chapter 9 " prospective analysis" financial analysis statement

8/10/2019 Chapter 9 " prospective analysis" FINANCIAL ANALYSIS STATEMENT

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Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

FinancialStatement

Analysis

K R SubramanyamJ o h n J Wi ld


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9CHAPTER

Prospective Analysis


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Prospective Analysis

Security Valuation - free cash flow and residualincome models require estimates of future financialstatements.

Management Assessment - forecasts of financialperformance examine the viability of companies

strategic plans.

Assessment of Solvency - useful to creditors toassess a companys ability to meet debt service

requirements, both short-term and long-term.

Importance


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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 (strategicinitiatives)


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The Projection ProcessTarget Corporation Income Statements

(in millions) 2005 2004 2003Sales.......................................................................................... $46,839 $42,025 $37,410Cost of goods sold ..................................................................... 31,445 28,389 25,498Gross profit................................................................................ 15,394 13,636 11,912Selling, general and administrative expense . .. .. .. .. .. .. .. .. .. .. .. .. .. .. 10,534 9,379 8,134Depreciation and amortization expense . .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 1,259 1,098 967Interest expense... ... ... ... ... ... ... ... ... .... ... ... ... ... ... ... ... ... ... ... ... ... ... ... 570 556 584Income before tax ...................................................................... 3,031 2,603 2,227Income tax expense... .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. . 1,146 984 851Income (loss) from extraordinary itemsand discontinued operations................................................. 1,313 190 247Net income................................................................................. $ 3,198 $ 1,809 $ 1,623Outstanding shares .. ... .... ... ... ... ... ... ... ... ... ... ... ... ... ... ... .... ... ... ... ... 891 912 910

Selected Ratios (in percent)Sales growth............................................................................ 11.455% 12.336%Gross profit margin.................................................................. 32.866 32.447Selling, general and administrative expense/Sales ................. 22.49 22.318Depreciation expense/Gross prior-year PP&E ........................... 6.333 5.245

Interest expense/Prior-year long-term debt .............................. 5.173 4.982Income tax expense/Pretax income........................................... 37.809 37.803


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Steps :1. Project sales2. Project cost of goods sold and gross profit margins using

historical averages as a percent of sales3. Project SG&A expenses using historical averages as a

percent of sales4. 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 fixedand projected rates if variable

6. Project tax expense as an average of historical taxexpense to pre-tax income

Projected Income Statement


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The Projection ProcessTarget Corporation Projected Income Statement

1. Sales: $52,204 = $46,839 x 1.114552. Gross profit: $17,157 = $52,204 x 32.866%3. Cost of goods sold: $35,047 = $52,204 - $17,1574. 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) x7. Income before tax: $3,513 = $17,157 - $11,741 - $1,410 - $4938. Tax expense: $1,328 = $3,513 x 37.809%9. Extraordinary and discontinued items: none10.

Net income: $2,185 = $3,513 - $1,328


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The Projection ProcessTarget Corporation Projected Income Statement

(in millions) Forecasting Step 2006 EstimateIncome statementTotal revenues......................................................................................... 1 $52,204Cost of goods sold .................................................................................. 3 35,047Gross profit............................................................................................. 2 17,157

Selling, general, and administrative expense ............................................ 4 11,741Depreciation and amortization expense .................................................. 5 1,410Interest expense...................................................................................... 6 493Income before tax ................................................................................... 7 3,513Income tax expense................................................................................. 8 1,328Income (loss) from extraordinary items and discontinued operations ...... 9 0Net income.............................................................................................. 10 $ 2,185

Outstanding shares ......................................................................... 891Forecasting Assumptions (in percent)Sales growth........................................................................................... 1 11.455%Gross profit margin................................................................................. 1 32.866Selling, general, and administrative expense/Sales ............................... 1 22.49Depreciation expense/Gross prior-year PP&E .......................................... 1 6.333

Interest expense/Prior-year long-term debt............................................. 1 5.173Income tax expense/Pretax income ......................................................... 1 37.809


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Steps :1. Project current assets other than cash, using projected sales

or cost of goods sold and appropriate turnover ratios asdescribed below.

2. Project PP&E increases with capital expenditures estimatederived from historical trends or information obtained in theMD&A section of the annual report.

3. Project current liabilities other than debt, using projected salesor cost of goods sold and appropriate turnover ratios asdescribed below

4. Obtain current maturities of long-term debt from the long-termdebt footnote.

5. Assume other short-term indebtedness is unchanged fromprior year balance unless they have exhibited noticeabletrends.

(continued)

Projected Balance Sheet


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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

years balance unless they have exhibited noticeable trends. 8. Assume initial estimate of common stock is equal to the prior

years balance 9. Assume retained earnings are equal to the prior years

balance plus (minus) net profit (loss) and less expecteddividends.

10. Assume other equity accounts are equal to the prior yearsbalance unless they have exhibited noticeable trends.



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The Projection ProcessTarget Corporation Balance Sheet

(in millions) 2005 2004 2003

Cash ..................................................................... $ 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 20,936

Accumulated 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.......................... 504 863 975 Accrued expenses ............................................... 1,633 1,288 1,545

Income 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 76

Additional 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 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 3,189CAPEX/Sales ....................................................... 6.431% 6.356% 8.524%


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If the estimated cash balance is muchhigher or lower, further adjustments can bemade to:

1. invest excess cash in marketable securities2. reduce long-term debt and/or equity

proportionately so as to keep the degree offinancial leverage consistent with prior years.


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Target Corporation Projected Statement of Cash Flows

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Sensitivity Analysis

Vary projection assumptions to find those withthe greatest effect on projected profits andcash flows

Examine the influential variables closely

Prepare expected, optimistic, and pessimisticscenarios to develop a range of possibleoutcomes

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Application of Prospective Analysis in theResidual Income Valuation Model

The residual income valuation model defines equity valueat time t as the sum of current book value and the present

value of all future expected residual income:

where BV t is book value at the end of period t, RI t + n is residual incomein period t + n, and k is cost of capital (see Chapter 1). Residual incomeat time t is defined as comprehensive net income minus a charge onbeginning book value, that is, RI t = NI t - (k x BV t - 1 ).


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Trends in Value Drivers

The Residual Income valuation model defines residual income as:RI t = NI t (k X BV t-1)

= (ROE t k ) X BV t-1Where ROE = NI/BV t-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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chapter 9 " prospective analysis" financial analysis statement

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