# 6.1What Causes Financial Statement Numbers to Change?

The impacts of natural changes

Using the historical financial statements as a starting point, we can systematically create a forecast of next year’s financial statements.

First, let’s consider the balance sheet. Not all balance sheet accounts change according to the same process.

Some items increase naturally as sales volume increases.

Others increase only in response to specific long-term expansion plans.

And other balance sheet items change only in response to specific financing choices made by management.

Let’s first talk about those items that increase naturally with an increase in sales volume. By the way, this highlights the importance of starting the whole forecasting process with a reliable sales forecast.

For Year 2, a careful analysis of historical trends, economic conditions, and company plans has led the financial planners of Derrald Company to agree that sales are expected to increase a whopping 50% in Year 2. Here are the balance sheet assets for Derrald Company for last year, Year 1.

Actual
Year 1
Cash 10
Accounts Receivable 100
Inventory 150
Property, Plant, and Equipment (net) 300
Total Assets 560

If Derrald Company plans to increase its sales volume by 50 percent in Year 2, it seems logical to assume that Derrald will need about 50 percent more cash with which to handle this increased volume of business. In other words, the increased level of activity itself will create the need for more cash.

The same is true of accounts receivable and inventory. In short, a planned 50 percent increase in the volume of Derrald’s business means that, in the absence of plans to significantly change its methods of operation, Derrald will also experience a 50 percent increase in the levels of its accounts receivable and inventory.

These forecasted natural increases are reflected in this forecasted balance sheet asset listing for Year 2.

Actual Forcasted
Year 1 Year 2
Cash 10          15
Accounts Receivable 100          150
Inventory 150          225
Property, Plant, and Equipment (net) 300          ?????
Total Assets 560          ?????

Note that we don’t yet have a forecast for the amount of property, plant, and equipment needed in Year 2. The amount of property, plant, and equipment doesn’t naturally rise as sales increase. Instead, a specific plan is necessary, based on existing capacity, expected sales in Year 2, and expected developments beyond Year 2.

The planned acquisition of property, plant, and equipment is discussed in a subsequent module.

Now let’s talk about the income statement. Derrald Company’s income statement for Year 1 (up through the computation of operating profit) looks like this.

Actual
Income Statement Year 1
Sales 1,000
Cost of Goods Sold (700)
Gross Profit 300
Depreciation Expense (15)
Other Operating Expenses (185)
Operating Profit 100

The amount of some expenses is directly tied to the amount of sales for the year. Derrald Company’s sales are forecasted to increase by 50 percent in Year 2 (from $1,000 to$1,500), so it is reasonable to predict that cost of goods sold will increase by the same 50 percent.

Another way to perform this calculation is to assume that the ratio of cost of goods sold to sales remains constant from year to year. Thus, because cost of goods sold was 70 percent of sales in Year 1 ($700 ÷$1,000 = 70%), cost of goods sold should increase to $1,050 ($1,500 × 0.70) in Year 2.

Similarly, other operating expenses, such as wages and shipping costs, are also likely to maintain a constant relationship with the level of sales. So, if operating expenses were 18.5% of sales of $1,000 in Year 1, as a forecasting starting point we can assume that those operating expenses will be 18.5% of forecasted sales of$1,500 in Year 2, or $278 ($1,500 × 0.185).

By way, we will talk about the expected change in operating expenses in more detail later when we discuss the impact of fixed costs and variable costs. In this simple example, we are assuming that all operating expenses are variable costs.

Forecasted items from Derrald Company’s income statement for Year 2 appear like this.

Actual Forcasted
Income Statement Year 1 Year 2
Sales 1,000          1,500
Costs of Goods Sold (700)          (1,050)
Gross Profit 300          450
Depreciation Expense (15)          ?????
Other Operating Expenses (185)          (278)
Operating Profit 100          ?????

Note that we don’t yet have a forecast for depreciation expense in Year 2 because the amount of depreciation is driven not by sales but by the level of property, plant, and equipment. We will consider this in another module.

Some balance sheet and income statement items can be expected to change roughly in proportion to the change in sales. We can use this insight in constructing forecasted financial statements.

The impacts of long-term planning decisions

Long-term assets, such as property, plant, and equipment, do not increase naturally as sales volume increases. Instead, the addition of a new factory building, for example, only occurs as the result of a long-term planning process.

Thus, a business anticipating an increase of sales in the coming year of only 10 percent may expand its productive capacity by 50 percent as part of its long-term strategic plan.

Similarly, a business forecasting 25 percent sales growth may plan to use existing excess capacity to handle the entire sales increase without any increase in long-term assets.

In short, forecasting future levels of long-term assets requires some knowledge of a company’s strategic expansion plan. For Derrald Company, a careful long-term planning process has led management to decide that property, plant, and equipment should be increased from $300 in Year 1 to$700 in Year 2.

A forecasted 50% sales increase leads to more than a doubling in property, plant, and equipment? Why?

Answering this “why” questions requires lots of detailed information about internal circumstances and plans. Perhaps it is the case that in Year 1, Derrald Company was operating its property, plant, and equipment at a level way above capacity. So even without any sales increase, Derrald would have needed to increase its level of property, plant, and equipment to a more sustainable level.

And perhaps Derrald Company expects not only a 50% sales increase in Year 2, but similar increases in subsequent years. When a company buys or builds new production and operations facilities, it doesn’t expand just enough to fit next year’s needs. These are long-term assets, and long-term implications need to be considered in deciding on the appropriate level of property, plant, and equipment for next year.

The complete forecast of Derrald Company’s assets for Year 2 looks like this.

Actual Forcasted
Year 1 Year 2
Cash 10          15
Accounts Receivable 100          150
Inventory 150          225
Property, Plant, and Equipment (net) 300          700
Total Assets 560          1,090

In a subsequent module, we will consider the obvious question: Where can Derrald get the money to buy this $1,090 in assets? Now, on to the forecasted income statement. The amount of a company’s depreciation expense is determined by how much property, plant, and equipment the company has. In Year 1, Derrald Company had$15 of depreciation expense on $300 of property, plant, and equipment, meaning that depreciation was equal to 5% ($15 ÷ $300) of the amount of property, plant, and equipment. Another way to think of this is that the implied depreciation life for the property, plant, and equipment is 20 years =$300 ÷ $15. If the same relationship holds in Year 2, Derrald can expect to report depreciation expense for the year of$35 ($700 × 0.05 or$700 ÷ 20 years).

The Year 2 forecasted income statement, up through operating profit, looks like this.

Actual Forcasted
Income Statement Year 1 Year 2
Sales 1,000          1,500
Costs of Goods Sold (700)          (1,050)
Gross Profit 300          450
Depreciation Expense (15)          (35)
Other Operating Expenses (185)          (278)
Operating Profit 100          138

Forecasting the level of property, plant, and equipment, and the associated amount of depreciation expense, requires careful consideration of current circumstances in terms of level of utilization as well as consideration of expected future expansion plans.

The impacts of financing choices

Now that we know that Derrald Company expects to need $1,090 in assets in Year 2, we need to determine where Derrald will get the money to buy those assets. One easy source of financing to forecast is the amount of accounts payable. Accounts payable represents the operational financing provided by the suppliers. As with the other financial statement items that increase naturally, accounts payable also increases naturally as sales increases. So, if sales are expected to increase by 50%, then inventory purchases are also expected to increase by 50%, and supplier financing will also increase by about 50%. In Year 2, accounts payable will increase to$150 from $100 in Year 1. The level of long-term debt and of stockholders’ equity is determined by management’s decisions on how to best obtain financing. In fact, management often uses forecasted financial statements, prepared under a variety of different financing scenarios, to help determine what financing choices to make. For now we will make the simple assumption that Derrald is planning to partially finance its operations in Year 2 by increasing its bank loans payable from$300 to $400. The Year 2 forecasted liabilities and equity section of the balance looks like this so far. Actual Forcasted Year 1 Year 2 Accounts Payable 100 150 Loans Payable 300 400 Paid-in Capital 100 PLUG Retained Earnings 60 ????? Total Liabilities and Equities 560 1,090 How about retained earnings and paid-in capital? And how do we know that the total is$1,090?

Well, let’s address the last question first. Total liabilities and equities HAVE to equal $1,090 because that is the amount of financing needed to buy the$1,090 in assets forecasted to be needed in Year 2.

To forecast retained earnings, we need to first complete the forecasted income statement. Here is where we are so far.

Actual Forcasted
Income Statement Year 1 Year 2
Sales 1,000          1,500
Costs of Goods Sold (700)          (1,050)
Gross Profit 300          450
Depreciation Expense (15)          (35)
Other Operating Expenses (185)          (278)
Operating Profit 100          138
Interest Expense (30)          ?????
Income before Taxes 70          ?????
Income Taxes (30)          ?????
Net Income 40          ?????

Interest expense depends on how much interest-bearing debt a company has. In Year 1, Derrald Company reported interest expense of $30 with a bank loan payable of$300. These numbers imply that the interest rate on Derrald’s loans is 10 percent ($30 ÷$300). Because the bank loan payable is expected to increase to $400 in Year 2, Derrald can expect interest expense of$40 ($400 × 0.10 =$40).

The assumptions made so far imply that Derrald’s income before taxes in Year 2 will total $98 . . .$138 in operating profit less $40 in forecasted interest expense. Income tax expense is determined by how much pretax income a company has. And the most reasonable assumption to make is that a company’s income tax rate, equal to income tax expense divided by pretax income, will stay constant from year to year. Derrald’s tax rate in Year 1 was 43 percent ($30 ÷ $70) which, when applied to the forecasted pretax income for Year 2 of$98, implies that income tax expense in Year 2 will total $42 ($98 × 0.43).

The complete forecasted income statement for Year 2 looks like this.

Actual Forcasted
Income Statement Year 1 Year 2
Sales 1,000          1,500
Costs of Goods Sold (700)          (1,050)
Gross Profit 300          450
Depreciation Expense (15)          (35)
Other Operating Expenses (185)          (278)
Operating Profit 100          138
Interest Expense (30)          (40)
Income before Taxes 70          98
Income Taxes (30)          (42)
Net Income 40          56

The computation of the forecasted amount of retained earnings for Year 2 now looks like this.

Actual Forcasted
Year 1 Year 2
Beginning Retained Earnings 35           60
+ Net Income 40           56
- Dividends (15)           (20)
Ending Retained Earnings 60           96

Part of this forecast is the management decision to increase dividends from $15 in Year 1 to$20 in Year 2. Depending on how the forecasted financial statements look, management might decide to change this preliminary dividend decision.

Now, we have EVERYTHING … except for the forecasted paid-in capital amount for Year 2.

Actual Forcasted
Year 1 Year 2
Accounts Payable 100          150
Loans Payable 300          400
Paid-in Capital 100          PLUG
Retained Earnings 60          96
Total Liabilities and Equities 560          1,090

But we know what the amount it… it has to be the number that causes total liabilities and equity to be the same as forecasted total assets of $1,090. Here I call this number the “plug” figure. The number is$444. This implies that $344 in new equity ($444 - \$100) needs to be solicited from shareholders during Year 2.

Note: The Paid-in Capital balance doesn’t have to serve as the PLUG figure; there are other possibilities. We will talk about this in a later module.

What if now is not the right time to solicit new funds from shareholders? Well, the good news is that we haven’t done it yet; this is just a forecasting exercise. If we don’t like the implications, we can change the plan before the year ever begins. Don’t reduce property, plant, and equipment so much. Increase the planned amount of borrowing.

Financial modeling and the preparation of forecasted financial statements allows us, in advance, to evaluate whether Derrald Company’s operating, investing, and financing plans are feasible and internally consistent.