Chapter 17
Projecting Cash Flow and Earnings
Slides
17-1. Chapter 17
17-2. Projecting Cash Flow and Earnings
17-3. Learning Objectives
17-4. Earnings and Cash Flow Analysis
17-5. Sources of Financial Information, I.
17-6. Sources of Financial Information, II.
17-7. Sources of Financial Information, III.
17-8. Three Important Financial Statements
17-9. The Balance Sheet
17-10. Borg Corporation Balance Sheet
17-11. Borg Corporation, Condensed Balance Sheet
17-12. The Income Statement
17-13. Borg Corporation, Income Statement
17-14. The Cash Flow Statement
17-15. Borg Corporation, Condensed Cash Flow Statement
17-16. Performance, or Profitability, Ratios
17-17. Example: Calculating Profitability Ratios
17-18. Price Ratio Inputs
17-19. Price Ratios
17-20. Financial Statement Forecasting, I.
17-21. Financial Statement Forecasting, II.
17-22. Building the Pro Forma Income Statement, I.
17-23. Building the Pro Forma Income Statement, II.
17-24. The Pro Forma Income Statement
17-25. Building the Pro Forma Balance Sheet
17-26. The Partial Pro Forma Balance Sheet, I.
17-27. The Partial Pro Forma Balance Sheet, II.
17-28. The Partial Pro Forma Balance Sheet, III.
17-29. The Pro Forma Balance Sheet
17-30. Another Scenario to Consider
17-31. The Resulting Pro Forma Balance Sheet
17-32. Notes on this Other Pro Forma Balance Sheet
17-33. Projected Profitability and Price Ratios, The Borg Corporation
17-34. Projected Stock Prices for Year 2537, The Borg Corporation
17-35. Starbucks Corporation, Case Study
17-36. Starbucks Corporation, 2015 and 2014 Condensed Balance Sheet
17-37. Starbucks Corporation, 2015 and 2014 Condensed Income Statements
17-38. Pro Forma Statements, Notes I.
17-39. Starbucks Corporation, 2016 Pro Forma Income Statement
17-40. Starbucks Corporation, 2016 Partial Pro Forma Balance Sheet
17-41. Starbucks Corporation, 2016 Pro Forma Balance Sheet
17-42. Pro Forma Statements, Notes II.
17-43. Projected Profitability and Price Ratios, Starbucks Corporation
17-44. Valuing Starbucks Corporation Using a Two-Stage Dividend Growth Model
17-45. Other Starbucks Price Estimates from the Two-Stage Dividend Growth
Model
17-46. Valuing Starbucks: What Does the Market Say
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Earnings and Cash Flow Analysis 17-2
17-47. Useful Internet Sites
17-48. Chapter Review, I.
17-49. Chapter Review, II.
Chapter Organization
17.1 Sources of Financial Information
17.2 Financial Statements
A. The Balance Sheet
B. The Income Statement
C. The Cash Flow Statement
D. Performance Ratios and Price Ratios
17.3 Financial Statement Forecasting
A. The Percentage of Sales Approach
B. The Pro Forma Income Statement
C. The Pro Forma Balance Sheet
D. Scenario One
E. Scenario Two
F. Projected Profitability and Price Ratios
17.4 Starbucks Corporation Case Study
A. Pro Forma Income Statement
B. Pro Forma Balance Sheet
C. Valuing Starbucks Using Ratio Analysis
D. Valuing Starbucks Using a Two-Stage Residual Income Model
E. Valuing Starbucks: What Does the Market Say?
17.5 Summary and Conclusions
Selected Web Sites
www.thestreet.com (see research/tools for earnings estimates)
www.cnbc.com (stock screening tool)
Sources for financial statement information:
www.sec.gov (reference for electronic data archives, EDGAR)
www.prars.com (Free Annual Reports)
finance.yahoo.com
www.reuters.com/finance/stocks
Useful Internet sites for company analysis:
www.global-reports.com
www.corporateinformation.com
Company sites
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Earnings and Cash Flow Analysis 17-3
www.dupont.com
www.3m.com
www.starbucks.com
Annotated Chapter Outline
17.1 Sources of Financial Information
EDGAR: Electronic archive of company filings with the SEC.
10K: Annual company report filed with the SEC.
10Q: Quarterly updates of 10K reports filed with the SEC.
Regulation FD (Fair Disclosure): Requires companies making a public
disclosure of material nonpublic information to do so fairly and without
preferential recipients.
Material nonpublic information: Any information that could reasonably
be expected to affect the price of a security.
Reliable financial information is a prerequisite to doing good financial analysis.
There are many sources of financial information, including annual reports, The
Wall Street Journal, and SEC information, which includes the EDGAR archives.
EDGAR includes company 10Ks and 10Qs, as well as other financial data. The
internet also provides a wealth of financial information. The Selected Web Sites
above provide a good starting point for finding financial information on the web.
17.2 Financial Statements
Balance sheet: Accounting statement that provides a snapshot view of a
company’s assets and liabilities on a particular date.
Income statement: Summary statement of a firm’s revenues and
expenses over a specific accounting period, usually a quarter or a year.
Cash flow statement: Analysis of a firm’s sources and uses of cash over
the accounting period, summarizing operating, investing, and financing
cash flows.
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Earnings and Cash Flow Analysis 17-4
The firm’s balance sheet, income statement, and cash flow statement provide
essential, interrelated information necessary for performing a financial analysis.
Remind students that reading and interpreting these financial statements isn’t just
“accounting work.” It’s a requirement of any good financial analyst.
A. The Balance Sheet
Asset: Anything a company owns that has value.
Liability: A firm’s financial obligation.
Equity: An ownership interest in the company.
The Borg balance sheet has four major asset categories: current assets, fixed
assets, goodwill, and other assets. It has three major liability categories: current
liabilities, long-term liabilities, and other liabilities. Shareholder equity is the
difference between total assets and total liabilities, and it includes paid-in capital
and retained earnings. The fundamental accounting identity is:
Assets = Liabilities + Equity
This implies that the left side of the balance sheet always equals the right side.
Financial analysts also find it useful to condense a balance sheet down to its
principle categories.
B. The Income Statement
Income: The difference between a company’s revenues and expenses. It
is used to either pay dividends to stockholders or kept as retained
earnings within the company to finance future growth.
The income statement reports revenue and expenses for a corporation over a
one-year (or quarter) period. Subtracting cost of goods sold and operating
expenses from net sales yields operating income. Subtracting investment
income, interest expense, and income taxes yields net income. This is also
referred to as “the bottom line.” Net income is apportioned to dividends and
retained earnings, in fact:
Net income = Dividends + Retained earnings
C. The Cash Flow Statement
Cash flow: Income realized in cash form.
Noncash items: Income and expense items not realized in cash form.
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Earnings and Cash Flow Analysis 17-5
Operating cash flow: This is cash generated by a firm’s normal business
operations.
Investment cash flow: This is cash flow resulting from purchases and
sales of fixed assets and investments.
Financing cash flow: This is cash flow originating from the issuance or
repurchase of securities and the payment of dividends.
The cash flow statement reports the sources and uses of a firm’s cash over a
specified accounting period. The statement begins with net income, and adjusts it
for noncash charges to obtain the operating cash flow. The next two categories of
the statement include investment cash flow and financing cash flow. After
adjusting for these items, the result is the firm’s net cash flow during the
accounting period.
D. Performance Ratios and Price Ratios
Return on assets (ROA): Net income stated as a percentage of total
assets.
Return on equity (ROE): Net income stated as a percentage of
shareholder equity.
The firm’s profitability ratios are calculated as follows:
Gross Margin = Gross profit / Sales
Operating Margin = Operating income / Sales
ROA = Net income / Total assets
ROE = Net income / Shareholder equity
The firm’s per-share values are calculated as follows:
Book Value Per Share (BVPS) = Total equity / # shares outstanding
Earnings Per Share (EPS) = Net income / # shares outstanding
Cash Flow Per Share (CFPS) = Operating cash flow / # shares
outstanding
Notice that the cash flow used above refers to operating cash flow, not the cash
flow from the cash flow statement.
The firm’s market value ratios are calculated as follows:
Price / Book (or Market / Book) = Stock price / BVPS
Price / Earnings (P/E) = Stock price / EPS
Price / Cash flow (P/CF) = Stock price / CFPS
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Earnings and Cash Flow Analysis 17-6
17.3 Financial Statement Forecasting
Pro forma financial statements: Statements prepared using certain
assumptions about future income, cash flow, and other items. Pro forma
literally means according to prescribed form.
To analyze the impact of possible changes, investments, or changes in sales for
the firm, it is necessary to construct pro forma financial statements for the firm
under various scenarios. This allows the analyst to investigate and analyze the
impact of these actions.
A. The Percentage of Sales Approach
A simple model to construct pro forma financial statements is one in which every
item increases at the same rate as sales. This may be a reasonable assumption
for some financial statement items. For others, such as long-term debt, it
probably is not, because the amount of long-term debt is something set by
management. Therefore, long-term debt levels do not necessarily relate directly
to the level of sales.
A more sophisticated model builds on the basic idea of separating the income
statement and balance sheet items into two groups: those that do vary directly
with sales and those that do not. Given a sales forecast, calculating how much
financing the firm will need to support the predicted sales level is easy. This quick
and practical model is known as the percentage of sales approach.
B. The Pro Forma Income Statement
The pro forma income statement begins with a projection of sales, usually for
more than one scenario. The analyst then works down the income statement.
One assumption we make in the text is that depreciation also increases with
sales. Although accountants would cringe, you can explain that this assumption
is essentially harmless. This is because the analyst could plug in whatever
depreciation number was deemed appropriate and move on.
Lecture Note: It is useful to discuss that a 10 percent increase in sales does not
typically result in the same percentage change in earnings. Depending on the
operating and financing leverage in the business, scale effects could increase
earnings by a much larger percentage.
C. The Pro Forma Balance Sheet
To generate a pro forma balance sheet, we start with the balance sheet for 2536.
On this balance sheet, we assume that some of the items vary directly with sales
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Earnings and Cash Flow Analysis 17-7
and others do not. For the items that do vary with sales, we express each as a
percentage of sales for the year just completed, year 2536. When an item does
not vary directly with sales, we write “n/a” for “not applicable.”
Important focus: The ratio of total assets to sales for 2536 is $88,000/$110,000
= .80, or 80 percent. The ratio of total assets to sales is sometimes called the
capital intensity ratio.
This ratio tells us the amount of assets needed to generate $1 in sales. So the
higher this ratio, the more capital intensive is the firm. For the Borg Corporation,
$.80 in assets was needed to generate $1 in sales in 2536. If we assume that
capital intensity ratio is constant, total assets of $110,000 will be needed to
generate sales of $137,500 in 2537. This represents an increase of $22,000 over
2536.
Note: It is only a coincidence that sales were $110,000 in 2536 and total assets
were $110,000 in 2537.
On the liability side of the balance sheet, we have assumed that only accounts
payable vary with sales. The reason is that we expect Borg to place more orders
with its suppliers as sales increase, so payables will change directly with sales.
Short-term debt represents bank borrowing. This account is not likely to vary
directly with sales, because this account represents decisions made by
management. Therefore, we write n/a in the “Percent of Sales” column for short-
term debt. Similarly, we write n/a for long-term debt because long-term debt will
not vary directly with sales. The same is true for other liabilities and the paid-in
capital account.
Retained earnings, however, will change with an increase in sales, but the
increase in retained earnings will not be a simple percentage of sales. Instead,
we must calculate the change in retained earnings based on our projected net
income and dividends, which come from the pro forma income statement.
A partial pro forma balance sheet for the Borg Corporation can now be
constructed (partial means, loosely, that the balance sheet does not balance yet).
We construct the column labeled 2537 in Table 17.6 by using the percentage of
sales wherever possible to calculate projected amounts. For items that do not
vary directly with sales, note that we initially assume no change and simply write
in the existing amounts. Inspecting the partial pro forma balance sheet for the
Borg Corporation, we see that total assets are projected to increase by $22,000
in 2537 (i.e., the amount we thought it would if we assumed the capital intensity
ratio remained constant).
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Earnings and Cash Flow Analysis 17-8
However, without additional financing, liabilities and equity will increase by only
$4,400, leaving a shortfall, or imbalance, of $22,000 − $4,400 = $17,600. We
have labeled the shortfall amount as external financing needed (EFN).
D. Scenario One
In this scenario, Borg will have to raise additional equity, or issue debt, if sales of
$137,500 is the goal. This results from the assumption that the capital intensity
ratio is constant.
We allocate $2,500 to short-term debt. The reasoning is that Borg will quite likely
want the ratio of current assets to current liabilities to remain constant. The
remaining $15,100 is raised through long-term debt.
E. Scenario Two
In this scenario, we assume that the Borg Corporation is running at 75 percent of
capacity. This means that the need for external funds will be quite different. When
we say “75 percent of capacity,” we mean that the current sales level is 75
percent of the full-capacity sales level:
Current sales = $110,000 = .75 × Full-capacity sales
Therefore:
Full-capacity sales = $110,000 / .75 = $146,667
This calculation tells us that sales could increase by one-third, from $110,000 to
$146,667, before any new fixed assets would be needed. We leave fixed assets
constant at $60,000, but the other asset accounts still vary with the increase in
sales. In this scenario, the level of external financing required is $2,600.
F. Projected Profitability and Price Ratios
Using the pro forma statements, the analyst now calculates the relevant ratios to
determine the impact of the projected changes. Using these ratios, the analyst
can compute projected stock prices as described in the last chapter. Three
estimates of the stock price can be obtained from:
BVPS x P/B
EPS x P/E
CFPS x P/CF
These numbers may vary greatly. It will then be the analyst’s job to determine
which stock prices are the most accurate, and the least sensitive to variance in
the estimates of the inputs.
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Earnings and Cash Flow Analysis 17-9
17.4 Starbucks Corporation Case Study
In this section, we provide a complete analysis using the Starbucks Corporation,
building on the techniques used in section 17.3.
We then value Starbucks using ratio analysis and a two-stage dividend growth
model. Like a two-stage dividend growth model, the two-stage dividend growth
model allows for earnings to grow at a rate g1 for T periods and at a rate g2
forever thereafter.
A. Pro Forma Income Statement
B. Pro Forma Balance Sheet
C. Valuing Starbucks Using Ratio Analysis
D. Valuing Starbucks Using a Two-Stage Dividend Growth Model
E. Valuing Starbucks: What Does the Market Say?
Lecture Tip: To reinforce the information in this chapter, it is helpful to introduce
a project or case that relates to this chapter’s material. If grading is not a
consideration, the project could be done individually, with each student selecting
a different firm. To minimize grading, this project could be completed using
teams, with each team doing a different company or assigning all teams the
same firm. The advantage of all teams (or students) analyzing the same firm is
that all the computations can be completed beforehand by the instructor, which is
very helpful in answering student questions and checking the results.
One way of formatting this project is to require the students to select a firm and
gather the following material for the firm: annual report, 10K, Standard & Poor’s
report, Dunn & Bradstreet report, and Value Line report. Note that this material
can also be used for projects that relate to other chapters in the text. Using a
spreadsheet, the students will prepare an income statement, balance sheet, cash
flow statement, and ratio analysis for the firm. The instructor will then give
instructions for a change within the firm to allow a pro forma analysis. This could
be as easy as a change in sales of plus or minus ten percent. The students will
use this information to prepare complete pro formas for the firm, calculate ratios,
and estimate projected stock prices for the firm one-year hence. Since writing is
very important, the students should also prepare a report that includes the
following: describe what they did, provide a complete analysis of the firm, and
make recommendations for the future. Of course, a one-page Executive
Summary would be very beneficial.
17.5 Summary and Conclusions
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Earnings and Cash Flow Analysis 17-10
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