LOS B requires us to:
forecast a company’s future net income and cash flow
For any strategic decision regarding whether to invest in a company or provide debt to it etc., we need to first find the estimates of future cash flows. There can be two ways of forecasting future cash flows. They are:
1. Top-Down Approach
a. According to this approach, we begin with forecasting the topmost line item in the cash flow statements, i.e. the revenues, and then move down to the lower line items.
b. This can be done by first forecasting the GDP growth, then moving over to the industry forecasts. Then we can estimate, how much of this growth would translate into the growth of the company’s revenue. There could also be internal factors affecting the company’s growth, these also need to be kept in mind.
c. Once the revenue forecast is made the estimates of income and cash flow could also be made. These could be made based on the historical levels/trends in ratios etc.
d. There should be separate forecasts for each expense item, based upon the relationship with the sale or the slated company’s strategy.
e. Then we find out the expected cash flow to estimate the required working capital or capital expenditure etc.
2. Bottom-Up Approach
Under this approach, an opposite strategy is followed. We begin with estimating the required cash flow for capital expenditure etc. and then moving over to the revenues estimates.