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Finance Terms Ch. 2

Terms in this set (55)

pro forma statement
used in creating financial projections
steps for creating a pro forma statement
1. qualitative analysis 2.quantitative analysis 3. test the critical assumptions
qualitative & quantitative factors
p.21 Industry Definition, Sales Influences, cost structure
in every case
accuracy diminishes with the length of time.
Time Horizon
period of time defined for financial analysis. Can be any amount of time but would be applied to companies being compared so that they were measured for the same time.
historical evaluations
at a minimum you should gather the necessary information to quantify the industry's historical sales growth, asset usage skill, porfitability, return on equity, dividend policy, liquidity and structure. test assumptions against this.
projecting pro forma statements
don't be concerned with accuracy yet. do not over compensate by making overly conservative assumptions. determine sales figures first, then income statement using the vertical analysis % to project.
statistical analysis method
if the historical observations are indistinguishable, that is, there were no unique influences, then other averages, variances, standard deviations and other statistical methods should be employed.
projections in a pro forma
always remember that the most significant portions of your projections are, no matter how carefully contrived, are still little more than educated guesses
pro forma statements
balance sheets come after the income statement.
plug
figure used in the balance sheet to make it balance in a pro forma statement projection. (assets=liabilities + owner's equity). projected balance sheets will never balance on their own.
plug method
where assets have been projected to grow at a rate faster than liabilities and equity, the plug would indicate outside financing (either debt or equity) must be obtained.
forecasting statements
usually only balance sheets and income statements. all remaining statements if required can be derived from these statements
forecasting cash budget
combines methods used in forecasting income statements and balance sheets. detailed info is necessary to include working capital policy, planned purchases, operating cycle, and typical seasonal sales patterns. (usually projected month by month). analysts rarely have access to this so they usually forecast cash flow from operations
cash flow from operations
usually calculated instead of cash flow budget. These are projected annually. Net Income is the only thing needed.
sensitivity Analysis
tests the assumptions made in the financial forecasting. Test the validity of the calculations. (economy plays a part). Vary the assumptions on by one in the financial statements to see how they would effect the projections. Create best and worst case scenarios
analysts, managers and investors both internal to and external to a firm have interests in making
financial projections
The medium used to look into an organization's financial future is the
pro forma statement
Historical company-specific
trend analysis is used as one means of estimating the future.
Better projections can generally be derived by first studying the environment in which a firm competes both for
quantitative and qualitative factors
factors related to a firm's industry include
industry definition, that is, what type of products are sold, how stable is the industry, on what basis do firms compete, etc.
Other industry factors include (qualitative)
sales influence - how is the economy affecting the industry, and what are the marketing strategies of the competitors.
One should evaluate the cost structure of the industry (qualitative)
is the industry more susceptible to a drop in volume or a drop in prices
After an industry assessment is done (evaluating industry, sales influence and cost structure) the analyst should also evaluate (qualitative)
product line, management, facilities, market strategy, and cost structure for the same types of companys
Quantitative analysis (follows qualitative)
determine time horizon, apply the assumptions made to first the income statement (sales first because it is the largest) followed by expenses to be historically consistent. Can use statistical methods
forecasted balance sheet
uses trends and ratios to develop along with a plug figure to make it balance.
Plug
represents excess cash or a deficit of capital given the forecaster's assumptions.
Pro forma cash flow analysis
calculated after the forecasted balance sheet
sensitivity analysis
assumptions should be challenged to measure the bottom-line impact of changes to key variables
analysts within a company are more likely to fall into the "false accuracy trap" when they develop pro formas than would external analysts because insiders have access to more detailed information.
TRUE: whether analysts are inside or outside a company, they should not lose sight of their objectives in doing financial forecasts. As a rule of thumb, the greatest attention should be directed to those items that have the most material impact on the pro forma because of 1) magnitude or 2) their uncertainty
when making financial projections, if a particular expense item cannot be predicted with any degree of confidence, it should b forecast at the highest level it would ever likely reach, so as to make the pro forma conservative
FALSE: if a projected data item is subject to great uncertainty, it is probably better to project a most likely value rather than the extreme value, unless you are piecing together a "best-case" or "worst-case" scenario. In general, if items cannot be predicted, projecting at the midpoint of a range, will on average, allow errors from over-estimates to cancel errors from under-estimates.
The greater the detail in a pro forma the greater the accuracy will be
FALSE: false assumptions can be built on with great precision and result in poor pro formas. Do not confuse accuracy with precision - it is much more important to be accurate when forecasting than it is to be precise.
during the qualitative portion of developing pro formas: a. economic issues are ignored because they will be reflected in the sales levels of various years later in the quantitative analysis, b. relative marketing strategies are not considered, c. industry-wide consideration are more important than company-specific ones because they are more applicable, d. industry-wide considerations may be less important than company specific issues
D. You are projecting the statements of a company and no company moves exactly the same footsteps as the industry in which it competes. It makes sense, then, to spend more of your time on company-specific issues than more global industry phenomena.
the qualitative portion of a financial analysis is analogous to the hypothesis forming stage of scientific investigation because: a. assumptions are not tested until the numbers are run, b. false hypotheses (assumptions) may be formed, c. empirical measurement is performed later, d. A & B, e. A, B & C
E. A, B & C: all of the statements equate qualitative analysis and hypothesis testing
An assumption is considered critical if: a. it is questionable, b. it affects the bottom line greater than other assumptions do, c. it reflects a judgment about the firm's ability to perform one of the "keys to success", d. B & C, e. it is related to the general economy
D. B & C: critical assumptions are those around which an analysis is built. Since they represent the foundation of the analysis, they probably have a material impact on the bottom line. In addition, they should also be rooted in the key success factors as determined in the qualitative analysis.
Horizontal and vertical percentage trends are useful in projecting future financial statements
TRUE: horizontal analysis can help you identify trends over time that can be extrapolated into the future. Vertical analysis allows you to project items relative to a benchmark, such as sales.
In a stable, predictable industry, an average of the previous ten years' sales growth figures probably provides a more accurate forecast than assuming the same level of sales next year as in the current year
TRUE: whenever information is available which would support an educated forecast, employing that information should provide a more accurate projection than would assuming the naive "last year repeated" forecast
When performing sensitivity analysis: a. statistical methods can be usefully employed, b. electronic spreadsheets can save time, c. assumptions should be changed one at a time, d. all of the above, e. B & C
D. All of the above
The final step in using pro formas is to: a. test the assumptions, b. compare the results of the sensitivity analysis to the decision-makers risk tolerance in the current situation, c. create best and worst case scenarios, d. A & C, e. A, B & C
B Compare the results of the sensitivity analysis to the decision maker's risk tolerance in the current situation; pro formas are generated because a decision has to be made. Thus, the analysis cannot end with analysis.
statistical assessment of sales and cost structures will be useful when
the industry is mature and stable and the industry performance is widely documented.
industries that are made up of few large competitors
will survive years of innovation from others. It is unlikely that a single competitor could render its competitors obsolete overnight especially considering anti-trust considerations.
payables and accruals includes
notes payable, accounts payable and other current liabilities.
an increase in a current liability is a source of
cash (therefore it is an increase in accounts payable source in the cash flows statement)
what is the most compelling reason to project a firm's income statement before projecting its balance sheet? a. it is easier to project sales than assets, b. the change in retained earnings is determined by net income and dividend payments, c. working capital account balances are affected by sales levels, d. A & C, e. B & C
E. B & C: it is necessary to know the balance of retained earnings before the plug figure can be calculated to balance the balance sheet. The change in retained earnings is a consequence of the income statement. Accounts receivable and inventory, among other current assets and current liabilities, will change with changes in sales or other income statement accounts.
when doing a comprehensive financial forecast, which account warrants the most thorough relational and trend analysis? a. sales, b. return on equity, c. earnings per share, d. common stock
a. Sales; sales is generally the single most significant item in a financial projection, because changes in many expenses and working capital are closely correlated with changes in sales. Return on equity and EPS are bottom line figures that are results of operations (ie determined by sales). Changes in common stock are generally the result of management plans and market conditions, factors which would not be discovered through historical analysis.
the most significant difference between projecting balance sheets and projecting cash flow is that: a. a projected balance sheet will show dividend distributions, b. the balance sheet does not require a plug figure to balance because assets equal liabilities plus equity, c. the cash flow statement shows the periodic increase or decrease in the plug figure, d. none of the above
C. Statement C is correct because the cash flow statement, like an income statement, measures activity between two points in time. Since it reports changes in cash flow, and the balance sheet plug figure represents the accumulated excess or shortage of cash flow, projecting a cash flow statement shows the increase of decrease in the plug.
Hypothesis that are formed during the qualitative stage can be verified by reviewing historical records
TRUE; part of the analysis consists of testing your hypotheses against the facts
Statistical methods can be employed to: a. smooth out historical performance trends, b. aid the analyst in making estimates, c. establish boundaries for sensitivity analysis, d. B & C, e. A, B & C
A B & C;
If projected assets exceed liabilities and owner's equity, it is assumed that the difference is funded through excess cash
FALSE; A projected excess of assets over liabilities and equity implies a shortfall, not an excess of cash. This shortfall is typically assumed to be financed through short-term or long-term debt
What is the most compelling reason to project a firm's income statement before projecting its balance sheet? a. it is easier to project sales than assets, b. the change in retained earnings is determined by net income and dividend payments, c. working capital account balances are affected by sales levels,d. A & C, e. B & C
E; It is necessary to know the balance of retained earnings before the "plug" figure can be calculated to balance the balance sheet. The change in retained earnings is a consequence of the income statement. Accounts receivable and inventory, among other current assets and current liabilities, will change with changes in sales or other income statement accounts.
When doing a comprehensive financial forecast, which account warrants the most thorough relational and trend analysis? a. sales, b. return on equity, c. earnings per share, d. common stock
A sales; Sales is generally the single most significant item in a financial projection, because changes in many expenses and working capital are closely correlated with changes in sales. Return on Equity and EPS are bottom line figures that are results of operations i.e. they are determined by sales. Changes in common stock are generally the result of management plans and market conditions, factors which would not be discovered through historical analysis.
The most significant difference between projecting balance sheets and projecting cash flow is that a. a projected balance sheet will show dividend distributions, b. the balance sheet does not require a plug figure to balance because assets equal liabilities plus equity, c. the cash flow statement shows the periodic increase or decrease in the plug figure, d. none of the above
C; The cash flow statement, like an income statement, measures activity between two points in time. Since it reports changes in cash flow, and the balance sheet plug figure represents the accumulated excess of shortage of cash flow, projecting a cash flow statement shows the increase or decrease in the plug.
The most accurate pro formas contain the most detail
FALSE; It is important not to confuse accuracy with precision. Projections that accurately anticipate future reality provide meaningful information on which to base decisions. Precise forecasts which may be supported by great detail are useless if they do not approximate reality
In projecting an income statement based on a balance sheet, which of the following categories would you content to be least likely to vary directly with a change in sales? a. accounts payable, b. depreciation, c. inventory, d. cost of goods sold
B depreciation; Receivables, inventory and cost of goods sold all would have a direct relationship with a change in sales
Sensitivity analysis should not be performed a. on an item subject to great uncertainty, b. on an item which comprises a major proportion of the projected data, c until the best and worst case scenarios are complete, d. on a predictable, immaterial item
D; Sensitivity analysis should be performed on items that will have a material impact on the outcome of the forecast and which are subject to some uncertainty
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