Fourth Edition
Peter D. Easton
Mary Lea McAnally
Greg Sommers
MODULE 11
Forecasting
Financial Statements
©Cambridge Business Publishers, 2015
Xiao-Jun Zhang
Learning Objective 1
Explain the process of
forecasting financial statements.
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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 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.
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Overview of the Forecasting Process
(continued)
 Level of Precision – borderline decisions that depend
on a high level of forecasting precision are probably illadvised.
 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.
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Revenues Forecast Impacts Both the
Income Statement and the Balance Sheet
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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.
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Dynamics of Growth (I/S and B/S)
(continued)
 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.
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Dynamics of Growth (I/S and B/S)
(continued)
 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.
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Dynamics of Balance Sheet Growth
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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.
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Learning Objective 2
Forecast revenues and
the income statement.
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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 from 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.
 Impact of Foreign Currency Fluctuations – a change in the strength
of the $US vis-à-vis foreign currencies has a direct effect on the $US
equivalent for revenues, expenses, and income of the foreign
subsidiary.
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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
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P&G Data from MD&A
 P&G’s net sales (in dollars) increased by 1% in 2013 as a result of a 2%
increase in units sold and a 1% increase in prices.
 Net sales declined, however, as a result of changes in product mix for the
Beauty, the Fabric Care, and the Baby Care segments (more lower-priced
products were sold), although the overall effect was negligible.
 During 2013, the U.S. dollar strengthened vis-à-vis other world currencies
in which P&G conduct its business. Thus, revenues denominated in
foreign currencies decreased by 2% when translated into U.S. dollars.
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Organic Growth
From these segment disclosures, we can develop
a history of the factors impacting organic sales
growth:
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Determining the Revenue Growth Forecast:
Using Publicly-Available Information
P&G’s 4Q earnings release and FY’14 Guidance:
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Determining the Revenue Growth Forecast:
Using Proprietary Databases
(Morgan Stanley)
 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.
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Morgan Stanley Forecasts
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Forecasting Expenses
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Forecasted Income Statement for P&G
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Learning Objective 3
Forecast the balance sheet.
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Forecasting the Balance Sheet
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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.
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Computational Options
 Forecasts using percent of revenues:
 Forecasts using turnover rates:
 Forecasts using days outstanding:
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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 many investment firms.
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Forecasted Balance Sheet for P&G
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Adjusted Forecasted Income Statement
for P&G
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Learning Objective 4
Forecast the
statement of cash flows.
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Forecasted SCF for P&G
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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 re-compute 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.
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Learning Objective 5
Prepare multiyear forecasts
of financial statements.
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Two-Year Ahead Forecasts
of the P&G Income Statement
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Two-Year Ahead Forecasts
of the P&G Balance Sheet
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Two-Year Ahead Forecasts
of the P&G Statement of Cash Flows
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Learning Objective 6
Implement a parsimonious method
for multiyear forecasting of
net operating profit and
net operating assets.
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Parsimonious Method
of Multiyear Forecasting
Inputs:
 Sales growth
 Net operating profit margin (NOPM = NOPAT / Sales)
 Net operating asset turnover (NOAT = Sales / NOA)
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The End