TN8 the Body Shop International PLC 2001

CASE 8

THE BODY SHOP INTERNATIONAL PLC 2001: AN INTRODUCTION TO FINANCIAL MODELING

Teaching Note

Synopsis and Objectives

In this case, the student is cast in the role of adviser to Anita Roddick, the managing director of The Body Shop. The student must prepare a three-year forecast of the firm’s income statements and balance sheets. The case is intended to introduce percentage-of-sales forecasting and walks the student through the preparation of a simplified forecast, first using pencil and paper, then using a spreadsheet program on the personal computer. The case emphasizes the importance of being able to speak plainly about one’s financial forecast and the insights that are of use to the general manager.

Suggested Instructions for Advance Assignment to Students

Advance instructions to students for this case are relatively simple:

Work through the exercises in this case, first using pencil and paper, and then using your personal computer. Then follow the directions in the case to make the three-year forecast, and prepare responses to the questions posed at the end of the case.

This teaching note was written by Robert F. Bruner. The author thanks Professor Oyvind Bohren for comments, though any errors that may remain are the author’s. The Batten Institute provided financial support. Copyright © 2001 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

A suggested complementary case dealing with percentage of sales forecasting: “Deutsche Brauerei,” (Case 11)

72 Case 8 The Body Shop International PLC 2001

The Microsoft Excel spreadsheet file Case_8.xls supports student analysis and saves a few keystrokes in formatting and entering data for the final exercise of the case. The instructor’s work file, TN_8.xls, contains the completed model shown in Exhibit TN2—this model should not be distributed to the students.

Case 8 The Body Shop International PLC 2001 73

Supplemental References

The case presents a self-contained exposition of forecasting, and will require two to four hours of preparation by a novice student. We have been reluctant to load more preparation upon the student. The instructor may wish to offer supplemental resources depending on the audience, setting, and the availability of student preparation time. The following are potentially valuable complements to this case.

Higgins, Robert C. “Financial Forecasting” in Analysis for Financial Management. 6th ed. (Burr Ridge, IL: Irwin/McGraw-Hill, 2001). This is one of the best concise discussions of financial forecasting, and would be especially useful with executive audiences.

Current corporate finance textbooks offer presentations that link the mechanics of forecasting to the larger subject of financial planning. Two good discussions are these:

Brealey, Richard A., and Stewart C. Myers, “Financial Analysis and Planning.” chap. 28 in Principles of Corporate Finance. 6th ed. (Burr Ridge, IL: Irwin/McGraw-Hill, 2000).

Ross, Stephen, Westerfield, Randolph, and Jaffe, Jeffrey. “Corporate Financial Models and Long-Term Planning.” chap. 28 in Corporate Finance. 6th ed. (Burr Ridge, IL: Irwin/McGraw-Hill, 2002).

Some novices will ask for more practice drills in forecasting mechanics. The following is a CD-ROM–based tutorial that walks students through the preparation of spreadsheet forecasting models for three companies:

Bruner, Robert F., Kenneth M. Eades, and Robert S. Harris. Finance Interactive. (Burr Ridge, IL: Irwin/McGraw-Hill, 1997). Students welcome the self-guided aspect of this tutorial, and show quicker mastery when they use it. We provide this resource after students have received the introduction in The Body Shop case.

Hypothetical Teaching Plan

Although the mechanical tasks in the case are straightforward, a discussion of this case easily fills a solid class period. The instructor will need to balance faithfulness to the breadth of issues raised with appeals from novices for in-depth pointers.

1. Why would a company like The Body Shop want to forecast its financial statements?

This opening is a useful motivator for the discussion and lends seriousness to the exercise. The basic point should be that finance is concerned with expected performance. Investors forecast to value and invest. Managers forecast to plan and finance. Financial forecasts such as the exercises in this case lend rigor to expectations about future performance.


2. Let us vault past the exercise questions and go straight into the three-year forecasts: How did you prepare your forecast and what numbers did you get?

Exhibit TN1 offers a template for a transparency based on case Exhibit 8. The instructor can use the template to enter the forecasts for 2002 and 2003. One approach is to call on a student to present his or her entire set of results, then call on other students to describe their differences, innovations, and points of difficulty. The instructor might keep a list on the chalkboard of modeling questions and their answers.

3. How much debt financing will The Body Shop need over this forecast period? What are the key drivers of this need, and how much do debt needs vary as the assumptions vary?

This phase of the discussion pushes students past mere modeling into the exercise of their models and the interpretation of results. The aim here should be to engage the students in the insights to be derived from data tables, the intuitive explanations for the significance of key drivers, and an appreciation of sensitivity analysis, scenario analysis, and the identification of break-even assumptions.

4. What issues does this analysis raise for Roddick?

This segment of the discussion should distill the insights from the sensitivity analysis into practical questions or suggestions for a general manager. For instance, key drivers identified in the preceding section should be ranked in importance with the most important one or two made the focus of questions. If growth rate proves important, students might develop questions about the source of that growth, its stability, the effect of changes in product mix, and the possible impact of moves by competitors.

The instructor can close with summary comments derived in part from the list of mechanical issues kept on the board and in part from exhortations to master modeling and move into interpretation and recommendation.

Case Analysis

Motives for modeling

Decision makers wrestle with uncertainty about the future. Financial modeling can help illuminate the future, identify strengths and potential problems, and clarify the implications of alternative choices. The Body Shop has enjoyed mediocre financial performance in recent years. Concerns exist about the future, particularly from the entry of large competitors into The Body Shop’s retail specialty, and the fight for market share that ensued; and about the ability of The

Discussion question 1


Body Shop to sustain its rate of growth as it saturates markets in developed countries. Investors and managers alike would be interested to see the financial impact of potential adverse changes in the firm’s business.


Modeling mechanics

The types of concerns students raise about financial modeling will hinge on their comfort with computer spreadsheet programs. Accordingly, an instructor will need to tailor the modeling to meet the student’s skill levels. Exhibit TN2 presents one example of a finished three-year model available in the instructor’s Microsoft Excel spreadsheet file, TN_8.xls. This forecast is useful mainly as an example for the instructor’s preparation. Actual class discussion should be derived from the students’ work.

Exhibit TN2 shows the forecasted assumptions in a straightforward manner. It uses overdrafts as the debt plug figure. Cash is the offsetting plug, if debt were to turn negative; if debt is positive, cash is programmed to hold constant at GBP10 million. The resulting excess cash figure in 2002 is considerably lower than in case Exhibits 5 through 7, primarily because the case exhibits assume a very high ratio of current liabilities to sales (28%). Exhibit TN2 assumes that current liabilities (other than overdrafts) amount to only 13.5% of sales. An important learning point is to question the assumption (implied in case Exhibits 5–7) that all current liabilities arise spontaneously in the course of business (for example: as accounts payable and accruals do). Short-term debt does not arise spontaneously, it must be borrowed. This distinction is crucial if one’s objective is to determine a company’s financing needs.

When discussing the students’ detailed three-year forecasts, the instructor should try to cover the following important issues.

Which items vary with sales? One may reasonably assume that the cost of goods sold varies directly with sales. Net fixed assets, inventory, and selling, general, and administrative expenses probably vary imperfectly with sales, however, and categories like land or goodwill vary little with sales. Students should appreciate that professionalism in the use of percentage-of-sales forecasting requires sensitivity to the various accounts’ relationships to sales.

Circularity in the model: The case describes the need to iterate through the model to solve for debt, but students may need some help in understanding why: The income statement drives the balance sheet, and the balance sheet affects the income statement through interest expense. No solution can be found except by iteration.

Sources of assumptions: Students will debate the efficacy of various sources for their assumptions. For instance, growth rates could originate from the:

historical growth rate for the firm



historic growth rates for peers

target growth rates used by the firm

expectations of investors and securities analysts (the case presents only analysts’ expectations and historic data)

Novices usually plead for the right answer as the basis for assumptions. Analysts’ and managers’ expectations may be more correct than the others, but the instructor should encourage students to derive their own expectations through an analysis of the fundamentals of the company.

Is percentage-of-sales forecasting the most appropriate technique? Students tend to fasten onto one technique while neglecting others. The instructor might mention that other techniques exist. The polar opposite of percentage-of-sales forecasting is the T-account method, which anticipates specific transactions and works through the accounts to derive the forecast statements. This method requires more information than the percentage-of-sales technique and can be tedious without the aid of a computer. Practically speaking, financial forecasting is inevitably a mix of the two techniques: Accounts that vary with sales are forecast as a percentage of sales; accounts that vary with specific transactions (for example: capital expenditures) are forecast through the T-accounts.

Sensitivity analysis

The forecast in Exhibit TN1 reveals a financing need (overdrafts) of (British pounds) GBP16.1 million in 2003, and GBP28.6 million in 2004. It is very important for the instructor to help the students rise above the pure mechanics of the forecasting task and aid them in the interpretation of the economics of the firm’s future. What creates the growing financing need? The simple answer is growth of the scope of the firm. One teaching strategy would be to digress into a discussion of the self-sustainable growth rate concept, and to show that the firm is not retaining enough earnings to finance its growth in assets. But the same insight can be derived from a more practical discussion of key drivers or assumptions that are influential in estimating the firm’s financing needs. It is valuable for students to consider how to find key drivers and to assess their effects. Three classic approaches are useful:

Simple manipulation of key assumptions: Novices typically start at this point, which at least allows them to check whether a model works according to their intuitions. On the other hand, simple manipulation can be an inefficient way to exercise the model and can quickly turn into aimless churning of the assumptions. If students do not offer alternatives, the instructor might offer the next few.

Scenario analysis: This effort is akin to simple manipulation, but is guided by a vision of the interdependency among assumptions. If sales decline, might management cut capital spending and administrative expenses? Students should be encouraged to think consciously



about how managers respond to external pressures and how managers’ reactions might affect the sensitivity analysis.

Data tables: Data tables offer a way for the analyst to develop a feel for the sensitivities, and thus to identify key drivers in the forecast. Another use of data tables is break-even analysis: the identification of pivotal values in key assumptions. Case Exhibit 7 shows that—between 44% and 45% of cost of goods sold/sales—the company moves from lending to borrowing. The identification of such break-even points helps highlight important thresholds for managers. Much of the artistry in devising those tables, however, is to choose sensible steps by which values change in the assumptions. For instance, change on the order of 1% in cost of goods sold relative to sales is large; changes running from 35% to 48%, as shown in the table in case Exhibit 7, are very large.

Exhibit TN3 presents a data table showing the variation in overdrafts in 2004 according to changes in revenue growth rate and the COGS/sales ratio. The novice can derive several useful insights from this regarding key drivers. First, the overdraft balance varies immensely with these two assumptions. One would conclude that they belong in the category of key drivers. Second, the table shows that growth creates a financing need (in this case) and that lower profitability increases the financing need. These are common effects, and worth highlighting for novices. Third, one sees visibly the range of break-even assumptions where the firm turns from a net lender into a net borrower: These occur where the zero balances move into positive balances. And fourth, if one accepted an overdraft balance of GBP28 million as reasonable, then one could consider the range of combinations shown in the table that also produce that outcome (for example: lower growth [11%] and lower profitability [COGS/sales of 41%]). Such an exercise is another way of illuminating the influence of growth and profitability on financing needs.

Closing

It has been said that “there is no finance in corporate financial models.”1 This is strictly true if one focuses on the mechanical substance of the model and its typical accounting statement output. The teaching plan advocated here aims to move students as expeditiously as possible past the mechanics and accounting and into the arena of corporate financial reasoning where:

Students view modeling as a part of a process of analysis, rather than as an end in itself.

The firm is viewed as a financial system in which human managers must decide among competing policies rather than as an opaque box from which policy choices just emerge. The corporate financial reasoning toward which we strive should aim to expose the economic implications of policies and trade-offs among them within this system.

1 Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 6th ed. (Burr Ridge, IL: Irwin/McGraw Hill, 1997), 840.


The ultimate aim of the modeling process should be to identify actions that will increase investors’ returns and/or reduce their risks.

Our challenge as instructors is to help students see finance through modeling, not in spite of it. The teaching plan here offers what could be the first step toward this: to see the primacy and contestability of forecast assumptions, and to exercise models in ways that yield valuable insights.

As of the date of preparing this note (December 2001), the actual results for 2001–2003 were unavailable for comparison to the projections here or by students. However, the company’s Web site gives annual reports for the most recent years that might be useful in debriefing the student projections. See The Body Shop’s Web site, http://www.the-body-shop.com. The wisdom of comparing actual and projected results is debatable, since novices often conclude from this that the right answer to the case is whatever the actual results are. Since these results are unknowable when the analyst makes the projections, there is always some variance, a fact that novices fail to appreciate, and from which they might conclude that forecasting is futile. A fairer comparison would be between the student projections at 2001 and the company’s internal projections at 2001—but securities laws in most countries limit the projections that companies can publish; in any case, The Body Shop does not provide such projections. My bias, therefore, is to end this class without reference to actual results or company projections, and to focus instead on the concluding points outlined above.


Exhibit TN1


Hypothetical Three-Year Forecast Worksheet Drawing on Case Exhibit 8(in GBP millions)

Fiscal Year Ended February 28 Assumptions

1999 1999 2000 2000 2001 2001(GBP) (% sales) (GBP) (% sales) (GBP) (% sales) 2002–2004 2002 2003 2004

Income Statement

Turnover 303.7 100.0 330.1 100.0 374.1 100.0Cost of sales 127.7 42.0 130.9 39.7 149.0 39.8Gross profit 176.0 58.0 199.2 60.3 225.1 60.2

Operating expenses –excluding exceptional costs 151.4 49.9 166.2 50.3 195.7 52.3 –exceptional costs 4.5 1.5 0.0 0.0 11.2 3.0Restructuring costs 16.6 5.5 2.7 0.8 1.0 0.3Net interest expense 0.1 0.0 1.5 0.5 4.4 1.2Profit before tax 3.4 1.1 28.8 8.7 12.8 3.4Tax expense 8.0 2.6 10.4 3.2 3.5 0.9Profit/(loss) after tax (4.6) (1.5) 18.4 5.6 9.3 2.5

Ordinary dividends 10.9 3.6 10.9 3.3 10.9 2.9Profit/(loss) retained (15.5) (5.1) 7.5 2.3 (1.6) (0.4)

Fiscal Year Ended February 28

1999 1999 2000 2000 2001 2001Balance Sheet (GBP) (% sales) (GBP) (% sales) (GBP) (% sales) 2002 2003 2004

AssetsCash 34.0 11.2 19.2 5.8 13.7 3.7 Accounts receivable 27.8 9.2 30.3 9.2 30.3 8.1Inventories 38.6 12.7 44.7 13.5 51.3 13.7Other current assets 12.5 4.1 15.6 4.7 17.5 4.7Net fixed assets 87.8 28.9 104.7 31.7 110.6 29.6Other assets 0.0 0.0 6.0 1.8 6.7 1.8Total assets 200.7 66.1 220.5 66.8 230.1 61.5

Liabilities and equityAccounts payable 13.0 4.3 20.5 6.2 10.7 2.9Taxes payable 11.3 3.7 11.7 3.5 7.1 1.9Accruals 10.8 3.6 15.6 4.7 11.5 3.1Overdrafts 0.0 0.0 0.3 0.1 0.7 0.2Other current liabilities 21.6 7.1 13.3 4.0 16.9 4.5Long-term liabilities 28.0 9.2 36.7 11.1 61.2 16.4Other liabilities 1.7 0.6 1.0 0.3 0.4 0.1Shareholders' equity 114.3 37.6 121.4 36.8 121.6 32.5Total liabilities and equity 200.7 66.1 220.5 66.8 230.1 61.5

Forecast


Exhibit TN2


Hypothetical Three-Year Forecast Drawing on Case Exhibit 8(in GBP millions)

Fiscal Year Ended February 28 Assumptions Forecast

Income Statement 2002 2003 2004Turnover 303.7 100.0% 330.1 100.0% 374.1 100.0% Growth 13.0% 422.7 477.7 539.8Cost of sales 127.7 42.0% 130.9 39.7% 149.0 39.8% % sales 40.0% 169.1 191.1 215.9Gross profit 176.0 58.0% 199.2 60.3% 225.1 60.2% 253.6 286.6 323.9Operating expenses

–excluding exceptional costs 151.4 49.9% 166.2 50.3% 195.7 52.3% % sales 52.0% 219.8 248.4 280.7–exceptional costs 4.5 1.5% 0.0 0.0% 11.2 3.0% % sales 0.0% 0.0 0.0 0.0

Restructuring costs 16.6 5.5% 2.7 0.8% 1.0 0.3% % sales 0.0% 0.0 0.0 0.0Net interest expense 0.1 0.0% 1.5 0.5% 4.4 1.2% % of debt 6.0% 3.4 4.1 4.8Profit before tax (PBT) 3.4 1.1% 28.8 8.7% 12.8 3.4% 30.4 34.1 38.4Tax expense 8.0 2.6% 10.4 3.2% 3.5 0.9% % of PBT 30.0% 9.1 10.2 11.5

Profit/(loss) after tax (4.6) -1.5% 18.4 5.6% 9.3 2.5% 21.3 23.9 26.9

Ordinary dividends 10.9 3.6% 10.9 3.3% 10.9 2.9% Constant 10.9 10.9 10.9 10.9Profit/(loss) retained (15.5) -5.1% 7.5 2.3% (1.6) -0.4% 10.4 13.0 16.0

Balance SheetCash 34.0 11.2% 19.2 5.8% 13.7 3.7% Plug, min.10mm 4.7 10.0 10.0Accounts receivable 27.8 9.2% 30.3 9.2% 30.3 8.1% % sales 8.0% 33.8 38.2 43.2Inventories 38.6 12.7% 44.7 13.5% 51.3 13.7% % sales 13.7% 57.9 65.4 74.0Other current assets 12.5 4.1% 15.6 4.7% 17.5 4.7% % sales 4.7% 19.9 22.5 25.4Net fixed assets 87.8 28.9% 104.7 31.7% 110.6 29.6% % sales 30.0% 126.8 143.3 161.9Other assets 0.0 0.0% 6.0 1.8% 6.7 1.8% % sales 1.8% 7.6 8.6 9.7

Total assets 200.7 66.1% 220.5 66.8% 230.1 61.5% 250.7 288.0 324.2

Accounts payable 13.0 4.3% 20.5 6.2% 10.7 2.9% % sales 4.0% 16.9 19.1 21.6Taxes payable 11.3 3.7% 11.7 3.5% 7.1 1.9% % sales 2.0% 8.5 9.6 10.8Accruals 10.8 3.6% 15.6 4.7% 11.5 3.1% % sales 3.5% 14.8 16.7 18.9Overdrafts 0.0 0.0% 0.3 0.1% 0.7 0.2% Plug 0.0 16.9 28.6Other current liabilities 21.6 7.1% 13.3 4.0% 16.9 4.5% % sales 4.0% 16.9 19.1 21.6Long-term liabilities 28.0 9.2% 36.7 11.1% 61.2 16.4% Fixed 61.2 61.2 61.2Other liabilities 1.7 0.6% 1.0 0.3% 0.4 0.1% % sales 0.1% 0.4 0.5 0.5Shareholders' equity 114.3 37.6% 121.4 36.8% 121.6 32.5% 132.0 145.0 161.0

Total liabs. & equity 200.7 66.1% 220.5 66.8% 230.1 61.5% 250.7 288.0 324.2

Trial assets 246.0 278.0 314.2 Trial liabs. & equity 250.7 271.2 295.6

Trial plug (4.7) 6.9 18.6Min. cash blance 10.0 10.0 10.0Plug 5.3 16.9 28.6

1999 2000 2001 2002–2004


Exhibit TN3


Sensitivity Analysis of Overdrafts in 2004 according to Variationsin Revenue Growth and COGS/Sales Ratio

(in GBP millions)

10% 11% 12% 13% 14% 15%35% 0.0 0.0 0.0 0.0 0.0 0.036% 0.0 0.0 0.0 0.0 0.0 0.037% 0.0 0.0 0.0 0.0 0.0 0.038% 0.0 0.0 0.0 0.0 11.7 16.739% 0.0 0.0 12.5 17.6 22.8 28.140% 13.0 18.1 23.3 28.6 34.0 39.441% 23.4 28.7 34.1 39.5 45.1 50.842% 33.8 39.2 44.8 50.5 56.3 62.243% 44.1 49.8 55.6 61.4 67.4 73.544% 54.5 60.4 66.3 72.4 78.6 84.945% 64.9 70.9 77.1 83.3 89.7 96.246% 75.2 81.5 87.8 94.3 100.9 107.647% 85.6 92.0 98.6 105.3 112.0 118.948% 96.0 102.6 109.3 116.2 123.2 130.3

CO

GS

to

Sal

es R

atio

Growth Rate in Revenues

Note: bolded value is given in the base case of Exhibit TN2.

TN8 the Body Shop International PLC 2001

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