There is no historical financial information to base the figures on. But those involved with dot.coms say that there is no rocket science in putting together those numbers.
The steps go like this: identify the market, decide on the size of the particular area or niche you are going for, and then forecast the market penetration you will achieve and the timescale in which you will get it.
Sensible forecasters will then discount the figure they have arrived at to allow for uncertainty, learning curve and cock-ups. The final figure is the revenue. The cost base is gained by looking at the amount of activity needed to sustain the top line.
The key point, as emphasised to me by the CFO of an incubator company, is that the first forecast is pure assumption. This prospective financial information (PFI) has to be tested against reality and lessons learned from that reality-check. Indeed, switched-on companies will adjust their PFI in real-time, producing a continuous budget. The incubator CFO reckons that the other key point is that you will never get the budget right first time.
In all types of business, PFI, in the form of budgets and forecasts, is a standard tool used to help managers manage. It sets expectations against which performance can be evaluated, and drives improvement. It is also used for valuation purposes, to support asset and business values, to carry out feasibility studies and appraise investments. But if PFI can be used internally, it can also be used externally. External investors, lenders, business parties and others can use PFI to assess whether directors are delivering against investors’ expectations and to assist in determining the value of an investment.
Although there are certain rules and practices relating to PFI for the quoted sector, no foundations underpin them, and accounting standard setters have no brief to help. In the UK, companies are not required by law or market regulators to publish formal PFI to assist investors. However, financial analysts maintain their own models of listed companies’ prospective cash flows and earnings based on industry knowledge. This externally-generated PFI will not and should not take over from historical financial information; in fact, prospective and historical perspectives should complement each other.
Quoted companies generally publish prospective financial information when the directors think that the market needs to reassess management’s performance, company value, or – as we have seen recently – when the directors want to reassure the market that all is not lost.
Profit warnings are covered by listing rules, which say that companies must tell the market about any major new developments. The number of profit warning are currently on the increase, but whether this is a blip or a trend is unclear. According to Ernst & Young, profit warnings by UK quoted companies increased by 64% in the third quarter – the first increase since 1998.
In this climate, it is timely that the ICAEW has published a discussion paper on forward looking information. The paper redraws the distinction between forecasts and projections, and specifies conditions for the preparation of both types of information. The idea, according to the ICAEW, ‘is to enhance the credibility of forward-looking information published by many new economy start-ups and other businesses with little or no track record.’
Predicting the future is difficult. The paper proposes that preparers of prospective financial information should acknowledge their responsibility for it, explain its limitations, avoid misleading presentation and accept that comparisons will be made between PFI and what eventually happens.
This idea of accountability is crucial to the quality of PFI and learning how to improve it. The paper also distinguishes between two types of PFI: forecasts that are confidently expected to be achieved and contain only limited information about assumptions; and PFI in which assumptions are explained in detail.
Within the new economy there are a host of questions that spring to mind with regard to the accuracy and value of these kinds of projections. But these have to be balanced against the long-running grumbles about the shortcomings of standard historical cost accounts. As it is, any sort of forward-looking information has to be welcomed, even if directors of quoted companies are understandably reluctant to offer themselves up as hostages to fortune. So the ‘won’t publish future figures’ school of thought is looking increasingly unsustainable. The question that FDs have to answer now is not whether to get to grips with forward-looking information, but how to do it well.
- Peter Williams is a chartered accountant and freelance journalist.
The discussion paper Prospective financial information: challenging the assumptions is open for comment until 16 February 2001. Download copies from www.icaew.co.uk/news/pressreleases/document.asp?WSDOCID=4758
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