skills/three-statement-model-builder/references/forecast-judgment-guide.md

# Forecast Judgment Guide

Use this reference to make forecast assumptions CFO-grade and Portfolio Manager-grade.

## Senior judgment standard

A strong 3-statement model does not just project numbers. It explains the business engine, tests whether assumptions are plausible, and shows how decisions affect liquidity, profitability, and value.

When setting or reviewing assumptions, ask:

1. What actually drives revenue?
2. Which costs are fixed, variable, semi-variable, or discretionary?
3. What operating leverage is plausible?
4. What working capital investment is required to support growth?
5. What capex is required to sustain or expand the business?
6. What financing constraints or covenants matter?
7. What assumptions would a skeptical board member, lender, or PM challenge first?
8. What is the downside path, not just the upside story?

## Assumption hierarchy

Prefer assumptions in this order:

1. User-provided facts and source documents
2. Historical company data after normalization
3. Management guidance or budget, clearly labeled
4. Contractual data such as debt terms, leases, backlog, pricing, or customer agreements
5. Operating KPIs and unit economics
6. External benchmarks or comparable-company logic, cited when available
7. Modeler assumption, clearly flagged for review

Do not invent facts. If a key input is missing, create a placeholder and label it as requiring review.

## Historical analysis before forecasting

Before forecasting, calculate historical diagnostics where data is available:

- revenue growth by period
- gross margin
- EBITDA margin
- operating expense ratios
- headcount productivity, if applicable
- DSO, DIO, DPO, and cash conversion cycle
- capex as percent of revenue
- D&A as percent of PP&E or capex
- effective tax rate
- interest rate on average debt
- cash conversion and free cash flow conversion
- leverage and coverage ratios

Use these diagnostics to challenge forecast assumptions.

## Revenue forecast judgment

Choose the revenue method that fits the business model.

Common methods:

- price x volume
- customers x ARPU
- ARR / subscription base x retention x new bookings
- GMV x take rate
- transactions x fee per transaction
- backlog conversion
- same-store sales and new store openings
- utilization x bill rate x billable headcount
- production volume x average selling price
- project pipeline conversion

Avoid lazy revenue forecasting when driver data exists. A percentage-growth revenue row can be acceptable for a high-level model, but it should be tied to historical trend, management case, market logic, or a clear scenario narrative.

Challenge revenue assumptions for:

- customer concentration
- churn or retention
- pricing power
- sales capacity
- implementation lag
- backlog quality
- market size
- cyclicality
- FX exposure
- seasonality
- one-time revenue
- channel constraints

## Gross margin and COGS judgment

Gross margin should reflect how the business earns money.

Consider:

- product mix
- labor productivity
- input costs
- hosting / infrastructure costs
- fulfillment / logistics
- warranty / returns
- utilization
- volume leverage
- pricing pass-through
- inventory reserves
- contract margin profile

Do not assume margin expansion solely because revenue grows. Explain why scale benefits, mix shift, pricing, automation, or procurement improvements support the change.

## Opex judgment

Operating expense forecasts should reflect organizational design, not just percentages.

Consider:

- headcount by department
- compensation, benefits, bonus, and payroll taxes
- sales capacity and quota coverage
- R&D roadmap
- G&A infrastructure required for scale
- public-company costs, if relevant
- systems, software, facilities, insurance, and professional fees
- one-time restructuring or integration costs

For high-growth companies, opex often precedes revenue. For mature companies, opex may scale more slowly but still needs inflation, hiring, and capability assumptions.

## Working capital judgment

Working capital is often where models hide unrealistic growth.

Use the right driver by account:

- accounts receivable: DSO or revenue timing
- inventory: DIO, turns, production plan, or SKU logic
- accounts payable: DPO or COGS / inventory purchasing base
- deferred revenue: billings, bookings, or subscription terms
- accrued expenses: opex or payroll timing
- other current assets / liabilities: specific operating logic or stable percentage base

Challenge:

- growth without receivables investment
- inventory reduction while sales accelerate
- payables extension beyond vendor reality
- negative working capital assumptions without a clear business model reason
- cash conversion cycle changes with no explanation

## Capex and D&A judgment

Capex should support the operating plan.

Consider:

- maintenance vs growth capex
- store, facility, plant, or equipment rollout
- software development capitalization
- capacity utilization
- replacement cycle
- leasehold improvements
- technology infrastructure
- regulatory or safety capex

D&A should follow the asset base and useful lives. Do not let D&A drift disconnected from PP&E or capex unless immaterial and clearly simplified.

## Debt, interest, and liquidity judgment

For debt and liquidity, model both economics and constraints.

Include where relevant:

- debt tranches
- amortization
- maturities
- cash sweep
- revolver draws and repayments
- minimum cash
- interest rates, floors, spreads, and PIK interest
- fees
- covenants
- restricted cash
- dividends or distributions

Under stress, cash should not behave magically. Debt should not go negative unless explicitly allowed. Liquidity pressure should show up through cash balance, revolver usage, covenant headroom, or funding need.

## Tax judgment

Tax assumptions should consider:

- pre-tax income base
- losses and NOLs
- valuation allowances
- cash vs book taxes
- jurisdictional mix
- interest deductibility limits
- deferred taxes if material
- one-time tax items

Do not blindly apply a tax rate to negative pre-tax income without checking whether tax benefit recognition is reasonable.

## Scenario design

Scenarios must tell economically coherent stories.

### Base case

The most supportable plan based on current data, management assumptions, historical performance, and reasonable execution.

### Downside case

A credible stress case. It should usually combine more than one pressure point, such as slower revenue, margin compression, working capital drag, and financing pressure.

### Upside case

A plausible outperform case. It should include the investments or constraints required to achieve it, not just better revenue and margins.

### Lender case

Often more conservative than management case. Focus on cash generation, covenant headroom, debt capacity, and downside protection.

### Investment case

Should explicitly bridge from base assumptions to the investment thesis and identify what must go right.

## Assumption challenge checklist

For each material assumption, ask:

- Is this supported by historical data?
- Is the magnitude plausible?
- Is the timing plausible?
- Does the assumption conflict with another schedule?
- Does the model explain why this changes?
- What happens if this assumption is wrong?
- Is this an input, calculated output, or hidden plug?

## Red flags

Flag these as senior-review issues:

- hockey-stick revenue with no driver
- margin expansion without operating rationale
- working capital release while revenue grows rapidly
- capex too low to support growth
- debt paydown despite weak cash generation
- taxes that improve economics without support
- EBITDA growth not converting to cash
- scenario labels that do not change calculations
- outputs moving in the wrong direction under stress
- assumptions buried in formulas

## Equity PM Forecast Overlay

For Public Equity Investing, the three-statement model is an equity forecast engine. Prioritize revenue/KPI build, margin bridge, EPS revision path, FCF conversion, cash burn as common-equity risk, working-capital surprises, share count, buybacks, SBC, estimate sensitivity, and handoff to DCF/comps. Covenant and debt-stack detail is included only when it changes common-equity downside; primary covenant, maturity wall, debt-stack, spread/yield, or recovery analysis routes to Credit Markets.