Parte III – Financial Analysis

9. Prospective Analysis

178

Prospective Analysis
(Planeamento Financeiro)
 Prospective analysis is “the final step in the financial
statement analysis process” (Subramanyam, 2014, p. 507)
 It includes forecasting of the Income Statement, Balance
Sheet and Statement of Cash Flows
 It aims to integrate the prospects for the evolution of the
business on a financial plan that forecasts the economic and
financial position of the company/“Visa integrar as
perspetivas de evolução do negócio num plano financeiro
que perspetive a evolução económica e financeira da
empresa” (Neves, 2002, p. 69) 179

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 Prospective Analysis
Examples of applications
Importance
Security Valuation - free cash flow and residual
income models require estimates of future financial
statements.

Management Assessment - forecasts of financial

performance examine the viability of companies’
strategic plans.

Assessment of Solvency - useful to creditors to

assess a company’s ability to meet debt service
requirements, both short-term and long-term.

Prospective Analysis
Financial planning steps
Inputs Planning Model Outputs

Inputs - Current financial statements. Forecasts of key

variables (such as sales, interest rates, …)

Planning Model - Equations specifying key relationships

Outputs - Projected financial statements (pro forma).

Financial ratios. Sources and uses of cash.

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 Prospective Analysis
Financial planning models
 Projections - Projected or forecasted financial statements

 Percentage of Sales Model - Planning model in which

sales forecasts are the driving variable and most other
variables are proportional to sales.

 Balancing Item - Variable that adjusts to maintain the

consistency of a financial plan

Prospective Analysis
Financial planning models
 Quick method: the goal is to get in a quick way, the
estimate for the financing needs (main assumption is the
evolution of sales)
FN=(A/S*∆S)-(L/S*∆S)-(ROS*S1*(1-d))
 Direct method: the starting point is the turnover (sales)
forecasts. Then estimates of the accounts that change with
turnover are obtained. The accounts that are independent
of sales should be estimated autonomously. Based on
these estimates we will be able to prepare pro forma
financial statements.
183

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 Prospective Analysis
Financial planning models
 Budgetary Consolidation method: This method derives
from the budgetary process of the companies and the pro
forma Financial Statements are obtained by consolidating
all budgets produced by the different departaments of the
company.
Sales budget, Production budget, Purchasing budget,
Administrative expenditures budget, Investment budget,
Financing budget, Cash budget

184

Prospective Analysis
Implementation of the direct method

 The first step is the historical financial analysis

 The process continues with the projection of Financial
Statements:
1º) Income Statement
2º) Balance Sheet
3º) Statement of cash flows

185

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 The Projection Process

Projected Income Statement

Sales forecasts are a function of:

1) Historical trends
2) Expected level of macroeconomic activity
3) The competitive landscape
4) Strategic initiatives (New versus old store
mix,…)
197

The Projection Process

Projected Income Statement

Steps:
1. Project sales
2. Project cost of goods sold and gross profit margins using
historical averages as a percent of sales
3. Project SG&A expenses using historical averages as a percent
of sales
4. Project depreciation expense as an historical average
percentage of beginning-of-year depreciable assets
5. Project interest expense as a percent of beginning-of-year
interest-bearing debt using existing rates if fixed and projected
rates if variable
6. Project tax expense as an average of historical tax expense to
pre-tax income

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 The Projection Process

Projected Balance Sheet

Steps:
1. Project current assets other than cash, using projected sales or
cost of goods sold and appropriate turnover ratios.
2. Project PP&E increases with capital expenditures estimate
derived from historical trends or information obtained in the
annual report.
3. Project current liabilities other than debt, using projected sales or
cost of goods sold and appropriate turnover ratios
4. Obtain current maturities of long-term debt from the long-term
debt footnote.
5. Assume other short-term indebtedness is unchanged from prior
year balance unless they have exhibited noticeable trends.

The Projection Process

Projected Balance Sheet

Steps:
6. Assume initial long-term debt balance is equal to the prior period
long-term debt less current maturities from Step 4.
7. Assume other long-term obligations are equal to the prior year’s
balance unless they have exhibited noticeable trends.
8. Assume initial estimate of common stock is equal to the prior year’s
balance
9. Assume retained earnings are equal to the prior year’s balance plus
(minus) net profit (loss) and less expected dividends.
10. Assume other equity accounts are equal to the prior year’s balance
unless they have exhibited noticeable trends.

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 The Projection Process

Projected Balance Sheet

If the estimated cash balance is much higher or lower,

further adjustments can be made to:
1. invest excess cash in marketable securities
2. reduce long-term debt and/or equity proportionately
so as to keep the degree of financial leverage
consistent with prior years

The Projection Process

 From the projected Income Statement and Balance sheet,

we can obtain estimates of cash flows (the projected
Statement of cash flows)

191

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 The Projection Process

Sensitivity Analysis

 Vary projection assumptions to find those with

the greatest effect on projected profits and
cash flows
 Examine the influential variables closely
 Prepare expected, optimistic, and pessimistic
scenarios to develop a range of possible
outcomes

Prospective Analysis
Short-term financial management

 Cash budget (Orçamento de Tesouraria): forecasts of

cash flows (receipts and payments) in the short-term
(week, month, quarter,…)
– A key tool in the short-term financial management/short-
term liquidity

– Relationship between operating and non-operating cash

flows

– The financial viability of a company is determined by its

ability to generate cash flows from operations
193

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 Prospective Analysis
Short-term financial management

 The short-term financial management includes:

– Cash management
– Marketable securities
– Credit management (Accounts receivable)
– Inventories managament
– Sources of short-term financing

194

Cash Management

“Cash provides liquidity, but it doesn’t pay interest”

(Brealey & Myers, 2003, p. 901)

195

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 Cash Management

 The level of Cash and Equivalents should be reduced to

the minimum required for the normal development of the
company's activity. It depends on:
– Foresight, planning, and control of short-term cash flows
– Flexibility in the relationship with customers and suppliers
– Existing credit lines or current assets that the company can easily
convert into cash

196

Marketable securities

 Investment in Marketable securities results from temporary

excess cash
– Analysis criteria: _________, _________, and ________
– Examples of short-term investments:
 Government bonds
 Bank deposits
 Mutual funds
 Commercial paper
 Investments in the operating cycle (pay in cash to obtain discounts from
suppliers, investment in inventories in anticipation of price increases,…)
197
 ...

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 Inventories Management

 As the order size increases, the number of orders falls and

therefore the order costs decline. However, an increase in
order size also increases the average amount in inventory,
so that the carrying cost of inventory rises.
– Companies need to balance between these two costs

198

Credit Management

 Credit Analysis: analysis to determine the likelihood a

customer will pay its bills.
– Credit agencies, such as Dun & Bradstreet (in Portugal Informa
D&B) and Coface provide reports on the credit worthiness of a
potential customer
– Financial ratios can be calculated to help determine a customer’s
ability to pay its bills.

199

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 Credit Management

 Terms of sale: Credit, discount, and payment terms

offered on a sale
 Collection period: its extension will tend to increase the
level of sales. However, it is necessary to consider the
impact on the Working Capital Requirements, the interest
expense associated with its financing, and the default rate.
 Cash payment discounts: a source of short-term
financing, and so the discount should take into
consideration the interest rate of alternative sources of
financing
200

Sources of short-term financing

 Required due to the existence of cash deficits that the

company needs to cover using external funds
 Selection criteria: interest rate, maturity (due date), guarantees.
 Alternative sources:
– Bank loans
– Factoring
– Commercial Paper
– Suppliers credit
– Discounts to customers
– …
201

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 Sources of short-term financing

 Suppliers credit: a firm that buys on credit is in effect

borrowing from its supplier. It saves cash today but will
have to pay later. This, of course, is an implicit loan from
the supplier.
 We can calculate the implicit cost of this loan

Effective annual rate

(
= 1 + discount
)
discounted price
365 / extra days credit
- 1

 Bibliography:
– Subramanyam (2014). Financial Statement Analysis,
McGraw-Hill International Edition (Chapter 9).
– Neves, J. C. (2002). Avaliação de Empresas e Negócios,
McGraw-Hill (5. Plano de negócio e plano financeiro para a
avaliação)
– Menezes, Caldeira (2001). Princípios de Gestão Financeira, 8ª
ed. (Cap. III, IV e V)
– Brealey, Myers and Allen (2014). Principles of Corporate Finance,
McGraw-Hill (Cap. 29 e 30). 203

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