Chapter 10
Forecasting
Financial
Statements
Forecasting Financial Statements
Forecasting
Necessary step in process of valuation.
Six-step Framework.
Chapter: 10
Process “builds” pro forma financial statements
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General Forecasting Principles
• Produce reliable and realistic expectations.
• Unbiased and objective - neither conservative nor optimistic.
• Forecasts should not manifest wishful thinking.
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• 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.
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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.
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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.
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Chapter: 10
Seven-Step Forecasting Game Plan -
Practical tips
• Steps are integrated and interdependent, not necessarily
sequential or linear.
• Forecasts must ARTICULATE between the 3 financial
statements.
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• 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.
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FSAP to Prepare 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
Chapter: 10
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.
7
FSAP to Prepare Forecasted Financial
Statements (Contd.)
• The subsequent sections illustrate the seven-step forecasting
procedure using PepsiCo’s 2012 financial statements as a base.
• We analyze and use PepsiCo’s financial statement data for 2010
through 2012 to carefully develop forecast assumptions and to
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compute financial statement forecasts for PepsiCo for 2013
through 2017, which we label Year +1 through Year +5 to denote
that they are forecasts of activities we expect to occur one year
ahead through five years ahead.
• All financial statement amounts appear in millions. Spreadsheets
take all computations to multiple decimal places. Some minor
rounding differences will arise and make it appear as though
various totals disagree with the sum of the individual items that 8
make up the total.
Step 1: Projecting Sales and Other
Revenues
• Start with projecting revenues from the principal business
activities of the firm.
• Sales – determined by price AND sales volume.
• Consider firm and its industry conditions.
Chapter: 10
• Life cycle.
• Technological conditions.
• Business cycle.
• Economic-wide conditions.
• Inflation
• Exchange rates.
• Segments.
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• Other revenues
Step 1: Projecting Sales and Other
Revenues
• If firm’s historical revenue growth rate is reasonably steady and nothing
indicates that economic, industry, or firm-specific factors will change
significantly use historical growth rate.
Chapter: 10
• If the firm’s historical revenue growth rate has been affected by
changes in foreign exchange rates or by other factors : you
should adjust for these effects when making projections.
10
Step 1: Projecting Sales and Other
Revenues : Projecting Revenues for
PepsiCo
• Consumer foods industry in the United States is mature. Industry
revenues have grown at the growth rate for the general population,
approximately 2% per year.
• PepsiCo has generated a compounded rate of growth in net revenues
Chapter: 10
of 6.4% between 2010 and 2012.
• In PepsiCo’s 2012 Annual Report, it discloses information about
revenues and operating profits for each of PepsiCo’s six operating
divisions (segments), which it organizes into four business units,
grouped by product and geography.
• For each division, PepsiCo discloses overall revenue growth rates as
well as revenue growth rates attributable to volume, pricing, foreign
exchange rates, acquisitions and divestitures, and a 53rd week of 11
business in fiscal year 2011 (fiscal 2012 and 2010 only contained 52
weeks).
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12
Chapter: 10
13
Step 2: Projecting Operating Expenses
Fixed vs. Variable components
•If certain operating expenses vary directly with sales and if you
anticipate no changes in the relation between these expenses and sales,
you can project these future operating expenses using common-size
Chapter: 10
income statement percentages.
•You can project the future operating expense amounts by either
multiplying projected sales by the appropriate common-size percentage
or by projecting those operating expenses to grow at the same rate as
sales.
•If operating expenses do not change linearly with sales or may remain
relatively fixed even if sales decrease, then using the common-size
income statement approach can result in operating expense projections
14
that are too high or too low.
Step 2: Projecting Operating Expenses
Fixed vs. Variable components
•Many expenses have both a fixed portion and a portion that varies
with sales
•When sales grow at faster rates than costs of goods sold or selling,
Chapter: 10
general, and administrative expenses, it often indicates the presence of
fixed costs.
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Step 2: Projecting Operating Expenses
• Projecting Cost of Goods Sold. The common-size income
statement data indicate that PepsiCo’s cost of goods sold as a
percent of sales has steadily increased from 45.9% in 2010 to
47.8% in 2012. Given this analysis, we predict that PepsiCo’s
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cost of goods sold will increase gradually from 47.9% of sales
in Year +1 to 48.3% in Year +5 and beyond.
Actuals Forecasts
Year 2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5
INCOME STATEMENT
Revenues 57,838 66,504 65,492 68,198 71,044 74,038 78,672 80,504
common size 100.0% 100.0% 100.0% 4.1% 4.2% 4.2% 6.3% 2.3%
rate of change 15.0% -1.5%
<Cost of goods sold> -26,575 -31,593 -31,291 -32,667 -34,101 -35,612 -37,920 -38,883
common size -45.9% -47.5% -47.8% -47.9% -48.0% -48.1% -48.2% -48.3%
rate of change 18.9% -1.0%
Gross Profit 31,263 34,911 34,201 35,531 36,943 38,426 40,752 41,621 16
common size 54.1% 52.5% 52.2% 52.1% 52.0% 51.9% 51.8% 51.7%
rate of change 11.7% -2.0% 3.9% 4.0% 4.0% 6.1% 2.1%
Step 2: Projecting Operating Expenses
(Contd.)
Projecting Selling, General, and Administrative expenses.
•PepsiCo’s SG&A expenses varied from 39.4% of revenues in
2010, down to 37.8% in 2011, and then up to 38.1% in 2012.9 I
•It is likely that PepsiCo will continue to experience minor
Chapter: 10
variations in SG&A expenses as a percentage of revenues, and
therefore we project SG&A expenses will be on average roughly
38.1% of revenues in the future.
Actuals Forecasts
Year 2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5
<Selling, general and administrative expenses> -22,814 -25,145 -24,970 -25,984 -27,068 -28,208 -29,974 -30,672
common size -39.4% -37.8% -38.1% -38.1% -38.1% -38.1% -38.1% -38.1%
rate of change 10.2% -0.7%
• If you expect these individual expense items to be driven by factors other than
sales growth, or if you expect the proportionate composition of these expenses 17
to change relative to future sales, then you should project the items
individually and sum them to obtain total SG&A expense projections.
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Cash and Cash Equivalents
•During 2011, PepsiCo had average cash balances were roughly
27.5 days and 28.9 days of sales, respectively (computed as 365
days divided by the ratio of revenues to the average balance in
Chapter: 10
cash; in 2012, 28.9 days = 365/{$65,492/[($4,067 + $6,297)/2]}.
•We assume that PepsiCo will maintain ending cash balances
equivalent to 28 days of sales in the future..
Actuals Forecasts
2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5
BALANCE SHEET
ASSETS:
Cash and cash equivalents 5,943 4,067 6,297 5,232 5,450 5,680 6,035 6,176
common size 8.7% 5.6% 8.4% 28.0 28.0 28.0 28.0 28.0
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rate of change -31.6% 54.8% Assume ending cash balances equal to 28 days sales.
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Marketable Securities
•During 2010 through 2012, PepsiCo’s marketable securities
balances have been trending steadily down. It appears PepsiCo
primarily manages its liquidity through its fairly large cash
Chapter: 10
balances rather than through its very small amounts of
marketable securities.
•We assume that PepsiCo assume ending marketable securities
balances will shrink by 9% per year.
Actuals Forecasts
2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5
BALANCE SHEET
Marketable securities 426 358 322 293 267 243 221 201
common size 0.6% 0.5% 0.4% -9% -9% -9% -9% -9%
Assume 9 percent decline, consistent with trend since 2010.
rate of change -16.0% -10.1% 19
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Accounts Receivable
PepsiCo’s accounts receivable turnover ratios (Chapter 4)
revealed that PepsiCo’s collection period has grown over the
last three years, from an average of 35 days during 2010, to 36
Chapter: 10
days in 2011, and 39 days in 2012. We project accounts
receivable by assuming that PepsiCo will maintain an average
39-day collection period into the Future.
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Accounts Receivable
Chapter: 10
Actuals Forecasts
2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5
BALANCE SHEET
Accounts and notes receivable—net 6,323 6,912 7,041 7,287 7,591 7,911 8,406 8,602
common size 9.3% 9.5% 9.4% 39.0 39.0 39.0 39.0 39.0
Assume ending accounts receivable equals 39 days sales..
rate of change 9.3% 9.5% 9.4%
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Inventories
PepsiCo’s inventory turnover ratios (Chapter 4) revealed that
PepsiCo’s collection period has experienced gradually longer
inventory turnover rates of 41 days in 2010, 42 days in 2011,
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and 43 days in 2012. we project PepsiCo’s inventory turnover
days continue to gradually increase, reaching 46 days by Year +5
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Inventory
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Actuals Forecasts
2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5
BALANCE SHEET
Inventories 3,372 3,827 3,581 3,938 4,158 4,391 4,727 4,900
common size 4.9% 5.3% 4.8% 44.0 44.5 45.0 45.5 46.0
Assume continued increase in ending inventory, consistent with
rate of change 13.5% -6.4% recent trend.
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets represent items
such as prepaid rent, advertising, and insurance. These items
often vary in relation to the level of operating activity, such as
Chapter: 10
sales, advertising, production, new stores or restaurants, and
total assets. In the case of PepsiCo, we will simply assume
prepaid expenses and other current assets will grow in the
future at the same rate as revenues.
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Investments in Noncontrolled Affiliates
•These investments grew at a rate of 8.0% in 2011 and 10.6% in
2012.
•We assume that investments in noncontrolled affiliates will
Chapter: 10
continue to grow 8.0% per year over the five-year forecast
horizon.
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Property, Plant, and Equipment
• PepsiCo’s fixed-assets turnover ratio has declined a bit from 3.6
in 2010 to 3.4 in 2012 (computed for 2012 as 3.4=
$65,492/[($19,136 + $19,698)/2]). This indicates PepsiCo is not
utilizing its fixed assets as efficiently as it had in the past.
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•In the 2012 Annual Report, PepsiCo’s MD&A discloses that
management expects 2013 net capital spending to be
approximately $3.0 billion, within its long-term capital spending
target of less than or equal to 5% of net revenue.
•Given this guidance, we assume that net capital spending in Year
+1 will be $3.0 billion, which amounts to 4.4% of projected
revenues of $68,198 million. Given PepsiCo’s guidance and stable
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history of capital spending, we also assume that capital spending
in Year +2 and beyond will average 4.8% of revenues.
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Property, Plant, and Equipment
Chapter: 10
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting depreciation expense
Chapter: 10
Like most firms, PepsiCo does not report depreciation expense as a separate line
item on the income statement, but it allocates depreciation expense to cost of
goods sold and SG&A expense based on whether the underlying assets are being
used in production or sales and administration. 28
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Chapter: 10
29
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Goodwill and Nonamortizable Intangible Assets
•In 2011, PepsiCo increased the goodwill and nonamortizable
intangible assets accounts (primarily because it acquired WBD, a
Russian subsidiary).
Chapter: 10
• In 2012, PepsiCo increased those accounts by an additional net
amount (foreign currency translation gains). In the absence of
inside information, it is very difficult to forecast specific
acquisitions.
•Thus, we assume that PepsiCo’s goodwill and nonamortizable
intangible assets will grow at the same rate as sales. We will also
assume that no future impairment charges will be necessary for
these assets. 30
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Goodwill and Nonamortizable Intangible Assets
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Other Noncurrent Assets
•In the absence of inside information, it is very difficult to forecast
specific acquisitions.
•Thus, we assume that PepsiCo’s goodwill and nonamortizable
intangible assets will grow at the same rate as sales. We will also
Chapter: 10
assume that no future impairment charges will be necessary for
these assets.
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Accounts Payable
PepsiCo’s days payable was 45 days in 2010 and 2011, but it
jumped to 50 days in 2012. We assume that PepsiCo will continue
to maintain an accounts payable period of 50 days in the future.
Chapter: 10
33
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Other Current Accrued Liabilities
We therefore forecast that other current accrued liabilities will
grow with SG&A expenses, which grow with revenues (allow for
rounding).
Chapter: 10
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Current Liabilities: Income Taxes Payable
Income taxes payable varies with the income tax provision on the
income statement, but income taxes payable also varies with tax
payments, settlements of tax disputes, mergers and acquisitions,
changes in deferred tax assets and liabilities, and other elements
Chapter: 10
that are difficult to predict with confidence.
•PepsiCo’s income taxes payable has varied within a narrow range
between 0.1% and 0.5% of total assets over 2010–2012.
•We simply assume that PepsiCo’s income taxes payable will
average 0.5% of total assets in the future. The projected amounts
are as follows:
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Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Current Liabilities: Income Taxes Payable
Chapter: 10
36
Step 3: Projecting Operating Assets and
Liabilities on the Balance Sheet
Projecting Other Noncurrent Liabilities
• Includes liabilities for expenses that relate to pension obligations, health
care obligations, long-term compensation, and other operating and
administrative activities.
• We therefore project other noncurrent liabilities will grow with SG&A
Chapter: 10
expenses, which we assume grow with revenues (allow for rounding):
37
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Project Financial assets
Most firms use financial assets, such as cash, short-term and long
term investment securities, to accomplish one or all of the following:
• manage seasonal swings in operating liquidity.
Chapter: 10
•provide a financial cushion for future uncertainties.
•have financial flexibility to take advantage of profitable
opportunities when they arise.
38
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Project Financial assets
• We assume that PepsiCo will continue to increase short-term
and long-term debt obligations, which will become larger
proportions of total assets, consistent with this recent trend.
Chapter: 10
• We project that short-term and long-term debt will grow at rates
that are 1% faster than the projected growth rates in total assets
(derived from our projected amounts for total assets) in Year +1
through Year +5
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Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Project Financial assets
• Excess cash and/or short-term or long-term investments that are
not needed for operating liquidity purposes, and are instead
intended for future financial purposes, such as debt retirement,
Chapter: 10
corporate acquisitions, repurchasing shares, or paying dividends.
• The cash and securities in the sinking fund would represent
financial assets intended for debt retirement and should be
projected with the firm’s financial structure rather than as part of
the firm’s operating activities.
• Because PepsiCo is not likely to need future reserves of
investment securities for debt retirement, we will not forecast
them. 40
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Short-Term and Long-Term Debt
• PepsiCo appears to be issuing greater amounts of long-term debt
• In 2012 PepsiCo issued seven new debt issues with maturities
ranging from 2015 to 2042.
Chapter: 10
• We assume that PepsiCo will continue to increase short-term and
long-term debt obligations, which will become larger proportions
of total assets, consistent with this recent trend.
• We project that short-term and long-term debt will grow at rates
1% faster than the projected growth rates in total assets.
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Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Short-Term and Long-Term Debt
Chapter: 10
42
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Interest Expense
•We may use data disclosed in PepsiCo’s Note 9 to estimate the
weighted-average interest rate on total debt outstanding. We
therefore project interest expense using an interest rate of 3.65% on
the average amount of interest-bearing debt.
Chapter: 10
43
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Interest Expense
Chapter: 10
44
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Noncontrolling Interests
• Noncontrolling interests therefore account for the equity
ownership of minority investors that own less than 50% of the
shares of the subsidiary company
• At the end of 2012, PepsiCo has $105 million of equity
Chapter: 10
capital from noncontrolling interest shareholders. These
investors own significant but not controlling proportions of
the equity in certain subsidiaries which PepsiCo controls
and consolidates
45
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Noncontrolling Interests
• in 2012, the net income attributable to noncontrolling interests
amounted to $36 million, or roughly an 18% return on the average
amount invested, whereas in 2011 the return was only about 6%.
• For simplicity, we assume these investors receive a 10% return on
Chapter: 10
their investments ($10.5 million on $105 million invested), and all
of this income will be distributed to them each year by the
subsidiary companies.
Net Income 6,338 6,462 6,214 6,168 6,387 6,609 6,983 7,075
Net income attributable to
noncontrolling interests -18 -19 -36 -10.5 -10.5 -10.5 -10.5 -10.5
Net Income attributable to 46
common shareholders 6,320 6,443 6,178 6,158 6,377 6,598 6,972 7,064
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Common Stock and Capital in Excess of Par Value
• The common-sized balance sheet data show that PepsiCo’s paid-
in capital accounts jumped from 0.7% of total assets at the end
of 2009 to 6.7% at the end of 2010. That percentage has
declined a bit since then, to 6.2% at the end of 2011, and 5.6%
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at the end of 2012.
• Given that PepsiCo has shifted its capital strategy to increase the
proportion of long-term debt, we do not expect significant future
issues of common equity.
• We therefore simply project common stock and capital in excess
of par value to grow with total assets, remaining at 5.6% of total
assets
47
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Common Stock and Capital in Excess of Par Value
Chapter: 10
48
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Treasury Stock
•PepsiCo’s MD&A disclosures reveal that the firm projects
that it expects to make treasury stock purchases of
Chapter: 10
approximately $3.0 billion in 2013 (Year +1). We project that
PepsiCo’s treasury stock repurchases, net of treasury stock
issued for stock compensation plans, will amount to $3.0
billion during Year +1 and will continue at this level through
Year +5. 49
Step 4: Project Financial Assets, Financial
Leverage, Common Equity Capital and Financial
Income Items.
Projecting Treasury Stock
Chapter: 10
50
Step 5: Project Dividends and Retained
Earnings.
• In general, retained earnings typically increases by the
amount of net income and decreases for dividends declared
and net losses.
• From 2010 to 2012, PepsiCo’s dividend payout rates have
increased from 47.0% to 48.9% to 53.2% of net income,
respectively.
Chapter: 10
• In the 2012 annual report, PepsiCo discloses that PepsiCo’s
board of directors approved a 5.6% increase in dividend
payouts, to $2.27 per share in 2013.
• Relying on that disclosure, we project that PepsiCo’s dividend
payout policy will average 55% of net income from
continuing operations.
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Step 5: Project Dividends and Retained
Earnings.
Chapter: 10
52
Step 6: Balancing the Balance Sheet
• the balance sheet does not balance because we have projected
individual asset and liability accounts to capture their underlying
business activities, which are not perfectly correlated.
• The difference between the initial projected total assets and the
Chapter: 10
projected total liabilities and shareholders’ equity each year
represents the amount by which we must adjust a ‘‘flexible’’
financial account to balance the balance sheet
53
Step 6: Balancing the Balance Sheet
Chapter: 10
54
Step 6: Balancing the Balance Sheet
We could use a number of flexible financial accounts for this
adjustment each year, depending on PepsiCo’s strategy for
investments and capital structure. Consider the following options:
•Increase marketable securities, assuming PepsiCo will retain
excess capital in marketable securities for financial flexibility.
Chapter: 10
•Reduce short-term or long-term debt, assuming PepsiCo will use
its financial flexibility to reduce leverage.
• Reduce retained earnings by increasing projected dividends.
•Reduce the treasury stock account by increasing treasury stock
repurchases
55
Step 6: Balancing the Balance Sheet
Projecting Treasury Stock
•Given this disclosure and the fact that PepsiCo has clearly
demonstrated its willingness and ability to pay out increasing
amounts of capital to shareholders through dividends and share
repurchases, we adjust share repurchases as the flexible financial
Chapter: 10
account. We will have the same effect on total assets, total
liabilities, total shareholders’ equity, and net income.
•Therefore, in Year +1,we will increase the share
repurchase forecast by $150 million, the amount necessary
to balance the balance sheet.
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Step 6: Balancing the Balance Sheet
Chapter: 10
57
Step 6: Balancing the Balance Sheet
Chapter: 10
58
