A key to successfully valuing a business is assessing the level and stability of future cash flows. Consequently, valuators often request financial forecasts prepared by business owners. Valuators then work with the business owners to make sure that the ﬁnancial forecasts are reasonable and do not contain unsupportable assumptions and/or calculation errors that would result, after the application of a valuation multiple, in erroneous valuation conclusions. This is especially the case in the midst of the COVID-19 crisis when future cash flows are more uncertain than in “normal” times.
The following areas related to ﬁnancial forecasts are important to keep in mind:
Revenues are the key from which other components of the forecasts are derived. During the uncertainty and unpredictably related to the COVID-19 pandemic, revenues are more difficult to forecast especially in moderately- or hard-hit businesses. Consequently, it may be necessary to use more than one scenario in the forecast. Using scenario/probabilistic analysis will assist in dealing with revenue and hence, cash-flow uncertainty. Multiple forecasts can include time-tested, best-case-worst-case analysis, or a two-pronged approach with one scenario including a second wave of the pandemic and one that does not. It may also be possible to use Monte Carlo simulations in certain situations to incorporate lack of precision inherent in the forecasting process.
Different industries have been affected in different ways depending on where they are located and how consumers are changing their behaviors at this time. One interesting site that provides industry specific economic and financial analysis of the COVID-19 crisis is one provided by McKinsey & Company. One particularly good chart shows projected small-business recoveries by industry. The chart shows McKinsey’s estimates of recovery periods by major industry group with some industries taking more than five years to recover. This is the kind on information that needs to be incorporated into a forecast prepared during the COVID-19 era.
The level of expenses will continue to be uncertain as the economic landscape keeps shifting. New protocols and worker safety requirements are changing the expenses that businesses are incurring. With more workers at home, employee costs may be less while other costs, for instance investment in technology, might increase. Rent expense may be directly affected in the long-term due to the changes brought on by COVID-19. In addition, in this shifting landscape, a preparer of a forecast needs to stay updated on legislative initiatives and developments. Given the current market uncertainties caused by the nature and extent of the impact on business operations, the following potential issues may need to be considered in developing forecasts and in determining valuation assumptions:
- Store or facility closures
- Loss of customers or customer traffic
- The impact on distributors
- Supply chain interruptions
- Production delays or limitations
- The impact on human capital
- Regulatory changes
- The risk of loss on significant contracts
All of these considerations must be reflected in the forecast or in multiple probability weighted forecasts.
Of course, no one knows what the future holds, which makes the preparation of ﬁnancial forecasts diﬃcult. Being aware of these areas, however, will hopefully oﬀer some guidance when preparing ﬁnancial forecasts based on reasonable and sustainable assumptions and/or estimates.
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