CH09

MBAD 7090 Chapter 9 – Prospective Analysis Page 1 of 15

Chapter 9

Prospective Analysis

Prospective Analysis is the forecasting of future financial

information

Projecting and Income Statement

Perhaps the most critical step is the projection of revenue

growth. For our purposes we will assume an observed growth

rate, but in a full analysis you should also consider:

o Economy wide factors

o Industry wide factors

o Company specific factors

Process:

1. Project revenue using the most recent period amount and the

most recent period growth rate.

So if a company had revenue of 1,000,000 in the prior year (say,

2006) and 1,200,000 in revenue in the current year (say, 2007),

then the growth rate would be 20% [(1,200,000-

1,000,000)/1,000,000] and we would project the next year (say,

2008) to have revenue of 1,440,000 [1,200,000 X 1.2].

2. Project the gross profit using the most recent period’s gross

profit rate.

So, if cost of goods sold for the current year was 900,000, then

the gross profit rate would be 25% [(1,200,000-

900,000)/1,200,000]. Therefore we would project the gross profit

for the next year to be 360,000 [1,440,000 X .25].

MBAD 7090 Chapter 9 – Prospective Analysis Page 2 of 15

3. Once you know the revenue and the gross profit you can

determine the cost of goods sold.

Since GP = Sales – COGS, therefore COGS = Sales – GP

1,080,000 = 1,440,000-360,000

4. Operating Expenses* can be projected by using the historical

OE/Sales rate with the projected sales.

So, if current year Operating Expenses are 120,000, then the

OE/Sales rate is 10% [120,000/1,200,000]. Therefore we would

project OE for the next year as 144,000 [1,440,000 X .10].

*In the chapter the author assume that total SG&A is decomposed

into operating expenses and depreciation expense. If they are not

presented that way in the income statement you can separate

them out by getting depreciation expense from the Statement of

Cash Flows and the subtracting it from total SG&A.

5. Depreciation Expense can be projected by using the historical

rate of depreciation expense to gross PPE from the prior year.

So, if the prior period’s balance sheet had Gross PPE of 1,200,000

and the current period depreciation expense was 60,000, then the

rate would be 5% [60,000/1,200,000]. Therefore, if Gross PPE at

the end of the current year was 1,500,000 we would project

Deprecation Expense for next year to be 75,000.

MBAD 7090 Chapter 9 – Prospective Analysis Page 3 of 15

6. Interest Expense is estimated by computing the interest rate

paid in the current year. This rate is computed by dividing

interest expense by total interest bearing debt from the prior

year’s balance sheet. Then the projected interest expense is

computed by multiplying the total interest bearing debt at the

end of the current period by this rate.

So, if the prior period’s balance sheet had total interest bearing

debt of 500,000 and current period interest expense was 35,000,

then the interest rate would be 7%. Therefore if the current

period balance sheet included 600,000 of interest bearing debt,

projected interest would be 42,000.

7. Income Tax Expense is projected multiplying the current year

income tax rate by the projected income before income taxes.

The income tax rate would be computed by dividing current

income tax expense by current income before tax.

So, if income before tax in the current year was 85,000 and the

income tax expense was 34,000, the income tax rate would be

40% [34,000/85,000]. Therefore income tax expense would be

projected to be 39,600 [(1,440,000-1,080,000-144,000-75,000-

42,000)X.4]

MBAD 7090 Chapter 9 – Prospective Analysis Page 4 of 15

Best Buy Exercise

1. Project Sales

2. Project Gross Profit

3. Determine COGS

4. Project Operating Expenses (excluding depreciation)

5. Project Depreciation

\

MBAD 7090 Chapter 9 – Prospective Analysis Page 5 of 15

6. Project Interest Expense

7. Project Income Tax Expense

Best Buy Projected Income Statement

Sales 34,689

Cost of Goods Sold 25,999

Gross Profit 8,690

Operating Expenses 6,327

Depreciation Expense 526

Interest Expense 35

Net Income Before Tax 1,802

Income Tax Expense 608

Net Income 1,194

MBAD 7090 Chapter 9 – Prospective Analysis Page 6 of 15

Projected Balance Sheet

Basic Process

o Project most current asset and liability accounts using

historical turnover ratios combined with projected income

statement numbers

o Project PPE using historical Capital Expenditures

o Project current maturities of long-term debt from current

year footnote information

o Assume short-term debt, other long-term liabilities and

initial common stock amounts based on current year

balance

o Calculated Projected Retained Earnings based on current

ending retained earnings, projected Net Income and

projected Dividends

o Assume all other Stockholders’ Equity accounts based on

current balances

MBAD 7090 Chapter 9 – Prospective Analysis Page 7 of 15

o At this point you will have a projected amount for Total

Liabilities and Total Stockholders’ Equity and, therefore,

you will have a projected amount for Total Assets. You can

determine projected Cash based on Projected Total Assets

less Projected amount for all non-Cash Current Assets and

all non-Current Assets

o If projected Cash is negative you can issue additional debt

and equity keeping historical levels of financial leverage.

o If projected Cash is unusually high you can reduce the

balance by using it to retire debt and/or repurchase stock,

again keeping financial leverage in line with historical levels

Item Turnover Ratio Ratio Formula Accounts Receivable Accounts Receivable

Turnover Sales/Accounts Receivable

Inventory Inventory Turnover Cost of Goods

Sold/Inventory

Accounts Payable Accounts Payable

Turnover

Cost of Goods

Sold/Accounts Payable

Accrued Expenses Accrued Expenses Turnover

Sales/Accrued Expenses Payable

Taxes Payable Historical Rate Taxes Payable/Income Tax Expense

Dividends Dividends per Share Total Dividends/Number

of Shares Oustanding

Capital Expenditures CAPEX/Sales Capital

Expenditures/Sales

MBAD 7090 Chapter 9 – Prospective Analysis Page 8 of 15

Best Buy Example

1. Receivables

2. Inventory

3. Plant and Equipment, Net

4. Accounts Payable

MBAD 7090 Chapter 9 – Prospective Analysis Page 9 of 15

5. Accrued Expenses Payable

6. Income Taxes Payable

7. Long-Term Debt

8. Retained Earnings

MBAD 7090 Chapter 9 – Prospective Analysis Page 10 of 15

Best Buy Projected Balance Sheet

Assets

Cash and Short-Term Investments 4,325

Receivables 569

Inventory 3,752

Other Current Assets 409

Total Current Assets 9,055

Plant and Equipment, Net 2,914

Other Non-current Assets 1,167

Total Assets 13,136

Liabilities and Stockholders’ Equity

Accounts Payable 3,636

Accrued Expenses 1,912

Accrued Income Taxes 736

Current Portion of LT Debt 16

Total Current Liabilities 6,300

Long Term Liabilities 373

Long Term Debt 162

Total Liabilities 6,835

Common Stock 49

Additional Paid-in Capital 643

Retained Earnings 5,348

AOCI 261

Total Stockholders’ Equity 6,301 Total Liabilities and Stockholders’ Equity 13,136

MBAD 7090 Chapter 9 – Prospective Analysis Page 11 of 15

Best Buy Projected Statement of Cash Flows

Operating Activities

Net Income 1,194

Add: Depreciation Expense 526

Increase in Receivables (63)

Increase in Inventory (414)

Increase in Accounts Payable 402

Increase in Accrued Expenses 211

Increase in Income Taxes Payable 33

Net Cash Flow from Operations 1,889

Investing Activities

Capital Expenditures (728)

Net Cash Flow from Investing Activities (728)

Financing Activities

Long Term Debt (418)

Dividends (150)

Net Cash Flow from Financing Activities (568)

Net Increase in Cash and ST Investments 593

Beginning Cash and ST Investments 3,732

Ending Cash and ST Investments 4,325

MBAD 7090 Chapter 9 – Prospective Analysis Page 12 of 15

Best Buy - Consolidated Balance Sheets ($ in millions, except per share amounts)

Assets

February 25,

2006

February 26,

2005

Current Assets

Cash and cash equivalents

$ 681

$ 354

Short-term investments

3,051

2,994

Receivables

506

375

Merchandise inventories

3,338

2,851

Other current assets

409

329

Total current assets

7,985

6,903

Property and Equipment

Land and buildings

580

506

Leasehold improvements

1,325

1,139

Fixtures and equipment

2,898

2,458

Property under master and capital lease

33

89

4,836

4,192

Less accumulated depreciation

2,124

1,728

Net property and equipment

2,712

2,464

Goodwill

557

513

Tradename

44

40

Long-Term Investments

218

148

Other Assets

348

226

Total Assets

$ 11,864

$ 10,294

Liabilities and Shareholders’ Equity

Current Liabilities

Accounts payable

$ 3,234

$ 2,824

Unredeemed gift card liabilities

469

410

Accrued compensation and related expenses

354

234

Accrued liabilities

878

844

Accrued income taxes

703

575

Current portion of long-term debt

418

72

Total current liabilities

6,056

4,959

Long-Term Liabilities

373

358

Long-Term Debt

178

528

Shareholders’ Equity

Preferred stock, $1.00 par value: Authorized — 400,000 shares; Issued and outstanding — none

—

—

Common stock, $.10 par value: Authorized — 1 billion shares; Issued and outstanding — 485,098,000 and

492,512,000 shares, respectively

49

49

Additional paid-in capital

643

936

Retained earnings

4,304

3,315

Accumulated other comprehensive income

261

149

Total shareholders’ equity

5,257

4,449

Total Liabilities and Shareholders’ Equity

$ 11,864

$ 10,294

MBAD 7090 Chapter 9 – Prospective Analysis Page 13 of 15

Best Buy - Consolidated Statements of Earnings ($ in millions, except per share amounts)

For the Fiscal Years Ended

February 25,

2006

February 26,

2005

February 28,

2004

Revenue $ 30,848 $ 27,433 $ 24,548

Cost of goods sold 23,122 20,938 18,677

Gross profit 7,726 6,495 5,871

Selling, general and administrative expenses 6,082 5,053 4,567

Operating income 1,644 1,442 1,304

Net interest income (expense) 77 1 (8 )

Earnings from continuing operations before income tax expense 1,721 1,443 1,296

Income tax expense 581 509 496

Earnings from continuing operations 1,140 934 800

Loss from discontinued operations (Note 2), net of tax — — (29 )

Gain (loss) on disposal of discontinued operations (Note 2), net of tax — 50 (66 )

Net earnings $ 1,140 $ 984 $ 705

Basic earnings (loss) per share:

Continuing operations $ 2.33 $ 1.91 $ 1.65

Discontinued operations — — (0.06 )

Gain (loss) on disposal of discontinued operations — 0.10 (0.14 )

Basic earnings per share $ 2.33 $ 2.01 $ 1.45

Diluted earnings (loss) per share:

Continuing operations $ 2.27 $ 1.86 $ 1.61

Discontinued operations — — (0.06 )

Gain (loss) on disposal of discontinued operations — 0.10 (0.13 )

Diluted earnings per share $ 2.27 $ 1.96 $ 1.42

Basic weighted-average common shares outstanding (in millions) 490.3 488.9 485.0

Diluted weighted-average common shares outstanding (in millions) 504.8 505.0 500.8

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Best Buy - Consolidated Statements of Cash Flows ($ in millions) For the Fiscal Years Ended February 25, 2006 February 26, 2005 February 28, 2004

Operating Activities

Net earnings $ 1,140 $ 984 $ 705

(Gain) loss from and disposal of discontinued operations, net of tax — (50 ) 95

Earnings from continuing operations

1,140

934

800

Adjustments to reconcile earnings from continuing operations to total cash provided by operating

activities from continuing operations:

Depreciation 456 459 385

Asset impairment charges 4 22 22

Stock-based compensation 132 (1 ) 8

Deferred income taxes (151 ) (28 ) (14 )

Excess tax benefits from stock-based compensation (33 ) — —

Other, net (3 ) 24 8

Changes in operating assets and liabilities, net of acquired assets and liabilities:

Receivables (110 ) (30 ) (27 )

Merchandise inventories (457 ) (240 ) (507 )

Other assets (11 ) (50 ) (7 )

Accounts payable 385 347 272

Other liabilities 165 243 250

Accrued income taxes 178 301 197

Total cash provided by operating activities from continuing operations

1,695

1,981

1,387

Investing Activities

Additions to property and equipment, net of $75, $117 and $26 non-cash capital expenditures in

fiscal 2006, 2005 and 2004, respectively

(648 ) (502 ) (545 )

Purchases of available-for-sale securities (4,319 ) (8,517 ) (2,989 )

Sales of available-for-sale securities 4,187 7,730 2,175

Change in restricted assets (20 ) (140 ) (18 )

Other, net 46 7 1

Total cash used in investing activities from continuing operations

(754 )

(1,422 )

(1,376 )

Financing Activities

Repurchase of common stock (772 ) (200 ) (100 )

Issuance of common stock under employee stock purchase plan and for the exercise of stock

options

292 256 114

Dividends paid (151 ) (137 ) (130 )

Long-term debt payments (69 ) (371 ) (17 )

Net proceeds from issuance of long-term debt 36 — —

Excess tax benefits from stock-based compensation 33 — —

Other, net (10 ) (7 ) 46

Total cash used in financing activities from continuing operations

(641 )

(459 )

(87 )

Effect of Exchange Rate Changes on Cash

27

9

1

Cash Flows from Discontinued Operations (Revised — See Note 2)

Operating cash flows — — (52 )

Investing cash flows — — (1 )

Net Cash Used in Discontinued Operations

—

—

(53 )

Increase (Decrease) in Cash and Cash Equivalents

327

109

(128 )

Cash and Cash Equivalents at Beginning of Year 354 245 373

Cash and Cash Equivalents at End of Year

$ 681

$ 354

$ 245

Supplemental Disclosure of Cash Flow Information

Income tax paid $ 547 $ 241 $ 306

Interest paid 16 35 22

MBAD 7090 Chapter 9 – Prospective Analysis Page 15 of 15

Sensitivity Analysis

Since the projected financial statements are built

around a series of assumptions you should perform

sensitivity analysis

The purpose of this is to examine which results are

particularly sensitive to your assumptions