Prospective Analysis.ppt
- 2. 9-2 Introduction • Prospective analysis is the final step in the financial statement analysis process. It can be undertaken only after the historical financial statements have been properly adjusted to accurately reflect the economic performance of the company. • Prospective analysis includes forecasting of the balance sheet, income statement and statement of cash flows.
- 3. 9-3 Security Valuation Examine viability of companies strategic plan Assess a companies ability to meet its debt services
- 4. 9-4 The importance of prospective analysis • Prospective analysis is central to security valuation. – Both the FCF and residual income valuation 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 current stock price. • Prospective analysis is also useful to examine the viability of companies’ strategic plans. – For this, we analyse whether a company will be able to generate sufficient CFs from operations to finance expected growth or whether it will be required to seek debt or equity financing in the future. – We are also interested in analysing whether current strategic plans will yield the benefits forecasted by company management. • Prospective analysis is useful to creditors to assess a company’s ability to meet its debt service requirements (solvency).
- 5. 9-5 Prospective Analysis Security Valuation - free cash flow and residual income models require estimates of future financial statements. Management Assessment - forecasts of financial performance examine the viability of companies’ strategic plans. Assessment of Solvency - useful to creditors to assess a company’s ability to meet debt service requirements, both short-term and long-term. Importance
- 6. 9-6 Financial forecast • 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, & CFs. • A financial forecast is based on the responsible party’s assumptions reflecting the conditions it expects to exist and the course of action it expects to take. • A financial forecast may be expressed in specific monetary amounts as a single point estimate of forecasted results or as a range, where the responsible party selects key assumptions to form a range within which it reasonably expects, to the best of its knowledge and belief, the item or items subject to the assumptions to actually fall.
- 7. 9-7 Financial projection • Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions, an entity’s expected financial position, results of operations, & CFs. • A financial projection is sometimes prepared to present one or more hypothetical courses of action for evaluation, as in response to a question such as, “What would happen if . . . ?” A financial projection is based on the responsible party’s assumptions reflecting conditions it expects would exist and the course of action it expects would be taken, given one or more hypothetical assumptions. • A projection, like a forecast, may contain a range.
- 8. 9-8 Cash Flow forecasting with Pro Forma Analysis • The reasonableness and feasibility of short-term cash forecasts are usefully checked by means of pro forma financial statements. • We accomplish this by using assumptions underlying cash forecasts to construct a pro forma income statement for the forecast period and a pro forma balance sheet for the end of the forecast period. • Financial ratios and other relations are derived from these pro forma financial statements and checked for feasibility against historical relations.
- 9. 9-9 The Projection Process Projected Income Statement Sales forecasts are a function of: 1) Historical trends 2) Expected level of macroeconomic activity 3) The competitive landscape 4) New versus old store mix (strategic initiatives)
- 10. 9-10 The Projection Process • Expected level of macroeconomic activity. – 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. 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 growth in the local economy. Our analysis must consider, therefore, expansion plans announced by management.
- 11. 9-11 The Projection Process Target Corporation Income Statements (in millions) 2005 2004 2003 Sales.......................................................................................... $46,839 $42,025 $37,410 Cost of goods sold ..................................................................... 31,445 28,389 25,498 Gross profit................................................................................ 15,394 13,636 11,912 Selling, general and administrative expense ............................. 10,534 9,379 8,134 Depreciation and amortization expense ..................................... 1,259 1,098 967 Interest expense......................................................................... 570 556 584 Income before tax ...................................................................... 3,031 2,603 2,227 Income tax expense.................................................................... 1,146 984 851 Income (loss) from extraordinary items and discontinued operations................................................. 1,313 190 247 Net income................................................................................. $ 3,198 $ 1,809 $ 1,623 Outstanding shares ................................................................... 891 912 910 Selected Ratios (in percent) Sales growth............................................................................ 11.455% 12.336% Gross profit margin.................................................................. 32.866 32.447 Selling, general and administrative expense/Sales ................. 22.49 22.318 Depreciation expense/Gross prior-year PP&E ........................... 6.333 5.245 Interest expense/Prior-year long-term debt .............................. 5.173 4.982 Income tax expense/Pretax income........................................... 37.809 37.803
- 12. 9-12 The Projection Process Steps: 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 Projected Income Statement
- 13. 9-13 The Projection Process Target Corporation Projected Income Statement 1. Sales: $52,204 = $46,839 x 1.11455 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 10. Net income: $2,185 = $3,513 - $1,328
- 14. 9-14 The Projection Process Target Corporation Projected Income Statement (in millions) Forecasting Step 2006 Estimate Income statement Total revenues......................................................................................... 1 $52,204 Cost of goods sold .................................................................................. 3 35,047 Gross profit............................................................................................. 2 17,157 Selling, general, and administrative expense ............................................ 4 11,741 Depreciation and amortization expense .................................................. 5 1,410 Interest expense...................................................................................... 6 493 Income before tax ................................................................................... 7 3,513 Income tax expense................................................................................. 8 1,328 Income (loss) from extraordinary items and discontinued operations ...... 9 0 Net income.............................................................................................. 10 $ 2,185 Outstanding shares ......................................................................... 891 Forecasting Assumptions (in percent) Sales growth........................................................................................... 1 11.455% Gross profit margin................................................................................. 1 32.866 Selling, general, and administrative expense/Sales ............................... 1 22.49 Depreciation expense/Gross prior-year PP&E .......................................... 1 6.333 Interest expense/Prior-year long-term debt............................................. 1 5.173 Income tax expense/Pretax income ......................................................... 1 37.809
- 15. 9-15 The Projection Process Steps: 1. Project current assets other than cash, using projected sales or cost of goods sold and appropriate turnover ratios as described below. 2. Project PP&E increases with capital expenditures estimate derived from historical trends or information obtained in the MD&A section of the annual report. 3. Project current liabilities other than debt, using projected sales or cost of goods sold and appropriate turnover ratios as described below 4. Obtain current maturities of long-term debt from the long-term debt footnote. 5. Assume other short-term indebtedness is unchanged from prior year balance unless they have exhibited noticeable trends. (continued) Projected Balance Sheet
- 16. 9-16 The Projection Process Steps: 6. Assume initial long-term debt balance is equal to the prior period long-term debt less current maturities from Step 4. 7. Assume other long-term obligations are equal to the prior year’s balance unless they have exhibited noticeable trends. 8. Assume initial estimate of common stock is equal to the prior year’s balance 9. Assume retained earnings are equal to the prior year’s balance plus (minus) net profit (loss) and less expected dividends. 10. Assume other equity accounts are equal to the prior year’s balance unless they have exhibited noticeable trends. Projected Balance Sheet
- 17. 9-17 The Projection Process Target Corporation Balance Sheet (in millions) 2005 2004 2003 Cash .................................................................................. $ 2,245 $ 708 $ 758 Receivables ....................................................................... 5,069 4,621 5,565 Inventories ......................................................................... 5,384 4,531 4,760 Other current assets .......................................................... 1,224 3,092 852 Total current assets....................................................... 13,922 12,952 11,935 Property, plant, and equipment (PP&E).............................. 22,272 19,880 20,936 Accumulated depreciation ................................................. 5,412 4,727 5,629 Net property, plant, and equipment ................................... 16,860 15,153 15,307 Other assets ...................................................................... 1,511 3,311 1,361 Total assets ....................................................................... $32,293 $31,416 $28,603 Accounts payable............................................................... $ 5,779 $ 4,956 $ 4,684 Current portion of long-term debt......................................504 863 975 Accrued expenses .............................................................. 1,633 1,288 1,545 Income taxes & other ......................................................... 304 1,207 319 Total current liabilities .................................................. 8,220 8,314 7,523 Deferred income taxes and other liabilities........................ 2,010 1,815 1,451 Long-term debt.................................................................. 9,034 10,155 10,186 Total liabilities .............................................................. 19,264 20,284 19,160 Common stock ...................................................................74 76 76 Additional paid-in capital.................................................. 1,810 1,530 1,256 Retained earnings ............................................................. 11,145 9,526 8,111 Shareholders’ equity...................................................... 13,029 11,132 9,443 Total liabilities and net worth ............................................ $32,293 $31,416 $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%
- 18. 9-18 The Projection Process Steps in Projection (Target) 1 Receivables: $5,650 = $52,204 (Sales)/9.24 (Receivable turnover). 2 Inventories: $6,001 = $35,047 (Cost of goods sold)/5.84 (Inventory turnover). 3 Other current assets: no change. 4 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). 5 Accumulated depreciation: $6,822 = $5,412 (Prior balance) + $1,410 (Depreciation estimate). 6 Net PP&E: $18,807 = $25,629 - $6,822. 7 Other long-term assets: no change. 8 Accounts payable: $6,441 = $35,047 (Cost of goods sold)/5.441 (Payable turnover). 9 Current portion of long-term debt: amount reported in long-term debt footnote as the current maturity for 2006. 10 Accrued expenses: $1,820 $52,204 (Sales)/28.683 (Accrued expense turnover). 11 Taxes payable: $352 = $1,328 (Tax expense) x 26.527% (Tax payable/Tax expense). 12 Deferred income taxes and other liabilities: no change. 13 Long-term debt: $8,283 = $9,034 (Prior year’s long-term debt) - $751 (Scheduled current maturities from step 9). 14 Common stock: no change. 15 Additional paid-in capital: no change. 16 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). 17 Cash: amount needed to balance total liabilities and equity less steps (1)–(7).
- 19. 9-19 The Projection Process Target Corporation Balance Sheet Forecasting 2006 2005 (in millions) Step Estimate Cash .......................................................................... 17 $ 1,402 $ 2,245 Receivables ............................................................... 1 5,650 5,069 Inventories................................................................. 2 6,001 5,384 Other current assets .................................................. 3 1,224 1,224 Total current assets ..................................... 14,277 13,922 Property, plant, and equipment.................................. 4 25,629 22,272 Accumulated depreciation ......................................... 5 6,822 5,412 Net property, plant, and equipment ........................... 6 18,807 16,860 Other assets .............................................................. 7 1,511 1,511 Total assets ................................................ $34,595 $32,293 Accounts payable....................................................... 8 $ 6,441 $ 5,779 Current portion of long-term debt.............................. 9 751 504 Accrued expenses ...................................................... 10 1,820 1,633 Income taxes & other ................................................. 11 352 304 Total current liabilities.................................... 9,364 8,220 Deferred income taxes and other liabilities................ 12 2,010 2,010 Long-term debt.......................................................... 13 8,283 9,034 Total liabilities ............................................. 19,657 19,264 Common stock ........................................................... 14 74 74 Additional paid-in capital.......................................... 15 1,810 1,810 Retained earnings ..................................................... 16 13,054 11,145 Shareholders’ equity ...................................... 14,938 13,029 Total liabilities and net worth......................... $34,595 $32,293 Selected Ratios Accounts receivable turnover rate.................... 9.240 9.240 Inventory turnover rate.................................... 5.840 5.840 Accounts payable turnover rate ....................... 5.441 5.441 Accrued expenses turnover rate ...................... 28.683 28.683 Taxes payable/Tax expense............................. 26.527% 26.527% Dividends per share......................................... $ 0.310 $ 0.310 Capital expenditures (CAPEX)—in millions......... 3,357 3,012 CAPEX/Sales ................................................. 6.431% 6.431%
- 20. 9-20 The Projection Process • 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. Projected Balance Sheet
- 21. 9-21 The Projection Process Target Corporation Projected Statement of Cash Flows
- 22. 9-22 The Projection Process Sensitivity Analysis • Vary projection assumptions to find those with the greatest effect on projected profits and cash flows • Examine the influential variables closely • Prepare expected, optimistic, and pessimistic scenarios to develop a range of possible outcomes
- 23. 9-23 Application of Prospective Analysis in the Residual Income Valuation Model The residual income valuation model defines equity value at time t as the sum of current book value and the present value of all future expected residual income: where BVt is book value at the end of period t, RIt + n is residual income in period t + n, and k is cost of capital. Residual income at time t is defined as comprehensive net income minus a charge on beginning book value, that is, RIt = NIt - (k x BVt - 1).
- 24. 9-24 Application of Prospective Analysis in the Residual Income Valuation Model In its simplest form, we can perform a valuation by projecting the following parameters: -Sales growth. -Net profit margin (Net income/Sales). -Net working capital turnover (Sales/Net WC). -Fixed-asset turnover (Sales/Fixed assets). -Financial leverage (Operating assets/Equity). -Cost of equity capital
- 25. 9-25 9-25
- 26. 9-26 Trends in Value Drivers The Residual Income valuation model defines residual income as: RIt = NIt – (k X BVt-1) = (ROEt – k) X BVt-1 Where ROE = NI/BVt-1 - Stock price is only impacted so long as ROE ≠ k - Shareholder value is created so long as ROE > k - ROE is a value driver as are its components - Net Profit Margin - Asset Turnover - Financial leverage Two relevant observations: - ROEs tend to revert to a long-run equilibrium. - The reversion is incomplete.
- 27. 9-27 Short-term forecasting • For analysis of short-term liquidity. • Short-term cash forecasting is of interest to internal users like managers and auditors in evaluating a company’s current and future operating activities. • It is also of interest to external users like short-term creditors who need to assess a company’s ability to repay short-term loans.
- 28. 9-28 Short-term forecasting • The accuracy of cash flow forecasting is inversely related to the forecast horizon—the longer the forecast period, the less reliable the forecasts. • This is due to the number and complexity of factors influencing cash inflows and outflows that cannot be reliably estimated in the long term. • Even in the case of short-term cash forecasting, the information required is substantial. Since cash flow forecasting often depends on publicly available information, our objective is “reasonably accurate” forecasts.
- 29. 9-29 Cash Flow (CF) Patterns • It is important for us to review the nature of CF patterns before examining models for CF analysis & projection. • Cash & cash equivalents are the most liquid of assets. – Mgmt. decisions to invest in assets or pay expenses require the use of cash. – Some users (like creditors) consider receivables & inventories part of liquid assets given their near-term conversion into cash. • Holding cash provides little or no return and, is exposed to purchasing power loss. – Mgmt. is responsible for the decisions to invest cash in assets or to immediately pay costs. – These cash conversions increase risk because the ultimate recovery of cash from these activities is less than certain.
- 30. 9-30 3-30 Cash Planning • General Format of a Cash Budget
- 34. 9-34 3-34 Cash budget (cash forecast)
- 35. 9-35 Cash inflows and outflows are interrelated • A failure of any aspect of the company’s business activities to successfully carry out its assigned task affects the entire cash flow system. – A lapse in sales affects the conversion of finished goods into receivables and cash, leading to a decline in cash availability. – restricting expenditures on items like advertising and marketing can slow the conversion of finished goods into receivables and cash. • Long-term restrictions in either cash outflows or inflows can lead to company insolvency.
- 36. 9-36 Interrelations between cash flows, accruals, and profits. • Sales is the driving source of operating flow. • When finished goods representing the accumulation of many costs and expenses are sold, the company’s profit margin produces an inflow of liquid funds through receivables and cash. • The higher the profit margin, the greater the growth of liquid funds. • Items like long-term instalment sales of land create noncurrent receivables limiting the relevance of accruals for cash flows. • Our analysis must appropriately use these measures in assessing cash flow patterns.
- 37. 9-37 Importance of forecasting sales • The reliability of our cash forecast depends on the quality of the sales forecast. • With few exceptions, such as funds from financing or funds used in investing activities, most cash flows relate to and depend on sales. • Our forecasting of sales includes an analysis of: 1. Directions and trends in sales. 2. Market share. 3. Industry and economic conditions. 4. Productive and financial capacity. 5. Competitive factors.
- 38. 9-38 Cash flow forecasting with pro forma analysis • The reasonableness and feasibility of short-term cash forecasts are usefully checked by means of pro forma financial statements. • We accomplish this by using assumptions underlying cash forecasts to construct a pro forma income statement for the forecast period and a pro forma balance sheet for the end of the forecast period. • Financial ratios and other relations are derived from these pro forma financial statements and checked for feasibility against historical relations. • These comparisons must recognize adjustments for factors expected to affect them during the cash forecast period.