2.1.8 Forecasting the Income Statement

Welcome to On Judgement. A spreadsheet can extend last year’s 20% growth indefinitely. What evidence would make that a forecast rather than a copied pattern? Take a first view. You can change it when you have considered the evidence.

Forecast revenue through volume, price and mix where feasible. Check capacity, contracts, repeat purchases, customer concentration and competitors. Historical CAGR and external consensus can be cross-checks; neither proves future growth. State the explicit forecast horizon and why it fits the business. Long-duration projects may require longer forecasts than a simple operating-company exercise.

Use historical cost relationships as a starting point, then adjust for input inflation, productivity, new capacity and product mix. Some costs vary with sales, some are fixed within a range and others step up. A fixed-cost percentage need not remain constant as revenue changes. Keep depreciation treatment consistent so it is not counted again when moving from EBIT to cash flow.

Forecast financing costs using borrowing, rates and refinancing assumptions rather than mechanically linking them to revenue. Accounting tax expense and cash tax paid are different concepts. An accounting effective tax rate relates tax expense to pre-tax profit on the stated basis. The simplified tax assumption here is a teaching input, not a claim about a real company’s legal tax liability.

A base case is a coherent set of assumptions, not a fact. Build downside and upside cases that connect demand, margin, working capital and investment. Keep original assumptions and compare them with later evidence. A more precise number does not justify greater confidence. To value the firm later, extend profit forecasts into cash flows and check the financing implications.

Let's work through Harbour next-year base and downside · £m. Base: 10% revenue growth from 240; cost of sales 60% of revenue; operating expenses 64 including depreciation 6; net finance cost 4; tax expense 25% of positive pre-tax profit; 20m shares. Downside: revenue stays 240, cost ratio rises to 62%, operating expenses remain 64. Other assumptions unchanged. Pause here and try the calculation or reasoning before continuing.

Base revenue = 264; cost of sales = 158.4; gross profit = 105.6. Base EBIT = 41.6; PBT = 37.6; tax = 9.4; net profit = 28.2; EPS = £1.41. Downside cost of sales = 148.8; EBIT = 240 − 148.8 − 64 = 27.2. Downside PBT = 23.2; tax = 5.8; net profit = 17.4; EPS = £0.87.

Revenue is only one driver: an adverse cost mix and a relatively fixed expense base change profit substantially. Cash-flow consequences still need modelling.

Now try the choices in this lesson. If your answer changes, identify the reason. Explain uncertainty without false precision. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.