Spring 2009 NBA 5060

Lectures 9 – Pro Forma Financial Statements & Forecasting II

1. Pro forma financial statements

2. Some Coaching Tips

3. A structured forecasting approach

• Step 1: Forecasting Sales
• Step 2: Forecasting the rest of the income statement
• Step 3: Forecasting the balance sheet
• Step 4: Computing the statement of cash flows and free
cash flows to equity
• Step 5: Terminal year assumptions
• Step 6: Economic reality checks and an iterative process

For next class: Read SBW, chapters 11, 12, and 13

Lecture 9 Page 1 of 10
Step 2. Forecast the rest of the income statement

2007 2008 Forecast as: Also Consider:

2351.6 2384.5 Total Revenues

Expenses
-744.3 -773.8 Cost of Goods Sold
-892.8 -909.5 Labor and Other Related Expenses
-138.7 -128.7 General and Administrative Expenses
-411.9 -422.3 Other Store Operating Expenses
0.0 0.0 Impairment and Store Closing Charges
-59.4 -57.4 Interest Expense
7.8 0.2 Interest Income
112.2 93.0 Earnings before Taxes
Taxes and Other Expenses
-39.0 -28.0 Provision for Income Tax
0.0 0.0 Earnings of Discontinued Operations
73.2 64.9 Net Income (Loss)

Additional considerations:

Cost of Goods Sold:

SGA:

Other operating expenses:

Lecture 9 Page 2 of 10
Step 3. Forecasting the Balance Sheet

Balance Sheet 2007 2008 Assumptions 2009 2010

Current Assets
Cash and Cash Equivalents 14.2 12.0 23.6 47.7
Accounts Receivables 11.8 13.5 14.2 14.3
Incomes Taxes Receivable 0.0 6.9 7.1 7.2
Inventories 144.4 156.0 159.2 164.7
Deferred Income Taxes 12.6 18.1 18.9 19.1
Prepaid Expenses 0.0 0.0 0.0 0.0
Prepaid Expenses 12.6 11.0 11.8 11.9
Property Held for Sale 4.7 3.2 0.0 0.0
Current Assets of Disc. Ops 0.0 0.0 0.0 0.0
Total Current Assets 200.3 220.6 234.7 264.9
Non Current Assets
PPE, net 1019.0 1045.2 1058.6 1077.7
Goodwill 0.0 0.0 0.0 0.0
Other Assets 45.8 47.8 47.2 47.7
Total Assets 1265.0 1313.7 1340.5 1390.4
Current Liabilities
Accounts Payable 93.1 93.1 94.4 83.5
Accrued Employee Benefits 34.9 34.2 42.5 38.2
Taxes W ithheld and Accrued 32.2 29.5 30.7 31.0
Other Accrued Expenses 18.3 17.9 16.5 16.7
Accrued Employees Comp. 48.6 46.2 47.2 47.7
Accrued Interest Expense 0.2 12.5 11.8 11.9
Current Maturities of L TD 8.2 8.7 8.7 8.7
Income Taxes Payable 18.1 0.0 0.0 0.0
Deferred Revenue 21.2 22.6 23.6 23.9
Current Liabilities of Disc. Ops 0.0 0.0 0.0 0.0
Total Current Liabilities 274.7 264.7 275.3 261.7
Non Current Liabilities
Long-term Debt 756.3 779.1 768.8 754.4
Deferred Income Taxes 62.4 54.3 59.0 59.7
Interest Rate Swap Liability 13.7 39.6 38.3 37.7
Other Long-term Obligations 53.8 83.2 82.6 83.5
Shareholders' Equity 104.1 92.8 116.6 193.3
Total Liabilities & Equity 1265.0 1313.7 1340.5 1390.4

General Procedure:

1. Forecast operating assets and liabilities (e.g., as turnovers)

2. Forecast intangible assets (amortize applicable amount)
3. Forecast non-operating assets and liabilities
4. Forecast long-term debt (e.g. as a percentage of projected total
assets)
5. Plug the shareholders equity to insure the statements balance
Lecture 9 Page 3 of 10
Steps in Forecasting a Balance Sheet

1. Forecasting operating assets and liabilities

• Working capital accounts (and usually PPE) are expected to

grow with the level of sales. Hence, forecast future turnover
levels for these accounts using historical turnover ratios as a
guide. Are recent turnover ratios likely to change?

2. Forecasting Intangible Assets

• These do not necessarily grow with sales. Thus, we often just

take the balance of intangibles and depreciate at the current
rate.
• This might vary depending on the company specifics.

3. Forecasting Other non-operating assets and liabilities

• Often these are not predictable and, hence, the best future
prediction is to leave these at the current level, or as a constant
percentage of sales.

4. Forecasting Long-term liabilities

• The projected amount of LTD will depend on the ‘optimal’

capital structure for the firm. A useful starting point is the
current capital structure. Consider a long-term capital structure
that matches industry averages.

5. Forecasting Shareholders Equity

• Equity will increase with net income and decrease with net
payments to equity holders (dividends and repurchases). For
simplicity, collapse equity into a single line-item. Alternatively,
you can plug debt.

Lecture 9 Page 4 of 10
Step 4. Compute the statement of cash flows and derive Free
Cash Flow to Equity

Given a beginning balance sheet, an ending balance sheet, and an

income statement for the period, we can compute the statement of
cash flows. See the supplemental notes for lecture 6 and chapter 3
from the text for information on how to do this.

Once the statement of cash flows is computed, we can calculate free

cash flow to equity. Free cash flow to equity is the cash flow available
to shareholders without hampering the firm’s operations and after
servicing the debt.

Three common ways to define FCFE:

1. FCFE = Net income – Increase in Common Equity

2. FCFE = Cash dividends + Net repurchases

3. FCFE = CFO – CFI – Net debt payments – Increase in cash +

Other financing cash flows

All three approaches will give you the same estimate of FCFE as
long as equity is the plug.

Lecture 9 Page 5 of 10
Step 4. Computing the SCF and FCFE (continued)

All items required for free cash flow are derived directly from the
forecast of the income statement and balance sheet. Simply derive
the statement of cash flows using techniques outlined in lecture 6 and
in the text.

Statement of Cash Flows 2009

Operating Activities
Net Income 48.7
Depreciation and Amortization 61.0
Change in working capital accounts 12.7
Operating Cash Flows 122.4

Investing Activities
Capital Expenditures -74.3
Goodwill 0.0
Investing Cash Flows -74.3

Financing Activities
Current Maturities of Long-term Debt 0.0
Long-term Debt -10.3
Interest Rate Swap Liability -1.3
Dividends -12.2
Repurchases of Common Stock -12.7
Financing Cash Flows -36.4

Change in Cash 11.6

Beginning Cash on Balance Sheet 12.0
Ending Cash per SCF 23.6
Ending Cash per Balance Sheet 23.6
Unreconciled Difference 0.0

Lecture 9 Page 6 of 10
Step 5. Computing Terminal Year

You should include one year past the forecasting horizon for your
terminal year. In the CBRL example, we forecast for 10 years (2009-
2018), and use 2019as the terminal year. This step is critical to keep
all relations constant with the immediately preceding year (i.e.
assume the firm has reached steady state).

This will ensure your valuations converge under the residual income
and discounted cash flow models.

Sales growth can be projected at the growth in GDP. We will come

back to this in the lectures on valuation.

Lecture 9 Page 7 of 10
Step 6. Check for economic consistency

After you have ensured the mathematical consistency of your

forecast (via balancing the balance sheet and reconciling the balance
sheet with the statement of cash flows), you should check for
economic consistency.

Check to see that near the end of the forecasting horizon, the ROA,
ROE, asset turnovers, and profit margins appear attainable and
plausible.

In particular, ROE at the end of the forecast horizon should be close

to the cost of equity capital.

Lecture 9 Page 8 of 10
Step 6. Check for economic consistency (cont’d)

Also, RONA at the end of the forecast horizon should be close to

weighted average cost of capital.

Why should ROE be close to the cost of equity capital? Why should RONA be
close to the weighted average cost of capital?

Lecture 9 Page 9 of 10
Reasonableness checks for CBRL
Profitability Analysis 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Terminal
2018
ROA Decomposition
ROE 13.5% 12.1% 16.9% 36.0% 65.9% 46.5% 32.5% 25.5% 22.0% 19.7% 18.4% 17.4% 16.6% 15.9% 15.4%
CSL 1.66 1.70 2.74 7.25 13.10 12.68 8.81 6.22 4.99 4.27 3.77 3.40 3.10 2.85 2.63
CEL 0.95 0.95 0.87 0.65 0.62 0.56 0.59 0.63 0.66 0.68 0.71 0.73 0.76 0.78 0.80
ROA 8.5% 7.5% 7.1% 7.6% 8.1% 6.6% 6.3% 6.5% 6.7% 6.8% 6.9% 7.0% 7.1% 7.2% 7.3%
PM 4.9% 5.1% 5.1% 4.8% 4.4% 3.7% 3.6% 3.7% 3.8% 3.9% 3.9% 3.9% 3.9% 3.9% 4.0%
ATO 1.72 1.48 1.38 1.60 1.85 1.78 1.75 1.76 1.76 1.75 1.76 1.78 1.80 1.82 1.84

RONA Decomposition
ROE 13.5% 12.1% 16.9% 36.0% 65.9% 46.5% 32.5% 25.5% 22.0% 19.7% 18.4% 17.4% 16.6% 15.9% 15.4%
Debt/Equity 0.22 0.23 0.97 4.14 7.88 7.48 4.97 3.31 2.51 2.01 1.66 1.39 1.17 0.99 0.83
Spread 8.6% 7.6% 7.2% 6.1% 6.8% 4.9% 4.7% 4.9% 5.0% 5.0% 5.2% 5.4% 5.6% 5.7% 5.9%
Eff. Interest Rate 2.9% 2.8% 2.7% 4.6% 5.2% 5.0% 4.6% 4.6% 4.6% 4.6% 4.6% 4.6% 4.6% 4.6% 4.6%
RONA 11.5% 10.4% 9.9% 10.7% 12.0% 9.9% 9.2% 9.4% 9.5% 9.6% 9.7% 9.9% 10.1% 10.3% 10.5%

Turnover Decomposition
FATO 2.21 1.88 2.02 2.35 2.31 2.24 2.23 2.28 2.30 2.33 2.37 2.41 2.45 2.49 2.54
ITO 17.14 15.39 16.37 17.25 15.88 14.97 14.74 14.82 14.82 14.76 14.71 14.66 14.61 14.57 14.57

Common Size Income Statement 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Terminal

Total Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of Goods Sold -33.0% -32.7% -31.8% -31.7% -32.4% -33.0% -32.9% -32.9% -32.8% -32.8% -32.7% -32.7% -32.6% -32.6% -32.5%
Labor and Other Related Expenses -37.0% -37.5% -37.5% -38.0% -38.1% -38.0% -38.0% -38.1% -38.1% -38.1% -38.2% -38.2% -38.2% -38.3% -38.3%
General and Administrative Expenses -5.3% -5.2% -5.8% -5.9% -5.4% -5.4% -5.4% -5.3% -5.3% -5.2% -5.2% -5.1% -5.1% -5.0% -5.0%
Other Store Operating Expenses -17.0% -16.9% -17.3% -17.5% -17.7% -18.4% -18.2% -18.1% -18.0% -18.0% -18.0% -18.0% -18.1% -18.1% -18.2%
Impairment and Store Closing Charges 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Interest Income 0.0% 0.0% 0.0% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1%
Earnings before Taxes 7.3% 7.3% 6.6% 4.8% 3.9% 2.9% 3.2% 3.6% 3.8% 4.1% 4.2% 4.4% 4.6% 4.7% 4.9%
Provision for Income Tax -2.6% -2.5% -2.1% -1.7% -1.2% -0.8% -1.1% -1.3% -1.3% -1.4% -1.5% -1.5% -1.6% -1.7% -1.7%
Earnings of Discontinued Operations 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Net Income (Loss) 4.9% 5.1% 5.1% 4.8% 4.4% 3.7% 3.6% 3.7% 3.8% 3.9% 3.9% 3.9% 3.9% 3.9% 4.0%

Lecture 9 Page 10 of 10