838 APPENDIX H

capitalized. Given this circumstance, we add the capitalized value of leases to

invested capital and the reconciliation of total funds invested. Going forward,
this step will no longer be necessary. Chapter 22 explains how to adjust for
operating leases under the new standards. Exhibit 22.10 demonstrates how to
value operating leases for 2019, the last year of our Costco historical data, by
using the present value of rental commitments.
Exhibit H.9: Reconciliation of Total Funds Invested. To better understand how
the business is financed and to assure accuracy through a second set of calcu-
lations, recalculate total funds invested, but this time using sources of capital.
Exhibit H.9 calculates debt and debt equivalents, which include capitalized
operating leases. Equity includes common stock and retained earnings. Equity
equivalents include deferred-tax accounts, except for tax loss carryforwards. For
Costco, the deferred-tax accounts are negative in some years and act as an offset
to equity because deferred-tax assets are larger than the corresponding liabilities.
Costco’s total funds invested are financed mostly by equity. For more on
how to evaluate and create an appropriate capital structure to support the
operations of a business, see Chapter 33.

FORECASTING THE FINANCIALS

For each financial statement, we present a ten-year forecast. Chapter 13 dem-

onstrates how to create a set of forecasts, link your forecasts to the financial
statements, and avoid common pitfalls.
Exhibit H.10: Income Statement Forecast Ratios. To estimate revenue growth
and cost of sales for Costco, we rely on analyst reports from September 2019.
One such report is detailed in Exhibit 13.3. We forecast the remaining accounts
using financial ratios from either the last fiscal year or an average of the last
five fiscal years, depending on the account’s stability.
To forecast the interest expense on debt, we estimate interest expense as a
percentage of prior-year debt. Since we value operations using free cash flow,
our forecast of interest expense will not affect the value of operations. We
create a forecast solely for the purpose of cash flow planning and to create an
integrated set of financial statements. Integrated financials reduce the likeli-
hood of modeling errors.
Exhibit H.11: Balance Sheet Forecast Ratios. For the balance sheet, we orga-
nize the forecast ratios into working capital, long-term assets, debt, and equity.
Most working-capital items are forecast using days in revenues. The excep-
tions are merchandise inventories and accounts payable, which are linked to
merchandise cost. Long-term assets and liabilities are estimated at a constant
percent of revenues.
To estimate leverage, we assume Costco will maintain its current debt-
to-value ratio. We then split total leverage across short-term debt, long-term