Forecasting Future Periods

Forecasting is the process of taking information about the firm obtained from strategy, accounting and financial analysis in order to make predictions about the firm's performance in the future. Importantly, it should recognize the opportunities and constraints on future performance imposed by the economic environment, and the strategies being employed by the firm. Forecasting is not limited to profit but also includes the balance sheet and free cash flows to ensure consistency. Given the nature of forecasting, and the inherent uncertainty of future events, forecasting focuses its attention only on the major components of the financial statements.

Forecast Profit and Loss

The major determinant of firm performance is the level of firm activity, and hence the initial focus is on revenue.

For Qantas, passenger revenues represent almost 80% of total revenues. Consequently a major factor in Qantas' revenue, and revenue growth, is the level of activity in the industry. The long-term growth rate for international passengers is 6.3% p.a., and for domestic passengers 5.0% p.a. In the absence of major economic disturbances growth can be expected to continue at these rates, whilst still remaining sensitive to general economic conditions and the level of competition. With increased competition, both the domestic and international yields will come under pressure, and it is unlikely that there will be substantial revenue growth. Revenue increased at an average of 4.8% p.a. over the period 2000-13. However, this fell to an average of just 0.3% between 2008 and 2013.

Freight revenues have experienced little growth in recent periods and this is continued in the forecasts.

Other revenues are forecast to increase at the same rate as passenger revenues; however, these are not expected to have a significant impact on the forecasts due to the relatively minor size of these revenue streams for Qantas overall revenue.

The most significant expense category is staff costs, which represented 24.4% of total revenues in 2013.

There have been minor variations in this proportion over recent years, but over the longer term it has remained around this level, notwithstanding efforts by management to reduce this cost. On this basis staff expenses can be forecast at 25.0% of total revenues, although sensitivity analysis should be undertaken over the range 24% to 26%.

Variable aircraft operating costs represented 19.5% of total revenues in 2013, close to the 2000 rate of 20.1%. On the basis that this likely reflects long-term contracts and fixed operating requirements this can be forecast to stay at 19.5% of total revenues.

Fuel expenses have been volatile in recent years and over the period 2008-13 this cost has remained at approximately 24% of total revenues. The strengthening of the AUD against the USD in 2010-11 was offset by an increase in oil prices. A weakening of the AUD may see fuel expenses rise; however, forecast fuel expenses should remain at the long-term average of 24% of total revenues.

Given the uncertainty of exchange rates and fuel prices, sensitivity is undertaken for fuel expenses ranging from 23% to 25%. To the extent that hedge positions were entered at historic rates, reported fuel expense may not reach this forecast position immediately, but can be expected to approximate spot prices over time.

All remaining expenses represent less than 10% of total revenues and can be forecast to remain at present levels. Interest is calculated at 3% of net financial obligations and tax (calculated at the present marginal corporate tax rate of 30%).

Balance Sheet

Changes in the level of business activity flow through to the balance sheet as changes in the level of net operating assets required, and changes in the financing of the firm's operations. Historically Qantas has maintained current operating assets at approximately 36% of total revenues.

Accordingly current operating assets can be forecast at 36% of total revenues. Current operating liabilities have been volatile; however, in recent years they have stabilized at 35% of total revenues. Therefore they can be forecast to continue at this level.

Forecasting of non-current operating assets is problematic due to Qantas' program of aircraft acquisition. As a consequence of these acquisitions, the ratio of property, plant and equipment (PPE) to sales has increased to 0.879 in 2013. Further increases can be expected as acquisitions continue and PPE turnover has been forecast at 1.00. Reflecting the possibility for error, the sensitivity of forecasts to variations in turnover between 0.90 and 1.10 are considered.

Other non-current operating assets are forecast at 10% of total revenues and non-current operating liabilities are forecast at 16% of total revenues. Borrowings are calculated as the balancing item in the statement of financial position.

Dividends are forecast 25 % of operating profit after tax. This has the significant problem; however, that profit retention at this level is insufficient to limit the Increase in leverage caused by borrowings to fund asset acquisitions. Accordingly, if this payout ratio is adopted Qantas will be required to raise equity and with current levels of profitability this will be difficult.

Question:

Use the analysis and suggested forecasts presented in this case, and any recent material available to you.

1. Prepare forecast financial statements for Qantas in 2014, based on the most likely forecasts.

2. Choosing the cost favourable forecast for each item for which a range of possible forecasts are given, prepare a 'worst-case' forecast financial statements for Qantas in 2014. What level of borrowing or equity-raising is required in this scenario?

3 Choosing the most favourable forecast for each item for which a range of possible forecasts are given, prepare a 'best-case' forecast financial statements for Qantas in 2014. What level of borrowing or equity-raising is required in this scenario?

4 Update the forecast assumptions for the most recent Qantas annual report available to you. Prepare the forecast financial statements for Qantas for the following year.

5 How confident do you feel about any of these forecasts, and why?