Chapter 6 Forecasting

1
Chapter 6 - Forecasting

• Forecasting is a synthesis of
• Strategy analysis
• Accounting analysis
• Financial analysis

2
Pro forma definition

• 4 steps of financial statement analysis
• Step 1 Understand the firms operations and
  strategies
• Step 2 Accounting Analysis
• Step 3 Evaluate current position of the firm
  (profitability, sustainability, risk, governance)
• Step 4 Predict future course of the firm

3
Pro forma definition

• Pro forma (as if) financial statements are
  those statements prepared under a particular set
  of assumptions (prepared as if a set of
  outcomes were to occur).
• Needed assumptions about firm performance
  (sales growth, cost structure, etc.)
• Needed assumptions about investment and
  financing strategies.

4
Pro forma definition

• Why prepare pro forma financials?
• To supplement historical analyses. If the firm
  continues with current strategies, what might
  happen? If they change strategies, what might
  happen?
• As part of due diligence (e.g., highly leveraged
  transaction, assess credit worthiness)
• To value the enterprise

5
Procedure general principles

• Overview of main steps
• Forecast sales
• Forecast profitability of sales
• Forecast the assets that are necessary to produce
  sales
• Forecast desired level of debt to finance assets
• Plug owners equity that is necessary to finance
  the remaining assets by
• Paying dividends and/or repurchasing shares or
• Issuing stock

6
Procedure general principles
Follow the solid (green) line!
7
Procedure general principles

• Make sure the statements articulate
• The relationships among the financial statements
  must be maintained
• For example
• Income Revenue Expense
• DRE Income Dividends
• DOE DRE Stock Issued Stock Repurchased
• DCash Bottom line on statement of cash flows
• Changes in various balance sheet accounts must be
  equal to line items on the statement of cash
  flows

8
Procedure general principles

• Youll have to plug someplace, make sure it is
  reasonable
• Eventually, you will have to back into or
  plug someplace so that the financial statements
  articulate
• Make sure that the amount that was plugged
  makes some sense.
• If it does not, go back and make changes in other
  forecasts to insure that all forecasted items
  pass a reasonableness test.

9
Procedure general principles

• Why should we start with sales
• Sales is the basis for both the level of activity
  (balance sheet) and the profitability (income
  statement) of the firm.
• Sales can then be used to forecast other items
• sales gross margin ratio to forecast cost of
  goods sold
• sales receivables turnover to forecast accounts
  receivable balance
• sales gross margin ratio inventory turnover
  to forecast inventory balance

10
Forecasting Income Statement

• Step One Forecast Sales Growth
• Sales growth can be based on
• Historical growth rate
• Adjusted for past and future industry outlook
• Adjusted for past and future macroeconomic
  outlook
• May use segment data to estimate separate growth
  rates for each segment and compute weighted
  average
• Growth rate does not need to be equal every year
• Sales growth is mean reverting

11
Forecasting Income Statement

• Forecast Sales Growth
• Once sales has been forecasted each year into the
  future, it is possible to forecast that all other
  items on the income statement and balance sheet
  will grow at the same rate
• But this ignores the possibility of changes in
  profitability, efficiency or leverage
• What should we do if there is a possibility of
  improvement or deterioration in these areas?

12
Forecasting Income Statement

• Step Two Cost of Goods Sold
• Can be based on
• Historical relation to sales (gross margin ratio)
• Historical trend could continue (temporarily) as
  efficiency improves or worsens
• Possibly adjusted by difference from industry
  average (i.e. may trend toward average)
• Growth rate does not need to be equal every year

13
Forecasting Income Statement

• Step Three Sales and Administrative Expense
• Can be based on
• Historical relation to sales (ratio of sales and
  admin exp to net sales)
• Historical trend could continue (temporarily) as
  efficiency improves or worsens
• Possibly adjusted by difference from industry
  average (i.e. may trend toward average)
• Ratio does not need to be equal each year

14
Forecasting Income Statement

• Other Income, if necessary
• This item captures all of the miscellaneous line
  items on the income statement not specifically
  addressed in other steps
• This item does not include either interest income
  or interest expense
• This item is likely to include at least some
  nonrecurring items
• The recurring portion of this item may or may not
  vary with activity level (sales)

15
Forecasting Income Statement

• Step Four Interest Income / Expense
• Forecast should be a rate of interest applied to
  the forecasted cash balance or beginning balance
  of debt
• Forecasted interest rate can be based on
• Historical ratio of interest income to cash
• Need to decide whether most recent year should be
  given more weight
• Forecasts of changes in interest rates in the
  near future

16
Forecasting Income Statement

• Step five Tax Expense
• Forecast should be a tax rate applied to
  forecasted earnings before income taxes
• Forecasted tax rate can be based on
• Statutory tax rate
• Historical ratio of tax expense to net income
  before tax, i.e. historical effective rate
• Need to decide whether most recent year should be
  given more weight
• Forecasts of changes in tax rates in the near
  future

17
Forecasting Balance Sheet

• Cash
• The amount of cash should vary with the activity
  (sales) of the firm
• Base forecast on historical ratio of cash to
  sales and/or the same ratio for the firms
  industry
• Adjust for extra cash or insufficient cash
  that firm has held in the past or is expected to
  hold in the future

18
Forecasting Balance Sheet

• Accounts Receivable/Inventory/ Accounts Payable
  Operating Assets/Liab.
• Calculation
• Normally vary with level of activity (sales)
• Efficiency ratios previously discussed
• Historical trend could continue (temporarily) as
  efficiency improves or worsens
• Possibly adjusted by difference from industry
  average (i.e. may trend toward average)
• Days in Receivables/Inventory/Payables do not
  need to be equal each year

19
Forecasting Balance Sheet

• Other Current Assets/Other Current Liab.
• These can be catch-all categories to include
  all current assets/liabilities not specifically
  addressed
• Normally, let these items vary with activity
  (sales) unless stated otherwise in footnotes,
  MDA
• Let these items grow at the same rate that sales
  is expected to grow

20
Forecasting Balance Sheet

• Property and Equipment
• Need to take into account
• Assumed level of capital expenditures
• Depreciation expense assumptions
• Turnover ratio does not need to be equal each
  year

21
Forecasting Balance Sheet

• Intangible Assets
• Depends on if the item has a definite useful life
  (eg. non-compete agreement) or indefinite useful
  life (eg. goodwill)
• If definite useful life the asset needs to be
  amortized
• With goodwill need to consider if an acquisition
  is going well (keep the goodwill on the books) or
  poorly (impairment)

22
Forecasting Balance Sheet

• Interest-Bearing Liabilities
• Can be based on
• Historical debt to assets ratio(ratio of
  interest-bearing debt to total assets)
• Possibly adjust for known or expected changes in
  leverage
• Possibly adjusted for differences from industry
  average (i.e. may trend toward average)
• Include current maturities of LT debt in ratios
  in calculations
• Leverage does not need to be equal each year

23
Forecasting Balance Sheet

• Deferred Taxes
• This item is very difficult to forecast
• Deferred taxes are the result of temporary
  differences between GAAP income and IRS income
• Usually not material so allow it to vary with
  activity (sales) unless there is another obvious
  choice

24
Accounting Sidetrack

• Deferred tax Liabilities (DTL) represent future
  taxable amounts-higher future tax payments
• Deferred tax liabilities are normally generated
  by PPE
• The IRS allows quicker depreciation of PPE than
  the GAAP method most companies choose.
• So if a companys investment in PPE is expected
  to grow so should its DTL

25
Accounting Sidetrack

• Deferred Tax Assets (DTA) represent future
  deductible amounts lower your future tax
  payments
• One item that generates deferred tax assets is
  losses
• The IRS allows losses to be carried forward and
  offset future income for tax purposes, GAAP does
  not.
• These types of DTA will decrease as the company
  starts to become profitable
• Other types of DTA are created by timing
  differences and are more likely steady state
  amounts

26
Forecasting Equity Section

• Dividends
• Dividends, when they are paid, usually increase
  slowly over time.
• The simplest method is to forecast dividends to
  be the same dollar PER SHARE amount for the
  reasonable future
• So if shares outstanding change so will dividends

27
Forecasting Equity Section

• Retained Earnings
• This item is computed from items already forecast
• It is equal to last years balance, plus this
  years net income, minus this years dividends

28
Forecasting Equity Section

• Contributed Capital
• This item is plugged to make sure that the
  balance sheet balances.
• The implicit assumption is that everything occurs
  as has been forecast, and
• whatever additional resources the firm might need
  it will generate by issuing stock, or
• Whatever extra resources the firm has it will use
  to repurchase its own stock
• You should make sure that this amount is
  reasonable especially in the last year of the
  forecast period

29
Forecasting Statement of Cash Flows

• The Statement of Cash flows is derived from the
  forecasted balance sheet and income statement

30
Forecasting

• The forecasted financial statements are based on
  many assumptions, but only a few will be critical
• Of course, those assumptions may not be accurate
• To anticipate the effect of inaccurate
  assumptions, we could conduct a sensitivity
  analysis in which assumptions are allowed to vary

31
Forecasting

• The main assumptions that could vary are related
  to
• Growth the sales growth rate
• Profitability the ratios of cost of goods sold
  and selling and administrative expense to sales
• Efficiency the days of inventory on hand,
  accounts receivable outstanding, accounts payable
  outstanding, and the fixed asset turnover ratio
• Leverage the percentage of assets funded by debt

32
Forecasting one example

• We will use the Shirts Pants case to illustrate
  the detailed steps.

33
Step 1 forecast income statement
34
Step 1 forecast income statement
35
Step 2 forecast assets
36
Step 3 forecast liabilities
37
Back to step 1 complete I/S
38
Step 3 forecast liabilities
39
Step 4 forecast SCF
Implies that shares issued is 60,390/154,026,
which in turn affects EPS.
40
Calculate free cash flow
For 2006-2008, I used identical assumptions as
those for 2005.
41
Shirts Pants pro forma

• Base scenario
• Assuming equity financing
• Scenario 1
• Assume excess cash used to pay dividends instead
  of buying back stocks. Usually easier to
  forecast.

42
Procedure final words

• Length and detail of the pro forma depends on the
  context
• Typically 5 years for valuation of a mature firm
• It is a good practice to calculate the forecast
  ratios and compare them with historical trends
  and industry peers to assess sensibility.

43
Forecasting Issues

• One problem that may result when preparing pro
  forma financial statements is artificial
  volatility.
• This results from using turnover ratios when
  forecasting items like A/R, A/P Inventory

44
Example - A/R

• Year 1-Beginning Balance of A/R 791M
• Year 1-Ending Balance of A/R 807M
• Year 1 Sales 3,002M
• Assumptions
• Sales growth will be equal to 6 per year
• A/R turnover will stay constant throughout the
  forecast period

45
Forecast Issues
46
Solutions to the Sawtooth problem

• Do not use the average balance sheet account
  balance when initially calculating turnover
  ratios-base it on the ending balance
• Forecast using average turnover ratios and then
  smooth changes using the compound average growth
  rate

47
Compound Average Growth Rate
48
Smoothing using CAGR
49
Comparison of methods