Forecasting Financial Statements

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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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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
Michael Dimond
School of Business Administration
Overview of the Forecasting Process
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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.
Michael Dimond
School of Business Administration
Revenues Forecast Impacts Both the Income Statement and
the Balance Sheet
Michael Dimond
School of Business Administration
Dynamics of Growth (I/S and B/S)
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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.
Michael Dimond
School of Business Administration
Dynamics of Balance Sheet Growth
Michael Dimond
School of Business Administration
Forecasting Steps
1. Forecast revenues.
2. Forecast operating and nonoperating expenses. We
assume a relation between revenue and each specific
expense account.
3. Forecast operating and nonoperating assets,
liabilities and equity. We assume a relation between
revenue and each specific balance sheet account.
4. 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.
Michael Dimond
School of Business Administration
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.
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
P&G Data from MD&A
Michael Dimond
School of Business Administration
Determining the Revenue Growth Forecast
Michael Dimond
School of Business Administration
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.
Michael Dimond
School of Business Administration
Forecasting Expenses
Michael Dimond
School of Business Administration
Morgan Stanley Forecasts
Michael Dimond
School of Business Administration
Forecasted Income Statement for P&G
Michael Dimond
School of Business Administration
Forecasting the Balance Sheet
Michael Dimond
School of Business Administration
Forecasting Balance Sheet Items
1. Forecast amounts with no change - common for
nonoperating assets (investments in securities,
discontinued operations, and other nonoperating
investments).
2. Forecast contractual or specified amounts - we assume
that the required payments are made as projected.
3. Forecast amounts in relation to revenues - the
underlying assumption is that, as revenues change, so
does that item in some predictable manner.
Michael Dimond
School of Business Administration
Computational Options
• Forecasts using percent of revenues :
• Forecasts using turnover rates :
• Forecasts using days outstanding :
Michael Dimond
School of Business Administration
Equivalence of Forecasting Methods
We use the percent of sales in our forecasts of balance sheet
accounts because
1. it appears to be the most commonly used method,
2. it is the method that P&G management uses in its meetings
with analysts, and
3. it is the method used by Morgan Stanley in the real-world
analysis illustration we provide in the Module and in
Appendix 11A.
Michael Dimond
School of Business Administration
Morgan Stanley Assumptions
Michael Dimond
School of Business Administration
Forecasted
Balance
Sheet for
P&G
Michael Dimond
School of Business Administration
Adjusted Forecasted Income Statement
for P&G
Michael Dimond
School of Business Administration
Forecasted SCF for P&G
Michael Dimond
School of Business Administration
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.
Michael Dimond
School of Business Administration
Two-Year Ahead forecasts of the P&G Income
Statement
Michael Dimond
School of Business Administration
Two-Year
Ahead
Forecasts
of the P&G
Balance
Sheet
Michael Dimond
School of Business Administration
Two-Year Ahead Forecasts of the SCF
Michael Dimond
School of Business Administration
Parsimonious Method of Multiyear Forecasting
Inputs:
• Sales growth
• Net operating profit margin (NOPM = NOPAT / Sales)
• Net operating asset turnover (NOAT = Sales / NOA)
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
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