# Forecasting free cash flow - Investments

## Forecasting free cash flow

The simplest method of forecasting is the calculation of the historical values ​​ FCF based on the financial information of the company and the rationale for them of some constant growth rate. To apply this approach, it is necessary to comply with the principle of sustainability of the company's development (for companies at the stage of mature development for the life cycle, this assumption is possible), i.e. maintaining the relationship between the cash flow and the main components, its determining (profit, net investment).

The second method of forecasting FCF, which is traditionally implemented by investment analysts, is component-wise. This method involves forecasting profits, non-cash expenditures, tax burdens, investments in fixed and working capital, and then combining them in a number of forecasted FCF indicators. The most popular algorithm of componentwise forecasting is the algorithm of sales quotas.

Sales Algorithm is based on the assumption of maintaining stable proportions between revenue and the needs for investment in fixed and working capital, net profit.

The analyst assumes that to obtain each ruble of additional revenue, a certain amount of capital investments and the amount of investments in net working capital are required. Past financial statements allow you to find these ratios (profitability of sales, the need for investment). Average sectoral values ​​of the coefficients (median) may also be used.

Example 5

Analyst for the company XYZ forecasts financial indicators for 2006. The algorithm used is the "share of sales". In 2005, the volume of sales was \$ 40 million. In the coming year, demand is forecasted and an increase in sales volume (revenue) of \$ 3 million is planned. The analyst takes a profit margin ( RM ) at an unchanged level, as the structure of costs does not change with the company, and the rise in prices for raw materials and materials, wages is assumed at the level of changes in prices for manufactured products. PM is included in the calculation at 6.5%.

Previously, the company adhered to a constant dividend yield of 50%. Let's say that there is an opportunity to increase output without attracting additional non-current assets (since capacities are not fully loaded). It is assumed that all current assets and accounts payable are directly proportional to the change in revenue. The initial cost of the equipment is \$ 15 million. Wear of past years amounted to \$ 5 million, therefore, the balance sheet reflects the residual value of \$ 10 million (line

Non-current assets ). Articles that change with the change in sales volume:

- direct production costs - 66% of sales volume

- other transaction costs - 20% of the sales volume.

Balance XYZ As of December 31, 2005, \$ mn

 Non-current assets 10 (-) Authorized and additional capital 5 Current assets Including: 4 (10%) Retained earnings 1.5 Inventory 1 (2.5%) Borrowed capital (10%) 6 Accounts receivable 2.25 (5.6%) Short-term liabilities 1.5 Funds 0.75 (1.9%) Including accounts payable 1.35 (3.37%) Total assets 14 (10%) Total Liabilities 14 (3.37%)

Note that the proportion of current assets, which grow in proportion to revenue, is 10%. The share of balance sheet items that grow in proportion to the growth in sales is 3.37%.

Implementation of the sales share method:

Increase in revenue = Δ Sales = \$ 3 million. The coefficient of dividend yield is 0.5. The effective income tax rate was adopted at 35% (as a ratio of the income tax paid to operating profit by financial accounting standards).

Articles that do not change with sales volume:

1) depreciation (1.12 million dollars);

2) payment of interest on borrowed capital (10% of \$ 6 million = \$ 0.6 million).

The preliminary income statement (on financial results), made using the fraction of sales volume method, is as follows.

Provisional Statement of Financial Results at the end of the year (December 31, 2006), \$ mln:

Sales revenue 43

Costs of 0.66 ∙ 43 -28.38

0.2 ∙ 43 -8.6

Amortization -1.12

Operating profit (EBIT) 4.9

Repayments on borrowed capital -0.6

Taxable profit 4.3

Profit tax of 0.35 ∙ 4.3 -1.5

Net profit of 43 ∙ 0.065 2.8

Dividends 1,4

Undistributed profit for the period of 1.4

Forecast balance as of December 31, 2006, \$ mn:

- non-current assets - 8.88 (for the year the depreciation increased by the amount of depreciation of 1.12 and amounted to \$ 6.12 mln, residual value = 15-6.12 = 8.88)

- current assets - 4.3 (10% of the projected sales volume). Recall that when calculating FCF not all items of current assets are taken into account, but only reserves and accounts receivable. Coefficients sales share on them leave 2.5 and 5.6% respectively. The factor of accounts payable is 3,37%. These values ​​will be taken into account, showing how the elements of net working capital will change with revenue growth of \$ 3 million.

FCF = 4,9 (1 - 0,35) + 1,12 -3 (0,025 + 0,056) + 3 • 0,0337 = 4,163.

A more correct calculation, related to investments in working capital and fixed capital, is based on the calculation of the following coefficients:

■ working capital requirement factor = growth of adjusted net working capital for the period)/revenue growth in absolute terms over the period;

■ investment ratio in fixed capital = (Capital investment for the period - Amortization for the period)/Revenue growth in absolute terms over the period.

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