AIRA Newsletter

How many times have you found yourself in the enviable position of dealing with a company whose results have exceeded its financial forecast while operating in a distressed business situation? If your experience is similar to most others, the answer would have to be not very often. While financial forecasting can be a difficult proposition even under normal circumstances, in a distressed or turnaround environment, it can be fraught with unpredict-ability and traps for the unwary. Nevertheless, the importance of having a realistic and achievable forecast is of the utmost importance. How else can interested parties determine whether or not a business can be turned around or emerge from bankruptcy without having this crucial information? The following discussion will serve as a primer for individuals dealing with the review or preparation of a forecast in a distressed business situation. It is not a technical “how to” guide but instead will deal with some key underlying concepts that drive a sound and achievable forecast in a distressed business setting.

What is a financial forecast and why?
There are many terms used to describe models that predict future financial performance besides forecast, such as, business plan or pro forma or financial projection. Regardless of the term used, the base model for a forecast begins with the three classic financial statements – the balance sheet, the income statement and the statement of cash flows. Many times, typically due to the time constraints prevalent in a crisis situation, only cash flow is dealt with initially. However, short term cash flow projections are not a substitute for a substantive fully integrated forecast. A one month or 13-week rolling cash flow is an essential tool in nearly all distressed situations and can be an excellent launching pad for preparing the longer term forecast. However, once the initial cash crisis has been dealt with effectively, the time investment necessary to prepare a forecast for all three financial statements should then be made.

Forecasts provide the financial roadmap and quantify the financial impact of management’s future plans. They usually incorporate a three to five year period with the first year of the forecast (possibly two depending on circumstances) broken down on a month by month basis. It allows all parties in interest to assess the feasibility of management’s plans. The forecast also serves as the basis for estimating future going concern value through a valuation as compared to selling or liquidating. In other words, is the business salvageable? The forecast also provides insight into how much capital or financing may be required to sustain the business through the initial critical period as it returns to profitability. In a bankruptcy setting, the forecast quantifies the amount of available cash to satisfy creditors, both secured and unsecured, and the timing of such payments. All of these uses combine to make the forecast an essential tool in the turnaround/workout process. Not having a solid and achiev-able forecast would be the equivalent of driving the back roads of a foreign country at night without directions.

The Fundamentals – What type of business is involved?
For general discussion purposes, most businesses can be classified as either service businesses or sellers of tangible products (either self manufactured or purchased from others). Specialized industries such as real estate development, insurance companies, banking, etc. are beyond the scope of this article. For obvious reasons, service businesses are usually less complicated from a forecasting perspective, because they typically don’t involve the sale of inventory as the primary source of revenue generation. A business selling only services does not have the added complexity of dealing with supplier cost issues, inventory levels, inventory turns, manufacturing costs and factory overhead. Its primary concern is normally the personnel cost of the people providing the service which, in most cases, is easier to forecast. Understanding the type of business involved sets the stage for determining the critical factors to successfully hit the numbers.

Why are distressed situations different?
Under normal circumstances, a financial forecast is based on historical data. For example, sales last year were a certain amount, so manage-ment determines that a percentage increase or decrease is appropriate and goes from there.

But in distressed situations, many other complicating factors exist that need to be taken into account. In particular, external factors beyond management’s control may limit the feasibility of certain actions. In many cases, the inability to finance increases in working capital requirements could make it impossible to buy the inventory needed to support a sales increase. Additionally, the excessive optimism that can exist in management’s outlook needs to be tempered.

A troubled company finds itself in unfamiliar territory facing issues that management may not have dealt with in the past. Below is a list of potential actions typically encountered in troubled situations that need to be carefully considered to determine the impact on a forecast:

Sale of a division, product line or group of assets
Profit improvement and manufacturing efficiency initiatives
Liquidation of excess inventory or other assets
Restructuring or cancellation of indebtedness
Workforce reductions
Customer loyalty assessment

Once all of the above issues have been thoroughly considered, a rational “bridge” from what was once considered normal to the current environment can be built. And the place to begin building is the Income Statement.

The Income Statement
Traditionally, the first and most obvious step is to forecast sales or revenue based on past history. While that may have worked in the past, additional scrutiny should be applied as noted above. One way to test this first pass at projecting revenue is to do a ground up customer by customer assess-ment to see who will “hang with” the company during its hour of need. Things to consider in this assessment would be the impact of reduced customer service due to layoffs or cost reductions, loss of key salesmen that have longstanding customer relationships, reduced order fulfillment percentages due to lack of inventory and increased back-order wait times. All of these potential negative scenarios are typical of companies in distress and must be weighed carefully to arrive at a realistic sales goal. On the positive side, the potential for new customers or expansion of existing relationships should be considered. However, caution is the word of the day when predicting sales growth. Performing an analysis of this nature is time consuming and involves many different departments in order to be as effective as possible. And, it is not just an exercise for upper management. Employees who have direct contact with customers should be involved, as well.

An alternative to the customer by customer approach would be a product by product approach. If the business involves an excessive number of products, then a product line basis can be utilized. Using this method to predict revenue can be useful in situations where customer relationships are less important than the product itself. Key factors to consider in this particular business situation might be the obsolescence of a product, competitive pricing pressure, the need to raise prices, loss of key suppliers due to payment concerns, cutbacks in new product development and elimination of marginal products or low volume items. As with the customer by customer approach, any positive sales growth, either from existing products or new products, should be approached cautiously to guard against excessive optimism.

Once sales have been determined, the cost of goods sold or services provided should be determined. As with sales fore-casting, all of the factors of distress must be included in the equation in order to arrive at a realistic cost. The key financial driver in this area is gross margin. Distressed situations are commonly preceded by declining margins which is either caused by declining prices, rising manufacturing costs or both. Ferreting out the causes of declining margins is imperative to arriving at a realistic go forward scenario.

Moving down the traditional income statement, selling, general and administrative (“SG&A”) costs should then be addressed. These types of cost are usually easier to predict and will not be dealt with at length here except to provide the following cautionary note. It is important to identify SG&A costs that are fixed and those that vary with sales volume. It is all too common for forecasts to assume all SG&A costs are fixed in nature or, the entire SG&A cost category is pegged to a percentage of sales in the forecasting model. In reality there are a number of expenses that fluctuate with sales volume and there are many that remain fixed. Items such as commissions, customer rebates, coop advertising costs and freight are just a few examples of variable costs. Examples of fixed costs would be the usual items such as office rent, communications cost, IT expense and office administrative personnel (i.e. accounting, marketing, customer service, etc.). In a distressed business, the difference between survival and failure can be a fine line. There-fore, SG&A costs should not be overlooked or dealt with in a summary fashion.

The Balance Sheet
Once the Income Statement has been solidified, the operational blueprint for the business has now begun to take shape. Sales volumes should be known, costs levels have been set and appropriate personnel needs have been established for the anticipated sales level. Often overlooked, the Balance Sheet can be a very useful source of infor-mation. A primary focus should be working capital (current assets minus current liabil-ities). For purposes of this article, the focus will be on the normal key drivers of working capital: accounts receivable (“AR”), inventory and accounts payable (“AP) or the “big three.” For the reviewer or preparer of a financial forecast, particular attention should be paid to certain financial ratios related to these three areas of the balance sheet.

For AR, days sales outstanding or “DSO” should be chosen carefully. In many dis-tressed businesses, customers have begun to slow down payments waiting to “see what happens” with the business, or they are simply taking advantage of an opportunity to enhance their own short term cash flow. Whatever the reason, AR levels will climb as invoices go unpaid, causing DSO to increase. The trap that exists for forecasting purposes is in relying on historical DSO rates. It is important to look at the most recent data to determine an appropriate number of days. Once the rate has been determined, assuming it reflects a higher than normal rate, the next question is to decide how quickly it will return to more normal levels. Obviously, shipping goods out the door or providing services that will now take 60 days to get paid on versus a more normal 45 days can have a profound effect on the business.

Inventory can be one of the most difficult areas to forecast. There are numerous factors and potential problems to consider. In distressed situations, inventory manage-ment can fall by the wayside, because management is preoccupied fighting fires. When inventory mix gets out of balance, suppliers refuse to ship, sales slip and slow moving or obsolete items accumulate, etc. These issues are just a sampling of the problems which might occur. The dilemma for forecasting purposes is accurately knowing the quality and quantity of inventory reflected in the beginning balance. A good question o ask is whether or not a recent physical inventory has been done. If not, be cautious in assuming beginning inventory is adequate. A quick burst in purchasing needs and the associated cash requirement can be prob-lematic. Once these issues have been dealt with, the key driver is inventory turns. A business that turns their inventory over four times a year needs 3 months of inventory on hand. As with AR, if sales have slowed, historical turns may not be indicative of the current status quo. In addition, if profit improvement initiatives have been under-taken (lean manufacturing, just-in-time, six sigma, etc.), then the impact on inventory levels needs to be calculated.

The last of the “big three” is AP. This balance sheet account is the catch-all for all payments that are due. If the forecast is for a business selling inventory, the largest type of payment running through AP will probably be to inventory suppliers. If the business has been put on cash on delivery (“COD”) status by many of its suppliers, this AP will be a crucial area requiring close scrutiny. Normal terms of Net 30 may no longer apply. And if so, how long will it be before there is a return to normalcy? Additionally, SG&A costs must be considered, as well. The bottom line is that all inventory purchases and all costs must eventually be paid for at some point. Forecasting the timing of that payment is the key.

Cash Flow – The Rubber Meets the Road
In all distressed business situations, the old adage “cash is king” still rings true. By having the Income Statement and Balance Sheet forecasts completed, the foundation has been laid allowing for the projection of cash inflows and outflows. The cash flow forecast acts as the reality check for the other forecasting assumptions taken as a whole. For example, if sales volume dictates a higher level of inventory (or hiring personnel if a service business), but the cash requirement necessary to support it is not feasible due to the timing of customer (inflow) and supplier (outflow) payments, then the forecast needs to be revised. As you can see, the assumptions built into the Income Statement and Balance Sheet interact to present a certain cash flow reality that must be met. The distressed situation may call for a choice among any number of factors. To meet the shortfall, the business may need to increase debt or raise capital. Another alternative, might be cutting costs more severely. A third choice could be working with suppliers to extend credit terms versus COD or lengthen existing terms, say Net 10 to Net 30. The potential decision points are endless and will be dictated by management’s best efforts at determining what is possible under the circumstances.

An excellent way to check the reason-ableness of a forecast is to perform a sensitivity analysis on the model or “stress test” it. For example, what would happen if sales were increased or decreased by 5% or 10%? What if customers paid quicker and DSO was 35 instead of 45? What if excess inventory was liquidated within 30 days or inventory turns were off up or down by a month? All of these factors could have a profound impact on the financial outcome being forecasted. To arrive at a forecast that builds in a certain amount of conservatism, yet sets the business up for future success, is a delicate balancing act. Stress testing can be a very useful tool in that regard.

A final comment on the Statement of Cash Flow should be mentioned at this point. Generally accepted accounting principles, commonly called GAAP, prescribe a certain format for presentation of cash flows. The GAAP presentation breaks cash flow down into 3 sections – cash flow from operating, financing and investing activities. Cash flow from operations begins with Net Income to which non-cash charges, such as depreciation and amortization, are added back along with the increase or decrease from changes in working capital. The problem with the GAAP presentation is that it is difficult or impossible to track the inflow and outflow of cash related to specific activities. For example, in a GAAP cash flow statement, cash receipts from customers are buried in two places. They are hidden in the Net Income amount and the net change in AR in the working capital section.

In a distressed situation, it is paramount that specific cash outflows be clearly identified and easily tracked. The ability to monitor total customer receipts, payroll costs, inventory purchases, etc. and compare it to the forecast is an essential tool. An alternative to the GAAP approach of forecasting in these type situations is one best described as the Balance Sheet approach. In this approach, there are two sections to the forecasted Statement of Cash Flow, cash receipts and cash disbursements. The total ins and outs for cash on each significant Balance Sheet account should be shown separately in the appropriate section. For example, a quick cash sale of liquidated inventory would show up as a cash receipt, while a disburse-ment for purchase of inventory would show up in the disbursements section. The same concept holds for AR. A sale on credit to a customer would cause AR to increase in the working capital section of the GAAP model. In the approach advocated here, a sales on credit would show up in the cast receipts section only when the customer paid. A sale on credit has no effect on cash. Following this approach also allows for easier comparisons between the longer term 3-5 year forecast and the short term cash forecast. The approach found most often in short term cash forecasting is one that simply begins with the question “Where is cash coming in from and where is it going?” Consequently, it is a more practical represent-ation and mirrors the Balance Sheet approach described above.

Summary
An achievable and realistic financial forecast is an invaluable tool that is essential to navigating the minefield of a turnaround or workout. Following some of the guidelines noted above, while being aware of the potential pitfalls that exist in distressed situations, will ultimately lead to better forecasting. In general, everyone is happy when “they beat the numbers.”

Mr. Belt is a Managing Director at FTI Consulting and acts as a financial advisor to creditors, debtors and equity holders for both in and out of court reorganizations. He earned his BS in Accounting degree from the University of Kentucky and is a licensed CPA in Kentucky and Arizona. He is a Certified Insolvency and Restructuring Advisor, a member of the AIRA and the TMA, awaiting formal receipt of his Certified Turnaround Professional certification for which he has completed all requirements. Mr. Belt can be contacted at dale.belt@fticonsulting.com