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Chapter 4
Forecasting Financial Statements
https://www.boundless.com/nance/forecasting-nancial-
statements/
Strategic Planning
AFN
Adjusting Capacity
Section 1
Role of Financial Forecasting in Planning
234
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Strategic Planning The nancial forecast is a key input to strategic planning, a rm's process of dening strategy and making decisions about allocating resources.
KEY POINTS
• Using historical internal accounting and sales data, in addition to external market and economic indicators, a financial forecast is an economist's best guess of what will happen to a company in financial terms over a given time period, which is usually one year.
• Financial forecasting is often helped by financial modeling processes. Financial modeling is the task of building an abstract representation (a model) of a financial decision- making situation.
• Assumptions play a key role in financial forecasts and can affect the way the forecasts predict the outcomes of decisions made on the corporate level.
Strategic Planning
Strategic planning is an organization's process of defining its
strategy, or direction, and making decisions about allocating
resources to pursue this strategy. In order to determine the
direction of the organization, it is necessary to understand its
current position and the possible avenues through which it can
pursue a particular course of action.
A financial forecast is an estimate of future financial outcomes
for a company. Using historical internal accounting and sales data,
in addition to external market and economic indicators, a financial
forecast is an economist's best guess of what will happen to a
company in financial terms over a given time period—which is
usually one year. Often, the forecaster's own assumptions and
beliefs will be used to guess future growth rates and potential events
that will affect the numbers on a financial statement.
Arguably, the most difficult aspect of preparing a financial forecast
is predicting revenue. Future costs can be estimated by using
historical accounting data; variable costs are also a function of
sales. Unlike a financial plan or a budget, a financial forecast
doesn't have to be used as a planning document. Outside analysts
can use a financial forecast to estimate a company's success in the
coming year (Figure 4.1).
Financial forecasting is often helped by processes of financial
modeling. Financial modeling is the task of building an abstract
representation (a model) of a financial decision making situation.
This is a mathematical model designed to represent a simplified
version of the performance of a financial asset or portfolio of a
business, project, or any other investment. Financial modeling is a
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general term that means different things to different users; the
reference usually relates either to accounting and corporate finance
applications, or to quantitative finance applications.Typically,
financial modeling is understood to mean an exercise in either asset
pricing or corporate finance, of a quantitative nature. In other
words, financial modeling is about translating a set of hypotheses
about the behavior of markets or agents into numerical predictions;
for example, a firm's decisions about investments or investment
returns. Once again, these are assumptions that will factor into the
financial forecasting and planning for the corporation. Once the
financial statements are forecast, one can attach a value to the firm,
and see what changes need to be made to put the company in a
better financial position.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/role-of-financial-forecasting-in-planning/strategic-
planning/
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Financial forecasting is essential for a company's strategic planning, management, and organization.
Figure 4.1 Strategic Planning
AFN AFN is "additional funds needed," and refers to the additional resources that will be needed for a company to expand its operations.
KEY POINTS
• AFN is a way of calculating how much new funding will be required, so that the firm can realistically look at whether or not they will be able to generate the additional funding and therefore be able to achieve the higher sales level.
• The simplified formula is: AFN = Projected increase in assets – spontaneous increase in liabilities – any increase in retained earnings. If this value is negative, this means the action or project which is being undertaken will generate extra income for the company, which can be invested elsewhere.
• The mathematical formulas used to determine AFN are based on showing how liabilities will grow relative to new assets and sales when a project is undertaken and can be used as tools to determine whether a project or operational expansion is worthwhile.
AFN stands for "additional funds needed." It is a concept used most
commonly in business looking to expand operations and influence.
Since a business that seeks to increase its sales level will require
more assets to meet that goal, some provision must be made to
accommodate the change in assets. To phrase it another way, the
business must have some plan to actually finance the new assets
that will be needed to increase sales.
AFN is a way of calculating how much new funding will be required,
so that the firm can realistically look at whether or not they will be
able to generate the additional funding and therefore be able to
achieve the higher sales level. Determining the amount of external
funding needed is a key part of calculating AFN. This can be
determined by mathematical formulas which use inputs that can be
found in a company's financial statements.
The simplified formula is:
AFN = Projected increase in assets – spontaneous increase in
liabilities – any increase in retained earnings.
If this value is negative, this means the action or project which is
being undertaken will generate extra income for the company,
which can be invested elsewhere.
The more formal equation for AFN is
AFN = (A*/S0)ΔS – (L*/S0)ΔS – MS1(RR)
• A- Assets tied directly to sales
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• L-spontaneous liabilities that are affected by sales
• S0=the previous year's sales
• S1=total projected sales for next year
• ΔS=the change in sales between S0 and S1
• M=profit margin
• MS1=projected net income
• RR=the retention ratio from net income (equal to 1 minus the
dividend payout ratio; disregard if dividends are not
declared).
Source: https://www.boundless.com/finance/forecasting-financial-
statements/role-of-financial-forecasting-in-planning/afn/
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Adjusting Capacity Capacity adjustment takes into account maximum production levels and the alteration of this level depending on how the rm wants to grow.
KEY POINTS
• Capacity planning is the process of determining the production capacity needed by an organization to meet changing demands for its products.
• Capacity utilization is a concept in economics and managerial accounting which refers to the extent to which an enterprise or a nation actually uses its installed productive capacity.
• When planning out how to manage capacity at the optimal level to attain the long term goals of the firm, capacity planning and utilization and other processes should be analyzed.
Adjusting capacity takes into account the maximum level of output
that can be produced by a firm, and how that can be changed in
order to change the potential forecasts of a firm's performance long
term (Figure 4.2). This involves capacity planning and management
that will keep a firm from growing too fast in sales and making sure
it is utilizing capital in the most efficient way possible. Capacity
planning is the process of determining the production capacity
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needed by an organization to meet changing demands for its
products. In the context of capacity planning, "design capacity" is
the maximum amount of work that an organization is capable of
completing in a given period. "Effective capacity" is the maximum
amount of work that an organization is capable of completing in a
given period due to constraints such as quality problems, delays,
material handling, etc.
Capacity utilization is a concept in economics and managerial
accounting that refers to the extent to which an enterprise or a
nation actually uses its installed productive capacity. Therefore, it
refers to the relationship between actual output that 'is' produced
with the installed equipment and the potential output which 'could'
be produced with it, if capacity was fully used. Implicitly, the
capacity utilization rate is also an indicator of how efficiently the
factors of production are being used. Much statistical and anecdotal
evidence shows that many industries in the developed capitalist
economies suffer from chronic excess capacity. Therefore, critics of
market capitalism argue the system is not as efficient as it may
seem, since at least 1/5 more output could be produced and sold, if
buying power was better distributed. However, a level of utilization
somewhat below the maximum prevails, regardless of economic
conditions. As a result, we look into capacity utilization to forecast a
firm's success and growth numbers when predicting how financial
statements will look into the future. The decision makers at the firm
will be able to adjust this capacity in order to grow the firm in a way
they feel is optimal.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/role-of-financial-forecasting-in-planning/adjusting-
capacity/
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239
Adjusting capacity will aect the amount of items produced on the assembly line.
Figure 4.2 Thunderbird Assembly Line
Inputs
Steps Required to Forecast
Section 2
Overview of Forecasting
240
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Inputs The main inputs of forecasting include time series, cross-sectional and longitudinal data, or using judgmental methods.
KEY POINTS
• Forecasting is the process of making statements about events whose actual outcomes (typically) have not yet been observed.
• Time series is a sequence of data points, measured typically at successive time instants spaced at uniform time intervals.
• Cross-sectional data refers to data collected by observing many subjects at the same point of time, or without regard to differences in time.
• A longitudinal data involves repeated observations of the same variables over long periods of time — often many decades.
• Judgmental forecasting methods incorporate intuitive judgements, opinions and subjective probability estimates.
Forecasting in Accounting
In corporate finance, investment banking, and the accounting
profession, financial modeling is largely synonymous with cash flow
forecasting.
This usually involves the preparation of detailed company specific
models used for decision making purposes and financial analysis.
A financial forecast is an estimate of future financial outcomes for a
company or country (for futures and currency markets). Using
historical internal accounting and sales data, in addition to external
market and economic indicators, a financial forecast is an
economist's best guess of what will happen to a company in
financial terms over a given time period—usually one year.
Challenges
Arguably, the most difficult aspect of preparing a financial forecast
is predicting revenue. Future costs can be estimated by using
historical accounting data; variable costs are also a function of sales.
Forecasting vs. Financial Plans and Budgets
Unlike a financial plan or a budget, a financial forecast doesn't have
to be used as a planning document. Outside analysts can use a
financial forecast to estimate a company's success in the coming
year.
Forecasting is the process of making statements about events whose
actual outcomes (typically) have not yet been observed. A
commonplace example might be the estimation of some variable of
interest at some specified future date. Prediction is a similar, but
241
more general term. Both might refer to formal statistical methods
employing time series, cross-sectional or longitudinal data, or less
formal judgmental methods.
Time Series Data
Time series is a sequence of data points, measured typically at
successive time instants and spaced at uniform time intervals.
Examples of time series are the daily closing value of theDow
Jones index or the annual flow volume of the Nile River at Aswan.
Time series analysis comprises methods for analyzing time series
data in order to extract meaningful statistics and other
characteristics of the data. Time series forecasting is the use of a
model to predict future values based on previously observed
values. Time series are very frequently plotted via line charts.
Cross-sectional data
Cross-sectional data refers to data collected by observing many
subjects (such as individuals, firms or countries/regions) at the
same point in time, or without regard to differences in time.
Analysis of cross-sectional data usually consists of comparing the
differences among the subjects.
For example, if we want to measure current obesity levels in a
population, we could randomly draw a sample of 1,000 people from
the population (also known as a cross section of that population),
measure their weight and height, and calculate what percentage of
that sample is categorized as obese. For example, 30% of our
sample may be categorized as obese based on our measures. This
cross-sectional sample provides us with a snapshot of that
population, at that one point in time. Note that we do not know
based on one cross-sectional sample if obesity is increasing or
decreasing; we can only describe the current proportion. Cross-
sectional data differs from time series data also known as
longitudinal data, which follows one subject's changes over the
course of time. Another variant, panel data (or time-series cross-
sectional (TSCS) data), combines both and looks at multiple
subjects and how they change over the course of time. Panel
analysis uses panel data to examine changes in variables over time
and differences in variables between subjects.
Longitudinal Data
A longitudinal study is a correlational research study that involves
repeated observations of the same variables over long periods of
time — often many decades. It is a type of observational study.
Longitudinal studies are often used in psychology to study
developmental trends across the life span, and in sociology to study
life events throughout lifetimes or generations. The reason for this
is that unlike cross-sectional studies, in which different individuals
with same characteristics are compared, longitudinal studies track
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the same people, and therefore the differences observed in those
people are less likely to be the result of cultural differences across
generations. Because of this benefit, longitudinal studies make
observing changes more accurate, and they are applied in various
other fields. In medicine, the design is used to uncover predictors of
certain diseases. In advertising, the design is used to identify the
changes that adverts have produced in the attitudes and behaviors
of those within the target audience who have seen the advertising
campaign.
Judgmental methods
Judgmental forecasting methods incorporate intuitive judgements,
opinions and subjective probability estimates, such as Composite
forecasts, Delphi method, Forecast by analogy, Scenario building,
Statistical surveys and Technology forecasting.
Usage of forecasting can differ between areas of application: for
example, in hydrology, the terms "forecast" and "forecasting" are
sometimes reserved for estimates of values at certain specific future
times, while the term "prediction" is used for more general
estimates, such as the number of times floods will occur over a long
period.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/overview-of-forecasting—2/inputs—2/
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243
Steps Required to Forecast Steps of forecast include problem denition, cash ow forecast, prot forecast, balance sheet forecast and prot determination.
KEY POINTS
• It is important to note those earlier identified 'threats' to your business to ensure that as you forecast you can see the deviation of the best and worst models.
• Three key forecasts include problem definition, cash flow forecast, profit forecast, and balance sheet forecast.
• By completing these scenarios you gain an insight into the various risks that a business faces.
Problem definition
It is important to note those earlier identified 'threats' to your
business to ensure that, as you forecast, you can see the deviation of
the best and worst models. For example, if a business has previously
identified the threat of a diminishing cheap labor force, then its
forecast needs to reflect that the price of labor (or any other
resource, such as power) is going to go up. There are three key
forecasts involved.
Cash flow forecast
This seeks to forecast a bank balance after a period – typically 12
months. This forecast shows the sources and application of funds.
Profit forecast
This modifies the cash flow in an attempt to calculate taxable
income and, in the process, forecast a businesses income tax
liability. There are two differences between a cash flow and a profit
forecast. The cash flow forecast includes all expenditure in the
period, whereas the profit forecast looks to match revenue with the
costs associated with generating that revenue. To achieve this, one
uses non-cash expenses to estimate some of the costs associated
with running a business.
These two forecasts are reconciled with a forecast balance sheet.
Balance sheet forecast
While we have based this example on a smaller business and, while
forecasting balance sheets demonstrates completeness and a high
level of technical integrity in forecasting, we feel the process is
complex and better left to a professional. We also feel that the
additional benefit is outweighed by the costs for a small business.
It is always easier to forecast the future performance of a business if
your business is already up and running as there are past trading
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results to look at. When a completely
new venture is being planned, a certain
amount of imagination is required.
However, this is in no way a license to
be overly optimistic.
Basic Steps
By completing these scenarios you gain
an insight into the various risks that a
business faces. Spreadsheet programs
make this quite easy if they are well set
up (Figure 4.3).
1. The sales forecast This is the dominant influence on the
performance of your business. Also, many expenses have a
link to the level of activity in a business. For existing
businesses, past sales are the best predictor of future sales,
for new businesses it is less simple. However, once the
business is established, you will find you have a better
understanding between the business's products and its
markets. The most important thing is to keep detailed
records of sales as it is these that will provide you with the
growing ability to forecast income accurately.
• Forecast the number of units you expect to sell
• Begin with an analysis of current performance
• Divide sales into appropriate categories
• Consider factors that affect each category
• Internal factors might include staffing changes (for service
industries)
• External factors might include the impact of inflation –
current relevance
• Now attempt to forecast unit sales in cash category
2. Multiply by unit price
3. Determine market price
4. Cost plus
• Expected mark-up
• Expected revenue per unit sold
• Statistical review of the market
• Determination of units sold
• Seasonal sales pattern
• Cash flow
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Forecasting steps to success
Figure 4.3 Steps
• Every business needs cash (sometimes called liquidity) to
keep going.
• Forecasting cash flow lets us anticipate liquidity problems
and helps identify solutions.
5. Profit determination
The essential difference between cash flow and profit is that cash
flow includes all items of income and expense, whereas profit seeks
to match income and costs related to the generation of the income
in a period of time; usually 12 months.
To facilitate the calculation of profit (and hence, the income tax
due) the cash flow statements were split into four sections. We now
take the total of income and the operational costs into a Profit
Statement. We add depreciation to the operational costs and
subtract our adjusted operational costs from income. This
difference will indicate a profit (where the difference is positive) or
a loss (where the difference is negative).
Where there is profit, we need to then calculate income tax. This
calculation depends on the legal structure adopted for the business.
Where a business is registered for Goods and Services Tax, we take
only the net payments and receipts into account.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/overview-of-forecasting--2/steps-required-to-forecast--2/
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246
Sales Forecast Input
Production Schedule Input
COGS Input
Other Expenses Input
Pro Forma Income Statement
Section 3
Forecasting the Income Statement
247
https://www.boundless.com/nance/forecasting-nancial-statements/forecasting-the-income-statement/
Sales Forecast Input Target volume, price, and contribution margin per unit are the key inputs to a sales forecast.
KEY POINTS
• Net sales are operating revenues earned by a company for selling its products or rendering its services.
• Gross sales are the sum of all sales during a time period. Net sales are gross sales minus sales returns, sales allowances, and sales discounts.
• The purpose of profit-based sales target metrics is to ensure that marketing and sales objectives mesh with profit targets.
Sales
Net sales are operating revenues earned by a company for selling its
products or rendering its services. Also referred to as revenue, they
are reported directly on the income statement as Sales or Net sales.
For financial ratios that use income statement sales values, "sales"
refers to net sales, not gross sales. Sales are the unique transactions
that occur in professional selling or during marketing initiatives.
The term sales in a marketing, advertising or a general business
context often refers to a contract in which a buyer has agreed to
purchase some products at a set time in the future. "Outstanding
orders" refers to sales orders that have not been filled.
A sale is a transfer of property for money or credit. In double-entry
bookkeeping, a sale of merchandise is recorded in the general
journal as a debit to cash or accounts receivable and a credit to the
sales account. A discount from list price might be noted if it applies
to the sale (discount expense debit).
Fees for services are recorded
separately from sales of
merchandise, but the bookkeeping
transactions for recording sales of
services are similar to those for
recording sales of tangible goods
(Figure 4.4).
Forecasting: Gross Sales and Net Sales
Net sales = Gross sales - (Customer discounts, returns, allowances)
Gross sales are the sum of all sales during a time period. Net sales
are gross sales minus sales returns, sales allowances, and sales
discounts. Gross sales do not normally appear on an income
statement. The sales figures reported on an income statement are
net sales.
248
Increasing sales revenue is one of the goals of businesses.
Figure 4.4 Sales
• sales returns are refunds to customers for returned
merchandise/credit notes
• debit notes
• sales journal entries non-current, current batch-processed
transactions, predictive analytics in strategic management/
administration/governance research metaframeworks
• sales allowances are reductions in sales price for merchandise
with minor defects, the allowance agreed upon after the
customer has purchased the merchandise
• sales discounts allowed are reduced payments from the
customer based on invoice payment terms such as 2/10, n/30
(2% discount if paid within 10 days, net invoice total due in 30
days)
• interest received for amounts in arrears
• includes/excludes amounts capital goods & services, non-
capital goods & services, input valued-added tax, with cost of
non-capital goods sold
• input vat - output vat
• sales of portfolio items and capital gains taxes
• Sales Returns and Allowances and Sales Discounts are contra-
revenue accounts
Sales Forecasting
In launching a program, managers often start with an idea of the
dollar profit they desire and ask what sales levels will be required to
reach it. Target volume is the unit sales quantity required to meet
an earnings goal. Target revenue is the corresponding figure for
dollar sales. Both of these metrics can be viewed as extensions of
break-even analysis. Increasingly, marketers are expected to
generate volumes that meet the target profits of their firm. This will
often require them to revise sales targets as prices and costs change.
• Target volume: the volume of sales necessary to generate the
profits specified in a company’s plans.
• Target Volume = [Fixed costs + Target Profits] /
Contribution per Unit
• The formula for target volume will be familiar to those who
have performed break-even analysis. The only change is to
add the required profit target to the fixed costs. From another
perspective, the break-even volume equation can be viewed as
a special case of the general target volume calculation — one
in which the profit target is zero, and a company seeks only to
cover its fixed costs.
• In target volume calculations, the company broadens this
objective to solve for a desired profit.
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• Target Revenue = Target Volume * Selling Price per Unit; or
• Target Revenue = 100 * [ { Fixed Costs + Target Profits } /
Contribution Margin ]
The purpose of profit-based sales target metrics is to ensure that
marketing and sales objectives mesh with profit targets. In target
volume and target revenue calculations, managers go beyond break-
even analysis (the point at which a company sells enough to cover
its fixed costs) to determine the level of unit sales or revenues
needed not only to cover a firm’s costs but also to attain its profit
targets.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/sales-forecast-input/
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Production Schedule Input Production schedule can be divided into raw materials, work in process, nished goods and goods for resale.
KEY POINTS
• A good purchased as a "raw material" goes into the manufacture of a product.
• A good only partially completed during the manufacturing process is called "work in process".
• When the good is completed as to manufacturing but not yet sold or distributed to the end-user, it is called a "finished good".
• Inventory management is primarily about specifying the shape and percentage of stocked goods.
• Basic reasons for keeping an inventory involve time, uncertainty and economics of scales.
Production schedule inputs:
• A good purchased as a "raw material" goes into the
manufacture of a product.
• A good only partially completed during the manufacturing
process is called "work in process."
250
• When the good is completed as to manufacturing but not yet
sold or distributed to the end user, it is called a "finished
good." (Figure 4.5)
Raw materials - materials and components scheduled for use in
making a product.
A raw material is the basic material from which a product is
manufactured or made, frequently used with an extended meaning.
For example, the term is used to denote material that came from
nature and is in an unprocessed or minimally processed state.
Latex, iron ore, logs, and crude oil, and salt water are examples. The
use of raw material by non-human species includes twigs and found
objects as used by birds to make nests.
Work in process, WIP - materials and components that have
begun their transformation to finished goods.
Work in process (WIP) or in-process inventory includes the set at
large of unfinished items for products in a production process.
These items are not yet completed but either just being fabricated or
waiting in a queue for further processing or in a buffer storage. The
term is used in production and supply chainmanagement.
Optimal production management aims to minimize work in
process. Work in process requires storage space, represents bound
capital not available for investment, and carries an inherent risk of
earlier expiration of shelf life of the products. A queue leading to a
production step shows that the step is well buffered for shortage in
supplies from preceding steps, but may also indicate insufficient
capacity to process the output from these preceding steps.
Finished goods - goods ready for sale to customers.
Finished goods are goods that have completed the manufacturing
process but have not yet been sold or distributed to the end user.
Finished goods is a relative term. In a Supply chain
management flow, the finished goods of a supplier can constitute
the raw material of a buyer.
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Production budget is important for inventory and sales revenue
Figure 4.5 Production budget
Goods for resale - returned goods that are salable.
Inventory management
Inventory management is primarily about specifying the shape and
percentage of stocked goods. It is required at different locations
within a facility or within many locations of a supply network to
precede the regular and planned course of production and stock of
materials.
The scope of inventory management concerns the fine lines between
replenishment lead time, carrying costs of inventory, asset
management, inventory forecasting, inventory valuation, inventory
visibility, future inventory price forecasting, physical inventory,
available physical space for inventory, quality management,
replenishment, returns and defective goods, and demand
forecasting. Balancing these competing requirements leads to
optimal inventory levels, which is an on-going process as the
business needs shift and react to the wider environment.
Inventory management involves a retailer seeking to acquire and
maintain a proper merchandise assortment while ordering,
shipping, handling, and related costs are kept in check. It also
involves systems and processes that identify inventory
requirements, set targets, provide replenishment techniques, report
actual and projected inventory status, and handle all functions
related to the tracking and management of material. This would
include the monitoring of material moved into and out of stockroom
locations and the reconciling of the inventory balances. It also may
include ABC analysis, lot tracking, cycle counting support, etc.
Management of the inventories, with the primary objective of
determining/controlling stock levels within the physical
distribution system, functions to balance the need for product
availability against the need for minimizing stock holding and
handling costs (Figure 4.6).
There are three basic reasons for keeping an inventory:
• Time: The time lags present in the supply chain, from supplier
to user at every stage, requires that you maintain certain
amounts of inventory to use in this lead time. However, in
252
Production schedule plays an important role in nancial forecasting.
Figure 4.6 Production schedule
practice, inventory is to be maintained for consumption
during variations in lead time. Lead time itself can be
addressed by ordering that many days in advance.
• Uncertainty: Inventories are maintained as buffers to meet
uncertainties in demand, supply and movements of goods.
• Economies of scale: Ideal condition of "one unit at a time at a
place where a user needs it, when he needs it" principle tends
to incur lots of costs in terms of logistics. So bulk buying,
movement, and storing brings in economies of scale, thus
inventory.
EXAMPLE
By taking the Costs-To-Date divided by the Cost Estimate, the "percentage complete" for the project is calculated. For example: Assume a project is estimated to cost $70,000 by the time the work is complete, Assume at the end of December, $35,000 has been spent to date for the project, $35,000 divided by $70,000 is 50%, therefore, the project can be considered 50% complete at December 31.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/production-schedule-
input/
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COGS Input COGS is dicult to forecast due to the sheer amount of expenses included and diering methods of estimating each.
KEY POINTS
• Costs include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
• The key components of cost generally include: parts - raw materials and supplies used, labor - including associated costs such as payroll taxes and benefits, and overhead of the business allocable to production.
• A miscalculation or faulty estimation can be amplified drastically, causing a vastly different forecasted amount of income than what will actually come to pass.
Cost of goods sold (COGS) refer to the inventory costs of the goods a
business has sold during a particular period. Costs include all costs
of purchase, costs of conversion, and other costs incurred in
bringing the inventories to their present location and condition.
Costs of goods made by the business include material, labor, and
allocated overhead. The costs of those goods not yet sold are
deferred as costs of inventory until the inventory is sold or written
down in value.
Because costs of goods sold is a major expense for most companies,
it is an extremely important input to a forecast of the income
statement. A miscalculation or faulty estimation can be amplified
drastically, causing a vastly different forecasted amount of income
than what will actually come to pass. Specifically, underestimating
the costs associated with goods to be sold can cause the forecasted
income to be much higher than what it actually will be, and vice
versa. Also, because cost of goods sold is such a broad input,
encompassing many separate expenses with different methods of
estimating each, it becomes difficult to accurately forecast all phases
(Figure 4.7).
Parts, RawMaterials, and Supplies Used
Most businesses make more than one of a particular item.
Therefore, costs are incurred for multiple items rather than a
particular item sold. Determining how much of each of these
components to allocate to particular goods requires either tracking
the particular costs or making some allocations of costs. Parts and
raw materials are often tracked to particular sets (e.g., batches or
production runs) of goods, then allocated to each item.
254
Labor and Associated Costs
Labor costs include direct labor and indirect labor. Direct labor
costs are the wages paid to those employees who spend all their
time working directly on the product being manufactured. Indirect
labor costs are the wages paid to other factory employees involved
in production. Costs of payroll taxes and employee benefits are
generally included in labor costs, but may be treated as overhead
costs. Labor costs may be allocated to an item or set of items based
on timekeeping records.
Overhead of the Business Allocable to Production
Determining overhead costs often involves making assumptions
about what costs should be associated with production activities
and what costs should be associated with other activities.
Traditional methods attempt to make these assumptions based on
past experience and management judgment as to factual
relationships. Activity based costing attempts to allocate costs based
on those factors that drive the business to incur the costs.
Variable production overheads are allocated to units produced
based on actual use of production facilities. Fixed production
overheads are often allocated based on normal capacities or
expected production. More or fewer goods may be produced than
expected when developing cost assumptions (like burden rates).
These differences in production levels often result in too much or
too little cost being assigned to the goods produced. This also gives
rise to variances.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/cogs-input/
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255
The cost of goods sold in a given accounting period is recorded on a company's income statement.
Figure 4.7 A
Sample Income
Statement
Other Expenses Input Other expenses include SG&A, depreciation, amortization, R&D, nance costs, income tax expense, discontinued operations expenses.
KEY POINTS
• Other expenses include operation expenses section and non- operation expenses section.
• Operation section expenses include SG&A, depreciation, amortization, and R&D expenses.
• Non-operation section expenses include finance costs, income tax expense, and discontinued operations expenses.
• SG&A is usually understood as a major portion of non- production related costs, in contrast to production costs such as direct labour.
Selling, General, and Administrative expenses (SG&A or
SGA)
• Selling, General, and Administrative expenses (SG&A or SGA)
consist of the combined payroll costs. SGA is usually
understood as a major portion of non-production related
costs, in contrast to production costs such as direct labor.
• Selling expenses - represent expenses needed to sell products
(e.g. salaries of sales people, commissions and travel
expenses, advertising, freight, shipping, depreciation of sales
store buildings and equipment, rent, and all expenses and
taxes directly related to producing and selling product, etc.)
• General expenses- general operating expenses and taxes that
are directly related to the general operation of the company,
but don't relate to the other two categories.
• Administrative expenses - executive salaries, general support,
and all associated taxes related to the overall administration
of the company (Figure 4.8).
Depreciation
1. The decrease in value of assets (fair value depreciation).
2. The allocation of the cost of assets to periods in which the
assets are used (depreciation with the matching principle).
256
Operational expenses and non-operational expenses are the main cash outow of a business.
Figure 4.8 Expenses
The former affects values of businesses and entities. The latter
affects net income. Generally, the cost is allocated, as depreciation
expense, among the periods in which the asset is expected to be
used. Such expense is recognized by businesses for financial
reporting and tax purposes. Methods of computing depreciation
may vary by asset for the same business. Methods and lives may be
specified in accounting and/or tax rules in a country. Several
standard methods of computing depreciation expense may be used,
including fixed percentage, straight line, and declining balance
methods. Depreciation expense generally begins when the asset is
placed in service.
Amortization
Amortization (or amortization) is the process of decreasing or
accounting for an amount over a period. When used in the context
of a home purchase, amortization is the process by which loan
principal decreases over the life of a loan. With each mortgage
payment that is made, a portion of the payment is applied towards
reducing the principal, and another portion of the payment is
applied towards paying the interest on the loan. An amortization
table shows this ratio of principal and interest and demonstrates
how a loan's principal amount decreases over time. Amortization is
generally known as depreciation of intangible assets of a firm.
Research & Development (R&D) Expenses
The term R&D or research and development refers to a specific
group of activities within a business. The activities that are
classified as R&D differ from company to company, but there are
two primary models. In one model, the primary function of an R&D
group is to develop new products. In the other model, the primary
function of an R&D group is to discover and create new knowledge
about scientific and technological topics for the purpose of
uncovering and enabling development of valuable new products,
processes, and services.
Non-operating section
• Other expenses or losses - expenses or losses not related to
primary business operations, (e.g. foreign exchange loss).
• Finance costs - costs of borrowing from various creditors (e.g.
interest expenses, bank charges).
• Income tax expense - sum of the amount of tax payable to tax
authorities in the current reporting period (current tax
liabilities/ tax payable) and the amount of deferred tax
liabilities (or assets).
• Discontinued operations are the most common type of
irregular items. Shifting business location(s), stopping
257
• production temporarily, or changes due to technological
improvement do not qualify as discontinued operations.
Discontinued operations must be shown separately.
• Extraordinary items are both unusual (abnormal) and
infrequent, for example, unexpected natural disaster,
expropriation, prohibitions under new regulations.
EXAMPLE
Extraordinary items: natural disaster might not qualify depending on location.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/other-expenses-input/
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Boundless is an openly licensed educational resource
Pro Forma Income Statement A pro forma income statement is planned and prepared in advance to of a transaction to project the future status of the company.
KEY POINTS
• The pro forma accounting is a statement of the company's financial activities while excluding "unusual and nonrecurring transactions" when stating how much money the company actually made.
• Income statement is a company's financial statement that indicates how the revenue is transformed into the net income during a certain period of time.
• Pro forma Income statement includes revenue, COGS, operational expenses and non-operational expenses.
Pro forma
The term pro forma, Latin for "as a matter of form" or "for the
sake of form", is a term applied to practices or documents that are
done as a pure formality, perfunctorily, or seek to satisfy the
minimum requirements or to conform to a convention or doctrine.
It has different meanings in different fields.
258
Pro forma financial statements are prepared in advance of a
planned transaction, such as a merger, an acquisition, a new capital
investment, or a change in capital structure like an incurrence of
new debt or issuance of equity.
The pro forma models the anticipated results of the transaction,
with particular emphasis on the projected cash flows, net revenues
and (for taxable entities) taxes. Consequently, pro forma statements
summarize the projected future status of a company, based on the
current financial statements. For example, when a transaction with
a material effect on a company's financial condition is
contemplated, the Finance Department will prepare, for
management and Board review, a business plan containing pro
forma financial statements demonstrating the expected effect of the
proposed transaction on the company's financial viability. Lenders
and investors will require such statements to structure or confirm
compliance with debt covenants, such as debt service reserve
coverage and debt to equity ratios. Similarly, when a new
corporation is envisioned, its founders will prepare pro forma
financial statements for the information of prospective investors.
Pro forma accounting is a statement of the company's financial
activities while excluding "unusual and nonrecurring transactions"
when stating how much money the company actually made.
Expenses often excluded from pro forma results include company
restructuring costs, a decline in the value of the company's
investments, or other accounting charges, such as adjusting the
current balance sheet to fix faulty accounting practices in previous
years.
Income Statement
The income statement is a company's financial statement that
indicates how the revenue is transformed into the net income (the
result after all revenues and expenses have been accounted for, also
known as Net Profit or the "bottom line"). It displays the revenues
recognized for a specific period, and the cost and expenses charged
against these revenues, includingwrite-offs (e.g., depreciation and
amortization of various assets) and taxes.
Pro Forma Income Statement
(Figure 4.9)Pro forma figures should be clearly labeled as such and
the reason for any deviation from reported past figures clearly
explained. A pro forma Income statement could be planned and
prepared in advance, which includes the items below:
Operating Section:
• Revenue - Cash inflows or other enhancements of assets of an
entity during a period from delivering or producing goods,
rendering services, or other activities that constitute the
259
entity's ongoing major operations. It is usually presented as
sales minus sales discounts, returns, and allowances.
• Expenses - Cash outflows or other using-up of assets or
incurrence of liabilities during a period from delivering or
producing goods, rendering services, or carrying out other
activities that constitute the entity's ongoing major operations.
• Cost of Goods Sold (COGS) / Cost of Sales - represents the
direct costs attributable to goods produced and sold by a
business (manufacturing or merchandizing). It includes
material costs, direct labour, and overhead costs (as in
absorption costing).
• Selling, General and Administrative expenses (SG&A or SGA) -
consist of the combined payroll costs. SGA is usually
understood as a major portion of non-production related
costs, in contrast to production costs such as direct labour.
• Depreciation / Amortization - the charge with respect to fixed
assets / intangible assets that have been capitalized on the
balance sheet for a specific (accounting) period. It is a
systematic and rational allocation of cost rather than the
recognition of market value decrement.
• Research & Development (R&D) expenses - expenses included
in research and development.
Non-Operating Section:
• Other revenues or gains - income from other than primary
business activities (e.g. rent, income from patents). It also
includes gains that are either unusual or infrequent, but not
both (e.g. gain from sale of securities or gain from disposal of
fixed assets)
260
Pro forma income statement is an estimate for the prots or losses of a company.
Figure 4.9 Income
statement
• Other expenses or losses - not related to primary business
operations, (e.g. foreign exchange loss).
• Finance costs - costs of borrowing from various creditors (e.g.
interest expenses, bank charges).
• Income tax expense - sum of the amount of tax payable to tax
authorities in the current reporting period (current tax
liabilities / tax payable) and the amount of deferred tax
liabilities (or assets).
• Irregular items - these are reported separately because this
way users can better predict future cash flows - irregular items
most likely will not recur. These are reported net of taxes.
• Discontinued operations is the most common type of irregular
items. Shifting business location(s), stopping production
temporarily, or changes due to technological improvement do
not qualify as discontinued operations. Discontinued
operations must be shown separately.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/pro-forma-income-
statement/
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261
Pro Forma Balance Sheet
Balance Sheet Analysis
Section 4
Forecasting the Balance Sheet
262
https://www.boundless.com/nance/forecasting-nancial-statements/forecasting-the-balance-sheet/
Pro Forma Balance Sheet A pro forma balance sheet summarizes the projected future status of a company after a planned transaction, based on the current nancial statements.
KEY POINTS
• The pro forma accounting is a statement of the company's financial activities while excluding "unusual and nonrecurring transactions" when stating how much money the company actually made.
• In business, pro forma financial statements are prepared in advance of a planned transaction, such as a merger, an acquisition, a new capital investment, or a change in capital structure such as incurrence of new debt or issuance of equity.
• Pro forma figures should be clearly labeled as such and the reason for any deviation from reported past figures clearly explained.
Pro Forma Financial Statements
In business, pro forma financial statements are prepared in advance
of a planned transaction, such as a merger, an acquisition, a
new capital investment, or a change in capital structure such as
incurrence of new debt or issuance of equity. The pro forma models
the anticipated results of the transaction, with particular emphasis
on the projected cash flows, net revenues and (for taxable entities)
taxes. Consequently, pro forma statements summarize the projected
future status of a company, based on the current financial
statements. For example, when a transaction with a material effect
on a company's financial condition is contemplated, the Finance
Department will prepare, for management and Board review, a
business plan containing pro forma financial statements
demonstrating the expected effect of the proposed transaction on
the company's financial viability.
263
Simple balance sheet including basic items
Figure 4.10 Balance
Sheet
Pro Forma Balance Sheet
If applicable to the business, summary values for the following
items should be included in the pro forma balance sheet
(Figure 4.10):
• Assets
• Current assets
• Cash and cash equivalents
• Accounts receivable
• Inventories
• Prepaid expenses for future services that will be used within a
year
• Non-current assets (Fixed assets)
• Property, plant and equipment
• Investment property, such as real estate held for investment
purposes
• Intangible assets
• Financial assets (excluding investments accounted for using
the equity method, accounts receivables, and cash and cash
equivalents)
• Investments accounted for using the equity method
• Biological assets, which are living plants or animals. Bearer
biological assets are plants or animals which bear agricultural
produce for harvest, such as apple trees grown to produce
apples and sheep raised to produce wool.
• Liabilities
• Accounts payable
• Provisions for warranties or court decisions
• Financial liabilities (excluding provisions and accounts
payable), such as promissory notes and corporate bonds
• Liabilities and assets for current tax
• Deferred tax liabilities and deferred tax assets
• Unearned revenue for services paid for by customers, but not
yet provided
• Equity
• The net assets shown by the balance sheet equals the third
part of the balance sheet, which is known as the shareholders'
equity. It comprises:
• Issued capital and reserves attributable to equity holders of
the parent company (controlling interest)
264
• Non-controlling interest in equity
• Formally, shareholders' equity is part of the company's
liabilities: they are funds "owing" to shareholders (after
payment of all other liabilities). Usually, however, "liabilities"
is used in the more restrictive sense of liabilities excluding
shareholders' equity. The balance of assets and liabilities
(including shareholders' equity) is not a coincidence. Records
of the values of each account in the balance sheet are
maintained using a system of accounting known as double-
entry bookkeeping. In this sense, shareholders' equity by
construction must equal assets minus liabilities, and are a
residual.
• Regarding the items in equity section, the following
disclosures are required:
• Numbers of shares authorized, issued and fully paid, and
issued but not fully paid
• Par value of shares
• Reconciliation of shares outstanding at the beginning and the
end of the period
• Description of rights, preferences, and restrictions of shares
• Treasury shares, including shares held by subsidiaries and
associates
• Shares reserved for issuance under options and contracts
• A description of the nature and purpose of each reserve within
owners' equity
Lenders and investors will require such statements to structure or
confirm compliance with debt covenants such as debt service
reserve coverage and debt to equity ratios. Similarly, when a new
corporation is envisioned, its founders will prepare pro forma
financial statements for the information of prospective investors.
Pro forma figures should be clearly labeled as such and the reason
for any deviation from reported past figures clearly explained.
EXAMPLE
For example, when a transaction with a material effect on a company's financial condition is contemplated, the Finance Department will prepare, for management and board review, a business plan containing pro forma financial statements demonstrating the expected effect of the proposed transaction on the company's financial viability.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-balance-sheet/pro-forma-balance-sheet/
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Boundless is an openly licensed educational resource
265
Balance Sheet Analysis Balance sheet analysis is process of understanding the risk and protability of a rm through analysis of reported nancial information.
KEY POINTS
• Balance sheet is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation or other business organization. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year.
• Balance sheet analysis (or financial analysis) the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports.
• Financial ratio analysis should be based on regrouped and adjusted financial statements. Two types of ratio analysis are performed: 3.1) Analysis of risk and 3.2) analysis of profitability.
• Balance sheet analysis consists of 1) reformulating reported Balance sheet, 2) analysis and adjustments of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted Balance sheet.
Balance sheet
In financial accounting, a
balance sheet or statement of
financial position is a summary
of the financial balances of a sole
proprietorship, a business
partnership, a corporation or
other business organization.
Assets, liabilities and ownership
equity are listed as of a specific
date, such as the end of its
financial year. A balance sheet is
often described as a "snapshot of
a company's financial
condition". Of the four basic financial statements, the balance sheet
is the only statement which applies to a single point in time of a
business' calendar year.
A business operating entirely in cash can measure its profits by
withdrawing the entire bank balance at the end of the period, plus
any cash in hand. However, many businesses are not paid
immediately; they build up inventories of goods and they acquire
buildings and equipment. In other words: businesses have assets
and so they cannot, even if they want to, immediately turn these
266
Classied balance sheet
Figure 4.11 Balance sheet
into cash at the end of each period. Often, these businesses owe
money to suppliers and to tax authorities, and the proprietors do
not withdraw all their original capital and profits at the end of each
period. In other words businesses also have liabilities (Figure 4.11).
Balance sheet analysis
Balance sheet analysis (or financial analysis) the process of
understanding the risk and profitability of a firm (business, sub-
business or project) through analysis of reported financial
information, particularly annual and quarterly reports.
Balance sheet analysis consists of 1) reformulating reported Balance
sheet, 2) analysis and adjustments of measurement errors, and 3)
financial ratio analysis on the basis of reformulated and adjusted
Balance sheet. The two first steps are often dropped in practice,
meaning that financial ratios are just calculated on the basis of the
reported numbers, perhaps with some adjustments. Financial
statement analysis is the foundation for evaluating and pricing
credit risk and for doing fundamental company valuation.
Financial ratio analysis should be based on regrouped and adjusted
financial statements. Two types of ratio analysis are performed: 3.1)
Analysis of risk and 3.2) analysis of profitability:
3.1) Analysis of risk typically aims at detecting the underlying credit
risk of the firm. Risk analysis consists of liquidity and solvency
analysis. Liquidity analysis aims at analyzing whether the firm has
enough liquidity to meet its obligations when they should be paid. A
usual technique to analyze liquidity risk is to focus on ratios such as
the current ratio and interest coverage. Cash flow analysis is also
useful. Solvency analysis aims at analyzing whether the firm is
financed so that it is able to recover from a losses or a period of
losses.
3.2) Analysis of profitability refers to the analysis of return on
capital, for example return on equity, ROE, defined as earnings
divided by average equity. Return on equity, ROE, could be
decomposed: ROE = RNOA + (RNOA -NFIR) *NFD/E
Purposes of balance sheet analysis
"The objective of financial statements is to provide information
about the financial position, performance and changes in financial
position of an enterprise that is useful to a wide range of users in
making economic decisions." Financial statements should be
understandable, relevant, reliable and comparable. Reported assets,
liabilities, equity, income and expenses are directly related to an
organization's financial position.
Financial statements are intended to be understandable by readers
who have "a reasonable knowledge of business and economic
activities and accounting and who are willing to study the
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