It can be tempting to prepare a “naïve” annualization or monthly projection using one of two different approaches. Under the first naïve approach, the annualization is made by dividing the interim numbers by the number of months covered and then multiplying by twelve. The other naïve option is to apply a “sales cycle” expressed as a percentage of the total sales in relation to a given month. These monthly percentages are then applied to all line items. Both of these produce very specious results because they ignore business realities.
Elements of Monthly Projections
The key elements of a projection (including monthlies) are the collection of data, the period covered, the base values for each line item, any observations about the behavior of a given line item, determining the appropriate approach, and the variables to be applied.
- Collect and Organize Data: The analyst needs to obtain the information necessary to diligently prepare the projections. Information includes financial statements, budgets, sales forecasts, market studies and any other reliable source. The degree of information provided by management is going to depend upon the reasons for the valuation and the party on whose behalf it is being prepared.
- Period Covered: Monthly projections are most useful in the short-term. They are useful to annualize an Interim Financial Statement and can provide insights into the impact of seasonality, business cycles and growth patterns upon the company’s earnings and financial position. It’s pretty much an article of faith. Confidence in projections decreases as the number of projected months increase.
- Base Values: Unless an analyst magically pulls numbers out of thin air (which is not diligent or ethical), projection assumptions should have continuity with the past and present. The analyst starts with the last value for the line item and the changes to that value over the observable past. The value could be as stated on the financial statement (historic or normalized) or adjusted.
- Observing Line-Item Behavior and Relationships: A line-item value is not a static number. It is the result of actions undertaken by the company. It has a relationship to the other accounts. A company can have multiple revenue sources each having its own cycle, inventory requirements, and the related line item expenses. Some expenses follow sales, some follow a set budget, some expenses are level or fixed. In addition, the company’s chart of accounts is not set in stone and new accounts may need to be added. The same applies to Balance Sheet line items.
- Determining the Appropriate Approach: The analyst next needs to determine whether to use all or part of projections provided by the client, the Top-Down approach, the Bottom-Up approach or a hybrid thereof. Different approaches can be used for different line items based upon available data.
- Variable Application: Once the analyst has determined the period covered, base values, the best approach and has a handle on the line items’ behavior and relationship to the whole, it is appropriate to proceed to applying the variable. The variable is usually a percentage (i.e., percentage of growth, percentage of sales or percentage of wages) or a turnover rate (i.e., account receivable turns, inventory turns and so on). Variables can change from period-to-period.
In addition, there are a number of accounts that are calculated independently such as depreciation, amortization, interest, and such.
Focus on Substance Instead of Process
The analyst can use a spreadsheet to prepare the monthly projections or a financial modeling system like the one that is included with Corporate Valuation Professional. Home-grown spreadsheets give the analyst maximum flexibility, but require formula writing, link management, print control and usually lack a cohesive interface. Every time a line item is added or deleted or a variable is changed, formulae need to be re-written and the entire spreadsheet should be checked to make sure that any dependencies have also been updated. As an alternative, a system like Corporate Valuation Professional provides all of the formulae management and presentation formatting so the analyst can focus his or her attention on getting inside of the numbers and their implications.
Closing Thoughts
It’s worth keeping in mind that by annualizing the interim statement and/or using monthly projections, you are increasing the number of assumptions that can be challenged by the opposing side of any controversy involving the valuation. In addition, there may be an unspoken assumption that an analyst who prepares monthly projections has exercised care and thought beyond the level required to prepare annual projections. For that reason, diligence and care in the gathering and use of data is advised, plus the analyst wants to clearly disclose the limitations of the projections.
Furthermore, the analyst wants to make certain that the projections are not used or construed to be representations or promises of any kind with respect to the performance of the company. This is of special concern to brokers and intermediaries who include projections of any kind as part of a selling memorandum or presentation.
While monthly projections take additional time for data gathering, organizing and application, the benefits are a deeper understanding of the business and its more immediate financial ebb and flow. If properly prepared and used, monthly projections can be an important component of a quality valuation.
Editor’s Note:
Although the term “projection” is used in this article, the financial statements prepared by MoneySoft’s Corporate Valuation Professional might be more accurately defined as forecasted financial statements. The terms, forecast and projection, are often used interchangeably, but they are defined differently by the American Institute of Certified Public Accountants (AICPA). A financial forecast is based upon actual conditions that are expected to exist during the forecast period. This differs from a projection which, by definition of the AICPA, is based upon conditions given one or more hypothetical assumption.
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