Class 5, 6, 7, and 8

What tools can we use to help predict earnings manipulation?

Beneish developed a profit model to identify the financial characteristics of firms likely to engage in earnings manipulation Beneish developed both a 12-factor model and an 8-factor model: the 12 factor model relies on a combination of financial statement items and changes in stock prices for a firm's shares, the 8 factor model uses only financial statement items

Step 1 Cont. What are three channels for sales growth? Three drivers of sales growth? What should the terminal sales growth rate be?

Industry sales growth Increase in market share within industry Enter new industry Increase productive capacity Increase efficiency with which existing productive capacity is used Increase price at which product is sold Terminal sales growth rate should equal long-term economy-wide growth rate Total sales growth = (1+store growth)(1+comp store)-1

Operating cash flow to total liabilities ratio

considers the firms ability to generate cash flow from operations to service debt

Days of working capital financial required

days inventory held + days A/R outstanding

Credit Risk

potential lenders to a firm assess the likelihood that a firm will pay periodic interest and repay the principal amount Lenders may use the following checklist as factors: -circumstances leading to need for loan, credit history (has a firm borrowed in past and has it successfully repaid it?), cash flows (generates sufficient cash flows to pay interest and repay principal on a loan), collateral, capacity for debt (contingencies, character of management, communication, conditions or covenants)

How to calculate basic EPS? (simple capital structure) For the firms do not have: outstanding convertible bonds or convertible preferred stock that can be exchanged for shares of common stock or options or warrants that holders can use to acquire common stock

(Net Income - Preferred Stock Dividends)/Weighted Average Number of Common Shares Outstanding

How to calculate diluted EPS? (complex capital structure) -For the firms that have convertible securities and/or stock options or warrants outstanding -Presents two EPS amounts: basic EPS and diluted EPS -Diluted EPS reflecte the dilution potential of convertible securities, options, and warrants

(Net income - Preferred stock dividends + Adjustments for dilutive securities) / (weighted average number of common shares outstanding + weighted average number of shares issuable from dilutive securities)

What tools are useful to analyze a firm's profitability?

Alternative transformations of net income: earnings per share analysis, common-size analysis, percentage change analysis, alternative definitions of profits Rate of return metrics: return on total assets, return on common equity

What to do after the seven-step forecasting plan?

Analyze the Projected Financial Statements Test the reasonableness of forecast assumptions and their internal consistency. Use ratios and other analytical tools for testing. But, ratios cannot confirm whether our forecast assumptions will turn out to be correct. Sensitivity Analysis Can be used to assess the impact of new announcements from the firm. Can be used to assess the sensitivity of firm's liquidity and leverage to key assumptions. Helps react quickly and efficiently to new announcements.

Microeconomic Theory

Capacity Constraint: Heavy fixed capacity costs & lengthy periods required to add new capacity. Upper limit on the size of assets turnover achievable. Only way to increase ROA is to increase profit margin. Usually achieve high profit margin by some form of entry barrier. Competitive Constraint: For firms whose products are commodity- like. Few entry barriers and intense competition. Upper limit on the achievable level of profit margin for ROA. Only way to improve ROA is to achieve high asset turnover. Achieve the high assets turnovers by controlling costs with aggressively low prices to gain market share.

What to look at when analyzing asset turnover for ROA?

Captures how efficiently assets are being utilized to generate revenues Provides insight into changes in the total assets turnover by examining turnover ratios: AR turnover--indicates the average time until firms collect accounts receivable in cash Inventory turnover--indicates the length of time needed to produce, hold, and sell inventories Fixed assets turnover--measures the relation between sales and the investment in property, plant, and equipment

Step 7: Projecting the Statement of Cash Flows

Characterize all changes in the Balance Sheet in terms of impact on Cash. Derive the statement of Cash flows from Projected Income Statement and Balance Sheets. Tips for Forecasting Statement of Cash Flows: Ensure that the Balance Sheet is in balance. Do not use historical cash flows as they do not provide good basis for projecting future cash flows. Use Implied Statement of Cash Flows computed from projected Income Statements and Balance Sheets.

When you use eVal to prepare forecasted financial statements, what should you check at the end?

Check that the balance sheet plug (net issuance of common stock) and the implied return on equity are plausible

What are some financial analysis tools?

Common-size financial statements Percentage change financial statements Financial statement ratios (profitability: EPS, ROE, etc.; Dupont framework; Risk: Current Ratio, Debt to Equity, etc.) Cash flow analysis

What is a cross-sectional analysis (comps)? And why is it used?

Comparing a firm's ratios with the ratios of comparable firms -Facilitates the identification of differences in performance and the detection of the underlying causes -Consider the following: definition of the industry, calculation of industry average, distribution of ratios around the mean, definition of financial statement ratios

What is a time-series analysis? And why is it used?

Comparing firm's ratios over time -Facilitates the identification of changes in performance and the detection of the underlying causes -Has the firm made a significant change in its product, geographic, or customer mix? -Has the firm made a major acquisition or divestiture? -Has the firm changed its methods of accounting over time? -Are there any unusual or nonrecurring amounts that impair a comparable analysis of financial results across?

How can we prepare a statement of cash flows?

Converts revenues and expenses to a cash basis May be necessary for firms outside U.S. Estimates made should approximate actual values. Change in Non-cash assets Liabilities Shareholders' equity to cash flow

What are different forms of econometric forecasts?

Cross-sectional models (across firms) Pooled cross-sectional time-series models (firms & time) Time-Series models (just time)

What are criticisms of EPS?

Does not consider the amount of assets to capital required to generate a particular level of earnings Two firms with the same earnings and EPS are not necessarily equally profitable Number of shares of common stock outstanding serves as a poor measure of the amount of capital in use -Despite the above criticisms of EPS as a measure of profitability, it remains one of the focal points of announcements and is frequently used for valuing firms

Financial Reporting Manipulation Risk

Earnings manipulation--refers to reporting amounts outside the limits of U.S. GAAP or IFRS, i.e. fraudulent reporting, focus on more flagrant violations of accounting standards and oversight bodies such as FASB, IASB, and SEC Motivations for financial statement manipulation--influence stock prices positively, increase management bonuses, lower cost debt financing, avoid violation of debt covenants (or technical default), influence corporate control transactions, avoid regulatory or political consequences

Cash flow analysis

Evaluate the cash flow implications of the firm's operating, investing and financing activities: are net operating and investing cash flows negative? - if so, how is the cash shortfall to be financed? are net operating and investing cash flows positive? - if so, what does management propose to do with the free cash flow? what are the cash flow commitments associated with the firm's financing policy? - how does management propose to meet these commitments? what are management's capital expenditure plans and how will these be financed? This type of analysis is required in the 'Liquidity and Capital Resources' section of the MD&A

What are some different time series behaviors?

Examples of modeling permanent component in a variable's time-series behavior Random walk without drift Random walk with drift Mean reversion -time series is stationary (and mean-reverting) if the absolute value of coefficient is less than 1, u is long-term mean, coefficient is speed of convergence

Step 2: Projecting Operating Expenses

Fixed vs. Variable components Does cost change proportionately to sales? Careful of the "relevant range". Industry knowledge important here. -Should forecast capital expenditures. Projecting Cost of Goods Sold. Analyze by segment. Closely linked to sales through gross margin Need to factor in potential shifts in gross margin -Economies of scale in production/allocation of fixed overhead -Impact of competitive pressures on gross margin Research & Development Expenses Not directly tied to current sales, but tend to closely track sales Check MD&A for discussion of existing and potential new R&D projects Projecting Selling, General, and Administrative expenses. Closely linked to sales Often subject to economies of scale, particularly for early-stage companies Often exhibit 'sticky cost' phenomenon, whereby costs are relatively less responsive to reductions in sales growth Projecting Other Operating Expenses. Depreciation -May need a CapEx forecast first -The depreciation rate on gross PP&E equals the reciprocal of the useful life -For a firm in 'steady-state', the depreciation rate on net PP&E equals the reciprocal of half the useful life of asset ***possible exam question -Remember that depreciation expense is often buried in, and hence implicitly forecast as, part of other expenses Amortization -For definite-lived intangibles, similar -pointers to depreciation -For indefinitely-lived intangibles, amortization is replaced by periodic impairments -Impairments are more difficult to forecast, but if the firm has a track record of losses in the business unit to which the intangible is attached, then an impairment is more likely Projecting Nonrecurring Operating Gains and Losses.

How does ROA relate to ROCE?

ROA measures operating performance independent of financing ROCE considers the cost of debt and preferred stock financing ROA NI + interest expense net of taxes/ average total assets Return to creditors interest expense net of taxes/average total liabilities Return to preferred shareholders preferred dividend/average preferred shareholders' equity Return to common shareholders net income to common/average common shareholders' equity

How can we disaggregate ROA?

ROA=Profit Margin for ROA x Assets Turnover Where: Profit Margin = Adjusted Net Income/Sales Assets Turnover = Sales/Average Total Assets

How can we disaggregate ROCE?

ROCE=profit margin for ROCE x assets turnover x capital structure leverage net income to common/sales x sales/average total assets x average total assets/average common shareholder's equity -Leverage refers to use of debt to increase return to common stockholders ROCE>ROA when ROA>cost of debt and preferred stock financing

What are the key drivers of value for ROE and growth in equity?

ROE -create value by generating long-run ROE that exceeds r -business strategy and competitive environment -accounting distortions affect short-run ROE Growth in Equity -magnifies value created by ROE if ROE>r, then growth creates value; if ROE<r, then growth destroys value

Advanced Dupont Formula

ROE=RNOA+leverage x (RNOA-NBC) RNOA-NBC = spread If we assume all financing is either debt or common equity, then leverage=debt/common equity NBC=(interest expense/debt)(1-tax)= interest ratex(1-tax)=i(1-tax) ROE=RNOA + (debt/equity) x (RNOA-(i x (1-tax)))

Does realized ROA equal expected ROA?

Realized ROA is derived from financial statement data for a particular period and will not necessarily correlate perfectly with expected returns Reasons for this may be: faulty assumptions were used in deriving expected ROAs, changes in the environment, ROA is an incomplete measure of economic rates of return

What forecasts should be used as the anchor for other forecasts?

Sales forecasts

What types of risk are investors concerned with?

Short-term liquidity risk, Long-term solvency risk, Credit risk, Bankruptcy risk, Financial reporting manipulation risk

Why use common-size analysis?

Simple way of creating greater comparability across firms and for same firm through time Most frequently utilized in income statement: by expressing line items scaled by revenues and balance sheet: by expressing line items scaled by total assets Common scaling enables figures across firms and across time to be more comparable

Overall takeaway about financial analysis?

Start with DuPont decomposition: ROE=NI/Sales Sales/TA TA/SE Profitability, Efficiency, Leverage Then choose ratios that will help you understand what is affecting the major drivers: -common-sized and trend I/S and B/S, specific turnover (i.e., "days") ratios, liquidity vs. solvency Supplement with SCF data/patterns

Step 1: Projecting Sales and Other Revenues

Start with principal business activities. Sales - determined by price AND volume. Consider firm and its industry conditions. -Life cycle. -Technological conditions. -Business cycle. Economic-wide conditions. Exchange rates. Segments. Other revenues

Practical tips for the forecasting game plan

Starting point is most recent financial statements Steps are integrated and interdependent, not necessarily sequential or linear. Forecasts must ARTICULATE between the 3 financial statements. Preparing financial forecasts is an iterative and circular process. And requires at least one flexible financial account. Incorporate what you have learned from business strategy, accounting & financial analysis Quality will depend on assumptions! Financial statements will be no better than these. Sweat the big stuff. Do not sweat the little stuff. Major on the Major; Minor on the Minor You should perform sensitivity analysis on forecasts.

Terminal Period Assumptions

Terminal sales growth rate should approximate long-term forecast of GDP growth rate (about 3%) Terminal ROE should approximate the cost of capital assuming: Competitive equilibrium No accounting distortions

What are some caveats of ratio analysis?

There is no generally accepted set of rules for computing ratios Ratios do not provide answers, they just help direct you in your search for answers Managers know investors fixate on certain ratios, and many window-dress accordingly

How can we use "Big Data" to forecast accounting numbers?

Three basic approaches: "Visual" "Plot" variable X and examine for evidence of systematic patterns "Economic" Predict the systematic pattern you would expect in X given causal factors uncovered during your business strategy analysis "Econometric" Use statistical tools to detect systematic patterns in X

Why do we use financial ratios?

To extract economic relations from the data (mitigate "information overload") Evaluate current and past performance of the firm Assess future performance of the firm Help forecast pro-forma financials

Debt ratios: Liabilities to Assets Ratio Liabilities to SE Ratio Long-Term Debt to Lon-Term Capital Ratio Long-Term Debt to SE Ratio

Total Liabilities/Total Assets Total Liabilities/Total SE Long-Term Debt/(Long-Term Debt/Total SE) LT Debt/ Total SE

Business strategy

Two generic alternative strategies for a particular product are: Product differentiation strategy- Differentiate a product to obtain market power over revenues and, therefore, profit margins. Low-cost leadership strategy- Enabling the firm to charge the lowest prices and to achieve higher sales volumes.

What are misclassification errors?

Type II error (beta) - predicted bankrupt, but was not bankrupt; also H0 not rejected, false negative) Type I error (beta) - predicted non bankrupt but was bankrupt (true H0 rejected, fall positive) H0-firm will go bankrupt

Step 6: Balancing the Balance Sheet

Usually a financial asset plug (e.g., cash) or liability/equity, but which one? Cash & Marketable Securities (but what if there isn't enough?) Debt (but what if we can't find a lender on favorable terms) Equity (but what if we can't sell new stock on favorable terms) Note that eVal plugs to equity. Projected assets less Projected liabilities and shareholders' equity = Amount of adjustment (flexible financial account.) If Projected assets > Projected liabilities and shareholders' equity: Raise additional capital. Raise additional debt. Sell financial assets. If Projected assets < Projected liabilities and shareholders' equity: Pay down debt. Issue larger dividends. Repurchase more shares. Invest in financial assets. Evaluate the firms financial flexibility and adjust the balance sheet.

Step 3: Projecting Operating Assets and Liabilities on the Balance Sheet PP&E

Usually tracks sales growth But not sales growth that originates from increased efficiency in the use of productive capacity or from price increases Check whether your PP&E and depreciation expense forecasts generate implied capex forecasts that correspond with management's capex spending plans in MD&A T Account for Net PP&E Beg balance plus Capex - Deprec. Expense = End balance

The Discounted Residual Income Valuation Model

We can rewrite the dividend discounting formula as: Value0=Equity0+RI1/(1+r)+RI2/(1+2)^2 where equity=book value of equity; and RI=residual income; and r=discount rate RI=income-(r x equity) RI=((income/equity)-r) x equity RI=(ROE-r) x equity

Forecasting EPS

We have already forecast earnings But what about the number of shares? Two issues Number of shares outstanding We have already forecast $ of new share issuances, but at what price will new shares be issued? Adjustments for diluted EPS For diluted EPS, we need to adjust for potentially dilutive securities (employee stock options, convertible debt etc.)

Bankruptcy Risk

Will the company be able to repay its debt? What is the likelihood of financial distress? (fail to make required interest payments on time, default on principal payment, bankruptcy, liquidation)

Altman's Z-Score

Z-Score =1.2(WC/TA) + 1/4 (RE/TA) + 3.3(EBIT/TA) + .6(MVE/TL) + 1(Sales/TA) <1.81=high probability of bankruptcy 1.81-3.00=gray area >3.00=low probability of bankruptcy Accuracy of Altman's model: -95% correct one year prior -83% correct two years prior -52% correct three years prior

Why do cash flows not equal income flows?

accrual accounting used for net income (e.g. accounts receivable, accounts payable) noncash expenses (e.g. stock option expense, depreciation)

What alternative measures of profit do analysts consider?

analysts use measures of past profitability to forecast the firm''s future profitability these may include: comprehensive income, operating income, EBIT, EBITDA (a proxy for cash), and other profit measures, segment profitability, pro forma, adjusted, or street earning

How can we prepare a statement of cash flows? Accounting equation to use

change in cash flows = change in liabilities + change in SE - change in non-cash assets in general: Changes in current assets and current liabilities affect Operating Activities. Changes in Fixed Assets and other noncurrent assets affect Investing Activities. Changes in Long-term liabilities and Stockholders' Equity accounts (except net income) affect Financing Activities. Notable Exceptions Marketable securities These are considered to be Investing Activities, regardless of short-term nature. Notes payable If payable to banks, are considered financing activities, even if very short-term. Current portion of long-term debt Financing

Why use percentage change analysis?

computes percentage changes in individual line items can be compared across firms or across time focus is not on the financial data themselves, but on the changes in individual line items through time

What are useful ratios for short-term liquidity risk?

current ratio--indicates current assets relative to obligations coming due quick ratio (also called acid test ratio)--includes in only those current assets the firm could convert quickly into the cash operating cash flow to current liabilities--it indicates the amount of cash from operations after funding working capital needs working capital activity ratios--A/R turnover, inventory turnover, AP turnover revenues to cash ratio--reflects net effect of operating, investing, and financing activities on cash days revenue held in cash--measures the number of days sales the firm has on hand as available cash

Long-term solvency risk

examines a firm's ability to make interest and principal payments on long-term debt and similar obligations what are useful ratios for long-term solvency risk? -debt ratios, interest coverage ratio, operating cash flow to total liabilities ratio

What are some things to keep in mind?

garbage in, garbage out Control for accounting method changes Seasonality Denominator negative or close to zero Be consistent in your definition of numerator and denominator Doesn't provide answers, it just helps guide you in your search for answers Should be interpreted in the context of the firm's business environment What's proper benchmark? Theoretical, cross-section, time-series Managers know you're analyzing ratios...

Interest coverage ratio

it indicates the number of times a firm's income or cash flows could cover interest charges

Return on common equity (ROCE) can be further analyzed through

leverage (operating vs. financial leverage)

Return on total assets (ROA) can be further be analyzed with

margin (various expense ratios) turnover (various asset utilization ratios)

Short-term liquidity risk

measures firm's ability to generate sufficient cash to supply operating working capital and service debts liquidity problems can arise from the following: untimed cash inflows and outflows, high degree of long-term leverage

rate of return: return on common equity How to calculate?

measures the return to common stock holders after subtracting operating expenses and costs of debt financing and preferred stock should adjust net income for nonrecurring charges, as in ROA explicitly accounts for the cost of debt and preferred stock financing (Net income-Preferred stock dividends)/ Average Common SE

Return on equity (income/equity)

net profit margin (income/sales) -detailed margin analysis x asset turnover (sales/assets) -detailed turnover analysis x total leverage (assets/equity) -detailed solvency and liquidity analysis

Per-share analysis

one of the most frequently used measures of profitability the only financial ratio that GAAP requires firms to disclose on the face of the income statement

Days of working capital provided

required - AP outstanding

What to look at when analyzing the profit margin of ROA?

sales individual expenses (COGS, SG&A expenses, income taxes) profit margin segment data: allows you to examine ROA, profit margin, and assets turnover at an additional level of depth

What insight can we get from the statement of cash flow?

the three sections logically corresponding to the primary pursuits to generate profits the cash flows to and from the entities with which the business conducts business can be combined with other financial statements to assess the overall quality of overall financial statements

What tools can we use for bankruptcy prediction?

univariate bankruptcy prediction models: examines the relation between a particular financial statement ratio and bankruptcy; what variables are most related to financial distress (profitability, activity, liquidity, solvency) What are potential shortcomings of using univariate models? (small firms are more likely to go bankrupt) multivariate bankruptcy prediction models: "solves" the problem with univariate models: Y = Beta0 + Beta1X1 + Beta2X2 +...

Debt ratios

used to measure the amount of liabilities, particularly long-term debt in a firm's capital structure higher this proportion, the greater the long-term solvency risk alternative computation of leverage used in the ROCE

Step 3: Projecting Operating Assets and Liabilities on the Balance Sheet

Forecasting future operating assets and liabilities from operating activities projected. To forecast individual operating assets and liabilities, determine the underlying operating activities that drive them. Turnover Based techniques: Used to forecast any operating asset and liability accounts that vary reliably with sales. Should not be used if the firm experiences a substantially different future growth rate or if the relation between sales and forecast account varies unpredictably. Cash Need a small amount of cash to facilitate operations (approx. 3% of assets) Many companies stockpile cash Companies with positive free cash flow accumulate cash Companies with negative free cash flow raise a significant amount of capital in the form of cash and then 'burn' through the cash over several years In such cases, model the firm's financing decisions and use cash as the 'plug' Receivables Usually track sales Changes in credit policy and bargaining power of key customers can change the relationship to sales Turnover example company has 28 days receivable in past (and assume keeps this) 365 / (A/R Turnover) = Sales / [ (Beg A/R + End A/R) / 2 ] With Sales and A/R Turnover forecasts, can solve for End A/R Inventories Usually track sales Slowing turns can indicate either: Build up of obsolete inventory that must be written off Stockpiling of new product that will lead to higher future sales Read MD&A, Notes etc. to try and figure this out Other Current Assets Identify the nature of any material items and try to determine whether they are likely to track sales or remain fixed Accounts Payable Usually track sales Changes in credit policy and bargaining power of key suppliers can change the relationship to sales Other Current Liabilities Identify the nature of any material items and try to determine whether they are likely to track sales or remain fixed

How can we use the statement of cash flows to assess earnings quality?

Gauge whether reported net income reflects the underlying economics of the business. Highlights accounting accruals, which can provide insight into the overall sustainability and quality of a firm's reported earnings.

Advanced Dupont Framework: Terminology

Goal is to distinguish between operating performance and the impact of financial leverage Define: tax=effective tax rate=(income tax expense)/(earnings before taxes) net financing expense (NFE) = interest expense×(1-tax) + preferred dividends + minority interest in earnings net operating income (NOI) = net income + net financing expense net financial obligations (NFO) = debt + minority interest + preferred stock net operating assets (NOA) = common equity + NFO = invested capital = total assets - (total liabilities + debt) = total assets - operating liabilities return on net operating assets (RNOA) = NOI/NOA net borrowing cost (NBC) = NFE/NFO leverage = NFO/common equity

How do Profit Margin and Asset Turnover tradeoff?

Important to examine the differences between the relative mix of profit margin and assets turnover Differences in ROA due to relative mix of profit margin and assets turnover can be explained by: -microeconomic theory--capacity/competitive constraints -business strategy--product differentiation/low-cost leadership

Rate of return: Return-on-assets How do we calculate ROA?

Independent of firm's financing decisions Measures ongoing profitability Unusual or nonrecurring items (such as restructuring charges, may be removed, net of tax) [Net Income + (1-tax rate)(interest expense) + minority interest in earnings]/ Average total assets

How does a product life cycle affect the relationship among cash flow items?

Introduction Revenues are low Net income may be negative Negative CF from operating activities Negative CF from investing activities External financing (Positive CF from financing) Growth Increasing revenues. Net income becomes positive. Increasing cash flows from operations. Continuing negative CF from investing activities. Decreasing positive CF from financing activities. Maturity Peak revenues. Peak net income. Positive cash flows from operations. Investing CF may begin to increase. Financing CF may become negative (repayment of debt, stock repurchases, etc.). Decline Revenues decrease. Net income decreases (may become negative). Cash flows from operations decreases. Cash flows from investing activities positive (as firm divests). Cash flows from financing activities negative.

What is the overall takeaway?

No "correct" way of doing this... Recommended approach (in order): -Do ratio analysis using key financial ratios -Forecast key financial ratios based on information you learned during business strategy and ratio analysis stages Use sales forecasts as anchor -Using relations in key financial ratio forecasts, continue with: Operating expenses Assets Liabilities Interest and tax expense Shareholders' equity Recommended approach: To make the B/S balance, plug in difference somewhere. Potential choices: Cash Notes payable "New" short-term liability account Dividends Forecast SCF based on forecast B/S and I/S Go back to the B/S and I/S and make any necessary adjustments When making adjustments, best to use journal entries to keep statements "balanced" Compute financial ratios on your forecasts as a "check" to determine whether your pro forma financial statements seem reasonable

What are two types of adjustments using indirect method?

Non-working capital accounts (usually increase cash flows over net income) Depreciation and amortization Deferred income taxes Employee stock option expense Gain/loss on disposition of asset Adjustments for changes in working capital accounts (effects depend on firm's life cycle & operating cycle) Accounts receivable Inventories Prepaid expenses Accounts payable Income taxes payable

What are general forecasting principles?

Produce reliable and realistic expectations. Unbiased - neither conservative nor optimistic. Forecasts should not manifest wishful thinking. 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.

Step 4: Project Financial Assets, Financial Leverage, Common Equity Capital and Financial Income Items

Project Financial assets, Financial debt and Shareholders' equity capital necessary. Project effects of financing on net income, considering future interest income interest expense and other elements of financial income. To maintain a particular capital structure, Common sized balance sheet and projected amounts of total assets can be used to project. Consider the financial leverage strategy of the firm. Investments Don't usually track sales Identify the nature of any material items and try to determine their key drivers Intangibles Don't usually track sales, since only purchased intangibles are recognized If the firm has a track record of losses in the business unit to which the intangible is attached, then an impairment is likely Other Assets and Liabilities Identify the nature of any material items and try to determine whether they are likely to track sales or remain fixed Debt Typically tracks totals assets based on company's target debt-asset ratio Pay attention to management's financing plans in MD&A Preferred Stock and Minority Interest Unless management expressly indicates that they plan to change these sources of financing, the best forecast can be to leave at current levels Interest Income/Expense Tied to investments & cost of debt Beware of classification issues, whereby interest expense is combined with other items, such as interest income May become circular as changing balance sheet items will change interest income/expense

Step 5: Projecting Nonrecurring Items, Provisions for Income Tax, and Changes in Retained Earnings

Project Nonrecurring Items. Project provisions for Income taxes. Effective Tax Rate Statutory Federal rate of 35% plus state and other taxes Remember to model the impact of permanent differences and the valuation allowance on deferred tax assets Calculate Net Income. Calculate changes in Retained Earnings

What is the seven-step forecasting game plan?

Project revenues from sales and operating activities. Project operating expenses and derive projected income. Project operating assets and liabilities. Project the financial leverage and capital structure. Project non recurring gains or losses (if any). Check whether the projected balance sheet is in balance. Derive the projected statement of cash flows.