University of Nairobi
Msc (Finance)
DAC 511: CORPORATE FINANCIAL REPORTING & ANALYSIS
PROSPECTIVE ANALYSIS
GROUP 7
GROUP SEVEN MEMBERS
MERCY CHELANGAT
D63/79059/2012
KOSGEI JUSTINE
D63/61383/2013
DAVID CHIKEKA
D63/73044/2012
ABDIRIZAK MOALIM
D63/60121/2013
NYANGALA ALLAN H.
D63/67803/2011
FRANK KILONZO M
D63/80470/2012
RICHARD NOAH
D63/60864/2013
ESBON WAMATHU W.
D63/61264/2013
DENNIS KIMANI
D63/60534/2013
VERA NYABOKE
D63/61416/2013
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TABLE OF CONTENT.
Introduction……………………………………………………………………………………………………………1
Importance Of Prospective Analysis…………………………………………………………….…………………1
Compilation Of Prospective Financial Statements……………………………………………………….………1
Compilation Of Prospective Financial Statements……………………………………………………………….2
The Procedure and steps………………………………………………………………………………………..….2
Projecting The Income Statement……………………………………………………………………………….....3
Projecting Cost Of Goods Sold……………………………………………………………………………..………3
Projecting Operating Expenses………………………………………………………………………...……..……4
Projecting Depreciation And Interest Expense………………………………………...……………………..…..4
Spreadsheet Considerations. Example. ………………………………………………………………….…...….5
Projecting The Remainder Of The Income Statement………………………………………..……….…………5
Steps In Projecting The Income Statement………………………………………………………...……………..5
Example. ………………………………………………………………………………………………………….….6
Target Projected Income Statement Computation. ………………………………………………………….…6
Target Projected Income Statement………………………………………………………..….….……………….7
Projected Balance Sheet……………………………………………………………...……………….……………7
Basic Process…………………………………………………………………………….………………..…………8
Some Important Ratios And Formulas……………………………………………………………………..….…..8
Target Corporate Financial Position……………………………..……………………………………..……...…..9
Steps in Projection (Target) ………………………………………………………………………………………10
Target Financial Position………………………………………………………………………………………..…11
Projected Cash Flow Statement……………………………………….……………………………....…………12
Importance Of Projection Of Cash Flows: ………………………………………………………………………12
Steps in Determining The Projection Of Cash Flow …………………………………………..…………….…12
Example…………………………………………………………………………………………………………….13
Trends in Value Drivers……………………………………………………………………..…………….………14
Observations from the Graphs…………………………………………………………………………..………..18
Sensitivity Analysis……………………………………………………………………………………..……..……16
Importance Of Sensitive Analysis…………………………………………………………………………..……17
References……………………………………………………………………………..……………………..…….17
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PROSPECTIVE ANALYSIS AND THE PROJECTION PROCESS
INTRODUCTION
Prospective analysis can only be undertaken after the historical financial statements have been
properly adjusted to accurately reflect the economic performance of the company. Prospective
analysis is central to security valuation where both the free cash flow and residual income
models require estimates of future financial statements. The residual income model for example
requires projections of future net profits and book values of equity in order to estimate stock
prices. In forecasting financial statements we start with historical financial statements and from
them we identify the patterns and relationships of different items, the implicit policies, growth
rates etc.
What are prospective financial statements? Prospective financial statements encompass financial
forecasts and financial projections. Financial forecasts are prospective financial statements that
present, to the best of the responsible party’s knowledge and belief, an entity’s expected financial
position, results of operations, and cash flows. They are based on assumptions about conditions
actually expected to exist and the course of action expected to be taken.
Financial projections are prospective financial statements that present, to the best of the
responsible party’s knowledge and belief, an entity’s expected financial position, results of
operations, and cash flows. They are based on assumptions about conditions expected to exist
and the course of action expected to be taken, given one or more hypothetical (i.e., “what-if”)
assumptions. Responsible parties are those who are responsible for the underlying assumptions.
While the responsible party is usually management, it may be a third party. Example: If a client
is negotiating with a bank for a large loan, the bank may stipulate the assumptions to be used.
Accordingly, in this case, the bank would represent the responsible party.
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Prospective analysis is usually carried out in two broad stages:
1. Long term forecasting – This involves the analysis of past data and forecasting of financial
statements.
2. Implementation – This is the use of the forecasts to value common stock or to accomplish any
other objective for which the forecast was carried out.
IMPORTANCE OF PROSPECTIVE ANALYSIS
1) Security Valuation-Free cash flow and residual income models require estimates of future
financial statements
2) Management assessment-Forecasts of financial performance examine the viability of
companies’ strategic plans.
3) Assessment of solvency-Prospective analysis is useful to creditors to assess a company’s
ability to meet debt service requirements, both short term and long term.
4) Prediction of future performance-Forecasting financial statements is imperative for
management because it can provide a rough guide to the future performance of the firm.
COMPILATION OF PROSPECTIVE FINANCIAL STATEMENTS
The Procedure
– Compilation procedures applicable to prospective financial statements are not designed to
provide any form of assurance on the presentation of the statements or the underlying
assumptions. They are essentially the same as those applicable to historical financial statements.
1.
Inquire of the responsible party as to the underlying assumptions developed.
2.
Compile or obtain a list of the underlying assumptions and consider the possibility of obvious
omissions or inconsistencies.
3.
Verify the mathematical accuracy of the assumptions.
4.
Read the prospective financial statements in order to identify departures from IAS 1
presentation guidelines.
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5.
Obtain a client representation letter in order to confirm that the responsible party
acknowledges its responsibility for the prospective statements (including the underlying
assumptions).
In performing an examination of prospective financial statements, the practitioner should
follow the following steps:
1.
Step-1. Assess inherent and control risk as well as limit his or her detection risk.
2.
Step-2. Consider the sufficiency of external sources (such as government and industry
publications) and internal sources (such as management-prepared budgets) of information
supporting the underlying assumptions.
3.
Step-3. Determine the consistency of the assumptions and the sources from which they are
predicated.
4.
Step-4. Determine the consistency of the assumptions themselves.
5.
Step-5. Determine the reliability and consistency of the historical financial information used.
6.
Step-6. Evaluate the preparation and presentation of the prospective financial statements:

Does the presentation reflect the underlying assumptions?

Are the assumptions mathematically accurate?

Do the assumptions reflect an internally consistent pattern?

Do the accounting principles in use reflect those expected to be in effect in the
prospective period?
7.

Are the IAS1 presentation guidelines followed?

Is there adequate disclosure of the assumptions?
Step-7. Obtain a client representation letter to confirm that the responsible party
acknowledges its responsibility for the presentation of the prospective financial statements
and the underlying assumptions.
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PROJECTING THE INCOME STATEMENT
Projecting financial statements must begin with projecting the Income Statement and projecting an
Income Statement begins by estimating sales.
The sales figure is by far the most important assumption in any set of projected financial statements,
because so many other numbers in both the income statement and balance sheet will ultimately be
derived from it. Therefore, it is well worth the most careful attention of all numbers in the construction and
sensitivity analysis of the statements.
The sales estimate can be tested for plausibility in four different contexts the trend of past sales, the
market share it implies (if reliable market data is available), and its relation to planned marketing efforts
and to production capacity.
Past Sales Trends are a good starting point, although these can change for both external or internal
reasons. External reasons could be market growth, which would help all companies competing in that
industry; increased competition from new participants might hurt all current companies’ sales. Internal
reasons could be product line changes, enhanced marketing efforts or meaningful price changes.
Market Share implied by the sales estimate is an essential context if reliable market data is available.
Market share is a "zero-sum game" because there are only 100 points of market share to go around.
Thus any increase in market share for a company has to be offset by an exactly equal decrease in market
share distributed in some way among the other competitors in the industry. Predicting from which
competitors’ market share gains will come is an excellent reality check on sales projections, and prepares
management for competitive retaliation.
Expected level of macroeconomic activity - Since Target customers’ purchases are influenced
by the level of personal disposable income, our analysis might incorporate estimates relating to
the overall growth in the economy and the expected growth of retail sales in particular. For
example, if the economy is in a cyclical upturn, we might be comfortable in projecting an
increase in sales greater than that of the recent past.
The competitive landscape - Has the number of competitors increased? Or, have weaker rivals
ceased operations? Changes in the competitive landscape will influence our projections of unit
sales as well as Target’s ability to raise prices. Both of these will impact top line growth.
New versus old store mix - New stores typically enjoy significantly greater sales increases than
older stores since they may tap poorly served markets or provide a more up-to-date product mix
than existing competitors. Older stores, by comparison, typically grow at the overall rate of
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growth in the local economy. Our analysis must consider, therefore, expansion plans announced
by management.
The Marketing Plan can provide further context. Relating the sales estimate to the number of
salespeople and / or dollars of advertising spending, the number of customer accounts to be solicited or
direct mail prospects to be reached is also important reality check.
Similarly, sales can be put in the context of operating capacity. Is there enough production capacity to
produce the amount of product implied by these sales. What percentage capacity utilization or sales per
business hour for a service business does the sales project imply?
Projecting Cost of Goods Sold
Cost of Goods Sold (CoGS) is by definition all costs which can be directly linked to sales. As such it is
always projected as percentage of sales. This percentage is also a very important assumption in any
projected financial statements because it will determine the Gross Profit from which all other expenses of
the organization must be paid.
Like Sales, the percentage CoGS assumption can be affected by a variety of factors, both external and
internal to the company. Obviously any external factor which increases costs, such as rising raw material
prices, will increase the CoGS percentage, unless these costs increases plus margin can be passed on to
customers. However, even without any cost increases external factors which limit or force reductions in
company pricing, such as increased price sensitivity or competitive activity will also increase the CoGS
percentage. In this latter case, the decrease is caused not by increased costs, but by the lower markup
above costs which the company can obtain.
Internally, production efficiencies may decrease this percentage through lowering costs. Price increases
will also decrease CoGS as a percentage of Sales, not by affecting costs, but by increasing the markup
above costs. Price increases would have to be accompanied by favorable market conditions or enhanced
product value, or they would decrease sales growth.
Projecting Operating Expenses
Operating Expenses by definition are not directly linked to sales, and therefore should not increase
proportionately with sales. Instead, these expenses should be projected on an item by item basis, based
on management plans for the future.
A first step in this process would be to identify the line items which will change materially due to some
aspect of future plans new management positions will affect salary expense, new head office premises
may change rental expense to property taxes, etc. These specific changes tend to be absolute amount
differences from previous years rather than percentage increases.
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There will also be other operating expenses which are not specifically affected by future plans office
supplies and equipment leases, telephone and fax charges, trade association membership fees for
example. These do tend to increase over time due to inflation and as the company grows due to
increased business activity. Therefore, for convenience, they are sometimes projected as a percentage of
sales, even though they are not a strictly speaking a function of sales.
Projecting Depreciation and Interest expense
Projecting Depreciation and Interest expense requires a look ahead to the projected balance sheet.
Depreciation will relate to the fixed assets on the balance sheet. Interest expense will relate to the level of
interest-bearing debt.
Although it would be possible to calculate these two items in some detail, it is rarely worth the effort for
depreciation, particularly since it is a non-cash expense, and as such, set by accountants, rather than
incurred through actions. However, if net fixed assets are increased through new purchases, depreciation
expense for subsequent periods should increase as well. Of course, the opposite would be true if net
fixed assets were to decrease through sale or write-off.
Similarly interest expense must vary in the same direction as total interest-bearing debt. This is worth
more attention, because interest is a cash expense, and one which must be paid on time if the company
is to maintain the confidence of its creditors. In fact, one of the purposes of projected financial statements
is to establish the level of financing necessary to support management plans, and the company’s ability to
service it.
Past interest expense can be analyzed as a percentage of past debt balances, and the trend extended
into the future. To this, add interest expense for any new debt added, which can be calculated fairly
accurately, since the terms of new debt are usually explicitly addressed in the plan.
Spreadsheet Considerations
The assumption on interest rate for any debt should be made explicit, and built into separate cell of the
spreadsheet model to facilitate sensitivity analysis.
Making interest expense a mathematical function of the liabilities on the balance sheet may cause a
circular function error. Interest affects Profit, which affects Retained Earnings, which can affect the level of
Liabilities necessary to make the balance sheet balance, which affects Interest.
Projecting the remainder of the Income Statement
Extraordinary items if any will be specifically known, and can be estimated accordingly.
Income tax rate can be specifically determined from government sources, but it is usually sufficient simply
to infer this from the past ratio of taxes to income before tax.
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Steps in Projecting the Income Statement
1. Project sales
2. Project cost of goods sold and gross profit margins using historical averages as a percent
of sales
3. Project SG&A expenses using historical averages as a percent of sales
4. Project depreciation expense as an historical average percentage of beginning-of-year
depreciable assets
5. Project interest expense as a percent of beginning-of-year interest-bearing debt using
existing rates if fixed and projected rates if variable
6. Project tax expense as an average of historical tax expense to pre-tax income
We begin with an assumption that sales as shown below will grow at 11.455% in 2006, the same
growth rate as in 2005. Once the projection has been completed, sensitivity analysis will examine
the implications of higher and lower growth rates on our forecasts
EXAMPLE. Target Corporation statement of income
Figures
in
$millions
Sales
Cost of goods sold
Gross profit
Selling, general and administrative expense.
Depreciation and amortization expense
Interest expense
Income before tax
Income tax expense
Income
(loss)
from
extraordinary items
and discontinued operations.
Net income
Outstanding shares
Selected Ratios
(in percent)
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2005
2004
2003
46,839
31,445
15,394
10,534
1,259
570
3,031
1,146
42,025
28,389
13,636
9,379
1,098
556
2,603
984
37,410
25,498
11,912
8,134
967
584
2,227
851
1,313
3,198
891
190
1,809
912
247
1,623
910
Sales growth
Gross profit margin
Selling, general and administrative expense/Sales
Depreciation expense/Gross prior-year PP&E
Interest expense/Prior-year long-term debt
Income tax expense/Pretax income.
Selling, general, and administrative expense/Sales
11.455%
32.866
22.49
6.333
5.173
37.809
12.336%
32.447
22.318
5.245
4.982
37.803
22.49%
Depreciation expense/Gross prior-year PP&E
6.333%
Interest expense/Prior-year long-term debt
5.173%
Income tax expense/Pretax income
37.809%
Target’s gross profit margin has increased slightly to 32.866% of sales. For our purposes, we
assume 32.866%, the most recent gross profit margin. In practice, our estimate of gross profit
margin will be influenced, in part, by the strength of the economy and the level of competition in
Target’s markets. For example, in an increasingly competitive environment we might question
the company’s ability to increase gross profit margin as selling prices will be difficult to
increase. Selling, general, and administrative (SG&A) expenses have also remained constant at
about 22% of sales. Our projection of SG&A expense is 22.49% of sales, the most recent
experience. In practice, we might examine individual expense items and estimate each
individually, incorporating knowledge we have gained from the MD&A section of the financial
statements or from outside sources. For a retailing company like Target, trends in wage and
occupancy costs and advertising expenses require greater scrutiny.
Depreciation expense is a significant line item and should be projected separately. It is a fixed
expense and is a function of the amount of depreciable assets. In recent years, Target has
reported depreciation expense of approximately 6% of the balance of beginning-of-year gross
property, plant, and equipment. Our projection assumes 6.333% of the 2005 property, plant, and
equipment (PP&E) balance, the most recent experience. Similarly, we compute the historical
ratio of interest expense relative to beginning of year interest-bearing debt. This ratio has
recently increased slightly over the past two years from 4.982% to 5.173%. Our projection
assumes 5.173% of the beginning-of year balance of interest-bearing debt. In practice, our
estimates will incorporate projections of future levels of long-term interest rates. Finally, tax
10 | P a g e
expense as a percentage of pre-tax income has been constant at the most recent level of 37.809%,
used in our projection.aptene | Prospective Analysis 4
Target Projected Income Statement computation.
1. Sales: $52,204 = $46,839 x1.11455
2. Gross profit: $17,157 = $52,204 x 32.866%
3. Cost of goods sold: $35,047 = $52,204 - $17,157
4. Selling, general, and administrative: $11,741 = $52,204 x 22.49%
5. Depreciation and amortization:
$1,410 =$22,272 (beginning-period PP&E gross) x 6.333%
6. Interest: $493 = $9,538 (beginning-period interest-bearing debt) x 5.173%
7. Income before tax: $3,513 = $17,157 - $11,741 - $1,410 - $493
8. Tax expense: $1,328 = $3,513 x 37.809%
9. Extraordinary and discontinued items: none
1
Net income: $2,185 = $3,513 - $1,328
0.
Target Projected Income Statement
(in millions)
Income statement
Total revenues.........................................................................................
Cost of goods sold..................................................................................
Gross profit.............................................................................................
Selling, general, and administrative expense............................................
Depreciation and amortization expense ..................................................
Interest expense......................................................................................
Income before tax ...................................................................................
Income tax expense.................................................................................
Income (loss) from extraordinary items and discontinued operations ......
Net income..............................................................................................
Forecasting Step
2006 Estimate
1
3
2
4
5
6
7
8
9
10
$52,204
35,047
17,157
11,741
1,410
493
3,513
1,328
0
$ 2,185
Outstanding shares .........................................................................
Forecasting Assumptions (in percent)
Sales growth...........................................................................................
Gross profit margin.................................................................................
11 | P a g e
891
1
1
11.455%
32.866
PROJECTED BALANCE SHEET
Projecting your balance sheet can be quite a complex accounting problem, but that does not
mean you need to be a professional accountant to do it. The desired result is not a perfect
forecast, but rather a considerate plan detailing what additional resources will be needed by the
company, where they will be needed, and how they will be financed. Using your last historical
balance sheet as a starting point, project what your balance sheet will look like at the end of the
12 month period covered in your Profit & Loss and Cash Flow forecasts. How will the year's
operations affect assets, debts and owners’ equity? For example, if you are planning significant
sales growth in the coming year, go through the balance sheet item by item and think about the
probably effects of assets.
Ex. ASSETS: Inventory and Accounts Receivable will have to grow. New equipment may be
needed for increased production. You may draw down on cash to finance some of this.
Now, since a balance must balance, you need to consider the effects on the other half of the
statement, liabilities and equity.
Ex. LIABILITIES & EQUITY: Some of the growth may be financed by profits retained in the
business as Retained Earnings. Your Profit & Loss Projection will tell you how much might be
available from that source. Funds may be contributed by the owners through contributions of
more Invested Capital or loans to the company (Notes Payable to Stockholders). Suppliers may
provide some of the financing via increased Accounts Payable. The rest will have to be financed
by borrowing, which can be: Short term loans (due within 12 months) such as a line of credit or
by Long Term Debt (maturity greater than 12 months).
Basic Process
 you need to have a projection for the latest current asset as well as the liability having
made use of the historical turnover ratios multiplying it with the elements projected in the
Income Statement
 One may easily determine the projected Property; Plant and Equipment after getting the
historical Capital Expenditures
 Project current maturities of long-term debt from current year footnote information
12 | P a g e
 Assume short-term debt, other long-term liabilities and initial common stock amounts
based on current year balance
 Calculated Projected Retained Earnings based on current ending retained earnings,
projected Net Income and projected Dividends
 Assume all other Stockholders’ Equity accounts based on current balances
 At this point you will have a projected amount for Total Liabilities and Total
Stockholders’ Equity and, therefore, you will have a projected amount for Total Assets.
You can determine projected Cash based on Projected Total Assets less Projected amount
for all non-Cash Current Assets and all non-Current Assets
 If projected Cash is negative you can issue additional debt and equity keeping historical
levels of financial leverage.
 If projected Cash is unusually high you can reduce the balance by using it to retire debt
and/or repurchase stock, again keeping financial leverage in line with historical levels
Some important ratios and formulas
Item
Turnover Ratio
Accounts Receivable
Accounts Receivable Turnover
Inventory
Inventory Turnover
Accounts Payable
Accounts Payable Turnover
Accrued Expenses
Accrued Expenses Turnover
Taxes Payable
Historical Rate
Dividends
Dividends per Share
Capital Expenditures
CAPEX/Sales
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Ratio Formula
Sales/Accounts Receivable
Cost of Goods Sold/Inventory
Cost of Goods Sold/Accounts
Payable
Sales/Accrued
Expenses
Payable
Taxes Payable/Income Tax
Expense
Total Dividends/Number of
Shares Outstanding
Capital Expenditures/Sales
Target corporate Financial Position
(in millions)
2005
2004
Cash ..................................................................................
$ 2,245
$ 708
Receivables .......................................................................
5,069
4,621
Inventories .........................................................................
5,384
4,531
Other current assets ..........................................................
1,224
3,092
Total current assets.......................................................
13,922
12,952
Property, plant, and equipment (PP&E)..............................
22,272
19,880
Accumulated depreciation .................................................
5,412
4,727
Net property, plant, and equipment ...................................
16,860
15,153
Other assets ......................................................................
1,511
3,311
Total assets .......................................................................
$32,293
$31,416
Accounts payable...............................................................
$ 5,779
$ 4,956
Current portion of long-term debt......................................
504
863
Accrued expenses ..............................................................
1,633
1,288
Income taxes & other .........................................................
304
1,207
Total current liabilities ..................................................
8,220
8,314
Deferred income taxes and other liabilities........................
2,010
1,815
Long-term debt..................................................................
9,034
10,155
Total liabilities ..............................................................
19,264
20,284
Common stock ...................................................................
74
76
Additional paid-in capital..................................................
1,810
1,530
Retained earnings .............................................................
11,145
9,526
Shareholders’ equity......................................................
13,029
11,132
Total liabilities and net worth ............................................
$32,293
$31,416
2003
$ 758
5,565
4,760
852
11,935
20,936
5,629
15,307
1,361
$28,603
$ 4,684
975
1,545
319
7,523
1,451
10,186
19,160
76
1,256
8,111
9,443
$28,603
Selected Ratios
Accounts receivable turnover rate....................................
9.240
9.094
6.722
Inventory turnover rate.....................................................
5.840
6.266
5.357
Accounts payable turnover rate .......................................
5.441
5.728
5.444
Accrued expenses turnover rate .......................................
28.683
32.628
24.214
Taxes payable/Tax expense...............................................
26.527% 122.663% 37.485%
Dividends per share .........................................................
$ 0.310
$ 0.260
$ 0.240
Capital expenditures (CAPEX)—in millions ......................
3,012
2,671
3,189
CAPEX/Sales ....................................................................
6.431%
6.356%
8.524%
14 | P a g e
Steps in projection (Target)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
Receivables: $5,650 = $52,204 (Sales)/9.24 (Receivable turnover).
Inventories: $6,001 = $35,047 (Cost of goods sold)/5.84 (Inventory turnover).
Other current assets: no change.
PP&E: $25,629 = $22,272 (Prior year’s balance) + $3,357 (Capital expenditure
estimate: estimated sales of $52,204 = 6.431% CAPEX/sales percentage).
Accumulated depreciation: $6,822 = $5,412 (Prior balance) + $1,410 (Depreciation
estimate).
Net PP&E: $18,807 = $25,629 - $6,822.
Other long-term assets: no change.
Accounts payable: $6,441 = $35,047 (Cost of goods sold)/5.441 (Payable
turnover).
Current portion of long-term debt: amount reported in long-term debt footnote
as the current maturity for 2006.
Accrued expenses: $1,820 $52,204 (Sales)/28.683 (Accrued expense turnover).
Taxes payable: $352 = $1,328 (Tax expense) x 26.527% (Tax payable/Tax
expense).
Deferred income taxes and other liabilities: no change.
Long-term debt: $8,283 = $9,034 (Prior year’s long-term debt) - $751 (Scheduled
current maturities from step 9).
Common stock: no change.
Additional paid-in capital: no change.
Retained earnings: $13,054 = $11,145 (Prior year’s retained earnings) + $2,185
(Projected net income) - $276 (Estimated dividends of $0.31 per share x 891
million shares).
Cash: amount needed to balance total liabilities and equity less steps (1)–(7).
15 | P a g e
Target Financial Position
Forecasting
(in millions)
Step
Cash ..........................................................................
17
Receivables ...............................................................
1
Inventories.................................................................2
Other current assets ..................................................3
Total current assets .....................................
Property, plant, and equipment.................................. 4
Accumulated depreciation .........................................5
Net property, plant, and equipment ........................... 6
Other assets ..............................................................7
Total assets ................................................
Accounts payable.......................................................8
Current portion of long-term debt.............................. 9
Accrued expenses ......................................................
10
Income taxes & other .................................................
11
Total current liabilities....................................
Deferred income taxes and other liabilities................ 12
Long-term debt..........................................................13
Total liabilities .............................................
Common stock ...........................................................
14
Additional paid-in capital.......................................... 15
Retained earnings .....................................................16
Shareholders’ equity ......................................
Total liabilities and net worth.........................
2006
Estimate
$ 1,402
5,650
6,001
1,224
14,277
25,629
6,822
18,807
1,511
$34,595
$ 6,441
751
1,820
352
9,364
2,010
8,283
19,657
74
1,810
13,054
14,938
$34,595
2005
Selected Ratios
Accounts receivable turnover rate....................
Inventory turnover rate....................................
Accounts payable turnover rate .......................
Accrued expenses turnover rate ......................
Taxes payable/Tax expense.............................
Dividends per share.........................................
Capital expenditures (CAPEX)—in millions.........
CAPEX/Sales .................................................
9.240
9.240
5.840
5.840
5.441
5.441
28.683
28.683
26.527% 26.527%
$ 0.310
$ 0.310
3,357
3,012
6.431%
6.431%
$ 2,245
5,069
5,384
1,224
13,922
22,272
5,412
16,860
1,511
$32,293
$ 5,779
504
1,633
304
8,220
2,010
9,034
19,264
74
1,810
11,145
13,029
$32,293
If the estimated cash balance is much higher or lower, further adjustments can be made to:
1. invest excess cash in marketable securities
2. Reduce long-term debt and/or equity proportionately so as to keep the degree of financial
leverage consistent with prior years.
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PROJECTED CASH FLOW STATEMENT:
The statement of cash flows is another financial statement that provides financial information
just as the balance sheet and the income statement. The purpose of this statement of cash flows is
to provide information on the cash inflows and outflows of a certain business for a period. It
distinguishes the sources and uses of cash flows by separating them into operating, financing and
investing activities. Most businesses prefer that their source of cash sprout from their operating
activities, therefore the cash flow statement shows aspects of liquidity of a firm. This brings out
the concept of projection so that we are able to determine what is in store for the company in the
near future whether it is failing or succeeding.
Therefore there is a difference between Cash Flow Projection and Cash Flow Statement. The
Cash Flow Statement shows how cash has flowed in and out of the business. The Cash Flow
Projection shows the cash that is anticipated to be generated over a chosen period of time in the
future.
Importance of projection of cash flows:
Uses of projection of cash flows are that it enables us to determine the:
Credit worthiness of a company- the financial condition of a company can be tested and assessed
by use of these projected cash flows to determine whether one can offer a particular company
credit and also in that way see how to enhance the company’s intrinsic credit worthiness
Loan structuring: specific weaknesses in the credit can be identified, thereby enabling the loan
facility to be optimally structured in terms of amount, tenor and pricing
Financial covenanting: specific financial covenants can be created and tailored to the borrower’s
financial condition.
All in all the main purpose of preparing a cash flow projection is to determine shortages or
excesses in cash from that necessary to operate the business. If cash shortages are revealed in the
project, financial plans must be altered to provide more cash until a proper cash flow balance is
obtained. For example, more owner cash, loans, increased selling prices of products, or less
credit sales to customers will provide more cash to the business. Ways to reduce the amount of
cash paid out includes having less inventory, reducing purchases of equipment or other fixed
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assets, or eliminating some operating expenses. If excesses of cash are revealed, it might
indicate excessive borrowing or idle money that could be used more effectively.
Steps in determining the projection of cash flow
Using the projected income statement and projected balance sheet then we:
1. Determine the total cash receipts which results from the cash sales, other income(credit
accounts) and loans/other cash injections
2. Determine the total cash paid out which results from purchases, wages, Taxes (real
estate, etc.), Supplies (office & operations), ,repair and maintenance, marketing,
advertising, car delivery and travel, accounting and legal charges, rent, telephone and
postal charges, utilities among others.
3. Determine noncash operations such as depreciation, gains or losses to assist us in
changing from accrual basis to cash basis
4. Once all that is determine then we can formulate our projected cash flow statement where
we may use the direct or indirect method
5. Using the indirect method we determine the net income from the income statement ,
where we deduct the expenses from the income then we adjust the non cash charges such
as depreciation, gains or losses
6. After that we determine the net change in cash from operating, financing and investing
activities where operating involve increase(decrease) in assets and liabilities, financing
activities say increase(decrease) in long term debt, dividends among others and investing
activities resulting from increase(decrease) in capital expenditures
7. Finally add (deduct) the net change in cash from the beginning balance to determine the
projected ending balance.
The main danger when putting together a Cash Flow Projection is being over optimistic about
the projected sales.
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Example of a projected cash flow statement of a certain company:
XYZ projected cash flow statement:
(in millions) 2006 Estimate
Net income ........................................................ $2,185
Items to adjust income to cash flows
Depreciation and amortization .......................... 1,410
Receivables....................................................... (581)
Inventories ........................................................ (617)
Accounts payable .............................................. 662
Accrued expenses.............................................. 187
Income taxes and other ..................................... 48
Net cash flow from operations........................... 3,294
Capital expenditures......................................... (3,357)
Net cash flow from investing activities ............. (3,357)
Long-term debt ................................................. (504)
Dividends .......................................................... (276)
Net cash flow from financing activities............. (780)
Net change in cash............................................ $ (843)
Beginning cash ................................................. 2,245
Ending cash ...................................................... $1,402
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USE OF PROSPECTIVE ANALYSIS IN THE RESIDUAL INCOME VALUATION
MODEL
Valuing A Company Using The Residual Income Method
There are many different methods to valuing a company or its stock.
One could opt to use a relative valuation approach, comparing multiples and metrics of a firm in
relation to other companies within its industry or sector.
Another alternative would be value a firm based upon an absolute estimate, such as
implementing discounted cash flow modelling or the dividend discount method, in an attempt
to place an intrinsic value to said firm.
One absolute valuation method which is widely used by analysts is the residual income method.
Typical Example of Valuation Using Residual Income
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The residual income model attempts to adjust a firm's future earnings estimates, to compensate
for the equity cost and place a more accurate value to a firm.
Although the return to equity holders is not a legal requirement like the return to bondholders, in
order to attract investors firms must compensate them for the investment risk exposure. In
calculating a firm's residual income the key calculation is to determine its equity charge. Equity
charge is simply a firm's total equity capital multiplied by the required rate of return of that
equity, can be estimated using the capital asset pricing model.
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For example, if SYMINEX reported earnings of $8856 in 2006 and financed its capital
structure with $20624 worth of equity at a required rate of return of 12.5% its residual income
would be:
Equity
Charge:
$20624
Net Income
$8856
Equity Charge
-$2578
Residual Income
$6278
x
0.125=
$2578
Intrinsic Value with Residual Income
Now that we've found how to compute residual income, we must now use this information to
formulate a true value estimate for a firm. Like other absolute valuation approaches, the concept
of discounting future earnings is put to use in residual income modeling as well. The intrinsic or
fair value, of a company's stock using the residual income approach can be broken down into its
book value and the present values of its expected future residual incomes, as illustrated in the
formula below.
BVt is book value at the end of period t
RIt + n is residual income in period t + n
k is cost of capital.
After getting the residual value of that given period we discount it by a given discounting factor
to get the present value of the residual income.
$6278*0.8889=$5581
Advantages of Residual income model
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1. Residual income models make use of data readily available from a firm's financial statements
and can be used well with firms who do not pay dividends or do not generate positive free cash
flow.
2. Residual income models look at the economic profitability of a firm rather than just its
accounting profitability.
Drawback of using residual Income model
The biggest drawback of the residual income method is the fact that it relies so heavily on
forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to
psychological biases or historic misrepresentation of a firms financial statements.
Conclusion
Therefore, the model is useful when;
1. A company does not pay dividends or dividends are not predictable
2. FCF is negative over a comfortable forecast horizon
3. There is great uncertainty in estimating terminal values
Not useful when;
1. There are significant departures from clean surplus accounting. For example,
a. Gains on marketable securities are reflected in stockholder’s equity as
“comprehensive income” rather than as income on the income statement
b. Wide use of employee stock options
c. Foreign currency translations
d. Some pension adjustments
2. Determinants of residual income (e.g., book value and ROE) are not predictable
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All that having been said, the residual income valuation approach is a viable and increasingly
popular method of valuation and can be implemented rather easily by even novice investors.
When used alongside the other popular valuation approaches, residual income valuation can give
you a clearer estimate of what the true intrinsic value of a firm may be.
TRENDS IN VALUE DRIVERS
The Residual Income valuation model defines residual income ratio as:
RIt
= NIt – (k X BVt-1)
Also residual Income can be stated as:
= (ROEt – k) X BVt-1
Where Return on Equity (ROE) ratio = Net Income
Book Value of equity (t-1)
ROE highlights that stock price is only impacted so long as ROE ≠ k and Shareholder value is created so
long as ROE > k
At equilibrium, competitive forces tend to drive rate of return (ROE) to cost of capital so abnormal profits
are competed away.
Estimation of stock price results to estimation of stock price in the long run by reversion of ROE to its long
run value for a particular company and industry.
ROE is mapped on a graph on which we have ROE on the Y axis and number of years on the X axis.
Each company’s roe is followed for a period of years. The graph presents a median value for each
portfolio.
Observations from the Graphs
i.
ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition. Furthermore,
the reversion rate for the least profitable firms is greater than that for the most profitable firms. And
finally, reversion rates for the most extreme levels of ROE are greater than those for firms at more
moderate levels of ROE
ii.
The reversion is incomplete. That is, there remains a difference of about 12% between the
highest and lowest ROE firms even after 10 years.
This may be the result of two factors:
(a) Differences in risk that are reflected in differences in their costs of capital (k); or,
(b) Greater (lesser) degrees of conservatism in accounting policies.
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Exhibit 1 shows that mostly after 5 years there will be less impact on share price since ROE=k regardless
of the growth rate assumption for sales.

ROE is a value driver since it is a variable that directly affects stock prices.

ROA is split into two Net profit margin and Asset Turnover. The two are seen as value drivers
together with financial leverage and used in project valuation
Reversion of ROE
Exhibit 1:
Reversion of Net Profit Margin
Exhibit 2:
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Exhibit 2 shows a reversion of net profit margin in the compustat graph. NPM graph is constructed in a
similar manner to ROE graph. Reversion rate for the lowest and highest NPM are evident. Also the
reversion rate of least profitable firm is greater than that of profitable firms and reversion rate at both
extremes are greater than those for less. Lastly there remains a difference similar to ROE at the end of
year 10. Much of the reversion of ROE is driven by NPM.
Reversion of Asset Turnover
Exhibit
3:
Exhibit 3 is second component of ROA. It is constructed on the same basis as ROE and NPM. The
reversion is evident but less than profitability measures. There is a great difference between asset
turnover of highest and lowest turnover firms.
SENSITIVITY ANALYSIS
The relations between the income statement and the balance sheet accounts primarily form the basis of
projected financial statements. Different assumptions and approaches can be used to arrive at estimates
and projections for the period intended depending on the operations or nature of the business.
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
The most recent ratios can be used to estimate expected figures for the following period if the
business operations are fairly stable and assumptions are made that there will be no significant
changes in operating strategy.

Companies which implement their investment strategies in cycles or definite period, it may be
important to use the compounded growth ratios over a certain period to estimate the expected
earnings/figure for the coming year or cycle. i.e. compounded Annual Growth Rate (CAGR) for 5
or 10 years depending on the number of years in a cycle.
E.g. Centum Investment employs a cycle of 5 years, KQ uses 10 years etc. This enables a company to
be able to determine the maximum if not optimal return of an investment having had enough time to fully
utilize the investment amount especially if it is a capital intensive investment. The management is also
able to assess their strength in implementing its strategy.
It is often useful, however, to vary these assumptions in order to analyze their impact on financing
requirements, return of an investment, and so on.
Example (Target Corporation), if we assume increases in capital expenditures to 8.0% of sales, capital
expenditures will rise to $4.17bn in 2006F and $4.65bn in 2007F, and the cash balance will decline to
$584m in 2006F and a deficit of ($1,468) in 2007F, 1.68% of total assets and below the level of prior
years.
In that case, an external financing in the form of debt and/or equity will be required. This can be possible
if the company has indicated the possibility of raising additional capital through a rights issue, bonus or
debt. If not the analyst will be forced to squeeze his/her projections in line with the available funds the
same way the company is expecting to operate in the coming financial period with the limited funds.
Similar increases in financial requirements would also result in decrease in receivable or inventory turns.
Importance of Sensitive analysis

Sensitive analysis by preparing several projections is used to examine the best or worst case
scenarios in addition to the most likely case. It highlights which assumptions have the greatest
impact on financial results which in turn help to identify the areas that need more scrutiny.

Based on a build model (excel) an analyst can be able to adjust the assumptions e.g. inflation
rate, GDP growth when the actual figures are announced to reflect the accurate returns or fair
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price of a company to be used by investors in making investment decisions. Any material
information in the economy, industry or the company could change the projections.
References
1. Financial statement analysis by K.R. Subramanyam and John J. Wild
2. Cash flow forecasting by Andrew Fight
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