How Did You Derive Your Forecast? Why Did You Choose the Base Case Assumptions That You Did?

Individual Analysis: Case 9

1. How did you derive your forecast? Why did you choose the base case assumptions that you did?

    The forecasting method I used for this case is Percentage-of-sales forecasting. I chose this method because sales in 2002 can be derived according to the set sales growth rate. Without transaction information, we can’t forecast the accounts in the financial statements we got unless we derive them based on their relationship with sales.

·Sales

    For Sales account, I applied the assumption of a 13% growth rate, same as the set growth rate suggested by the textbook. The growth rate in 2000 and 2001 were 8.69% and 13.33% respectively. And the average is 11.01%. Although the average is lower than 13%, the company is trying to improve their performance and the growth rate in 2001 is around 13%. So I think 13% of growth is a fair rate to apply.

·COGS/SALES

    The cost of goods sold to sales ratio has a little fluctuation for the past three years, with an average of 40.51%. Although COGS may gradually decline, it’s still very hard to reduce COGS generally unless there is a major technology improvement. So I adopted the average of the historical ratio to reflect the cost of goods sold.  

·Operating Expenses/SALES

    Operating expenses accounts for a very high percentage of sales, with the highest of 55.31% and the lowest of 50.35%. The historical figures went up and down so I meant to use the average for this account. However, I noticed that one of Gournay’s new strategies was to reduce product and inventory costs so as to achieve operational efficiencies. So operating expenses in the future is likely to go down in the future. Regarding this, I decided to use the lowest historical ratio for my forecast.

·Tax Rate

    According to the historical statements, the tax rate in 1999 was an unusual 235.29% and the following two years were respectively 36.11% and 27.34%. I assumed there was something unusual happened causing the super high tax rate and I excluded it when I calculated the average. The average is 31.73%, which I adopted for my forecast since tax policy usually wouldn’t change too much.

·Dividends

    From the historical statement, it’s easy to find that the dividends were the same every year. So I assume the dividend policy of this company is paying out the same amount every year and I used the same figure during my forecast.

·Others

In the assets accounts, every account was measured as a portion of sales in the historical statement and most accounts had a steady percentage. So I used the average of historical figures to reflect the current assets to sales ratio. And current assets account includes accounts receivable, inventories and other current assets.

Similarly, I used the average of historical figures to reflect the current liabilities to sales ratio. Current liabilities account includes accounts payable, taxes payable, accruals, overdrafts and other current liabilities.

As for equity account, I used the assumption that it is equal to the previous year’s shareholders’ equity plus this year’s retained earnings.

1. Based on your pro forma projections, how much additional financing will The Body Shop need during this period?

Based on my pro forma projections, The Body Shop will need a debt of £35.454 million in 2002, and a debt of £42.415 million and £48.864 million in 2003 and 2004 respectively.

1. What are the three or four most important assumptions or key drivers in this forecast? What is the effect on the financing need of varying each of these assumptions up or down from the base case? Intuitively, why are these assumptions so important?

The key drivers in this forecast are Sales growth rate, cost of goods sold (COGS) and operating expenses.

 Sales growth rate is the most important assumption simply because all the other accounts have a close relationship with sales. Sales growth has a very close relationship with the company’s financing plan. Sensitivity analysis showed that if growth rate went up by 1% (from 13% to 14%), the company will need an additional £1.3 million to support the growth. Intuitively, if a company wants a bigger growth, it will need more funding to expand and reach that growth target.