Forecasting Financial Statements Module 11 Forecasting Financial Statements

Explain the process of forecasting financial statements. Learning Objective 1 Explain the process of forecasting financial statements. ©Cambridge Business Publishers, 2015

Overview of the Forecasting Process Reformulated financial statements – we adjust the financial statements to reflect the company’s net operating assets and the operating income that we expect to persist into the future. Garbage-In, Garbage-Out – the quality quality of our decision is only as good as the quality of the information on which it is based. Optimism vs Conservatism – our objective is not to be overly optimistic or overly conservative. The objective for forecasting is accuracy. ©Cambridge Business Publishers, 2015

Overview of the Forecasting Process (continued) Level of Precision – borderline decisions that depend on a high level of forecasting precision are probably ill-advised. Smell Test – our forecasts must appear reasonable and consistent with basic business economics. Internal Consistency – forecasted financial statements must articulate and our forecast assumptions must be internally consistent. Crucial Forecasting Assumptions – assumptions that are identified as crucial to a decision must be investigated thoroughly to ensure that forecast assumptions are as accurate as possible. ©Cambridge Business Publishers, 2015

Revenues Forecast Impacts Both the Income Statement and the Balance Sheet ©Cambridge Business Publishers, 2015

Dynamics of Growth (I/S and B/S) Cost of goods sold are impacted via increased inventory purchases in anticipation of increased demand, added manufacturing personnel, and greater depreciation from new manufacturing PPE. Operating expenses increase concurrently with, or in anticipation of, increased revenues; these expenses include increased costs for buyers, higher advertising costs, payments to sales personnel, costs of after-sale customer support, logistics costs, and administrative costs. Cash increases and decreases directly with increases in revenues as receivables are collected and as payables and accruals are paid. ©Cambridge Business Publishers, 2015

Dynamics of Growth (I/S and B/S) (continued) Accounts receivable increase directly with increases in revenues as more products and services are sold on credit. Inventories normally increase in anticipation of higher sales volume to ensure a sufficient stock of inventory available for sale. Prepaid expenses increase with increases in advertising and other expenditures made in anticipation of higher sales. PPE assets are usually acquired once the revenues increase is deemed sustainable and the capacity constraint is reached; thus, PPE assets increase with increased revenue, but with a lag. ©Cambridge Business Publishers, 2015

Dynamics of Growth (I/S and B/S) (continued) Accounts payable increase as inventories are purchased on credit. Accrued liabilities increase concurrent with increases in revenue-driven operating expenses. Other operating assets and liabilities such as deferred revenues, deferred taxes, and pensions, increase and decrease concurrent with revenues. ©Cambridge Business Publishers, 2015

Dynamics of Balance Sheet Growth ©Cambridge Business Publishers, 2015

Forecasting Steps Forecast revenues Forecast operating and nonoperating expenses – We assume a relation between revenue and each specific expense account. Forecast operating and nonoperating assets, liabilities and equity – We assume a relation between revenue and each specific balance sheet account. Adjust short-term investments or short-term debt to balance the balance sheet – We use marketable securities and short-term debt to balance the balance sheet. We then recompute net nonoperating expense (interest/dividend income or interest expense) to reflect any adjustments we make to nonoperating asset and liability account balances. ©Cambridge Business Publishers, 2015

Forecast revenues and the income statement. Learning Objective 2 Forecast revenues and the income statement. ©Cambridge Business Publishers, 2015

Forecasting Revenues Impact of Acquisitions – revenues from acquisitions are only included from the date of the acquisition. Historical revenues used for comparison do not include the acquired company. Impact of Divestitures – revenues and expenses of divested business are excluded from current and historical totals. Existing vs. New Store Growth – new store growth can be more costly than organic growth. Impact of Unit Sales and Price Disclosures – forecasts that are built from anticipated unit sales and current prices are generally more informative, and accurate, than those derived from historical dollar sales. Impact of Foreign Currency Fluctuations – a change in the strength of the $US vis-à-vis foreign currencies has a direct effect on the $US equivalent for revenues, expenses, and income of the foreign subsidiary. ©Cambridge Business Publishers, 2015

Sources of Information Public disclosures via meetings and calls Recordings and supporting documents are frequently available on the “Investor Relations” section of the company’s web site Public reports: segment disclosures and MD&A Companies are required to disclose summary financial results for each of their operating segments along with a discussion and analysis of each ©Cambridge Business Publishers, 2015

P&G Data from MD&A P&G’s net sales (in dollars) increased by 1% in 2013 as a result of a 2% increase in units sold and a 1% increase in prices. Net sales declined, however, as a result of changes in product mix for the Beauty, the Fabric Care, and the Baby Care segments (more lower-priced products were sold), although the overall effect was negligible. During 2013, the U.S. dollar strengthened vis-à-vis other world currencies in which P&G conduct its business. Thus, revenues denominated in foreign currencies decreased by 2% when translated into U.S. dollars. ©Cambridge Business Publishers, 2015

Organic Growth From these segment disclosures, we can develop a history of the factors impacting organic sales growth: ©Cambridge Business Publishers, 2015

P&G’s 4Q earnings release and FY’14 Guidance: Determining the Revenue Growth Forecast: Using Publicly-Available Information P&G’s 4Q earnings release and FY’14 Guidance: ©Cambridge Business Publishers, 2015

Determining the Revenue Growth Forecast: Using Proprietary Databases (Morgan Stanley) Each product forecast is built from the bottom up; that is, analysts use information about a product’s market share and the forecasted growth rate for the market of each product within each country the product is sold. Morgan Stanley analysts also have internally-developed databases of commodity-price indices, inflation indices, and other macroeconomic indices against which to evaluate the reasonableness of company-provided forecasts. Sales forecasts are determined by quantity and price along with growth forecasts of the product markets, the company-provided future pricing strategy, and forecasts of price elasticity of demand. ©Cambridge Business Publishers, 2015

Morgan Stanley Forecasts ©Cambridge Business Publishers, 2015

Forecasting Expenses ©Cambridge Business Publishers, 2015

Forecasted Income Statement for P&G ©Cambridge Business Publishers, 2015

Forecast the balance sheet. Learning Objective 3 Forecast the balance sheet. ©Cambridge Business Publishers, 2015

Forecasting the Balance Sheet ©Cambridge Business Publishers, 2015

Forecasting Balance Sheet Items Forecast amounts with no change – common for nonoperating assets (investments in securities, discontinued operations, and other nonoperating investments). Forecast contractual or specified amounts – we assume that the required payments are made as projected. Forecast amounts in relation to revenues – the underlying assumption is that, as revenues change, so does that item in some predictable manner. ©Cambridge Business Publishers, 2015

Computational Options Forecasts using percent of revenues: Forecasts using turnover rates: Forecasts using days outstanding: ©Cambridge Business Publishers, 2015

Equivalence of Forecasting Methods We use the percent of sales in our forecasts of balance sheet accounts because: it appears to be the most commonly used method, it is the method that P&G management uses in its meetings with analysts, and it is the method used by many investment firms. ©Cambridge Business Publishers, 2015

Forecasted Balance Sheet for P&G ©Cambridge Business Publishers, 2015

Adjusted Forecasted Income Statement for P&G ©Cambridge Business Publishers, 2015

Forecast the statement of cash flows. Learning Objective 4 Forecast the statement of cash flows. ©Cambridge Business Publishers, 2015

Forecasted SCF for P&G ©Cambridge Business Publishers, 2015

Reassessing the Financial Statement Forecasts Many analysts and managers prepare “what-if” forecasted financial statements. They change key assumptions, such as the forecasted sales growth or key cost ratios and then re-compute the forecasted financial statements. These alternative forecasting scenarios indicate the sensitivity of a set of predicted outcomes to different assumptions about future economic conditions. Such sensitivity estimates can be useful for setting contingency plans and in identifying areas of vulnerability for company performance and condition. ©Cambridge Business Publishers, 2015

Prepare multiyear forecasts of financial statements. Learning Objective 5 Prepare multiyear forecasts of financial statements. ©Cambridge Business Publishers, 2015

Two-Year Ahead Forecasts of the P&G Income Statement ©Cambridge Business Publishers, 2015

Two-Year Ahead Forecasts of the P&G Balance Sheet ©Cambridge Business Publishers, 2015

Two-Year Ahead Forecasts of the P&G Statement of Cash Flows ©Cambridge Business Publishers, 2015

Implement a parsimonious method for multiyear forecasting of Learning Objective 6 Implement a parsimonious method for multiyear forecasting of net operating profit and net operating assets. ©Cambridge Business Publishers, 2015

Parsimonious Method of Multiyear Forecasting Inputs: Sales growth Net operating profit margin (NOPM = NOPAT / Sales) Net operating asset turnover (NOAT = Sales / NOA) ©Cambridge Business Publishers, 2015