6 - Projected Operating Assumptions

6 - Projected Operating Assumptions - Projected Operating...

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Unformatted text preview: Projected Operating Assumptions Chapter 6 Using old numbers to project future ones Revenue ­Cost of Goods Sold Gross Profit ­Selling General and Adminstrative Expenses EBITDA ­Depreciation and Amortization EBIT Capital Expenditures When forecasting, use growth rates When forecasting, use growth rates rather than estimating cash flows directly Thinking of future revenue in terms of growth rates rather than dollar numbers is much more intuitive and… Easier to sell to your clients That means… That means… The growth rates will be your INPUTS, and the cash flows will be calculated This is OPPOSITE from the historical assumptions It all starts with Revenue (Sales) It all starts with Revenue (Sales) Revenue is the measure of the inflow of Assets or reduction of Liabilities from selling goods or services to customers. For a balance sheet driven firm, revenue would be the total amount generated from the sale of its inventory to consumers. A service company generates revenue based upon the amount of money the firm charges for its services. Cash and accrual accounting Cash and accrual accounting The key issue with revenue is when it is recognized for accounting purposes. The two accounting practices that govern when revenues are recognized are the cash and accrual methods. Example – lawyer spends ten hours Example – lawyer spends ten hours for a client When the issue is resolved, the law firm will send a bill for those ten hours of work to their client. Thirty days later, it receives a check from its client. Differences between cash and Differences between cash and accrual accounting Under the cash accounting method Under the accrual accounting method The law firm recognizes the revenue when it receives the check from its client. The revenue is recognized upon sending the bill. How to forecast Revenues? Three popular methods Grow revenues at a certain rate Grow revenues at a certain rate Perhaps at the rate of inflation, an industry growth rate, or the historical growth rate Eg., in the automotive industry, growth is normally equal to the overall growth in GDP. Salest +1 = Salest (1 + growth ) RED FLAG: historical growth rates RED FLAG The purchase of another company could skew the growth rate upward A divestiture could result in a one­time Revenue decline, depending on the accounting method Footnotes and/or MD&A reveal the accounting treatment used for acquisitions and divestitures and may provide a clue of the firm's growth adjusted for these activities Sales = Price x Quantity Sales = Price x Quantity Determine revenue by multiplying the number of units sold by the price per unit. If the law firm billed ten hours one month and each hour was billed at a rate of $100 per hour, the revenue for the month would be $1,000 Sales are additive Sales are additive If the firm has more than one product, then add up the individual revenues. If you were trying to determine the total revenues for the Gap, you might separately estimate the revenues for Banana Republic, Gap, and Baby Gap, then add them together to achieve Gap's total revenues Organic Growth Organic Growth What is the core growth? Excludes the impact of acquisitions and divestitures. Using organic historical growth rates allows us to forecast the future despite the complications that acquisitions and divestitures introduce to the numbers Other sources for growth rates Other sources for growth rates Ask the firm’s Management directly Analysts reports from brokerage houses Putting assumptions in context: Putting assumptions in context: comps Use the company's competitors (or industry) growth rates to calibrate your forecast Pay close attention to the competitive environment in the industry, competitive advantages of the firm, and the overall outlook for the industry and economy Do your assumptions make sense? Use Market share to calibrate Use Market share to calibrate Compute the market share implied by your forecasts A company's revenues divided by total market size (industry­wide revenues) Given the implied market share, are your sales assumptions reasonable? In the future, we will use an In the future, we will use an operating “build up” Rather than directly plug in values for Revenue, EBITDA and Capex, we "build up" to them by detailed forecasts of their components Eg., if forecasting Revenue for a company that sells one primary product, you may want to project the average price per unit and multiply by the quantity sold per year If there are several of these products, you would forecast each separately and calculate total revenue as the sum of the products' revenue. For now, For now, Calculate Revenue using the growth rate as a driver Salest +1 = Salest (1 + growth ) What about COGS? What about COGS? Commonly forecasted as a percentage of sales If on average COGS were 75% of Sales historically, we might use this as a baseline forecast Remember the assumption you make when you do this. Notes of forecasting COGS Notes of forecasting COGS Using % of sales implies constant returns to scale This may not be the case if the firm is growing rapidly Use competitor comps to calibrate Are there any hiccups (non­recurring expenses) in the historical ratios? Use an operating build up for each of the different business sectors to help identify problems Operating Leverage Operating Leverage The ratio of fixed costs to total costs Fixed Costs (e.g., factory overhead) remain roughly constant as a company grows Variable Costs (e.g., raw materials) fluctuate proportionally with Revenue Impact of High Operating Leverage Impact of High Operating Leverage High Operating Leverage ­ When revenue increases, costs will not change much, leading to a substantial bottom­line impact. BUT… When revenue declines, profit will decline substantially, since costs will remain high. What does this mean for What does this mean for forecasting COGS? If a firm's cost structure is primarily fixed, then as Sales increase, COGS as a % of Sales will decrease Why? Because the numerator, COGS, will stay constant while the denominator, Sales, increases. For now, For now, Calculate COGS using the historical ration as a driver COGSt +1 COGS = Salest +1 (1 + ) Sales What about depreciation? We will discuss this in more detail later. For now, use straight line depreciation What is SGAE? What is SGAE? Costs to sell products ­ includes marketing, advertising, (R&D), corporate overhead and Amortization Corporate overhead ­ the CEO is not a cost of the good sold, so his salary cannot be a part of that calculation, instead it is included in SG&A Costs associated with a corporate headquarters Business development costs SGAE – what does it mean? SGAE – what does it mean? SG&A represents the cost of operating the business. It does not include the direct costs associated with making the product or service, but includes many of the costs that allow for the production of those products. In most cases, SG&A is estimated using a percentage of sales. Breaking down SGAE Selling, General, and Administrative Expenses Selling Expenses Selling Expenses A significant component of the selling expense is variable ­­ notably sales commissions. Although, SG&A often gets labeled as the "fat" in a company. Selling expenses are not “fat” General and Administrative General and Administrative expenses G&A costs typically have a very high fixed component. G&A expenses primarily relate to corporate overhead. They include marketing, advertising, R&D, corporate overhead, and entertainment costs. G&A expenses and Growth G&A expenses and Growth As a company grows, these expenses sometimes balloon out of proportion to the rate of revenue growth Because of this fact, G&A is typically one of first areas an acquirer looks to cut costs in the event of a merger or buyout G&A and efficiency G&A and efficiency A very high G&A expense as a percent of sales can be a signal of a bloated cost structure That being said, a certain degree of G&A is always required to support the business Building up SGAE Building up SGAE You might want to do a separate build up for Selling expenses versus General and Administrative Expenses Selling expense should have a component tied to Revenue. G&A should probably be based primarily on a growth rate (e.g. inflation). What about amortization? What about amortization? When Assets are acquired under Purchase Accounting, Intangible assets are created on the Balance Sheet as certain assets get written up to fair value. Amortization reflects the gradually write­ down of this amount. Forecasting Amortization Forecasting Amortization Amortization is a non­cash expense that functions very similarly to Depreciation for modeling purposes The amortization schedule You will want to forecast this separately For now… For now… Forecast SGAE as a percentage of sales That means that your EBIDTA margins will be constant… this is to be expected CAPEX CAPEX Capex is usually a fixed, lump­sum cost that rarely increases linearly with sales When CAPEX changes, it changes discretely (big jumps) If you are looking at a model with hefty growth in sales and no increase in CAPEX, be suspicious Two kinds of CAPEX Two kinds of CAPEX Maintenance CAPEX Expansion CAPEX The level of Capital Expenditures required to sustain a base level of growth additional Capital Expenditures necessary to add significant amounts of capacity (and growth potential) When forecasting CAPEX… When forecasting CAPEX… Especially Expansion CAPEX, keep an eye on the capacity utilization of the firm. Make sure your forecasts are internally consistent and provide enough capacity to meet demand as the business grows. ...
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This document was uploaded on 11/02/2011 for the course FINANCE 390 at Rutgers.

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