Financial Projections Forecast—Budget—Analyze

Three Methods of Analyzing Financial Statements Vertical analysis Horizontal analysis Ratio analysis

Vertical Analysis Vertical analysis is the process of using a single variable on a financial statement as a constant and determining how all of the other variables relate as a percentage of the single variable.

Vertical Analysis of an Income Statement The vertical analysis of the income statement is used to determine, specifically, how much of a company’s net sales consumed by each individual entry on the income statement. Constant is net sales. The formula is :

Horizontal Analysis Horizontal analysis is a determination of the percentage increase or decrease in an account from a base time period to successive time periods. The basic formula is:

Vertical Analysis of a Balance Sheet Vertical analysis of the balance sheet is always carried out by using total assets as a constant, or 100 percent, and dividing every figure on the balance sheet by total assets.

Ratio Analysis Ratio analysis is used to determine the health of a business, especially as that business compares to other firms in the same industry or similar industries. A ratio is nothing more than a relationship between two variables, expressed as a fraction.

Types of Business Ratios Liquidity ratios determine how much of a firm’s current assets are available to meet short-term creditors’ claims. Activity (Efficiency) ratios indicate how efficiently a business is using its assets. Leverage (debt) ratios indicate what percentage of the business assets is financed with creditors’ dollars.

Types of Business Ratios (continued) Profitability ratios are used by potential investors and creditors to determine how much of an investment will be returned from either earnings on revenues or appreciation of assets. Market ratios are used to compare firms within the same industry. They are primarily used by investors to determine if they should invest capital in the company in exchange for ownership.

Liquidity Ratios Current Ratio: The current ratio is calculated by dividing total current assets by total current liabilities. The current ratio is given by the following:

Liquidity Ratios (continued) Quick, or Acid Test, Ratio: This ratio does not count the sale of the company’s inventory or prepaids. It measures the ability of the firm to meet its short-term obligations without liquidating its inventory. The acid test ratio is given by the following:

Activity Ratios Inventory turnover ratio (or, simply, inventory turnover) indicates how efficiently a firm is moving its inventory. It basically states how many times per year the firm moves it average inventory. Inventory turnover is given as follows:

Activity Ratios (continued) Accounts receivable turnover ratio allows us to determine how fast our company is turning its credit sales into cash. Accounts receivable turnover is given by the following:

Activity Ratios (continued) Average collection period is the average number of days that it takes the firm to collect its accounts receivable. Average collection period is given by the following:

Activity Ratios (continued) Fixed asset turnover ratio indicates how efficiently fixed assets are being used to generate revenue for a firm. Fixed asset turnover is given by the following:

Activity Ratios (continued) Total asset turnover ratio indicates how efficiently our firm uses its total assets to generate revenue for the firm.  Total asset turnover is given by the following:

Leverage Ratios Debt-to-equity ratio indicates what percentage of the owner’s equity is debt. Debt-to-equity is given by the following:

Leverage Ratios (continued) Debt-to-total-assets ratio indicates what percentage of a business’s assets is owned by creditors.  Debt-to-total-assets is given by the following:

Leverage Ratios (continued) Times-interest-earned ratio shows the relationship between operating income and the amount of interest in dollars the company has to pay to its creditors on an annual basis.  Times-interest-earned is given by the following:

Profitability Ratios Gross profit margin ratio is used to determine how much gross profit is generated by each dollar in net sales.  Gross profit margin is given by the following:

Profitability Ratios (continued) Operating profit margin ratio is used to determine how much each dollar of sales generates in operating income.  Operating profit margin is given by the following:

Profitability Ratios (continued) Net profit margin ratio tells us how much a firm earned on each dollar in sales after paying all obligations including interest and taxes.  Net profit margin is given by the following:

Profitability Ratios (continued) Operating return on assets ratio is also referred to as operating return on investment and allows us to determine how much we are actually earning on each dollar in assets prior to paying interest and taxes.  Operating return on assets is given by the following:

Profitability Ratios (continued) Net return on assets (ROA) ratio is also referred to as net return on investment and tells us how much a firm earns on each dollar in assets after paying both interest and taxes.  Net return on assets is given by the following: This Ratio is the same as Return on Investment (ROI) Earning Power

Profitability Ratios (continued) Return on equity (ROE) ratio tells the stockholder, or individual owner, what each dollar of his or her investment is generating in net income.  Return on equity (ROE) is given by the following:

Market Ratios Earnings per share ratio is nothing more than the net profit or net income of the firm, less preferred dividends (if the company has preferred stock), divided by the number of shares of common stock outstanding (issued).  Earnings per share is given by the following:

Market Ratios (continued) Price earnings ratio is a magnification of earnings per share in terms of market price of stock.  Price earnings ratio is given by the following:

Price Earnings to Growth ratio(PEG ratio) The price earnings to growth ratio (PEG ratio) compares the company’s price earnings ratio to its expected earnings per share (EPS) growth rate over the next several years.  The PEG ratio is given by the following formula:

Market Ratios (continued) Operating cash flow per-share ratio compares the operating cash flow on the statement of cash flows to the number of shares of common stock outstanding.  Operating cash flow is given by the following:

Break-e=Even Analysis Break-even analysis is a process of determining how many units of production must be sold, or how much revenue must be obtained, before we begin to earn a profit. FC = Fixed cost P = Price VC = Variable Cost

Break-Even Graph

Break-Even Analysis (continued) Break-even dollars: Where VC is variable cost expressed as a percentage of sales (revenue). – For retail firm: VC percentage =(Cost of Goods Sold)/(Net Sales) – For manufacturing firm: VC percentage = (Variable cost of a unit)/(Selling price)

Break-Even Analysis (continued) Contribution margin is the amount of profit that will be made by a company on each unit that is sold above and beyond the break-even quantity. Contribution margin is also the amount the company will lose for each unit of production by which it falls short of the break-even point.

Profit and Break-Even Desired profit with break-even analysis in quantity to produce. – VC is variable cost per unit Desired profit with break-even analysis in dollars. – VC is a percentage of sales dollar (e.g., cost of goods sold as a percent).

Break-Even Charts

Leverage Leverage uses those items that have a fixed cost to magnify the return to a company. Fixed costs can be related to company operations or related to the cost of financing. – Interest expenses paid on the amount of debt incurred is the fixed cost of financing. – A firm is heavily financially leveraged if the fixed costs of financing are high.

Leverage (continued) Degree of operating leverage (DOL) is the percentage change in operating income divided by the percentage change in sales.

Leverage (continued) Degree of financial leverage (DFL) is the percentage change in earnings per share divided by the percentage change in operating income.

Leverage (continued) Degree of combined leverage (DCL) is the percentage change in earnings per share divided by the percentage change in sales.

Leverage Ratios Applied If the DOL is 3, then for every percentage of increase in net sales an equal increase in operating income will be realized. However for percentage decrease an equal decrease in operating income will be realized.

Types of Forecasting Models Judgmental models, which use qualitative methods Time series models, which use quantitative methods Causal models, which use cause- and-effect methods

Judgmental Models Judgmental models are qualitative and essentially use estimates based on expert opinion. – Survey of Sales Forces: most appropriate for manufacturing and wholesale firms. – Surveys of Customers: applicable to all firms. Customers express preference for new or modified products.

Judgmental Models (continued) – Historical Analogy most appropriate for firms that have several outlets. Introduction of new product which has characteristics similar to previous products. – Market Research can include surveys, tests, and observations. Results are statistically extrapolated to develop forecasts of demand for products.

Judgmental Models (continued) Delphi Method uses a panel of experts to obtain a consensus of opinion. Used primarily for unique new products or processes for which no previous data exist.

Time Series Models Time series forecasting models normally use historical records that are readily available within the firm or industry to predict future sales. – For this reason they are often referred to as internal or intrinsic models. – Assumption in time series forecasting is that past sales are a fairly accurate predictor of future sales.

Time Series Models (continued) Moving average model Weighted moving average model Exponential smoothing model Linear regression model