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Accounting & Financial Reporting. BUSG 503 Michael Dimond. Minicase #1. Smithfield Foods Minicase 1 is to understand the financials Minicase #2 will be to forecast the financials & estimate the value of the business Final Cases
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Accounting & Financial Reporting BUSG 503Michael Dimond
Minicase #1 • Smithfield Foods • Minicase 1 is to understand the financials • Minicase #2 will be to forecast the financials & estimate the value of the business • Final Cases • Final cases will be the same process, but for a company you choose • Work in teams of 3 or 4 • You will make a brief presentation of your work-in-progress in two weeks • Final writeup will be due the following week
Overview of the Forecasting Process • Reformulated financial statements - we adjust the financial statements to reflect the company’s net operating assets and the operating income that we expect to persist into the future. • Garbage-In, Garbage-Out - the quality of our decision is only as good as the quality of the information on which it is based. • Optimism vs Conservatism - our objective is not to be overly optimistic or overly conservative. The objective for forecasting is accuracy. • Level of Precision - borderline decisions that depend on a high level of forecasting precision are probably ill-advised. • Smell Test - our forecasts must appear reasonable and consistent with basic business economics. • Internal Consistency - forecasted financial statements must articulate and our forecast assumptions must be internally consistent. • Crucial Forecasting Assumptions - assumptions that are identified as crucial to a decision must be investigated thoroughly to ensure that forecast assumptions are as accurate as possible.
Revenues Forecast Impacts Both the Income Statement and the Balance Sheet
Dynamics of Growth (I/S and B/S) • 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. • Cash increases and decreases directly with increases in revenues as receivables are collected and as payables and accruals are paid. • Accounts receivable increase directly with increases in revenues as more products and services are sold on credit. • Inventories normally 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. • PPE assets 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. • Other operating assets and liabilities such as deferred revenues, deferred taxes, and pensions, increase and decrease concurrent with revenues.
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. We assume a relation between revenue and each specific balance sheet account. • Adjust short-term investments or short-term debt to balance the balance sheet. We use marketable securities and short-term debt to balance the balance sheet. We then recompute net nonoperating expense (interest/dividend income or interest expense) to reflect any adjustments we make to nonoperating asset and liability account balances.
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 • Recordings and supporting documents are frequently available on the “Investor Relations” section of the company’s web site • Public reports: segment disclosures and MD&A • Companies are required to disclose summary financial results for each of their operating segments along with a discussion and analysis of each
Morgan Stanley Forecast • Each product forecast is built from the bottom up; that is, analysts use information about a product’s market share and the forecasted growth rate for the market of each product within each country the product is sold. • Morgan Stanley analysts also have internally-developed databases of commodity-price indices, inflation indices, and other macroeconomic indices against which to evaluate the reasonableness of company-provided forecasts. • Sales forecasts are determined by quantity and price along with growth forecasts of the product markets, the company-provided future pricing strategy, and forecasts of price elasticity of demand.
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 Morgan Stanley in the real-world analysis illustration we provide in the Module and 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.
Parsimonious Method of Multiyear Forecasting • Inputs: • Sales growth • Net operating profit margin (NOPM = NOPAT / Sales) • Net operating asset turnover (NOAT = Sales / NOA)
