1. A Global Reach with a Local Perspective www.decosimo.com FINANCIAL FORECASTS AND PROJECTIONS P A U L B E C K M A N N , C P A P A U L B E C K M A N N @ D E C O S I M O . C O M

2. 1960 1970 1980 1990 2000 2010 2020 2030 Changing Business Environment UNCERTAINTY Steady, Continuous Change: - Shareholders demand incremental improvements - Financial capital is dominant - Innovation is steady - Prices reflect costs - Customers are loyal - Investors and regulators ignore ethical standards Unpredictable, Discontinuous Change: - Shareholders demand "best-in-class" performance - Intellectual capital is dominant - Innovation is rapid - Globalization is driving prices down - Customers are fickle - Investors and regulators are demanding higher ethical standards 3. Business leaders are focused on understanding the impact of uncertainty and volatility, and theyre looking to their finance teams to help them understand the trade-offs around strategy. They (CFOs) must have a comprehensive understanding of what drives profitability, cash flow and shareholder value creation within the organization. Finance professionals need to become better synthesizers and communicators of information, offering insight on what is important to the executive and the decisions he or she is trying to make. Too often we dwell in the past . . . There needs to be a balance of backward-looking and forward-looking information. The ability to do upfront scenario-planning allows organizations to make more confident decisions when the environment changes, instead of being thrown into reactive mode. - David A. J. Axson 4. BOILING DOWN FORECASTING Purpose of Long-term forecast Speculative investment Capital budgeting Purpose of medium-term forecast Prioritize capital investment Develop product strategy Purpose of short-term forecast Pricing decisions Customer demand Supply chain requirements Marketing plans 5. THE RELATIONSHIP BETWEEN TIME AND DETAIL Good Poor Short Long Predictability Time Horizon Candidates for automated statisticalforecasting Only death and taxes Forecastfrequently and develop contingencies Candidates for scenario planning Selecting a forecast approach 6. PITFALLS WHY ARE FORECASTS FRUSTRATING? Not understanding the role of forecasting within the organization Planning vs. predicting Controlling vs. strategizing Descriptive vs. Insightful Too mush detail Forecasts should not include the same level of detail as financial reporting and budgeting Too time consuming because . . . Timeliness of information can be hard if there is a long accounting close process Too much detail can mean there is not enough time to create an estimate for each line item Information related to forecast is spread across too many disconnected excel spreadsheets 7. PITFALLS WHY ARE FORECASTS FRUSTRATING? If a forecast is subject to manipulation it will lose its value within an organization Forecasts can be frustrating to management if they only describe future revenues and expenses without also giving insight on volume, drivers and expenses such as customer development The past is not a good indicator of the future Using growth percentages instead of drivers is one of the most common mistakes that can detract from the insightfulness of a forecast. 8. FORECASTING - BEST PRACTICES Using volume and other comprehensive drivers throughout the organization facilities a better understanding of trends and influences. Forecasting drivers might include: Planned production New product introduction Sales force initiatives Sales to existing customer factoring in attrition Promotions and advertising Pricing relative to competition Availability of raw materials One of the most common mistakes in forecasting is using growth percentages rather than volumes for forecasting revenue. 9. BEST PRACTICES WITH GROWTH % 10. distance Sales sq feet to big city 233,456 1,693 13 101,018 678 6 134,673 1,189 11 343,272 2,610 1 207,540 1,601 6 324,184 2,568 12 216,465 1,718 5 313,707 2,329 14 294,574 2,109 7 145,680 1,268 3 144,126 1,279 12 156,741 1,330 11 145,550 1,017 4 203,809 1,779 13 278,819 2,648 8 89,875 837 7 164,773 1,584 14 224,913 1,511 1 220,639 1,672 3 55,797 463 13 R = 0.925 - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 - 500 1,000 1,500 2,000 2,500 3,000 Square Feet R = 0.0121 - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 - 2 4 6 8 10 12 14 16 Distance to big city 11. FORECASTING BEST PRACTICES ONE THING IS TRUE ABOUT FORECASTS THEY WILL BE WRONG Make the forecasting process a learning process. Unwind different revenue and expense drivers into as many predictable elements as possible. Forecast with confidence and gain insight into the likely behavior of unpredictable variables. Reduce level of time needed to create forecast allow for more analysis and what-if questions. Use scenario analysis to create a management playbook. Management needs tools to mitigate risk Management needs tools to take advantage of opportunities Communicate your thoughts to management After creating scenarios, schedule the various ranges for each significant driver Express ranges that reflect confidence levels less confidence means less reliance 12. SCENARIO ANALYSIS 13. FORECASTING BEST PRACTICES To make a forecast relevant certain elements need to be clearly defined: Purpose Still relevant? Subject Defining the subject helps define the drivers developed in the forecast Time horizon Give flexibility for forecasting outside normal decision making cycles Scenario Assumptions and descriptions of multiple alternative outcomes Frequency Tied to accounting calendar or triggered by events? Level of detail Match level of detail with value added Participation Accountability and follow up 14. FORECASTING BEST PRACTICES SALES IS THE MOST IMPORTANT ITEM TO FORECAST, AND ITS THE HARDEST Best practices for forecasting revenue: Ensure that the sales team take responsibility for and has a vested interest in its forecast Make forecasting a collaborative process with open discussion about assumptions and tactics Balance sales potential with delivery potential Its only revenue when billed and collected Leverage all value driver input Set near-term milestones to provide early notification of performance Tie incentives to results 15. FORECASTING ADDING VALUE USING FORECASTS CAN HELP MANAGEMENT AVOID UNHEALTHY CYCLES OF SURPRISE AND REACTION Give management the tools that they need to understand the impact of decisions on various levels: A good forecast should include relevant information about: Promotional plans Market share Competitive position Material supply External influences Customer acquisition and retention Pricing Personnel turnover What are the key value drivers in your organization and how can they be better tracked through forecasting? 16. FORECASTING ADDING VALUE Forecasting provides a learning process that allows management to gain insight into an organizations KPIs; their trends and relative performance The forecasting can provide insight into KPIs such as: Customer conversion Promotion response rates Inventory turns Sales margins Employee turnover expense Performance leagues for various segments or projects Comparison to prior year Free cash flows Return on employed capital Consider presenting information about key performance indicators (KPIs) as well as sales, margins and expenses 17. HOW FORECASTS CAN CREATE A MORE ADAPTIVE BUDGETING PROCESS 18. THE TWO MAIN OBJECTIVES IN THE BUDGETING PROCESS ARE STRATEGIC PLANNING AND CONTROL ANNUAL BUDGET MONTHLY or QUARTERLY BUDGET STRATEGIC PLANNING CONTROL 19. There terms of the commitment between management and subordinates usually includes: A fixed target An incentive or reward An agreed upon plan A statement of resources A commitment to cross-company actions A reporting schedule BOILING DOWN BUDGETING The purpose of a budget is to commit a subordinate team to achieving agreed-upon outcome and then to enable management to control the results against the outcome. 20. COMMON PITFALLS OF THE BUDGETING PROCESS Do you have these problems/inefficiencies in your budgeting process?: Backward looking or forward looking? Do you spend too much time trying to determine why variances occurred instead of planning for future? Is the budget driven by the chart of accounts or by measuring output? Does the budgeting process facilitate planning and analysis? Does you budget contain too much detail? Is the budget report process too labor intensive? 21. Always negotiate the lowest targets and the highest rewards Always make the bonus, whatever it takes Never put customer care above sales targets Never share knowledge of resources with other teams Always ask for more resources than you need, expecting to be cut back to what you actually need Always spend whats in the budget Always have the ability to explain adverse variances Never provide accurate forecasts Always meet the numbers, never beat them Never take risks WHEN BUDGETING BECOMES DYSFUNCTIONAL IF MISUNDERSTOOD OR MISUSED BUDGETS CAN CREATE UNDESIRABLE AND DYSFUNCTIONAL OUTCOMES AT MANY LEVELS, ESPECIALLY IF ECONOMIC CONDITIONS ARE DETERIORATING. 22. The role of forecasting in a more adaptive budget Strategic Plan Forecast Control Spending Performance Management 23. Rhodia Chemical Company Key performance indicators in goal setting: Improve supply chain, make acquisitions, become #1 in customer service, improve product introduction Forecasting: Uses the latest quarterly rolling forecast compared to objectives in the five year strategic plan. Borealis Petrochemical Company Key performance indicators in goal setting: Cost reduction, new product introductions, and customer satisfaction ratings. Forecasting: Rolling forecasts combined with activity accounting and balanced scorecard Svenska Handelsbanken Swedish Bank Key performance indicators in goal setting: Competitive KPIs such as ROE, and regional cost-to- income ratio, and profit per employee. Forecasting: Quarterly rolling cash forecasts. Reduction in budgeting process in favor of open, current and relevant information. EXAMPLES OF INTEGRATING FORECASTS INTO THE BUDGET PROCESS 24. Use rolling forecasts Rolling forecasts cover the important figures only. Orders, sales, costs, profits, and cash flows are the typical variables used. Moreover, these are flash forecasts that are often collated by off-line staff who have no interest in the implications of the figures. These forecasts perform a number of roles. They help senior executives to manage shareholder expectations, they enable finance people to consolidate and manage cash requirements, and they help operations managers to make decisions. - Hope & Fraser INTEGRATING FORECASTS INTO THE BUDGET PROCESS Forecasts form the core information for the monthly meetings, the development programs, and the strategy reviews. 25. Rolling forecasts show the impact of action plans on future profits and cash flows The efficient use rolling forecasts in decision making: Rolling forecasts only cover important figures used by upper management in decision making. They are not time consuming and can be created in a flash when real-time information is needed for pivoting or adjusting plans Created by disinterested staff with no connection to the implications of the forecast Trigger action The forecasting process creates KPIs KPIs help monitor performance against medium-term goals Early warning indicators Historical lagging indicators Prospective leading indicators KPIs help monitor performance with agreed upon boundaries INTEGRATING FORECASTS INTO THE BUDGET PROCESS Forecasts assist with a more adaptive process KPIs: External benchmarks Competition benchmarks Performance leagues Operating expense across different units Return on employed capital Inventory turnover 26. A MORE ADAPTIVE PROCESS - PLANNING Predetermined timeline and plans Predetermined actions Difficulties with governanceand monitoring Traditional Budgeting Approach Adapt to ensure value creation for customers and shareholders Managers incentivized to preparefor change and preparefor scenarios Link financial goals with operational change A More Adaptive Process 27. A MORE ADAPTIVE PROCESS - PERFORMANCE Performance goals baseduponannually negotiatedtargets Fixed performance targets that canlead to dysfunctional behavior Budget gamingand manipulation Underperforming managers slipby Predetermined timeline andplan; predetermined actions Traditional Budgeting Approach Performance goals seekto maximize short-term andlong- term potential Goals canbe stretched to full potential. Managers make decisions to create value Managers use judgement andtake risks, developing dynamic strategies Rewards linkedwith targets inhindsight. Performance results quicklyexpose free riders Managers are more likelyto prepare for change anddifferent scenarios A More Adaptive Process 28. A MORE ADAPTIVE PROCESS - CONTROL Centralizedcontrol Monitoring- Revised budgets Precise outcomes Budgetto actual reports Traditional Budgeting Approach Correctlyincentivized decentralization Change triggers reviewof current actualswithleading indicatorsandtrends Effective governance createscontrol that encourages decentralizeddecision making Fast financial actuals, trendanalysis,rolling forecasts,KPIs, performance leagues A More Adaptive Process 29. A MORE ADAPTIVE PROCESS CONTROL (CONTINUED) Focus on fiscal year Fixed capacity - Standard costing to monitor efficiency variances Fixed capacity - Focus on recovering direct overhead Sales targets Traditional Budgeting Approach Trailing months rolling review Rescheduling priorities based upon customer needs Adapt to meet customer needs and requests Targets based upon customer / product profitability A More Adaptive Process 30. EFFICIENCY - CONTROL FUNCTION When considering the reports used in the control function, make sure the detail is not too cumbersome by asking the following questions: Is this line item significant or can it be combined in a more meaningful group? Does this line item have enough impact on the bottom line to warrant the time and attention of control measures? Is this line item controllable to begin with? Or can it be controlled within set parameters? 31. CASH FLOW PROJECTION MODEL 32. CAPITAL BUDGETING AND DECIDING BETWEEN PROJECTS 33. CAPITAL BUDGETING AND DECIDING BETWEEN PROJECTS Weighted average cost of capital The minimum required return on existing assets to satisfy creditors and owners. Internal rate of return The rate of return used to compare projects in the capital budgeting process. 34. CAPITAL BUDGETING AND DECIDING BETWEEN PROJECTS What is the bottom line when projecting cash flows for a project? Tax affected EBIT Plus: Depreciation and amortization Less: Change in net working capital Less: Required capital expenditures Equals: Net cash flow to invested capital (free cash flows) 35. GOAL SEEK IRR Discount rate 16.9% Investment cash flows => Investment period 1 period 2 period 3 period 4 period 5 period 6 period 7 period 8 period 9 period 10 period 11 period 12 (25,000) 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 Net PV 25,000 0 36. SCENARIO ANALYSIS Pessimistic Base Optimistic Range of Values +/- 10% 10% Cost 1,200,000.00$ Cost 1,200,000.00$ Cost 1,200,000.00$ Years 5 Years 5 Years 5 Depr Method SL Depr Method SL Depr Method SL Salvage 0 Salvage 0 Salvage 0 Depre Ex Depre Ex Depre Ex Unit Sales per year Unit Sales per year 90,000 Unit Sales per year Price per unit Price per unit 43.00$ Price per unit VC per unit VC per unit 29.00$ VC per unit FC per year FC per year 800,000.00$ FC per year Tax Rate 0.35 Tax Rate 0.35 Tax Rate 0.35 RRR 0.15 RRR 0.15 RRR 0.15 NWC 10,000 NWC 10,000 NWC 10,000 OCF: Pessimistic case. OCF: Base case. OCF: Optmistic case. NPV: Pessimistic case. NPV: Base case. NPV: Optimistic case. 37. SENSITIVITY ANALYSIS Sensitivity Analysis Pessimistic Base Optimistic Cost 250,000 Units Sold 9,000 10,000 11,000 Salvage - Price per unit 72 Years 5 VC per unit 55 Depr SL FC per year 75,000 Depr Ex 50,000 RRR 0.15 Cash Flow 68,480 79,700 90,920 Tax Rate 0.34 NPV (20,444) 17,167 54,778 No NWC - Units Sold NPV Pessimistic 9,000 (20,444) Base 10,000 17,167 Optimistic 11,000 54,778 Steepness = Slope 38 *For every unit of x, how far does y move? Sensitivity Analysis - Relationship between units and NPV The steeper the line, the more forecast risk is associated with variable. 38. CITATIONS Axson, David A. J. (2014). Nimble Thinking Takes the Lead. CGMA Magazine, Issue 2, pages 12 15. Axson, David A. J. (2010). Best Practices in Planning and Performance Management: Radically Rethinking Management for a Volatile World (3rd ed.). Hoboken, NJ: John Wiley & Sons, Inc. Fraser, Robin & Hope, Jeremy (2003). Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap. Boston, MA: Harvard Business School Publishing. 39. paulbeckmann@decosimo.com 423-266-3730