Modeling of corporate financial activity is an essential part of financial analysis, budgeting and company valuation. A model, consisting of selected items from financial statements usually is constructed and used for forecasts without any specific techniques – simply predicting potential growth of a company’s income according to historical trends (adjusted by overall economic situation or intentions of management) and calculating other items, such as profit or working capital, using historical or desired ratios. Choosing assumptions for modeling and forecasting includes a high amount of subjectivity, caused by human factor. It could be reduced by using econometric techniques.

It is common knowledge that corporate activity is highly influenced by macroeconomic environment and econometric methods could be useful to incorporate both, endogenous financial statement (also called accounting) variables (e.g. sales, expenditures, investments, liabilities etc.) and exogenous macroeconomic (e.g. GDP growth, inflation, interest rates, etc.) ones.

As it was mentioned before, one of the purposes of financial modeling is company valuation (not only for companies listed on exchanges, but also for those involved in mergers and acquisitions (hereinafter – M&A) process), which can be performed using discounted cash flow (hereinafter – DCF) method. Due to this reason mainly items necessary for calculating free cash flow (hereinafter – FCF) and equity value will be modeled in the empirical part of the Thesis. These are: operating profit, depreciation and amortization, short-term assets and liabilities, long-term assets, financial debt and other auxiliary items.

The research problem is how to model and forecast items necessary to calculate a company’s FCF using econometric methods. From the problem definition the main aim to verify major hypothesis, whether financial statement items can be modelled using econometric techniques appears. The hypothesis can be split in three minor ones, which will be easier to verify:

There are “causal relationships between variables “ from financial statements (Medeiros, 2005);

Macroeconomic variables are useful for modelling company’s financial statement items;

Econometric models are useful for short-term (one year ahead) forecasting of financial statement items.

The objectives necessary to achieve the aim and to solve the problem will be:

Analyze the literature on the subject of econometric modelling of corporate performance;

Specify a theoretically reasonable model(s) to explain selected accounting variables using macroeconomic variables;

Choose some Lithuanian companies providing sufficient amount of data;

Estimate the model(s);

Test validity of the models in terms of goodness-of-fit criteria and forecasting performance.

All except one (Doornik, Medeiros and Oliveira (2009)) researches analyzed used structural simultaneous-equations models (SEM) estimating them by ordinary least squares (hereinafter OLS) or two-step least squares (hereinafter 2SLS) techniques. The major possible problem to encounter in the research can be insufficient amount of data available, as only companies listed on exchanges provide their financial statements publicly and for rather short period of time. In Elliott’s work (1973) such problem occurred and he said his “model is overidentified simultaneous system having a large number of exogenous and lagged endogenous variables relative to number of observations.” To tackle the problem “the structurally ordered instrumental variables [hereinafter – IV] approach” was used and this method will be possible (if necessary) in this Thesis.

Doornik et al. (2009) presented alternative way for modeling corporate activity: vector autoregression (hereinafter VAR) model, followed by vector error correction model (hereinafter VECM), mainly reasoning that “its forecasts are considered superior to simultaneous equation models”.

In order to get the most valid models for selected Lithuanian companies (in aspects of the best fitting to data and forecasting performance) all types of before mentioned methods will be used and conclusions, which of them are the most suitable (if suitable at all), will be provided.

In the Thesis secondary quantitative data will be used. It will include:

Official statistics, such as economical indicators (e.g., GDP growth, inflation and unemployment rates, growth of gross wage, interest rate, etc.) available through internet pages of state institutions (e.g. Department of Statistics to the Government of the Republic of Lithuania www.stat.gov.lt, The Ministry of Finance of the Republic of Lithuania www.finmin.lt, the Bank of Lithuania www.lb.lt.

Data from companies’ financial statements (income, profit, depreciation, liabilities, etc.) will be collected from internet page of exchange operator NASDAQ OMX Vilnius www.nasdaqomxbaltic.com. The companies that provided financial statements for the longest period of time (approximately for 10 years) will be selected.

The quantitative data analysis will be prepared with statistical / econometrical computer software, like R, EViews (Model object (Cuddington et al. (2008)), Gretl or / and simply Excel add-inn for data analysis.

The research was started carefully analyzing works previously done on similar topics. A summary of comprehensive literature analysis and evaluation is provided in Literature Review part. After discussing previous approaches on the topic Problem Definition part is provided. In the Methodological Approach part techniques chosen are justified and models specified. After this the most time consuming and various types of knowledge and skills requiring analytical part was performed. The results of it are summarized in Empirical Research Report. The last but not the least parts are Discussion and Conclusions, where literature review and findings of empirical research are integrated and everything summarized.

Literature Review

Application of econometric methods in corporate finance sphere is not very popular due to lack of data available and usually short time series. But there are some works devoted exactly to the econometric modeling of company’s financial statements incorporating macroeconomic variables. These are presented in section 2.1. and further research will based on theoretical framework constructed combining these works. Other literature, reviewed in section 2.2. …

Review and Analysis of Historical Researches on Econometric Modeling of Company’s Financial Activity

Saltzman (1967) was the first who broke the ice using econometric techniques to model a company’s financial statements. He constructed a simultaneous equation model consisting “of ten relational equations and five definitional equations” (p. 332). Endogenous variables, such as sales, production prices, amount of output, inventories, various costs and expenses, investments were taken from the company’s financial statements and other reports. The main exogenous variables, included into the model, were wage rates, raw materials prices and determinants of external demand. All the data used was quarterly, for nine years “allowing 35 observations for estimating purposes” (p. 339). The author chose to analyze a large US corporation’s subsidiary, working in oligopolistic market of manufacturing and selling home laundry appliances.

In order to get better interpretable results, theoretically specifying model it was divided into three parts:

Sales, prices, inventory and output

Investment and expenses

Cost and profit

Speaking about the first group of endogenous variables, Saltzman describes the company’s sales as demand function, depending on rather large amount of factors: sales in previous period; sales and product engineering expenses, “deflated by an appropriate average wa