Guide to Forecating the Income tatement

Common approache to forecating all the major income tatement line item

 Thi article i part of a larger guide on 3-tatement modeling.

Forecating the income tatement i a ke part of uilding a 3-tatement model ecaue it drive much of the alance heet and cah ow tatement
forecat. In thi guide, we addre the common approache to forecating the major line item in the income tatement in the context of an
integrated 3-tatement modeling exercie.

Hitorical data
efore an forecating can egin, we tart  inputting hitorical reult. The proce involve either manual data entr from the 10K or pre releae,
or uing an xcel plugin through nancial data provider uch a Factet or Capital IQ to drop hitorical data directl into xcel.

Here i Apple’ 2016 income tatement:

Common iue when inputting hitorical income tatement data

When inputting hitorical income tatement data, everal iue are uuall encountered:

Deciding the level of revenue (ale) detail

ome companie report egment- or product-level revenue and operating detail in footnote (which roll up into the conolidated income tatement).
For example, while Apple provide a conolidated “net ale” gure in the income tatement, the footnote provide ale  product (iPhone, iPad,
Apple Watch, etc.).

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If it’ important that the nal model include a cenario anali — for example, what if iPhone unit ale are etter than expected, ut the iPhone
average elling price i wore than expected? — a detailed hitorical egment reakout i ueful to provide a foundation for forecat. Otherwie,
reling on the net ale line on the income tatement i u cient.

Line item clai cation

Not all companie claif their operating reult the ame wa. ome companie will aggregate all operating expene into one line, while other will
reak them into everal line item. If our model will e ued to compare performance acro other rm, the clai cation need to e apple-to-
apple and often require u to make judgment on how to claif line item and whether to hunt for more detailed reakdown in the nancial
footnote.

For example, notice that Apple’ 2016 income tatement aove contain a line called “Other income/(expene), net” of $1,348 million. Thi line
aggregate interet expene, interet income and other non-operating expene, a we can ee in Apple’ 10K footnote:

ince 3-tatement nancial model need to forecat future interet expene aed on det level and interet income aed on future cah level, we
needed to identif and ue the more detailed reakout provided in the footnote.

Data cruing

Companie prepare their hitorical income tatement data in line with U GAAP or IFR. That mean income tatement will not contain nancial
metric like ITDA and Non GAAP operating income, which ignore certain item like tock-aed compenation. A a reult, we often have to dig in
footnote and other nancial tatement to extract the data needed to preent income tatement data in a wa that’ ueful for anali.

Putting it all together

elow i an example of how to input Apple’ hitorical reult into a nancial model:

If ou compare it with Apple’ actual income tatement (hown previoul) ou’ll notice everal di erence. In the model:
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 Other income i roken out to explicitl how interet expene and interet income.

Depreciation and amortization a well a tock aed compenation i explicitl identi ed in order to arrive at ITDA.

Growth rate and margin are calculated.

Notice the adherence to everal nancial modeling et practice including:

Formula are colored lack and input are lue.

The model preent data from left to right (unfortunatel companie report reult from right to left).

Decimal place are conitent (two for per-hare data, none in Apple’ cae for operating reult).

Negative numer are in parenthee.

xpene are all negative (not all model follow thi convention — the ke here i conitenc).

Forecating
Once the hitorical data i inputted into the model, forecat can e made. efore diving in, let’ etalih a few realitie of forecating.

 ective forecating ha ver little to do with modeling

While our focu in thi article i to give ou guidance on the mechanic of e ective modeling, a much more important facet of forecating i omething
thi guide cannot provide: A deep undertanding of the uine and indutr in quetion. To forecat a compan’ revenue, an analt mut have an
undertanding of the compan’ uine model, ke cutomer, addreale market, competitive poition and ale trateg. Garage in = garage
out, a the old aing goe.

Your role will determine how much time ou pend on getting the aumption right

Mot invetment anking analt pend ver little time conducting the due diligence required to arrive at their own aumption. Intead, the rel on
equit reearch and management etimate to provide a “management cae” and “treet cae” for future performance. Then the analt ideall uild
other cae that hould how what would happen if the treet and management cae don’t materialize. That’ wh a lot of people knock invetment
anking model a all tle and no utance. On the other hand, a u ide or private equit analt will pend far more time undertanding the
uinee the are conidering a an invetment. If the get the aumption wrong, after all, their return will u er.

Me model are uele

Aumption are the mot important part of getting a model “right.” ut a model that i me, error-prone and i not integrated will never e a ueful
tool depite great underling aumption.

Revenue

The revenue (or ale) forecat i argual the ingle mot important forecat in mot 3-tatement model. Mechanicall, there are two common
approache for forecating revenue:

1. Grow revenue  inputting an aggregate growth rate.

2. egment level detail and a price x volume approach.

Approach 1. i traightforward. In our example, Apple’ revenue growth lat ear wa 9.2%. If, for example, the analt expected that growth rate to
perit throughout the forecat period, revenue would impl e grown at that rate.

egment level detail and a price x volume approach

Alternativel, if the analt ha a thei on change in price and volume  egment, a more comprehenive forecat approach i required. In thi cae,
the analt would make explicit aumption for volume and price  each egment. In thi cae, intead of explicitl forecating a conolidated growth
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rate, the conolidated growth rate i an output of the model aed on the price/volume egment uildup.

egment level detail and a price volume uildup for Apple

naphot from Wall treet Prep’ elf tud Program

Cot of good old

Make a percentage gro pro t margin (gro pro t/revenue) or percentage COG margin (COG/revenue) aumption and reference that ack into
the dollar amount of COG. Hitorical margin help to provide a enchmark which the analt can either traight-line into the forecat period or re ect
a thei that emerge from a particular viewpoint (which the analt develop on their own, or more likel from equit reearch).

Operating expene

Operating expene include elling cot, general and adminitrative expene and reearch and development expene. All of thee expene are
driven  revenue growth or  an explicit expectation for poile change in margin. For example, if lat ear’ G&A margin wa 21.4%, an “We don’t
have a thei on G&A”-forecat for next ear would impl e to triaght-line the prior ear’ 21.4% margin. Ovioul, if we do expect change, it
would uuall e re ected with an explicit change to the margin aumption.

Depreciation and amortization

Depreciation and amortization expene are uuall not clai ed explicitl on the income tatement. Rather, the are emedded within other
operating expene categorie. However, ou uuall need to forecat D&A in order to arrive at an ITDA forecat. ince D&A expene are a function
of hitorical and expected future capital expenditure and purchae of intangile aet, the are actuall forecat a part of the alance heet
uildup and referenced ack into the income tatement after the uildup i complete.

tock-aed compenation expene

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Like D&A, tock-aed compenation i emedded within other operating expene categorie, ut the hitorical amount can e explicitl found on the
cah ow tatement. tock-aed compenation i uuall forecat a a percentage of revenue.

Forecating interet expene

Like forecating depreciation and amortization, forecating interet expene i done a part of the alance heet uildup in a det chedule and i a
function of projected det alance and the projected interet rate.

Interet expene i determined aed on the compan’ det alance and interet income i determined aed on the compan’ cah alance.
Analt calculate interet in nancial model uing one of two approache:

1. Interet rate x average period det

For example, if our model i forecating a $100m det alance in the end of 2019 and $200m at the end of 2020, at an aumed interet rate of
5%, the interet expene would e calculated a $150m (average alance) x 5% = $7.5m.

2. Interet rate x eginning period det

Under thi approach, ou would calculate interet o the eginning of period alance (which i lat ear’ end of period alance) of $100m x 5% =
$5m.

Which approach i etter?

Conceptuall, forecating uing average det i conidered more logical ecaue det alance change over the period. However, det (and more
peci call revolver det) i often ued a plug in a model, and when uing average det, thi create a circularit in the model. Circularit i
prolematic in xcel, and that’ wh analt often ue eginning det alance intead. To learn more aout circularit, go to the “Circularit” ection
of thi article aout nancial modeling et practice.

Interet income

While revolver det i uuall the de cit plug, cah i the urplu plug uch that an exce cah ow forecat  the model naturall lead to higher
cah alance on the alance heet. Thi mean that we deal with the ame circularit iue here a we do when forecating interet income.
Interet income i a function of projected cah alance and the projected interet rate earned on idle cah. We can onl forecat it once we complete
oth the alance heet and the cah ow tatement. Like interet expene, analt can calculate interet  uing either the eginning- or average-
period approach. And like interet expene, if ou forecat interet income aed on average cah alance, ou’ll e creating a circularit.

Other non-operating item

In addition to interet income and interet expene, companie ma have other non-operating income and expene preented on the income
tatement, for which the nature i not explicitl dicloed. Thoe item are uuall et forecat on a traight-line ai (a oppoed to operating
expene, which are uuall tied to revenue growth).

Taxe

Uuall, impl traight-lining the lat hitorical ear’ tax rate i u cient. However, there are time where tax rate hitoricall are not indicative of
what a compan can reaonal expect to face in the future. Learn more aout thi in our article on modeling tax rate.

hare outtanding and earning per hare

The lat element of the income tatement forecat i forecating hare outtanding and P. We cover thi in our primer on forecating hare and
P.

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