Module 11

Forecasting Financial Statements

Overview of the Forecasting Process

Reformulated financial statements - we adjust the financial statements to reflect the companys net operating assets and the operating income that we expect to persist into the future. Garbage-In, Garbage-Out - the 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. 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.

Revenues Forecast Impacts Both the Income Statement and the Balance Sheet

Dynamics of Income Statement Growth

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. 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. Accounts payable increase as inventories are purchased on credit. Accrued liabilities increase concurrent with increases in revenue-driven operating expenses.

Dynamics of Balance Sheet Growth

Forecasting Steps
1. 2.

3.

4.

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. We set cash equal to the amount necessary to balance the balance sheet. (Optional) Adjust the balance sheet to the target cash balance. We assume that excess cash is used to purchase marketable securities, reduce debt, or repurchase shares; whereas a cash deficit is financed with short-term debt. Then, we recompute net nonoperating expense to reflect any adjustments we make to nonoperating asset and liability account balances.

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 form 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.

Sources of Information

Public disclosures via meetings and calls

Public reports: segment disclosures and MD&A

P&G Data from MD&A

Determining the Revenue Growth Forecast

Impact of Foreign Exchange Rates

Final P&G revenues forecast is $82,944 million = $83,503 x (1 [4.33% - 5%]).

Forecasting Expenses

Forecasted Income Statement for P&G

Forecasting the Balance Sheet

Forecasting Balance Sheet Items

1.

2.

3.

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.

Computational Options

Forecasts using percent of revenues -

Forecasts using turnover rates -

Forecasts using days outstanding -

Equivalence of Forecasting Methods

We use the percent of sales in our forecasts of balance sheet accounts because 1. It appears to be the most commonly used method, 2. it is the method that P&G management uses in its meetings with analysts, and 3. it is the method used by Oppenheimer in the real-world analysis illustration we provide in Appendix 11A.

Forecasted Balance Sheet for P&G

Forecasted SCF for P&G

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 recompute 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.

Two-Year Ahead forecasts of the P&G Income Statement

Two-Year Ahead Forecasts of the P&G Balance Sheet

Two-Year Ahead Forecasts of the SCF

Step 4 (optional): Adjust for Cash Target

Possible approaches: 1. Invest excess cash in marketable securities. 2. Use excess cash to retire short-term debt. 3. Use excess cash to acquire treasury stock.

When adjusting the balance sheet to reflect a targeted cash level, we must take care to not inadvertently change the companys financial leverage.

Forecasting P&Gs balance sheet with a cash target

Parsimonious Method of Multiyear Forecasting

Inputs: Sales growth Net operating profit margin (NOPM = NOPAT / Sales) Net operating asset turnover (NOAT = Sales / NOA)

P&G Income Statement Forecast with a Cash Target

P&G Balance Sheet forecast with Cash Target

P&G SCF Forecast with Cash Target

Adjustments for Cash Deficit

When forecasted cash is negative, we can increase the projected cash balance by 1. Selling marketable securities. 2. Borrowing money. 3. Issuing common stock. Selling marketable securities or borrowing money result in less interest income and/or higher interest expense in the income statement.