FINANCIAL STATEMENT ANALYSIS & FORECASTING

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 – • The Balance Sheet • The Income Statement • The Statement of Cash Flows • 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. • 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. • Debt ratio = Total debt / Total assets [%] Purpose/Use: Measures the percentage of total assets provided by creditors. • 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. • Net profit margin = Net profit / Sales revenue [%] Purpose/Use: Measures net income generate by each dollar of sales • Return on assets (ROA) = Net income / Total assets [%] Purpose/Use: Measures overall profitability of asset • 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. • 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. Book value per share = Common equity or Net worth / Number of common shares outstanding [amount] Purpose/Use: Measures theamount 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: • What is the level of current sale • Expected economic activities • Competitive conditions • 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- • Determining how much money the firm will need during a given period, • Determining how much money (funds) the firm will generate internally during the same period, and • 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 – • Higher sales must be supported by higher asset levels, • Some of the asset increases can be financed by spontaneous increases in accounts payable and accruals and by retained earnings, and • 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.