2024-09-01
Contents
Prospective analysis is the process of forecasting the future performance of a company.
Managers use prospective analysis to:
Investors and creditors forecast financial statements because it allows them to:
The forecast starts when the historical financial statements have been appropriately adjusted:
Limited objective: no every single line item in the financial statements is forecasted. Aggregation.
The projected income statement is the starting point of the prospective analysis.
Step 1.1 we need an estimation of the company’s expected sales growth rate:
Step 1.2, we need to estimate the company’s expected gross profit margin:
As a subproduct, we can calculate the company’s expected cost of sales (COGS) as a sales - gross profit (step 1.3)
Let’s jump to the example in MS Excel.
Step 1.4, we need to estimate the company’s expected selling, general, and administrative expenses (SG&A):
Problem: how to estimate the variable and fixed portions of SG&A?
Let’s jump to the example in MS Excel.
Step 1.5, we need to estimate the company’s expected depreciation and amortization (D&A):
Let’s jump to the example in MS Excel.
Step 1.6, we need to estimate the company’s expected interest expenses:
Step 1.7 we can calculate the company’s expected Income before tax as a sales - COGS - SG&A - D&A - interest expenses
Step 1.8, we need to estimate the company’s expected tax_expenses:
Step 1.9, we focus on special items and discontinued operations:
Step 1.10, we can calculate the company’s expected net income as a income before tax - tax expenses - extraordinary items - discontinued operations
Step 2.1, estimate the company’s expected accounts receivable:
\[\text{Accounts receivable turnover rate}=\frac{\text{Net (credit) Sales}}{\text{Accounts receivable balance}} \]
If credit sales information is not available, the norm is to use total net sales or revenues. If the rate is 12, it means that the company collects its accounts receivable 12 times a year. This rate is likely a industry characteristics rather than a firm’ decisiom. Potential problems: manipulation of allowances of bad debt expenses or changes in credit policies.
The forecast: \[\text{Forcasted accounts receivable} =\frac{\text{Forecasted Sales}}{\text{Accounts receivable turnover rate}} \]
Step 2.2, estimate the company’s expected inventories:
\[\text{Inventory turnover rate}=\frac{\text{COGS}}{\text{Ending inventory}} \]
If the rate is 2, it means that the company sells (and restock), on average, its inventory twice a year.
The forecast:
\[\text{Forcasted ending inventory} =\frac{\text{Forecasted COGS}}{\text{Inventory turnover rate}} \]
We can add more sophistication to the forecast when the firm discloses more information:
Step 2.4, estimate the company’s expected PPE:
PPE is estimated as the prior year’s gross PP&E balance + historical capital expenditures as a percentage of sales.
Historical capital expenditures are obtained from the statement of cash flows.
News on new investments in PP&E should be incorporated into the forecast.
Step 2.5, estimate expected accumulated depreciation:
Accumulated depreciation is estimated as the prior year’s accumulated depreciation balance + forecasted depreciation (step 1.5).
Step 2.6, estimate the company’s expected net PP&E:
Now we move to the liabilities and equity side of the balance sheet.
Step 2.8, estimate the company’s expected accounts payable:
\[\text{Accounts payable turnover rate}=\frac{\text{COGS}}{\text{Accounts payable balance}} \]
The forecast: \[\text{Forcasted accounts payable} =\frac{\text{Forecasted COGS}}{\text{Accounts payable turnover rate}} \]
Step 2.9, update the current portion of long-term debt using the latest financial statements (footnotes).
Step 2.10, estimate expected accrued expenses:
Step 2.11, estimate expected tax payable:
Step 2.13, estimate expected Long-term debt:
if there is no reason to expect changes in the company’s debt structure, we can assume that other long-term liabilities will be the same as the prior year’s balance minus the expected current portion of long-term debt (step 2.9).
if there are news on refinancing or new debt, we should incorporate this information into the forecast.
Step 2.16, estimate expected retained earnings: \[\text{F. retained earnings}=\text{Prior year’s retained earnings}+\text{F. net income}-\text{F. dividends}\]
Step 2.17, estimated expected cash:
How much does the company need to increase sales to meet EPS target?
Find the solution: MS Excel: Data>What-if-Analysis>Goal Seeker.
Let’s jump to the example in MS Excel.
How much must the company adjust its assumptions to meet the net income (or EPS) target?
Find the solution: MS Excel: File>Options>Add-in> Solver.
Is the net income (or EPS) very sensitive to minor variations in the assumptions?
Find the solution: MS Excel: Data>What-if-Analysis>Data Table.
Now we bunch assumptions together to create specific scenarios and ask:
What if the company’s assumptions are too optimistic or too pessimistic?
What if next year the economy is in a recession as in 2008?
What if we have a pandemic as in 2020? Or if we lose a major client?
We must tailor an MS sheet and assemble assumptions to create each scenario.
Questions?
Check my website for an updated version of this presentation:
https://www.marceloortizm.com/
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