Projecting Income Statement Line Items

What does projecting income statement line items mean?

Projecting Income Statement Line Items refers to predicting the value of each income statement item for a future period.

The income statement, also known as the statement of profit and loss (P&L), summarizes a company’s financial performance, showing its revenues, expenses, and net income over a specific time frame, usually a month, quarter, or year.

Forecasts will differ in length depending on how the projections will be used. Creating a forecast for the line items in an Income Statement is like creating a roadmap for the business’s future. Stakeholders can use it to get important information about the company's financial future.

Different stakeholders will have differing interests. However, they will all be interested in the future ability of the company to make money and what it plans to use it on.

You make predictions about the appearance of the income statement when you project line items in the income statement.

This process involves making educated assumptions and using different forecasting techniques to create a financial model to inform decision-making, budgeting, and planning.

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Projecting income statement line items is crucial for predicting the performance and financial strength of a company over the coming months and years.
You should go through the income statement line-by-line to make your projections.
It is crucial to understand and clearly state assumptions that you are making as you go through each line item.
Your predictions for the future will be limited by the quality of your data, so it is important to obtain high-quality past performance information before beginning.

Understanding The Income Statement

An income statement gives a snapshot view of a company’s financial health. It is a crucial measurement of how effectively a company is able to make money and how much profit it can generate from that money.

Structure: Income statements have three main sections: revenue, expenses, and income. Revenue shows how much money the company was able to generate. Expenses cover the costs the company incurred to generate that revenue. Income measures the profit after accounting for expenses.
Importance of history: To project future income, you must look back. Historical data helps you spot trends and patterns.
Reasonable assumptions: Forecasts typically require educated guesses. For example, you may have to make assumptions about the sales growth rate. These assumptions often form the foundations for the forecast.

Below is an example of an income statement. It follows the 3-section structure of revenues, costs, and then income at the bottom.

While other income statements may look different (e.g., they may not have ‘membership and other income’ disclosed on the face of the income statement), they will follow the same structure.

Historical Data in the Income Statement

Historical data is crucial to understand. Past performance is a useful tool for making predictions about the future. Below are a few pointers on how to find and use historical data for income statement projections:

How to find historical data: Annual reports and accounting records are often the most reliable sources. Publicly traded companies must provide this information. However, private companies do not face the same requirements. Contacting the management team or searching online are the most effective ways to get data for private companies.
How to use historical data: This depends on the source of the information. If it comes directly from an annual report, you must manually put it into Excel. If you are getting it from a financial data provider, you can often export it straight into Excel. Likewise, if you get the data from the company’s management, it may already be in Excel format.
Looking for patterns: Look through the data for trends. You may need to use visual aids such as line graphs to help. Did the company’s revenue grow consistently over recent years? Were there significant expense fluctuations? These patterns help you make informed assumptions about what might happen in the future.
Why it matters: Historical data gives you a reality check. It helps you make realistic projections and avoid unfounded guesses.

Issues when inputting historical data

Data inaccuracy can cause problems. Data is only as good as its accuracy and integrity, so if these are compromised, your forecasts will suffer. Some reasons for this include:

Reporting errors: Companies make mistakes when reporting financial data. This is more likely if the data comes from a private company, as their financial results do not require as much regulation as public companies.
Accounting changes: Companies sometimes change their accounting processes, which can create inconsistencies in historical data. For example, switching from the FIFO (first-in-first-out) to the LIFO (last-in-first-out) inventory valuation method would have a significant impact on COGS in the period where the change is made.

Missing data can also pose a challenge. Some financial reports may not include data for certain periods, making it hard to conduct a comprehensive analysis.

If a company has undergone mergers, acquisitions, or divestitures in recent history, then coherent financial data may be difficult to reconcile.

Methods for projecting income statement line items

First, assumptions must be set out. Our assumptions are educated guesses about various factors that will impact the income statement, such as future sales growth, changes in expenditures, and more.

These assumptions should be grounded in logic and data. If they are not, the resulting projections will be unreliable.

Next, the forecast needs to be made. The methods are the tools you have available in your financial toolbox. They are techniques and approaches you use to turn assumptions into numbers. These vary depending on what you are projecting and the available data.

There are different approaches that can be taken when projecting line items, and your choice will depend on how much time you have, your resource access, and how detailed the projection needs to be. The common methods are as follows:

Trend Analysis: Looking at past data to predict future performance. Consider it like using a ruler to continue a line of best fit beyond the existing data points.
Industry benchmarks: Compare your business to others in the same industry to make predictions.
Expert opinions: Consulting with experts or industry specialists who can provide insights and educated guesses.

Once projections have been made, it is important to remember they are not set in stone. They need to be tested and adjusted as conditions change. Think of them as maps and tools to use on a financial journey. If you encounter unexpected obstacles, you may need to adjust your route.

Sales Revenue

Revenue is crucial to a business. Accurate revenue projections help you plan for growth, set sales targets, and make critical financial decisions.

Revenue is (hopefully) the largest item on the income statement, so it is prudent to ensure your estimates and predictions are as accurate as possible.

You should consider all initiatives the company is planning to implement over the forecast period, and how these might impact revenue.

Factors to consider when forecasting revenue

Revenue is (hopefully) the largest item on an income statement, so inherently, it is the most important to accurately forecast. Factors that should be considered in the projection are:

Historical performance: How has the revenue behaved in the past? If it has grown consistently, then it is safe to assume it will continue to do so.
Market conditions: The state of the market and your industry plays a big role. You could combine internal predictions for the market along with expert opinions to increase the reliability of forecasts.
Sales strategies: Consider the impact of planned and potential new sales strategies (e.g., a new pricing policy) on revenue. You may need to build different scenarios based on different sales strategies being pursued.
Economic factors: Economic conditions, such as inflation, consumer spending habits, and changing consumer confidence, can affect how much consumers are willing to spend.

Revenue projection methods

When creating the forecast numbers, you can utilize one or more of the following:

Sales forecasting: This is where you estimate future sales based on past data, market trends, and other factors.
Customer segmentation: By categorizing customers and analyzing their behavior, you can predict how different groups will contribute to revenue.
Scenario analysis: This involves considering various scenarios, like best and worst case, to prepare for different outcomes. This is also known as stress testing.

Cost of Goods Sold (or Gross Profit)

COGS is all about revealing how much it costs a business to produce its output. COGS directly impacts the profitability of a company.

COGS is made up of direct costs. These are costs associated directly with producing or purchasing goods. It includes expenses like raw materials, labor, and manufacturing costs.

Forecasting COGS is effectively the same as forecasting gross profit because gross profit is revenue minus COGS. Therefore, once revenue and COGS are forecasted, we also get a forecast of gross profit.

Revenue - COGS = Gross Profit

Methods for forecasting the cost of goods sold

Your COGS forecast will depend on how in-depth your projections are going to be. The percentage of revenue will take considerably less effort than cost analysis but may be less accurate.

A few common methods are:

Cost analysis: Estimating future costs of raw materials and manufacturing processes is a common method.
Production volume: Projecting how many goods you will produce affects COGS. If you are forecasting revenue to increase due to increased sales volume, it is important for COGS to reflect this.
Percentage of revenue: A simplistic method to model COGS is by measuring it as a % of revenue. You take the new value of revenue and multiply it by the average COGS/revenue over the previous, say, 5 years.

Selling, General, and Administrative Expenses

Operating expenses, also known as selling, general, and administrative expenses (SG&A), are the expenses a business incurs to keep its operations running smoothly. It includes rent, utilities, marketing, office supplies, taxes, and more.

Operating expenses can be projected using the same percentage of revenue method outlined in the COGS section above. For a more robust forecast, the items in operating expenses can be separated and treated individually.

To project each line item, it is important to look at historical trends:

How have expenses changed over time? Have they been rising steadily?
Are there any exceptional events that should be removed from this analysis?
Are there any cost-cutting plans that will impact this expense?

Answering these questions should give you a growth rate for each line item. You can use this growth rate to project future values of the expense.

Operating expenses commonly include depreciation and interest expenses, we will look at these items individually.

Depreciation Expense

Financial methods for distributing the cost of non-current assets over their useful lives are depreciation and amortization, or D&A.

The useful life of an asset measures the length of time it will continue to work effectively. It makes sense to divide the expense of an item over the course of time you plan to use it. D&A is employed for this purpose.

There are numerous ways of calculating D&A. Historical information should be available in the financial statements; if it isn't on the face of the income statement, it can be found in the financial statements' notes. Once you have past data, it can be utilized to forecast future D&A amounts.

If you have access to future capital expenditure plans, then you will be able to build a more reliable projection. You can use the company’s depreciation method to anticipate annual depreciation charges resulting from the expenditures.

Interest Expense

Interest expenses are determined by both expected future interest rates and projected debt levels. When forecasting the balance sheet, these projected debt levels should be calculated in a debt schedule.

As for future interest rates, unless you have reason to expect otherwise, it is safe to use the current interest rate on debt as the expected future rate.

As for calculating the expense itself, there are two options:

Opening debt balance * interest rate

Average debt balance over the period * interest rate

It is theoretically more appropriate to use the average balance over the period as that will more closely represent the expense. However, this can cause problems in Excel, so analysts often use the opening debt balance to simplify the calculation.

Tax Expense

It is acceptable to assume that the tax rate will not change over time. Therefore we take the average tax rate from the last 3 periods and apply this to projected earnings before tax.

Earnings before tax (EBT) can be calculated by subtracting all the above expenses from sales revenue, i.e.,

Revenue - COGS - SG&A - D&A - interest expenses = EBT

Simply multiply EBT by the calculated tax rate to find the projected income tax figure.

EBT * estimated tax rate = tax expense

Sensitivity Analysis

Now that the income statement is completed, it is important to test it for different situations. This step will help you understand how different variables can affect your projections.

Scenario analysis can be performed quite easily; all you need to do is change variables individually and review the impact on the income statement. In Excel, you can use the scenario manager feature to compare your model’s exposure to changing variables.

Scenario analysis helps you understand the potential risks and uncertainties in your projections and helps you make informed decisions going forward.

Presenting and Reporting

Presenting and reporting is all about communicating financial insights from the projections clearly and understandably.

The key elements to focus on when creating your presentation are:

Clarity: reports should be easy to read and understand. Use simple language and visual aids such as charts and graphs.
Transparency: be honest about the assumptions you have made and the data you have used. This will build trust with the audience.
Relevance: Focus on the most critical information to emphasize the key findings of the projections.

It is important to consider your audience and their requirements. Investors may want detailed, comprehensive reports, while your team may want a simplified presentation.