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in whole or in part.
CHAPTER 10
FORECASTING FINANCIAL STATEMENTS
Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases
10.1 Relying on Accounting to Avoid Forecast Errors. This question encourages
students to think about the internal consistency in accounting and how it can help
avoid forecast errors. By forecasting financial statements that add up, the analyst is
less likely to miss a key account. By forecasting financials that articulate over time,
the analyst is more likely to capture all of the income flows (and cash inflows and
outflows) over the period.
10.2 Objective and Realistic Forecasts. In answering this question, students consider
why different parties to the financial reporting process have different incentives and
biases. Managers tend to be optimistic to present their firm and their own
performance in good light. Accountants are conservative, in part, to be a
counterweight to managers’ optimism and to mitigate their own professional risk
and liability. The analyst should be as objective as possible in forecasting the future
in order to make better investment decisions.
10.3 Projecting Revenues: The Effects of Volume versus Price. This question gets
students thinking about different drivers of different components of revenue growth
in a general setting. A firm’s competitive strategic advantages should help it sustain
revenue growth from sales volume growth and price growth. The nature of
competition in the firm’s industry and the position of the industry in its life-cycle
(introduction, growth, mature, or decline) will likely influence the firm’s ability to
sustain growth, particularly in more competitive and mature industries. Economy-
wide factors such as demographic growth may help sustain volume growth, whereas
economy-wide inflation may help sustain price growth. Although the question relies
on a one-year horizon, you could push the discussion further so that students
consider how the factors are likely to affect sales volume growth and price growth
in the long run.
10.4 Projecting Gross Profit: The Effects of volume Versus Price. This question gets
students thinking about how drivers of different components of revenue growth
have different effects on gross profit and gross profit margin (as a percentage of
sales revenues) in a general setting. Both factors drive up gross profit. Only price
increases drive up the gross profit margin because the question assumes the strictly
variable production costs. Thus, cost of goods sold is a variable cost per unit, so
sales volume increases are accompanied by proportional increases in cost of goods
sold. However, price increases do not trigger cost increases.
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10.5 Projecting Revenues, Cost of Goods Sold, and Inventory. In this exercise,
students work through the computations to project revenue, cost of goods sold, and
ending inventory for Walgreens. The data and computations follow:
Walgreens’ (data in millions) Year 11 Year 12 Growth Rates Year +1
Sales Revenue ……………………. $53,762 $59,034 9.8% $64,823
Cost of Goods Sold …………….. $38,518 $42,391 10.1% $46,653
Ending Inventory ……………….. $6,791 $ 7,249
Year 12 Inventory Turnover … $42,391/[($6,791 + $7,249)/2] = 6.04
Projected Average Inventory .. $46,653/6.04 = $7,724
Projected Ending Inventory …. ($7,724 × 2) – $7,249 = $8,199
10.6 The Flexible Financial Account. This question asks students to discuss how a
firm’s financial flexibility will change as the firm progresses through stages of the
life cycle. During the introduction phase, the firm needs capital but may be
somewhat constrained to issue debt, so it is more likely the firm will balance the
balance sheet by issuing equity. As equity issues raise cash, startup firms commonly
hold the cash in liquid accounts until it is invested in growth-related assets. During
the growth phase, firms are more likely to meet their capital needs by issuing debt
or equity capital. During the mature and decline phases, the firm’s capital needs are
more likely to be met with cash flow from operations and the firm should return
capital to stakeholders, so the firm will likely balance the balance sheet by paying
dividends, buying back stock, or paying down debt.
10.7 Dividends as the Flexible Financial Account. This exercise asks students to
compute the plug to dividends to balance the balance sheet for Schwartz Company
for Year +1. Students can compute the plug to dividends as follows:
Year +1 Balance Sheet Amounts before Plugging Dividends:
Total Assets $200
Accrued Liabilities $ 43
Long-Term Debt 80
Common Stock (at par) 20
Beginning Retained Earnings 34
Year +1 Net Income 40
Total Liabilities and Equity
before Plugging Dividends $217
Necessary plug to increase dividends to balance the balance sheet: $17.
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Forecasting Financial Statements
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in whole or in part.
Year +1 Balance Sheet Amounts after Plugging Dividends:
Total Assets $200
Accrued Liabilities $ 43
Long-Term Debt 80
Common Stock (at par) 20
Ending Retained Earnings 57 = $34 + $40 – $17
Total Liabilities and Equity $200
10.8 Long-Term Debt as the Flexible Financial Account. This exercise asks students
to compute the plug to long-term debt to balance the balance sheet for Schwartz
Company for Year +1. This exercise introduces circularity to balancing the balance
sheet because the amount of debt needed depends on net income, which is affected
by the interest expense on the amount of debt needed. Students should input these
amounts into a spreadsheet and have the spreadsheet compute the amounts
iteratively. Students should obtain the following amounts:
Year +1
Projected Income Statement Amounts
Operating Income …………………………. $58.00
Interest Expense …………………………… –8.87
Income before Tax ……………………….. $49.13
Tax Provision (20.0% rate) ……………. –9.83
Net Income ………………………………….. $39.30
Year +1
Projected Balance Sheet Amounts
Total Assets …………………………………. $200
Accrued Liabilities ……………………….. $ 43
Long-Term Debt ………………………….. 88.70
Common Stock (at par) …………………. 20
Retained Earnings (end of Year +1) .. 48.30 = $34.00 + $39.30 – $25.00
Total Liabilities and Shareholders’ Equity $200
10.9 Store-Driven Forecasts. In this exercise, students work through the computations
to project revenue, capital expenditures, and ending inventory for The Home Depot,
using 100 new stores as the driver of growth forecasts in Year +1. The exercise
requires students to use the average number of stores to compute sales, the number
of new stores to compute capital expenditures, and the ending number of total stores
to compute ending inventory. The data and computations follow:
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Forecasting Financial Statements
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in whole or in part.
The Home Depot (data in mil-
lions except number of stores) 2011 2012 Year +1 Computations
Number of Stores ………………. 2,234 2,274 2,374
New Stores ……………………….. 40 100
Average Stores ………………….. 2,254 2,324
Sales Revenues………………….. $77,349 $71,288 $73,502 = 2,324 × $31.63
Sales per Average Store ……… $31.63 = $71,288/2,254
Inventory ………………………….. $11,731 $10,673 $11,142 = 2,374 × $4.69
Ending Inventory per Store …. $4.69 = $10,673/2,274
Capital Expenditures (Net) …. $3,558 $1,847 $4,618 = 100 × $46.18
Capital Expenditures per
New Store …………………….. $46.18 = $1,847/40
10.10 Projecting Property, Plant, and Equipment. This exercise gets students working
through the computations to project property, plant, and equipment and depreciation
expense for Year +1 for Intel, a leading manufacturer of semiconductors.
a. The average useful life that Intel used in 20X2 for depreciation was 10.80 years,
computed as follows:
Useful Life ………………… 10.80 Years = [($46,052 + $48,088)/2]/$4,360.
b. Depreciation expense for Year +1 on (1) existing property, plant, and equipment
at the end of 20X2; (2) capital expenditures in Year +1 assuming that there is
$6,000 in expenditures on depreciable assets in Year +1 and assuming that Intel
takes a full year of depreciation in the first year of service; and (3) the sum of
(1) and (2) to obtain total depreciation expense for Year +1:
Depreciation Expense on Existing PPE …… $ 4,453 = $48,088/10.80 years
Depreciation Expense on Year +1 Capital
Expenditures …………………………………….. $ 556 = $6,000/10.80 years
Total Depreciation Expense …………………… $ 5,009 = $4,453 + $556
c. The Year +1 ending balance in property, plant, and equipment, both at cost and
net of accumulated depreciation:
Intel (data in millions) 2011 2012 Year +1 Computations
Property, Plant, and Equip., at Cost .. $ 46,052 $ 48,088 $ 54,088 = $48,088 + $6,000
Accumulated Depreciation …………… $–29,134 $–30,544 $–35,553 = $–30,544 – $5,009
Property, Plant, and Equip. (Net) ….. $ 16,918 $ 17,544 $ 18,535 = $54,088 – $35,553
Depreciation Expense ………………….. $ 4,360 $ 5,009 Computed above
Capital Expenditures (Net) …………… $ 5,200 $ 6,000 Assumption given
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10.11 Identifying the Cost Structure and Projecting Gross Margins for Capital-
Intensive, Cyclical Businesses.
a. Compute the cost structure for each firm as follows:
Variable Cost per Dollar of Sales = Change in Cost of Products Sold/Change in
Sales
Total Variable Cost = Variable Cost per Dollar of Sales × Sales
Total Fixed Cost = Total Cost of Product Sold – Total Variable Cost
AK Steel:
Variable Cost per Dollar of Sales = ($4,554 – $3,887)/($5,217 – $4,042) = $0.568
Total Variable Cost = $0.568 × $5,217 = $2,963 (65% of cost of products sold)
Total Fixed Cost = $4,554 – $2,963 = $1,591 (35% of cost of products sold)
Nucor:
Variable Cost per Dollar of Sales = ($9,129 – $5,997)/($11,377 – $6,266) = $0.613
Total Variable Cost = $0.613 × $11,377 = $6,974 (76% of cost of products sold)
Total Fixed Cost = $9,129 – $6,974 = $2,155 (24% of cost of products sold)
b. AK Steel is more capital-intensive than Nucor and therefore has a higher
proportion of fixed costs and a lower proportion of variable costs in its cost
structure. AK Steel also offers steel and steel products at the higher end of the
market than Nucor does and should, therefore, have higher selling prices and a
higher gross margin. Both of these factors explain the lower variable cost as a
percentage of sales for AK Steel.
c. (amounts in millions)
AK Steel
Year +1 Year +2 Year +3 Year +4 Year +5
Sales $5,478 $6,026 $7,231 $6,508 $5,206
Less Cost of Products Sold:
Variable Costs (0.568 of sales) 3,112 3,423 4,107 3,697 2,957
Fixed Costs 1,591 1,591 1,591 1,591 1,591
Total Costs of Products Sold $4,703 $5,014 $5,698 $5,288 $4,548
Gross Profit $775 $1,012 $1,533 $1,220 $658
Gross Margin % 14.1% 16.8% 21.2% 18.7% 12.6%
Nucor
Year +1 Year +2 Year +3 Year +4 Year +5
Sales $11,946 $13,140 $15,768 $14,191 $11,353
Less Cost of Products Sold:
Variable Costs (0.613 of sales) 7,323 8,055 9,666 8,699 6,959
Fixed Costs 2,155 2,155 2,155 2,155 2,155
Total Costs of Products Sold $9,478 $10,210 $11,821 $10,854 $9,114
Gross Profit $2,467 $2,931 $3,947 $3,337 $2,239
Gross Margin % 20.7% 22.3% 25.0% 23.5% 19.7%
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d. The average gross margin of AK Steel is 16.7%, with a standard deviation of
3.5%. The average gross margin of Nucor is 22.2%, with a standard deviation of
2.1%. Despite a higher variable cost per dollar of sales and larger total fixed
costs, Nucor generates a higher gross margin than AK Steel because Nucor’s
much larger size creates economies of scale. For example, Nucor’s fixed costs
are 24% of cost of products sold compared to AK Steel’s fixed costs, which
amount to 35% of the cost of products sold. The larger variability of the gross
margin for AK Steel also occurs because of the higher proportion of fixed costs
in its cost structure. Compared with Nucor, AK Steel realizes greater
incremental economies of scale as sales increase but greater diseconomies of
scale as sales decrease. For example, given the same rates of sales growth over
Years +1 to +3, AK Steel’s gross margin grows from 14.1% to 21.2%, whereas
Nucor’s gross margin percentage grows from only 20.7% to 25.0%.
10.12 Identifying the Cost Structure (amounts in billions).
a. Change in Cost of Goods Sold: (¥6,290 – ¥5,890) …………………… ¥400
Change in Sales: (¥8,871 – ¥8,296) ………………………………………. ¥575
Variable Cost Percentage: ¥400/¥575 …………………………………….. 0.696
Fixed Cost: 2011, [¥5,890 – (0.696 × ¥8,296] ………………………… ¥116
2012, [¥6,290 – (0.696 × ¥8,871] ………………………… ¥116
b. Change in Selling and Administrative Expense: (¥1,714 – ¥1,670) ¥44
Change in Sales: from Requirement a ……………………………………. ¥575
Variable Cost Percentage: ¥44/¥575 ………………………………………. 0.077
Fixed Cost: 2011, [¥1,670 – (0.077 × ¥8,296)] ……………………….. ¥1,031
Fixed Cost: 2012, [¥1,714 – (0.077 × ¥8,871)] ……………………….. ¥1,031
c. and d. Year +1 Year +2 Year +3 Year +4
Sales ……………………………………… ¥9,936 ¥10,929 ¥11,804 ¥12,512
Cost of Goods Sold:
Fixed …………………………………. (116) (116) (116) (116)
Variable (0.696 of Sales) ……… (6,915) (7,607) (8,216) (8,708)
Selling and Administrative Expense:
Fixed …………………………………. (1,031) (1,031) (1,031) (1,031)
(0.077 of Sales) …………………… (765) (842) (909) (963)
Operating Income before Income
Taxes ………………………………… ¥1,109 ¥1,333 ¥1,532 ¥1,694
Operating Income before Income
Taxes/Sales ………………………… 11.2% 12.2% 13.0% 13.5%
e. The percentage of operating income before income taxes to sales increases over
time because Sony Corporation spreads its fixed operating costs over a larger
sales volume. These increasing percentages do not portray a full picture of the
changes in the firm’s profitability. Although sales are projected to increase, they
increase at a continually decreasing rate. It is likely that Sony Corporation would
adjust its selling prices, manufacturing costs, or selling and administrative costs in
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Forecasting Financial Statements
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response to the projected declining rate of growth in sales. Such adjustments
would change the cost structure computed in Requirements a and b above.
10.13 Smoothing Changes in Accounts Receivable (amounts in millions).
a. Hasbro accounts receivable turnover: $4,022/[0.5($655 + $612)] = 6.35.
b.
Percentage
Accounts Average Ending Accounts Receivable Change in
Receivable Accounts Beginning End of Accounts
Sales Turnover Receivable of Year Year Receivable
Year +1 $4,543 6.35 $ 716 $ 612 $ 819 +33.8%
Year +2 5,132 6.35 808 819 798 –2.6%
Year +3 5,797 6.35 913 798 1,029 +29.0%
Year +4 6,548 6.35 1,031 1,029 1,034 +0.5%
Year +5 7,397 6.35 1,165 1,034 1,298 +25.5%
c. The changes in receivables exhibit the sawtooth pattern described in the chapter
and in Exhibit 10.E (p. 10-20–10.22). Such a pattern does not seem reasonable
in light of the assumptions of smooth growth in sales and steady accounts
receivable turnover. The cause of the sawtooth pattern is the slight drop in
receivables during 20X2, which causes the change in receivables in Year +1 to
be unusually large to compensate; the same holds true for Year +2, Year +3, and
Year +4, and so on.
d. The increase in accounts receivable from $612 million at the of 20X2 to $1,296
million at the end of Year +5 represents a compound annual rate of growth of
16.2% over those five years. Using this rate of growth to project a smooth
pattern of receivables growth leads to the following projections:
Ending Accounts Receivable
Year +1 $612 × 1.162 = $711
Year +2 $711 × 1.162 = $826
Year +3 $826 × 1.162 = $960
Year +4 $960 × 1.162 = $1,116
Year +5 $1,116 × 1.162 = $1,297
e. An increase in accounts receivable from $612 million to $1,034 million over
four years represents a compound annual rate of growth of 14.0%.
Ending Accounts Receivable
Year +1 $612 ×1.14 = $698
Year +2 $698 ×1.14 = $795
Year +3 $795 ×1.14 = $907
Year +4 $907 ×1.14 = $1,034
Year +5 $1,034 ×1.14 = $1,178
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The difference in growth rate in Requirements d and e results from using an
ending accounts receivable date that is an upward “sawtooth” (Requirements c)
and a downward “sawtooth” (Requirements d). Observe from Requirements b
that accounts receivable increased 0.5% during Year +4 (a down “sawtooth”)
but increased 25.3% during Year +5 (an up “sawtooth”).
f. Turnover based on year-end accounts receivable balance: $4,022/$612 = 6.57
Accounts Accounts Receivable Change in
Receivable Beginning End of Accounts
Sales Turnover of Year Year Receivable
Year +1 $4,543 6.57 $612 $ 691 13.0%
Year +2 $5,132 6.57 691 781 13.0%
Year +3 $5,797 6.57 781 882 13.0%
Year +4 $6,548 6.57 882 997 13.0%
Year +5 $7,397 6.57 997 1,126 13.0%
10.14 Smoothing Changes in Inventories (amounts in thousands).
a. Barnes & Noble inventory turnover: $3,541/[0.5($1,358 + $1,203)] = 2.77
b. Cost of Inventories Percentage
Goods Inventory Average Beginning End of Change in
Sold Turnover Inventories of Year Year Inventories
Year +1 $3,952 2.77 $1,427 $1,203 $1,655 +37.6%
Year +2 4,410 2.77 1,595 1,655 1,535 –7.3%
Year +3 4,922 2.77 1,780 1,535 2,025 +32.0%
Year +4 5,493 2.77 1,986 2,025 1,947 –3.8%
Year +5 6,130 2.77 2,217 1,947 2,486 +27.6%
These projections exhibit substantial volatility in ending inventory, which is
unrealistic considering the assumptions of smooth growth in sales and costs of
sales.
c. The above projections indicate an increase in inventories from $1,203 to $2,486
over five years, representing a compound annual rate of growth of 15.62%
[($2,486/$1,203)^(1/5) –1].
Ending Inventories
Year +1 $1,203 × 1.1562 = $1,391
Year +2 $1,391 × 1.1562 = $1,608
Year +3 $1,608 × 1.1562 = $1,859
Year +4 $1,859 × 1.1562 = $2,150
Year +5 $2,150 × 1.1562 = $2,486
These smoothed inventory forecasts more closely match the assumptions of
smooth growth in sales and costs of goods sold.
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d. Barnes & Noble inventories actually decreased from $1,358 at the end of 20X1
to $1,203 at the end of 20X2, a decline of 11.4%. Using this growth rate leads to
the following projections of inventories and implied turnover rates:
Ending Inventories Implied Turnover
Year +1 $1,203 × 0.886 = $1,066 $3,952/[($1,203 + $1,066)/2] = 3.48
Year +2 $1,066 × 0.886 = $944 $4,410/[($1,066 + $944)/2] = 4.39
Year +3 $944 × 0.886 = $836 $4,922/[($944 + $836)/2] = 5.53
Year +4 $836 × 0.886 = $741 $5,493/[($836 + $741)/2] = 6.97
Year +5 $741 × 0.886 = $656 $6,130/[($741 + $656)/2] = 8.77
This exercise demonstrates that simply assuming that past growth rates will
persist can lead to unreasonable forecasts. In this case, it is highly unlikely that
Barnes & Noble can continue to decrease inventory while at the same time
generating an increase in sales. It would be very unusual for a retail bookstore
such as Barnes & Noble to be able to achieve 8.77 inventory turns a year by
Year +5.
10.15 Identifying Financial Statement Relations.
a. Retained Earnings, Beginning of Year +1 ……………………………….. $ 21,700
Net Income for Year +1 ………………………………………………………… 1,153
Retained Earnings, End of Year +1 ………………………………………… (22,043)
Dividend Declared and Paid for Year +1 …………………………………. $ 810
b. Accumulated Depreciation, End of Year +1 …………………………….. $ 36,112
Accumulated Depreciation, End of Year 0 ………………………………. (33,100)
Depreciation Expense for Year +1 ………………………………………….. $ 3,012
c. Inventories, End of Year +1 …………………………………………………… $ 8,223
Increase in Inventories for Year +2 ………………………………………… 1,322
Inventories, End of Year +2 …………………………………………………… $ 9,545
d. Average Notes Payable for Year +2: 0.5($6,852 + $7,195) …….. $ 7,023.50
Average Long-Term Debt for Year +2: 0.5($49,094 + $51,549) 50,321.50
Average Interest-Bearing Liabilities for Year +2 …………………… $ 57,345.00
Interest Rate ……………………………………………………………………… × 0.07
Interest Expense for Year +2 ………………………………………………. $ 4,014.15
e. Other Current Liabilities, End of Year +1 ……………………………….. $ 3,630
Increase in Other Current Liabilities for Year +2 ……………………… 436
Other Current Liabilities, End of Year +2 ……………………………….. $ 4,066
f. Fixed Assets, End of Year +2 ………………………………………………… $126,467
Acquisitions of Fixed Assets during Year +3 …………………………… 24,796
Fixed Assets, End of Year +3 ………………………………………………… $151,263
Chapter 10
Forecasting Financial Statements
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g. Retained Earnings, End of Year +2 ………………………………………… $ 23,700
Net Income for Year +3 ………………………………………………………… 4,206
Dividends Declared and Paid during Year +3 ………………………….. (1,016)
Retained Earnings, End of Year +3 ………………………………………… $ 26,890
h. Long-Term Debt, End of Year +2 ………………………………………….. $ 51,549
Increase in Long-Term Debt during Year +2 …………………………… 10,107
Long-Term Debt, End of Year +3 ………………………………………….. $ 61,656
i. Income Tax Expense for Year +4 …………………………………………… $ 2,892
Net Income before Income Taxes for Year +4: $5,370 + $2,892 … 8,262
Income Tax Rate: $2,892/$8,262 ……………………………………………. 35%
j. Cost of Goods Sold for Year +4 …………………………………………….. $ 46,465
Inventories, End of Year +4 …………………………………………………… 11,333
Inventories, End of Year +3 …………………………………………………… (10,711)
Purchase of Inventories during Year +3 ………………………………….. $ 47,087
10.16 Preparing and Interpreting Financial Statement Forecasts.
This problem provides students with an extensive exercise in building financial
statement forecast models. The problem allows students to focus on building the
models (computing forecast amounts, determining projected net income, and
balancing balance sheets and cash flow statements) rather than developing the
forecast assumptions, which are given in the problem. In addition, the problem
requires students to consider the use of different financial flexible accounts to balance
the balance sheet (cash versus dividends) and the implications of each. The problem
is based on Walmart data through 2012 and requires students to build forecasts
through Year +5. For continuity, this problem can be used in conjunction with
Chapter 4’s problems involving ratio computation and analysis as well as problems
dealing with valuation in Chapters 11–14. To provide a structured approach in
evaluating the underlying assumptions in financial statement forecasts, this problem
also can be used to lead students to debate and challenge the forecast assumptions
given in the problem. An FSAP template is available for this problem on the textbook
website. Go to instructor’s resources page at www.cengagebrain.com.
a. The financial statement forecasts and financial ratios for Walmart for Year +1 to
Year +5 appear in Exhibits 10.A–10.C.