FINANCIAL STATEMENT

ANALYSIS (ACCT3064)

TOPIC 7 – FORECASTING
FINANCIAL STATEMENTS
 OBJECTIVES
1. Develop skills to build forecasts of future income
statements & balance sheets
2. Identify and incorporate important business and
strategic factors into expectations of future business
activities, which can be measured with forecasts of
future accounting numbers and financial statements
3. Apply various steps and ratios in the building of
financial statement forecasts.
4. Calculate the compound growth rate
5. Forecast future income statements and balance
sheet for at least 3 years using historical data.
2
 FORECASTING FINANCIAL
STATEMENTS
 Forecasting
 Necessary step in process of valuation.
 Seven-step Framework.
 Process “builds” pro forma financial statements
 Using Business and Strategic Factors in Forecasting.
 Shortcut Forecasting Techniques.
 When and how to use.
 Forecast Models.

3
FORECASTING FINANCIAL
STATEMENTS

4
 GENERAL FORECASTING
PRINCIPLES
 Produce reliable and realistic expectations.
 Unbiased - neither conservative nor optimistic.
 Forecasts should not manifest wishful thinking.
 Forecasts should be comprehensive.
 Include ALL expected future activities.
 Assumptions must be internally consistent.
 Forecasts must rely on externally valid assumptions.
 Assumptions should pass the test of common
sense.
 Impose reality checks.
5
SEVEN-STEP FORECASTING GAME
PLAN
1. Project revenues from sales and operating activities.
2. Project operating expenses and derive projected
income.
3. Project operating assets and liabilities.
4. Project the financial leverage and capital structure.
5. Project non recurring gains or losses (if any).
6. Check whether the projected balance sheet is in
balance.
7. Derive the projected statement of cash flows.
6
Chapter: 10 7
SEVEN-STEP FORECASTING GAME
PLAN
 Steps are integrated and interdependent, not
necessarily sequential or linear.
 Forecasts must ARTICULATE between the 3
financial statements.
 Preparing financial forecasts is an iterative and
circular process and requires at least one flexible
financial account.
 Quality will depend on assumptions!
 Financial statements will be no better than these.
 Sweat the big stuff. Do not sweat the little stuff.
 Analyst should perform sensitivity analysis on
forecasts. 8
 PREPARING FORECASTED
FINANCIAL STATEMENTS
 Contains a forecast spreadsheet to prepare financial
statement forecasts.
 Excel spreadsheets can provide a basis.
 Proper design of a spreadsheet and preparation of
forecasts can provide an excellent learning experience.
 Helps solidify understanding of the relationships
between the various financial statements.
 Provides a scratch pad to compute various detailed
forecast assumptions
9
STEP 1: PROJECTING SALES AND
OTHER REVENUES
 Start with principal business activities.
 Sales – determined by price & volume.
 Consider firm and its industry conditions.
 Life cycle.
 Technological conditions.
 Business cycle.
 Economic-wide conditions.
 Exchange rates.
 Segments.
 Other revenues

10
Step 2: Projecting Operating Expenses
 Fixed vs. Variable components
 Does cost change proportionately to sales?
 Careful of the “relevant range”.
 Industry knowledge important here.
 Forecast capital expenditures.
 Projecting Cost of Goods Sold.
 Analyze by segment.
 Projecting Selling, General, and Administrative
expenses.
 Projecting Other Operating Expenses.
 Projecting Nonrecurring Operating Gains and Losses.

11
STEP 3: PROJECTING OPERATING
ASSETS & LIABILITIES
 Forecasting future operating assets and liabilities from
operating activities projected.
 To forecast individual operating assets and liabilities,
determine the underlying operating activities that drive
them.
 Turnover Based techniques:
 Used to forecast any operating asset and liability
accounts that vary reliably with sales.
 Should not be used if the firm experiences a substantially
different future growth rate or if the relation between
sales and forecast account varies unpredictably.
12
 STEP 4: PROJECT FINANCIAL ASSETS,
FINANCIAL LEVERAGE, COMMON EQUITY
CAPITAL AND FINANCIAL INCOME ITEMS.
 Project Financial assets, Financial debt and
Shareholders' equity capital necessary.
 Project effects of financing on net income, considering
future interest income interest expense and other
elements of financial income.
 To maintain a particular capital structure, Common
sized balance sheet and projected amounts of total assets
can be used to project.
 Consider the financial leverage strategy of the firm.
13
 STEP 5: PROJECTING NONRECURRING
ITEMS, PROVISIONS FOR INCOME TAX,
AND CHANGES IN RETAINED EARNINGS.

 Project Nonrecurring Items.

 Project provisions for Income taxes.
 Calculate Net Income.
 Calculate changes in Retained Earnings.

14
 STEP 6: BALANCING THE
BALANCE SHEET
 Projected assets less Projected liabilities and
shareholders’ equity = Amount of adjustment
(flexible financial account.)
 If Projected assets > Projected liabilities and
shareholders’ equity:
 Raise additional capital.
 Raise additional debt.
 Sell financial assets.

15
 STEP 6: BALANCING THE
BALANCE SHEET
 If Projected assets < Projected liabilities and
shareholders’ equity:
 Pay down debt.
 Issue larger dividends.
 Repurchase more shares.
 Invest in financial assets.
 Evaluate the firms financial flexibility and adjust
the balance sheet.

16
 STEP 7: PROJECTING THE
STATEMENT OF CASH FLOWS
 Characterize all changes in the Balance Sheet in terms
of impact on Cash.
 Derive the statement of Cash flows from Projected
Income Statement and Balance Sheets.
 Tips for Forecasting Statement of Cash Flows:
 Ensure that the Balance Sheet is in balance.
 Do not use historical cash flows as they do not provide
good basis for projecting future cash flows.
 Use Implied Statement of Cash Flows computed from
projected Income Statements and Balance Sheets.

17
 APPROACH TO FORECASTING
 Efficient only if firm is stable and mature in an
industry in steady-state equilibrium.
 Historical data is important
 Projected Sales and Income Approach
 Use recent sales growth rate.
 Use recent profit margin.
 Projected Total Assets Approach
 Use historical asset growth rate in total assets.
 Also consider the link between sales growth and
asset growth.
 Alternative approach: use the total assets turnover
ratio, linking sales growth and asset growth.
18
 APPROACH TO FORECASTING
Historical data is important
Before any forecasting can begin, we start by inputting
historical results. The process involves either manual
data entry from the financials from the Jamaica Stock
Exchange, Company Websites or press release, or using
and Excel plugin through financial data providers (if
available) to drop historical data directly into Excel.
Some companies report segment – or product-level
revenue and operating detail in the notes (which roll up
into the consolidated income statement).

19
 APPROACH TO FORECASTING
Historical data is important
Not all companies classify their operating results the
same way. Some companies will aggregate all operating
expenses into one line, while others will break them into
several line items.
If a model is to be used to compare performance across
other firms, the classifications need to be apples-to-
apples and often require to make judgments on how to
classify line items and whether to hunt for more detailed
breakdowns in the financial footnotes

20
 FORECASTING THE INCOME
STATEMENT
REVENUE/SALES:
The revenue/sales forecast is arguably the single
most important forecast. Mechanically, there are two
common approaches for forecasting revenue/sale:
Grow revenues by inputting an aggregate growth
rate. This is more straightforward, if the company’s
compound annual growth rate was 10%. If the
analyst expected that growth rate to persist
throughout the forecast period, revenue would simply
be grown at that rate.
Segment level detail and price by volume approach.
21
 FORECASTING EXAMPLE
VISION LIMITED
CONSOLOIDATED STATEMENT OF COMPREHENSIVE IN COME
AS AT 31 MAY
2015 2016 2017 2018 2019
Revenue 451,601,345 584,489,311 752,399,634 926,149,391 1,146,606,736
Cost of Goods Sold 346,625,143 410,419,601 524,546,595 655,570,178 842,023,606
Gross Profit 104,976,202 174,069,710 227,853,039 270,579,213 304,583,130
Other income 944,597 3,934,644 8,531,808 1,500,000 1,687,763
Depreciation 25,220,858 37,381,782 56,023,044 72,415,730 94,226,117
Operating profit 80,699,941 140,622,572 180,361,803 199,663,483 212,044,776
Finance income 1,786,262 1,852,735 1,747,067 2,257,656 8,287,292
Interest Cost 8,017,577 14,197,161 17,742,465 21,959,670 27,151,038
Profit before taxation 74,468,626 128,278,146 164,366,405 179,961,469 193,181,030
Taxation (Credit)/ Charge 5,128,830 6,438,077 (5,973,876) 2,374,336 4,709,345
Profit after tax 69,339,796 121,840,069 170,340,281 177,587,133 188,471,685
EPS $0.69 $1.22 $1.70 $0.36 22
$0.38
 FORECASTING EXAMPLE
VISION LIMITED
CON SOLOIDATED STATEMENT OF FIN ANCIAL POSITION
AS AT 31 MAY
ASSETS
N on-current Assets 2015 2016 2017 2018 2019
Goodwill 4,500,000 4,500,000 4,500,000 4,500,000 11,075,500
Property, plant and equipment 174,222,176 293,930,590 345,147,482 435,814,561 732,703,377
Related party - lease payment 4,750,000 4,625,000 4,500,000 4,375,000 4,250,000
Term deposit - restricted 2,439,183 2,511,064 2,559,433 2,608,735 2,656,010
185,911,359 305,566,654 356,706,915 447,298,296 750,684,887
Current Assets
Inventories 15,755,144 22,264,022 17,618,201 19,876,454 22,657,244
Accounts receivables 20,850,173 26,986,352 56,562,277 54,131,561 35,248,926
Short term investments 12,058,657 43,287,156 91,865,296 92,763,565 122,462,198
Cash and Bank Balances 45,408,631 44,666,367 64,664,605 137,951,557 132,115,739
94,072,605 137,203,897 230,710,379 304,723,137 312,484,107
Total Assets 23
279,983,964 442,770,551 587,417,294 752,021,433 1,063,168,994
 FORECASTING EXAMPLE
Equity
Share capital 51,805,097 51,805,097 51,805,097 51,805,097 51,805,097
Accumulated surplus 177,647,847 284,487,917 430,828,198 574,415,331 727,841,219
229,452,944 336,293,014 482,633,295 626,220,428 779,646,316
Non-current Liabilities
Notes payable 7,415,168 39,045,734 39,629,108 47,629,483 38,179,682
Bond payable 150,000,000
Shareholders' loans 452,840 452,840 452,840 452,840 452,840
Defferred tax liability 11,802,146 18,120,223 12,056,347 14,280,683 15,108,213
19,670,154 57,618,797 52,138,295 62,363,006 203,740,735
Current Liabilities
Accounts payable 19,721,261 28,319,179 30,888,507 32,198,416 48,879,855
Current portion of notes payble 11,139,605 20,539,561 21,757,197 31,329,583 27,241,371
Taxation payable 3,660,717
30,860,866 48,858,740 52,645,704 63,527,999 79,781,943
Total Equity & Liabilities 279,983,964 442,770,551 587,417,294 752,111,433 1,063,168,994
24
 FORECASTING THE INCOME
STATEMENT
 Compound annual growth rate (CAGR) is the rate of return
that would be required for an investment to grow from its
beginning balance to its ending balance, assuming the profits
were reinvested at the end of each year of the investment's
lifespan
 CAGR = (End Value/Start Value)^(1/Years)-1.

25
 FORECASTING THE INCOME
STATEMENT
 To calculate the CAGR in excel, there is a basic formula shown
as: = ((End value/Start value) ^( (1/Periods))-1.
 Select a blank cell, for example Cell F2, enter the formula =
((F2/B2) ^ (1/4))-1. [ ^ (Shift6)]

26
 FORECASTING THE INCOME
STATEMENT
COST OF GOODS SOLD (COGS):
Make a percentage gross profit margin(gross
profit/revenue) or
Percentage COGS margin (COGS/revenue)
assumption and reference that back into the dollar
amount of COGS.
Historical margins help to provide a benchmark
which the analysis can either straight-line into the
forecast period or reflect a thesis that emerges from a
particular viewpoint (which the analysis develops on
their own, or more likely from equity research). 27
 FORECASTING THE INCOME
STATEMENT
COST OF GOODS SOLD (COGS):

28
 FORECASTING THE INCOME
STATEMENT
OPERATING EXPENSES:
Operating expenses include selling costs, general and
administrative expenses and research and development
expenses. All of these expenses are driven by revenue
growth or by an explicit expectation for possible changes
in margin. For example, if last year’s SG&A margin was
21.4%, an “we don’t have a thesis on SG&A” – forecast
for next year would simply be to straight-line the prior
year’s 21.4% or average margins. Obviously, if we do
expect changes, it would usually be reflected with an
explicit change to margin assumptions.
29
 FORECASTING THE INCOME
STATEMENT
DEPRECIATION & AMORTIZATION:
Depreciation & amortization expenses are usually not
classified explicitly on the income statement. Rather,
they are embedded within other operating expenses
categories. However, you usually need to forecast
depreciation & amortization in order to arrive at an
EBITDA forecast. Since depreciation & amortization
expenses are a function of historical and expected future
capital expenditures and purchases of intangible assets,
they are actually forecast as part of the balance sheet
buildup and referenced back into the income statement
after the buildup is complete. 30
 FORECASTING THE INCOME
STATEMENT
INTEREST EXPENSE:
Forecasting interest expenses is done as part of the balance sheet
buildup in a debt schedule and is a function of projected debt
balances and the projected interest rate.
Interest expense is determined based on the company’s debt
balances and interest income is determined based on the company’s
cash/investment balances.
If you forecast debt balance to be $100,000 in the end of 2019 and
$200,000 at the end of 2020, at an assumed interest rate of 5%, the
interest expenses would be calculated as $150,000 (average balance)
& 5% = $7,500.

31
 FORECASTING THE INCOME
STATEMENT
INTEREST INCOME:
Interest income is a function of projected
cash/investment balances and the projected interest rate
earned.
Like interest expenses, analysts can calculate interest
by using either beginning or average-period approach.

32
 FORECASTING THE INCOME
STATEMENT
OTHER NON-OPERATING EXPENSES:
Those items are usually best forecast on a straight-line
basis (as opposed to operating expenses, which are
usually tied to revenue growth).

TAXES:
Straight-lining the last historical year’s tax rate is
sufficient. However, there are times where tax rates
historically are not indicative of what a company can
reasonably expect to face in the future.

33
 FORECASTING THE BALANCE
SHEET
BALANCE SHEET BEST PRACTICES:
1.At least three years of historical data - It is
recommended that at least three years of historical results
are inputted into the model to help provide some context
to forecasts. Data is organized in columns ascending
from left to right.

34
 FORECASTING THE BALANCE
SHEET
BALANCE SHEET BEST PRACTICES:
2.Reclassify IFRS to suit your needs - Companies present
their balance sheet in ways that are not always optimized
for analysis. For example, companies may lump line items
with different drivers together. In these cases, the line items
need to be separated and forecasting approaches should be
tailored to the nature of the items. Conversely, IFRS
requires that certain line items be broken out into current
and long-term components (deferred taxes and deferred
revenue are common examples). However, for forecasting
purposes, they can be combined because they are forecast
using the same drivers.
35
 FORECASTING THE BALANCE
SHEET
BALANCE SHEET BEST PRACTICES:
3.Use supporting schedules - All forecasting needs to be
done in supporting schedules — either in the same
worksheet or in dedicated separate worksheets. This is
where the forecasting and calculations should take place.
The consolidated balance sheet simply pulls the finished
product — the forecasts — to present a complete picture.

36
 FORECASTING THE BALANCE
SHEET
EARNING ASSETS:
Earning assets are income-producing investments that are
owned, or held, by a business, institution or individual.
These assets also have a base value and the ability to
produce additional funds beyond the inherent value for
the investment holder. This allows the investment holder
to maintain the assets as a source of earnings or sell the
assets for a lump sum based on the inherent value.

37
 FORECASTING THE BALANCE
SHEET
EARNING ASSETS:
Earning assets include stocks, bonds, income from rental
property, certificates of deposit (CDs), interest bearing bank
accounts (savings & current accounts) and other interest or
dividend earning accounts or instruments.
They can provide a steady income, which makes
particularly useful for long-term goals, such as expansions,
acquiring fixed assets etc. Earning assets are a reflection of
only part of the total assets of an institution.

38
 FORECASTING THE BALANCE
SHEET
The following are the main accounts we need
to cover when projecting balance sheet items:
Assets
 Accounts Receivables
 Inventory
 Other current Assets
 Property, Plant & Equipment (PP&E)
 Other non-current assets

39
 FORECASTING THE BALANCE
SHEET
Liabilities
 Accounts Payables
 Long-term Debt
Equity
 Shareholder Capital
 Retained Earnings

40
 FORECASTING THE BALANCE
SHEET
FORECAST TOTAL ASSETS:

Grow with the sales growth factor OR

Compute the annual asset growth (find the average) OR

Compute the asset growth factor (using the CAGR) OR
Grow with the assets turn over ratio (sales/average total assets).


41
 FORECASTING THE BALANCE
SHEET
WORKING CAPITAL LINE ITEMS:

Start the balance sheet forecast by forecasting

working capital items. Broadly speaking,
working capital items are driven by the
company's revenue and operating forecasts.
Conceptually, working capital is a measure of a
company’s short-term financial health.

42
 FORECASTING THE BALANCE
SHEET
WORKING CAPITAL LINE ITEMS:
Accounts receivables, Inventory & Accounts
Payables are unique in that they have a specific
method of forecasting. Because these accounts
are all involved in the operating cash cycle.
Using the formula for their respective days
outstanding, we can forecast future accounts
receivables, inventory & accounts payables.

43
 FORECASTING THE BALANCE
SHEET
USEFUL FORMULAS:
Average Receivables * 365
Accounts Receivable Days =
Net sales/Revenues

Average Payables * 365

Accounts Payable Days =
Cost of sales

Average inventory * 365

Inventory Days =
Cost of sales

44
 FORECASTING THE BALANCE
SHEET
USEFUL FORMULAS:

Cost of sales
Inventory turnover =
Average stock

Net Sales/Revenues
Total assets turnover =
Average Total Assets

45
 FORECASTING THE BALANCE
SHEET
ACCOUNTS RECEIVABLE (AR):

Grow with sales growth rate OR

Grow as a percentage of Revenues/Sales OR

Grow with days sales outstanding (DSO)
projection/Accounts Receivable Days (ARD).

Receivable Days * Sales (Revenues)

Forecast Average 365
Receivables  

46
 FORECASTING THE BALANCE
SHEET
ACCOUNTS RECEIVABLE (AR):
Example:
Accounts receivables in 2019 is $27,648. Average
accounts receivable days for the five years is 120. If
sales revenue was $100,000 in 2020, then:
120 * 100,000
Average Accounts Receivables 365
$32,876


Total receivables = 2 * 32,876 = $65,752

What is the accounts receivable for 2020?
47
 FORECASTING THE BALANCE
SHEET
INVENTORY:

Grow with cost of goods sold (COGS) OR

Grow with inventory turnover OR

Grow as a percentage of sales OR

Grow using inventory days projection.

Forecast Average
Inventory Days * Cost of goods sold
Inventory 365
 

48
 FORECASTING THE BALANCE
SHEET
PREPAID EXPENSES:

If prepaid expenses comprise expenses predominantly
classified as Selling, General &Administrative (SG&A),
grow with SG&A. If you aren’t sure, grow with revenue.

OTHER CURRENT ASSETS:


Grow with revenues (presumably these are tied to
operations and grow as the business grows).

If there's reason to believe they are not tied to
operations, straight-line the projections

49
 FORECASTING THE BALANCE
SHEET

ACCOUNTS PAYABLE

If the payables are generated predominantly for
inventory, grow with COGS OR

Grow with revenue OR

Grow Accounts Payable Days assumption.

Payables Days * Cost of goods sold

Forecast Average 365
Payables  

50
 FORECASTING THE BALANCE
SHEET

ACCRUED EXPENSES

If the accrued expenses are largely for expenses that will
be classified as SG&A, grow with SG&A. If you aren’t
sure, grow with revenue.
DEFERRED ASSETS & LIABILITIES

Grow with the revenue growth rate.

Straight-lining is also acceptable in the absence of
enough disclosures to fully understand the nature of the
DLs & DAs.

51
 FORECASTING THE BALANCE
SHEET
TAXES PAYABLE:

Grow with the growth rate in tax expense on the income
statement.
OTHER CURRENT LIABILITIES:

Grow with revenues.

If there's reason to believe they are not tied to operations,
straight-line the projections.

52
 FORECASTING THE BALANCE
SHEET
PROPERTY, PLANT & EQUIPMENT AND
INTANGIBLES:
The largest component of most company’s long term
assets are fixed assets (property plant and equipment)
For financial institutions – Loans and Investments are
usually large as well.
Goodwill and other intangible assets arise mainly in
connection with acquisition of other companies. Unless
an acquisition is pending at year-end, and we have
sufficient information about its financial impact, we
forecast no change for goodwill and other intangibles. 53
 FORECASTING THE BALANCE
SHEET
PROPERTY, PLANT & EQUIPMENT AND
INTANGIBLES:
These line items are also driven largely by the
company’s operations. In other words, the more revenue,
the more capital spending and purchases of intangibles
we expect to see.
Unlike working capital, PP&E and intangible assets are
depreciated or amortized (with a few notable exceptions
like land and goodwill).

54
 FORECASTING THE BALANCE
SHEET
OTHER NON-CURRENT ASSETS AND
LIABILITIES
We often encounter catch-all line items on the balance
sheet simply labeled “other.” Sometimes the company
will provide disclosures in the footnotes about what’s
included, but other times it won’t.
If you don’t have good detail on what these line items
are, straight-line them as opposed to growing with
revenue. That’s because unlike current assets and
liabilities, there’s a likelihood these items could be
unrelated to operations such as investment assets,
pension assets and liabilities, etc. 55
 FORECASTING THE BALANCE
SHEET
LONG TERM DEBT
Holding the company’s long term debt balance constant

OR
Growing long term debt at the growth in the company’s
net income (arguably a better approach because it ties
debt to equity growth by using net income as a proxy for
equity growth).

56
 FORECASTING THE BALANCE
SHEET
SHAREHOLDERS EQUITY:
Common stock – keep this amount constant
Retained earnings is the link between the balance
sheet and the income statement. In a 3-statement model,
the net income will be referenced from the income
statement.
Meanwhile, barring a specific thesis on dividends,
dividends will be forecast as a percentage of net income
based on historical trends (keep the historical dividend
payout ratio constant).
57
 FORECASTING THE BALANCE
SHEET
SHAREHOLDERS EQUITY:
The retained earnings roll-forward: retained
earnings (BOP) + net income - dividends (common and
preferred) = retained earnings (EOP)
Other Comprehensive Income, assume no change
year-over-year going forward (in other words, straight-
line the last historical OCI balance on the balance sheet).

58
 BALANCING THE MODEL
Finally, any balance sheet forecast isn't complete if the
balance sheet does not balance. While a company's
reported balance sheet will always show assets equaling
liabilities plus equity, when forecasting the balance sheet,
any number of mistakes can lead to the model getting out
of balance. In fact, the strength of a 3-statement model is
that the three statements are interlinked. However, these
inter-linkages also increase the potential for error. Some
of the most common reasons the balance sheet doesn't
balance includes:

59
 BALANCING THE MODEL

1. Signs (+/-) are switched - For example, if your

capital expenditures is inputted in the balance sheet
as a negative (or in the cash flow statement as a
positive), your model will be out of balance.
2. Mislinks - For example, if your model accidentally
references dividends instead of stock-based
compensation into the common stock schedule, your
model will be out of balance.

60
 BALANCING THE MODEL
3. Cash flow statement errors - Getting a model to
balance is usually more about getting the cash flow
statement correct than it is about getting the balance
sheet correct. For example, if you forecast that "other
long term assets" on the balance sheet grow at the
same rate as revenues but forget to include the cash
impact of this change on the cash flow statement,
your model will not balance

61
 BALANCING THE MODEL
Consider the following options when attempting to
balancing the Balance Sheet:
Increase/decrease cash and/or marketable/short term
securities
Reduce short-term or long-term debt
Reduce retained earnings by increasing projected
dividends
Use goal-seek in e

62
 BALANCING THE MODEL
Use GOAL SEEK in excel to find the amount that is
needed to balance the Balance Sheet, since there are
linkages between the Income Statement (finance
cost/finance income) and the Balance Sheet (debts,
retained earnings, earning assets).

63
 ANALYZING PROJECTED
FINANCIAL STATEMENTS
 Test the reasonableness of forecast assumptions and
their internal consistency.
 Use ratios and other analytical tools for testing.
 But, ratios cannot confirm whether our forecast
assumptions will turn out to be correct.

64