You can make assumptions in a number of ways.
- You can use historical data i.e. look at previous years’ averages and hope that the company maintains these and uses them.
- Or you can use the historical data as a base, adjusting the averages for expected changes in the operating cycle by stressing the parts that you want emphasized.
Financial statements are projected in two stages. First, you state what you know about the direction the company’s management is planning on taking and the impact that these strategic decisions will have on the company’s financial performance. Remember these are supposed to be solid assumptions about the company and not just wild guesses.
The second step it that you translate these assumptions into numerical percentages that can be used to make financial statement projections.
Here are some assumptions about what AMD’s management is planning to do in the future.
- An increase in spending on Marketing and Sales as a result of continued competition with Intel.
- The core business of making processors will continue to grow due to constant demand of consumers for faster chips.
- Concentrating on its line of processors and Flash memory, the firm will continuously improve its existing product lines.
- Research and development activities will be maintained until and unless Intel raises the bar.
- The Cost of Goods is likely to decrease as technological advances make it cheaper to produce processors.
You may be wondering about how these assumptions can be translated into numerical assumptions.
Assumptions are set only for line items. So we can set a figure for cash, securities, net receivables, inventory, etc but not for grand totals (like Total Assets) and sub totals (like Total current assets). The grand totals and sub-totals would, therefore, be sums of the projected numbers. For example, current assets would be the sum of Cash, Securities, Net Receivables, Inventory & Other Current Assets.
As we are making projections for the future and the business is growing, we need to make a decision on the financing strategy. Any kind of growth comes at a cost. Increasing levels of sales require a higher level of resources, like cash, receivables, inventory and fixed assets. For example, if you take out loans or buy things on credit to fund your growth, your liabilities will increase. If you take on more debt, you are going to have to pay for it sooner or later. So, there are two alternatives that are available to a business to finance its growth:
- The business can issue debt that can be used to finance growth. In this situation, any difference between assets and existing total liabilities and equity will go into long-term debt.
- The second option is that the business will go out and issue equity. The differences between assets and total existing liabilities and equity will flow into shareholder equity.
Let’s work with an example that explains both, Option (A) and Option (B)
Here is the balance sheet for two years (1998 and 1999). The figures for the two years quote historical results. (All figures are in 000’s)
|Deferred income tax|
|Prepaid Expenses andOther current assets|
Have you noticed that the total current assets between 1999 and 1998 have decreased by $152,149?
|Property and Equipment,|
|Investment in joint venture|
Now take a look at the total assets. Over the same period, the figure shows an increase of $124,730. How did this occur even though the current assets decreased?
The asset section of the balance sheet has created some interesting questions. A good place to try and find the answers is the liability section of the balance sheet. So let’s look at it now.
|Long term Liabilities|
|Total Liabilities and|
AMD borrowed $150,506. However, they also bought back $25,776 worth of stock, probably to boost sagging stock prices. These two actions equated to $124,730 that AMD was free to invest and which it did – in assets. You might still be wondering why current assets went down but total assets went up.
If you look really closely, you will see that the item with the largest change was Property and Equipment. Notice that huge leap? That’s probably where most of the borrowed money and current assets went. AMD is funneling more of its assets into Property and Equipment than any other line item. Now let’s make some quantitative assumptions about AMD for the coming years.
These are the assumptions that we will be using to project the financial statements, including the income statement and the balance sheet. All of these assumptions are represented in the form of a percentage of sales.
AMD’s cash balance is expected to fluctuate between 10% and 9% of sales from 2000 onwards to ensure that sales are achieved in line with the objectives set. Securities will also remain constant at 12%. Cash and securities will remain relatively constant due to the fact that AMD is spending most of its revenue into Marketing & Sales and Plant & Property.
Instead of projecting for allowances and receivables separately, we will be projecting both under the head of Net Receivables. The combined value will be around 17% and will spiral downward, finally bottoming out at 14%. Inventory will remain at 7%.
|Balance Sheet Assumptions|
Property and Equipment will increase as AMD opens more manufacturing plants and buys newer equipment to produce its chips. It will steadily rise but will eventually stop at 178%
Depreciation should be calculated as a percentage of Fixed Assets and not as a percentage of sales. Due to the increase in the level of Property and Equipment, depreciation will also rise in the coming years.
Current liabilities will fall until they become stable at 30% of sales. Long-term liabilities will steadily rise to 60%. This is will occur because borrowing on long term notes is the usual fashion in which AMD generates needed funds. We will use equity as a plug and set it at zero.
|Balance Sheet Assumptions|
|Property and Equipment, Gross|
|Long Term Liabilities|