Learn how studying and analyzing the historical performance of a company allows financial statement users to project the future performance of a company.
- A common criticism I hear about accounting is that it's too focused on the past, it's about the financial history of a company. Well, managers and investors don't want to know about the past, they want to know about the future, and accounting leans too heavily on the past. - I'm going to go with Winston Churchill on this topic. He said, "The farther back you can look, "the further forward you are likely to see." Churchill, a student of history, understood that studying the past allowed one an educated glimpse into the uncertain future.
- Studying and analyzing the historical performance of a company allows financial statement users to project the future performance of a company. We make some reasonable assumptions about a company's future performance and it is fairly straightforward to see what future financial statements might look like. - So, let's discuss forecasting a company's income statement. But the same concepts would apply if we were looking at the balance sheet. To begin, we recognize that the amount of some expenses is tied directly to the amount of sales for the year.
- For example, if we do nothing differently in the future, it seems reasonable to predict that the cost of sales will increase by the same percentage that sales increases. Similarly, other operating expenses, such as wages and shipping costs, are also likely to maintain a constant relationship with the level of sales. - Some expenses don't necessarily vary with sales. For example, depreciation expense will vary with the amount of a company's plant and equipment. If that increases, it's reasonable to expect a depreciation expense to increase.
- Another one is interest expense. That amount is typically not going to vary with sales. Rather, it will change, depending on the amount of debt a company has. If debt goes up, it's reasonable to forecast that interest expense will go up. If debt goes down, then we would expect interest expense to go down. - Finally, let's look at income tax expense. Tax expense is not a function of sales. Rather, it's a function of pretax income. Dividing last year's tax expense by last year's pretax income will provide me with a tax rate that I can use to forecast future tax expense.
- Now, a major point is this. We just kind of think about how income statement numbers change, what events or activities drive those changes, and then we forecast the future based on our expectations about those changing activities. - Now, our initial forecast assumes that overall economic and industry conditions will stay the same into the future. We can modify our forecast and then do what-if analysis after we develop an initial, simple baseline forecast. - Now, the most critical number to forecast when trying to see what a future income statement might look like is how much sales will grow.
Many numbers on the income statement are contingent upon that growth number. - A lot of marketing research can go into what that number, that sales number, might reasonably be. And once we are comfortable with that sales forecast, then we can start projecting a full entire income statement. - Let's consider a company with which most of us are familiar, Home Depot, the giant do-it-yourself home repair company. They sell lumber, paint, and about a cabillion other home repair and construction items. - Here is Home Depot's income statement for the 12 months ended February 1, 2015.
You can see that they had sales of over 83 billion dollars and reported net income of 6.3 billion dollars. - Now, we don't need to go through the intricate details of how we forecasted, we cover those details in one of our courses. Basically, we do what we just summarized. But, with just a few simple reasonable assumptions, and assuming a forecasted growth in sales of 6.4%, we can forecast 2016 results that look like this. - So, the real interest inquisition now is this, how does that forecast compare with what actually happened? - And the nice thing is, we know the answer to that.
We can compare our 2016 forecast with the 2016 actual results. Here, we compare our forecast to Home Depot's actual results. - You can see here that our forecast of net income was within 2.5% of Home Depot's actual results, and we didn't even work up a sweat making this forecast. - Using historical information and making some reasonable assumptions, we can get a look at what the future might be, and, if we were to put in a little more investigative effort into our assumptions, we could get an even more accurate picture of what the future might look like.
- Historical accounting information can be used to help provide us a glimpse as to a company's financial future. We just need to think carefully about the relations among the various financial statement numbers. - It's not hard, and it's kind of fun. And the nice thing about getting a glimpse of what the future looks like is that, if you don't like it, you can change the assumptions associated with your forecast. - Yeah, you can change your assumptions to get a different forecast. You just then need to make sure that those changed assumptions are reasonable. If they are, you can achieve a different financial future.
Skill Level Beginner
Q: Why can't I earn a Certificate of Completion for this course?
A: We publish a new tutorial or tutorials for this course on a regular basis. We are unable to offer a Certificate of Completion because it is an ever-evolving course that is not designed to be completed. Check back often for new movies.