FINANCIAL STATEMENT

CFA LEVEL 1 ANALYSIS

CHAPTER 13
“CRAFTING YOUR
CFA TRIUMPH
WITH EFFECTIVE
SUMMARIES.”
CONCEPT NOTES
Introduction to Financial Statement Modeling
-Forecasting financial statements 1
-Biases affecting forecasts 3

-Competitive environment analysis 5

-Forecasting subject to price fluctuation 6

-Explicit forecast horizon 9

-Terminal period 10

TABLE OF
CONTENTS
Introduction to Financial
Statement Modeling
What is forecasting of financial statements?
Projecting future financial statements involves forecasting a company's financial
performance based on various assumptions and historical data. This process is
crucial for strategic planning, budgeting, and decision-making.
Gather Historical Financial Data:
Collect historical financial statements, including income statements,
balance sheets, and cash flow statements. This data provides a baseline
for understanding past performance.
Understand the Business Environment:
Analyze the external factors that may impact the company, such as
economic conditions, industry trends, and regulatory changes. Consider
how these factors might influence revenue, costs, and other financial
variables.
Define Assumptions:
Identify and document the key assumptions that will drive the
projections. These may include sales growth rates, cost trends, pricing
strategies, capital expenditures, and working capital changes.
Assumptions should be realistic and based on thorough analysis.
Build the Sales Forecast:
Develop a detailed sales forecast based on the assumptions. Consider
historical sales data, market research, and trends in the industry. Break
down the forecast by product lines, geographic regions, or customer
segments if applicable.
Project Operating Expenses:
Estimate operating expenses, such as salaries, marketing costs, utilities,
and rent. Consider any changes in cost structures and identify areas
where costs may fluctuate.

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Project Non-Operating Items:
Include non-operating items such as interest expenses and taxes. If the
company has debt, estimate interest payments based on current debt
levels and interest rates.
Project Capital Expenditures:
Forecast capital expenditures (CAPEX) for the period. This includes
investments in property, plant, equipment, and other long-term assets.
Consider the company's growth plans and the need for new or
replacement assets.
Estimate Changes in Working Capital:
Forecast changes in working capital, including accounts receivable,
accounts payable, and inventory. Adjustments in working capital affect
cash flow and financing needs.
Build the Income Statement:
Based on the sales forecast, operating expenses, non-operating items,
and taxes, construct the projected income statement. This will show the
expected profitability of the company over the projection period.
Build the Balance Sheet:
Use the projected income statement, along with assumptions about
changes in assets and liabilities, to construct the projected balance sheet.
Ensure that the balance sheet balances at the end of each period.
Construct the Cash Flow Statement:
Based on the income statement and changes in working capital, build
the projected cash flow statement. This statement helps identify the
sources and uses of cash and ensures that the company can meet its
short-term and long-term obligations.

Remember that projecting future financial statements

involves a degree of uncertainty, and assumptions may
change over time. Flexibility and adaptability are crucial
in refining projections as the business landscape
evolves.

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What are the behavioral bases affecting financial forecasts?
Behavioral biases are systematic patterns of deviation from rationality or
objective decision-making in judgment and decision processes. These biases
often result from mental shortcuts, emotional factors, and cognitive limitations
that influence individuals to deviate from making purely rational and objective
choices. They can impact various aspects of decision-making, including financial
judgments, risk assessments, and forecasting, leading individuals to make
suboptimal or biased decisions.
Here's how each of the specified biases can affect the forecasting process:
Overconfidence Bias:
Effect on Forecasting: Overconfidence bias can lead forecasters to
overestimate their abilities and the accuracy of their predictions. This
may result in overly optimistic financial forecasts.
Impact on Decision-Making: Overconfident forecasters may not
adequately account for potential risks and uncertainties. They may be
more likely to ignore contradictory information or dismiss alternative
scenarios.
Illusion of Control Bias:
Effect on Forecasting: Individuals with an illusion of control bias
tend to believe they have more control over events than they actually do.
This can lead to overestimating the predictability of certain financial
variables, leading to inaccurate forecasts.
Impact on Decision-Making: Forecasters influenced by the illusion
of control bias may be more inclined to make aggressive assumptions
about future performance, potentially overlooking external factors
beyond their control.
Conservatism Bias:
Effect on Forecasting: Conservatism bias is characterized by a
tendency to be cautious and slow to update one's beliefs. In forecasting,
this can result in underestimating future performance, as forecasters
may be reluctant to revise assumptions even in the face of new
information.

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 Impact on Decision-Making: Conservatism bias can lead to a more
cautious approach to risk-taking and decision-making. Forecasters may
be less likely to incorporate new, positive information into their
projections, leading to a potential understatement of future earnings.
Representativeness Bias:
Effect on Forecasting: Representativeness bias involves relying on
stereotypes or generalizations rather than considering specific
information. In forecasting, this can lead to the projection of past
patterns onto the future without considering changes in circumstances.
Impact on Decision-Making: Forecasters influenced by
representativeness bias may fail to recognize unique factors or changes
in the business environment, resulting in forecasts that do not accurately
reflect the evolving conditions.
Confirmation Bias:
Effect on Forecasting: Confirmation bias occurs when individuals
seek or give more weight to information that confirms their existing
beliefs. In forecasting, this can lead to a selective consideration of data
that supports preconceived notions, potentially resulting in biased
projections.
Impact on Decision-Making: Forecasters affected by confirmation
bias may be less open to alternative viewpoints or conflicting
information. This can lead to a lack of objectivity and an overreliance on
data that supports their initial expectations, potentially leading to
inaccurate forecasts.
In summary, being aware of and actively addressing behavioral biases is crucial
in ensuring that financial statement forecasts are as accurate and unbiased as
possible.

"Behavioral biases can cast shadows on financial forecasts,

distorting projections with the hues of overconfidence,
selective perception, and the illusions of control, shaping
a forecast more reflective of cognitive quirks than
objective analysis."

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What is competitive environment analysis?
Competitive environment analysis involves evaluating the industry and market
conditions in which a company operates to understand the competitive forces
that shape its strategic landscape. Michael Porter's Five Forces model is a widely
used framework for conducting such an analysis. The Five Forces model
identifies five factors that influence the level of competition within an industry:
Threat of New Entrants:
Examines the ease with which new companies can enter the industry.
High barriers to entry, such as high capital requirements or strong brand
loyalty, can reduce the threat.
Bargaining Power of Buyers:
Assesses the power of customers to influence pricing and terms. High
buyer power can give customers the ability to demand lower prices or
higher quality.
Bargaining Power of Suppliers:
Evaluates the influence of suppliers on the industry. If suppliers have
significant power, they can demand higher prices for inputs, affecting
the profitability of companies within the industry.
Threat of Substitute Products or Services:
Considers the availability of alternative products or services that could
meet similar needs. The existence of substitutes can limit the pricing
power of companies in the industry.
Intensity of Competitive Rivalry:
Analyzes the degree of competition among existing firms in the industry.
High rivalry can lead to price wars and reduced profitability.
Reasons to why using such a model is crucial for financial statement forecasting:
Informed Assumption Setting:
A thorough understanding of the competitive environment, as provided
by the Five Forces model, helps in setting more informed assumptions
for financial forecasting. For example, if there is a high threat of new
entrants, it may impact assumptions about market share and pricing.

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 Risk Management:
Identifying and understanding competitive forces enables businesses to
incorporate risk factors into their financial forecasts. This enhances the
accuracy of risk-adjusted projections.
Strategic Alignment:
Financial forecasts are closely tied to strategic decisions. Porter's Five
Forces model ensures that financial forecasts are aligned with the
strategic direction of the company, taking into account competitive
dynamics.
Scenario Planning:
The model facilitates scenario planning by considering different
competitive scenarios. Businesses can create forecasts that account for
variations in competitive intensity, customer behavior, and other
industry dynamics.

"Porter's Five Forces illuminate the strategic

battlefield of business, revealing the unseen dynamics
that shape competition and empowering companies to
fortify their positions and thrive in a dynamic
marketplace."

How price fluctuations affect financial statement forecasting?

(1) Inflation:
Impact on Forecasting:
Inflation erodes the purchasing power of money over time, affecting
both revenues and expenses. When forecasting financial statements, it's
crucial to consider the potential impact of inflation on various line items.
Examples by Industry:
Retail: In an inflationary environment, retailers may experience
increased costs for inventory, transportation, and labor. They might
need to adjust pricing strategies to maintain profit margins.

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 Real Estate: Inflation can lead to higher construction costs and
property values. Real estate developers may need to factor in increased
building expenses when forecasting future projects.
Financial Services: Inflation can impact interest rates and the value
of financial assets. Financial institutions must consider the effects on
loan interest income, investment returns, and the purchasing power of
customers.
(2) Deflation:
Impact on Forecasting:
Deflation, a decrease in the general price level of goods and services, can
have contrasting effects. While it may lead to cost savings, it can also
suppress demand and revenues, affecting various line items in financial
statements.
Examples by Industry:
Consumer Goods: In a deflationary environment, consumer goods
companies might experience reduced pricing power and lower revenues
as consumers delay purchases, expecting lower prices in the future.
Technology: Deflation can lead to falling prices for technology
products. Technology companies may need to adjust their revenue
forecasts to account for decreased product prices and potential impacts
on profit margins.
Automotive: Deflation may lead to decreased vehicle prices and lower
revenues for the automotive industry. Companies may need to reassess
production volumes and pricing strategies.
Considerations for Forecasting:
Revenue and Pricing:
Forecasters must anticipate how inflation or deflation will impact
consumer purchasing power and adjust revenue projections accordingly.
Pricing strategies may need to be flexible to adapt to changing economic
conditions.

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Costs and Expenses:
In an inflationary environment, costs such as raw materials, labor, and
utilities may rise. Forecasters need to estimate these increased costs
accurately. Conversely, in deflation, cost-saving measures may be
necessary, but potential decreases in revenue should also be considered.
Interest Rates:
Inflation often leads to higher interest rates. Industries heavily reliant on
borrowing, such as real estate or construction, need to factor in
increased interest expenses. Conversely, in a deflationary environment,
lower interest rates may impact interest income for financial
institutions.
Consumer Behavior:
Changes in inflation or deflation can influence consumer spending
patterns. Forecasters need to consider how shifts in consumer behavior
may affect sales volumes and product demand.
Investment and Depreciation:
Inflation can impact the value of assets, affecting depreciation
calculations. Forecasters should assess the potential need for increased
capital expenditures in inflationary periods. Conversely, deflation may
result in asset value reductions.
Currency Effects:
For businesses operating in multiple countries, fluctuations in currency
values can impact financial results. Inflation or deflation in one country
may affect exchange rates and, subsequently, revenue and expense
translations.

Forecasting financial statements requires a nuanced

understanding of the potential impacts of price changes.
Industries and companies must carefully consider these
economic factors to make accurate projections and
strategic decisions in a dynamic economic environment.

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What is explicit forecast period?
In financial statement modeling, the explicit forecast period refers to the
specified timeframe during which detailed and explicit projections are made for
the key financial statements, including the income statement, balance sheet, and
cash flow statement. Typically, financial analysts break down the forecasting
process into two periods: the explicit forecast period and the terminal value
period.
Here's how the explicit forecast period is decided by financial analysts:
Determining the Forecast Horizon:
Analysts first need to determine the appropriate forecast horizon. This
period could span several years, depending on the industry, the nature
of the business, and the visibility of future cash flows. Common forecast
horizons range from three to five years.
Consideration of Business Dynamics:
The choice of the explicit forecast period is influenced by the nature of
the business and industry. For industries with high uncertainty or rapid
changes, a shorter explicit forecast period may be chosen. Conversely,
for stable and predictable industries, a longer period might be
appropriate.
Data Availability and Quality:
The availability and quality of historical and current data play a crucial
role in determining the explicit forecast period. If there is limited
visibility or reliable data for a particular metric, analysts may opt for a
shorter forecast period.
Strategic Planning Cycle:
The strategic planning cycle of the company can influence the explicit
forecast period. Companies often conduct strategic planning exercises
on a regular basis, such as every three to five years. The explicit forecast
period aligns with this cycle to ensure consistency between financial
forecasts and strategic initiatives.
Investor and Stakeholder Expectations:
Analysts may consider the expectations of investors and stakeholders.

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 For publicly traded companies, the explicit forecast period often aligns
with guidance provided to investors, such as in annual reports or
investor presentations.
Industry Standards and Practices:
Certain industries may have standard practices regarding the length of
the explicit forecast period. Analysts may look to industry benchmarks
or standards to guide their decision on the forecast horizon.
Sensitivity to Assumptions:
The sensitivity of financial metrics to various assumptions can influence
the choice of the explicit forecast period. If a small change in
assumptions has a significant impact on the projections, analysts may
choose a shorter explicit forecast period to reduce uncertainty.
Integration with Terminal Value Calculation:
The explicit forecast period is closely tied to the calculation of the
terminal value, which represents the estimated value of a business
beyond the explicit forecast period. The choice of the explicit forecast
period affects the determination of when to apply the terminal value
calculation.

"The explicit forecast period in financial modeling is

the canvas where analysts paint a detailed picture of a
company's financial future, balancing precision with
the inherent uncertainties that lie beyond the
horizon."

What is terminal period?

In financial statement modeling, the terminal period represents the timeframe
beyond the explicit forecast period. It is a critical component in estimating the
total enterprise value of a business.
The terminal period is typically characterized by more simplified assumptions,
often assuming steady-state growth, and is usually valued using a terminal value
calculation.

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Here’s how the terminal period is generally decided:
Choice of Valuation Method:
Analysts use different methods to calculate the terminal value, such as
the perpetuity growth model (Gordon Growth Model) or the exit
multiple method. The choice of valuation method can influence how the
terminal period is determined.
Forecast Horizon:
The terminal period usually begins at the end of the explicit forecast
period. The length of the explicit forecast period is determined based on
factors like industry dynamics, business visibility, and strategic planning
cycles. The terminal period extends beyond this point.
Stable Growth Assumption:
The terminal period assumes a more stable and sustainable growth rate.
Analysts often use a perpetual growth rate to model the business's
expected long-term growth. This rate is typically lower than the growth
rates used in the explicit forecast period.
Consideration of Industry Norms:
Analysts may consider industry norms and practices when determining
the length of the terminal period. Some industries may have longer or
shorter terminal periods based on the characteristics of their business
cycles and growth patterns.
Economic and Business Environment:
The broader economic and business environment can influence the
decision about when to start the terminal period. Economic stability and
the long-term outlook for the industry may impact the choice of the
length of the terminal period.
Company-Specific Factors:
The specific circumstances and characteristics of the company under
analysis can also play a role. For instance, a company with a mature and
stable business may have a longer terminal period compared to a
company in a rapidly evolving and uncertain industry.

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Management Guidance:
Analysts may consider any guidance or indications from the company's
management regarding the long-term outlook and growth prospects.
Sensitivity Analysis:
Conducting sensitivity analysis on the terminal value by varying the
length of the terminal period can help analysts assess its impact on the
overall valuation. This analysis assists in understanding the range of
potential outcomes and the sensitivity of the valuation to changes in the
terminal period.
Investor Expectations:
The expectations of investors and stakeholders, especially in terms of
long-term performance, may influence the decision on the length of the
terminal period.
Review of Historical Performance:
Analyzing the historical performance of the company and assessing how
well it has maintained stability and growth over time can inform the
decision on the terminal period. Companies with a consistent track
record may have a longer terminal period.

Assessing Tesla’s Future Performance

By creating detailed models that factored in production volumes,

pricing strategies, and cost structures, they were able to make
more informed investment decisions. Tesla's stock performance and
financial results aligned closely with analysts' projections,
highlighting the utility of financial modeling for predicting outcomes
and guiding investment strategies.

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CFA L1 Notes

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Published: December 2023