Financial Statement Analysis 2024 Level I High Yield Notes

LM12 Introduction to Financial Statement Modeling

Income statement modeling: Revenue

Top-down approach begins at the economy level, then the industry and finally to the
company level. There are two top-down approaches:
Growth relative to GDP growth: In this approach, we:
• Forecast nominal GDP growth rate (can forecast real GDP growth and inflation
separately).
• Forecast revenue growth relative to GDP depending on the company’s position in
the lifecycle and/or business cycle sensitivity. The forecasted revenue is expressed
in two ways:
o As percentage point discounts or premiums. For instance, Pfizer’s revenue is
projected to grow at 100 bps above nominal GDP growth rate.
o In relative terms: GDP is forecasted to grow at 4% and Oracle’s revenue is
forecasted to grow at a 25% faster rate.
Market growth and market share: In this approach, we:
• Forecast growth rate of relevant market
• Forecast change of company’s market share in the market. For example, assume
Tesla is expected to maintain a market share of 1% in the automobile market. If the
automobile market is expected to grow to $30 billion in annual revenue, then Tesla’s
annual revenue is forecasted to grow to 1% * $30 billion = $300 million.
Bottom-up approaches begin at the level of the individual company or unit within the
company. Examples of bottom-up approaches include:
• Time-series: Forecasts based on historical growth rates or time-series analysis.
• Return on capital: Forecasts based on balance sheet accounts and rates or ratios.
• Capacity-based measure: Forecasts (for example, in retailing) based on same-store
sales growth and sales related to new stores.
A hybrid approach combines top-down and bottom-up approaches.

Income statement modeling: Operating and non-operating costs

Similar to revenue forecasting, costs may be forecasted using a top-down, bottom-up, or

hybrid approach
• Top-down approach: Consider factors such as overall level of inflation, or industry-
specific costs.
• Bottom-up approach: Consider factors such as segment-level margins, historical
cost-growth rates, historical margin levels, etc.
• Hybrid view: Incorporate elements from both top-down and bottom-up approaches.

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Financial Statement Analysis 2024 Level I High Yield Notes

A positive correlation between operating margins and sales suggests economies of scale.
Forecasting income statement elements
• Forecast COGS by segment, product category, or by volume and price, to improve
forecasting accuracy. COGS is forecasted as a percentage of sales using historical
relationships.
• In SG&A, selling and distribution costs such as wages are variable and can be
estimated as a percentage of sales. General and administrative expenses are more or
less fixed and increase or decrease gradually.
• Two non-operating expenses are financing expenses and taxes.
o To forecast debt financing expenses, forecast the level of debt and the
corresponding interest rates.
o There are three types of taxes: statutory tax rate, effective tax rate, and cash
tax rate. Use effective tax rate to forecast net income and the cash tax rate to
forecast cash flows. To forecast future tax expense, often the tax rate based
on normalized operating income, adjusted for special items, is used.

Balance sheet and cash flow statement modeling

The table below summarizes the approach for forecasting balance sheet items.
Item Forecasting method Comment
Accounts receivable Use sales and DSO Top-down: project economy
to slow sales down, lower
inventory turnover.
Bottom-up: use company’s
historical ratios
Inventory Use COGS and inventory Estimate maintenance and
turnover growth capital
expenditures.
PP&E and depreciation Consider the future need for
PP&E and depreciation
disclosures.
Debt (capital structure) Use debt/equity,
debt/capital, debt/EBITDA
Retained earnings Net income and dividend
policy
Cash flow statement can be derived based on the income statement and balance sheet.

Biases that influence analyst forecasts

Five key biases that influence analyst forecasts are:

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Financial Statement Analysis 2024 Level I High Yield Notes

• Overconfidence bias: A bias in which people demonstrate unwarranted faith in

their own abilities.
• Illusion of control bias: Tendency to overestimate the ability to control what
cannot be controlled and to take ultimately fruitless actions in pursuit of control.
• Conservatism bias: People maintain their prior views or forecasts by inadequately
incorporating new information.
• Representative bias: Tendency to classify information based on past experiences
and known classification.
• Confirmation bias: Tendency to look for and notice what confirms prior beliefs and
to ignore or undervalue whatever contradicts them.

Impact of competitive factors in prices and costs

Competitive factors affect a company’s ability to negotiate lower input prices with
suppliers and to raise prices for products and services. Porter’s five forces framework can
be used as a basis for identifying such factors. The table below summarizes this framework.
Force Comment
Threat of substitutes Fewer substitutes or higher switching costs increase industry
profitability.
Internal rivalry Lower rivalry increases industry profitability.
Supplier power Presence of many suppliers limits their pricing power, which in
turn does not put a downward pressure on the industry’s
profitability.
Customer power Presence of many buyers limits their negotiating power, which
in turn does not put a downward pressure on the industry’s
profitability.
Threat of new entrants High barriers to entry increase industry profitability.

Modeling inflation and deflation

Effect on sales:
• Higher input costs usually result in higher prices for end products. Since most
products have an elastic demand, when prices are increased sales volume decrease.
• In an inflationary environment, companies that raise prices too soon will experience
volume losses. Whereas, companies that raise prices too late will experience
declining profit margins.
Effect on costs:
• If the company uses hedging instruments such as long-term forward contracts, then
input price increases will be gradual instead of a sudden hike.

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Financial Statement Analysis 2024 Level I High Yield Notes

• If companies have access to alternative inputs or are vertically integrated, the

impact of volatility of input costs will be low.

Long-term forecasting

Forecast time horizon is influenced by factors such as:

• Investment strategy for which the stock is being considered
• Cyclicality of the industry
• Company specific factors
• Analyst’s employer preferences
Longer-term projections often provide a better representation of the normalized earnings
potential of a company than a short-term forecast, especially when certain temporary
factors are present. Normalized earnings are the expected level of mid-cycle earnings for a
company in the absence of any unusual or temporary factors that impact profitability
(either positively or negatively). “Growth relative to GDP growth” and “market growth and
market share” methods can be applied to develop longer term projections.
Along with earnings projections over the forecast period, analysts also determine the
terminal value of the stock at the end of the forecast period. Terminal values are usually
estimated using a multiples-based approach or a DCF approach.
• While using the multiples-based approach, if the future growth is likely to differ
from the historical average, then the target multiple should include a premium or
discount to account for this difference.
• While using the DCF approach, the terminal year cash flow should be normalized to
a mid-cycle value, to remove the impact of short-term events. An appropriate long-
term perpetual growth rate should be determined that matches the future outlook
of the company.

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