Title LM07 Financial Statement Modeling IFT Notes.pdf ✅

LM07 Financial Statement Modeling 2023 Level II Notes © IFT. All rights reserved 1 LM07 Financial Statement Modeling 1. Introduction ........................................................................................................................................................ 2 Financial Statement Modeling: An Overview ........................................................................................ 2 2. Income Statement Modeling: Operating Costs ...................................................................................... 3 3. Modeling Operating Costs: Cost of Goods Sold and SG&A ................................................................ 4 SG&A Expenses ................................................................................................................................................. 4 4. Modeling Non-operating Costs and Other Items .................................................................................. 5 Financing Expenses......................................................................................................................................... 5 Corporate Income Tax ................................................................................................................................... 5 Income Statement Modeling: Other Items ............................................................................................. 6 5. Balance Sheet and Cash Flow Statement Modeling ............................................................................. 6 6. Building a Financial Statement Model ...................................................................................................... 7 7. Behavioral Finance and Analyst Forecasts ............................................................................................. 8 8. The Impact of Competitive Factors in Prices and Costs .................................................................... 9 9. Inflation and Deflation ................................................................................................................................. 10 Sales Projections with Inflation and Deflation ..................................................................................10 Cost Projections with Inflation and Deflation....................................................................................11 10. Technological Developments .................................................................................................................11 11. Long-Term Forecasting ............................................................................................................................12 Summary ................................................................................................................................................................14 This document should be read in conjunction with the corresponding reading in the 2023 Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM07 Financial Statement Modeling 2023 Level II Notes © IFT. All rights reserved 2 1. Introduction The learning module introduces us to financial modeling; we will learn how to forecast each item of the income statement, balance sheet, and cash flow statement, and subsequently construct a pro forma income statement, balance sheet and cash flow statement. Then, we will discuss five key behavioral biases that influence the modeling process and strategies to mitigate them. We will also look at the nuances required to build forecasting models such as: the impact of competitive forces on prices and costs, the effects of inflation and deflation, technological developments, and long-term forecasting considerations. Financial Statement Modeling: An Overview Financial modeling typically begins with forecasting items on the income statement. Income Statement Modeling: Revenue Most companies have multiple sources of revenue. A company’s revenue sources can be broken down by:  Geographical regions  Business segments  Product lines Once the sources of revenue are known, an analyst can use the following approaches to forecast revenue:  The top-down approach begins at the level of the overall economy. We then move down to sector, industry, and market for a specific product to forecast the revenue for an individual company.  The bottom-up approach begins at the level of the individual company or a unit within the company (e.g. a product line). We then sum up the projections for the individual products to forecast the total revenue for the company.  The hybrid approach combines top-down and bottom-up approaches. By using elements from both approaches, a hybrid approach can reveal implicit assumptions or errors that may arise from using a single approach. Top-down Approaches to Modeling Revenue Two common top-down approaches to modeling revenue are: Growth relative to GDP growth approach: In this approach, we first forecast the growth rate of nominal GDP. We then forecast the company’s revenue growth relative to GDP growth. For example, we can assume that the company’s revenue will grow at a rate of 150 bps above the nominal GDP growth rate. The forecast may also be in relative terms. For example, if we forecast that the GDP will grow
LM07 Financial Statement Modeling 2023 Level II Notes © IFT. All rights reserved 3 at 4%, and we believe that the company’s revenue will grow at a 20% faster rate, then the forecasted increase in the company’s revenue is 4% x (1 + 0.20) = 4.8%. Market growth and market share: In this approach, we combine forecasts of growth in particular markets with forecasts of a company’s market share. For example, assume Tesla is expected to maintain a market share of 1% in the automobile market. If the automobile market is expected to grow to $30 billion in annual revenue, then Tesla’s annual revenue is forecasted to grow to 1% * $30 billion = $300 million. Bottom-Up Approaches to Modeling Revenue Examples of bottom-up approaches include:  Time-series: Forecasts based on historical growth rates or time-series analysis. For example, we may assume that the historical growth rate will continue, or that the growth rate will decline linearly from current rates to some long-run rate.  Return on capital: Forecasts based on balance sheet accounts. For example, a bank’s interest revenue can be calculated as loans multiplied by the average interest rate.  Capacity-based measure: For example, a retailer’s revenue may be forecasted based on same-store sales growth and sales related to new stores. Hybrid Approaches to Modeling Revenue Hybrid approaches are the most commonly used approaches in practice. They combine elements of both top-down and bottom-up approaches. For example, we may use a market growth and market share approach to model individual product lines or business segments (top-down), and then combine the individual projections to arrive at a forecast for the overall company (bottom-up). 2. Income Statement Modeling: Operating Costs Operating costs include cost of goods sold (COGS) and selling, general, and administrative expenses (SG&A). Disclosures about operating costs are often less detailed than revenue. If information is available, then we can match cost analysis to revenue analysis. For example, costs may be modeled separately for different geographic regions, business segments or product lines. Similar to revenue forecasting, costs can also be forecasted using a top-down, bottom-up, or hybrid approach:  Top-down approach: Consider factors such as overall level of inflation, or industry- specific costs.  Bottom-up approach: Consider factors such as segment-level margins, historical cost- growth rates, historical margin levels, etc.  Hybrid view: Incorporate elements from both top-down and bottom-up approaches. Some points that analysts must consider when projecting operating costs are:
LM07 Financial Statement Modeling 2023 Level II Notes © IFT. All rights reserved 4  Since variable costs are linked to revenue growth, they can be forecasted as a percentage of revenue.  Since fixed costs are not directly related to revenue, they are assumed to grow at their own rate or at the rate of future PP&E growth.  Determine whether a company has economies of scale at the current level of output. Economies of scale means the average costs per unit of a good produced falls as volume increases. Gross and operating margins tend to be positively related to sales, if there are economies of scale.  Be aware of the uncertainty related to cost estimates such as reserve accounts, competitive factors and technological developments. For example, banks and insurance companies create reserves against estimated future losses. However, the actual losses may not be known for many years. We will now look at how to forecast operating costs. 3. Modeling Operating Costs: Cost of Goods Sold and SG&A Cost of Goods Sold Since COGS are directly related to sales, we can forecast future COGS as a percentage of future sales. Analysts should understand the historical relationship between COGS and sales, and determine if this relationship is likely to decrease, increase, or remain unchanged. Sales – COGS = gross margin. Therefore, COGS and gross margin are inversely related. Some factors that analysts should consider while forecasting COGS are:  Forecasting accuracy can be improved by forecasting COGS for the company’s various segments or product categories separately.  Determine if a company has employed hedging strategies to protect its gross margins. When input prices increase, COGS increase and gross margin decreases. However, hedging strategies can help mitigate this impact.  Examine gross profit margins of competitors. This can be a useful cross check for estimating a realistic gross margin. Any difference in gross margins for companies in the same segment must relate to differences in their business operations. SG&A Expenses As compared to COGS, SG&A expenses are less directly related to revenue. SG&A can be broken down into two components – fixed and variable. The fixed components such as R&D expenses, management salaries, head office expenses, supporting IT and administrative operations tend to increase and decrease gradually over time. They do not fluctuate with sales. On the other hand, the variable components such as selling and distribution costs are more directly related to sales. For example, when sales increase, the company may pay out higher