Modeling Non-operating Costs and Other Items

Financing Expenses

Financing costs comprise interest expense and interest income, which are typically netted. Interest income is less significant to non-financial companies but a key revenue component for financial institutions such as banks and insurance companies. Interest income depends on the amount of investment, cash on the balance sheet, and rates of return earned from investments. On the other hand, interest expense depends on the interest rate associated with debt and the debt level on the balance sheet. Changes in interest rates affect the market value of a company’s debt and net interest expense.

A company’s capital structure is a key determinant when forecasting financing expenses. The main drivers in forecasting interest expense are the interest rate and level of debt. A company’s interest rates and debt maturity structure can be found in the notes to the financial statements.

Corporate Income Taxes

The nature of a business, the geographic composition of profits, and the tax rate can determine income taxes. Some companies receive more tax treatment from the government than others, which can alter the tax rates. There are three types of taxes:

• The cash tax rate: This is the actual tax paid divided by pre-tax income.
• The effective tax rate: This tax rate is calculated as the reported income tax.
• The statutory tax rate: This is the corporate tax rate in the company’s home country.

Differences in tax laws and financial accounting standards result in differences between the reported taxes and cash taxes, often referred to as deferred tax assets or deferred tax liability. The cash tax and effective tax rates are key when forecasting cash taxes and tax expenses. Adjustments to previous years, expenses not deductible for tax purposes, withholding tax on dividends and tax credits are among the reasons a difference may arise between the effective tax rate and the statutory tax rate.

Effective taxes will be different when a company operates in a country other than that in which it is domiciled. A company may report low profits in a country with low taxes and high profits in a country with high taxes. In such an instance, the weighted average of the rates higher than the simple average tax rate of both countries will be the effective tax rate. Companies can use special purpose entities to minimize their taxes, which can create a risk when tax laws change. When forecasting future tax expenses, additional attention is needed when the effective tax rate is consistently lower than the effective tax rate of a competitor or statutory tax rate.

Cash flows are forecasted using the cash tax rate, and the effective tax rate is relevant for earnings projection in the income statement. Analysts should make an adjustment for a one-time event when they are developing an estimated tax rate for forecasts. If income from equity-method investees is a large proportion of pre-tax income and is volatile, it would be best to omit the amount from the effective tax rate for future tax costs for the company.

A tax rate based on normalized operating income before associates and special items results is a good starting point for estimating future tax expenses. The deferred tax liability or asset should be the reconciliation between cash flow tax figures and profit and loss tax figures.

Income Statement Modeling: Other Items

Future dividend growth is modeled using a company’s dividend policy. A company will report minority interest income or expense from consolidated affiliates on its income statement if the company shares an ownership interest in a business unit with a third party. A company that owns more than 50% of an affiliate will report the portion of income it doesn’t own as a minority interest and consolidate the affiliates’ results with its own. If the ownership is less than 50%, the company will report its share of income from the affiliate under the equity method, but no consolidation will occur. When the affiliate loses, minority interest will be reported as net income addition to shareholders. In contrast, when the affiliate makes a profit, minority interest will be deducted from net income.

Share count changes occur because of the following:

• Convertible bonds.
• Issuance of new securities or share repurchases.
• Dilution related to stock options.

Share count change estimation can be difficult to perform due to share market price changes. Analysts exclude unusual charges from forecasts due to their predictability.

Question

Which of the following metric is an analyst least likely to consider when forecasting financing expenses?

1. The capital structure of the company.
2. The interest rate.
3. Benefit from special tax treatment

Solution

The correct answer is C.

Benefits from special tax treatments are more likely to affect the forecasting of corporate income taxes.

A and B are incorrect. Debt and interest rates are the main drivers when forecasting financing expenses.

Reading 17: Financial Statement Modeling

LOS 17 (e) Demonstrate methods to forecast non-operating items, financing costs and income taxes.