Financial
Statement
Analysis &
Valuation Sixth Edition
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 11
Financial Statement Forecasting
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Learning Objective 1
Explain the process of
forecasting financial statements.
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Forecasting Process
Forecasting financial performance is integral to a variety of
business decisions.
Managers, investors and others forecast future financial
statements to:
Value stocks and inform investment decisions
Evaluate the creditworthiness of a prospective borrower
Determining bond ratings
Evaluate alternative strategic investment decisions
Assess the shareholder value created by strategic investments
All of these decisions require accurate financial forecasts.
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Adjusted Financial Statements
The forecasting process begins with a retrospective analysis.
We adjust financial statements to ensure they accurately reflect the
company’s financial condition and performance.
Because we seek to forecast future income and cash flow, we first
identify and eliminate transitory items including:
Restructuring expenses
Litigation expenses
Discontinued operations
Gains and losses on asset dispositions and impairments
Unusual income tax expense or benefit
Acquisitions and divestitures
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Forecasting Order and Mechanics
We forecast future income statements, balance sheets, and statements of
cash flows, in that order.
The revenues forecast is the most crucial in the forecasting process
because other income-statement and balance sheet accounts derive from
the revenues forecast.
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Forecasting
Consistency and Precision
It is important to keep two points in mind:
Internal consistency
The forecasted financial statements are linked in the same way historical financial
statements are—they must articulate within and across time.
We also must ensure that our forecast assumptions are internally consistent.
Level of precision
Computing forecasts to the “nth decimal place” is easy and might appear to make the
resulting forecasts appear more precise, but they are not necessarily more accurate.
Decisions that depend on a high level of forecasting precision are ill-advised.
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Company Guidance
Companies frequently provide guidance for forecasting purposes.
For example―P&G provided the following sales growth guidance that
we can use to inform our revenue forecast assumptions:
We use 3.5% growth, the midpoint of the range, in our forecasting
process.
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Company Guidance
P&G also provides guidance regarding anticipated capital spending
(CAPEX), dividends, and share repurchases:
We use this guidance to produce the following forecasts:
CAPEX as 4.75% of sales
Dividends of $7.5 billion
Share repurchases (treasury stock purchases) of $7 billion
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Learning Objective 2
Forecast revenues
and the income statement.
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Forecasting the Income Statement
Overview
We forecast the Income Statement first.
Sales estimate―for P&G we use 3.5% (from company guidance)
Expense estimate
COGS―as a % of sales
SG&A―as a % of sales
Nonoperating expenses―assume no change and adjust later
One-time items―assume the items will not recur
Income tax―as a % of pre-tax income (from company guidance)
Noncontrolling interest―no change in historic ratio
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P&G’s Forecasted
2020 Income Statement
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Forecasting Cost of Goods Sold
Start with historic ratio of COGS / Sales.
Companies often discuss COGS in the MD&A to provide insight into
recent trends, anticipated effects of planned restructuring, or product
mix changes.
For example P&G reports:
For P&G, we use the FY2019 rate of 51.4% to forecast FY2020.
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Forecasting SG&A
To forecast SG&A expense, we start with historic ratio of SG&A /
Sales and then check the MD&A:
We use the FY2019 percent of 28.2% because the MD&A includes no
significant operational changes to SG&A.
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Forecasting Interest Expense
Interest expense
= Average debt balance × Estimated interest rate
For 2019 P&G reported $509M interest expense and average debt of
$30,689M.
We calculate an estimated rate = $509M / $30,689M = 1.7%
We apply the average FY2019 rate to the expected FY2020 debt.
FY2019 debt – Expected FY2020 repayments = $20,704M
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Forecasting Income Tax Expense
We estimate tax expense using an estimated tax rate.
For FY2020, we use an effective rate of 17.5% from PG’s guidance.
In the absence of company guidance, we use tax footnotes:
Given that the Goodwill impairment is a one-time occurrence, and
Stock option taxes and “Other” are so volatile, we might forecast a tax
rate of 20.2% (21% - 0.5% - 0.3%).
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Impact of Acquisitions
When one company acquires another, the revenues and expenses of the
acquired company are consolidated, but only from the date of
acquisition onward.
Acquisitions can greatly impact the acquirer’s income statement and
distort the growth rates that we compute.
P&G acquired Gillette in October 2005.
Growth = 20.2%
20.2% is incorrect because 2006 Net sales include Gillette sales for 8
months and 2005 Net sales include NO Gillette sales.
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Impact of Acquisitions
Until all three income statements include the acquired company, the
acquirer must disclose what revenue and net income would have been.
For example, P&G disclosed the following re: Gillette
Sales Growth = 4.5%
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Impact of Divestitures
When companies divest of discontinued operations, they are
required to:
Exclude sales and expenses of discontinued operations from continuing
operations.
Separately report net income from the discontinued operations on one line.
Report any gain/loss on the disposal.
Report discontinued assets and liabilities on separate line items, labeled
“held for sale”.
We assume these discontinued operations will be sold in the
coming year and we forecast zero balances for them.
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Learning Objective 3
Forecast the balance sheet.
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Forecasting the Balance Sheet
Overview
Here is an overview of balance sheet forecasting:
Working capital accounts―as a % of sales
PPE―increase estimated CAPEX and reduce by forecasted depreciation
expense
Intangible assets―subtract forecasted amortization expense
Current and long-term debt―assume company makes all contractual
payments of long-term debt, assume total debt remains unchanged
Stockholders’ equity―assume no change for paid-in capital accounts except
for stock-based compensation and planned treasury stock transactions
Retained earnings―increase by forecasted net income and reduced by
estimated dividends
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Forecasting Working Capital
We use each working capital item’s historical relation to sales to
forecast the item for next year.
We use this approach for P&G for seven working capital
accounts.
We assume that nonoperating will remain unchanged.
Where provided, we use company guidance such as with debt due
within one year.
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Forecasting PPE
For P&G, we use the guidance about anticipated purchases of PPE
assets (called capital expenditures or CAPEX).
P&G expects fiscal 2020 CAPEX to be 4.5% to 5% of sales.
We use the midpoint of 4.75% of sales and forecast CAPEX of $3,328
million ($70,053 million of forecasted sales × 4.75%).
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Forecasting PPE
Absent CAPEX guidance, we can use the following approach:
Also consider additional CAPEX We use PRIOR year PPE to measure
expansion plans in MD&A historical depreciation rate
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Forecasting Intangible Assets
Analysts typically forecast intangible assets to decrease during the year
by the amount of amortization.
It is common to assume no change in amortization expense from the
prior year.
If the company provides guidance about amortization expense, like
P&G does, we can consider using it.
For P&G, we forecast 2020 intangible assets to be $359 lower than in
2019.
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Forecasting Long-Term Debt
Companies report maturities of long-term debt for the next five years in
debt footnote, which we use to forecast long-term debt.
P&G’s footnote provides the following details
To forecast debt we make the following three adjustments:
1. Subtract $3,388M from debt due within one year
2. To reclassify long term debt, we add $2,009 M to debt due within 1 year
3. Subtract $2,009M from long-term debt to reflect the reclassification
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Forecasting Dividends
and Retained Earnings
We forecast retained earnings as follows:
This approach uses historic dividend payout ratio.
This might not be accurate if there were large one-time items in the
prior year—in that case:
Adjust for one-time items and recalculate payout
Use company guidance $7,500
Use historic dividend per share data and current shares outstanding.
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Forecasting Equity and Treasury Stock
Assume no change for common stock (par) and additional paid-in
capital unless MD&A suggests otherwise.
If a company uses stock-based compensation we add the fair-value
of anticipated awards to additional paid-in capital.
For treasury stock, we proceed as follows:
Many companies disclose multiyear stock repurchase programs in footnotes or in the
MD&A.
If a company provides guidance, we can use that to forecast repurchases.
Absent explicit disclosures or guidance, we can forecast future repurchases using
historic data, either from the most recent year or by looking for a trend over the past
two or three years.
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Forecasting Cash
We forecast cash last as the amount that balances the balance sheet after
we have forecast all other items.
We assess the forecasted cash balance and determine if it deviates
from the historical cash-to-sales percentage.
If cash forecast is higher than normal:
Increase marketable securities
We should attempt to
Reduce debt
maintain the historic debt-
Forecast additional stock repurchases
to-equity ratio when we
Increase dividend payments
forecast additional
If cash forecast is lower than normal: borrowing, debt
Sell marketable securities repayment, stock
Increase debt
sales, or stock
repurchases.
Decrease dividend payments
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P&G’s Forecasted 2020 Balance Sheet
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Learning Objective 4
Prepare forecasts using
segment data.
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Forecasts from the Bottom Up
The sales forecast that we illustrate above relies on company
guidance to form assumptions and estimates.
An alternative approach that financial analysts typically use relies
on information from conference calls with company management
and other proprietary data sources.
Analysts often prepare separate sales forecasts for the company’s
business segments and then sum up the segment sales to arrive at
the overall sales estimate.
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Segment Data and Sales Forecasts
Companies report financial data for each
operating segment.
P&G’s segment disclosure includes
current and historical data for each of its
five operating segments.
These disclosures provide a wealth of
information that we can use to separately
forecast sales for each operating
segment.
Sales of forecasts are more accurate
when they incorporate all available data.
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Morgan Stanley Sales Forecasts
Morgan Stanley analysts forecast organic sales growth for each of
P&G’s segments by considering
Effects of changes in unit volume
Effects of expected price increases
Effects of expected changes in product mix
Morgan Stanley forecasts a 4.7%
growth for Beauty segment:
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Learning Objective 5
Forecast
the statement of cash flows.
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Forecasting the SCF
The Process
The process begins with net income, adds back or deducts any
noncash expenses or revenues.
Then we determine the cash flow effect of changes in working
capital accounts as well as in the remaining asset, liability, and
equity items.
A common method is to compute changes in each line item on the
forecasted balance sheet and classify changes as:
Operating
Investing
Financing
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P&G’s Forecasted
2020 Statement of Cash Flows
Significant
use of cash
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Learning Objective 6
Prepare multiyear forecasts
of financial statements.
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Multiyear Forecasting
Multiyear forecasting proceeds in the same way as for one-year
forecasting.
Analysts typically need multiyear forecasts to:
Value a firm’s equity or determine enterprise value
Assess a company’s ability to repay its debt
Assign credit ratings to firms
Managers typically use multiyear forecasts for:
Cash flow budgets
Capital expenditure plans
Divestiture decisions
Mergers and acquisitions
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Normal Cash Balance
We balance the balance sheet with a “plug” to the cash account and then
adjust cash to a normal balance.
For example, for P&G in FY2020:
FY2019 cash of $4,239 million is 6.3% of reported sales of $67,684M.
Maintaining the same proportion, the target level of cash will be $4,413M (forecasted
FY2020 sales of $70,053M × 6.3%).
Forecasted cash balance is $(1,550)million.
Consequently, we assume additional borrowing of $6,000 million (rounded up) to
achieve a 6.3% cash-to-sales percentage.
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P&G’s Forecasted
2021 Income Statement
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P&G’s Forecasted
2021 Balance Sheet
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Forecasting Sensitivity
Analysts commonly perform a sensitivity analysis of their
forecasts.
Typically, analysts prepare additional forecasts (characterized as
Bull and Bear scenarios) and present these together with their
“most likely” scenario forecasts.
The forecasted cash flow (and resulting stock price estimates) are
recomputed under these additional assumptions.
This sensitivity analysis allows analysts to develop a possible
range of stock prices that are included in their analyst’s report.
© Cambridge Business Publishers, 2021
Financial
Statement
Analysis &
Valuation Sixth Edition
Cambridge Business Publishers
www.cambridgepub.com
