Level I Β· Financial Statement Analysis

Learning Module 12
Introduction to Financial Statement Modeling

Key Outcomes Summary & Practice Problems

Learning Outcomes

What you must be able to do

Curriculum Year: 2026

LOS 1

Demonstrate the development of a sales-based pro forma company model.

LOS 2

Explain how behavioral factors affect analyst forecasts and recommend remedial actions for analyst biases.

LOS 3

Explain how the competitive position of a company based on a Porter's five forces analysis affects prices and costs.

LOS 4

Explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation.

LOS 5

Explain considerations in the choice of an explicit forecast horizon and an analyst's choices in developing projections beyond the short-term forecast horizon.

1 Β· Building a Financial Statement Model

    • Steps in model construction β€” revenue forecast β†’ COGS β†’ operating expenses β†’ non-operating items β†’ pro forma income statement β†’ cash flow β†’ balance sheet.

    • Revenue forecast β€” driven by volume, price/mix, and foreign exchange. Segment-level analysis often provides the most accurate view.

    • COGS & operating expenses β€” forecast using historical margins and expected changes (e.g., gross margin expansion from product mix).

    • Working capital β€” forecast using efficiency ratios (DOH, DSO, DPO) linked to sales and COGS.

    • Capital expenditures & depreciation β€” capex as % of sales; D&A based on prior-year fixed assets.

    • Balance sheet β€” generated by linking income statement and cash flow projections; all items must tie out.

    • Valuation inputs β€” free cash flow to the firm (FCFF) is derived from EBIT, taxes, D&A, change in working capital, and capex.

FCFF

FCFF = EBIT(1 βˆ’ t) + D&A βˆ’ Ξ”WC βˆ’ Capex
Used as the basis for DCF valuation models.

2 Β· Behavioral Biases in Forecasting

    • Overconfidence β€” unwarranted faith in own abilities; mitigate by recording and reviewing forecasts, and using scenario analysis.

    • Illusion of control β€” overestimating control over outcomes; mitigate by limiting model complexity and focusing on key drivers.

    • Conservatism (anchoring) β€” inadequately incorporating new information; mitigate by regular team reviews and flexible models.

    • Representativeness (base-rate neglect) β€” classifying new information based on past experiences; mitigate by combining inside view (company-specific) with outside view (industry base rates).

    • Confirmation bias β€” seeking information that confirms prior beliefs; mitigate by seeking diverse perspectives (e.g., bearish analysts) and conducting thorough competitor research.

3 Β· Competitive Factors β€” Porter's Five Forces

    • Threat of substitutes β€” availability of alternative products that can satisfy the same need.

    • Rivalry β€” intensity of competition among existing firms; higher rivalry reduces pricing power and margins.

    • Bargaining power of suppliers β€” ability of suppliers to raise input prices; low power means more favorable cost structure.

    • Bargaining power of buyers β€” ability of customers to drive prices down; high power erodes margins.

    • Threat of new entrants β€” barriers to entry; high barriers protect incumbent margins.

    • Analysis of these forces helps assess a company's ability to maintain prices and margins, which feeds into revenue and cost forecasts.

ROIC

ROIC = (NOPAT) / (Operating assets βˆ’ Operating liabilities)
High and persistent ROIC often indicates a sustainable competitive advantage.

4 Β· Modeling Inflation and Deflation

    • Inflation impact on sales β€” depends on price elasticity of demand and ability to pass through costs. Inelastic demand allows price increases without significant volume loss.

    • Inflation impact on costs β€” companies can mitigate through input substitution, hedging, long-term contracts, or operational efficiency.

    • Geographic mix β€” different inflation rates across countries affect revenue and cost projections.

    • Pricing strategy β€” companies may choose to pass on cost increases (protect margins) or absorb them (gain market share).

    • Deflation β€” can lead to price wars, lower margins, and inventory write-downs; forecasting requires careful volume–price trade-off analysis.

5 Β· Forecast Horizon & Long-Term Forecasting

    • Explicit forecast period β€” influenced by investment strategy, industry cyclicality, company-specific events (e.g., acquisitions), and firm policy.

    • Normalized earnings β€” mid-cycle earnings excluding temporary factors; used in terminal value calculations.

    • Terminal value β€” often derived using a perpetuity growth model or exit multiple; the cash flow used should be normalized.

    • Inflection points β€” economic disruption, regulation, and technology can cause future to look different from the past; analysts must anticipate these.

    • Long-term growth rate β€” should be realistic (usually ≀ GDP growth for mature companies) and consistent with industry life cycle.

TERMINAL VALUE (PERPETUITY)

TV = FCFFN Γ— (1+g) / (WACC βˆ’ g)
g = long-term growth rate; must be conservative and sustainable.