You will be able to forecast revenue, margins and reinvestment from drivers rather than straight-line growth.
The easiest forecast in the world is to take last year's revenue and add 10% a year. Marcus's first attempt at Larkspur did exactly that, and five years out it showed a company with revenue of about S$640 million, the same 14% margin it earned in a good year, and almost no extra spending on machines or stock to support it. It looked precise, and it was a guess with decimal places. A forecast built from drivers is still uncertain, but every number in it has a reason you can check and change.
Figures are made up and in S$ millions.
Revenue is the result of something else: volume times price, stores times sales per store, subscribers times revenue per subscriber, loans times the interest margin. Find the drivers for your company in its operating review and segment notes, and forecast those instead of the total.
For Larkspur, revenue depends on how much its equipment-maker customers spend on new machines, and on what share of that spending Larkspur captures through new parts. The customers' own results and guidance give a view of the first. Larkspur's announcements about newly qualified parts give a view of the second.
Marcus's drivers for FY6 were customer spending up about 6%, based on the two big customers' latest guidance, plus about 2% from new parts already announced, giving revenue growth of 8%. For later years he let growth fade: 6%, 5%, 4% and 3% from FY7 to FY10. That takes revenue from 400 to about 515.
Each number has a source. If a customer cuts its guidance next quarter, he knows which cell to change and why.
Over time, unusually high profitability attracts competitors, customers push back on prices and fast growth runs into the limits of the market. Unusually low profitability pushes companies to cut costs or exit. Researchers have documented that company margins and growth rates tend to drift towards industry averages over several years, though the speed varies by industry and company. Analysts call this mean reversion, and a forecast that ignores it usually ends up too optimistic about the good companies and too pessimistic about the bad ones.
For Larkspur, operating margin over five years ran from about 11% to 16%, averaging about 13.4%. FY5 came in at 14%. Rather than carry 14% forward, or extrapolate the recovery towards the 16% peak, Marcus set the forecast at 13.5% for every year, close to the five-year average across a full cycle.
That choice is a judgment, and it's the kind you should write down. If Larkspur is gaining a lasting edge, 13.5% is too low. If its biggest customer is qualifying a second supplier, as the risk section in lesson 6.2 said, it may be too high.
Revenue doesn't grow by itself. A growing manufacturer needs more machines, more stock and more credit for its customers, and all of that is paid for before the extra profit arrives. A forecast that grows revenue without growing the capital behind it shows free cash flow that the business could never produce.
Link the reinvestment lines to revenue.
Capital spending: Larkspur spent 34 on equipment in FY5, about 8.5% of revenue, and has averaged close to 8% over the cycle. Marcus set 8% of revenue. Depreciation, which was 24 in FY5, is set at 6% of revenue, so capital spending runs ahead of depreciation and the asset base grows with the business.
Working capital: lesson 7.3, Balance sheet: working capital, goodwill, leases and debt, found working capital at about 26% of revenue. Marcus kept it at 26%. So every 10 of extra revenue ties up about 2.6 of extra cash in receivables and inventory.
Tax: profit before tax at an assumed 17%, close to Larkspur's recent effective rate. Check your own company's effective tax rate in its tax note rather than using a headline rate.
With those links, FY6 revenue of 432 gives operating profit of about 58, capital spending of about 35, depreciation of about 26 and an increase in working capital of about 7. Lesson 7.8 turns this into a full forecast.
All of these numbers go on one tab, called Inputs, with one row per driver and one column per forecast year. Each row gets a short note: the value, the reason and the source. The statement tabs contain only formulas that read from Inputs and from each other. No number is typed into a statement tab.
That structure does two things. It makes your assumptions visible, so anyone, including you in six months, can see what the forecast depends on without hunting through formulas. And it lets you change one driver and watch the effect run through all three statements, which module 8 uses to build sensitivity tables and scenarios.
Marcus's Inputs tab had six rows: revenue growth, operating margin, depreciation, capital spending, working capital, and tax rate. Each had five yearly values, a reason and a source. It fitted on one screen.
For the activity, write your own company's forecast drivers for revenue, margin, capital spending and working capital, each with a value, a reason and a source.
Write your forecast drivers for revenue, margin, capital spending and working capital, each with a reason and a source.
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