DAC 511 CORPORATE FINANCIAL REPORTING & ANALYSIS

GROUP 7 PRESENTATION

Prospective Analysis

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Prospective analysis is the forecasting of the future financial information.

Two commonly used techniques for prospective analysis

are: Financial Statement forecasting

Valuation

Prospective analysis is central to security valuation where

both free cash flow and residual income models require

estimates of future financial statements.

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What are prospective financial statements?◦ Prospective financial statements encompass:

Financial forecasts and Financial projections

Two broad stages of financial prospective analysis

Long term forecasting : This involves the analysis of past data and forecasting of financial statements.

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.

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Security valuation:- Residual income model requires estimates of future financial statements

Management and assessment:- To examine

viability of companies’ strategic plans.

Assessment of solvency:- Ability to meet company’s debt obligations

Prediction of future performance

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Procedure:

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

5. Obtain a client representation letter in order to confirm that

the responsible party acknowledges its responsibility for the

prospective statements

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◦ Step1:- examine inherent and control risk

◦ Step2:- consider the sufficiency of internal and external sources

of information supporting the underlying assumptions

◦ step3:- Determine the consistency of the assumptions

◦ Step4:- Determine the reliability and consistency of the

historical financial information used

◦ Step5:- Evaluate the preparation and presentation of the

prospective financial statements

◦ Step6:- 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 financial statements must begin with

projecting the Income Statement

and projecting an Income Statement begins by

estimating sales.

The sales estimate can be tested for plausibility in four

different contexts :

◦ Past sales trends

◦ Market share implied by the sales estimate

◦ Its relation to planned marketing efforts

◦ Production capacity

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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)

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Cost of Goods Sold (CoGS) is all costs which can be directly

linked to sales.

Always projected as percentage of sales.

the percentage CoGS assumption can be affected by a variety

of factors, both external and internal to the company.

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

production efficiencies may decrease this percentage through

lowering costs.

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Operating expenses are those expenses which are not directly linked to sales.

Are projected on item by item basis

Projecting Depreciation and Interest expenses◦ Projecting Depreciation and Interest expense requires a

look ahead to the projected balance sheet

◦ Past interest expense will be analyzed as a percentage of past debt balances, and the trend extended into the future.

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1. Project sales

2. Project cost of goods sold and gross profit margins using historical averages

as a percent of sales

3. Project operating 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

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Figures 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 8,134

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 discounted operations 1,313 190 247

Net income 3,198 1,809 1,623

Outstanding shares 891 912 910

Selected rations 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

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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- Selling, general, and administrative: $11,741 = $52,204 x 22.49% $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

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Income statement in millions Forecasting steps

2006 Estimates

Total revenues $52,204

Cost of goods sold 35,047

Gross profit 17,157

Selling, general, and administrative expense 11,741

Depreciation and amortization expense 1,410

Interest expense 493

Income before tax 3,513

Income tax expense 1,328

Income (loss) from extraordinary items and discontinued operations

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Net income $ 2,185

Outstanding shares 891

Forecasting Assumptions (in percent)

Sales growth 11.455%

Gross profit margin 32.86615

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.

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(in millions) 2005 2004 2003Cash ..................................................................................$ 2,245 $ 708 $ 758Receivables .......................................................................5,069 4,621 5,565Inventories .........................................................................5,384 4,531 4,760Other current assets ..........................................................1,224 3,092 852Total current assets.......................................................13,922 12,952 11,935Property, plant, and equipment (PP&E)..............................22,272 19,880 20,936Accumulated depreciation .................................................5,412 4,727 5,629Net property, plant, and equipment ...................................16,860 15,153 15,307Other assets ......................................................................1,511 3,311 1,361Total assets .......................................................................$32,293 $31,416 $28,603

Accounts payable...............................................................$ 5,779 $ 4,956 $ 4,684Current portion of long-term debt......................................504 863 975Accrued expenses ..............................................................1,633 1,288 1,545Income taxes & other .........................................................304 1,207 319Total current liabilities .................................................. 8,220 8,314 7,523Deferred income taxes and other liabilities........................2,010 1,815 1,451Long-term debt..................................................................9,034 10,155 10,186Total liabilities ..............................................................19,264 20,284 19,160Common stock ...................................................................74 76 76Additional paid-in capital..................................................1,810 1,530 1,256Retained earnings .............................................................11,145 9,526 8,111Shareholders’ equity......................................................13,029 11,132 9,443Total liabilities and net worth ............................................$32,293 $31,416 $28,603

Selected RatiosAccounts receivable turnover rate....................................9.240 9.094 6.722Inventory turnover rate.....................................................5.840 6.266 5.357Accounts payable turnover rate .......................................5.441 5.728 5.444Accrued expenses turnover rate .......................................28.683 32.628 24.214Taxes payable/Tax expense...............................................26.527% 122.663% 37.485%Dividends per share .........................................................$ 0.310 $ 0.260 $ 0.240Capital expenditures (CAPEX)—in millions ......................3,012 2,671 3,189CAPEX/Sales ....................................................................6.431% 6.356% 8.524% 17

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 891million shares).

17 Cash: amount needed to balance total liabilities and equity less steps (1)–(7).

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Forecasting 2006 2005(in millions) Step EstimateCash .......................................................................... 17 $ 1,402 $ 2,245Receivables ............................................................... 1 5,650 5,069Inventories................................................................. 2 6,001 5,384Other current assets .................................................. 3 1,224 1,224 Total current assets ..................................... 14,277 13,922Property, plant, and equipment.................................. 4 25,629 22,272Accumulated depreciation ......................................... 5 6,822 5,412Net property, plant, and equipment ........................... 6 18,807 16,860Other assets .............................................................. 7 1,511 1,511 Total assets ................................................ $34,595 $32,293Accounts payable....................................................... 8 $ 6,441 $ 5,779Current portion of long-term debt.............................. 9 751 504Accrued expenses ...................................................... 10 1,820 1,633Income taxes & other ................................................. 11 352 304 Total current liabilities.................................... 9,364 8,220Deferred income taxes and other liabilities................ 12 2,010 2,010Long-term debt.......................................................... 13 8,283 9,034 Total liabilities ............................................. 19,657 19,264Common stock ........................................................... 14 74 74Additional paid-in capital.......................................... 15 1,810 1,810Retained earnings ..................................................... 16 13,054 11,145Shareholders’ equity ...................................... 14,938 13,029 Total liabilities and net worth......................... $34,595 $32,293

Selected RatiosAccounts receivable turnover rate.................... 9.240 9.240Inventory turnover rate.................................... 5.840 5.840Accounts payable turnover rate ....................... 5.441 5.441Accrued expenses turnover rate ...................... 28.683 28.683Taxes payable/Tax expense............................. 26.527% 26.527%Dividends per share......................................... $ 0.310 $ 0.310Capital expenditures (CAPEX)—in millions......... 3,357 3,012CAPEX/Sales ................................................. 6.431% 6.431%

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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

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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 (see Chapter 1). 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).

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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

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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.

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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

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Therefore, the model is useful when;

A company does not pay dividends or dividends are not

predictable

FCF is negative over a comfortable forecast horizon

There is great uncertainty in estimating terminal values Not useful when;

1. There are significant departures from clean surplus accounting. E.g

Gains on marketable securities are reflected in stockholder’s equity as “comprehensive income” rather than as income on the income statement

Wide use of employee stock options Foreign currency translations

2. Determinants of residual income (e.g., book value and ROE) are not predictable

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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.

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Reversion of ROE

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Reversion of Net Profit Margin

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Reversion of Total Asset Turnover

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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

cash flow statement shows aspects of liquidity of a firm

The Cash Flow Projection shows the cash that is anticipated

to be generated over a chosen period of time in the future.

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Uses of projection of cash flows are that it

enables us to determine the

◦ Credit worthiness of a company

◦ Loan structuring

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

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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 32

4. 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

5. 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

6. Finally add (deduct) the net change in cash from the beginning balance

to determine the projected ending balance.

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THANK YOU

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