Financial

Statement
Analysis &
Valuation Sixth Edition

Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 11
Financial Statement Forecasting

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Learning Objective 1
Explain the process of
forecasting financial statements.

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Forecasting Process

 Forecasting financial performance is integral to a variety of

business decisions.
 Managers, investors and others forecast future financial
statements to:
 Value stocks and inform investment decisions
 Evaluate the creditworthiness of a prospective borrower
 Determining bond ratings
 Evaluate alternative strategic investment decisions
 Assess the shareholder value created by strategic investments

 All of these decisions require accurate financial forecasts.

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Adjusted Financial Statements

 The forecasting process begins with a retrospective analysis.

 We adjust financial statements to ensure they accurately reflect the
company’s financial condition and performance.
 Because we seek to forecast future income and cash flow, we first
identify and eliminate transitory items including:
 Restructuring expenses

 Litigation expenses

 Discontinued operations
 Gains and losses on asset dispositions and impairments

 Unusual income tax expense or benefit

 Acquisitions and divestitures

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Forecasting Order and Mechanics
 We forecast future income statements, balance sheets, and statements of
cash flows, in that order.
 The revenues forecast is the most crucial in the forecasting process
because other income-statement and balance sheet accounts derive from
the revenues forecast.

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Forecasting
Consistency and Precision
It is important to keep two points in mind:
 Internal consistency
 The forecasted financial statements are linked in the same way historical financial
statements are—they must articulate within and across time.
 We also must ensure that our forecast assumptions are internally consistent.

 Level of precision
 Computing forecasts to the “nth decimal place” is easy and might appear to make the
resulting forecasts appear more precise, but they are not necessarily more accurate.
 Decisions that depend on a high level of forecasting precision are ill-advised.

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Company Guidance
 Companies frequently provide guidance for forecasting purposes.
 For example―P&G provided the following sales growth guidance that
we can use to inform our revenue forecast assumptions:

 We use 3.5% growth, the midpoint of the range, in our forecasting

process.

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Company Guidance
 P&G also provides guidance regarding anticipated capital spending
(CAPEX), dividends, and share repurchases:

 We use this guidance to produce the following forecasts:

 CAPEX as 4.75% of sales
 Dividends of $7.5 billion
 Share repurchases (treasury stock purchases) of $7 billion

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Learning Objective 2
Forecast revenues
and the income statement.

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Forecasting the Income Statement
Overview
 We forecast the Income Statement first.
 Sales estimate―for P&G we use 3.5% (from company guidance)
 Expense estimate
 COGS―as a % of sales
 SG&A―as a % of sales
 Nonoperating expenses―assume no change and adjust later

 One-time items―assume the items will not recur

 Income tax―as a % of pre-tax income (from company guidance)
 Noncontrolling interest―no change in historic ratio

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P&G’s Forecasted
2020 Income Statement

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Forecasting Cost of Goods Sold
 Start with historic ratio of COGS / Sales.
 Companies often discuss COGS in the MD&A to provide insight into
recent trends, anticipated effects of planned restructuring, or product
mix changes.
 For example P&G reports:

 For P&G, we use the FY2019 rate of 51.4% to forecast FY2020.

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Forecasting SG&A
 To forecast SG&A expense, we start with historic ratio of SG&A /
Sales and then check the MD&A:

 We use the FY2019 percent of 28.2% because the MD&A includes no

significant operational changes to SG&A.
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Forecasting Interest Expense
Interest expense
= Average debt balance × Estimated interest rate

 For 2019 P&G reported $509M interest expense and average debt of
$30,689M.
 We calculate an estimated rate = $509M / $30,689M = 1.7%
 We apply the average FY2019 rate to the expected FY2020 debt.
 FY2019 debt – Expected FY2020 repayments = $20,704M

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Forecasting Income Tax Expense
 We estimate tax expense using an estimated tax rate.
 For FY2020, we use an effective rate of 17.5% from PG’s guidance.
 In the absence of company guidance, we use tax footnotes:

 Given that the Goodwill impairment is a one-time occurrence, and

Stock option taxes and “Other” are so volatile, we might forecast a tax
rate of 20.2% (21% - 0.5% - 0.3%).

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Impact of Acquisitions
 When one company acquires another, the revenues and expenses of the
acquired company are consolidated, but only from the date of
acquisition onward.
 Acquisitions can greatly impact the acquirer’s income statement and
distort the growth rates that we compute.
 P&G acquired Gillette in October 2005.

Growth = 20.2%
 20.2% is incorrect because 2006 Net sales include Gillette sales for 8
months and 2005 Net sales include NO Gillette sales.

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Impact of Acquisitions

 Until all three income statements include the acquired company, the
acquirer must disclose what revenue and net income would have been.
 For example, P&G disclosed the following re: Gillette

Sales Growth = 4.5%

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Impact of Divestitures

 When companies divest of discontinued operations, they are

required to:
 Exclude sales and expenses of discontinued operations from continuing
operations.
 Separately report net income from the discontinued operations on one line.
 Report any gain/loss on the disposal.
 Report discontinued assets and liabilities on separate line items, labeled
“held for sale”.
 We assume these discontinued operations will be sold in the
coming year and we forecast zero balances for them.

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Learning Objective 3
Forecast the balance sheet.

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Forecasting the Balance Sheet
Overview
Here is an overview of balance sheet forecasting:
 Working capital accounts―as a % of sales
 PPE―increase estimated CAPEX and reduce by forecasted depreciation
expense
 Intangible assets―subtract forecasted amortization expense
 Current and long-term debt―assume company makes all contractual
payments of long-term debt, assume total debt remains unchanged
 Stockholders’ equity―assume no change for paid-in capital accounts except
for stock-based compensation and planned treasury stock transactions
 Retained earnings―increase by forecasted net income and reduced by
estimated dividends

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Forecasting Working Capital

 We use each working capital item’s historical relation to sales to

forecast the item for next year.

 We use this approach for P&G for seven working capital

accounts.
 We assume that nonoperating will remain unchanged.
 Where provided, we use company guidance such as with debt due
within one year.

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Forecasting PPE

 For P&G, we use the guidance about anticipated purchases of PPE

assets (called capital expenditures or CAPEX).

 P&G expects fiscal 2020 CAPEX to be 4.5% to 5% of sales.

 We use the midpoint of 4.75% of sales and forecast CAPEX of $3,328
million ($70,053 million of forecasted sales × 4.75%).

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Forecasting PPE
 Absent CAPEX guidance, we can use the following approach:

Also consider additional CAPEX We use PRIOR year PPE to measure

expansion plans in MD&A historical depreciation rate

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Forecasting Intangible Assets
 Analysts typically forecast intangible assets to decrease during the year
by the amount of amortization.
 It is common to assume no change in amortization expense from the
prior year.
 If the company provides guidance about amortization expense, like
P&G does, we can consider using it.

 For P&G, we forecast 2020 intangible assets to be $359 lower than in

2019.

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Forecasting Long-Term Debt
 Companies report maturities of long-term debt for the next five years in
debt footnote, which we use to forecast long-term debt.

 P&G’s footnote provides the following details

 To forecast debt we make the following three adjustments:

1. Subtract $3,388M from debt due within one year
2. To reclassify long term debt, we add $2,009 M to debt due within 1 year
3. Subtract $2,009M from long-term debt to reflect the reclassification

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Forecasting Dividends
and Retained Earnings
 We forecast retained earnings as follows:

 This approach uses historic dividend payout ratio.

 This might not be accurate if there were large one-time items in the
prior year—in that case:
 Adjust for one-time items and recalculate payout
 Use company guidance $7,500
 Use historic dividend per share data and current shares outstanding.

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Forecasting Equity and Treasury Stock

 Assume no change for common stock (par) and additional paid-in

capital unless MD&A suggests otherwise.
 If a company uses stock-based compensation we add the fair-value
of anticipated awards to additional paid-in capital.
 For treasury stock, we proceed as follows:
 Many companies disclose multiyear stock repurchase programs in footnotes or in the
MD&A.
 If a company provides guidance, we can use that to forecast repurchases.
 Absent explicit disclosures or guidance, we can forecast future repurchases using
historic data, either from the most recent year or by looking for a trend over the past
two or three years.

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Forecasting Cash
 We forecast cash last as the amount that balances the balance sheet after
we have forecast all other items.
 We assess the forecasted cash balance and determine if it deviates
from the historical cash-to-sales percentage.
 If cash forecast is higher than normal:
 Increase marketable securities
We should attempt to
 Reduce debt
maintain the historic debt-
 Forecast additional stock repurchases
to-equity ratio when we
 Increase dividend payments
forecast additional
 If cash forecast is lower than normal: borrowing, debt
 Sell marketable securities repayment, stock
 Increase debt
sales, or stock
repurchases.
 Decrease dividend payments

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P&G’s Forecasted 2020 Balance Sheet

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Learning Objective 4
Prepare forecasts using
segment data.

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Forecasts from the Bottom Up

 The sales forecast that we illustrate above relies on company

guidance to form assumptions and estimates.
 An alternative approach that financial analysts typically use relies
on information from conference calls with company management
and other proprietary data sources.
 Analysts often prepare separate sales forecasts for the company’s
business segments and then sum up the segment sales to arrive at
the overall sales estimate.

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Segment Data and Sales Forecasts
 Companies report financial data for each
operating segment.
 P&G’s segment disclosure includes
current and historical data for each of its
five operating segments.
 These disclosures provide a wealth of
information that we can use to separately
forecast sales for each operating
segment.
 Sales of forecasts are more accurate
when they incorporate all available data.

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Morgan Stanley Sales Forecasts
 Morgan Stanley analysts forecast organic sales growth for each of
P&G’s segments by considering
 Effects of changes in unit volume
 Effects of expected price increases
 Effects of expected changes in product mix

 Morgan Stanley forecasts a 4.7%

growth for Beauty segment:

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Learning Objective 5
Forecast
the statement of cash flows.

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Forecasting the SCF
The Process

 The process begins with net income, adds back or deducts any
noncash expenses or revenues.
 Then we determine the cash flow effect of changes in working
capital accounts as well as in the remaining asset, liability, and
equity items.
 A common method is to compute changes in each line item on the
forecasted balance sheet and classify changes as:
 Operating
 Investing
 Financing

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P&G’s Forecasted
2020 Statement of Cash Flows

Significant
use of cash

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Learning Objective 6
Prepare multiyear forecasts
of financial statements.

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Multiyear Forecasting
 Multiyear forecasting proceeds in the same way as for one-year
forecasting.
 Analysts typically need multiyear forecasts to:
 Value a firm’s equity or determine enterprise value

 Assess a company’s ability to repay its debt

 Assign credit ratings to firms

 Managers typically use multiyear forecasts for:

 Cash flow budgets

 Capital expenditure plans

 Divestiture decisions

 Mergers and acquisitions

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Normal Cash Balance

 We balance the balance sheet with a “plug” to the cash account and then
adjust cash to a normal balance.
 For example, for P&G in FY2020:
 FY2019 cash of $4,239 million is 6.3% of reported sales of $67,684M.
 Maintaining the same proportion, the target level of cash will be $4,413M (forecasted
FY2020 sales of $70,053M × 6.3%).
 Forecasted cash balance is $(1,550)million.

 Consequently, we assume additional borrowing of $6,000 million (rounded up) to

achieve a 6.3% cash-to-sales percentage.

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P&G’s Forecasted
2021 Income Statement

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P&G’s Forecasted
2021 Balance Sheet

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Forecasting Sensitivity
 Analysts commonly perform a sensitivity analysis of their
forecasts.
 Typically, analysts prepare additional forecasts (characterized as
Bull and Bear scenarios) and present these together with their
“most likely” scenario forecasts.
 The forecasted cash flow (and resulting stock price estimates) are
recomputed under these additional assumptions.
 This sensitivity analysis allows analysts to develop a possible
range of stock prices that are included in their analyst’s report.

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Financial
Statement
Analysis &
Valuation Sixth Edition

Cambridge Business Publishers

www.cambridgepub.com