Case 8 The Body Shop International PLC 2001 71 THE BODY SHOP INTERNATIONAL PLC 2001: AN INTRODUCTION TO FINANCIAL MODELIN Teaching Note Synopsis and Objectives In this case, the student is cast in the role of adviser to Anita Roddick, the managing director of The Body Shop. The student must prepare a three-year forecast of the firm’s income statements and balance sheets. The case is intended to introduce percentage-of-sales forecasting and walks the student through the preparation of a simplified forecast, first using pencil and paper, then using a spreadsheet program on the personal computer. The case emphasizes the importance of being able to speak plainly about one’s financial forecast and the insights that are of use to the general manager. Suggested Instructions for Advance Assignment to Students Advance instructions to students for this case are relatively simple: Work through the exercises in this case, first using pencil and paper, and then using your personal computer. Then follow the directions in the case to make the three- year forecast, and prepare responses to the questions posed at the end of the case. The Microsoft Excel spreadsheet file Case 8.xls supports student analysis and saves a few keystrokes in formatting and entering data for the final exercise of the c: ‘The instructor's work file, TN_8.xls, contains the completed model shown in Exhibit TN2—this model should not be distributed to the students.72 Case 8 The Body Shop International PLC 2001 Supplemental References The case presents a self-contained exposition of forecasting, and will require two to four hours of preparation by a novice student. We have been reluctant to load more preparation upon the student. The instructor may wish to offer supplemental resources depending on the audience, setting, and the availability of student preparation time. The following are potentially valuable complements to this case. Higgins, Robert C. “Financial Forecasting” in Analysis for Financial Management. 6th ed. (Burt Ridge, IL: Inwin/McGraw-Hill, 2001). This is one of the best concise discussions of financial forecasting, and would be especially useful with executive audiences Current corporate finance textbooks offer presentations that link the mechanics of forecasting to the larger subject of financial planning. Two good discussions are these: Brealey, Richard A., and Stewart C. Myers, “Financial Analysis and Planning.” chap. 28 in Principles of Corporate Finance. 6th ed, (Burr Ridge, IL: Irwin/McGraw-Hill, 2000). Ross, Stephen, Westerfield, Randolph, and Jaffe, Jeffrey. “Corporate Financial Models and Long- ‘Term Planning.” chap. 28 in Corporate Finance. 6th ed. (Burr Ridge, IL: Irwin/McGraw-Hill, 2002). Some novices will ask for more practice drills in forecasting mechanics. The following is a CD- ROM-based tutorial that walks students through the preparation of spreadsheet forecasting ‘models for three companies: Bruner, Robert F., Kenneth M. Eades, and Robert S. Harris. Finance Interactive. (Burr Ridge, IL: Inwin/McGraw-Hill, 1997). Students welcome the self-guided aspect of this tutorial, and show quicker mastery when they use it, We provide this resource after students have received the introduction in The Body Shop case. Hypothetical Teaching Plan Although the mechanical tasks in the case are straightforward, a discussion of this case easily fills a solid class period. The instructor will need to balance faithfulness to the breadth of issues raised with appeals from novices for in-depth pointers. 1. Why would a company like The Body Shop want to forecast its financial statements? This opening is a useful motivator for the discussion and lends seriousness to the exercise. The basic point should be that finance is concemed with expected performance. Investors forecast to value and invest. Managers forecast to plan and finance, Financial forecasts such as the exercises in this case lend rigor to expectations about future performance.Case 8 The Body Shop International PLC 2001 73 2. Let us vault past the exercise questions and go straight into the three-year forecasts: How did you prepare your forecast and what numbers did you get? Exhibit TN1 offers a template for a transparency based on case Exhibit 8, The instructor can use the template to enter the forecasts for 2002 and 2003. One approach is to call on a student to present his or her entire set of results, then call on other students to describe their differences, innovations, and points of difficulty. The instructor might keep a list on the chalkboard of modeling questions and their answers. 3. How much debt financing will The Body Shop need over this forecast period? What are the key drivers of this need, and how much do debt needs vary as the assumptions vary? This phase of the discussion pushes students past mere modeling into the exercise of their ‘models and the interpretation of results. The aim here should be to engage the students in the insights to be derived from data tables, the intuitive explanations for the significance of key drivers, and an appreciation of sensitivity analysis, scenario analysis, and the identification of break-even assumptions. 4. What issues does this analysis raise for Roddick? This segment of the discussion should distill the insights from the sensitivity analysis into practical questions or suggestions for a general manager. For instance, key drivers identified in the preceding section should be ranked in importance with the most important one or two made the focus of questions. If growth rate proves important, students might develop questions about the source of that growth, its stability, the effect of changes in product mix, and the possible impact of moves by competitors. The instructor can close with summary comments derived in part from the list of mechanical issues kept on the board and in part from exhortations to master modeling and move into interpretation and recommendation. Case Analysis Motives for modeling Decision makers wrestle with uncertainty about the future. Financial modeling can help illuminate the future, identify strengths and potential problems, and clarify the implications of alternative choices. The Body Shop has enjoyed mediocre financial performance in recent years. Concems exist about the future, particularly from the entry of large competitors into The Body Shop’s retail specialty, and the fight for market share that ensued; and about the ability of The Body Shop to sustain its rate of growth as it saturates markets in developed countries. Investors74 Case 8 The Body Shop International PLC 2001 and managers alike would be interested to see the financial impact of potential adverse changes in the firm’s business.Case 8 The Body Shop International PLC 2001 75 The types of concems students raise about financial modeling will hinge on their comfort with computer spreadsheet programs. Accordingly, an instructor will need to tailor the modeling to meet the student’s skill levels. Exhibit TN2 presents one example of a finished three-year model available in the instructor's Microsoft Excel spreadsheet file, TN_8.xls. This forecast is useful mainly as an example for the instructor’s preparation, Actual class discussion should be derived from the students” work. Modeling mechanics Exhibit TN2 shows the forecasted assumptions in a straightforward manner. It uses overdrafts as the debt plug figure. Cash is the offsetting plug, if debt were to turn negative; if debt is positive, cash is programmed to hold constant at GBP10 million. The resulting excess cash figure in 2002 is considerably lower than in case Exhibits 5 through 7, primarily because the case exhibits assume a very high ratio of current liabilities to sales (28%). Exhibit TN2 assumes that current liabilities (other than overdrafts) amount to only 13.5% of sales. An important learning point is to question the assumption (implied in case Exhibits 57) that all current liabilities arise spontaneously in the course of business (for example: as accounts payable and accruals do). Short-term debt does not arise spontaneously, it must be borrowed. This distinction is crucial if one’s objective is to determine a company’s financing needs. When discussing the students’ detailed three-year forecasts, the instructor should try to cover the following important issues. Which items vary with sales? One may reasonably assume that the cost of goods sold varies directly with sales. Net fixed assets, inventory, and selling, general, and administrative expenses probably vary imperfectly with sales, however, and categories like land or goodwill vary little with sales. Students should appreciate that professionalism in the use of percentage-of-sales forecasting requires sensitivity to the various accounts’ relationships to sales. Circularity in the model: The case describes the need to iterate through the model to solve for debt, but students may need some help in understanding why: The income statement drives the balance sheet, and the balance sheet affects the income statement through interest expense. No solution can be found except by iteration. Sources of assumptions: Students will debate the efficacy of various sources for their assumptions. For instance, growth rates could originate from the: ‘historical growth rate for the firm ‘* historic growth rates for peers76 Case 8 The Body Shop International PLC 2001 | target growth rates used by the firm '* expectations of investors and securities analysts (the case presents only analysts’ expectations and historic data) Novices usually plead for the right answer as the basis for assumptions. Analysts’ and managers expectations may be more correct than the others, but the instructor should encourage students to derive their own expectations through an analysis of the fundamentals of the company. Is percentage-of-sales forecasting the most appropriate technique? Students tend to fasten onto one technique while neglecting others. The instructor might mention that other techniques exist. The polar opposite of percentage-of-sales forecasting is the T-account method, which anticipates specific transactions and works through the accounts to derive the forecast statements. This method requires more information than the percentage-of-sales technique and can be tedious without the aid of a computer. Practically speaking, financial forecasting is inevitably a mix of the two techniques: Accounts that vary with sales are forecast as a percentage ital expenditures) are ast through thi The forecast in Exhibit TN1 reveals a financing need (overdrafts) of (British pounds) GBP16.1 million in 2003, and GBP28.6 million in 2004. It is very important for the instructor to help the students rise above the pure mechanics of the forecasting task and aid them in the interpretation of the economics of the firm’s future, What creates the growing financing need? The simple answer is growth of the scope of the firm. One teaching strategy would be to digress into a discussion of the self-sustainable growth rate concept, and to show that the firm is not retaining enough earnings to finance its growth in assets. But the same insight can be derived from a more practical discussion of key drivers or assumptions that are influential in estimating the firm’s financing needs. It is valuable for students to consider how to find key drivers and to assess their effects. Three classic approaches are useful: Simple manipulation of key assumptions: Novices typically start at this point, which at least allows them to check whether a model works according to their intuitions. On the other hand, simple manipulation can be an inefficient way to exercise the model and can quickly turn into aimless churning of the assumptions. If students do not offer alternatives, the instructor might offer the next few. Scenario analysis: This effort is akin to simple manipulation, but is guided by a vision of the interdependency among assumptions. If sales decline, might management cut capital spending and administrative expenses? Students should be encouraged to think consciously about how managers respond to external pressures and how managers’ reactions might affect the sensitivity analysisCase 8 The Body Shop International PLC 200177 Data tables: Data tables offer a way for the analyst to develop a feel for the sensitivities, and thus to identify key drivers in the forecast. Another use of data tables is break-even analysis: the identification of pivotal values in key assumptions. Case Exhibit 7 shows that—between 44% and 45% of cost of goods sold/sales—the company moves from lending to borrowing. The identification of such break-even points helps highlight important thresholds for managers. Much of the artistry in devising those tables, however, is to choose sensible steps by which values change in the assumptions. For instance, change on the order of 1% in cost of goods sold relative to sales is large; changes running from 35% to 48%, as shown in the table in case Exhibit 7, are very large. Exhibit TN3 presents a data table showing the variation in overdrafts in 2004 according to changes in revenue growth rate and the COGS/sales ratio. The novice can derive several useful insights from this regarding key drivers. First, the overdraft balance varies immensely with these two assumptions. One would conclude that they belong in the category of key drivers. Second, the table shows that growth creates a financing need (in this case) and that lower profitability increases the financing need. These are common effects, and worth highlighting for novices. Third, one sees visibly the range of break-even assumptions where the firm turns from a net lender into a net borrower: These occur where the zero balances move into positive balances. And fourth, if one accepted an overdraft balance of GBP28 million as reasonable, then one could consider the range of combinations shown in the table that also produce that outcome (for example: lower growth [11%] and lower profitability [COGS/sales of 41%]). Such an exercise is another way of itluminating the influence of growth and profitability on financing needs. Closing It has been said that “there is no finance in corporate financial models.”' This is strictly ‘true iff one focuses on the mechanical substance of the model and its typical accounting statement output. The teaching plan advocated here aims to move students as expeditiously as possible past the mechanies and accounting and into the arena of corporate financial reasoning where: © Students view modeling as a part of a process of analysis, rather than as an end in itself. ‘© The firm is viewed as a financial system in which human managers must decide among competing policies rather than as an opaque box from which policy choices just emerge. The corporate financial reasoning toward which we strive should aim to expose the economic implications of policies and trade-offs among them within this system. ‘* The ultimate aim of the modeling process should be to identify actions that will increase investors’ returns and/or reduce their risks. 1 Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 6th ed. (Burr Ridge, IL: Irwin/MeGraw Hill, 1997), 840,78 Case 8 The Body Shop International PLC 2001 Our challenge as instructors is to help students see finance through modeling, not in spite of it. The teaching plan here offers what could be the first step toward this: to see the primacy and contestability of forecast assumptions, and to exercise models in ways that yield valuable insights. As of the date of preparing this note (December 2001), the actual results for 2001-2003 were unavailable for comparison to the projections here or by students. However, the company’s Web site gives annual reports for the most recent years that might be useful in debriefing the student projections. See The Body Shop’s Web site, ihttp://www.the-body-shop.com. The wisdom of comparing actual and projected results is debatable, since novices often conclude from this that the right answer to the case is whatever the actual results are, Since these results are unknowable when the analyst makes the projections, there is always some variance, a fact that novices fail to appreciate, and from which they might conclude that forecasting is futile. A fairer comparison would be between the student projections at 2001 and the company’s internal projections at 2001 —but securities laws in most countries limit the projections that companies can publish; in any case, The Body Shop does not provide such projections. My bias, therefore, is to end this class without reference to actual results or company projections, and to focus instead on the concluding points outlined aboveCase 8 The Body Shop International PLC 2001 79 Exhibit TN1 THE BODY SHOP INTERNATIONAL PLC 2001: NCIAL MODELING AN INTRODUCTION TO FINA} Hypothetical Three-Year Forecast Worksheet Drawing on Case Exhibit 8 (in GBP millions) x ETSY 7ssanptons Toma 1999 199920000902 2001 Te a TS poo || uz 2a aa face Suteneat “ccladingescptinslcons SLA 4991462503957 23 “exept cone 4S 0000 m2 30) csnturing cons Wwe 55 27 oR 10 03 eit ape ot oo is as 4 2 Jr oi sk RT Ta cry Profiles) tained uss sy qs 23 (16) wa Taina 999 199 202000210 falas Shs oP) (esis) GBP) esas) GRP) tess 2 2 " kcas so 112 2 sk rd ay Accounts esnebe za 92 ws 92 303 fl fone crete Rs 4 Ise 47 rns 47 tix aes sre 9 1K? S710 De oil wets ees a as] accounts pasa ms 62 107 2» exes payable "738 19 crate 647 a losers 03 On 02 fore crt ie ny 40 ‘5 Jonge abilities Barth 6a80 Case 8 The Body Shop International PLC 2001 Exhibit TN2 THE BODY SHOP INTERNATIONAL PLC 2001: AN INTRODUCTION TO FINANCIAL MODELING Hypothetical Three-Year Forecast Drawing on Case Exhibit 8 (in GBP millions) Tacexpense frie art frsinay avid [aaa less fone current sess Jorcroste Total ste Accra loved: fone crn ies Jug Haiiis fortis fsbo cau MLK mak 87% ns aa ofPT 300% Tica Ver Ended Febrary 28 Forecast st 1999 2000 2001 22003 __2004 Tener TORT Too Tan FL Tooke T7477 a8 Kcostor acs 177 20% 1309 190 398% won LL 2189 Kiros rote 1760 ssa% 2 os St wae 26 Ob “Prcidina cxcoionatcoss ISLA a9 2 sos 1987 2% posses ond a9 aes 807 “excel cose 45 000% n2 aoe frais om “on 000 Jnesrstring costs 166 a7 10 03% Poste oof oa fet ncrest expense ol 15 ast as ime fore om 34 aa wa a 9 09) 109. woo 20% woo 1s wo Mo 2 47 000 ma 303 Be M2 ba nee ur 9s 0 Ms 167 oo 169) 69 of osCase 8 The Body Shop International PLC 2001 81 Exhibit TN3 THE BODY SHOP INTERNATIONAL PLC 2001: AN INTRODUCTION TO FINANCIAL MODELING Sensitivity Analysis of Overdraft in 2004 according to Variations in Revenue Growth and COGS/Sales Ratio (in GBP millions) Growth Rate in Revenues 10% 1% 12% 13% 1% 15% 35% 0.0 0.0 0.0 0.0 0.0 0.0 36% 0.0 0.0 0.0 0.0 0.0 0.0 37% 0.0 0.0 0.0 0.0 0.0 0.0 38% 0.0 0.0 0.0 0.0 1716.7 39% 0.0 00 125 176 228 28.1 40% 130 181 23.3 28.6 34.0 39.4 M% = 234 28.734. 395 45.1 50.8 42% 338 39.2 448 S05 563 62.2 43% = 44.1 498 5560 OA TABS M% 545 604 66.3. 78.6 84.9 458% 64.9 70.9 77.1 833 89.7 6.2 46% 752 815 878 94.3 100.9 107.6 47% = 85.6 92.0 98H 105.312.0118. 48% 96.0 102.6 109.3. 16.2 123.2 130.3 Note: bolded value is given in the base case of Exhibit TN2.