Income Statement Projection Guide

Forecasting

Once the historical data is inputted into the model, forecasts can be made. Before diving in, let’s establish a few realities of forecasting.

Effective forecasting has very little to do with modeling

While our focus in this article is to give you guidance on the mechanics of effective modeling, a much more important facet of forecasting is something this guide cannot provide: A deep understanding of the business and industry in question. To forecast a company’s revenue, an analyst must have an understanding of the company’s business model, key customers, addressable market, competitive position and sales strategy. Garbage in = garbage out, as the old saying goes.

Your role will determine how much time you spend on getting the assumptions right

Most investment banking analysts spend very little time conducting the due diligence required to arrive at their own assumptions. Instead, they rely on equity research and management estimates to provide a “management case” and “street case” for future performance. Then the analyst ideally builds other cases that should show what would happen if the street and management cases don’t materialize. That’s why a lot of people knock investment banking models as all style and no substance. On the other hand, a buy side or private equity analyst will spend far more time understanding the businesses they are considering as an investment. If they get the assumptions wrong, after all, their returns will suffer.

Messy models are useless

Assumptions are the most important part of getting a model “right.” But a model that is messy, error-prone and is not integrated will never be a useful tool despite great underlying assumptions.

Revenue

The revenue (or sales) forecast is arguably the single most important forecast in most 3-statement models. Mechanically, there are two common approaches for forecasting revenue:

1. Grow revenues by inputting an aggregate growth rate.
2. Segment level detail and a price x volume approach.

Approach 1. is straightforward. In our example, Apple’s revenue growth last year was 9.2%. If, for example, the analyst expected that growth rate to persist throughout the forecast period, revenue would simply be grown at that rate.

Segment level detail and a price x volume approach

Alternatively, if the analyst has a thesis on changes in price and volume by segment, a more comprehensive forecast approach is required. In this case, the analyst would make explicit assumptions for volume and price by each segment. In this case, instead of explicitly forecasting a consolidated growth rate, the consolidated growth rate is an output of the model based on the price/volume segment buildup.

Segment level detail and a price volume buildup for Apple

Snapshot from Wall Street Prep’s Self Study Program

Cost of goods sold

Make a percentage gross profit margin (gross profit/revenue) or percentage COGS margin (COGS/revenue) assumption and reference that back into the dollar amount of COGS. Historical margins help to provide a benchmark which the analyst can either straight-line into the forecast period or reflect a thesis that emerges from a particular viewpoint (which the analyst develops on their own, or more likely from equity research).

Operating expenses

Operating expenses include selling costs, general and administrative expenses and research and development expenses. All of these expenses are driven by revenue growth or by an explicit expectation for possible changes in margin. For example, if last year’s SG&A margin was 21.4%, an “We don’t have a thesis on SG&A”-forecast for next year would simply be to striaght-line the prior year’s 21.4% margin. Obviously, if we do expect changes, it would usually be reflected with an explicit change to the margin assumptions.

Depreciation and amortization

Depreciation and amortization expenses are usually not classified explicitly on the income statement. Rather, they are embedded within other operating expense categories. However, you usually need to forecast D&A in order to arrive at an EBITDA forecast. Since D&A expenses are a function of historical and expected future capital expenditures and purchases of intangible assets, they are actually forecast as part of the balance sheet buildup and referenced back into the income statement after the buildup is complete.

Stock-based compensation expense

Like D&A, stock-based compensation is embedded within other operating expense categories, but the historical amounts can be explicitly found on the cash flow statement. Stock-based compensation is usually forecast as a percentage of revenue.

Forecasting interest expense

Like forecasting depreciation and amortization, forecasting interest expense is done as part of the balance sheet buildup in a debt schedule and is a function of projected debt balances and the projected interest rate.

Interest expense is determined based on the company’s debt balances and interest income is determined based on the company’s cash balances. Analysts calculate interest in financial models using one of two approaches:

1. Interest rate x average period debt
   For example,  if your model is forecasting a $100m debt balance in the end of 2019 and $200m at the end of 2020, at an assumed interest rate of 5%, the interest expense would be calculated as $150m (average balance) x 5% = $7.5m.
2. Interest rate x beginning period debt
   Under this approach, you would calculate interest off the beginning of period balance (which is last year’s end of period balance) of $100m x 5% = $5m.

Which approach is better?

Conceptually, forecasting using average debt is considered more logical because debt balances change over the period. However, debt (and more specifically revolver debt) is often used as plug in a model, and when using average debt, this creates a circularity in the model. Circularity is problematic in Excel, and that’s why analysts often use beginning debt balances instead. To learn more about circularity, go to the “Circularity” section of this article about financial modeling best practices.

Interest income

While revolver debt is usually the deficit plug, cash is the surplus plug such that any excess cash flows forecast by the model naturally lead to higher cash balances on the balance sheet. This means that we deal with the same circularity issues here as we do when forecasting interest income. Interest income is a function of projected cash balances and the projected interest rate earned on idle cash. We can only forecast it once we complete both the balance sheet and the cash flow statement. Like interest expense, analysts can calculate interest by using either the beginning- or average-period approach. And like interest expense, if you forecast interest income based on average cash balances, you’ll be creating a circularity.

Other non-operating items

In addition to interest income and interest expense, companies may have other non-operating income and expenses presented on the income statement, for which the nature is not explicitly disclosed. Those items are usually best forecast on a straight-line basis (as opposed to operating expenses, which are usually tied to revenue growth).

Taxes

Usually, simply straight-lining the last historical year’s tax rate is sufficient. However, there are times where tax rates historically are not indicative of what a company can reasonably expect to face in the future. Learn more about this in our article on modeling tax rates.

Shares outstanding and earnings per share

The last element of the income statement forecast is forecasting shares outstanding and EPS. We cover this in our primer on forecasting shares and EPS.