DAC 511 CORPORATE FINANCIAL REPORTING & ANALYSIS GROUP 7 PRESENTATION Prospective Analysis

GROUP MEMBERS No. Name Registration Number MERCY CHELANGAT 1 MERCY CHELANGAT D63/79059/2012 2 KOSGEI JUSTINE D63/61383/2013 3 DAVID CHIKEKA D63/73044/2012 4 ABDIRIZAK MOALIM D63/60121/2013 5 NYANGALA ALLAN H. D63/67803/2011 6 FRANK KILONZO M D63/80470/2012 7 RICHARD NOAH D63/60864/2013 8 ESBON WAMATHU W. D63/61264/2013 9 DENNIS KIMANI D63/60534/2013 10 VERA NYABOKE D63/61416/2013

Prospective Analysis Prospective analysis is the forecasting of the future financial information. Two commonly used techniques for prospective analysis are: Financial Statement forecasting Valuation Prospective analysis is central to security valuation where both free cash flow and residual income models require estimates of future financial statements.

Continue… Two broad stages of financial prospective analysis What are prospective financial statements? Prospective financial statements encompass: Financial forecasts and Financial projections Two broad stages of financial prospective analysis Long term forecasting : This involves the analysis of past data and forecasting of financial statements. Implementation :- This is the use of the forecasts to value common stock or to accomplish any other objective for which the forecast was carried out.

Importance of prospective anlaysis Security valuation:- Residual income model requires estimates of future financial statements Management and assessment:- To examine viability of companies’ strategic plans. Assessment of solvency:- Ability to meet company’s debt obligations Prediction of future performance

Compilation of prospective financial statement Procedure: Inquire of the responsible party as to the underlying assumptions developed. Compile or obtain a list of the underlying assumptions and consider the possibility of obvious omissions or inconsistencies. Verify the mathematical accuracy of the assumptions Read the prospective financial statements in order to identify departures from IAS 1 presentation guidelines Obtain a client representation letter in order to confirm that the responsible party acknowledges its responsibility for the prospective statements

Steps in examining prospective financial statements Step1:- examine inherent and control risk Step2:- consider the sufficiency of internal and external sources of information supporting the underlying assumptions step3:- Determine the consistency of the assumptions Step4:- Determine the reliability and consistency of the historical financial information used Step5:- Evaluate the preparation and presentation of the prospective financial statements Step6:- Obtain a client representation letter to confirm that the responsible party acknowledges its responsibility for the presentation of the prospective financial statements and the underlying assumptions.

Projecting income statement Projecting financial statements must begin with projecting the Income Statement and projecting an Income Statement begins by estimating sales. The sales estimate can be tested for plausibility in four different contexts : Past sales trends Market share implied by the sales estimate Its relation to planned marketing efforts Production capacity

Projecting income statement Sales forecasts are a function of: 1) Historical trends 2) Expected level of macroeconomic activity 3) The competitive landscape 4) New versus old store mix (strategic initiatives)

Projecting cost of goods sold Cost of Goods Sold (CoGS) is all costs which can be directly linked to sales. Always projected as percentage of sales. the percentage CoGS assumption can be affected by a variety of factors, both external and internal to the company. external factor which increases costs, such as rising raw material prices, will increase the CoGS percentage, unless these costs increases plus margin can be passed on to customers production efficiencies may decrease this percentage through lowering costs.

Projecting operating expenses Operating expenses are those expenses which are not directly linked to sales. Are projected on item by item basis Projecting Depreciation and Interest expenses Projecting Depreciation and Interest expense requires a look ahead to the projected balance sheet Past interest expense will be analyzed as a percentage of past debt balances, and the trend extended into the future.

Steps in projecting the income statement Project sales Project cost of goods sold and gross profit margins using historical averages as a percent of sales Project operating expenses using historical averages as a percent of sales Project depreciation expense as an historical average percentage of beginning-of-year depreciable assets Project interest expense as a percent of beginning-of-year interest-bearing debt using existing rates if fixed and projected rates if variable Project tax expense as an average of historical tax expense to pre-tax income

EXAMPLE. Target Corporation statement of income Figures in Millions 2005 2004 2003 Sales 46,839 42,025 37,410 Cost of goods sold 31,445 28,389 25,498 Gross profit 15,394 13,636 8,134 Selling, general and administrative expense. 10,534 9,379 Depreciation and amortization expense 1,259 1,098 967 Interest expense 570 556 584 Income before tax 3,031 2,603 2,227 Income tax expense 1,146 984 851 Income (loss) from extraordinary items and discounted operations 1,313 190 247 Net income 3,198 1,809 1,623 Outstanding shares 891 912 910 Selected rations in percent Sales growth 11.455% 12.336% Gross profit margin 32.866 32.447 Selling, general and administrative expense/Sales 22.49 22.318 Depreciation expense/Gross prior-year PP&E 6.333 5.245 Interest expense/prior-year long-term debt 5.173 4.982 Income tax expense/pretax income 37.809 37.803

Target Projected Income Statement computation. 1- Sales: $52,204 = $46,839 x1.11455 2- Gross profit: $17,157 = $52,204 x 32.866% 3- Cost of goods sold: $35,047 = $52,204 - $17,157 4- Selling, general, and administrative: $11,741 = $52,204 x 22.49% 5- Selling, general, and administrative: $11,741 = $52,204 x 22.49% $1,410 =$22,272 (beginning-period PP&E gross) x 6.333% 6- Interest: $493 = $9,538 (beginning-period interest-bearing debt) x 5.173% 7- Income before tax: $3,513 = $17,157 - $11,741 - $1,410 - $493 8- Tax expense: $1,328 = $3,513 x 37.809% 9- Extraordinary and discontinued items: none 10- Net income: $2,185 = $3,513 - $1,328

ABC Projected Income Statement Income statement in millions Forecasting steps 2006 Estimates Total revenues $52,204 Cost of goods sold 35,047 Gross profit 17,157 Selling, general, and administrative expense 11,741 Depreciation and amortization expense 1,410 Interest expense 493 Income before tax 3,513 Income tax expense 1,328 Income (loss) from extraordinary items and discontinued operations Net income $ 2,185 Outstanding shares 891 Forecasting Assumptions (in percent) Sales growth 11.455% Gross profit margin 32.866

Projected balance sheet Steps: Project current assets other than cash, using projected sales or cost of goods sold and appropriate turnover ratios as described below. Project PP&E increases with capital expenditures estimate derived from historical trends or information obtained in the MD&A section of the annual report. Project current liabilities other than debt, using projected sales or cost of goods sold and appropriate turnover ratios as described below Obtain current maturities of long-term debt from the long-term debt footnote. Assume other short-term indebtedness is unchanged from prior year balance unless they have exhibited noticeable trends.

ABC CORPORATION BALANCESHEET

Projection process

ABC CORPORATION BALANCESHEET

SENSITIVITY ANALYSIS Vary projection assumptions to find those with the greatest effect on projected profits and cash flows Examine the influential variables closely Prepare expected, optimistic, and pessimistic scenarios to develop a range of possible outcomes

Residual Income Valuation Model The residual income valuation model defines equity value at time t as the sum of current book value and the present value of all future expected residual income: where BVt is book value at the end of period t, RIt + n is residual income in period t + n, and k is cost of capital (see Chapter 1). Residual income at time t is defined as comprehensive net income minus a charge on beginning book value, that is, RIt = NIt - (k x BVt - 1).

Application of Prospective Analysis in the Residual Income Valuation Model In its simplest form, we can perform a valuation by projecting the following parameters: -Sales growth. -Net profit margin (Net income/Sales). -Net working capital turnover (Sales/Net WC). -Fixed-asset turnover (Sales/Fixed assets). -Financial leverage (Operating assets/Equity). -Cost of equity capital

Advantages of Residual income model 1. Residual income models make use of data readily available from a firm's financial statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow. 2. Residual income models look at the economic profitability of a firm rather than just its accounting profitability.

Drawback of using residual Income model The biggest drawback of the residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements

Continue…. Therefore, the model is useful when; A company does not pay dividends or dividends are not predictable FCF is negative over a comfortable forecast horizon There is great uncertainty in estimating terminal values Not useful when; 1. There are significant departures from clean surplus accounting. E.g Gains on marketable securities are reflected in stockholder’s equity as “comprehensive income” rather than as income on the income statement Wide use of employee stock options Foreign currency translations 2. Determinants of residual income (e.g., book value and ROE) are not predictable

Trends in Value Drivers The Residual Income valuation model defines residual income as: RIt = NIt – (k X BVt-1) = (ROEt – k) X BVt-1 Where ROE = NI/BVt-1 - Stock price is only impacted so long as ROE ≠ k - Shareholder value is created so long as ROE > k - ROE is a value driver as are its components - Net Profit Margin - Asset Turnover - Financial leverage Two relevant observations: - ROEs tend to revert to a long-run equilibrium. - The reversion is incomplete.

Trends in Value Drivers Reversion of ROE

Trends in Value Drivers Reversion of Net Profit Margin

Trends in value drivers Reversion of Total Asset Turnover

PROJECTED CASHFLOW STATEMENT The statement of cash flows is another financial statement that provides financial information just as the balance sheet and the income statement The purpose of this statement of cash flows is to provide information on the cash inflows and outflows of a certain business for a period cash flow statement shows aspects of liquidity of a firm The Cash Flow Projection shows the cash that is anticipated to be generated over a chosen period of time in the future.

Importance of Projections of cashflows Uses of projection of cash flows are that it enables us to determine the Credit worthiness of a company Loan structuring All in all the main purpose of preparing a cash flow projection is to determine shortages or excesses in cash from that necessary to operate the business

Steps in determining the projection of cash flow 1. Determine the total cash receipts which results from the cash sales, other income(credit accounts) and loans/other cash injections 2. Determine the total cash paid out which results from purchases, wages, Taxes (real estate, etc.), Supplies (office & operations),repair and maintenance, marketing, advertising, car delivery and travel, accounting and legal charges, rent, telephone and postal charges, utilities among others. 3. Determine noncash operations such as depreciation, gains or losses to assist us in changing from accrual basis to cash basis

Continue…. 4. Using the indirect method we determine the net income from the income statement , where we deduct the expenses from the income then we adjust the non cash charges such as depreciation, gains or losses 5. After that we determine the net change in cash from operating, financing and investing activities where operating involve increase(decrease) in assets and liabilities, financing activities say increase(decrease) in long term debt, dividends among others and investing activities resulting from increase(decrease) in capital expenditures 6. Finally add (deduct) the net change in cash from the beginning balance to determine the projected ending balance.

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