1. Forecasting Financial Statements
Module 11
Forecasting Financial Statements

2. Explain the process of forecasting financial statements.
Learning Objective 1
Explain the process of forecasting financial statements.
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3. 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.
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4. 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.
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5. Revenues Forecast Impacts Both the Income Statement and the Balance Sheet
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6. 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.
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7. 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.
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8. 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.
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9. Dynamics of Balance Sheet Growth
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10. 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.
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11. Forecast revenues and the income statement.
Learning Objective 2
Forecast revenues and the income statement.
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12. 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.
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13. 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
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14. 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.
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15. Organic Growth
From these segment disclosures, we can develop a history of the factors impacting organic sales growth:
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16. 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:
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17. 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.
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18. Morgan Stanley Forecasts
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19. Forecasting Expenses
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20. Forecasted Income Statement for P&G
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21. Forecast the balance sheet.
Learning Objective 3
Forecast the balance sheet.
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22. Forecasting the Balance Sheet
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23. 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.
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24. Computational Options
Forecasts using percent of revenues:
Forecasts using turnover rates:
Forecasts using days outstanding:
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25. 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.
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26. Forecasted Balance Sheet for P&G
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27. Adjusted Forecasted Income Statement for P&G
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28. Forecast the statement of cash flows.
Learning Objective 4
Forecast the statement of cash flows.
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29. Forecasted SCF for P&G
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30. 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.
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31. Prepare multiyear forecasts of financial statements.
Learning Objective 5
Prepare multiyear forecasts of financial statements.
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32. Two-Year Ahead Forecasts of the P&G Income Statement
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33. Two-Year Ahead Forecasts of the P&G Balance Sheet
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34. Two-Year Ahead Forecasts of the P&G Statement of Cash Flows
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35. 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.
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36. Parsimonious Method of Multiyear Forecasting
Inputs:
Sales growth
Net operating profit margin (NOPM = NOPAT / Sales)
Net operating asset turnover (NOAT = Sales / NOA)
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