Ep5 - Nostradamus - Forecast Financial Information

Welcome back. I'm the ESOP guy and let's continue on this journey to an ESOP. The podcast that we're creating, producing here is really been designed to try to educate business owners and management team members of companies that are not currently ESOPs, but have an interest in using the ESOP as maybe a possible exit strategy, a succession strategy, a growth strategy or a combination of those. Personally, I'm passionate about ESOPs because in the business marketplace, I see that there are just so many wrong notions about ESOPs. And also, I see that just in talking to clients that there are issues that come up that are pretty common and, and I feel like with the podcast, we can, we can address a lot of those issues upfront. And if you're in that place where you're considering an ESOP, this is the right podcast for you. If you like what you hear, please share it with a friend. Today's episode is called Notradamus. I have this question from clients all the time. And, and it comes to this, it's, we're in the part of the process of helping them with building their evaluation model. And I'm going to get their historical financial information. That's easy to get. Everybody has that. But when I asked the question, I need to get your financial forecast, then most of the time, uh, maybe a lot of, a lot of some of the time, the, the client looks at me and says, well, I don't have that. And I say, OK, well, let's talk about why we need it. And it's, and it's pretty important when you think about The way that that evaluation model and what we're trying to predict is going to do. Because the way that ESOPs are typically looked at for valuation, because they're typically utilizing a discounted cash flow method. Of doing the evaluation, the forecast is going to be really important in terms of understanding what the evaluation is. So, When you get down to the forecast, what it's estimating is just like in any income approach is what is the cash flow that the buyer's buying and what is the risk of that cash flow, but the difference is it's not historical cash flow, it's what is the cash flow from in the future that they're buying. The important thing here is that the work gets done, and it gets done the best way possible. And one of the questions that gets asked is, is, well, and sometimes very common. Next question is, well, what if I just make my forecast big and crazy and, and, and then what, you know, my evaluation just be at the roof? And the, the answer to that is no, it won't be. There's reasonableness that's considered and the evaluation firm that does it for the trustee is going to be, uh, you know, looking at that very objectively in comparison to the historical. So, um, there, there are other questions that come, but as we go into this, the forecast is really gonna be an important element and, and Looking at the forecast and the challenges of doing a forecast. In 1556, which is a long time ago, Nottradamus was a person who wrote books that predicted the future. One of his jobs in 1556 was to work as a physician to King Henry. And when he was working for King Henry, he had explained one of his prophecies in the book called Centuries One, which he assumed would refer to King Henry, and the prophecy told of a young lion who would overcome an older one on the field of battle. The young lion would pierce the eye of the older one, and he, the older one, would die a cruel death. Nottradamus. Delivered this this bad news and he said you should you should absolutely avoid ceremonial jousting. Three years later, King Henry at the age of 41, died in a jousting match when a lance from his opponent pierced his visor and entered his head behind the eye and went deep into his brain, so he held on to his life for about 1010, 10 more days and then died of an infection. Nottradamus was also credited with predicting numerous events in world history. He was credited with predicting the French Revolution, the rise of Napoleon, the rise of Hitler, the development of the atomic bomb, the September 11th terrorist attacks on the World Trade Center, and so all of that is like, first off, seemingly unbelievable. But when you look at what Nordreamus did, we're not asking for that. We're asking for a reasonable forecast of your financial um situation for your company going forward. So nobody expects you to predict the future. And I think that's, it's, it's kind of funny in a sense, but it's, it's important to understand that nobody knows the future and nobody can predict in the crystal ball. But based on How you go about doing your forecast, which is really where we're gonna lean in on this, on this podcast. I think you'll see that the steps we are advising in the podcast will be really helpful in terms of delivering um this type of thing. Now, recently at the conference, I was in the CFO meeting. And the question for this, these are CFOs of ESOP companies that are actually, um, ESOP, you know, existing ESOP companies. And so the question was, how do you build your forecast? How do you, how do you do your projection and what's the methodology? And so the, the issue that they have is if their forecast is changing every year dramatically. Then they could be experiencing some volatility within their valuation each year. So it could go up really high and it could come down really low, and that would be a a problem because then the evaluation statements that would come out to the employees would, would be all over the place and that would create some instability. So, forecasting for existing ESOP companies is very important. So I'll just share with you one of the things that came up from that meeting which was They start off with what they think is reasonable of reasonable growth rates. So the first off, they're not taking the, you know, the sales people get a, a sales plan of goals and objectives that they're, they're going to try to accomplish. It's understandable that that sales plan is going to be likely much higher in some sense than the actual business plan and the actual forecast. So there're so it needs to be said, they're not taking that sales plan and dumping into their forecast. Their forecast is going to be built around reasonable growth. But what happens is they're gonna, they're gonna look at the, the higher, this is just one methodology, but the higher growth that they're looking in their forecast at being in the first few years. As long as it's reasonable based on the business plan and what they're trying to accomplish and then this idea that will stagger then the growth rate down over the over the five year period so that maybe they have a 10% next year year growth, and then a 7 or 8 and then like a 5 and a 33 type of growth rate. So that creates some level of conservatism, but it doesn't also make it so conservative that it's just a flat 3% growth. And what they don't want to do is completely undervalue it either. So you can see how that's kind of important not to um You know, move it so high or move it so low. Um, it needs to make sense and it needs to make sense with history as well. So looking at the forecast, as I, as I started talking about, it's going to be the centerpiece of how we as evaluators build the discounted cash flow model. It's also going to help us in when we're looking at the next step after the valuation, um, the, the calculation of value is done for feasibility. And the next step of, of building out cash flows to predict what cash we have available to service the debt. And when we look at that, we're looking at also as, as how much cash flow would be available in a marketplace where we would have a downturn. So we're gonna be testing that cash flow. So that's the forecast is gonna be very important for that as well. The other place that's important is when we get through the valuation process, we get through the visibility process and we've actually engaged the trustee and their evaluation firm. In that case, the forecast is going to be important because they're, we're going to be uploading that to them for their due diligence, but they're going to be looking at um the monthly progression of the company through each through that year, that transaction year. So they're going to be comparing it. Likely with the forecasts that we just submitted. So if our forecast is too high in that case, and we're not meeting those monthly forecast numbers, then it's going to be, there's going to be some questions or there really should be some questions about it. So those are, those are areas where they're why the forecast is going to be important. So next as we go into it, these, these are things and there are many ways to do anything, right? There's, these are just recommendations in terms of how do you get started in building your own forecast. And the first step is to look at the historical results of the company. And what I do with that is I would just put that into your forecasting spreadsheet so that you can just start with 3 years of profit and loss statements. We're gonna start with just the income statement side first, so that we can restate those in those, those years and really understand what is your, what's your baseline of growth. And so we're going to build our growth model off of those baseline periods. The next thing we're going to do is we're going to start building out assumptions related to the revenue and the expenses. And so the assumptions are going to be important to um to understand now there's different ways to make assumptions. One way of making assumptions for revenue and as revenue relates to expenses is going to be what they call historical forecasting. And historical forecasting is going to base most of its assumptions around the historical performance of the company. And this is relatively easy as you think about it, because you're just taking those, say those 3 years and you're really estimating some type of, you know, maybe even just an inflationary conservative rate on the revenue. You're going to then add in things that are that you might know of at that point, but many times business owners and management team members don't know exactly if they're going to get that new contract or how that's all going to work. So historical forecasting can also be um too conservative when you look at it, because we're not really thinking enough about those assumptions that are that are that we need to. So the other way you can do it in or kind of add this to it is called research-based forecasting when you're looking at broader market trends, you're looking at um other aspects of what's happening in the geography, the, the specific business plan and how those That marketing plan itself is going to be affected. And so you're, you're going to start to try to tie out other parts of the business and go beyond just the historical financial approach and start looking at external and internal factors that are going to contribute to the assumptions we make with revenue. And that approach is a little bit more um specific and a little more valuable in the, in terms of, of providing the forecast. And the reason it is is because The questions that that will be asked eventually in the ESOP process when due diligence starts is there's going to be a lot of questions around The, the makeup of the revenue and the sales process and how the company is able to achieve its certain targets. And so as we represent those in say, an abbreviated business plan to the trustee and to the evaluation firm, we can then tie that back to the forecast to show that this approach is going to in an estimated way, yield these expected results at some margin of error. So it may be, for instance, we in our, in our business have decided to create a business plan and we're going to invest a little more marketing dollars, but we've, we're going to do instead of doing 20 proposals last year, we're going to increase the number of proposals and we, we're going to calculate within that new proposal matrix, a win rate of X. And so let's just call it, we're going to win. 30% of all the proposals that we do. And so we know that if we can boost the number of proposals at the 30% win rate, we're gonna have a much better prediction of what our revenue is going to be. And so that's one way to um To provide a little more meat to building out the revenue forecast. Um, other, other ways too are to look specifically at the customer list and instead of just dumping in the customer list into the the detail, you're, you're looking at the revenue per customer, and you're looking at specifically, and now this is for companies that have fewer customers because you can't do this if you got like thousands and thousands of customers, but if you have fewer customers, you can look at the growth trends and certainly look at Um, what you think you're gonna do with those customers in the next 4 to 5 years, that would help you kind of accumulate that revenue together. Um, there might be new customers added to that list. So what we are building out in our sales and marketing plan is the opportunity to, to go bid on some new relationships. So we might add some additional um new customers to that, to that um customer list. One thing that we're looking at in that customer list is what is the percentage makeup of your revenue related to each customer. That's going to be important for other reasons, but we're gonna be looking at that to determine the risk of the business and the, and the risk of that cash flow going forward because the more concentration of your customers, the higher risk your revenue is in terms of, of accomplishing your forecast. So, basically, in other words, if you lose a big customer, you, your revenue would go down sharply and we want to make sure we've considered that when we do our forecast. So if we shift over then from. The revenue side as we start thinking about the expense side, we know that there are expenses that are variable in nature, which means they're, they're tied to specifically to revenue. And so things like the cost of direct labor. would be a variable cost. The materials that we might use in the process of manufacturing would be related to the, the total revenue. And so we're going to identify uh some type of formula-based approach and estimating those variable expenses. So that we can predict reasonably well. If there's an increase in revenue, there's going to be an increase in variable expenses. Now, sometimes variable expenses don't change exactly with revenue. There might be opportunities for us to buy, say, larger supplies for materials and get some kind of discount. So we, we might want to include those types of things, um, from a simplistic standpoint, building out in your formula is some type of formula that ties itself to revenue is really the best place to start. And then start asking questions around each line item. How does that really affect if I, um, how does that really affect my expense if I do this much more revenue? Um, the fixed expenses are kind of the easier ones. That's just identifying if I have the same facility that I had before, I'm gonna have the same type of insurance. Um, if I have, um, Other, other expenses like accounting or I can, I can accomplish that with my, my general overhead expenses. I don't need to add a lot more to those in order. I might need an, an additional management team member or those kind of fixed expenses, but for the most part, just asking those questions. Through the process of looking at each expense line item, we'll we'll get you there. So what I would do would take my chart of accounts in that 3 year baseline period and then really identifying your expense chart of accounts as anything that you think is variable, anything that you think is fixed, and that will get you started to really start thinking about the impact to build the relationship between revenue and expenses so that we can then estimate what the expected net income would be in that scenario. Once we have the net income, then we're gonna be able to look at um bringing that to an EBITA or bringing it to the earnings, earnings before interest, taxes, depreciation and amortization. And we're going to want to estimate that in this forecast, and then go back to the business plan and look at specifically how much of, how much will this company need in terms of capital expenditures to continue with the growth plan. And so some companies are more capital intensive because they've got to buy more equipment, more trucks. Whatever it is, and so if their growth plan is bringing 10-15% growth in the revenue, then it would be realistic to think that there's gonna be additional capital expenditures. Sometimes in that, in that analysis, we find that they've spent, they've already got underutilized equipment and so the growth plan would utilize that so it's not gonna be as much, but the question there is gonna be how much capital expenditure should we be looking at, um, going forward in this business plan. As we bring the income statement together, the next piece that we're gonna want to do is tie that back to the balance sheet. And the first step that I look at is, is what is the required working capital on the balance sheet historically? And we're gonna test the balance sheet for working capital at the very front end because what we want to do is estimate what we believe required working capital will be. And what is say excess cash flow versus deficit cash flow or excess working capital versus deficit working capital, and will we create a formula that actually just estimates the day's inventory, days receivables and days payable to create a cash conversion cycle so that we can understand. When we have this type of revenue and cost of goods sold, we're gonna have this many days of, of cash conversion cycle, and that'll give us an estimate of required working capital. So if my forecast is going to grow my revenues, what I, what I have to understand is that I'm also gonna be growing my, my receivable base. And my cash conversion cycle could definitely be affected by that, which means I might need more required working capital. So as I test out the forecast on the income statement side, I really need to come back to my balance sheet and test the balance sheet out to determine whether or not I have the right amount of capital to fund that forecast going forward. So those are. The Quick steps towards building a, I, I would say a, a rough financial forecast to get started and understand the, uh, the elements of what's going to go in there. There are other steps that you would go through, but I wanted to go through just kind of an overview and look at the importance of, of why, again, we, we don't expect you to be Nottradamus and predict the future. But we do need to have a very, very good financial forecast for this very important part of business planning. So with that, thank you very much for listening all the way through. And please, if you like what you hear, please share it with a friend.