Approaches to Forecasting a Company’s Operating Expenses and Working Capital

Issuer’s Disclosures about Operating Costs

When it comes to operating costs, issuers tend to provide less detailed information compared to their revenue disclosures. Analysts often work with broader financial statement categories like cost of sales or SG&A. They might also use summary measures like EBITDA margins to evaluate costs across different geographic regions, business segments, or product lines.

The forecasts for revenues and costs should be coherent. If the sales of a low-margin product, segment, or geography are forecasted to grow faster than other revenues, a certain level of overall profit margin deterioration should be forecasted. This is applicable even if the analyst is uncertain about the precise margins earned on each object.

Cost of Sales and Gross Margins

Analysts should forecast any change in the product mix sold. For instance, in the case of a company that also sells higher-margin items, such as alcoholic products or pharmaceutical products, the analyst would want to forecast any change in the product mix sold.

Cost of sales, also known as cost of goods sold (COGS), is usually the largest cost for companies that manufacture and/or sell products. It is directly linked to sales, making it a crucial factor in forecasting. This cost can be forecasted as a percentage of sales or as a gross margin. The gross margin can fluctuate based on the company’s market position.

If a company is losing market share due to the introduction of cheaper substitute products, the gross margin is likely to decrease. Conversely, if a company is gaining market share through the introduction of differentiated products and achieving cost advantages, the gross margin is likely to increase.

Given the significant impact of the cost of sales, even a single basis point change in the gross margin forecast can materially affect the forecasts of operating profit and free cash flow. Therefore, a detailed analysis of these costs, such as by segment, input, product line, volume, and price components, can provide a better justification for the forecast.

For instance, companies that face fluctuating input costs that can only be passed on to customers after a time lag need to be considered. Particularly for companies with low gross margins, sudden shocks in input costs can significantly affect operating profit.

Analysts should also consider a company’s hedging strategy in their forecasts. Companies that rely heavily on commodities often see their gross margins decline when input prices increase significantly, as variable costs rise faster than output prices.

Through hedging strategies, companies can mitigate the impact on profitability. For example, brewers often hedge the cost of barley, a key raw material, one year in advance. While companies may not disclose specific hedging positions, their hedging strategy is often disclosed in the notes to the financial statements.

Another factor to consider is the impact of increasing sales prices on sales volume, especially if product demand is price elastic. This can be mitigated by a policy of gradual sales price increases. For instance, if a brewer anticipates higher barley prices due to a poor harvest, they can slowly increase prices to avoid a sharp price jump the following year.

While competitors’ gross margins can provide a useful cross-check for forecasting gross margins, differences in business models can make these margins incomparable. For example, some retailers own and operate their own stores, while others operate as wholesalers with franchised retail operations. In the franchise model, most of the operating costs are incurred by the franchisee, and the wholesaler sells products with only a small markup to these franchisees. Compared to a retailer with its own stores, a wholesaler will have a much lower gross margin but also much lower operating costs.

Selling, General and Administrative (SG&A) Expenses

SG&A expenses, also known as Selling, General, and Administrative expenses, are a major type of operating costs. Unlike the cost of sales, these expenses often have a less direct relationship with revenues. This means that they may not increase or decrease in direct proportion to the company’s sales.

It’s crucial to recognize that not all SG&A (Selling, General, and Administrative) expenses share the same degree of correlation with revenue. For instance, expenses related to sales and distribution often contain a significant variable element and can be projected as a percentage of sales. In contrast, general corporate expenditures tend to be more fixed in nature and might be more appropriately forecasted using a fixed growth rate derived from anticipated wage inflation.

Regarding segment disclosures, they commonly feature profitability indicators like operating and EBITDA margins for each segment. However, they typically do not provide detailed cost breakdowns such as cost of sales or SG&A by segment. If an analyst is creating a model based on segment projections, they may opt to utilize aggregated metrics specific to each segment instead.

Working Capital Forecasts

Working capital forecasts are crucial financial projections that help in predicting the future financial health of a business. They are typically made by using efficiency ratios, which are combined with sales and cost forecasts to project various elements of working capital. These elements include accounts receivable, inventories, accounts payable, and other current assets and liabilities.

Efficiency ratios are used as the forecast object in working capital forecasts. These ratios, which were discussed in earlier modules, are used to measure the effectiveness of a company’s use of its assets and liabilities. They are crucial in predicting the future financial health of a business.

While a historical results approach is common for working capital efficiency ratios, analysts can also use other forecast approaches. These approaches can be used to predict a company’s operating costs and working capital.

Operating costs and working capital are two key elements that are predicted in working capital forecasts. Operating costs refer to the expenses associated with running a business while working capital refers to the difference between a company’s current assets and current liabilities.

Question #1

A company is looking to improve its financial health and is focusing on its efficiency ratios. These ratios are crucial for the company as they measure certain aspects of the company’s financial performance. What do efficiency ratios most likely measure in a company?

1. The company’s profitability.
2. The company’s market share.
3. The effectiveness of a company’s use of its assets and liabilities.

The correct answer is C.

Efficiency ratios primarily measure the effectiveness of a company’s use of its assets and liabilities. These ratios are used to analyze how well a company is managing its assets and liabilities internally. They are also known as activity ratios or asset utilization ratios. Efficiency ratios include inventory turnover, receivables turnover, payables turnover, and asset turnover, among others. These ratios provide insights into the effectiveness of a company’s management in using its assets to generate sales and profits.

For example, a high inventory turnover ratio indicates that a company is efficiently managing its inventory and is able to quickly sell its goods. On the other hand, a low ratio may indicate poor inventory management or low demand for the company’s products. Therefore, by focusing on improving its efficiency ratios, a company can enhance its financial health by optimizing the use of its assets and liabilities.

A is incorrect. While efficiency ratios can indirectly impact a company’s profitability, they do not primarily measure profitability. Profitability ratios, such as the gross margin ratio, operating margin ratio, and net profit margin ratio, are used to measure a company’s profitability.

B is incorrect. Efficiency ratios do not measure a company’s market share. Market share is a measure of a company’s sales in relation to the total sales of all companies in the market. It is not directly related to the company’s use of its assets and liabilities.

Question #2

An analyst is preparing a working capital forecast for a company. She is considering various approaches to predict the company’s operating costs and working capital. Which of the following is most likely a common approach used for forecasting working capital efficiency ratios?

1. Historical results approach.
2. Current market trends approach.
3. Competitor analysis approach.

The correct answer is A.

The Historical results approach is a common method used for forecasting working capital efficiency ratios. This approach involves analyzing the company’s past performance to predict future trends. The historical results approach is based on the assumption that the past is a good predictor of the future. This method is often used because it is straightforward and easy to implement. It involves analyzing the company’s historical financial statements and calculating the working capital efficiency ratios for each period.

These ratios are then used to forecast future ratios. The historical results approach is particularly useful when the company’s operations have been stable over time. However, it may not be as effective if the company’s operations have changed significantly or if the company is facing new challenges or opportunities.

B is incorrect. The Current market trends approach is not typically used to forecast working capital efficiency ratios. While current market trends can provide useful information about the overall economic environment and industry conditions, they do not provide specific information about a company’s working capital management. Therefore, this approach is not typically used to forecast working capital efficiency ratios.

C is incorrect. The Competitor analysis approach involves comparing a company’s performance to that of its competitors. While this can provide useful insights, it is not typically used to forecast working capital efficiency ratios. This is because working capital management is highly company-specific and depends on a variety of factors, including the company’s business model, industry, and management practices. Therefore, while competitor analysis can provide useful context, it is not typically used as the primary method for forecasting working capital efficiency ratios.