# Forecasting an income statement and balance sheet: a case exercise for beginners

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1 Forecasting an income statement and balance sheet: a case exercise for beginners Hsin-hui I. H. Whited Colorado State University Pueblo Hailu Regassa, Colorado State University Pueblo Abstract This hypothetical finance case requires students to use various ratios and assumptions to forecast an income statement and balance sheet. The stock price for the company and new issues of common stock are then projected based on these statements. Keywords: Income statement, Balance Sheet, Forecasting Stock Price, P/E Ratio, Teaching Case. Forecasting an Income Statement and Balance Sheet, Page 1

3 (e) ABC s current dividend payout ratio is 28.99% while the average payout ratio for the plumbing industry is 22%. Smith has planned to cut down this ratio to 25% of retained earnings to make room for potential growth. As shareholders have in the past favored capital gains over cash dividends, Smith projects that the dividend reduction will not have much of a negative impact on the value of the firm. REQUIREMENTS 1. Incorporate and update the information given in Table 1 to reflect the changes for the upcoming year. 2. Prepare the income statement and balance sheet for next year based on these assumptions: (a) cash, fixed assets, payables and accruals will grow with sales; (b) the current composition of interestbearing debts, which includes short-term bank loans and long term bonds, will be maintained for next year; (c) a tax rate of 40%; (d) 10% interest rate on all interest-bearing debts; (e) 50 million common shares outstanding. 3. The current market price of ABC s common stocks is at \$ If all assumptions are realized, what is your estimate for ABC s stock a year from now based on today s P/E ratio? 4. If the growth rate of ABC next year is only 6%, but all other assumptions are maintained, what will ABC s stock price be? If this growth rate turns out to be a better-than-expected rate of 12%, how much will this stock be worth a year from now based on this model? 5. You believe that there is a 50% probability for ABC to grow at 10% next year, a 30% probability at 6%, and a 20% probability of attaining a maximum growth rate of 12%. Based on these three scenarios, what is your expected stock price of ABC next year? What is the standard deviation of your estimate? What will the price range be like if you place a 95% confidence interval? INSTRUCTOR S MANUAL 1. Days Sales Outstanding (DSO) is, by its definition, equal to Accounts Receivable/Daily Sales. This implies that the projected (Accounts Receivable/Sales) ratio to be equal to DSO/365. Employing this mathematical relationship generates a projected (Accounts Receivable/Sales) ratio of 9.589% (=35/365= 9.589%) when a DSO of 35 is applied. The inventory turnover ratio is the reciprocal of the (Inventories/Sales) ratio. As the inventory turnover ratio is projected to be 6x, the (Inventory/Sales) ratio becomes 16.67% (= 1/6 = 16.67%). The remaining ratios are also updated in Table 3 based on the new projections made by the various departments. 2. Projected income statements and balance sheets for the current as well as the upcoming year are compiled in Table 4. Abbreviated notes of reasoning are listed under the column Changes. Specific details of the rationale for the projected statements are provided, as is required, in the order in which they are presented in this section. All dollar values are expressed in millions, except for earnings per share (EPS), ratios, stock prices, and shares outstanding. (1) Sales: As Sales is expected to increase by 10%, Sales of next year will amount to \$3,000 *(1+ 10%) = \$3,300. (2) Operating Cost (including Deprecation): Operating Costs is expected to be 90% of projected Sales 90% * \$3, 300 = \$2, 970. (3) Earnings before Interest and Taxes (EBIT): EBIT = Sales minus Operating Costs \$3,300 -\$2,970 = \$330. Forecasting an Income Statement and Balance Sheet, Page 3

4 (4) Cash: Based on the assumption made in this case, Cash increases at the same rate as the growth in Sales, which amounts to \$50*(1+10%) = \$55. The above calculation implies that the ratio of Cash to Sales remains constant despite the growth in sales. The same could also be said regarding the line items Fixed Assets and (Payables + Accruals). As these two items are also growing with sales, ratios of Fixed Assets/Sales and (Payables + Accruals)/Sales, are implicitly assumed unchanged despite the growth in revenue. However, if the instructor does not wish to adhere to these assumptions, these three ratios could then be specified at some predetermined target levels to get around these implicit assumptions. (5) Accounts Receivable (AR): Accounts Receivable for next year is based on the projected AR/Sales ratio of 9.589% and is calculated as follows (9.589%)*(\$3,300) = \$ = \$316 (rounded) (6) Inventories: Inventory is projected to be 16.67% of sales (16.67% =1/6) *(\$3,300) = \$ = \$550 (rounded). (7) Fixed Assets (FA): Based on the assumptions given in this case, ABC s Fixed Assets increase at the same rate as Sales do and is equal to current Fixed Assets * (1+ 10%) = \$1,000 *1.1 = \$1,100. (8) Total Assets (TA): Projected Total Assets = Sum of Cash, AR, Inventory and FA = \$55 + \$ \$550 + \$1,100 = \$2, = \$2,021(rounded). (9) Total Liabilities (TL): Once Total Assets is determined, given Liabilities/Assets target ratio of 30%, Total Liabilities (TL) = 30% * \$2, = \$ = \$606 (rounded). (10) Total Common Equity (E): The company has not issued preferred stock. Total equity (E) in this case = Total Assets Total Liability = \$2, \$ = \$1,415.01= \$\$1,415 (rounded) (11) Payables + Accruals: (Payables + Accruals) are assumed to grow in proportion to Sales which is = \$200*(1+10%) =\$220. (12) Interest-Bearing Debts (IBD): Although these is no line item of interest-bearing debt (IBD), it could be calculated by subtracting non-interest bearing liabilities (Payables + Accruals) from Total Liabilities = TL (Payables + Accruals) = \$ \$220 = \$386.43= \$386 (rounded). (13) Interest Expense (IE): In this case, interest is assumed to be 10% of interest-bearing debts. Therefore, Interest Expense = 10% * Interest-Bearing Debts = 10% * \$ = \$38.64 = \$39 (rounded). (14) Short-Term Bank Loans (STBL): In this case, as the portion of Short-Term Bank Loans to total Interest-Bearing Debts is assumed to remain unchanged, we could determine this ratio from the current year s balance sheet and then multiply this ratio by the projected Interest-Bearing Debts. The ratio of Forecasting an Income Statement and Balance Sheet, Page 4

5 (STBL/IBD) for the current year = \$100/\$850. Multiplying this ratio by the projected IBD yields (\$100/\$850)* \$ = \$45.46 = \$45 (rounded). (15) Long-Term Bonds (LTB): As projected Interests-Bearing Debts comprises of Short-Term Banks Loans and Long-Term Bonds, LTB then equals projected IBD minus projected STBL = \$ \$45.46 = \$ =\$341 (rounded). (16) Earnings before Taxes (EBT): EBT is equal to EBIT Interest Expense and is = \$330 - \$38.64 = \$ = \$291(rounded). (17) Taxes: 40% of EBT (=\$291.36) = \$ = \$117(rounded). (18) Net Income (NI): Net Income = Earnings Before Taxes - Taxes = \$ \$ = \$175 (rounded). (19) Dividend: The CFO plans to reduce ABC s dividend payout ratio to 25% for next year. Total dividend is then projected to be 25% of Net Income 25% * \$ = \$43.70 = \$44 (rounded). (20) Addition to Retained Earnings: Addition to Retained Earnings = Net Income Dividend = \$175(rounded) - \$44 (rounded) = \$131.11= \$131. (21) Retained Earnings: Projected Retained Earnings next year = Retained Earnings (current year) + Addition to Retained Earnings (next year) = \$800 + \$ = \$ = \$931 (rounded). (22) Common Stock: Projected Common Stock = Projected Total Common Equity Projected Retained Earnings = \$1, \$ = \$ = \$484 (rounded). 3. In order to project the stock price based on the current P/E ratio, we need to know (a) Earnings Per Share (EPS) at the current year, (b) P/E ratio at the current year and (c) the projected EPS for next year. After (b) and (c) are found, multiplying (b) by (c) will yield the forecast for the stock price next year. Current EPS = Net Income at current year/number of outstanding common share = \$69 million/50 million= \$1.38 per share; (b) Current P/E = \$23.05/\$1.38 =16.70; (c) Projected EPS for next year is determined as follows. As projected common stock increases to \$483.9 million from \$150 million from the current -year level, an additional \$334 million (rounded) worth of stocks must be sold to the public. With the current stock valued at \$23.05 per share, ABC will need to issue additional (rounded) million shares (= \$ million/\$23.05 per share). Adding these million new shares to the existing 50 million shares gives us a total of (rounded) million shares outstanding for next year. Therefore the projected EPS = projected Net Income of million divided by million shares = \$2.71. Multiplying \$2.71 (rounded) by the current P/E ratio of results in a projected stock price of \$45.28 (see Table 5). 4. Applying the same method, if ABC s growth rate turns out to be 6%, assuming all other assumptions hold, the stock price of ABC will be reduced to \$ If the growth rate increases to 12%, the forecasted price will then be as high as \$ Refer to Table 6 and 7 for the calculations of projected prices under the growth-rate assumptions of 6% and 12%, respectively. 5. Use stated probabilities for this scenario analysis, the expected stock price of ABC is projected at \$45.23 (Table 8). In order to find out the standard deviation of this estimate, we first obtain the variance under this scenarios analysis, and then take a square-root of this variance to determine its Forecasting an Income Statement and Balance Sheet, Page 5

6 standard deviation (σ). The variance is the sum of the squared deviation under each scenario multiplied by the respective probabilities of a scenario. This deviation is measured by the distance between the projected stock price under a specific scenario and the expected mean of This procedure will result in an estimated variance of (refer to the column D in Table 9). The square-root of the variance yields a standard deviation (σ) of \$ Subtracting 1.96* standard deviation (σ) from the expected price of \$45.23, will generate a lower bound estimate of \$44.98 for a 95% confidence interval. Adding 1.96* standard deviation (σ) to the expected price will generate an upper bound estimate of \$45.48 for this interval. REFERENCE: Brigham, Eugene F and Joel F. Houston, (2010), Fundamentals of Financial Management, 6 th Edition, CENGAGE Learning, Southern- Western. Forecasting an Income Statement and Balance Sheet, Page 6

7 Table 1: Selected Ratios: ABC Plumbing, INC. and Its Industry ABC: Current Year Industry Operating Costs/Sales 93.33% 88.50% Receivables/Sales 11.67% 8.88% Inventories/Sales 20.00% 9.12% Liability/Assets 35.00% 25.00% Payout ratio 28.99% 22.00% Table 2: ABC s Income Statement and Balance Sheet Income Statement (in Million) Current year sales \$ 3,000 Operating cost (including depreciation) 2,800 Earning before interest and tax (EBIT) \$ 200 Less Interest expense 85 Earning before tax (EBT) \$ 115 Taxes 46 Net income \$ 69 Dividends 20 Addition to retained earning \$ 49 Balance Sheet (in Million) Current year Asset Cash \$ 50 Accounts receivables 350 Inventories 600 Fixed assets 1,000 Total assets \$ 2,000 Liabilities and Equity Payables + Accruals \$ 200 short-term bank loans 100 Total current liabilities \$ 300 Long-term bonds 750 Total liabilities \$ 1,050 Common stock 150 Retained earnings 800 Total common equity \$ 950 Total liabilities and equity \$ 2,000 Forecasting an Income Statement and Balance Sheet, Page 7

8 Table 3: Updated Ratios Updated Ratios ABC: Current Year ABC: Next Year Industry Operating costs/sales 93.33% 90.00% 88.50% Receivables/Sales 11.67% 9.589% 8.88% Inventories/Sales 20.00% 16.67% 9.12% Liability/Assets 35.00% 30.00% 25.00% Payout ratio 28.99% 25.00% 22.00% Table 4: Projected Income Statement and Balance Sheet (Rounded) Income Statements (in Million) Current year Changes Next Year Next Year sales \$ 3,000 (1+g%) \$ 3, \$ 3,300 Operating cost (including depreciation) 2, % of Sales 2, ,970 Earning before interest and tax (EBIT) \$ 200 \$ \$ 330 Less Interest expense 85 10% of (SR Loans + Long-term bonds) Earning before tax (EBT) \$ 115 \$ \$ 291 Taxes (40%) Net income \$ 69 \$ \$ 175 Dividends 20 25% of Net Income Addition to retained earning \$ 49 \$ \$ 131 Balance Sheets (in Million) Asset Cash \$ 50 (1+g%) \$ \$ 55 Accounts receivables % of Sales Inventories % of Sales Fixed assets 1,000 (1+g%) 1, ,100 Total assets \$ 2,000 \$ 2, \$ 2,021 Liabilities and Equity Payables + Accruals \$ 200 (1+g%) \$ \$ 220 short-term bank loans 100 (Its portion of current interest-bearing debt (IBD))* projected IBD Total current liabilities \$ 300 \$ \$ 265 Long-term bonds 750 (Its portion of current interest-bearing debt (IBD))* projected IBD Total liabilities \$ 1,050 \$ \$ 606 Common stock 150 current common stock + new issues Retained earnings 800 Plus "Addition to Retained Earning from Income Statement" Total common equity \$ 950 \$ 1, \$ 1,415 Total liabilities and equity \$ 2,000 \$ 2, \$ 2,021 *Interest-Bearing Debts (IBD) \$ \$ 386 Forecasting an Income Statement and Balance Sheet, Page 8

9 Table 5: Projected Stock Price Projected Stock Price (Rounded) Next Year Next Year Current EPS (current net income/# of current Shares million) \$ \$ 1.38 Current price of stock \$ \$ Current P/E ratio (current stock price/ current EPS) Current price of stock \$ \$ Addition to common stock (projected common Stock - current common stock, in \$ million)) \$ \$ New issue of shares ( addition to common stock / current stock price) \$ \$ Old Shares (in million) New Shares (in million) Projected EPS (Projected net income/# of total shares of next year million) \$ \$ 2.71 Projected stock price (current P/E multiplied by projected EPS) \$ \$ Forecasting an Income Statement and Balance Sheet, Page 9

10 Table 6: Projecting ABC s Stock Price for the Growth Rate of 6% - Assume All Other Assumption Are Realized. (Rounded) Income Statements (in Million) Current year Changes Next Year Next Year sales \$ 3,000 (1+g%) \$ 3, \$ 3,180 Operating cost (including depreciation) 2, % of Sales 2, ,862 Earning before interest and tax (EBIT) \$ 200 \$ \$ 318 Less Interest expense 85 10% of (SR Loans + Long-term bonds) Earning before tax (EBT) \$ 115 \$ \$ 281 Taxes (40%) Net income \$ 69 \$ \$ 168 Dividends 20 25% of Net Income Addition to retained earning \$ 49 \$ \$ 126 Balance Sheets (in Million) Asset Cash \$ 50 (1+g%) \$ \$ 53 Accounts receivables % of Sales Inventories % of Sales Fixed assets 1,000 (1+g%) 1, ,060 Total assets \$ 2,000 \$ 1, \$ 1,948 Liabilities and Equity Payables + Accruals \$ 200 (1+g%) \$ \$ 212 short-term bank loans 100 (Its portion of current interest-bearing debt (IBD))* projected IBD Total current liabilities \$ 300 \$ \$ 256 Long-term bonds 750 (Its portion of current interest-bearing debt (IBD))* projected IBD Total liabilities \$ 1,050 \$ \$ 584 Common stock 150 current common stock + new issues Retained earnings 800 Plus "Addition to Retained Earning from Income Statement" Total common equity \$ 950 \$ 1, \$ 1,364 Total liabilities and equity \$ 2,000 \$ 1, \$ 1,948 *Interest-Bearing Debts (IBD) \$ \$ 372 Projected Stock Price (Rounded) Next Year Next Year Current EPS (current net income/# of current Shares million) \$ \$ 1.38 Current price of stock \$ \$ Current P/E ratio (current stock price/ current EPS) \$ \$ Current price of stock \$ \$ Addition to common stock (projected common Stock - current common stock, in \$ million) \$ \$ New issue of shares ( addition to common stock / current stock price) \$ \$ Old Shares (in million) New Shares (in million) Projected EPS (Projected net income/# of total shares of next year million) \$ \$ 2.70 Projected stock price (current P/E multiplied by projected EPS) \$ \$ Forecasting an Income Statement and Balance Sheet, Page 10

11 Table 7: Projecting ABC s Stock Price for the Growth Rate of 12% - Assume All Other Assumption Are Realized. (Rounded) Income Statements (in Million) Current year Changes Next Year Next Year sales \$ 3,000 (1+g%) \$ 3, \$ 3,360 Operating cost (including depreciation) 2, % of Sales 3, ,024 Earning before interest and tax (EBIT) \$ 200 \$ \$ 336 Less Interest expense 85 10% of (SR Loans + Long-term bonds) Earning before tax (EBT) \$ 115 \$ \$ 297 Taxes (40%) Net income \$ 69 \$ \$ 178 Dividends 20 25% of Net Income Addition to retained earning \$ 49 \$ \$ 133 Balance Sheets (in Million) Asset Cash \$ 50 (1+g%) \$ \$ 56 Accounts receivables % of Sales Inventories % of Sales Fixed assets 1,000 (1+g%) 1, ,120 Total assets \$ 2,000 \$ 2, \$ 2,058 Liabilities and Equity Payables + Accruals \$ 200 (1+g%) \$ \$ 224 short-term bank loans 100 STBL/ Total current liabilities \$ 300 \$ \$ 270 Long-term bonds 750 (Its portion of current interest-bearing debt (IBD))* projected IBD Total liabilities \$ 1,050 \$ \$ 617 Common stock 150 (Its portion of current interest-bearing debt (IBD))* projected IBD Retained earnings 800 Plus "Addition to Retained Earning from Income Statement" Total common equity \$ 950 \$ 1, \$ 1,441 Total liabilities and equity \$ 2,000 \$ 2, \$ 2,058 *Interest-Bearing Debts (IBD) \$ \$ 393 Projected Stock Price (Rounded) Next Year Next Year Current EPS (current net income/# of current Shares million) \$ \$ 1.38 Current price of stock \$ \$ Current P/E ratio (current stock price/ current EPS) \$ \$ Current price of stock \$ \$ Addition to common stock (projected common Stock - current common stock, in \$ million) \$ \$ New issue of shares ( addition to common stock / current stock price) \$ \$ Old Shares (in million) New Shares (in million) Projected EPS (Projected net income/# of total shares of next year million) \$ \$ 2.72 Projected stock price (current P/E multiplied by projected EPS) \$ \$ Forecasting an Income Statement and Balance Sheet, Page 11

12 Table 8: Expected Stock Price Scenario Analysis Growth rate Probability Stock Price Probability * Stock Price 10% 0.5 \$ % 0.3 \$ % 0.2 \$ Expected Price Table 9: Standard Deviation and A 95 % Confidence Interval A B C D Growth rate Stock price - Expected price (\$45.23) Probability Square of Column B * Probability 10% % % Variance Standard Deviation % confidence Interval Expected price SD Expected price SD Forecasting an Income Statement and Balance Sheet, Page 12

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