Financial-Statement-Analysis Forecasting

Financial statements are formal records that provide a summary of a company's financial performance and position over a specific period. The primary types include the income statement, balance sheet, and cash flow statement. The income statement details revenues and expenses, revealing profitability, while the balance sheet presents a snapshot of assets, liabilities, and equity at a given time, indicating financial stability. The cash flow statement tracks the flow of cash in and out of the business, highlighting operational efficiency. Together, these statements offer stakeholders—such as investors, creditors, and management—essential insights for decision-making and assessing the company's overall health.

1. FINANCIAL STATEMENT ANALYSIS &
FORECASTING
Financial Statement:
Financial statements are principal means through which
financial information is communicated to those outside an
enterprise. These statements provides the company’s history
quantified in money term.
The financial statements most frequently provided are –
(a)The Balance Sheet
(b)The Income Statement
(c)The Statement of Cash Flows
(d)The Statement of Retained Earnings.

2. The Balance Sheet:
The balance sheet, sometimes referred to as the statement of
financial position, reports the assets, liabilities, and
stockholders’ equity of a business enterprise at a specific date.
This financial statement provides information about the nature
and amounts of investments in enterprise resources,
obligations to creditors, and the owners’ equity in net
resources. It therefore help in predicting the amount, timing,
and uncertainty of future cash flows.
Income Statement:
The income statement, often called the statement of income or
earnings, is the report that measure the success of enterprise
operation for a given period of time. It provides investors and
creditors with information that helps them predict the amounts,
timing, and uncertainty of future cash flows.

3. Statement of Cash Flows:
The statement of cash flows is a summary of the cash flows over
the period of concern. The statement provides insight into the
firm’s operating, investing, and financing cash flows and
reconciles them with changes in its cash and marketable
securities during the period.
Statement of Retained Earnings:
A statement reporting the change in the firm’s retained earnings
as a result of the income generated and retained during the year.
The balance sheet figure for retained earnings is the sum of the
earnings retained for each year the firm has in business.
Annual Report:
A report issued annually by a corporation to its stockholders,
which contains basic financial statements, as well as
management’s opinion of the past year’s operations and the
firm’s future prospects.

4. Financial Statement Analysis:
The process of comparing relationships among financial
statement items in order to evaluate a firm’s financial position
and operating performance is called financial statement
analysis. This analysis is often performed by individuals
Outside the firm to assist them in making credit and
Investment decisions. However, management also uses
financial statement analysis internally so that it can learn the
financial strengths and weaknesses of the firm.

5. Objectives of Financial Statement Analysis:
1. To provide analytical information to all interested parties.
2. To justify and analyse the earning capacity of the firm
3. To justify and analyse the financial position of the firm
4. To evaluate operations of the firm.
5. To evaluate progress of the business of the firm
6. To utilize resources properly and effectively
7. To analyze and evaluate management efficiency.
Standards of comparison:
1. Historical
2. Current/Budgeted
3. Selected firms
4. Industry average

6. Methods/Techniques of Financial Statement Analysis:
1. Common-size or Vertical Analysis –
The financial statement analysis in which the total asset
figure, total liability and equity figure and revenues are
considered as hundred percentage and the percentage of all
other individual item is determined with respect to that
hundred percentage is called common-size or vertical
statement analysis.
2. Horizontal analysis –
The financial statement analysis under which the amount and
percentage change of current year with respect to base year
are determined for all individual items is called horizontal
analysis. This analysis is performed generally in case of
multiple years’ financial statements.

7. 3. Trend percentage analysis –
The financial statement analysis under which the percentage of
all years of all individual items are determined with respect to
base year in case of multiple years’ financial statements is
called trend percentage analysis.
4. Ratio analysis –
The financial statement analysis in which the numerical
relationship between two financial figures of a financial
statement is determined is called ratio analysis. In financial
statement analysis, a number of ratios are commonly used in
assessing the financial position and operating performance of
the firm.

8. 5. Statement in changes in financial position (Cash flow
statement and funds flow statement) –
The external financial statement that shows where working
capital, cash flow and funds flow came from and how these
were used during the period is known as statement of changes
in financial position. The statement explains changes in the
noncurrent items of the balance sheet. It is used by
management and financial analysts to better understand the
firm’s overall position.

9. Ratio Analysis:
Liquidity Ratios:
Ratios that shows the relationship of a firm’s cash and other
current assets to its current liabilities.
1. Current Ratio = Current assets / Current liabilities [: or times or X form]
Purpose/Use: Measure the short-term debt paying ability
2. Quick asset or Acid test ratio = Quick assets / Current
liabilities [: or times or X form]
Purpose/Use: Measure immediate short-term debt paying
ability

10. Asset Management Ratios:
A set of ratios that measures how effectively a firm is managing
its assets.
1.Inventory turnover ratio = Cost of goods sold or Sales
revenue / Average inventory [times or X form]
Purpose/Use: Measures liquidity of inventory.
2. Average collection period or Days sales outstanding =
Receivables / Average sales per Day [Days]
Purpose/Use: Measures the average collection period.
3. Assets turnover ratio: Net Sales / Average Total Assets [times
or X form]
Purpose/Use: Measures how efficiently assets are used to
generate sales

11. Debt Management Ratios:
A set of ratios that measures how effectively a firm is managing
its debt.
1.Debt ratio = Total debt / Total assets [%]
Purpose/Use: Measures the percentage of total assets
provided by creditors.
2.Interest coverage ratio or Times interest earned =
Operating income (EBIT) / Interest expense [times or X form]
Purpose/Use: Measures ability to meet interest payments as
they came due.

12. Profitability Ratios:
A group of ratios showing the effect of liquidity, asset
management, and debt management on operating results.
1.Net profit margin = Net profit / Sales revenue [%]
Purpose/Use: Measures net income generate by each
dollar of sales
2.Return on assets (ROA) = Net income / Total assets [%]
Purpose/Use: Measures overall profitability of asset
3.Return on equity (ROE) = Net income available for
common stockholders’ / Common equity [%]
Purpose/Use: Measures profitability of owners’ investment

13. Market Value Ratios:
A set of ratios that relate the firm’s stock price to its earnings
and book value per share.
1.Earning per share (EPS) = Net income available for
common stockholders’ / Number of common shares
outstanding [amount]
Purpose/Use: Measures net income earned on sale of
common stock.
2. Price-earnings ratio or Earnings multiple = Market price per
share / EPS [times or X]
Purpose/Use: Measures the dollar amount investors will pay
for $ 1 of current earnings.

14. 3.Book value per share = Common equity or Net worth /
Number of common shares outstanding [amount]
Purpose/Use: Measures the amount each share would
receive if the company were liquidated at the amount reported
on the balance sheet.
4. Market to book value ratio = Market value per share /
Book value per share [times or X]
Purpose/Use: Measures the market price of a stock’s, that
investors are willing to pay, compare to its book value.
Trend Analysis:
An analysis of a firm’s financial ratios over time that is used to
determine the improvement or deterioration in its financial
situation.

15. Summery of ratio analysis: The DuPont Chart
DuPont Chart:
A chart designed to show the relationship among return on
investment, asset turnover, profit margin and leverage.
DuPont Equation:
A formula that gives the rate of return on assets by multiplying
the profits margin by the total assets turnover.
ROA = Net Profit Margin x Total Asset Turnover
= Net Income / Sales x Sales / Total Asset
ROE = ROA x Equity Multiplier
= Net Income / Total Asset x Total Asset / Common
Equity

16. Equity Multiplier is the ratio of assets to common equity, or
the number of times the total assets exceed the amount of
common equity.
ROE = x x
= Net Income / Sales x Sales / Total Assets x
Total assets / Common Equity
Profit
Margin
Total assets
turnover
Equity
Multiplier

17. Financial Planning and control:
The financial managers can use some of the information
obtained through financial statement analysis for financial
planning and control.
Financial Planning:
The financial planning process begins with –
•A sales forecast for the next few years.
•Then the asset required to meet the sales targets are
determined, and
•A decision is made concerning how to finance the required
assets.
•At that point, income statements and balance sheets can be
forecasted.

18. Sales Forecasts:
Forecasting is an essential part of the planning process, and a
sale forecast is the most important ingredient of financial
forecasting.
Sales Forecast is a forecast of a firm’s unit and dollar sales
for some future period; generally based on recent sales trends
plus forecasts of the economic prospects for the nation, region,
industry, and so forth.
Factors to be considered into sales forecasting:
1.What is the level of current sale
2.Expected economic activities
3.Competitive conditions
4.Product development and distribution, both in the market in
which the firm is currently operating and the market in which
it plans to enter in the future.

19. If the sale forecast is inaccurate, the consequences can be
serious-
First, if the market expends significantly more than the firm
has geared up for, the company probably will not be able to
meet demand, customers will buy competitors’ product and
firm will loss market share, which will hard to regain.
On the other hand, if the projections are overly optimistic-
Firm could end up with too much plant, equipment and inventory,
Low turnover ratio, high cost for depreciation and storage, and,
possibly, write-offs of obsolete or unusable inventory.
All of this would result in a low rate of return on equity, which in
turn would depress the company’s stock price.

20. Projected (Pro Forma) Financial statements:
Any forecast of financial requirements involves-
(1)Determining how much money the firm will need during
a given period,
(2)Determining how much money (funds) the firm will
generate internally during the same period, and
(3)Subtracting the funds generated internally from the
funds required to determine the external financial
requirements.

21. Estimating External Requirement:
One method used to estimate external requirements is the
projected or pro-forma, balance sheet method.
Projected Balance Sheet Method- project the asset
requirements for the coming period, then project the liabilities
and equity that will be generated under normal operations- that
is, without additional external financing- and subtract the
projected liabilities and equity from the required asset to
estimate the additional funds needed to support the level of
forecasted operations.
Additional Funds Needed (AFN):
Funds that a firm must raise externally through new borrowing
or by selling new stock.

22. Step 1 : Preparing the Pro Forma Income Statement
Projected (pro forma) balance sheet method begins with a
forecast of sale. The Income Statement for the coming year
Is forecasted to obtain an initial estimate of the amount of
retained earnings (internal equity financing) the company will
generate during the year.
This requires assumptions about the operating cost ratio, tax
rate, interest charges, and the dividends paid. In the simplest
case, the assumption is made that cost will increase at the
same rate as sales.

23. Step 1 : Preparing the Pro Forma Balance Sheet
For preparing the pro forma balance sheet, judgmental approach
can be used. Under which the values of certain balance sheet
accounts are estimated and the firm’s external financing is used
as a balancing, or “plug,” figure.
In general current liabilities that change naturally with sales
changes provide spontaneously generated funds, which
increases at the same rate as sales.
Notes payable, long-term bonds, and common stock will not rise
spontaneously with sales. Rather, the projected level of these
accounts will depend on conscious financing decisions that will
be made once it has been determined how much external
financing is needed to support the projected operations.
Therefore, for the initial forecast, it is assumed these account
balances remain unchanged.

24. These pro forma financial statements will show us that –
(a)Higher sales must be supported by higher asset levels,
(b)Some of the asset increases can be financed by
spontaneous increases in accounts payable and accruals
and by retained earnings, and
(c)Any shortfall must be financed from external sources, either
by borrowing or by selling new stock.
Step 3: Raising the Additional Funds Needed
Financial managers will base the decision of exactly how to raise
the additional funds needed on several factors, including its
ability to handle additional debt, conditions in the financial
markets, and restrictions imposed by existing debt agreements.
Step 4: Financial Feedbacks
The effect on the income statement and balance sheet of actions
taken to finance forecasted increases in assets.