Learn the stock market in 7 easy steps. Get spreadsheets & eBook with your free subscription!

Income Statement Forecasting: The First Step of a 3-Part Financial Model

Forecasting the income statement is the first step of a 3-statement financial model and it is the most critical part of any forward-looking financial analysis. The projections made in the income statement will drive various items on the balance sheet and cash flow statements. Forecasting the income statement is key to creating forward looking P/E estimates and valuations.

Using Historical Data to form Relationships

Projections need a solid base in reality and this is done by using historical financial data to form relationships which can then be carried forward into future years. If any metric has been steadily changing in a certain direction, it would be most wise to take the latest level. As always, using more years of historical data can help form a more accurate average. A good model will tell users the average level but will also allow users to override and adjust the historical figure if the analyst has good reason to believe the metric will change in the future from its historic average. Always keep in mind how realistic projections are and be able to support them with a strong thesis.

Side Note: A strong thesis is important, and it is good practice to write down your thesis in detail and different versions, so that you can refer back to the thought process and how it evolved.

The Major Income Statement Items

While every income statement looks similar, there will be certain naming conventions and groupings that are different between companies. As will be discussed, some income statement items, such as depreciation and interest expense, will be influenced by the amount of fixed assets and debt, respectively, on the balance sheet in an iterative process that requires separate schedules.

Revenue and Sales – Top-line revenue and sales figures are the first step to forecasting the incomes statement as most of the line items which follow are in some way “driven” by revenue. Estimating revenue has the most room for error and over confidence. It is good practice for all projections to be backed up by a strong thesis that is written down to refer back to later. A number of methods can be used to estimate revenue growth as can be seen below:

Standard:

  • Adding a growth rate to the previous year’s revenue. Short-term rates are more opinionated and should be backed up by a strong thesis. Medium and long-term growth should be based on the company’s sustainable growth rate (SGR).

Advanced:

  • A top-down, macroeconomic approach is incorporated that adds a growth rate premium on top of the consensus GDP growth estimate.
  • A bottom-up, micro economic approach estimating the revenue growth of each product line or operating segment of the business based on demand factors.

Cost of Goods Sold – As we move down the balance sheet, cost of goods sold (COGS) is subtracted from revenues to calculate gross profits. COGS represent direct costs associated with producing a product or service. As is the case with revenue, COGS can be estimated with general simplicity or a bottom-up meticulousness approach that could involve a combination of breaking out operating segments, product lines, and/or input costs separately.

Standard:

  • Cost of Goods Sold = Historical COGS (%) x Revenues

Advanced:

  • Separating COGS by product line or operating segment of the business.
  • Breaking out COGS by input costs (ex. price of oil and its proportion of COGS for airlines).

To estimate COGS with a bottom-up approach will require a thorough understanding of the input costs associated with the company’s product or service. The company’s internal finance department should properly use such a bottom-up approach in the company’s budget but any attempt by investors to do so should be back-checked against the historic COGS as a percent of revenue to ensure they are maintaining a realistic approach to the forecast.

Selling, General, and Administrative Expenses – As we move down the income statement, operating expenses, which are not directly associate with production, will be subtracted out before operating income is calculated. Such operating expenses are commonly grouped as selling, general and administrative (SG&A) expenses. SG&A can include various expenses such as advertising, selling and distribution, office rent, and head office salaries to name a few. Depreciation and amortization can also sometimes fall under the SG&A category but this type of expense will be touched on in more detail in the next section.

While SG&A expenses are generally considered more fixed in nature than COGS, they should still be forecast as a percentage of sales. It is common to forecast SG&A as a single line item but analysts and investors could also go a level deeper and forecast by individual items which could be correlated to revenue to varying degrees. Items such as advertising, sales salaries, and stock-based compensation will be highly correlated to revenues while other items such as office rent and administrative salaries will have a lower correlation to revenues.

Standard:

  • SG&A Expenses = Historic SG&A (%) x Sales

Advanced:

  • Break out SG&A by variable, step-fixed, and fixed expenses.  
  • Base SG&A on correlation approach taking into account sales but also other factors such as general inflation and wages.

Depreciation and Amortization – Fixed assets on the balance sheet are depreciated (for physical assets) or amortized (for intangible assets) through the income statement over the span of their useful life. Depending on industry norms, depreciation and amortization (D&A) might be expensed on the income statement in either operating expenses and/or within COGS as is the case with manufactures. D&A can be forecasted most simply by taking the historic average percentage based on dividing depreciation expense into the opening balance for fixed assets plus half the capital expenditures (CapEx) made in the year. Adding half the CapEx into the equation is in line with the half-year rule normal for tax purposes which assumes assets were purchased in the middle of the year.

To keep track of D&A, it is good practice to have a separate schedule. Once again, if analysts want to get meticulous, they can break down the value of assets on the balance sheet into the different categories they represent (land, building, machinery, etc) each with their own useful lifespan. Internally, the company’s finance department will be maintaining such a schedule and using it to make their financial statements. There will also be a choice of accounting policy for depreciation such as straight-line, declining-balance/accelerated, sums of years’ digits, and units of production which analysts could incorporate into their estimations.

Standard:

  • Depreciation & Amortization Expense = Historic D&A (%) x Sales

where, Historic D&A = D&A Expense / (Opening Fixed Assets + 0.5 x CapEx)

Advanced:

  • Schedule by individual asset class and usefull life lifespan.

Side Note: If goodwill impairment is expected (or has happened), the amount can be factored into the model (or excluded from the model) to see how it might affect earnings in the given year. Always keep in mind with a DCF that impairment is not cash flow.

Interest Expense – Even under the most simple approach, it is good practice to calculate interest expense with a separate schedule that bases the current year’s amount of interest on the historic average percentage which interest expense was of the total outstanding debt.

Taking the forecast up a notch, investors could incorporate the portion of bonds which carry fixed versus variable interest rates to help give a more accurate estimate which takes into account changes in interest rates. The most meticulous estimate for interest expenses will be to maintain a detailed schedule of each of the outstanding bonds for a company and the interest rate applicable to each.

Standard:

  • Interest Expense = Historic Interest (%) x (Beginning Year Debt + Net Debt Issuance)

where, Historic Interest (%) = Interest Expense / (Beginning Year Debt + Net Debt Issuance)

Advanced:

  • A schedule which calculates each outstanding bonds interest expense based on the amount and interest rate taking into account whether it is fixed or variable. Maturing bonds and newly issued bonds can be factored into the model at the maturity term and fixed or variable rate that would keep the average maturity rate of the debt payable the same with the interest rate based on the forward looking curve and risk premium spread given the debt characteristics of the company.

Taxes – If a business earns money, it pays taxes. Depending on the country, taxes can quickly add up to +20% of income before taxes and as such taxes represent a significant forecasting item. On the flip side, if a business is estimated to be making net losses for a period, the business is also building up deferred tax assets which can be used to offset taxes on future net income. In such a case, it could become necessary to give taxes their own separate schedule as well.

Tax expense could by approximated by historic average tax rates paid if no future tax code changes are expected. If future income tax changes are expected, it is critical that they are accounted for in the model. The most meticulous approach to forecasting taxes would be to break income down within the company’s geographic foot print and apply the appropriate tax rate to each country. That being said, with the convoluted tax schemes global companies use, such a schedule could only be produced with the help of a tax expert with knowledge of the company’s legal corporate structure. Using past tax rate averages are all the more appropriate because of this.

Standard:

  • Income Tax = Operating Income x Historic Average Tax Rate (%)

Advanced:

  • Taking into account historical losses which can be used to offset future income.
  • Breaking down income between global operating segments and corporate structure in order to apply country specific tax rates.

Side Note: Potential changes in tax rates open up big repricing opportunities in the market. Taxes are a major part of expenses and can easily change by a significant +/- 5% when new political parties step into the office.

Net Income – The sum of all revenue and expense of course brings us to the bottom line net income. Final net income figures should always be checked for reasonability. If forecasted net income margins are far different than historic averages, the variance should be investigated to see if the line item causing the discrepancy is correct and the estimated forecast is realistic.

Valuation is not all about net income and much weight should be given to cash flows and how they can be discounted to calculate a company’s intrinsic value. After the income statement has been forecasted, investors can move on to forecasting the balance sheet and cash flow statements in order to carry out a discounted cash flow intrinsic value calculation.