Question

Financial Projections & Explaining Uncertainties

When doing a financial projection, it is important to always somehow predict the financial cost of the unknowns and to have details surrounding those unknowns. Although they can be scary and cause worry, having detailed historical data or reason behind the uncertainty can help calm an audience almost immediately. In explaining a financial uncertainty, I would recommend starting with pointing out some positives based on the actual numbers. These positives should be the based off of the forecast that was built and defined. From here I would recommend briefly touching upon the fact that things sometimes don’t go as planned; a hurricane wipes out a town, a massive snow storm wipes the power from the state for multiple days or a competitor suddenly starts taking a portion of your customers. All of these things can’t be predicted and are therefore uncertainties. Giving the audience context around what these uncertainties are helps build a solid foundation of understanding.

From here I recommend that communication on the difference in the uncertainty and the actual financial prediction are discussed in great detail. Everything should be outlined, starting with this was our predicted number, this was our final number and these are the reasons we didn’t get to our actual number. It could be that there was an error in the number of days predicted in the month, it could be that the sale Nordstrom rolled out wasn’t discounted enough to sell more products or simply that the number of people predicted to make a purchase at Nordstrom was over projected. A solid reason around why the prediction versus the actual occurred will calm an audience.

Lastly, the audience wants to hear how this will be mitigated going forward and factored into future predictions. Outlining the detail around the uncertainty allows the predictor to learn and comprehend what actually happened versus what was predicted so that historically they can better predict next time as well as aid in calming the audience.

For Chegg: constructively critique my explanations. Support your initial comment and response with sound reasoning and relevant examples.

Answer 1

Financial projections need to essentially build with whatever data is available today and then taken forward. This would also include economic projections - such as what will be the GDP growth rate, what will be the interest rate and what will be the exchange rate. It is not possible to predict black swan events - such as a hurricane - and building them into a financial projection will simply make a particular project very expensive (in order to mitigate the risk) or perhaps make the project unviable.

Once the projections are done with the current forecast of financial and economic variables, it makes sense to do a sensitivity analysis of the future cashflows or profits or margins for changes in key input variables. Let us take the example of interest rate. We could include in the study how cashflows and other key indicators for the project will change for say 10 basis points to 100 basis point (in steps of 10 basis point) increase in interest rate. Then depending on the risk appetite of the promoter of the project, they can decide to enter into interest rate futures to lock a particular rate or buy options contract to prevent a significant negative on the downside.

While I do agree that we should look at the historical numbers, I do not think that historical numbers are necessarily an indication of the future. They do however give valuable insights into the workings or fundamentals of a company or economy respectively. It also makes sense to select outliers from the historical data and then study them in detail to understand what caused the behaviour. It could be that there was a war or recession during that year which caused the outlier. Then delve down into the reason for the factor - war, recession or anything else and try to explain why it is unlikely to re-occur in the future. If you do expect them to occur in the future - atleast over the forecast horizon - then it will already have been included in your base case scenario and thus included in your financial projections.

In short:

- Do sensitivity analysis of key project parameters for changes in financial factors and take suitable mitigating measures.

- Deep dive into outlier historical data and explain why they will not occur in the future.