Sandbags & Hockey Sticks Evaluating Prospective Financial Information

Sandbags & Hockey Sticks Evaluating Prospective Financial Information

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Somewhere in the middle of almost every restructuring transaction sits a set of prospective financial information. Prepared by the subject company or its advisors, this information can go by many names—e.g., a "budget," a "business plan," a "three-year forecast" or a "five-year projection." While there are clear differences among budgets, business plans, forecasts and projections, these differences are not important for this discussion, and the term "projection" will be used to refer to the prospective financial information being evaluated.1

The relative achievability of financial projections is an important driver of different decisions in the development and negotiation of a restructuring transaction. This information is used in preparing valuations and in structuring key terms of agreements. If one unwittingly relies on unreasonable projections, the ultimate deal structure is likely to be inappropriate. Sometimes the preparer will purposely skew projections one way or another, and it is therefore important to consider the projections' intended use to evaluate the developer's objectivity. For example, management's projections prepared to establish financial covenants or targets for a bonus program are more likely to be conservative than projections prepared to demonstrate financial viability or for attracting buyer candidates, which are more likely to be aggressive. Overly optimistic projections are often referred to as "hockey sticks," due to the shape of the performance trend shown. Overly conservative projections are often described as "sandbagged" due to the excess padding in the numbers.

The procedures involved in evaluating financial projections fall into three basic categories:

  • Internal consistency and mathematical accuracy,
  • Reasonableness of assumptions, and
  • General control and process environment.

Internal consistency should be checked to ensure that items within the projections that should agree actually do agree. Examples include the rollforward of retained earnings using projected net income and the movement of balance-sheet cash relative to the statement of cash flows. Checking mathematical accuracy is also important, as simple addition mistakes (generally bad spreadsheet formula references) could easily be overlooked when many hours are spent studying the details. However, these mistakes could have an even bigger impact on the projections than the worst of assumptions. Both internal consistency and mathematical accuracy are best evaluated using the actual financial model software.

Projections cannot be "right" or "wrong," only well-prepared, reasonable or not.

The majority of time spent in looking at a projection is in evaluating the assumptions. Projections can be built "top-down," with broader assumptions being made at a higher level of detail, or "bottom-up," with much more detail building up to the end-product. Generally speaking, bottom-up projections will be more supportable, as they result from a more thorough process. One should first understand how the projections were developed, as this can help dictate the appropriate procedures to be used in making the evaluation. It does not make a lot of sense, for example, to spend much time digging into detailed assumptions if the projection was developed by simply adding 10 percent to last year's results.

Most projections are developed using historical results as a starting point. These results are then adjusted for anticipated changes to controllable items, such as salary and wages rates and discretionary spending. Adjustments must also be made for anticipated non-controllable changes. These include changing costs of goods and services purchased, and perhaps most important, customer demand for the subject company's products. Projecting revenues is generally more difficult than projecting expenses, as there tend to be less controllable factors in the revenue assumptions.

Analyzing projections should follow the same methodology used for their development. The projections can be compared against a historical benchmark, and variations from actual results can be challenged and evaluated. A better-prepared projection will have support for both controllable and non-controllable changes, although it will be easier to get comfortable with the controllable changes. As noted above, supporting projected revenues involves analysis of less controllable factors such as customer demand. Tools to assess these factors might include general economic data, market analysis and information on competitor actions. The nature of the subject business and the length of the projection will dictate to what extent more specific support might exist for the revenue projection. If a company sells its product pursuant to long-term contracts, analyzing those contracts could be used as the primary support for revenues. If the projection period is short enough, an analysis of current order backlog could provide sufficient support.

Typically, projections developed in connection with a restructuring transaction are primarily used to evaluate cash flows. Cash flows drive valuations, debt capacity and returns to creditors. While a company's cash flows are the result of every activity in which a company is involved, analyzing projected cash flows can be performed by looking at six primary areas. The following summarizes the key points of focus in analyzing each of these areas.

  • Revenues: Historical revenues by product line, customer or geographic region. Long-term sales contracts. Backlog analysis. General economic and market data.
  • Gross Margin: Historical margin percentages. Forecasted revenue levels and impact on variable and fixed cost structure. Controllable and non-controllable changes to cost structure.
  • SG&A Expenses: Historical expenses by line item. Forecasted revenue levels and impact on variable (such as commissions) and fixed (such as rent) cost line items. Controllable and non-controllable changes to cost structure.
  • Financing Expenses: Proposed capital structure. Levels of debt outstanding. Proposed debt terms, including amortization and interest rate spreads. Forecasted interest base rate levels.
  • Capital Expenditures: Historical spending levels. Details of proposed expenditures. Maintenance vs. expansion expenditures. Levels of deferred spending and expansion plans.
  • Working Capital Changes: Accounts receivable, accounts payable and inventory levels. Corresponding days receivable, payable and turnover analyses. Customer and industry trends. Controllable action steps being taken.

An analysis of the general process and control environment is also an important part of assessing a financial projection. Questions such as the following should be addressed:

  • Who prepared the projections and were they adequately reviewed?
  • Are they "top-down" or "bottom-up?"
  • Was a detailed model used?
  • How reliable is the historical information being used?
  • How accurate have prior projections been for this company?

Answering these questions provides additional comfort (or appropriate lack of comfort) as detailed assumptions are evaluated. One other question may seem obvious, but could be lost in all of the detailed analysis: "Do these numbers make sense?" A gut reaction is many times an important guide in assessing the reasonableness of a projection.

Perhaps the most important thing for the user of a financial projection to remember is that unfortunately there is no such thing as a crystal ball. Projections cannot be "right" or "wrong," only well-prepared, reasonable or not. As projections are primarily driven by assumptions and not facts, differences of opinion will almost always exist. For this reason, one who is evaluating projections should consider using sensitivity analysis. This analysis focuses on the impact of changes of certain variables on the results of the projection. For example, while no one might be able to say with certainty whether sales will actually go up 3 percent next year, quantifying the impact of a 3 percent sales increase is fairly straightforward. Key drivers of the projection should be identified and sensitized in this manner so that users of the information could form their own opinions about potential results based on differing assumptions.

The actual analysis of a well-thought-out set of prospective financial information can be extremely complex, and only the fundamental concepts have been described herein. If not conducted properly, erroneous conclusions could be reached and transactions structured inappropriately. Accordingly, evaluation of forecasts and projections is often one of the most important tasks for a financial advisor in a restructuring transaction.


1 Note that this article is not intended to cover issues related to evaluating prospective financial information in accordance with the guidance set forth by the American Institute of Certified Public Accountants (AICPA). Return to article

Journal Date: 
Friday, February 1, 2002