From the course: Financial Modeling and Forecasting Financial Statements

Forecast investing cash flow

From the course: Financial Modeling and Forecasting Financial Statements

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Forecast investing cash flow

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Capital expenditures are purchases of long-term operating assets such as land, buildings, and equipment. To forecast the required annual level of Home Depot's capital expenditures, we start with a sales forecast. Supporting a higher level of sales requires more land and more buildings. Well, how much more? Well, this depends on how efficiently Home Depot is using its land and buildings to generate sales. For example, a common efficiency measure in retail businesses is sales per square foot. The higher this number, the more efficiently the company is using its land and buildings to generate sales. For example, in 2024, Home Depot's sales per square foot was $605, meaning that during the year, each square foot of space in Home Depot locations generated on average $605 of sales. This is pretty good. By comparison, Lowe's sales per square foot in 2024 was just $429. Another financial ratio that captures the same idea is the fixed asset turnover ratio, computed as sales divided by property, plant, and equipment. Let's say that this value is three. This means that during the year, each dollar's worth of property, plant, and equipment generates $3 of sales. The higher the number, the more efficient the company is at using fixed assets, the property plant and equipment, to generate sales. In 1985, Home Depot had a fixed asset turnover ratio of 3.5. With a forecasted sales growth of 40% per year in the 1986 to 1990 time period, here are the forecasted levels of necessary capital expenditures each year. These forecasts indicate that by 1990, Home Depot will need to spend $308 million purchasing new property, plant, and equipment to increase the level from 768 million in 1989 to 1.076 billion in 1990. Well, okay, let's see what would happen if Home Depot could use its fixed assets more efficiently to generate sales. Let's change the forecasted fixed asset turnover ratio to five. Now, this is an impossibly large increase from the existing level of 3.5, but let's just see what happens. Okay, well, this looks better. For example, with the 5.0 forecasted fixed asset turnover ratio, the necessary capital expenditure amount in 1990 is just 215 million compared to 308 million with the original 3.5 fixed asset turnover value. Better, but still not great. Even with this impossibly favorable assumption about efficiency in the use of property, plant, and equipment, these annual capital expenditures amount to five times the amount of net income each year. By comparison, in 2024, the capital expenditure amount for ExxonMobil, a pretty capital-intensive business, was $24 billion. Net income in the same year was $35 billion. So Home Depot's forecasted ratio of capital expenditures to net income of five to one, not good. Probably not sustainable. Now, just a quick note about the change in forecasted net income that we see when changing the fixed asset turnover ratio from 3.5 to 5.0. Forecasted net income goes up. In 1990, from 26 million to 43 million. Now consider, how is net income impacted by a change in fixed asset turnover ratio? which directly affects not the income statement, but the property plant and equipment amount in the balance sheet. Well, this illustrates the importance of careful financial modeling. Casual unstructured thinking won't capture all the interrelations within the financial statements. The increase in the forecasted fixed asset turbo ratio directly reduces the forecasted amount of property plant and equipment needed in each year. Fine, so far I don't see any impact on net income. Ha, but less property, plant and equipment in the balance sheet means lower depreciation expense in the income statement. So forecasted net income goes up. And a lower need to buy additional property, plant and equipment means lower need to borrow money to buy that property, plant and equipment. Lower borrowing means lower interest expense, which means higher net income. Ah, so an improvement in the forecasted fixed asset turnover ratio leads indirectly to an increase in forecasted net income. Careful financial modeling reflects all of the implications of changes in forecasted future actions.

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