Session 4 Flashcards
(15 cards)
What are the steps and key elements of Structured Forecasting?
Step 1: Reverse Engineering (Diagnostics)
- Analyze past financials to identify key performance drivers:
- Product line, pricing, cost structure
- Operating leverage & business cycle sensitivity
- Working capital patterns & capital intensity
Step 2: Forward Forecasting (Driver-Based Modeling)
Identify key drivers to forecast future financials:
- External: Industry growth, competition, pricing power
- Internal: Cost efficiency, capacity use, strategic actions
Step 3: Forecasting Flow
Logical sequence from sales to cash flows:
Sales → Margins → OpEx → Assets → Capital Structure → Interest & Tax → Net Income → Cash Flows
What are the key elements of forecasting sales growth?
Sales Growth Channels
- Industry growth – Driven by macroeconomic expansion
- Market share gain – Outperforming competitors in the same sector
- New market entry – Expanding into unrelated sectors
Sales Growth Drivers
- Increased capacity – e.g. new factories, more staff
- Improved efficiency – Better resource utilization
- Price increases – Charging more for the same product
Terminal Growth Rate Assumption
* Align long-term growth with sustainable economic levels (e.g. real GDP growth rate).
Forecasting Logic
* Macroeconomic trends → Industry sales forecast → Firm sales = Industry sales × Market share assumptions
How are operating expenses forecasted in financial modeling?
Operating Expenses → Based on margin ratios
COGS (Cost of Goods Sold)
Forecasted using the COGS-to-sales ratio
Influenced by:
- Pricing power: Higher prices ↓ COGS ratio
- Production efficiency: Economies of scale ↓ unit costs
SG&A (Selling, General & Administrative Expenses)
Forecasted using the SG&A-to-sales ratio
Composed of:
- Variable costs (tied to sales): e.g. commissions
- Fixed costs: Salaries, rent, etc.
How is the balance sheet forecasted in structured financial modeling?
Forecast Net Operating Assets (NOA)
- Based on: Asset Turnover = Sales / NOA
- Rearranged to calculate required NOA for a given sales forecast (reverse engineering)
Forecast Operating Assets & Liabilities
- Includes: Inventory, A/R, A/P, PP&E
- Forecasted as % of sales (or COGS for inventory/payables)
Influenced by:
- Inventory: Delivery model, product mix, obsolescence
- PP&E: Capacity needs, investment strategy
- Receivables/Payables: Payment terms, demand, bargaining power
Forecast Leverage & Financial Obligations
- Set target capital structure (Debt vs. Equity)
- Forecast Net Financial Obligations (debt – cash) to finance assets
Drives interest expense in the income statement
How are depreciation, interest, and tax forecasted in financial modeling?
Depreciation
Forecasted as % of gross PP&E/intangibles
Varies by firm type:
- Mature firms → Depreciation ≈ CAPEX
- Growth firms → Lower depreciation (newer assets)
- Declining firms → Higher depreciation (aging assets)
Impacts: Operating profit, taxes, cash flow (even if embedded in COGS/SG&A)
Interest Expense
Based on: Interest Rate × Net Financial Obligations
Adjust for:
- Leverage shifts (new debt, repayments)
- Market rate changes
- Impacts: Pre-tax income & cash flow
Must separate gross interest if netted with income in reports
Tax Expense
Based on: Effective Tax Rate × Forecasted Taxable Income
Influenced by:
- Profitability
- Loss carryforwards
- Affects: Net income & cash flow
Often estimated using guidance/footnotes
What is the balance sheet plug in financial modeling and how is it chosen?
Balance Sheet Plug
Purpose: Ensures the accounting identity holds:
Assets = Liabilities + Equity
→ One line must be adjusted after forecasting to balance the sheet.
Choosing the Plug:
- Should be a financing item (managerial choice)
- Typically: Equity (adjusted via retained earnings, equity issuance, or buybacks)
- Alternative: Cash (less common – may cause unrealistic liquidity)
Limitations:
- Financing surplus → model may imply dividends or share buybacks
- Financing deficit → may imply new equity issuance
How do you derive a forecasted (pro forma) cash flow statement from projected financials?
Steps to Forecast the Cash Flow Statement
1.Start with Net Income
→ From pro forma income statement
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2.Adjust for Non-Cash Items
→ Add back depreciation, amortization, provisions, etc.
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3.Include Changes in Working Capital
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↑ Receivables → Cash Outflow
↑ Payables → Cash Inflow
↑ Inventory → Cash Used
(reflects timing between revenue/expenses and actual cash)
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4.Subtract Capital Expenditures (CAPEX)
→ Real cash outflows for PP&E investments
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5.Include Financing Cash Flows
→ Interest paid, dividends, equity/debt issuance or repayment
(based on balance sheet financing items)
What is Clean Surplus Accounting and how does it ensure consistency in financial models?
How does the decomposed clean surplus formula explain why Net Income ≠ Cash Flow?
How are forecasted cash flows derived, and what are the main sections of the cash flow statement?
Cash Flow Forecasting Overview:
- Cash flows are not guessed — they are derived systematically from the forecasted income statement and balance sheet.
- This ensures internal consistency and provides insight into how a firm generates and uses cash.
Methods to Prepare CFO Section:
Direct Method
- Tracks actual cash inflows/outflows (e.g., customer payments, supplier payments).
- Rarely used in forecasting due to lack of forward-looking data.
Indirect Method (Standard in forecasting)
- Starts from net income.
- Adjusts for:
- Non-cash items (e.g., depreciation, provisions)
- Changes in operating assets and liabilities (e.g., receivables, payables)
How is the Indirect Method used to forecast Cash Flow from Operating Activities (CFO)?
The indirect method is the standard in modeling and forecasting. It starts from net income and adjusts for:
- Non-cash expenses
- Changes in working capital
- Other non-cash or non-operating items
Steps to Forecast CFO (Cash Flow from Operating Activities):
- Start with Net Income
- Add back Non-Cash Expenses e.g., Depreciation, Amortization, Provisions
- Adjust for Working Capital Changes
Use forecasted balance sheet to determine changes in:
- ↑ Accounts Receivable → Cash outflow
- ↑ Inventory → Cash outflow
- ↑ Accounts Payable → Cash inflow
→ These adjustments correct for timing mismatches between accounting entries and actual cash flows.
Formula:
CFO = Net Income + Depreciation ± ΔWorking Capital ± Other Non-Cash Items
Purpose: This method reconciles accounting profit with actual cash generated by core operations, giving a clearer view of operational cash generation.
How are CFI and CFF calculated in a forecast, and how do they contribute to total cash flow?
1. Cash Flow from Investing Activities (CFI)
Reflects long-term investments like CAPEX and asset purchases/sales.
Formula: CFI = – CAPEX ± Proceeds from Asset Sales ± Other Investment Activity
2. Cash Flow from Financing Activities (CFF)
Captures how capital is raised or repaid through debt or equity.
Derived from forecasted changes in balance sheet:
- ↑ Debt → Cash inflow
- ↓ Debt (repayment) → Cash outflow
- Equity issuance → Cash inflow
- Dividends / Share buybacks → Cash outflow
Formula: CFF = ± ΔDebt ± ΔEquity – Dividends
Note: CFF affects cash, not operating profit.
3. Total Cash Flow Calculation
ΔCash = CFO + CFI + CFF
Used to update cash on the forecasted balance sheet:
Cashₜ = Cashₜ₋₁ + ΔCash
What are the types of Free Cash Flow (FCF), how are they computed, and what do they represent?
1. Free Cash Flow to Equity (FCFE):
Cash available to common shareholders after operating costs, reinvestments, and debt repayments.
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Version 1 – Direct: FCFE = – ΔCommon Stock + Dividends
- New equity issuance = negative FCFE
- Share buybacks/dividends = positive FCFE
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Version 2 – Clean Surplus Approach: FCFE = Net Income – ΔTotal Common Equity
. - Based on accounting data (no direct-to-equity adjustments)
2. Free Cash Flow to All Investors (FCF):
Cash available to both debt and equity holders before interest payments.
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Version 1 – Direct: FCF = CFO + CFI
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* CFO = Cash Flow from Operations
* CFI = Cash Flow from Investing
Version 2 – Indirect (NOPAT-based): FCF = EBIT × (1 – Tax Rate) + D&A – ΔNWC + CFI
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* NOPAT = Net Operating Profit After Tax
* ΔNWC = Change in non-cash Net Working Capital (excl. cash, short-term debt, etc.)
Note:
- FCFE focuses on equity holders.
- FCF includes all capital providers.
- Choice of method depends on data availability and the user’s goal (equity valuation vs. firm valuation).
What are key forecasting assumptions for major P&L items?
- Sales Growth: Driven by industry trends, market share gains, or new market entry; influenced by capacity, efficiency, and pricing.
- COGS: Closely tied to sales via gross margin; affected by scale and competitive pressure.
- R&D Expenses: Track sales but not directly tied; check MD&A for new project guidance.
- SG&A: Linked to sales; includes fixed and variable components; may be sticky in downturns.
- Depreciation: Based on gross PP&E; often equals inverse of asset life or half-life in steady state.
What are key forecasting assumptions for major Balance Sheet items?
- Cash: Minimal for operations (~3% of assets); can act as plug; may accumulate or burn.
- PP&E: Scales with sales growth; validate against CAPEX plans from MD&A.
- Interest Expense: Based on debt level; review for potential misclassification.
- Effective Tax Rate: Includes federal/state taxes; adjust for deferrals and differences.
- Receivables: Track sales; sensitive to credit terms and customer power.
- Payables: Track sales; influenced by supplier terms and bargaining power.
- Inventories: Track sales; slow turns may signal obsolescence or stock buildup.
- Other Current Assets: Typically track sales.
- Investments: Do not usually track sales; assess individually.
- Intangibles: Only acquired intangibles included; impairment likely if related unit loses money.
- Debt: Tied to asset base; reflect target capital structure.
- Other Assets/Liabilities: Assess case by case; judge if they scale with sales.
- Preferred Stock & Minority Interest: Reflects financing plans; minority interest linked to profit sharing.
