Reading: Financial Projections

The recommened procedure to make financial projections is to focus on one or two primary drivers of the firm's business activity. 

In most industries, sales are the main driving force and many of the firm's activities (e.g., number of emplyees, purchase of material, marketing activities, etc.) depend more or less directly on sales. This also has implications for the firm's financial statements, as we would expect that many of the items in these statements are a function of sales.

In the income statement, for example, it is often fairly safe to assume that the Costs of sales are related to the amount of sales and that also SG&A as well as other operating expenses depend on sales. Also the operating assets (f. ex. Inventory and Accounts receivable) and liabilities (f. ex. Accounts payable) would often seem to be a function of sales.

 

Therefore, the suggested procedure is as follows:

1. Project sales (f. ex. based on analyst forecasts and industry reports)
2. Using financial analysis, investigate how other financial items are related to sales and whether it is reasonable to assume that these items are a function of sales.
3. Make explicit projections for items that are not related to sales.
4. and then relate many other financial items to sales. This is the so-called percentage-of-sales method.

 

Because sales play such a dominant role in this procedure, it is also called the "percentage-of-sales method."

 

Let's implement this forecasting approach on our hypothetical firm "X."

 

 

Let's also assume that our financial analysis reveals that many of the other financial items reflect a percentage of sales. The following table summarizes the assumptions we make for our projections.

  

Income statement	Assumption	Explanation
Net revenues	Explicit forecast	See above
Costs of sales (excluding d&a)	44% of net revenues	Historical value
Depreciation and amortization	19% of long-term assets at year end	Historical value
SG&A expenses	11% of net revenues	Historical value
Other operating expenses	Constant at 1'000
Interest expenses	5% of financial liabilities as year start	Historical value
Income taxes	20% of taxable income	Historical value
Assets
Excess cash	Constant at 200	All additional excess cash is paid out
Operating assets	29% of net revenues	Historical value
Long-term assets	Increase by 500 each year	Assumption
Liabilities and shareholder's equity
Operating liabilities	16% of net revenues	Historical value
Financial liabilities	Decrease by 1'000 each year	Assumption
Share capital	Constant	Assumption
Retained earnings	Set dividend such that all excess cash is paid out to shareholders

 

With this information, we are ready to make the projections for the next 2 years. Let's do this step by step.

Based on our estimates of net revenues, we can project all the items which are a percentage of net revenues, according to our assumptions from the above table: Cost of sales, SG&A expenses, Operating assets, and Operating liabilities. For example, the expected costs of sales in Year 2 are 44% of net revenues of 19'800:

 

We proceed accordingly for all other items which are directly related to net revenues. Moreover, the table provides us with some explicit forecasts of various other financial items. Several of these items (Other operating expenses, Excess cash, Share capital) are expected to remain constant over time whereas other items (Long-term assets and Financial liabilities) are expected to experience constant changes over time. The following table summarizes our projections so far. For comparison, we also report the numbers for Year 1, the current business year:

  

Income statement	Year 1	Year 2	Year 3
Net revenues (sales)	18'000	19'800	20'790
- Costs of sales (excluding D&A)	8'000	8'712	9'148
- Depreciation and amortization	3'000
Gross income	7'000
- SG&A expenses	2'000	2'178	2'287
- Other operating expenses	1'000	1'000	1'000
EBIT	4'000
- Interest expenses	500
Earnings before taxes (EBT)	3'500
- Income taxes	700
Net income	2'800
Assets	Year 1	Year 2	Year 3
Excess cash	200	200	200
Operating assets	5'300	5'742	6'029
Long-term assets	16'000	16'500	17'000
Total assets	21'500	22'442	23'229
Liabilities and shareholder's equity	Year 1	Year 2	Year 3
Operating liabilities	2'900	3'168	3'326
Financial liabilities	9'000	8'000	7'000
Share capital	100	100	100
Retained earnings	9'500
Total liabilities & equity	21'500

 

As we can see from the table, the only balance sheet item which is still missing is Retained earnings. Because the balance sheet has to remain in balance, we can derive the expected Retained earnings of Year 2 and Year 3 such that Total liabilities & equity equal Total assets. For example in Year 2, expected Total assets are 22'442. If we set expected Retained earnings equal to 11'174, the balance sheet will be in balance:

 

Similarly, Retained earnings of 12'803 will keep the proforma balance sheet of year 3 in balance.

 

We also have sufficient information for the remaining projections of the income statement:

• Depreciation and amortization: Equal 19% of Long-term assets according to our assumptions. We know from the previous table that expected Long-term assets are 16'500 and 17'000, respectively. Therefore, expected depreciation and amortization charges are 3'135 [= 0.19×16'500] and 3'230 [= 0.19×17'000], respectively.

• Interest expenses: Equal 5% of Financial liabilities at the beginning of the year. At the beginning of Year 2, Financial liabilities are 9'000, which implies interest expenses of 450 [= 0.05×9'000] for Year 2. Similarly, at the beginning of Year 3, Financial liabilities are 8'000, which implies interest expenses of 400 [= 0.05×8'000] for Year 3.

• Income taxes: Once we have projecte Depreciation and amortization as well as Interest expenses, we have all the relevant information to determine the firm's expected Earnings before taxes. As the following table shows, the expected pretax income of Year 2 and 3 is 4'325 and 4'726, respectively. Based on our assumptions, Income taxes equal 20% of Earnings before taxes.  Therefore, expected income taxes are 865 [= 0.2×4'325] and 945 [= 0.2×4'726], respectively.

 

With these steps, we have completed our projections of the balance sheets and income statements of firm X:

 

Income statement	Year 1	Year 2	Year 3
Net revenues (sales)	18'000	19'800	20'790
- Costs of sales (excluding D&A)	8'000	8'712	9'148
- Depreciation and amortization	3'000	3'135	3'230
Gross income	7'000	7'953	8'412
- SG&A expenses	2'000	2'178	2'287
- Other operating expenses	1'000	1'000	1'000
Earnings before interest and taxes (EBIT)	4'000	4'775	5'126
- Interest expenses	500	450	400
Earnings before taxes (EBT)	3'500	4'325	4'726
- Income taxes	700	865	945
Net income	2'800	3'460	3'780
Assets	Year 1	Year 2	Year 3
Cash	200	200	200
Operating assets	5'300	5'742	6'029
Long-term assets	16'000	16'500	17'000
Total assets	21'500	22'442	23'229
Liabilities and shareholder's equity	Year 1	Year 2	Year 3
Operating liabilities	2'900	3'168	3'326
Financial liabilities	9'000	8'000	7'000
Share capital	100	100	100
Retained earnings	9'500	11'174	12'803
Total liabilities & equity	21'500	22'442	23'229

 

In one of the previous sections, we have learned how to compile the cash flow statement based on the firm's balance sheets and income statements. We can follow the exact same steps with our projections from the table above. The following table shows the resulting cash flow statements:

 

Cash flow statement	Year 1	Year 2	Year 3
Net income	2'800	3'460	3'780
+ After-tax interest expenses	400	360	320
NOPLAT	3'200	3'820	4'100
+ Depreciation and amortization	3'000	3'135	3'230
- Increase in operating assets	300	442	287
+ Increase in operating liabilities	600	268	158
Operating cash flow	6'500	6'781	7'202
- Net investments	3'500	3'635	3'730
Free cash flow	3'000	3'146	3'472
- After-tax interest expenses	400	360	320
- Repayment of debt	1'000	1'000	1'000
Residual cash flow	1'600	1'786	2'152
+ Equity offerings	0	0	0
- Dividends	1'400	1'786	2'152
Change in cash	200	0	0

 

A few points are worth mentioning:

• Interest expenses: Remember from before that the after-tax interest expenses are ultimately relevant for our cash flow analysis. Given a tax rate of 20%, the after-tax interest expenses in Year 2 and 3 are 360 [= (1 - 0.2)× 450] and 320 [= (1 - 0.2)× 400], respectively.

• Net investments: As explained in detail in a previous section, the net investments correspond to the change in long-term assets plus the depreciation and amortization charges. For example, in Year 2, fixed assets increase by 500 (from 16'000 to 16'500) and depreciation and amortization is 3'135. Consequently, the net investments in Year 2 are 3'635 [= 500 + 3'135].

• Payout policy: Note from above that we have assumed that the firm pays out all additional excess cash to its shareholders. Accordingly, the balance sheet item Excess cash remains constant over time. Now the line Residual cash flow in the cash flow statement indicates that the firm is expected to generate significant cash flows which are available for distribution to the shareholders. For example, in Year 2, the expected residual cash flow is 1'786. Moreover, we know that the firm does not plan to issue (or retire) equity (the expected equity offerings are 0). Therefore, the total amount of cash the firm generates before dividend payments equals 1'786 in Year 2. To make sure that all excess cash is paid out to the shareholders, the firm therefore has to set dividend payments equal to 1'786 in Year 2.

• Another way to reach the same conclusion is to remember from the basic accounting framework that the change in retained earnings corresponds to the part of the net income which has not been paid out to the shareholders. From the table above we know that the projected Net income is 3'460 in Year 2 and that Retained earnings are expected to grow by 1'674 (from 9'500 in Year 1 to 11'174 in Year). If only 1'674 of the net income is retained, the remaining 1'786 will be paid out as dividends: