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Financial analysis

The process of evaluating businesses, projects, budgets and other finance-related entities
to determine their suitability for investment.Typically, financial analysis is used to analyze
whether an entity is stable, solvent, liquid, or profitable enough to be invested in. When looking
at a specific company, the financial analyst will often focus on the income statement, balance
sheet, and cash flow statement. In addition, one key area of financial analysis involves
extrapolating the company's past performance into an estimate of the company's future
performance.

One of the most common ways of analyzing financial data is to calculate ratios from the
data to compare against those of other companies or against the company's own historical
performance. For example, return on assets is a common ratio used to determine how efficient a
company is at using its assets and as a measure of profitability. This ratio could be calculated for
several similar companies and compared as part of a larger analysis.

Financial Analysis: Tools and Techniques

Analysis, as defined by Webster, is “a consideration of anything in its separate parts and


their relation to each other”. The relationships arrived at are interpreted by determining their
significance.

Financial analysis refers to examination of financial data of an entity to determine its


probability, growth, solvency, stability and effectiveness of its management. Relationships
between financial data are interpreted and their significances are used as guide in the decision
making process. Different tools and techniques are used in financial analysis depending on
whether it is undertaken for short-term or for long-term decision making. The methods used for
short-term decisions do not consider the time value of money; for long-term decisions, the time
value of money is considered.

Analysis of financial statements

Financial statement analysis is defined as the process of identifying financial strengths and
weaknesses of the firm by properly establishing relationship between the items of the balance
sheet and the profit and loss account.
There are various methods or techniques that are used in analyzing financial statements, such as
comparative statements, schedule of changes in working capital, common size percentages, funds
analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision
making purposes. They play a dominant role in setting the framework of managerial decisions.
But the information provided in the financial statements is not an end in itself as no meaningful
conclusions can be drawn from these statements alone. However, the information provided in the
financial statements is of immense use in making decisions through analysis and interpretation of
financial statements.

1.Horizontal Analysis or Trend Analysis- a procedure in fundamental analysis in which an


analyst compares ratios or line items in a company's financial statements over a certain period of
time. The analyst will use his or her discretion when choosing a particular timeline; however, the
decision is often based on the investing time horizon under consideration. It is the comparison of
two or more year's financial data.

Example of Horizontal or Trend Analysis:

Balance Sheet:

Comparative Balance Sheet


December 31, 2002, and 2001
(dollars in thousands)
Increase (Decrease)
2002 2001 Amount Percent
Assets
Current Assets:
Cash $1,200 $2,350 $(1,150)* (48.9)%
Accounts receivable 6,000 4,000 2000 50%
Inventory 8,000 10,000 (2000) (20.0)%
Prepaid Expenses 300 120 180 150.0%
---------- ----------- ---------- ----------
Total current assets $15,500 $16,470 (970) (5.9)%
----------- ----------- ---------- ---------
Property and equipment:
Land 4,000 4,000 0 0%
Building 12,000 8,500 3,500 41.2%
----------- ----------- ----------
Total property and equipment 16,000 12,500 3,500 28%
---------- ----------- ---------- ---------
Total assets 31,500 28,970 2,530 8.7%
====== ====== ====== ======
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payables $5,800 $4,000 1800 45%
Accrued payables 900 400 500 125%
Notes payables 300 600 (300) (50%)
---------- ---------- ----------- ---------
Total current liabilities 7,000 5,000 2,000 40%
---------- ---------- ---------- -----------
Long term liabilities:
Bonds payable 8% 7,500 8,000 (500) (6.3)%
---------- ---------- ---------- ----------
Total long term liabilities 7,500 8,000 (500) 6.3%
---------- ---------- ---------- ----------
Total Liabilities $14,500 13,000 1,500 (11.5)%
Stock holders equity:
Preferred stock, 100 par, 6%, $100 liquidation value $2,000 $2,000 0 0%
Common stock, $12 par 6,000 6,000 0 0%
Additional paid in capital 1,000 1,000 0 0%
---------- ---------- --------- --------
Total paid in capital 9,000 9,000 0 0%
Retained earnings 8,000 6,970 1,030 14.8%
---------- ---------- ---------- ----------
Total stockholders' equity 17,000 15,970 1,030 6.4%
---------- ---------- ---------- ---------
Total liabilities and stockholders' equity $31,500 $28,970 $2,530 8.7%
===== ====== ====== ======

*Since we are measuring the change between 2001 and 2002, the dollar amounts for 2001
become the base figure for expressing these changes in percentage form. For example, cash
decreased by figures $1,150 between 2001 and 2002. This decrease expressed in percentage form
is computed as follows:

[$1,150 ÷ $2,350 = 48.9%]

Horizontal analysis of financial statements can also be carried out by computing trend
percentages. Trend percentage states several years' financial data in terms of a base year. The
base year equals 100%, with all other years stated in some percentage of this base.
2.Vertical analysis is the procedure of preparing and presenting common size
statements. Common size statement is one that shows the items appearing on it in percentage
form as well as in dollar form.

Each item is stated as a percentage of some total of which that item is a part. Key financial
changes and trends can be highlighted by the use of common size statements.

Common size statements are particularly useful when comparing data from different
companies. For example, in one year, Wendy's net income was about $110 million,
whereas McDonald's was $1,427 million. This comparison is somewhat misleading because of
the dramatically different size of the two companies. To put this in better perspective, the net
income figures can be expressed as a percentage of the sales revenues of each company,
Since Wendy's sales revenue were $1,746 million and McDonald's were $9,794
million, Wendy's net income as a percentage of sales was about 6.3% and McDonald's was about
14.6%.

Example:

Balance Sheet:

One application of the vertical analysis idea is to state the separate assets of a company as
percentages of total sales. A common type statement of an electronic company is shown below:

Common Size Comparative Balance Sheet


December 31, 2002, and 2001
(dollars in thousands)
Common-Size Percentages
2002 2001 2002 2001
Assets
Current assets:
Cash $ 1,200 $ 2,350 3.8% 8.1%
Accounts receivable, net 6,000 4,000 19.0% 13.8%
Inventory 8,000 10,000 25.4% 34.5%
Prepaid expenses 300 120 1.0% 0.4%
------------ ------------ ----------- ------------
Total current assets 15,500 16,470 49.2% 56.9%
------------ ------------ ------------ ------------
Property and equipment:
Land 4,000 4,000 12.7% 13.8%
Building and equipment 12,000 8,5000 38.1% 29.3%
------------ ------------ ------------ ------------
Total property and equipment 16,000 12,500 50.8% 43.1%
------------ ------------ ------------ ------------
Total assets $ 31,500 $ 28,970 100.0% 100.0%
====== ====== ====== ======
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 5,800 $ 4,000 18.4% 13.8%
Accrued payable 900 400 2.9% 1.4%
Notes payable, short term 300 600 1.0% 2.1%
------------ ------------ ------------ ------------
Total current liabilities 7,000 5,000 22.2% 17.3%
------------ ------------ ------------ ------------
Long term liabilities:
Bonds payable, 8% 7,500 8,000 23.8% 27.6%
------------ ------------ ------------ ------------
Total liabilities 14,500 13,000 46.0% 44.9%
------------ ------------ ------------ ------------
Stockholders' equity:
Preferred stock, $100, 6%, $100 liquidation value 2,000 2,000 6.3% 6.9%
Common stock, $12 par 6,000 6,000 19.0% 20.7%
Additional paid in capital 1,000 1,000 3.2% 3.5%
------------ ------------ ------------ ------------
Total paid in capital 9,000 9,000 28.6% 31.1%
Retained earnings 8,000 6,970 25.4% 24.1%
------------ ------------ ------------ ------------
Total stockholders equity 17,000 15,970 54.0% 55.1%
------------ ------------ ------------ ------------
$ 31,500 $ 28,970 100.0% 100.%
====== ====== ====== ======

*Each asset in common size statement is expressed in terms of total assets, and each liability and
equity account is expressed in terms of total liabilities and stockholders' equity. For example, the
percentage figure above for cash in 2002 is computed as follows:

[$1,200 / $31,500 = 3.8%]


Notice from the above example that placing all assets in common size form clearly shows the
relative importance of the current assets as compared to the non-current assets. It also shows that
the significant changes have taken place in the composition of the current assets over the last
year. Notice, for example, that the receivables have increased in relative importance and that
both cash and inventory have declined in relative importance. Judging from the sharp increase in
receivables, the deterioration in cash position may be a result of inability to collect from
customers.

The main advantages of analyzing a balance sheet in this manner is that the balance sheets of
businesses of all sizes can easily be compared. It also makes it easy to see relative annual
changes in one business.

Income Statement:

Another application of the vertical analysis idea is to place all items on the income statement in
percentage form in terms of sales. A common size statement of this type of an electronics
company is shown below:

Common-Size Comparative income statement


For the year ended December 31, 2002, and 2001
(dollars in thousands)
Common-Size Percentage
2002 2001 2002 2001
Sales $52,000 $48,000 100.0% 100.0%
Cost of goods sold 36,000 31,500 69.2% 65.6%
------------ ------------ ------------ ------------
Gross margin 16,000 16,500 30.8% 34.4%
------------ ------------ ------------ ------------
Operating expenses:
Selling expenses 7,000 6,500 13.5% 13.5%
Administrative expense 5,860 6,100 11.3% 12.7%
------------ ------------ ------------ ------------
Total operating expenses 12,860 12,600 24.7% 26.2%
------------ ------------ ------------ ------------
Net operating income 3,140 3,900 6% 8.1%
Interest expense 640 700 1.2% 1.5%
------------ ------------ ------------ ------------
Net income before taxes 2,500 3,200 4.8% 6.7%
Income tax (30%) 750 960 1.4% 2.0%
------------ ------------ ------------ ------------
Net income $ 1,750 $2,240 3.4% 4.7%
====== ====== ====== ======

*Note that the percentage figures for each year are expressed in terms of total sales for the year.
For example, the percentage figure for cost of goods sold in 2002 is computed as follows:
[($36,000 / $52,000) × 100 = 69.2%]

By placing all items on the income statement in common size in terms of sales, it is possible to
see at a glance how each dollar of sales is distributed among the various costs, expenses, and
profits. And by placing successive years' statements side by side, it is easy to spot interesting
trends. For example, as shown above, the cost of goods sold as a percentage of sales increased
from 65.6% in 2001 to 69.2% in 2002. Or looking at this form a different view point , the gross
margin percentage declined from 34.4% in 2001 to 30.8% in 2002. Managers and investment
analysis often pay close attention to the gross margin percentage since it is considered a broad
gauge of profitability. The gross margin percentage is computed by the following formula:

Gross margin percentage = Gross margin / Sales

The gross margin percentage tends to be more stable for retailing companies than for other
service companies and for manufacturers. Since the cost of goods sold in retailing exclude fixed
costs. When fixed costs are included in the cost of goods sold figure, the gross margin percentage
tends to increase of decrease with sales volume. The fixed costs are spread across more units and
the gross margin percentage improves.

While a higher gross margin percentage is considered to be better than a lower gross margin
percentage, there are exceptions. Some companies purposely choose a strategy emphasizing low
prices and (hence low gross margin). An increasing gross margin in such a company might be a
sign that the company's strategy is not being effectively implemented.

Common size statements are also very helpful in pointing out efficiencies and inefficiencies that
might other wise go unnoticed. To illustrate, selling expenses, in the above example of
electronics company, increased by $500,000 over 2001. A glance at the common-size income
statement shows, however, that on a relative basis, selling expenses was no higher in 2002 than
in 2001. In each year they represented 13.5% of sales.

3. Financial ratios- are useful indicators of a firm's performance and financial situation. Most
ratios can be calculated from information provided by the financial statements. Financial ratios
can be used to analyze trends and to compare the firm's financials to those of other firms. In
some cases, ratio analysis can predict future bankruptcy.

Financial ratios can be classified according to the information they provide. The following types
of ratios frequently are used:

● LIQUIDITY RATIOS

Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the firm. Two
frequently-used liquidity ratios are the current ratio (orworking capital ratio) and the quick ratio.

Current ratio may be defined as the relationship between current assets and current liabilities.
This ratio is also known as "working capital ratio". It is a measure of general liquidity and is
most widely used to make the analysis for short term financial position or liquidity of a firm. It is
calculated by dividing the total of the current assets by total of the current liabilities. This ratio is
a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion
available to the creditors. It is an index of the firms financial stability. It is also an index of
technical solvency and an index of the strength of working capital.

[Current ratio= current assets/ current liabilities]

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may
prefer a lower current ratio so that more of the firm's assets are working to grow the business.
Typical values for the current ratio vary by firm and industry. For example, firms in cyclical
industries may maintain a higher current ratio in order to remain solvent during downturns.

One drawback of the current ratio is that inventory may include many items that are difficult to
liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative
measure of liquidity that does not include inventory in the current assets. The quick ratio is
defined as follows:

[Quick ratio= (current asset- inventory) / current liabilities]

The current assets used in the quick ratio are cash, accounts receivable, and notes receivable.
These assets essentially are current assets less inventory. The quick ratio often is referred to as
the acid test.

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets
except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:

[Cash ratio=( cash + marketable securities) / current liabilities]

The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some
reason immediate payment were demanded.

● ACTIVITY RATIOS

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are
referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two
commonly used asset turnover ratios are receivables turnover and inventory turnover.

Receivables turnover is an indication of how quickly the firm collects its accounts receivables
and is defined as follows:

[Receivables turnover= annual credit sales/ account receivables]

The receivables turnover often is reported in terms of the number of days that credit sales remain
in accounts receivable before they are collected. This number is known as the collection period.
It is the accounts receivable balance divided by the average daily credit sales, calculated as
follows:

[Average collection period= account receivables/ (annual credit sales/ 365)]


The collection period also can be written as:

[Average collection period= 365/ receivable turnover]

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time
period divided by the average inventory level during that period:

[Inventory turnover= cost of goods sold/ average inventory]

The inventory turnover often is reported as the inventory period, which is the number of days
worth of inventory on hand, calculated by dividing the inventory by the average daily cost of
goods sold:

[Inventory period= average inventory/( annual cost of good sold/ 365)]

The inventory period also can be written as:

[Inventory period= 365/ inventory turnover]

Other asset turnover ratios include fixed asset turnover and total asset turnover.

Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio measures the
efficiency and profit earning capacity of the concern. Higher the ratio, greater is the intensive
utilization of fixed assets. Lower ratio means under-utilization of fixed assets.

Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Assets

Working capital turnover ratio indicates the velocity of the utilization of net working capital.
The working capital turnover ratio measure the efficiency with which the working capital is
being used by a firm. A high ratio indicates efficient utilization of working capital and a low
ratio indicates otherwise. But a very high working capital turnover ratio may also mean lack of
sufficient working capital which is not a good situation.

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital]


● FINANCIAL LEVERAGE RATIOS

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios
measure the extent to which the firm is using long term debt.

The debt ratio is defined as total debt divided by total assets:

[Debt ratio= total debt/ total assets]

The debt-to-equity ratio is total debt divided by total equity:

[Debt-to-equity= total debt/ total equity]

Debt ratios depend on the classification of long-term leases and on the classification of some
items as long-term debt or equity.

The times interest earned ratio indicates how well the firm's earnings can cover the interest
payments on its debt. This ratio also is known as the interest coverage and is calculated as
follows:

[Interest coverage= EBIT/ interest changes]

where EBIT = Earnings Before Interest and Taxes

● PROFITABILTY RATIOS

Profitability ratios measure the results of business operations or overall performance and
effectiveness of the firm. It offer several different measures of the success of the firm at
generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin
considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:
[Gross profit margin= (sales- cost of goods sold)/ sales]

Return on assets is a measure of how effectively the firm's assets are being used to generate
profits. It is defined as:

[Return on assets= net income/ total assets]

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for
each dollar invested in the firm's stock. Return on equity is defined as follows:

[Return on equity= net income/ shareholder equity]

Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as percentage. NP
ratio is used to measure the overall profitability and hence it is very useful to proprietors. The
ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a
satisfactory return on its investment. This ratio also indicates the firm's capacity to face adverse
economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the
better is the profitability. But while interpreting the ratio it should be kept in mind that the
performance of profits also be seen in relation to investments or capital of the firm and not only
in relation to sales.

[Net Profit Ratio = (net profit / net sales) × 100]

Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is
generally expressed in percentage. Operating ratio shows the operational efficiency of the
business. Lower operating ratio shows higher operating profit and vice versa. An operating ratio
ranging between 75% and 80% is generally considered as standard for manufacturing concerns.
This ratio is considered to be a yardstick of operating efficiency but it should be used cautiously
because it may be affected by a number of uncontrollable factors beyond the control of the firm.
Moreover, in some firms, non-operating expenses from a substantial part of the total expenses
and in such cases operating ratio may give misleading results.
Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100

Expense ratios indicate the relationship of various expenses to net sales. The operating
ratio reveals the average total variations in expenses. But some of the expenses may be
increasing while some may be falling. Hence, expense ratios are calculated by dividing each item
of expenses or group of expense with the net sales to analyze the cause of variation of the
operating ratio.

[Particular Expense = (Particular expense / Net sales) × 100 ]

Return on Equity Capital (ROEC) Ratio. In real sense, ordinary shareholders are the real
owners of the company. They assume the highest risk in the company. (Preference
share holders have a preference over ordinary shareholders in the payment of dividend
as well as capital. Preference share holders get a fixed rate of dividend irrespective of
the quantum of profits of the company). The rate of dividends varies with the
availability of profits in case of ordinary shares only. Thus ordinary shareholders are
more interested in the profitability of a company and the performance of a company
should be judged on the basis of return on equity capital of the company. Return on
equity capital which is the relationship between profits of a company and its equity.

Return on Equity Capital = [(Net profit after tax − Preference dividend) / Equity share capital] ×
100

Dividend yield ratio is the relationship between dividends per share and the market value of the
shares. Share holders are real owners of a company and they are interested in real sense in the
earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is calculated to
evaluate the relationship between dividends per share paid and the market value of the shares.
This ratio helps as intending investor is knowing the effective return he is going to get on the
proposed investment.

[Dividend Yield Ratio = Dividend Per Share / Market Value Per Share]
Earnings per share ratio (EPS Ratio) is a small variation of return on equity capital ratio and is
calculated by dividing the net profit after taxes and preference dividend by the total number of
equity shares. The earnings per share is a good measure of profitability and when compared with
EPS of similar companies, it gives a view of the comparative earnings or earnings power of the
firm. EPS ratio calculated for a number of years indicates whether or not the earning power of
the company has increased.

[Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) / No. of equity
shares (common shares)]

● DIVIDEND POLICY RATIOS

Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for
future growth. Two commonly used ratios are the dividend yield and payout ratio.

The dividend yield is defined as follows:

[Dividend yield= dividends per share/ share price]

A high dividend yield does not necessarily translate into a high future rate of return. It is
important to consider the prospects for continuing and increasing the dividend in the future. The
dividend payout ratio is helpful in this regard, and is defined as follows:

[Payout ratio= dividend per share/ earning per share]

Advantages of Ratios Analysis:

Ratio analysis is an important and age-old technique of financial analysis. The following are
some of the advantages / Benefits of ratio analysis:

1. Simplifies financial statements: It simplifies the comprehension of financial statements.


Ratios tell the whole story of changes in the financial condition of the business
2. Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios
highlight the factors associated with with successful and unsuccessful firm. They also
reveal strong firms and weak firms, overvalued and undervalued firms.
3. Helps in planning: It helps in planning and forecasting. Ratios can assist management, in
its basic functions of forecasting. Planning, co-ordination, control and communications.
4. Makes inter-firm comparison possible: Ratios analysis also makes possible comparison
of the performance of different divisions of the firm. The ratios are helpful in deciding
about their efficiency or otherwise in the past and likely performance in the future.
5. Help in investment decisions: It helps in investment decisions in the case of investors and
lending decisions in the case of bankers etc.

Limitations of Ratios Analysis:

The ratios analysis is one of the most powerful tools of financial management. Though ratios are
simple to calculate and easy to understand, they suffer from serious limitations.

1. Limitations of financial statements: Ratios are based only on the information which has
been recorded in the financial statements. Financial statements themselves are subject to
several limitations. Thus ratios derived, there from, are also subject to those limitations.
For example, non-financial changes though important for the business are not relevant by
the financial statements. Financial statements are affected to a very great extent by
accounting conventions and concepts. Personal judgment plays a great part in
determining the figures for financial statements.
2. Comparative study required: Ratios are useful in judging the efficiency of the business
only when they are compared with past results of the business. However, such a
comparison only provide glimpse of the past performance and forecasts for future may
not prove correct since several other factors like market conditions, management policies,
etc. may affect the future operations.
3. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as final
regarding good or bad financial position of the business. Other things have also to be
seen.
4. Problems of price level changes: A change in price level can affect the validity of ratios
calculated for different time periods. In such a case the ratio analysis may not clearly
indicate the trend in solvency and profitability of the company. The financial statements,
therefore, be adjusted keeping in view the price level changes if a meaningful comparison
is to be made through accounting ratios.
5. Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There are
no well accepted standards or rule of thumb for all ratios which can be accepted as norm.
It renders interpretation of the ratios difficult.
6. Limited use of single ratios: A single ratio, usually, does not convey much of a sense. To
make a better interpretation, a number of ratios have to be calculated which is likely to
confuse the analyst than help him in making any good decision.
7. Personal bias: Ratios are only means of financial analysis and not an end in itself. Ratios
have to interpreted and different people may interpret the same ratio in different way.
8. Incomparable: Not only industries differ in their nature, but also the firms of the similar
business widely differ in their size and accounting procedures etc. It makes comparison
of ratios difficult and misleading.

Financial Forecasting describes the process by which firms think about and prepare for the
future. The forecasting process provides the means for a firm to express its goals and priorities
and to ensure that they are internally consistent. It also assists the firm in identifying the asset
requirements and needs for external financing.

For example, the principal driver of the forecasting process is generally the sales forecast. Since
most Balance Sheet and Income Statement accounts are related to sales, the forecasting process
can help the firm assess the increase in Current and Fixed Assets which will be needed to support
the forecasted sales level. Similarly, the external financing which will be needed to pay for the
forecasted increase in assets can be determined.
Firms also have goals related to Capital Structure (the mix of debt and equity used to finance the
firms assets), Dividend Policy, and Working Capital Management. Therefore, the forecasting
process allows the firm to determine if its forecasted sales growth rate is consistent with its
desired Capital Structure and Dividend Policy.

The basic steps in financial forecasting are: (1) project the firm's sales; (2) project variables such
as expenses and assets; (3) estimate the level of investment in current and fixed assets that is
required to support the projected sales; and (4) calculate the firm's financing needs. The basic
tools for financial forecasting include the percent-of-sales-method, regression analysis, and
financial modeling.

Conducting financial forecasting


Proper financial forecasting relies on methods and tools that bring rigor to the forecasting
process. Oversimplifying the forecasting process can create forecasts that ignore business cycles
and lead to missed investor expectations, excess inventory buildup, and overstaffing. Financial
analysts need processes and tools that help them provide management with forecasts in which
management can have confidence.

CONCEPTS:

Percentage of Sales Method

The Percentage of Sales Method is a Financial Forecasting approach which is based on the
premise that most Balance Sheet and Income Statement Accounts vary with sales. Therefore, the
key driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial
Statements (i.e., forecasted) can be constructed and the firms needs for external financing can be
identified. The calculations illustrated on this page will refer to the Balance Sheet and Income
Statement which follow. The forecasted Sales growth rate in this example is 25%

Balance Sheet ($ in Millions) Income Statement ($ in Millions)


Assets 1999 Liabilities and 1999 1999
Owners' Equity Sales 1200
Current Assets Current Liabilities Cost of Goods Sold 900
Cash 200 Accounts Payable 400 Taxable Income 300
Accounts Receivable 400 Notes Payable 400 Taxes 90
Inventory 600 Total Current 800 Net Income 210
Liabilities Dividends 70
Total Current Assets 1200 Long-Term Addition to Retained
140
Liabilities Earnings
Long-Term Debt 500
Fixed Assets Total Long-Term 500
Liabilities
Net Fixed Assests 800 Owners' Equity
Common Stock ($1 300
Par)
Retained Earnings 400
Total Owners' Equity 700
Total Assets 2000 Total Liab. and 2000
Owners' Equity

Percentages of Sales

The first step is to express the Balance Sheet and Income Statement accounts which vary directly
with Sales as percentages of Sales. This is done by dividing the balance for these accounts for the
current year (1999) by sales revenue for the current year.

The Balance Sheet accounts which generally vary closely with Sales are Cash, Accounts
Receivable, Inventory, and Accounts Payable. Fixed Assets are also often tied closely to Sales,
unless there is excess capacity. (The issue of excess capacity will be addressed in External
Financing Needed section.) For this example, we will assume that Fixed Assets are currently at
full capacity and, thus, will vary directly will sales.

Retained Earnings on the Balance Sheet represent the cumulative total of the firm's earnings
which have been reinvested in the firm. Thus, the change in this account is linked to Sales;
however, the link comes from relationship between Sales growth and Earnings

The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automatically
with Sales. The changes in these accounts depend upon how the firm chooses to raise the funds
needed to support the forecasted growth in Sales.
On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assuming
that all costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentage
of Sales. This indicates the Profit Margin.

Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividends
and Addition to Retained Earnings are expressed as a percentage of Net Income to determine the
Payout and Retention Ratios respectively.

Percentage of Sales Calculations


The examples in this box illustrate the calculations which were used to determine the percentages
provided in the following Balance Sheet and Income Statement.

Cash Cash/Sales = $200/$1200 = .1667 = 16.67%


Inventory Inventory/Sales = $600/$1200 = .5 = 50%
Accounts Payable (Accounts Payable)/Sales = $400/$1200 = .3333 = 33.33%
Costs Costs/Sales = $900/$1200 = .75 = 75%
Taxes Taxes/(Taxable Income) = $90/$300 = .3 = 30%
Net Income (Net Income)/Sales = $210/$1200 = .175 = 17.5%
Dividends/(Net Income) = $70/$210 = .3333 =
Dividends 33.33%

Balance Sheet ($ in Millions) Income Statement ($ in


Assets 1999 % Liabilities and 1999 % Millions)
Owners' 1999 %
Equity Sales 1200
Current Assets Current Cost of Goods
900 75%
Liabilities Sold
Cash 200 16.67% Accounts 400 33.33% Taxable Income 300 25%
Payable Taxes 90 30%*
Accounts 400 33.33% Notes Payable 400 N/A Net Income 210 17.5%
Receivable Dividends 70 33.33%*
Inventory 600 50.00% Total Current 800 Addition to
Liabilities Retained 140 66.67%*
Total Current 1200 Long-Term Earnings
Assets Liabilities
Long-Term 500 N/A
Debt
Fixed Assets Total Long- 500
Term
Liabilities
Net Fixed 800 66.67% Owners'
Assets Equity
Common Stock 300 N/A
($1 Par)
Retained 400 N/A*
Earnings
Total Owners' 700
Equity
Total Assets 2000 Total Liab. 2000
and Owners'
Equity

Partial Pro-Forma

The next step is to construct the Partial Pro-forma Financial Statements. First, determine the
forecasted Sales level. This is done my multiplying Sales for the current year (1999) by one plus
the forecasted growth rate in Sales.

S1= S0 (1 + g) = $1200(1 + .25) = $1500

Where

• S1 = the forecasted Sales level,


• S0 = the current Sales level, and
• g = the forecasted growth rate in Sales.

Once the forecasts Sales level has been determined, the Balance Sheet and Income Statement
accounts which vary directly with Sales can be determined by multiplying the percentages by the
Sales forecast. The accounts which do not vary directly with Sales are simply transferred to the
Partial Pro-Forma Financial Statements at their current levels.

Retained Earnings on the Balance Sheet are the one item whose amount is determined using a
slightly different procedure. The Partial Pro-Forma balance for Retained Earnings equals
Retained Earnings in the current year plus the forecasted Addition to Retained Earnings from the
Partial Pro-Forma Income Statement. The balances for summary accounts, such as Total Current
Assets and Total Current Liabilities, are determined by summing their constituent accounts.

Partial Pro-Forma Calculations


The examples in this box illustrate the calculations which were used to derive the following
Partial Pro-Forma Balance Sheet and Income Statement.

Cash (Cash%)(Sales Forecast) = (16.67%)($1500) = $250


Inventory (Inventory%)(Sales Forecast) = 50%($1500) = $750
Costs (Costs%)(Sales Forecast) = 75%(1500) = $1200
Addition to (Addition to Retained Earnings%)(Net Income Forecast) = 66.67%($262.5)
Retained = $175
Earnings
Retained Retained Earnings + Addition to Retained Earnings Forecast =
Earnings $400 + $175
(Balance Sheet)

Balance Sheet ($ in Millions) Income Statement ($ in


Assets 1999 2000 Liabilities and 1999 2000 Millions)
Owners' Equity 1999 2000
Current Assets Current Sales 1200 1500
Liabilities Cost of Goods Sold 900 1125
Cash 200 250 Accounts 400 500 Taxable Income 300 375
Payable Taxes 90 112.5
Accounts 400 500 Notes Payable 400 400 Net Income 210 262.5
Receivable Dividends 70 87.5
Inventory 600 750 Total Current 800 900 Addition to
140 175
Liabilities Retained Earnings
Total Current 1200 1500 Long-Term
Assets Liabilities
Long-Term Debt 500 500
Fixed Assets Total Long-Term 500 500
Liabilities
Net Fixed Assets 800 1000 Owners' Equity
Common Stock 300 300
($1 Par)
Retained 400 575
Earnings
Total Owners' 700 875
Equity
Total Assets 2000 2500 Total Liab. and 2000 2275
Owners' Equity

External Financing Needed (EFN)

The External Financing Needed (EFN) can be determined from the Partial Pro-Forma Balance
Sheet. It is simply equal to the difference between Partial Pro-Forma Total Assets and Partial
Pro-Forma Total Liabilities and Owners' Equity.

EFN = $2500 - $2275 = $225

Please note that the External Financing needed section explores the calculation of EFN when
there is excess capacity.

Pro-Forma Financial Statements

The final step is to determine how the EFN is to be raised. Firms can choose to raise the EFN by
borrowing on short-term basis (Notes Payable), borrowing on a long-term basis (Long-Term
Debt), issuing equity (Common Stock), or some combination of the above. The chosen method is
called the Plug.

In this example we shall assume that the EFN is to be raised through long-term borrowing. Thus
the plug is Long-Term Debt. To determine the Pro-Forma Financial Statements simply increase
Long-Term Debt by the EFN of $225 determined in the previous step.

Balance Sheet ($ in Millions) Income Statement ($ in


Assets 1999 2000 Liabilities and 1999 2000 Millions)
Owners' Equity 1999 2000
Current Assets Current Sales 1200 1500
Liabilities Cost of Goods Sold 900 1125
Cash 200 250 Accounts 400 500 Taxable Income 300 375
Payable Taxes 90 112.5
Accounts 400 500 Notes Payable 400 400 Net Income 210 262.5
Receivable Dividends 70 87.5
Inventory 600 750 Total Current 800 900 Addition to
140 175
Liabilities Retained Earnings
Total Current 1200 1500 Long-Term
Assets Liabilities
Long-Term Debt 500 500
Fixed Assets Total Long-Term 725 725
Liabilities
Net Fixed Assets 800 1000 Owners' Equity
Common Stock 300 300
($1 Par)
Retained 400 575
Earnings
Total Owners' 700 875
Equity
Total Assets 2000 2500 Total Liab. and 2000 2500
Owners' Equity

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