Long-Term Financial Statements Forecasting: Reinvesting Retained Earnings
Cheremushkin, Sergei V. 2010. “Long-Term Financial Statements Forecasting. Reinvesting Retained Earnings,” The Valuation Journal, Vol. 5, No. 2. pp. 46-87.
26 Pages Posted: 19 Oct 2008 Last revised: 13 Aug 2012
Date Written: September 18, 2008
One of the most intricate issues in the long-term financial statements forecasting concerns the employment of accumulated retained earnings for a profitable firm. Reinvesting retained earnings is a strategic choice of far-reaching consequences. Actually, optimistic forecast may imply exponential growth of income through reinvestment of retain earnings in business. If the retained earnings are kept as cash, that will result in decreasing return on capital, not to mention this to be unrealistic scenario. In a growing market the firm usually expands its business, acquiring new long-lived assets, increasing capacity and sales. So, the main task in the accurate forecast is to find the reliable relationship between capital expenditures and sales, taking proper account of operating margin of sales, generated by new assets.
The basic forecast, given the fixed or even neutral (only replacement of amortizable assets) investment policy, usually consists in finding the additional funds needed or excess cash amount. The case of negative cash balance is rather uninteresting. It requires the managers to take financial policy decisions to raise money needed. The implications of those decisions, assuming lack of changes in investment policy and capacity, are regular interest payments. However, the case of positive cash balance requires managers to decide how to place the excess cash. There are several possible ways to effectively use cash: share buyback, dividends, new investments in long-lived assets, and as a result in expanding business, investments in marketable securities or financial assets, investment property. The most complicated and the most realistic case is new investments in long-lived assets and strategic decisions. There may be alternatives - the firm may invest to increase sales of existing product or products or it may invest in developing new product(s). The paper considers different approaches to the problem in order to construct adequate financial model.
Keywords: financial statements forecasting, retained earnings, plugs, firm's valuation, financial modelling, business planning, additional funds needed, excess cash, reinvestments, sensitivity analysis, Monte-Carlo simulation, probabilistic analysis
JEL Classification: G31, M41
Suggested Citation: Suggested Citation