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Learn why and how to adjust financial statements to ensure accurate forecasting. Discover the dynamics and specific steps for forecasting revenues, expenses, and the balance sheet.
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Adjusting the Financial Statements • Although in conformity with GAAP, • The income statement might include transitory items that should not be forecasted • The balance sheet might include nonoperating items, or exclude operating items like leased assets or assets accounted for under the equity method • The statement of cash flows might not represent true operating cash flows due to excessive inventory reductions or leaning on the trade, cash inflows form asset securitizations, and so forth. • Consequently, we often prefer to adjust reported financial statements prior to commencing the projection process.
Why Adjust the Balance Sheet? • Separate operating and nonoperating assets/liabilities • Include non-reported assets/liabilities
Goal: Forecast NOPAT, NOA, FCF Short “Parsimonious” Method Long “Detailed” Method
Revenues Forecast Impacts Both the Income Statement and the Balance Sheet
Dynamics of Income Statement Growth • Cost of goods sold are impacted via increased inventory purchases in anticipation of increased demand, added manufacturing personnel, and greater depreciation from new manufacturing PPE. • Operating expenses increase concurrently with, or in anticipation of, increased revenues; these expenses include increased costs for buyers, higher advertising costs, payments to sales personnel, costs of after-sale customer support, logistics costs, and administrative costs. • Accounts receivable increase directly with increases in revenues as more products and services are sold on credit. • Inventoriesnormally increase in anticipation of higher sales volume to ensure a sufficient stock of inventory available for sale. • Prepaid expenses increase with increases in advertising and other expenditures made in anticipation of higher sales. • PPEassets are usually acquired once the revenues increase is deemed sustainable and the capacity constraint is reached; thus, PPE assets increase with increased revenue, but with a lag. • Accounts payable increase as inventories are purchased on credit. • Accrued liabilities increase concurrent with increases in revenue-driven operating expenses.
Forecasting Steps • Forecast revenues. • Forecast operating and nonoperating expenses. We assume a relation between revenue and each specific expense account. • Forecast operating and nonoperating assets, liabilities and equity. Weassume a relation between revenue and each specific balance sheet account. We set cash equal to the amount necessary to balance the balance sheet. • (Optional) Adjust the balance sheet to the target cash balance. (No class discussion)
Forecasting Revenues • Impact of Acquisitions - revenues from acquisitions are only included from the date of the acquisition. Historical revenues used for comparison do not include the acquired company. • Impact of Divestitures - revenues and expenses of divested business are excluded form current and historical totals. • Existing vs. new store growth - new store growth can be more costly than organic growth. • Impact of unit sales and price disclosures - forecasts that are built from anticipated unit sales and current prices are generally more informative, and accurate, than those derived from historical dollar sales.
Sources of Information • Public disclosures via meetings and calls • Public reports: segment disclosures and MD&A
Impact of Foreign Exchange RatesSkip this part on the project Final P&G revenues forecast is $82,944 million = $83,503 x (1 – [4.33% - 5%]).
Forecasting Balance Sheet Items • Forecast amounts with no change - common for nonoperating assets (investments in securities, discontinued operations, and other nonoperating investments). • Forecast contractual or specified amounts - we assume that the required payments are made as projected. • Forecast amounts in relation to revenues - the underlying assumption is that, as revenues change, so does that item in some predictable manner.
Computational Options • Forecasts using percent of revenues - • Forecasts using turnover rates - • Forecasts using days outstanding -
Equivalence of Forecasting Methods • We use the percent of sales in our forecasts of balance sheet accounts because • It appears to be the most commonly used method, • it is the method that P&G management uses in its meetings with analysts, and • it is the method used by Oppenheimer in the real-world analysis illustration we provide in Appendix 11A.
Reassessing the Financial Statement forecasts • Many analysts and managers prepare “what-if” forecasted financial statements. • They change key assumptions, such as the forecasted sales growth or key cost ratios and then recompute the forecasted financial statements. • These alternative forecasting scenarios indicate the sensitivity of a set of predicted outcomes to different assumptions about future economic conditions. • Such sensitivity estimates can be useful for setting contingency plans and in identifying areas of vulnerability for company performance and condition.
Two-Year Ahead forecasts of the P&G Income StatementPerfect sample!
Two-Year Ahead Forecasts of the P&G Balance SheetPerfect sample!
Parsimonious Method of Multiyear Forecasting • Approach is to assume that relationships among operating accounts remain stable in the future • Inputs: • Sales growth • Net operating profit margin (NOPM = NOPAT / Sales) • Net operating asset turnover (NOAT = Sales / NOA) • Forecasts • Sales • NOPAT= NOPM x Sales • Net Operating Assets = Sales / NOAT • Free cash flow = NOPAT – ∆NOA
Another Example of Dell ForecastAlso a Perfect sample! 2005F 2006F 2007F 2008F If you have reason to believe NOPM or NOAT will change in future periods, adjust those assumptions.
