 4. For interim financial reporting, which of the following may be accrued
or deferred to provide an appropriate cost for each period? A. Interest, but not Rent
B. Both Interest and Rent C. Rent, but not Interest D. Neither Rent nor Interest

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Reference
1. Clyde P. Stickney and Paul R. Brown (2010), “Financial Reporting and State-
ment Analysis: A Strategic Perspective”,7th edition, , The Dryden Press (Nel-
son).

2. White, G. I., Ashwinpaul, C. S and Fried, D. (1994), “The Analysis and Use
of Financial tatements, , John Wiley & Sons, Inc.

3. Kenneth S. H. and Livnat, J. (1996), “Cash Flow and Security Analysis”, 2nd
edition,

4. Foster, G (2000), “Financial Statement Analysis”, 5th edition, Prentice-Hall.

5. Rosenbloom J S, Hallman (1992), “Employee Benefit Planning”, 2nd Edition,

Prentice Hall Publishing.

6. Mitchell, O.E and Hustead, E. C (2000). Pensions in the Public Sector, Rout-
ledge, London

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