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Financial

Statement
Analysis
K R Subramanyam
John J Wild

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

9-2

Prospective Analysis

CHAPTER

9-3

Prospective Analysis
Importance
Security
SecurityValuation
Valuation -- free
freecash
cashflow
flow and
andresidual
residual
income
incomemodels
models require
requireestimates
estimatesof
of future
futurefinancial
financial
statements.
statements.
Management
ManagementAssessment
Assessment -- forecasts
forecastsof
offinancial
financial
performance
performanceexamine
examinethe
theviability
viabilityof
ofcompanies
companies
strategic
strategicplans.
plans.
Assessment
Assessmentof
ofSolvency
Solvency--useful
usefulto
tocreditors
creditorsto
to
assess
assessaacompanys
companysability
ability to
tomeet
meet debt
debt service
service
requirements,
requirements,both
bothshort-term
short-term and
andlong-term.
long-term.

9-4

The Projection Process


Projected Income Statement
Sales
Sales forecasts
forecasts are
are aa function
function of:
of:
1)
1)Historical
Historicaltrends
trends

2)
2)Expected
Expectedlevel
levelof
ofmacroeconomic
macroeconomicactivity
activity
3)
3)The
Thecompetitive
competitivelandscape
landscape
4)
4)New
New versus
versusold
old store
storemix
mix(strategic
(strategic
initiatives)
initiatives)

9-5

The Projection Process


Target Corporation Income Statements

9-6

The Projection Process


Projected Income Statement
Steps:
1.
2.
3.
4.
5.
6.

Project sales
Project cost of goods sold and gross profit margins using
historical averages as a percent of sales
Project SG&A expenses using historical averages as a
percent of sales
Project depreciation expense as an historical average
percentage of beginning-of-year depreciable assets
Project interest expense as a percent of beginning-ofyear interest-bearing debt using existing rates if fixed
and projected rates if variable
Project tax expense as an average of historical tax
expense to pre-tax income

9-7

The Projection Process


Target Corporation Projected Income Statement

9-8

The Projection Process


Target Corporation Projected Income Statement

9-9

The Projection Process


Projected Balance Sheet
Steps:
1.
2.
3.
4.
5.

Project current assets other than cash, using projected sales or


cost of goods sold and appropriate turnover ratios as described
below.
Project PP&E increases with capital expenditures estimate
derived from historical trends or information obtained in the
MD&A section of the annual report.
Project current liabilities other than debt, using projected sales
or cost of goods sold and appropriate turnover ratios as
described below
Obtain current maturities of long-term debt from the long-term
debt footnote.
Assume other short-term indebtedness is unchanged from prior
year balance unless they have exhibited noticeable trends.
(continued)

9-10

The Projection Process


Projected Balance Sheet
Steps:
6.

Assume initial long-term debt balance is equal to the prior


period long-term debt less current maturities from Step 4.
7. Assume other long-term obligations are equal to the prior
years balance unless they have exhibited noticeable trends.
8. Assume initial estimate of common stock is equal to the prior
years balance
9. Assume retained earnings are equal to the prior years
balance plus (minus) net profit (loss) and less expected
dividends.
10. Assume other equity accounts are equal to the prior years
balance unless they have exhibited noticeable trends.

9-11

The Projection Process


Target Corporation Balance Sheet

9-12

The Projection Process


Steps in Projection (Target)

9-13

The Projection Process


Target Corporation Balance Sheet

9-14

The Projection Process


Projected Balance Sheet

If the estimated cash balance is much


higher or lower, further adjustments can be
made to:
1. invest excess cash in marketable securities
2. reduce long-term debt and/or equity
proportionately so as to keep the degree of
financial leverage consistent with prior years.

9-15

The Projection Process


Target Corporation Projected Statement of Cash Flows

9-16

The Projection Process


Sensitivity Analysis
Vary
Vary projection
projection assumptions
assumptions to
to find
find those
those with
with
the
the greatest
greatest effect
effect on
on projected
projected profits
profits and
and
cash
cash flows
flows
Examine
Examine the
the influential
influential variables
variables closely
closely
Prepare
Prepare expected,
expected, optimistic,
optimistic, and
and pessimistic
pessimistic
scenarios
scenarios to
to develop
develop aa range
range of
of possible
possible
outcomes
outcomes

9-17

Application of Prospective Analysis in the


Residual Income Valuation Model

The
Theresidual
residualincome
incomevaluation
valuationmodel
modeldefines
definesequity
equityvalue
value
at
attime
timettas
asthe
thesum
sumof
ofcurrent
currentbook
bookvalue
valueand
andthe
thepresent
present
value
valueof
ofall
allfuture
futureexpected
expectedresidual
residualincome:
income:

where
whereBV
BVt tisisbook
bookvalue
valueat
atthe
theend
endofofperiod
periodt,t,RI
RIt +t +nnisisresidual
residualincome
incomeinin
period
periodt t++n,n,and
andkkisiscost
costofofcapital
capital(see
(seeChapter
Chapter1).
1).Residual
Residualincome
incomeatat
time
timet tisisdefined
definedas
ascomprehensive
comprehensivenet
netincome
incomeminus
minusaacharge
chargeon
on
beginning
beginningbook
bookvalue,
value,that
thatis,
is,RI
RIt ==NI
NIt --(k(kxxBV
BVt - 1).).
t

t-1

9-18

Application of Prospective Analysis in


the Residual Income Valuation Model
In
In its
its simplest
simplest form,
form, we
we can
can perform
perform aa
valuation
valuation by
by projecting
projecting the
the following
following
parameters:
parameters:

-Sales
-Salesgrowth.
growth.
-Net
-Netprofit
profit margin
margin(Net
(Netincome/Sales).
income/Sales).
-Net
-Networking
workingcapital
capitalturnover
turnover (Sales/Net
(Sales/NetWC).
WC).
-Fixed-asset
-Fixed-asset turnover
turnover (Sales/Fixed
(Sales/Fixedassets).
assets).
-Financial
-Financialleverage
leverage(Operating
(Operatingassets/Equity).
assets/Equity).
-Cost
-Cost of
ofequity
equitycapital
capital

9-19

9-20

Trends in Value Drivers


The
TheResidual
ResidualIncome
Incomevaluation
valuationmodel
modeldefines
definesresidual
residualincome
incomeas:
as:
RI
RIt t ==NI
NIt t(k
(kXXBV
BVt-1t-1))
==(ROE
(ROEt tk)
k)XXBV
BVt-1t-1
Where
WhereROE
ROE ==NI/BV
NI/BVt-1t-1
--Stock
Stockprice
priceisisonly
onlyimpacted
impactedso
solong
longas
asROE
ROE
kk
--Shareholder
Shareholdervalue
valueisiscreated
createdso
solong
longas
asROE
ROE >>kk
--ROE
ROEisisaavalue
valuedriver
driveras
asare
areits
itscomponents
components
--Net
NetProfit
ProfitMargin
Margin
--Asset
AssetTurnover
Turnover
--Financial
Financialleverage
leverage
Two
Tworelevant
relevantobservations:
observations:
--ROEs
ROEstend
tendto
torevert
revertto
toaalong-run
long-runequilibrium.
equilibrium.
--The
Thereversion
reversionisisincomplete.
incomplete.

9-21

Trends in Value Drivers


Reversion of ROE

9-22

Trends in Value Drivers


Reversion of Net Profit Margin

9-23

Trends in Value Drivers


Reversion of Total Asset Turnover