Chapter 11 Flashcards
why is forecasting financial performance important
important to business decisions
using financial forecasts to value stocks and inform investment decisions, investors and analysts
might be interested in evaluating the creditworthiness of a prospective borrower. In that case, they
forecast the borrower’s cash flows to estimate its ability to repay its obligations, and bond ratings
are influenced by those forecasts. Company managers also frequently forecast future cash flows
to evaluate alternative strategic investment decisions as well as to evaluate the shareholder value
that strategic investment alternatives will create.
why does the forecasting process begin with a retropersecptive analysis
analyze current and prior years’ statements to be sure that they accurately reflect the
company’s
core, economic
financial condition and performance. If we believe that they do not, we
adjust those statements to reflect the company’s net operating assets and liabilities and operating
income that we expect to persist.
why do we adjust historical results?
income statements can contain one-
time (transitory and/or nonoperating) income or expense items that affect reported profit. Because
our objective is to forecast
future
income and cash flow, we must first identify and eliminate
transitory items because, by definition, they will not recur.
This adjusting process, also referred to as recasting, reformulating, or scrubbing the numbers,
involves estimates. This estimation process requires judgment and varies by firm.
what’s the forecasting order of financial statements and why?
forecasting process estimates future
income statements, balance sheets, and statements of cash flows, in that order. The reason for this
ordering is that each statement uses information from the preceding statement(s).
why is revenue forecast the most crucial and difficult estimate?
It is a crucial estimate because other income statement and bal-
ance sheet accounts derive, either directly or indirectly, from the revenues forecast. As a result, both
the income statement and balance sheet grow with increases in revenues. The income statement
reflects this growth concurrently. However, different balance sheet accounts reflect revenue growth
in different ways. Some balance sheet accounts anticipate (or lead) revenue growth (inventories are
one example). Some accounts reflect this growth concurrently (accounts receivable). And some
accounts reflect revenue growth with a lag (for example, companies usually expand property, plant,
and equipment [PP&E] only after growth is deemed sustainable). Conversely, when revenues decline,
so do the income statement and balance sheet, as the company shrinks to cope with adversity. Such
actions include reduction of overhead costs and divestiture of excess assets.
what are 2 points to keep in mind for forecasting consistency and precision
Internal consistency.
The forecasted income statement, balance sheet, and statement of cash
flows are linked in the same way historical financial statements are. That is, they must articulate
(link together within and across time), as we explain in Module 2. Preparing a forecasted state-
ment of cash flows, although tedious, is often a useful way to uncover forecasting assumptions
that are inconsistently applied across financial statements (such as capital expenditures, depreci-
ation, debt payments, and dividends). If the forecasted cash balance on the balance sheet agrees
with that on the statement of cash flows, it is likely that our income statement and balance
sheet articulate. We also must ensure that our forecast assumptions are internally consistent. For
example, we would not forecast an increased gross profit margin during an economic recession
unless we can make compelling arguments based on known business facts about the company.
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Level of precision.
Computing forecasts to the “
nth decimal place” is easy using spread-
sheets. This increased precision makes the resulting forecasts appear more precise, but they
are not necessarily more accurate. As we discuss in this module, our financial statement fore-
casts are highly dependent on our revenues forecast. Whether revenues are expected to grow
by 2% or 3% can markedly impact profitability and other forecasts. Estimating cost of goods
sold (COGS) and other items to the
nth decimal place is meaningless if we have imprecise
revenue forecasts. Consequently, borderline decisions that depend on a high level of forecasting precision are ill-advised.
how to forecast the income statement
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Sales estimate.
The forecasting process begins with an estimate of the sales growth rate. For our
illustration, we assume a 1% growth rate, the midpoint of P&G’s guidance. Given the assumed
1% growth in sales, forecasted FY2023E sales are $80,989 million ($80,187 million × 1.01).
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Expense estimates.
To estimate operating expenses (cost of goods sold and the selling,
general, and administrative [SG&A] expenses) we multiply forecasted sales by a forecasted
percentage of sales ratio. We forecast depreciation expense as the beginning year PP&E,
gross balance multiplied by an estimated depreciation rate. We forecast interest expense using
average interest-bearing debt for the year multiplied by an estimated interest rate. For other
nonoperating expenses and revenues, we initially assume they will not change (“no change”), unless we gather information to the contrary. (In Appendix 11B, we relax the “no change”
assumption because we add debt to achieve a desired level of cash. Additional debt causes
interest expense to increase. We discuss these additional steps in Appendix 11B.)
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One-time item estimates.
One-time items such as asset impairments and discontinued opera-
tions, are, by definition, not expected to recur. We forecast these items to be $0. P&G does
not report any nonrecurring income or expenses in FY2022.
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Other nonoperating income and expenses.
Other nonoperating items may or may not
recur and our forecasts must consider the nature of such items. If the item is recurring and
the amount varies, we can normalize the amount (either in dollar terms or as a percent-
age of sales). P&G’s nonoperating income has fluctuated from $86 to $871 from FY2018
to FY2022. Because of this variation, we use a 5-year average to forecast the amount for
FY2023, which results in $437 million.
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Tax estimate.
Income tax expense is forecasted based on PG’s guidance of 19.25% of pretax
income.
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Noncontrolling interest estimate.
A common assumption is no change in the ratio of noncon-
trolling interest to consolidated net income. For our P&G illustration, we adopt that assumption.
what’s the role of sales in the income statement forecast
sales are used as a income statement forecast driver
forecast most income statement line items as a percent of sales - unless we are aware of transitory items that affect the current year’s income statement, we use the current year percentage of sales in our forecast
how is COGS, gross margin, SG&A expense, interest expense, income tax expense, impact of acquisitions, impact of divestitures forecasted in an income statement
COGS + gross margin - utilizing MD&A to forecast
SG&A expense - using MD&A to forecast, + costs
Interest expense - average debt balance during the year x estimated % interest rate
income tax expense - applying an estimated tax rate to pretax income
impact of acquisitions - when one company acquires another, the revenues and expenses of
the acquired company are consolidated, but only from the date of acquisition onward (we discuss
the consolidation process in an earlier module). Acquisitions can greatly impact the acquirer’s
income statement, especially if the acquisition occurs toward the beginning of the acquirer’s fiscal
year.
impact of divestures -
When companies divest of discontinued operations, they are required to:
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Exclude sales and expenses of discontinued operations from the continuing operations por-
tion of their income statements.
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Report net income and gain (loss) on sale of the divested entity, net of tax, below income from
continuing operations in the income statement.
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Segregate the assets and liabilities of discontinued operations and report them on separate line
items—these are labeled “assets held for sale” or “liabilities held of sale” on the balance sheet.
reassess the financial statements forecasts
how to forecast accounts in balance sheet
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Working capital accounts.
We use an assumed percentage of forecasted sales to estimate
accounts receivable, inventories, accounts payable, and accrued liabilities.
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PP&E and intangible assets.
To forecast PP&E, we increase the prior year’s PP&E, gross
balance by estimated CAPEX and reduce the estimate by forecasted depreciation expense (we
discuss the forecasting of PP&E assets below). We forecast intangible assets by subtracting
forecasted amortization expense, and we assume no purchases of new intangible assets during
the forecast year (see Analysis Insight box below for another approach).
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Short- and long-term debt.
We assume P&G will make all contractual payments of long-
term debt. Thus, we reduce short-term debt by the FY2022 current maturities of long-term
debt reported in the notes. Then, we reclassify the FY2024 current maturities from long-term
to short-term debt. Other than contractual repayments, we assume that short- and long-term
debt remain unchanged (we refine this assumption in Appendix 11B). We also assume that
capitalized leases will remain unchanged, which is consistent with P&G repaying existing
leases at the same rate as it adds new leases (in dollar terms).
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Stockholders’ equity.
We assume paid-in capital accounts remain at prior years’ levels,
except for planned repurchases of treasury stock, as reported by P&G in its FY2022 earnings
release. Retained earnings is
increased by forecasted net income and reduced by estimated
dividends.
(We discuss the forecasting of dividends below.)
The last step in the forecasting process is to balance the balance sheet. To do this, we determine
the amount needed in the Cash account to balance the balance sheet, computed as total assets (set
equal to total liabilities and equity) less all other asset balances. This balancing figure is referred
to as the
plug
amount (explained below).
how to forecast CAPEX
anticipated CAPEX
forecasted CAPEX = (current year CAPEX / Current year sales) x forecasted sales
how to forecast depreciation expense
historic depreciation expense rate = current year depreciation expense / prior year PP&E (gross)
how to forecast intangible assets
forecasted intangible assets = current year intangible assets - forecasted amortization expenses
how to forecast retained earnings
forecasted RE = current RE + forecasted net income - forecasted dividends
how to forecast dividends
forecasted dividends = (current year dividends / current year net income ) x forecasted net income
