Module 10 Adjusting and Forecasting Financial Statements

Why forecast?  We might, for example, wish to value a company’s common stock. To that end, we forecast free cash flows or residual operating profits as inputs into one of several valuation models.  Or, we might be interested in evaluating the credit worthiness of a prospective borrower. In that case, we forecast cash flows to estimate the ability of the firm to repay its obligations.  We might even be interested in evaluating alternative strategic plans for management decisions. In this case, our forecasts might be evaluated on the creation of shareholder value.

Adjusting the Financial Statements  The forecasting process begins with a retrospective analysis.  We are interested in the extent to which reported financial statements reflect our view of the financial condition and performance of the company.  Consequently, we often prefer to adjust reported financial statements prior to commencing the projection process.

Adjusting the Financial Statements  Although in conformity with GAAP, The income statement might include transitory items that should not be forecasted The balance sheet might include nonoperating items, or exclude operating items like leased assets or assets accounted for under the equity method The statement of cash flows might not represent true operating cash flows due to excessive inventory reductions or leaning on the trade, cash inflows form asset securitizations, and so forth.

Why Adjust the Income Statement? Separate core and transitory items – since transitory items are nonrecurring, they should be excluded for forecasting.Separate core and transitory items – since transitory items are nonrecurring, they should be excluded for forecasting. Separate operating and nonoperating items – core operating activities have the most long-lasting effects on future profitability and cash flows and, thus, are the primary value drivers for company stakeholders.Separate operating and nonoperating items – core operating activities have the most long-lasting effects on future profitability and cash flows and, thus, are the primary value drivers for company stakeholders. Included expenses that net income excludes – to the extent that a company fails to recognize expenses, such unrecognized expenses are included in the adjusting process. These unrecognized expenses may relate to under-accrual of reserves or liabilities or due to reduced expenditures for key operating activities.Included expenses that net income excludes – to the extent that a company fails to recognize expenses, such unrecognized expenses are included in the adjusting process. These unrecognized expenses may relate to under-accrual of reserves or liabilities or due to reduced expenditures for key operating activities.

Why Adjust the Balance Sheet?  Separate operating and nonoperating assets/liabilities  Include non-reported assets/liabilities

Why Adjust the Statement of Cash Flows?  Exclude nonoperating items  Exclude transitory items  Reclassify between operating and nonoperating

Full-Information Forecasting  Forecasting is much more than the mere extrapolation of historical results. Forecasting begin with a retrospective analysis. That is, we analyze current and prior years’ statements to be sure that they reflect the financial condition and performance of the company. If they do not, we adjust those statements to better reflect our perceptions.  The forecasting process utilizes all available information: historical financial and non- financial information, management’s strategic initiatives, forecasts of macroeconomic conditions, the competitive environment, and so forth.

Projecting Financial Statements Projected Income Statement  The projection process begins with an analysis of expected sales growth. We use historical trends to predict Target’s future sales levels. A more detailed analysis could use outside information such as the following: Expected macroeconomic activity. Competitive landscape. New versus old store mix.

Use of Other Information

Projected Income Statement  Steps in the projection of the income statement: Project sales Expense categories are projected either  As a percentage of sales  As a growth rate applied to dollar figures (inflation increase)  As a percentage applied to prior year asset (liability) balances – depreciation, interest  Effective tax rate (tax expense/pre-tax income) or at the marginal rate (35%)

Projected Balance Sheet 1)Forecast each asset account (other than cash) and each liability and equity account 2)Compute the cash amount needed to balance the forecasted accounting equation (Assets = Liabilities + Equity)

Projection Assumptions  No change  Use detailed relations and predicted events (e.g., CAPEX/Sales, Dep’n Exp / Prior Year PPE, scheduled LTD payments, dividend policies)  Use turnover rates

Is Projected Cash Too Low or Too High? Do not inadvertently change the firm’s financial leverage in the process of making adjustments to the cash balance.

Sensitivity Analysis of Projections  The projected financial statements are mainly based on expected relations between income statement and balance sheet accounts. It is often useful to vary these assumptions to assess their impact on financing requirements, return on assets and equity, and so forth.  Analysts often prepare several projections to examine best (worst) case scenarios in addition to the most likely case. This type of sensitivity analysis highlights those assumptions that have the greatest impact on financial results and, consequently, helps to identify those areas requiring greater scrutiny.