Framework: Four Steps of Analysis

1
Framework Four Steps of Analysis
Business Strategy Analysis
Accounting Analysis
Financial Analysis
Prospective Analysis
2
Why Forecast?

• Two users
• Internal users
• Managerial planning
• External users
• Financial analysts
• Merger and acquisition
• Security analysis
• Credit and bankruptcy analysis
• Two tasks in prospective analysis
• Forecasting
• Valuation

3
Relation to Other Analyses

• Summarize the findings from analysis of business
  strategy, accounting, and financing
• Business Strategy Analysis
• What does industry analysis indicate about future
  trends?
• What is the companys plan to respond to those
  trends?
• Accounting Analysis
• How does past accounting reporting imply about
  future accounting statements?
• Will accounting reflect the expected future
  trends?
• Financial Analysis
• What can be improved?
• What will be under pressure from competition?
  From government regulation?
• What are managements target areas for change?

4
General Approach

• Comprehensive vs. Piecemeal
• Comprehensive avoids internal inconsistencies and
  unrealistic assumptions
• Examples
• Increasing sales without supporting plant and
  working capital need
• Increasing new financing without additional
  interest
• Focus on key drivers
• Sales (grow prospect)
• Revenue and Expenses (profitability)
• Asset turnover (efficiency)
• ? Affect all the other financial statement items

5
Starting Points

• Gather historical data about the firm and its
  industry
• What relationships appear stable?
• past is surprisingly good predictor of the future
• Business Strategy Analysis provides insights into
  what changes are likely to occur
• why would things be different from last year?
• One-time events? Change in strategy? Change in
  business environment?

6
Recall Our Financial Analysis for Gap

• Key factors
• High gross margin
• Sales and cost of sales would be key factors in
  forecasting
• High fixed assets turnover ratio
• Net PPE is probably related to sales

7
Whats happened so far this year?

• Review the 10-Qs
• Lets look at Gaps 1st quarter 10-Q
• Imagine you had an interview with Gap. The
  interviewer tosses you a copy of the 10-Q and
  says, What do you think?
• How could you analyze the F/S in 5 minutes?

8
A Quick Look at 10-Q

• Need to know industry and competitive strategy to
  be able to know what to look for and how to
  evaluate recent changes (or lack thereof)
• Look at Income Statement , ratio, and trend
• Net income and EPS
• one-time items?
• Sales
• Gross Margin Percent
• SGA, RD
• Tax rate

9
A Quick Look at 10-Q

• Balance Sheet
• Current ratio
• amount and of inventory
• A/R turnover
• Inventory turnover
• L-T Debt to Equity

• Statement of Cash Flow
• Cash flow from operations
• greater than zero?
• greater than NI?
• why?
• What is the company doing with the cash?
• Investing
• Financing

10
Quick Look at Gaps 10Q (Q1 of 2000)

• I/S and MDA
• Increase in net sales
• More stores
• Drop in net sale per average square foot
• Old Navy (low margin)
• Higher COGS and operating expense but remain
  similar as in 1999
• Slight decrease in NI

• B/S
• More inventory and PPE
• More debt!
• SCF
• Lower OCF!
• More inventory
• More capital expenditures
• Expansion
• Positive financing cash flows

11
Back to Forecasting

• Armed with background knowledge about the company
  and recent trends, we can turn to the forecast
• A spreadsheet program, for example, Excel, will
  be extremely helpful

12
Key Driver Sales

• The behavior of sales
• Mean reverting of sales growth
• Growth in sales over time revert to a mean value
• demand saturation, competition
• random walk with drift process
• 2000 sales 1999 sales plus a drift term
• drift can be based on past trend in sales and
  output of prior analyses
• Time-series analysis e.g. Box and Jensen
  modeling
• Have your spreadsheet for Gap ready!

13
Seasonality

• Compare with the same quarter in previous years
• Gaps sales 1998 1999
• Q1(4/30) 1,720 2,278
• Q2(7/31) 1,905 2,453
• Q3(10/30) 2,400 3,045
• Q4(1/31) 3,030 3,859
• (Dollar amounts in millions)

14
Forecasting Step 1Sales

• How would you forecast sales for McDonalds?
• Number of stores
• new versus old
• domestic versus foreign
• same store sales in the past, adjusted for
• Relation between sales and general economic
  factors
• Demographic trends
• New menus
• New advertising
• Competitors activities
• Average of past performance does not work well!

15
Sales Forecast for Gap

• Trend?
• Company and Industry
• Annual and Quarterly
• Products?
• Customer mix?
• Geographic mix?

• Sources
• WSJ Interactive
• press releases
• news articles
• Economic indicator
• Lexis/Nexis
• Search for news, trade publications
• Value Line et al.

16
Sales Forecast for Gap (case)

• Past three years 15, 14, 13
• Refinements
• Management state 20 of growth
• New stores domestic and foreign
• Turnaround in economy
• Trend reducing by 1
• E.G.
• 1992 20 growth 2,519(120) 3,023
• 1993 19 growth 3,597
• Stabilized at 15 from 1997 and on

17
Earnings

• This is what many analysts are trying to predict
• But, research show that it also tends to follow a
  random walk with drift process
• 2000 NI 1999 NI plus drift term
• This is especially true when forecasting for the
  longer range
• Adjusted for the data found in most recent
  quarterly results
• We will check whether our earnings forecast make
  sense as a by product

18
Return on Equity

• ROE is also mean reverting
• High ROE firms will attract competition
• Unless there are sustainable barriers to entry
• Unless growing capital base can be reinvested at
  above average returns
• Low ROE firms will improve or go out of business
• Regression to mean of 10-15 ROE in no more than
  10 years for US firms
• Consider whether GAAP distorts ROE
• missing assets at high tech firms, and
  pharmaceuticals ? understates ROE
• We will again check whether our ROE prediction
  make sense or not

19
Forecasting Step 2Expenses

• Expenses should be forecast item by item
• Many expenses are related with sales
• COGS, SGA
• RD in the long-run
• Interest is a function of debt level and interest
  rates
• Depreciation is a function of PPE, lease
  decisions
• Taxes are a function of pretax income and
  operating decisions (e.g., location)
• Equity earnings are a function of the affiliates
  performance
• Interest income is a function of investment
  decisions
• Need to consider changes over time

20
Forecast Gaps Expenses

• COGS
• recent history and trends 60 in 1991, tend to
  increase
• Begin with 60, increased by 0.5 annually
  stabilized at 65.5
• SGA
• recent history and trends 23 of sales not
  changing too much
• RD
• MDA, recent history
• None for Gap
• Interest
• recent rates, forecast debt levels
• Taxes
• of pretax income

21
Forecast Gaps Expenses

• Depreciation
• Depend on PPE (forecast of B/S) and depreciation
  rate
• PPE
• Tax on EBIT
• Tax rate 38
• Deferred tax assets/liabilities assumed
  immaterial

22
Forecast Gaps Expenses

• Interest
• 8.87 on a new debt
• about 8.9 before tax
• S-T debt 0.2 of TA as in 1991
• L-T liability 12.1 of TA as in 1991
• Net interest after tax average of S-T and L-T
  debt8.9(1-38)

23
ExpensesForecast Refinements

• Gross Margin Percent
• by product
• by region
• Fixed and Variable SGA
• Taxes
• analysis of tax footnote
• news about tax breaks, e.g. foreign countries

24
There May Be More

• Investment Income
• Marketable Securities
• Excess cash

25
Forecasting Step 3Balance Sheet

• As with expenses, forecast item by item
• Current Assets
• Cash
• From cash flow forecast (?)
• Desired cash balance
• Gap 3.5 of sales as in 1990
• MS
• Cash flow forecast
• Investment plans
• A/R turnover tied with Sales forecast
• Inventory turnover tied with Sales forecast
• Other likely related to Sales
• Gap
• Non-cash CA 15 of sales as in 1990 and 1991

26
Forecasting Step 3Balance Sheet

• Net PPE turnover tied with Sales forecast,
  investing activities (capital expenditure),
  depreciation policy
• Other Non-Current acquisition plans?
• Gap Net PPE and other, 23 of sales as in 1991
• Liabilities
• Current function of Sales, target current ratio
• Noncurrent function of CAPEX, capital structure
  decisions
• Gap see Interest discussion

27
Forecasting Step 3Balance Sheet

• Equity
• Retained Earnings Opening RE NI - Dividends
  Other capital transactions
• Capital Stock Opening CS Issuances
  Repurchases and retirements
• Other equity items (foreign currency translation
  gains/losses,unrealized gains and losses on
  available for sale MS) are difficult to forecast.
  Assume no change?

28
Forecasting Cash Flows

• With pro forma I/S and B/S, we should be able to
  develop SCF
• Key factors (all related to other F/S)
• Depreciation from I/S
• Capital expenditure
• PPE(net), ending PPE(net), beginning
  Depreciation
• Deferred tax
• Assumed no change
• Financing
• Changes in S-T and L-T debt
• Dividend payment
• Assume all available cash is paid to the owners

29
Forecasting Summary

• Forecasting involves all prior steps in the
  framework
• Comprehensive, iterative approach
• Start with sales, determine operating costs
• Are balance sheet changes required?
• More capital expenditures?
• How will they be financed?
• Use I/S and B/S to forecast B/S
• Forecast of SCF may lead to changes in asset
  levels (depreciation should be reexamined), and
  debt levels (interest expense and income should
  be reexamined)
• Always a good idea to conduct ratio and
  sensitivity analyses on the forecasted numbers

30
Sensitivity Analysis

• Best guess versus optimistic versus pessimistic
• What if
• Competition heats up? Increase in operating
  costs?
• A product doesnt make it to market?
• A merger doesnt go through?
• A worker strike?