Income Statement Forecast and Balance Sheet Forecast - Case Study Example

Section 1 Forecast 2 1.1Income statement forecast 2 1.2Balance sheet forecast 0 Section 2 Valuation 3 2.1Discount cash flow model 3 2.2 Discount abnormal earning valuation (Earning abased valuation) 4 2.3 Sensitivity Analysis 5 Section 3 Recommendations 6 3.1 Summary of strategy, accounting, financial, prospective analysis 6 3.2 Recommendation to Shareholders 6 Section 1 Forecast 1.1 Income statement forecast Forecast assumption The Income statement forecast i.e. profit and loss can be defined as the main statement for planning financials in a business it also shows the businesses financial performance in a certain period i.e. accounting period. However, to forecast the income statement the businesses history must be well understood hence building financial statements. This can however, be done if only some assumptions are made like growth rate in revenue and expenses, COGS, salaries, rent and utilities, depreciation, taxes, financial modeling tips, interest expense etc. are all constant for the period of time the forecast will be done thus will not affect the income statement forecast. Forecasting revenue is simply forecasting the growth rates in revenue and we assume that they will remain constant over the years since a change in revenue in a forecasted year will affect the income statement forecast. Growth rates in revenue can be forecast in several ways 1. Macro approach. This is possible when we look at the forecast growth rate of the business thus making adjustments in the business depending on how the business is positioned. 2. Units and prices. To forecast unit information it can simply be done by redacting revenues from the forecast units and prices. In Forecasting operating expenses (COGS) they tend have a relationship with revenues i.e. their forecast is a percentage of revenue. However, an exception will be if the business deals with volatile components e.g. fuel and agricultural products. In this case, adjustments are done depending on forecast for these inputs. In forecasting expense and income we assume that the current expenses of the business and income will not change in the forecasted period since a change in either their expense and income will affect their forecast. Forecasting interest expense will depend on forecast size depending on the businesses assets. Future capital structure of the business will also affect the forecast of interest expense e.g. in share repurchases, new share issuances thus affecting the income statement forecast. In forecasting depreciation it will depend on forecast size of the businesses total assets, levels of additions to PP&E depending on the rate at which it grows which can be checked at the history of the business thus making adjustments depending on what the business says about future plans. Can be calculated as follows PP&E = average PP&E / depreciation. Forecasting assumptions for key items of income statement: 2015 2016 2017 2018 2019 2020 2021 7.05% 11.10% Sales growth rate 6.00% 6.00% 5.00% 5.00% 2.00% 100.00% 100.00% Gross margin 100.00% 100.00% 100.00% 100.00% 100.00% -27.56% -30.56% Depreciation and Amortisation/ PPE -36.00% -36.00% -36.00% -36.00% -36.00% -82.80% -84.35% SG&A/ Sales -90.00% -90.00% -90.00% -88.00% -88.00% -10.10% -9.30% Interest Rate -9.70% -9.70% -9.70% -9.70% -9.70% Forecast income statement (2017 – 2021) 1.2 Balance sheet forecast Forecast assumption In balance sheet forecast several assumptions are made so as to enhance the business to come up with a balance sheet forecast as calculated below. Assumptions in depreciation, prepaid expenses, accrued expenses, postpaid expenses, sales, dividend etc. are all constant for the period in forecast this is because a change in any of them will cause the business to get a wrong forecast in terms of balance sheet forecast. In Forecasting depreciation we assume that depreciation will remain constant over the years since a change in depreciation will indicate that the forecast will not be applicable in the business. In prepaid expenses such as insurance, communication expenses, electricity bill and other expenses will be constant. This can be calculated by using historical information about how much the expenses computed to in the previous years. The expenses can be computed and divided by the number of year’s thus comping up with an average expense in each expense thus using it to forecast the prepaid expenses. Accrued expenses in the balance sheet such as accrued rent, commissions etc. are to be calculated since a change in the accrued expenses will affect the businesses balance sheet forecast. This can be done by assuming that the businesses rent will remain constant in the forecasted period. In forecasting the sales of the business we assume that the businesses sales will remain constant for the period forecasted since a decrease or increase in the businesses sales will affect the balance sheet forecast for that period. Dividend forecasting can be done when we look at the business historical dividends this will help compute a reasonable about of dividends to be used in the balance sheet forecast. Forecasting Key items of Balance Sheet: 2015 2016 2017 2018 2019 2020 2021 -27.29% -20.67% Working Capital to Sales -26.00% -26.00% -26.00% -26.00% -26.00% 8.31% 8.24% PPE Asset / Sales 8.27% 8.27% 8.27% 8.27% 8.27% -105.91% -92.06% Net Debt to Equity ratio -107.16% -109.87% -112.36% -115.11% -116.30% 60.00% 60.00% Dividend Payout ratio 60.00% 60.00% 60.00% 60.00% 60.00% Forecast balance sheet (2017 – 2021) Section 2 Valuation 2.1 Discount cash flow model This is a valuation method to compute estimates attractiveness in an investment opportunity. Discussion of estimation of valuation parameters This can only be applicable to already grown businesses since young businesses are difficult to value since some are startups with little or no revenues however, this same young companies that are profitable may be depended on private capital hence as a result of standard techniques used to estimate cash flow growth rates and discounts rates end up yielding unrealistic numbers or even do not work. Discount rate(Cost of equity) Are interest rates to determine present value in depository institutions hence used in discounted cash flow? Risk free rate Is a theoretical rate of return with no risk in an investment? Terminal growth rate Growth rate between historical inflation rates usually 2-3% Market risk premium Is the difference in expected return in a market portfolio and risk free rate? Result of cash flow valuation Cash-flow base valuation Input for the valuation Terminal Growth rate 3.10% Risk free rate 2% Beta 0.93 Market premium 6% Cost of equity 7.6% Estimated Value per share using DCF model Sum of PV of FCF (2017 - 2021) 773,754,293 + Terminal value 3,470,523,974 Total present value of equity value 4,244,278,267 Divide by number of shares outstanding 100,927,520 Estimate value per share 42.05 2.2 Discount abnormal earning valuation (Earning abased valuation) Discussion of estimation of valuation parameters Are critical elements used in a valuation process i.e. factors determining values of group properties. Can be computed by, multiplying the number of units with the value per unit as computed below. Abnormal Earnings 2017F 2018F 2019F 2020F 2021F Equity at the beginning of year 1,345,945,000 1,205,866,521 1,176,124,816 1,150,048,257 1,122,558,466 net income to equity holders 147,126,178 155,333,534 162,583,366 215,725,618 219,833,393 required earnings 101,659,226 91,079,098 88,832,707 86,863,145 84,786,841 Abnormal earnings 45,466,952 64,254,436 73,750,659 128,862,473 135,046,552 Earning base valuation Input for the valuation Terminal Growth rate 3.10% Risk free rate 2% Beta 0.93 Market premium 6% Cost of equity 7.6% Valuation result Sum of PV of abnormal earnings (2017 -2021) 347,237,849 Terminal value 2,172,585,246 Beginging book value of equity 1,345,945,000 Total present value of equity 3,865,768,095 Divided by number of shares outstanding 100,927,520 Estimate value per share 38.30 2.3 Sensitivity Analysis Sensitivity analysis Market price Downside Upside Downside Upside Cost of equity (fill in) 7.55% 8.5530% 6.5530% 7.55% 7.55% Terminal Growth Rate 3.10% 3.10% 3.10% 2.1000% 4.1000% Cost of equity 7.55% 8.55% 6.55% 7.55% 7.55% Using FCFs 42.05 35.47 42.05 52.44 52.44 Using AE 38.30 41.83 38.30 57.12 57.12 Estimate Value 40.18 38.65 40.18 54.78 54.78 Market value 14/10/2016 35.66 Conclusion Undervalue Undervalue Undervalue Undervalue Undervalue Discussion of sensitivity analysis If the assumptions changed, conclusion changed? Section 3 Recommendations 3.1 Summary of strategy, accounting, financial, prospective analysis They aim to demonstrate and apply framework to the business using strategy, accounting, financial and prospective analysis. They mostly emphasis on, translating tools of the business analysis and valuation to practical situations. However, for the business to achieve this they need to develop methods which they are going to use so as to develop key skills hence demonstrating their applications. They also give trends in business analysis and help the business come up with forecast that will enable smooth running and guidelines of what is expected of the business and how to go about the daily activities of the business hence comping up with accounting and financial forecast for the business. These summaries also help the business to predict the future and work towards attaining specific goals and prevent the business from suffering losses hence reaching their goals as forecasted in the accounting and financial prospective. It is also recommended that all businesses should carry out prospective analysis in their accounting and financials this will help create goals for the businesses and show them what is expected of them by the end of the forecast period. This analysis are also helpful since they are able to help the businesses to maintain their strong areas since if they perform poorly they will not meet their targets thus it will not be possible for the business to meet their goals. The businesses accounting and financial prospective also help in understanding the linkage between the business analysis, strategic business analysis, accounting analysis, financial analysis and prospective analysis. 3.2 Recommendation to Shareholders After prospective analysis of the businesses financial and accounting analysis their various recommendations to shareholders. This is done to create a positive relationship between the business directors and the directors. This recommendations also help inform the stakeholders of the business how the business managers run the company and also give their reports. Shareholders after the analysis they are able to know if they will continue buying more shares in the business or will opt to buy shares from another business. Shareholders also are able to plan for the incentives they will receive from the business in the coming years their able to make investment plans thus providing proper planning. Shareholders are also able to know if the business will make losses or profits in the near future hence they are able to plan their investments. Shareholders are also recommended to trust the businesses directors since they are doing their best to make sure that the business runs smoothly. They are able to get consistent comparisons between the business and its shareholders hence providing financial statements for each year. This I recommendations also help the business work towards specific goals and pressure the directors to meet their goals since they are the key shareholders of the business. The shareholders are assured that the business is receiving correct information about the forecast and that they are achievable by the business since they are realistic and are based on previous years. The shareholders are also assured of consistence growth of the business. REFERENCES Evans, M. K. (2002). Practical business forecasting. John Wiley & Sons. Hyndman, R. J. (2011). Business forecasting methods. In International Encyclopedia of Statistical Science (pp. 185-187). Springer Berlin Heidelberg. Lapide, L. (2002). New developments in business forecasting. The Journal of Business Forecasting, 21(2), 11. O'Connell, R. T., & Koehler, A. B. (2005). Forecasting, time series, and regression: An applied approach (Vol. 4). South-Western Pub. Zhang, G. P. (Ed.). (2004). Neural networks in business forecasting. IGI Global. Read More