BAC2684

FINANCIAL STATEMENT
ANALYSIS

Prospective Analysis

Trimester 3 2022
Chapter 9
 Prospective Analysis
• Prospective analysis is the final step in the financial statement analysis.
• To be undertaken only after the historical financial statements have been properly
adjusted to accurately reflect the economic performance of the company.
• Adjustments – eliminating transitory items in income statement or reallocating
them to past or future years, capitalizing (expensing) items that has been
expenses (capitalized) by management, capitalizing operating leases, equity
method investment and other forms of off-balance sheet financing, etc.
• It includes forecasting of the balance sheet, income statement and statement of
cash flow.

Prospective
Analysis

Long Term Forecasting Implementation

Forecasting and stock

Analysis of past data valuation
Forecasting financial Reversion rates of value
statements drivers
 The Projection Process
Projection process begins with the income statement, followed by
balance sheet and the statement of cash flow.
• Example is based on the income statement of Target Corporation.

The projection process begins with the expect growth in sales. We use
historical trends to predict future sales.
A more detail analysis would include:
 Expected level of macroeconomic activity – incorporate estimates
relating to overall growth in the economy & expected growth of retail
sales.
 The competitive landscape – Has the number of competitors
increased? Have weaker rivals ceased operations. Changes in the
competitive landscape will influence our projection of unit sales as well
as the ability to raise prices. Both will impact the top line growth.
 New versus old store mix (strategic initiatives). Open new store and
what is the impact on sales. What is the expansion plan by the
management?
The Projection Process
Target Corporation Income Statements
 The Projection Process
The projection process begins with the following assumptions:
 Sales will grow at 11.455% in 2006, the same as 2005.
 Gross profit margin is assumed to be at 32.866,the most recent gross
profit margin.
 SG & A has remain constant at 22% of sales. Our assumption is that SG
& A will be 22.49% of sales as per the most recent figures for 2005.
 Depreciation is a significant line item and should be projected
separately. Target has reported depreciation expense of approximately
6% of the balance of the beginning-of-year gross property, plant and
equipment. Our project assumes 6.333% of the 2005 PPE balance.
 We compute the historical ratio of interest expense relative to the
beginning –year interest bearing debt. The ratio has increased to
5.173%. Our projection assumes 5.173% of the beginning-of-year
balance of interest bearing debt.
 Finally, tax expense as a % of pre-tax income has been constant as the
most recent level of 37.809% to be used in our projection.
The Projection Process
Target Corporation Projected Income
Statement
 The Projection Process

Target Corporation Projected Income Statement

 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 as described below.
2.Project PP&E increases with capital expenditures estimate derived from
historical trends or information obtained in the MD&A section of the annual
report.
3.Project current liabilities other than debt, using projected sales or cost of goods
sold and appropriate turnover ratios as described below
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.
(continued)
 The Projection Process
Projected Balance Sheet

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.
 The Projection Process
Target Corporation Balance Sheet
 The Projection Process
Steps in Projection (Target)
Given these assumption, Target’s projected balance sheet is derived as follows:
The Projection Process
Target Corporation Balance Sheet
 The Projection Process
Projected Balance Sheet
 The initial balance sheet estimate yields a cash balance of RM 1,402
million. This represents 4.1% of total assets.
 If the estimated cash balance is higher or lower, further adjustments can be
made to:

1. Invest excess cash in marketable securities (projected income need to be

adjusted for the additional non-operating income) or

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
Target Corporation Projected Statement of Cash Flows
 The Projection Process
Sensitivity Analysis

• The projected financial statements are primarily based on expected

relations between the income statement and balance sheet.
• In this example we use the most recent ratios as Target’s operations
are fairly stable and the assumption is that there is no significant
changes in operating strategy.
• Useful to vary these assumptions in order to analyse their impact on
financing requirements, return on assets and equity, etc.
• Analysts often prepare several projections to examine the best or
worst case scenarios.

• This sensitivity analysis highlights which assumptions have the

greatest impact on financial results and help identify those areas
which required attention.
 Short Term forecasting
 Cash and cash equivalent is the most liquid of assets.
 For analysis of short-term liquidity, one of the most useful tools
is short-term cash forecasting.
 It is of interest to internal users like managers and auditors in
evaluating a company’s current and future operating activities.
 Nearly all management decisions to invest in assets or to pay
expenses require the immediate or eventual use of cash.
 Accuracy of short-term cash forecasting is inversely related to
the forecast horizon – longer the forecast period, less reliable
the forecasts.
 Short Term forecasting
Importance of Forecasting Sales
 The reliability of cash forecast depends on the quality of the
sales forecast as most cash flows relates to and depends on
sales.
 Forecasting of sales includes:
• Direction and trend in sales
• Market share
• Industry and economic conditions
• Productive and financial capacity
• Competitive factors.
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• Management estimates sales ($ thousands) for the next 6
months ending June 30, Year 1 as follows:
Month RM (‘000)
Jan 100
Feb 125
March 150
April 175
May 200
June 250
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• Current cash balance at Jan 1, Year 1 is RM 15,000
• Company wants to maintain minimum monthly cash balance as
follows:
Month RM (‘000)
Jan 20,000
Feb 25,000
March 27,000
April 30,000
May 30,000
June 30,000
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• Company expects a need for additional funds to finance sales
expansion.
• Company expects new equipment values at RM 20,000 will be
purchased in February by giving a notes payable to the seller.
• The note will be repaid beginning in February at the rate of RM 1000 a
month. New equipment is not planned to be operational until August of
Year 1.
• To fund financing requirement, the company obtains a financing
commitment from an insurance company to acquire RM 110,000 of IT
Technology’s long term bonds (less RM 2,500 issue cost) Bond sales
is planned for April (RM 50,000 and May (RM 60,000)
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• Company plans to sell real estate for additional financing for RM 8,000
in May and RM 50,000 in June.
• In addition, it will sell equipment (originally costing RM 25,000 with a
book value of zero) for RM 25,000 in June
• The Company has also approached it’s banker for approval of short
term financing to cover additional funding needs.
• Management has requested the Treasurer to prepare a cash forecast
for the six months ending June 30.
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• As the first steps, the Treasurer estimates the pattern of receivables
collections as follows:
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• The collection pattern along with expected product sales allows the
Treasurer to construct estimated of cash collection:
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• Analyzing expense patterns in prior period financial statements yields
expenses estimates based on either sales or time. Exhibit below
depicts the expense pattern:
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• IT Technologies pays off these expenses (excluding the RM 1,000
monthly depreciation) when incurred.

• For purchase of materials 50% paid in the month of purchase and 50%
in the following month.

• Materials inventory on January 1 is RM 57,000. It is estimated that

material inventories for the end of each month from January to June of
Year 1 is as follows: RM 67,000, RM67,500, RM 65,500, RM 69,000
RM 67,000 and RM 71,000 respectively.
 Short Term forecasting
Illustration of cash forecasting:
Company is IT Technologies
• The exhibit below shows the pattern of payment on accounts payable
for these materials.
 Short Term forecasting
Cash Forecast For Months January – June Year 1
 Short Term forecasting
Illustration of cash forecasting:
• Note that from the information given and the cash forecast, we can
prepare Proforma Income Statement and Balance Sheet for six month
ending June 30, year 1.
• Our prospective analysis should critically examine the proforma
statements and submit then to feasibility study on both the forecast
and the assumptions made.
• We should evaluate both ratios and relations revealed in the proforma
financial statements and compare them to historical ratios to determine
their reasonableness and feasibility.
 Earnings Per Share.
• Earnings per share (EPS) are widely used in evaluating the operating
performance and profitability of a company.
• A key feature in earnings per share computation is recognition of the
potential impact of dilution.
• Dilution is the reduction in earnings per share (or increase in net loss per
share) resulting from dilutive securities being converted into common stock,
exercise of options and warrants, or the issuance of additional shares in
compliance with contacts.
• As these adverse effects on earnings per share can be substantial, the
earnings per share computation serves to call attention to the dilutive effects
on the firm’s capital structure.
 Earnings Per Share.
Purpose for reporting diluted EPS
• Earnings per share data are used in making investment decisions.
• EPS are used in evaluating the past operating performance of a company and in forming an
opinion as to its future potential.
• EPS commonly presented in prospectuses, proxy material, and reports to stockholders, and is
the only financial statement ratio that is audited
• EPS is used in the compilation of business earnings data for the press, statistical services, and
other publications.
• When presented with formal financial statements, assist the investor in weighing the
significance of a corporation's current net income and of changes in its net income from period
to period in relation to the shares an analyst holds or may acquire.
• In analyzing EPS, the analyst must be aware that basic EPS does not take into account
securities that, although not common stock, are in substance equivalent to common stock. The
analyst must take care to focus on diluted EPS, which intends to show the maximum extent of
potential dilution of current earnings that conversions of securities could create.
 Earnings Per Share.
• Requires a reconciliation of the numerator and denominator of basic EPS to
diluted EPS.
• Simple Capital Structure – consist only of common stock and non
convertible senior securities and does not include potential dilutive
securities. Computation is as follows:
• Basic EPS = Net income – preferred dividends
Weighted average number of common stock outstanding
• Dividends whether earned or not are deducted from net income or added to
net loss.
• Weighted average number of shares – sum of shares outstanding each day
divided by the number of days in the period.
 Earnings Per Share.
• Complex Capital Structure – Company is viewed as having a complex
capital structure if it has potentially dilutive securities such as convertible
securities, options, warrants.
• Relationship between basic and dilutive EPS is depicted as follows:

Net income less

Preferred Dividend EPS impact of dilutive EPS impact of
EPS = options & warrants Dilutive convertibles
Weighted-average
Common share

Basic EPS

Diluted EPS
 Earnings Per Share.
• Diluted EPS is computed on a as if basis. i.e. we assume that all convertible
securities are converted and options exercised at the earliest possible
opportunity.
• The numerator for diluted EPS adjust net income for the following effects of
the convertible securities or options:
1. If preferred shares have been converted into common, any preferred
dividends must be removed as we are assuming that the preferred shares are
no longer outstanding.
2. If bonds are converted, any interest expenses must be backed out of net
income by adding back the after tax amount of interest accrued.
 Earnings Per Share.
• The denominator adds the additional shares issued as a result of conversion
exercise of option.

• Convertible bonds – amount of shares to be issued upon conversion is added

directly.

• For options, assume that the proceeds from the exercise of the option are
used to repurchase shares in the open market at the average stock price .
Only net shares issued are added to the denominator.
 Earnings Per Share.
Example:
• Common stock: 1,000,000 shares outstanding for the entire year.
• Preferred stock: 500,000 shares outstanding for the entire year.
• Convertible bonds: RM 5,000,000 @ 6% bonds sold at par convertible into
200,000 shares of common stock.
• Employee stock option: Option to purchase 100,000 shares at RM30 have
been outstanding for the entire year. The average market price of the
company’s common stock during the year is RM 40.00
• Net income: RM3,000,000
• Preferred Dividend: RM 50,000
• Marginal tax rate : 35%
 Earnings Per Share.
Example:
• Common
• Basic EPS = RM3,000,000 – RM 50,000/1,000,000 = RM 2.95
• Diluted EPS = RM3,000,000-RM50,000+(RM5,000,000x6%)(1-0.35) /
1,000,000 + 200,000 + 25,000*
= RM 2.57
*
Share purchase upon exercise of option : 100,000 x RM30=RM3,000,000
RM 3,000,000/RM40 = 75,000
Net increase in shares due to exercise of option:
100,000 – 75,000 = 25,000
 Dilutive Vs Anti-Dilutive.
• Public traded companies can offer either dilutive or anti-dilutive securities.
• These terms commonly refer to the potential impact of any securities on the stock’s
earning per share.
• The fundamental concern of existing shareholding after new securities are issued,
or after securities are converted is that their ownership interest are diminished as a
result.
• It is not shareholders who are concerned about dilution of EPS through exercising
of security. Both accountants and financial analysts compute diluted earnings per
share as a worst-case scenario when evaluating a company’s stock
 Dilutive Vs Anti-Dilutive.
Dilutive Securities
• Dilutive securities are not common stock initially. Most dilutive securities
provide a mechanism through which the owner of the security can obtain
addition common stock.
• This can be either an option or conversion. If triggering the mechanism results
in a decreasing EPS for existing shareholders-by increasing the total amount of
outstanding shares – then the instrument is said to be dilutive security.
• Some examples of dilutive securities include convertible preferred stock,
convertible debt instruments, warrants and stock options.
 Dilutive Vs Anti-Dilutive.
Anti-Dilutive Securities
• Not all security mechanism result in decreased EPS, and some even increases
EPS. If securities are retired, converted or affected through certain corporate
activities, and the transaction results in an increased EPS, then the action is
considered to be anti-dilutive.
• Some security instruments have provisions or ownership rights that allow owners
to purchase additional shares when another security mechanism would otherwise
dilute their ownership interests. These are called anti-dilution mechanisms.
• Though not a security the word “antidilution” is sometimes applied to acquisition
of one company by another through issuing common stock, when the value added
through the acquisition offsets the new shares such that total EPS is increased.
 END

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