In school, we are taught to use excel and increase sales by a certain %, then every item in income statement and balance sheet as a % of sales. We will base the cash flow calculation on the income statement and balance sheet.
In real life, how do analysts do it? Is it the same?
That’s the quick and dirty way to do it, but not everything is really a function of sales. For example, depreciation expense is a function of fixed assets which might need to be put in place long before sales are realized. As a result, depreciation expense could decrease significantly as a percentage of sales going forward. Interest expense generally has very little connection to sales as well, unless the company’s debt is all short-term to fund working capital. Even salaries can be only loosely a function of sales depending on the type of company.
Any book to recommend? Strange that all these were not recorded down explicitly as an example in books or site. I went to a lot of site but cannot find any which teaches me how to do it. Am I right to say I should pro forma the income statement? With the income statement I can get a lot of things from balance sheet such as ar and ap. Then I should use both to get my cash flow statement
I’m not aware of any specific books. The IS is a good place to start.
Hey Maisatomai,
The logic which you put down was ok. Start with the Income Statement, move on to the Cash Flow Statement and finish with the Balance Sheet.
As Higgmond pointed out, the Income Statement projection is actually a pretty difficult task and requires good knowledge of the extent to which the company relies on fixed versus variable costs in its cost structure (operating leverage).
Additional assumptions are required when you move on to the cash flow statement and actually, by the time you get to the balance sheet, most of the assumptions will already have been made, making the balance sheet a pretty easy thing to get done.
In terms of books, I distinctly remember reading a chapter about the entire process with a fully worked 1-year projection and accompanying discussion of the assumptions made in the following book:
Financial Statement Analysis: A Practitioner’s Guide from Wiley Finance by Fridson and Alvarez. Not sure if it goes into enough detail for your needs though