Making projections from income statement requires:
- Spending a lot of time.
- Research and understand core of business model.
- Understand Revenue and Cost Structure.
- Future Performance.
A good model is functional, flexible and easy to adjust.
Revenue:
Revenue is very difficult to predict. It is very important to understand a company’s business model and gather as much information as possible to be able to make judgement of your own.
Revenue is usually driven by a product of pricing and volume. So for projecting revenue, you should understand company’s pricing and volume.
- What initiatives the company is taking to increase its volume?
- You should look into if the company is increasing its advertising?
- Is it acquiring other businesses or customers?
- What outside forces could affect the company’s pricing model?
- Is it increasing its prices?
- Is it facing tremendous market competition and must lower its prices?
Following sources can also provide important information:
Investor Presentations:
Try to look for recent investor presentations on investor relations section of the company’s website. These presentations can have high level projections.
Earning Calls:
At earning calls, you can listen to the management speaking about company’s most recent financial performances. Management also sometimes gives guidance on the company’s future performance.
Wall Street Research:
If a Wall Street analyst has a research report on a company, it will have estimated future performance.
Data Source:
Yahoo! Finance, Thompson, First Call and Bloomberg are few examples of data source.
Cost of Goods Sold:
For a best future estimate, it is very important to understand each cost.
First we need to consider if the costs are fixed or variable. A fixed cost is static and may grow a certain percentage.
Rent expense can be considered as a fixed cost. It may increase 5 – 10 percent each year and is independent of growth in revenue.
Variable costs on the other hand are directly proportional to growth of business. If revenue is expected to increase by 10%, variable cost will also increase by 10% and vice versa.
Cost of goods sold is usually considered a variable cost. If your revenue is decreasing, most likely you are selling less products, hence your costs should also be decreasing and vice versa.
If revenue increases due to increase in price, it means that costs are not increasing because there is no increase in volume.
If a supplier increases his prices, seller has to increase selling price also. In this case revenue and costs will increase proportionately.
This is why a company’s business model and cost structure are very important to understand.
Historical trends can help us determine how to make best projections. These are few of the methods:
1 – Take an average percentage of the last three years.
2 – Take a maximum percentage of the last three years. (Conservative approach)
3 – Take a minimum percentage of the last three years. (Aggressive approach)
4 – Take the last year’s percentage.
5 – Have the percentage steadily increase or decrease year over year.
Operating Expenses:
We can use same procedures for each cost on the income statement:
- Conduct adequate research.
- Analyze historical trends.
- Consideration of each cost to be fixed or variable.
Taxes:
We can take a look at the historical taxes as percentage of EBT (Earnings before taxes) to make our projections.
Disclaimer:
This information is for educational purposes only. It does not constitute any legal advice or opinion. Please do not use any of its contents without seeking a professional advice.
References:
Financial Modeling and Valuation by Paul Pignataro
Mansoor Suhail (Mani)
Accountant
MS TAX, BSBA – EA – ICIA – RA
Tax for Canada and U.S.A
Web: www.theaccountingandtax.com and www.taxservicesguru.com
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