FORECASTING FINANCIAL STATEMENTS February 3, 2003

Topics 1. Historicals (Due 2/10) 2. Operating sections of the financials (Due 2/17) 3. Investing & Financing sections of the financials (Due 3/10) 4. Example model (Excel file-”Sample company with model formulas”) 5. Forecasting Revenues – review of 4 methods 6. Errors

Historicals 1. Each group received via an Excel Workbook (entitled COMPANY NAME ) – during the semester, resave this file as COMPANY NAME MoDay02) a Word document (entitled Notes on the Excel Workbook and Preparing Deliverable 5) – detailed instructions & notes on common errors

Historicals Excel workbook is formatted in the Burkenroad Report Style and is not a model. The only automatic features are Subtotals and totals in the income statement (earnings statement), balance sheet and statement of cash flows – DO NOT ENTER ACTUAL AMOUNTS IN THESE AREAS

Historicals Selected common size information for the earnings statement and balance sheet & selected year-to-year changes for the earnings statement

Historicals Focus is operating assets & liabilities that tend to vary with sales volume Focus is current & noncurrent categories for assets and liabilities and on the sources of financing (debt & equity)

Historicals Cover page items linked to per share amounts on the STATEMENTS worksheet

Historicals NUMERATORS AND DENOMINATORS for ratios on the RATIO worksheet are linked to amounts on the STATEMENTS worksheet ROWS WITH NUM. & DENOM. Hidden for final print ROWS WITH NUM. & DENOM. unhidden

Common errors: Historicals 1. Use of standardized or aggregate data instead of 10-K and 10-Q data 2. Failing to revise historical data for RESTATEMENTS that occur as a result of discontinued operations, change in entity or certain changes in accounting principles Information reported in the 12/31/01 10-K should be used for 12/31/99, 12/31/00 and 12/31/01 (assuming a calendar year-end) Check the 5 years of summary information presented in the 10-K to be certain that historical information already included on the STATEMENT worksheet is still valid.

Common errors: Historicals Information reported in the 3/31/02 10-Q should be used for 3/31/02 and 3/31/01 (assuming a calendar year-end). Information reported in the 3/31/01 10-Q should be used for 3/31/00 unless quarterly information has been restated. If quarterly information is restated for the 3/31/02 report (as a result of discontinued operations or changes in accounting principles – the information reported in the 3/31/01 report must be discarded or you must insert a footnote indicating that the information presented is not comparable to quarterly information reported after NOTE THAT THE YEAR-TO-YEAR changes reported on the earnings statement will be wrong in 2001 if the 2001 numbers are restated and the 2000 numbers are not restated.

Common errors: Historicals RESTATEMENT EXAMPLE – discontinued operations

CASH FLOW STATEMENT ERRORS – QTR info

Forecasting 1. Forecasting equations are not included. As analysts you create the forecast model during the course. 2. ALL forecasting work must be completed within this workbook to insure that the links are not lost. 3. Add as many worksheets as needed. 4. See the EXCEL FILE – “Sample Company with Model Formulas” for an example of the types of forecast equations you could use. (Seasonal Inc.)

Forecasting Overview (covered in weekend workshop) We prepare the forecasts in 3 stages: Operating items on the income statement, balance sheet and cash flow statement Investing items on the income statement, balance sheet and cash flow statement Financing items on the income statement balance sheet and cash flow statement

Income Statement Revenues: $ 200,000 Operating expenses( 150,000) Operating income: 50,000 Interest expense ( 6,000) Investment income 1,000 Income before income tax 45,000 less: Income Tax ( 15,000) Net Income $ 30,000 Operating

Cash Flow Example Balance Sheet Assets: Cash$ 25,000 Accounts Receivable 32,000 Inventory 29,000 Investments 10,000 Fixed assets, net 180,000 Total $276,000 Liabilities and Equity: Accounts Payable$ 24,000 Long-term debt 80,000 Common Stock 147,000 Retained Earnings 25,000 Total$276,000 Operating Forecast all operating items simultaneously because operating items on each statement will be closely related to operating items forecast on the income statement. – Example: Accounts receivable is usually a consistent % of sales revenue.

Operating cash flows: Net income$30,000 Depreciation expense10,000 Change in A/R(2,000) Change in Inv(3,000) Change in A/P5,000 Total cash used by operating activities$ 40,000 Cash used by investing activities: Purchase of fixed assets($10,000) Cash from financing activities: Borrowing, net of repayments(35,000) Payment of dividends (5,000) Total cash provided by financing activities(40,000) Net inflow for the year(10,000) Beginning cash balance:35,000 Ending cash balance $ 25,000 Cash Flow Statement Operating

Operating cash flows: Net income$30,000 Depreciation expense10,000 Change in A/R(2,000) Change in Inv(3,000) Change in A/P5,000 Total cash used by operating activities$ 40,000 Cash used by investing activities: Purchase of fixed assets($10,000) Purchase of investments(1,000) Total cash used in investing activities(11,000) Cash from financing activities: Borrowing, net of repayments(34,000) Payment of dividends (5,000) Total cash provided by financing activities(39,000) Net inflow for the year(10,000) Beginning cash balance:35,000 Ending cash balance $ 25,000 Cash Flow Statement Operating Investing

Cash Flow Example Balance Sheet Assets: Cash$ 25,000 Accounts Receivable 32,000 Inventory 29,000 Investments 10,000 Fixed assets, net 180,000 Total $276,000 Liabilities and Equity: Accounts Payable$ 24,000 Long-term debt 80,000 Common Stock 147,000 Retained Earnings 25,000 Total$276,000 Operating Investing

Income Statement Revenues: $ 200,000 Operating expenses( 150,000) Operating income: 50,000 Interest expense ( 6,000) Investment income 1,000 Income before income tax 45,000 less: Income Tax ( 15,000) Net Income $ 30,000 Operating Investing Note that Depreciation expense is usually not included as a line item on the income statement. Here it is included in operating expenses.

Forecasting Revenues Revenues are the most important forecast item as this number is the primary determinate of the target price and investment recommendation. Written FORECASTING SECTION for your report (new this year) - to include the following Operating activities: Include assumptions used to model key operating items in the statements. This discussion will include a description of the basic assumptions used for modeling each segment’s revenues. (Note that you should build a revenue model for each revenue segment if possible) Include a discussion of other key operating items. Investing activities: Include discussion of the key assumptions used to model capital expenditures, any acquisitions, and disposals of property and equipment. Include a discussion of any other significant investing activities. Financing activities: Include discussion of the assumptions used.

Forecasting Revenues 4 Primary Revenue model types (review the notes from the Saturday Burkenroad workshop Revenue = Price per unit X Quantity Revenue = Total market revenue forecast X forecast market share for the company Revenues = Prior period revenues X forecast growth rate Balance sheet based model: Based on specific asset/revenue relationships

Consider using diagrams in your report to illustrate factors considered in modeling revenues

AVOIDING errors in your forecasts 1. Forecast OPERATING ITEMS allowing the balance sheet to flow from the income statement and the cash flows from the balance sheet. EXAMPLE: A/R and inventory

AVOIDING errors in your forecasts 1. Forecast INVESTING ITEMS allowing the balance sheet to flow from the cash flow items and basing income statement statement items (including depreciation & amortization) on balance sheet averages EXAMPLE: Net property, plant and equipment

Example – PPE Facts (assuming zero disposals): Beginning balance of PPE at cost $350,000 Beginning balance of Accum. Dep. $150,000 Annual depreciation rate calculated from reported depreciation and reported average cost of PPE: 20 year useful life (5% per year) Expected capital expenditures during the first quarter - $20,000. Required: Calculate and show the disclosure of the following amounts on the balance sheet and cash flow statement (1) the forecast ending balance of PPE at cost (2) Depreciation expense for the quarter (3) The forecast ending balance of PPE at net

Example – PPE

Example PPE

Example – PPE Facts (assuming disposals): Same facts except: Sell PPE with original cost of $5,000 and accumulated depreciation of proceeds of $4,000 for $3,000. Required: Calculate and show the disclosure on the balance sheet and cash flow statement (1) the forecast ending balance of PPE at cost (2) Depreciation expense for the quarter (3) Gain/loss for the quarter (3) The forecast ending balance of PPE at net

Example PPE

BCD BALANCE SHEET 33 Beginning balance of PPE, net Forecast ending balance of PPE, net=C33-C39-C40-C42-C43 Result CASH FLOW STATEMENT ITEMS 39 Depreciation forecast=C48*C53Result 40 Forecast gain on sale of PPE-2000Starting assumption 42 Capital expenditures - forecast-20000Starting assumption 43 Proceeds from sale of PPE - forecast3000Starting assumption CALCULATED FROM HISTORICAL INFORMATION 48 Quarterly depreciation rate=0.05/420 year average useful life Other 51 Beginning balance of PPE at cost Forecast ending balance of PPE at cost=C51-C42-C55Result 53 Average balance of PPE (calculated)=(C51+C52)/2 55 Original cost of PPE sold - forecast5000Starting assumption 56 Accum. Deprec. Of PPE sold - forecast=C55-C57 57 Book value of PPE sold - forecast1000

AVOIDING errors in your forecasts 1. Do not forecast cash directly on the balance sheet. Your cash flow statement provides you with a forecast of the ending cash balance. Link cash on the balance sheet to the ending balance of cash on the cash flow statement. Do not worry if the amount is negative while you are forecasting operating and investing activities. 2. Link net income on the cash flow statement to net income on the earnings statement. 3. Do not force the balance sheet to balance – it should not balance until you have completed all operating, investing & financing items as well as “Other” items.