Some balance sheet line items, such as retained earnings, flow directly from the income statement, whereas working capital accounts such as accounts receivable, accounts payable, and inventory are very closely linked to income statement projections.

Working capital accounts are forecasted using efficiency ratios. A common way to model working capital accounts is to hold efficiency ratios constant - working capital accounts will grow in line with the related income statement accounts. Analysts can look at historical efficiency ratios and recent project performance or a historical average to persist in the future.

To project long-term assets such as PP&E, analysts need to project capital expenditures and depreciation. They are less directly linked to the income statement.

• Net PP&E changes result from capital expenditures and depreciation, which are essential components of the cash flow statement.
• Depreciation forecasts are based on historical depreciation and disclosures about depreciation schedules.
• In contrast, capital expenditure forecasts depend on analysts' judgment and future need for new PP&E. An organization's capital expenditures are divided into maintenance capital expenditures, expenditures needed to sustain the current business, and growth capital expenditures, expenditures required to expand the business. Maintenance expenditures should be higher than depreciation because of inflation.

Analysts can determine return on invested capital (ROIC), which measures the profitability of the capital invested by the company's shareholders and debt holders. The numerator is after-tax earnings but before interest expense. The denominator is invested capital, which is equal to operating assets less operating liabilities. High and persistent levels of ROIC are often associated with having a competitive advantage.

A company's future debt and equity levels can be forecast using leverage ratios such as debt-to-capital, debt-to-equity, and debt-to-EBITDA.

After projecting the balance sheets and income statements, the future cash flow statement can be projected. The analyst will make assumptions about how a company will use its future cash flows, share repurchases, dividends, additional capital expenditures, and acquisitions.

Practice Question 1

Which balance sheet line item is closely related to income statement projections?

A. accounts receivable.
B. retained earnings.
C. invested capital.

Correct Answer: A

Retained earnings flow directly from the income statement.

Practice Question 2

For most companies, projections for ______ are least likely to be tied to the income statement.

A. retained earnings.
B. accounts receivable.
C. long-term assets.

Correct Answer: C

Practice Question 3

To project future inventory, an analyst can assume an inventory turnover rate and combine it with projected:

A. sales.
B. COGS.
C. operating income.

Correct Answer: B

Inventory = COGS / inventory turnover rate.

Practice Question 4

According to the textbook, which ratio is the best measure of profitability?

A. Return on invested capital.
B. Return on equity.
C. Return on assets.

Correct Answer: A

The numerator of ROIC is pre-interest earnings. It is not affected by a company's degree of financial leverage.

Practice Question 5

Which of the following is least likely a ratio used to forecast working capital accounts such as accounts receivables and inventory?

A. Days sales outstanding
B. Inventory turnover ratio
C. Sensitivity analysis

Correct Answer: C

Sensitivity analysis is a tool that involves changing only one assumption at a time to determine its effect on the estimate of the intrinsic value.

Days sales outstanding is an efficiency ratio used to measure the average number of days a firm takes to collect revenue from its customers. It is used to forecast accounts receivable. The inventory turnover ratio is an efficiency ratio used to forecast inventory. It measures how much inventory a company keeps on hand.

Practice Question 6

For most companies, projections for ______ are directly tied to the income statement.

A. retained earnings
B. accounts receivable
C. long-term assets

Correct Answer: A

Retained earnings are directly from income statement.

Practice Question 7

To project future accounts receivable, an analyst can assume a number of days sales outstanding and combine it with projected:

A. credit sales
B. COGS
C. credit purchase

Correct Answer: A

Accounts receivable = credit sales x days sales outstanding/365.