BIBLIOGRAPHY AND REFERENCES
5. To model interest expense
3.4 MODELLING THE INCOME STATEMENT
The FP&A is now ready to create the proforma financial statements for the years 2014 to 2017.
line of the income statement, the total turnover, which is a simple multiplication of volume in Metric Tons (MT) x unit prices in € as shown in Exhibit 3.11.
Note that since the unit prices are constant over the forecasting period, the rate of change of turnover is the same as that of the total volume.
The next income statement account is the gross margin excluding depreciation. We talked about depreciation in Chapter 2. Remember that depreciation is an accounting method of spreading out the cost of fixed assets over the period in which these assets are used. The part of depreciation that represents use of machinery for the purposes of production goes into cost of goods sold and it is frequently included in gross margin. For practical reasons it is a good idea to keep all the depreciation expenses in a single account and present them after EBITDA (Earnings Before Interest Tax Depreciation and Amortization). The 9.5% gross margin chosen for the forecasting period 2014 to 2017, if applied to the total turnover, gives the gross margin of the proforma income statements as shown in Exhibit 3.12:
EXHIBIT 3.11 Building the first line of the proforma income statement of SteelCo
EXHIBIT 3.12 Forecasting the gross margin account
Result Driver
EXHIBIT 3.13 Forecasting the income statement accounts up to EBITDA
Following are the accounts Other Operating Income, Operating Expenses, and Other Operating Expenses respectively. OPEX has already been calculated in the previous para-graph and it is €8,020k, €7,904k, €7,831k, and €7,801k for the years 2014 to 2017 respec-tively. Moreover, other operating income and other operating expenses as a percentage of sales have been chosen to keep constant during the forecasting period at 1.9% and 0.5%
respectively. So far the FP&A has forecast all the income statement accounts up to EBITDA and can derive EBITDA and EBITDA margin (EBITDA as a percentage of sales) as shown in Exhibit 3.13.
Next is the net interest expense account, that is, the interest expense minus the interest income gained from the cash deposits of the company. The interest expense is comprised of the interest that the company pays for its short-term debt plus the interest that it pays for its long-term debt. Usually the cost of these 2 kinds of debt differs. In the preliminary analysis of the historical financial statements the FP&A found out that these costs are 5.7% and 6.7%
respectively. Moreover the average income from the cash deposits of the firm is 1%. Then the net interest expense will be derived from the following equation:
Net Interest Expense = 5.7% × Long-term Debt + 6.7% × Short-term Debt − 1% × Cash Deposits
The balance of the long-term debt until its refinancing is known and thus the interest expense can be calculated explicitly. Moreover, the minimum amount of cash required by the company to operate smoothly can also be found from SteelCo’s treasury department. What is
not known is the amount of funds required in the form of short-term debt during the forecast period. So the FP&A leaves the calculation of this account for the time being and will come back to it later on.
Finally he needs to forecast depreciation expense. To do so he needs to forecast, in turn, the gross fixed assets which is a balance sheet account.
The relationship between 2 consecutive years’ fixed assets is as follows:
Fixed Assets 20XX = Fixed Assets 20XX−1 + Investments in Fixed Assets 20XX The investments in fixed assets or CAPital EXpenditure (CAPEX) made by the company in years 2011 to 2013 have been recorded in the assumption sheet during the collection phase of raw data (see Exhibit 3.2). For example, in 2013 the company’s CAPEX was €400k and thus the gross fixed assets for 2013 are €61,440k (gross fixed assets of 2012) plus €400k or
€61,840k in total. Dividing the gross fixed assets for 2013 by the depreciation expense for 2013, which is €2,235k, the FP&A gets:
3.6% = Depreciation 2013 / Gross Fixed Assets 2013 = €2,235 / €61,840k
He decides to keep this rate constant during the forecast period. What he now needs to do is to forecast the gross fixed assets for this period and then apply to them the depreci-ation rate derived earlier. As a rule of thumb, future CAPEX should be more or less equal to annual depreciation. This is almost true of the CAPEX for fiscal years 2011 and 2012 with minor deviations. But during 2013 the company invested in fixed assets well below that level.
Since sales volume is declining, only the CAPEX which is strictly necessary for the smooth operation of the company has been implemented. The FP&A decides to consult the Technical Director regarding any planned investments in the following years. The Technical Director, in turn, requests the forecast sales plan and the FP&A gives him or her the volumes presented in Exhibit 3.7. The Technical Director notices that sales volumes will continue to decline and thus informs the FP&A that the CAPEX will be kept to a minimal €300k in each of the years 2014 to 2017. This is the information the FP&A needed in order to model the gross fixed assets and thus the depreciation. The following are thus obtained:
Gross Fixed Assets 2014 = Gross Fixed Assets 2013 + CAPEX 2013, or Gross Fixed Assets 2014 = €61,840k + €300k = €62,140k.
In the same way, gross fixed assets for 2015 = €62,440k, gross fixed assets for 2016 =
€62,740k and, and gross fixed assets for 2017 = €63,040k. Depreciation is now easy to derive:
Depreciation 2014 = Gross Fixed Assets 2014 × Depreciation Rate, or Depreciation 2014 = €62,140k × 3.6% = €2,237k.
In the same way, depreciation for 2015 = €2,248k, depreciation for 2016 = €2,259k, and depreciation for 2017 = €2,269k. The proforma income statement now looks like the one in Exhibit 3.14:
Note that the FP&A could have forecast depreciation simply by selecting the actual depreciation for years 2011 to 2013 and then using the linear trend function of Excel to drag these cells to the left as shown in Exhibits 3.6 and 3.7. Had he done so, the depreciation fore-cast would have been €2,206k, €2,226k, €2,246k, and €2,266k for the years 2014, 2015, 2016, and 2017 respectively. You can see that the results would be quite similar.
Only the net interest expense is missing from the income statement and the tax expense if there are going to be profits. The FP&A will come back to these figures later on. He is now ready to model the balance sheet.