FINANCIAL ANALYSIS

Financial analysis

Financial Analysis

Having obtained a sales forecast, the trial pro-forma balance sheet can be created. Accounts that tend to vary with sales are typically forecasted first. Often the current assets and liabilities, such as accounts receivable, inventory, and accounts payable, will move with sales. For example, a firm may make a relatively constant 40 percent of sales on credit. In contrast, other accounts, such as long-term debt and dividends may be driven by overt management decisions, not sales. Some accounts such as plant and equipment may have a relationship to sales in the long run, but not necessarily from year to year. For example, a firm could have excess capacity allowing sales to grow without investing in new assets. Then, when the plant and equipment become capacity constrained, these fixed assets may grow at a faster rate than sales since equipment and factories tend to come in “lumpy” amounts. It may be hard to buy 10 percent of a factory when sales increase by 10 percent.

Three common ways to describe the historical relationship between sales and the current accounts are: percent of sales, ratios, and regression analysis. For illustrative purposes, inventory and accounts payable will be forecasted using the percent of sales method, accounts receivables and net income will be forecasted using ratios, and cash will be forecasted using regression analysis (Lucchetti, 2007).

Percentage of Sales: The current accounts, and net income for 1996 through 1998. Inventory was 13.5, 12.8, and 14.2 percent of sales for 1996, 1997, and 1998, respectively. On average , inventory has been 13.5 percent of sales. Thus, given the sales forecast of $350, inventory is forecasted to be $47.3 = 0.135($350). On average accounts payable has been 8.7 percent of sales; thus, accounts payable is estimated to be $30.5 = 0.087($350).

Using the accounts receivable and net income data from Table 1, the average collection period and the profit margin ratios can be calculated. Assuming all sales were on credit and a 365 day year, the firm took 38, 40, and 43 days to collect the typical account in 1996, 1997, and 1998, respectively. Given these ratios and some planned improvements in the billing and collection processes, management believes that next year's receivables will be collected in 40 days, on average. Thus, next year's receivables account is forecasted to be $38.4 = 40($350/365). The firm's profit margin ranged from 6.1 percent in 1997 to 4.8 percent in 1998 and averaged 5.4 percent. Using this three-year average, net income for 1999 is forecasted to be $18.9 = 0.054($350)

Two caveats are appropriate when applying the percent of sales, ratio, and regression approaches (Marshall, 2004, 11). The first concerns the number of years of historical data and the second concerns potential problems associated with forecasting accounts based on sales. First, judgment is needed in determining how far into the past one should go in estimating the historical relationship. In the example, three years of data were used. However, if a firm's policies or business environment has changed, ...