What Does Financial Forecast Mean?
A financial forecast, in the context of a sale, is a three to five-year projection that is prepared by the seller and presented to all potential buyers prior to receiving a letter of intent (LOI). Buyers are not only interested in understanding the past performance of the company, but want to also understand what management anticipates the future performance to be. After all, buyers value companies based on future performance, so the financial forecast is a key assumption in their valuation.
Financial forecasts are typically discussed during the management presentations. Good financial forecasts provide a full set of financial statements including an income statement, a balance sheet, and a cash flow statement that clearly identifies the company's ability to generate future free cash flow.
Divestopedia Explains Financial Forecast
Financial forecasts should provide all the assumptions that have gone into building them. These assumptions are primarily driven by historical financial metrics of the business. If these assumptions are not in line with what has happened in prior years, be prepared to justify them during a management presentation. It is also smart to provide a sensitivity analysis whereby several scenarios are presented by toggling some of the key assumptions. This shows the seller that the buyer understands how the financial forecast can change and how it is prepared to handle a worst case scenario.
A lot of financial forecasts are prepared by investment bankers and they often present a very rosy picture of the business. Be careful of presenting forecasts that are too aggressive or simply not believable. If the projection shows significant growth, you need to understand what the catalyst is for such growth — have you introduced a new customer, a new service line or completed an acquisition?
Similarly, completing the projection all the way to the cash flow line is imperative for buyers, but it is seldom done by sellers. In a high growth projection, a significant investment in working capital and capital assets may be required, and this needs to be reflected in the financial forecast so the buyer not only gets the profitability picture, but also understands the required investment.