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    Case 5 - 26082019 - 051123

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    Haryadi Widodo

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    N Everyday, fortunes ae won and lst onthe backs of business performance assessments ane fectss, Because ofthe uncertainty surrounding business perfomance the ran car aa recite that forecasting isnot the same as fortune telling natiipeend This nee way of making certain that specific forecasts are never exactly conece sre pole Purors, however, tat thoughtful forecasts grealy id managers moras Sanding the implications of various outcomes including the most probe outcome) with an appreciation of the odds of business success jis note examines principles inthe art and science of thoughtful financial fore- Sean fr the business manager. In panicular,it reviews the importance of (1) waco eanding the financial relationships of a busincss enterprise, (2) grounding tosltns tr cae ality of the industry and macroenvironment, 3) modeling forcace feat Embeds the implications of business strategy, and (4) recognizing te Potential for cognitive bias inthe forecasting process. The note closes with decaled example Understanding the Financial Relationships of the Business Enterprise Financial statements provide information on the financial activities of an enterprise, Mush like the performance stasis from an athletic contest, financial sea, Provide an array of identifying data on various historical strengths and weekrennee dey te 88 pied by Prfesir Michel. cl. Speci tanks goo Vine Klin or Sore ye Unnate io Le An Lae Tyran Ray Net or eine anaes Con VA. All ight reserved Pa Two Financial Anslsis and Forecasting ‘cross a broad spectrum of business activities. The income statement (also known as t profit-and-loss statement) measures flows of costs, revenue, and profits over a defi period of time, such as a year. The balance sheet provides a snapshot of business inves ‘ment and financing at a particular point in time, such as the end of a year. Both st ments combine to provide a rich picture of a business's financial performance. ‘analysis of financial statements is one important way of understanding the mechani the systems that make up business operations. Interpreting Financial Ratios Financial ratios provide a useful way to identify and compare relationships across fina cial statement line items.' Trends in the relationships captured by financial ratios Particularly helpful in modeling a financial forecast. The comparison of ratios ‘ime or with similar firms provides diagnostic tools for assessing the health ofthe vs ‘ous systems inthe enterprise. These tools and the assessments obtained with them p the foundation for financial forecasting. ‘We teview common financial ratios for examining business operating performance Itis worth noting that there is wide variation in the definition of financial ratios. A sure such as return on assets is computed many different ways in the business w. Although the precise definitions may vary, there is greater consensus on the interpret tion and implication of each ratio. This note presents one such definition and revi the interpretation, { Growth rates: Growth rates capture the year-on-year percentage change in a parti lar line item. For example, if total revenue for a business increases from $1.8 milo $2.0 million, the total revenue growth forthe business is said tobe 11.1% [(2.0 ~ 8/14 Total revenue growth can be further decomposed into two other growth measures: growth (the growth in revenue due to an increase in units sold) and price growth ( growth in revenue due to an increase in the price of each unit). In the above example, unit growth for the business is 5.0%, the remaining 6.1% of total growth can be attribute to increases in prices or price growth, ‘Margins: Margin ratios capture the percentage of revenue that flows into prof or, alternatively, the percentage of revenue not consumed by business costs. Busin Profits can be defined in many ways. Gross profit reports the gains to revenue a subtracting the direct expenses. Operating profit reports the gains to revenue aft subtracting all associated operating expenses. Operating profit is also commonly ferred to as earnings before interest and taxes (EBIT). Net profit reports the gai revenue after subiracting all associated expenses, including financing expenses taxes. Each of these measures of profits have an associated margin. For example if operating profit is $0.2 million and total revenue is $2.0 million, the operat tists i again useful in understanding how ratios provide adit ‘meaning information, In measuring the effectiveness of a ater in baseball, the bating average ‘of its + numb of at bats) may be more usefl than simply knowing the nurberof hits Ta measuring he succes fa running back in fatal, the rato of rushing yes guined per earty may be mere wef an simply knowing the total rushing yards ened (Case 5 Business Performance Evaluation: Approaches fr Thoughifl Forecasting 91. ‘margin is 10% (0.2/2.0). Thus, for each revenue dollar, an operating profit of $0.10 is Benerated and $0.90 is consumed by operating expenses. The margin provides the analyst with a sense ofthe cost structure of the business. Common definitions of mar. ‘gin include the following: Gross margin = Gross profitTotal revenue where gross profit equals total revenue les the cos of goods sod. Operating margin = Operating profi Total revenue ‘here operating profit equals total revenue less all operating expenses (EBIT). NOPAT margin = Net operating profit after tax (NOPAT)/Total revenue Nhere NOPAT equals EBIT multiplied by (1 ~ t), where ¢is the prevailing marginal income tax rate. NOPAT measures the operating profits on an after-tax basis without accounting for tax effects associated with business financing. Net profit margin = Net income/Total revenue where net income or net profit equals total revenue less all expenses forthe period. A Dusiness that has a high gross margin and low operating margin has a cost structure that ‘maintains high indirect operating expenses such asthe costs associated advertising or with property, plant, or equipment (PPE). Turnover: Turnover ratios measure the productivity, or efficiency, of business assets. The tumover ratio is constructed by dividing a measure of volume from the in Come statement (ic. total revenue) by a related measure of investment from the balance sheet (ie., total assets). Turnover provides a measure of how much business flow is generated per unit of investment. Productive or efficient assets produce high levels of asset turnover. For example, if total revenue is $2.0 million and total assets fare $2.5 million, the asset-tumover measure is 0.8 times (2.0/2.5). Thus, each dollar of ‘otal asset investment is producing $0.80 in revenue or, alternatively, total assets are {urning over 0.8 times a year through the operations of the business. Common mea, sures of turnover include the following: Accounts receivable turnover = Total revenue/Accounts receivable ‘Accounts receivable tumover measures how quickly sales on credit are collected. Busi- esses that take a long time to collect their bills have low receivable turnover because Of their large receivable levels Inventory tumover = Cost of goods sold/Inventory Inventory tumover measures how inventory is working in the business, and whether the business is generating its revenue on large levels or small levels of inventory, For inven, {ory tumover (es well as payable tumover) itis customary to use cost of sales asthe volume measure because inventory and purchases are on the books at cost rather than at the expected selling price PPE turnover = Total revenue/Net PPE n Pat Two Financial Analysis and Forecasting PPE tuover measures the operating efficiency of the fixed assets of the business. Businesses with high PPE turnover are able to generate large amounts of revenue on relatively small amounts of PPE, suggesting high productivity or asset efficiency. Asset tumnover = Total revenue/Total assets Total capital tumover = Total revenue/Total capital Total capital is the amount of capital that investors have put into the business and is defined as total debt plus total equity. Since investors require a return on the total capital | they have invested, total capital tumaver provides a good measure ofthe productivity of that investment Accounts payable tumover = Cost of goods sold/Accounts payable Accounts payable turnover measures how quickly purchases on eredit are paid Businesses that are able to take a long time to pay their bills have low payable turnover | because of ther large payables levels ] ‘An alternative and equally informative measure of aset productivity isa “days” measure, which is compoted asthe investnent amount divided by the volime amount mulipied by 365 days. This measure captures the average numberof days ina year that | an investment item is held by the business. For example, if total revenue is $2.0 million and accounts receivable is $0.22 million, the accounts receivable days measure is calcu- ; lated as 40.2 days (0.22/2.0 x 365). The days measure ean be interpreted as thatthe | average receivable is eld by the business for 40.2 days before being collected. The Jower the days measure, the more efficent ste investment tem. I the accounts receit= able balance equals the total revenue forthe year, the accounts receivable days measure is equal to 365 days asthe business has 365 days of receivables on their books. Ths means it takes the business 365 days, on average, to collect their accounts receivable While the days measure does not actually provide any information that i not aleady_ contained in the respective tumover ratio (as itis simply the inverse ofthe tumovee measure multiplied by 365 days), many managers find the days measure o be more in tuitive than the turnover measure. Common days measures include the following Accounts receivable days = Accounts receivable/Total revenue x 365 days Inventory days = Inventory/Cost of goods sold x 365 days Accounts payable days = Accounts payable/Cost of goods sold x 365 days Reiwrn on investment; Return on investment captures the profit generated per dol of investment, For example, if operating profit is $0.2 million and total assets a $2.5 million, pretax return on assets is calculated as operating profit divided by tot assets (0.2/2.5), or 8%. Thus, the total dollars invested in business assets are generat; pretax operating-profit returns of 8%. Common measures of return on investment itl clude the following: Return on equity (ROE) = Net income/Shareholders’ equit where shareholders’ equity is the amount of money that shareholders have put into business, Since net income is the money that is available to be distributed back to equit Case 5 Business Peformance Evalution: Approaches fe Thoughtful Forecasting 98, investors, ROE provides a measure ofthe return the busines is generating forthe equity investors Return on assets (ROA) = NOPAT/Total assets ‘where NOPAT equals EBIT x (1 —1), EBIT is the earnings before interest and taxes, and {is the prevailing marginal income tax rate. Like many ofthese ratios, there are many ‘ther common definitions. One common altemative definition of ROA is the following Return on assets (ROA) = Net income/Total assets and, lastly, ‘Return on capital (ROC) = NOPAT/Total capital Since NOPAT is the money that can be distributed back to both debt and equity inves- tors and foal capital measures the amount of capital invested by both debt and equity investors, ROC provides a measure of the return the business is generating for all investors (both debt and equity). It is important to observe that return on investment can be decomposed into a margin effect and a turnover effect. That relationship means that the same level of business profitability can be attained by a business with high margins and low turnover, such as Nordstrom, as by a business with low margins and high turnover, such as Wal-Mart. This decomposition can be shown algebraically for he ROC: ROC =NOPAT margin x Total capital tumover NOPAT__ _NOPAT Total revenue ‘Total capital ~ Total revenue ~ “Total capital "Notice thatthe equality holds because the quantity for total revenue cancels out across {he two right-hand ratios. ROE can be decomposed into three components ROC = Net profit margin x Total capital tumover x Total capital leverage Net income Netincome , Totalrevenue Total capital ‘Shareholders’ equity Total revenue ™ Total capital“ Shareholders equity [Tis decomporition shows that changes in ROE can be achieved in three ways: changes [ast Profit margin, changes in total capital productivity, and changes in total capital Using Financial Ratios In Financial Models Financial ratios provide the foundation for forecasting financial statements because fic rancial ratios capture relationships across financial statement line items that tend to be preserved over time. For example, one could forecast the dollar amount of gross profit fornext year through an explicit independent forecast, However, a better approach isso forecast two ratios: a revenue growth rate and a gross margin. Using these two rations 94 Pat Two Financial Analysis and Forecasting combination one ean apply the growth rate to the current year’s revenue, and then use the gross margin rate (o yield an implicit dollar forecast for gross profit. As an example, if we estimate revenue growth at 5% and operating margin at 24%, we can apply those ratios t last year’s total revenue of $2.0 million to derive an implicit gross profit fore- cast of $0.5 million [2.0 x (I + 0.05) x 0.24]. Given some familiarity withthe financial ratios of a business, the ratios are generally easir to forecast with accuracy than are the expected dollar values. The approach to forecasting is thus to model future financial statements based on assumptions about future financial ratios. Financial models based on financial ratios can be helpful in identifying the impact ‘of particular assumptions on the forecast. For example, models can easily allow one to see the financial impact on dollar profits ofa difference of one percentage point in op- crating margin, To facilitate such a scenario analysis, financial models are commonly builtin electronic spreadsheet packages such as Microsoft Excel. Good financial fore- ‘cast models make the forecast assumptions highly transparent. To achieve transparency, assumption cells for the forecast should be prominently displayed in the spreadsheet (€g., total revenue growth rate assumption cell, operating margin assumption cell), and then those cells should be referenced in the generation of the forecast. In this way, it becomes easy not only to vary the assumptions for different forecast scenarios, but also to scrutinize the forecast assumptions. Grounding Business Forecasts in the Reality of the Industry and Macroenvironment Good financial forecasts recognize the impact ofthe business environment on the per- formance of the business. Financial forecasting should be grounded in an appreciation for industry- and economy-wide pressures, Because business performance tends to be correlated across the economy, information regarding macroeconomic business trends should be incorporated into a business's financial forecast, If, for example, price in- creases for a business are highly correlated with economy-wide inflation trends, the financial forecast should incorporate price growth assumptions that capture the avail- able information on expected inflation. If the economy is in a recession, then the fore- cast should be consistent with that economic reality, ‘Thoughtful forecasts should also recognize the industry reality. Business prospects are dependent on the structure of the industry in which the business operates. Some in- dustries tend to be more profitable than others. Microeconomic theory provides some explanations for the variation in industry profitability. Profitability within an industry is likely to be greater if (1) barriers to entry discourage industry entrants, (2) case of indus- tay exit facilitates redeployment of assets for unprofitable players, (3) industry partici- pants exert bargaining power over buyers and suppliers, or (4) industry consolidation reduces price competition.” Table 5.1 shows the five most and the five least profitable industries in the United States based on median pretax ROAs for all public firms from, ®Michac . Porter, “How Competitive Forces Shae Strategy” Harvard Business Review $7, 0.2 (MatehApel 1979) 137-45, | / (Cese 5 Business Peformance Evaluation: Approaches for Thoughifl Foccasting 98 Most profitable and least profitable U.S. industries: 2005-2014, ost Profitable Industries Median Firm ROA Least Profitable Industries ‘Median Firm ROA ‘Apparel Tobacco Products 18% Chemicals and lied Products 25% Building Materials, Reta! 16% Metal Mining 14% Leather and Leather Products 13% Mining and Quarrying 4% ‘Apparel and Accessory Stoves 115, Building Construction 2% tox Oiland Gos Extraction —% 2005 to 2014. Based on the evidence, firms operating in the apparel and accessory retail industry should have systematically generated more profitable financial forecasts over that period than did firms in the metal-mining industry, One explanation forthe differ. ences in industry profitability i the ease of industry exit. Inthe retail industry, unprofit- able businesses are able to sell their assets easily for redeployment elsewhere. In the imining industries, where asset redeployment is much more costly, industry capacity ‘ay have dragged down industry profitability. Being within a profitable industry, however, does not ensure superior business performance. Business performance also depends on the competitive position of the firm within the industry. Table 8.2 shows the variation of profitability for firms within the U.S. apparel and accessory stores industry from 2005 to 2014. Despite being one of the most profitable industries as shown in Table 8.1, there is large variation in profit ability within the industry. All five firms atthe bottom of the profitability list generated median ROAS that were actually negative (Delia's, Frederick's, Bakers Footwear, Pacific Sunwear, and Coldwater Creek). Good forecasting considers the ability of a ‘business to sustain performance given the structure of its industey and its competitive position within that industry. Abnormal profitability is difficult to sustain overtime. Competitive pressure tends to bring abnormal performance toward the mean. To show that effect, we ean sort all U.S. public companies for each year from 2008 t0 2015 into five groups (group 1 with low profits through group 5 with high profits) based on their annual ROAS and sales Tovth, We then follow what happened tothe composition of those groups over the next TABLES.2 | Most and least profitable firms within the apparel and accessory stores retail industy: 2005-2014, Rankings in Tables 5.1 and 5.2 are based on all fms from Compustat organized into industries by 2-digt SIC codes. Most Profitable Firms Median Fitm ROA Least Proftable Firms Mealan Fiem ROA, Francesco's 538 Del's 29% Buckle 38% Frederick’ 17% ux 2% Bokers Footwear 10% Ross Stores 28% Pacific Sunwear 6% J.Crew 26% Coldwater Creek 5% 96 Pa Two Financial Analysis and Forecasting FIGURE 5.4. | Firm-ranking annual transitions by proftablity and seles growAh. Firms are sorted for each year into five groups by either annual pretax ROA or sales growth, For example, in the ROA panel, group 1 comprises the firms withthe lowest 20% of ROA for the year; group 5 ‘comprises the firms with the highest 20% of ROA for the year. The figure plots the mean Fanking number for all US. public firms in the Compustat database from 2005 to 2015. a Sates Grown 5 5 High ROA Group: High Growth Group. i 4 33 8, | i i *, 2 Tow ROR Gro (on Grom Group ' Word Wear Verdes Year Wear Ver Weed Year ter Ranking eer Aer Reng three years. The results of this exercise are captured in Figure 5.1. The ROA graph shows the mean group rankings for firms in subsequent years. For example, firms that ranked in group 5 with the top ROA at year 0 tend to have a mean group ranking of 4.5 in year 1, 4.3 in year 2, and 3.7 in year 3. Firms that ranked in group 1 with the low- | est ROA at year 0 tend to have a mean group ranking of 1.5 in year 1, 1.7 in year 2, and 2.2 in year 3. There is a systematic drift toward average performance (3.0) over time. ‘The effect is even stronger vis-d-vis sales growth. Figure 5.1 provides the transition ‘matrix for average groups sorted by sales growth. Here we see that, by year 2, the aver- ‘age sales growth ranking for the high-growth group is virtually indistinguishable from, that of the low-growth group. Figure 5.1 illustrates that business is fiercely competitive. is naive to assume that superior business profitability or growth can continue unabated for an extended period. Abnormally high profits attract competitive responses that eventually return profits 10 their normal levels, Modeling a Base-Case Forecast that Incorporates Expectations for Business Strategy With a solid understanding of the business's historical financial mechanics and of the environment in which the business operates, the forecaster can incorporate the firm's ‘operating strategy into the forecast in a meaningful way. All initiatives to improve revenue growth, profit margin, and asset efficiency should be explicitly reflected in the (Case Business Performance Evaiation: Approsches for Thoughifal Forecasting 97 financial forecast. The forecast should recognize, however, that business strategy does ‘not play out in isolation. Competitors do not stand still. A good foreeast recognizes that business strategy also begets competitive response. All modeling ofthe effects of busi- ‘ness strategy should be tempered with an appreciation for the effects of aggressive ‘competition. ‘One helpful way of tempering the modeling of business strategy’s effects is to complement the traditional bottom-up approach to financial forecasting with a top- own approach. The top-down approach starts with a forecast of industry sales and then works back to the particular business of interest. The forecaster models firm sales by ‘modeling market share within the industry. Such a forecast makes more explicit the challenge that sales growth must come from either overall industry growth or market share gain. A forecast that explicitly demands a market share gain of, say, 20% to 24%, is easier to scrutinize from a competitive perspective than a forecast that simply projects sales growth without any context (eg, at an 8% rate). Another helpful forecasting technique is to articulate business perspectives into a coherent qualitative view on business performance. This performance view encourages the forecaster to ground the forecast in a qualitative vision of how the future will play out. In blending qualitative and quantitative analyses into a coherent story, the fore- caster develops a richer understanding of the relationships between the finaneial fore- cast and the qualitative trends and developments in the enterprise and its industry Forecasters can better understand their models by identifying the forecast’s value drivers, which are those assumptions that strongly affect the overall outcome. For example, in some businesses the operating margin assumption may have a dramatic ‘impact on overall business profitability, whereas the assumption for inventory turnover ‘may make litle difference, For other businesses, the inventory turnover may have a tremendous impact and thus becomes a value driver. In varying the assumptions, the forecaster can better appreciate which assumptions matter and thus channel resources to improve the forecast’s precision by shoring up a particular assumption or altering the ‘business strategy to improve the performance of a particular line item, Lastly, good forecasters understand that it is more useful to think of forecasts as ranges of possible outcomes rather than as precise predictions. A common term in fore. casting is the “base-case forecast.” A base-case forecast represents the best guess oul. ‘come or the expected value of the forecasts line items, In generating forecasts, it is also {important to have an unbiased appreciation for the range of possible outcomes, which is commonly done by estimating a high-side and a low-side scenario. In this way, the forecaster can bound the forecast with a relevant range of outcomes and can best appreciate the key bets ofthe financial forecast, Recognizing the Potential for Cognitive Bias in the Forecasting Process AA substantial amount of research suggests that human decision making can be system. accally biased. Bias in financial forecasts creates systematic problems in managing and investing in the business. Two elements of cognitive bias that play a role in financial forecasting are optimism bias and overconfidence bias. This note defines optimism bias Pat Two Financial Analysis and Forecasting | Optimism and overconfidence biases in forecasting the sales growth rate. Forecast Distribution Probability Twe Distrbution as a systematic positive error in the expected value of an unknown quantity, and defin the overconfidence bias as a systematic negative error in the expected variance an unknown quantity. The definitions of those two terms are shown graphically Figure 5.2, The dark curve shows the true distribution of the sales growth rate, realization of the growth rate is uncertain, with a higher probability of its being in th ‘central part ofthe distribution. The expected value for the sales growth rate is g*; th the proper base-case forecast for the sales growth rate is precisely g*. The light shows the distribution expected by the average forecaster. This distribution is biased two reasons. Firs, the expected value is too high. The forecaster expects the base sales growth rate to beg’, rather than g*. Such positive bias for expected value is term ‘optimistic, Second, the dispersion of the distribution is too tight. This dispersion is capt by the variance (or standard deviation) statistic. Because the forecast dispersion is tight than the true dispersion, the forecaster exhibits negative variance bis, or overconfiden the forecaster believes that the forecast is more precise than it really is. 4 A description and the implications of an experiment on forecasting bias among students is provided in an Appendix to this note. Nestle: An Example In 2013, Nestle was one of the world’s largest food and health companies. Headquarter in Switzerland, the company was truly a multinational organization with factories 86 countries around the world, Suppose that in early 2014, we needed to forecast financial performance of Nestle for the end of 2014. We suspected that one sensible p to start was to look at the company's performance over the past few years. Exhibit S provides Nestle's income statement and balance sheet for 2012 and 2103, (Case Business Performance Evaluation: Approsche for Thoughtful Forecasting 99 One approach to forecasting the financial statements for 2014 is to forecast each line item from the income statement and balance sheet independently. Such an ap- Proach, however, ignores the important relationships among the different line items (Gg. costs and revenues tend to grow together). To gain an appreciation for those relationships, we calculate a variety of ratios (Exhibit 5.1, In calculating the ratios, Wwe notice some interesting patterns. First, sales growth declined sharply in 2013, from ‘7.4%6 to 2.7%, The sales decline was also accompanied by much smaller decline in profitability margins; operating margin declined from 14.9% to 14.1%. Meanwhile, the asset ratios showed modest improvement; total asset turnover improved only slighty, from 0.7x to 0.8x. Asset efficiency improved across the various classes of assets (€-g. accounts receivable days improved in 2013, from 53.0 days to 48.2 days; PPE turnover also improved, from 2.8x to 3.0x). Overall in 2013 Nestle's declines in sales growth and margins were counteracted with improvements in asset efficiency such that return on assets improved from 6.9% to 7.1%, Because return on assets com, prises both a margin effect and an asset-productivity effec, we can attribute the 2013 Improvement in retun on assets to a denominator effect—Nestle'sassot efficiency improvement. The historical ratio analysis gives us some sense ofthe trends in bush, ness performance. A common way to begin a financial forecast is to extrapolate current ratios into the future, For example, a simple starting point would be to assume that the 2013 financial ratios hold in 2014. If we make that simplifying assumption, we generate the financial forecast presented in Exhibit 5.2. We recognize this Forecast as naive, but it provides a straw-man forecast through which the relationships captured in the financial ratios can be scrutinized. In generating the forecast, all the line-item figures fare built on the ratios used in the forecast. The financial line-item forecasts are com. puted as referenced to the right of each figure based on the ratios below, Such a forecast is known 25 a financial model. The design of the model is thoughtful. By linking the dollar figures with the financial ratios, the model preserves the existing relationships across line items and can be easily adjusted to accommodate different ratio assumptions. Based om the naive model, we can now augment the model with qualitative and quantitative research on the company, its industry, and the overall economy. In early 2014, Nestle was engaged in important efforts to expand the company prociet lin in foods with all-natural ingredients as well the company presence in the Pacific Asian region. These initiatives required investment in new facilites. It was hoped that the initiatives would make up for ongoing declines in some of Nestle’s important prod. uct offerings, particularly prepared dishes. Nestle was made up of seven major busi. ness units: powdered and liquid beverages (22% of total sales), water (8%), milk Products and ice cream (18%), nutrition and health science (14%), prepared dishes and cooking aids (15%), confectionary (11%), and pet eare (12%). The food process, ing industry had recently seen a substantial decline in demand for its products in the developing world. Important macroeconomic factors had led to sizable declines in demand from this part of the world. The softening of growth had led to increased

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