Using Operating and Activity Ratios as a basis for Extrapolation

They say that Financial Modeling is one part science and one part art. While the physics of finance is fairly well known (formulas to calculate DCF's, NPV's, IRRs, and ratios), it can sometimes be difficult to project or determine operating levels in the future (which is critical to determining the present value that an asset is worth.

Extrapolation is a risky but rewarding game (and a necessary evil). But how can it be done appropriately? Unlike pure math in which derivatives (in the sense of functions dx/dy and not in the finance sense of value 'derived' from another asset) can be used with various regression analysis models, the human component of business makes pure mathematical extrapolation trickier to say the least. By 'human component' what do I mean? Although we create budgets, how will things change? Will people like and buy our new product lines? Will we have major changes in our HR due to various forms of attrition? It is therefore critical to include assumptions in the math of our model (as previously mentioned) to understand the senstivities of our model.

For instance, how can you predict where your sales numbers will be next year? There are some option.

• The standard assumption would be to grow sales by the average of the past 3 years (SEC regulation states last 3 years annual reports, 10k's, must be published.) - Arithmetic or Geometric (conservative) average
• Use last year's growth if previous years were unstable or volatile and not reflective of current environment
• Other projected number (aggressive) for a new product line expected to drive sales

Or how about operating and working capital? Well, using our CFA formulas for turnover and days on hand, if you assume that your operational efficiencies remain stable (or use one of the above methods to extrapolate a value), you can project out your budget based on that.

Check out my consulting post on operating efficiencies and cash cycle.

[Example] For the year finished, say 2008, if the AR is 1,000, Revenue is 10,000. If your sales grows at 10% per year, what should your budget reflect for sales targets in terms of Revenue and AR?

[Solution] Your DSO would be ($1,000/$10,000) * 360 days or 36 days. If you assume that your revenue grows at 10%, next year's Revenue will be 11k and if your DSO remains the same, your target AR should be $1,100. This method can be used to project out into future years.

By extension, assume that you expect to collect most of your AR within 30 days (DSO = 30), for the same revenue, your new target AR would be DSO = (AR / REV) * 360

so AR would be DSO * REV / 360 or 30 * 11k / 360 = $916.67
Note it has gone down from $1,100 because if you are collecting faster, your AR account should be smaller.