Financial analysis and forecasting Advanced Managerial Finance Spring 2013

Financial analysis and forecasting The Body Shop International Why would the company want to forecast? Finance is concerned with expected performance The value of any asset is equal to… Investors forecast to value and invest. “ImmunoMedics reports Q1 EPS (7c) vs. consensus (9c)” Financial managers forecast to plan and finance

Motives for modeling Decision makers wrestle with risk and uncertainty about the future. Financial modeling can help to: measure risk identify strengths and potential problems consider the implications of alternative choices provide the means for a firm to express its goals and priorities assist the firm in identifying the asset requirements and needs for external financing sensitivity analysis

The Body Shop International Role of adviser to Anita Roddick, the managing director You must prepare a three-year forecast of the firm’s income statements and balance sheets Percentage-of-sales forecasting method “A Financial Forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts vary with sales. Therefore, the key driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial Statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified”.

The Body Shop International Limitations because economic climate and demand can change or deteriorate over time, problems start to arise when applying assumptions of the past to the present or future using the percentage of sales forecasting method assumes that you are always operating at full capacity. It doesn't take into account fixed costs in the event of underutilized resources - it instead assumes everything scales evenly up or down with sales

The Body Shop International Background of the case Mid 1990’s revenues grew by 20% Late 1990’s revenue growth slowed down to 8% Change of management in 1998 Anita Roddick out and Patrick Gournay in Despite the change problems persisted In 2001 revenues grew 13 percent Pretax profit declined 21 percent

The Body Shop International Background of the case New CEO developed the following strategy Enhance firm’s brand through a focused product strategy and increased investment in stores. Achieve operational efficiencies in out supply chain by reducing product and inventory costs Reinforce our stakeholder culture

The Body Shop International Financial Forecasting T-account forecasting Select a base year Determine how each account will change What will the new balances be? Method is cumbersome and requires detailed information Percentage-of-sales forecasting: Start with a forecast of sales Estimate the other accounts based on a predetermined relationship between sales and that account. For example: Operating margin =

The Body Shop International Percentage-of-sales forecasting (cont.) Simple to execute Can be misused. For example: Financial analysts assumes operational capacity can increase in fractional amounts parallel to increases in sales, but airlines cannot buy just half an airplane. Use a hybrid system of T-accounts and Percentage-of-sales forecasting T-accounts for fixed assets and equity Percentage-of-sales for CA, CL, taxes, etc.

The Body Shop International A pencil and paper forecast (page 121) Let’s work on Income statement and Balance sheet sections Iterate section: The balance and the income statement depend on each other Interest expense is needed to estimate retained earnings Retained earnings is needed to estimate debt Circularity or “which came first? The chicken or the egg” problem. Problem is solved with iterations, easily done with Excel.

The Body Shop International Negative debt = excess cash Trial balance sheet line items