Financial Management

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I. Financial Analysis and Planning[1]

From the Statement of Cash Flows, or from the analyst’s well-tuned intuition, relevant financial ratios can be identified and calculated. Remember -- Do not just blindly begin calculating financial ratios – the number of possible financial ratios is almost limitless; life is too short to spend calculating irrelevant ratios! In short, have a good reason a priori for the financial ratios that you calculate. If you don’t, you will waste a tremendous amount of time and may wind up with too much information to effectively evaluate.

Financial ratios have two primary uses:

• Financial control (or analysis) and
• Financial planning.

Financial ratios are used to compare actual financial results with various benchmarks of performance, such as

• a firm’s own historical financial ratios to identify improving and deteriorating trends, • comparable ratios from other firms in the same industry,[2] or • comparison of actual ratios versus a previously developed financial plan.

We call the activity of comparing ratios to any of these benchmarks financial control.

Financial ratios also are used to project a firm’s future financial position. We call this activity financial planning.

Financial ratios often are classified into five categories:

• Liquidity ratios,
• Leverage ratios,
• Activity or turnover ratios,
• Profitability ratios, and
• Market ratios.

See the attached Appendix A, “Financial Ratios,” for more details on the calculation of various financial ratios.

Consider the use of one of the activity ratios, the Days Sales Outstanding (DSO) ratio. This ratio can be used to monitor a firm’s credit policy. DSO is calculated as

Credit Sales / Number of Days = Credit Sales per Day.[3]

DSO = Accounts Receivable / Credit Sales per Day.

Suppose a company had credit sales of $687,500 during the first quarter of 2000, which had 91 days.

Credit Sales per Day = $687,500/91 = $7,555.

On March 31, 2000, the accounts receivable balance was $264,423. The company’s DSO on March 31, 2000 was

$264,423 / $7,555 = 35 days.

This calculation indicates that customers were, on average, taking 35 days to pay.

Now suppose that during the first quarter of 2001 this company had credit sales of $790,625. The firm also had accounts receivable of $278,022 at the end of this quarter. Obviously accounts receivable have increased in magnitude. Does this increase imply that credit policy is “out of control,” i.e., customers were paying slower? Not necessarily!

DSO at the end of the first quarter 2001 were

DSO = $278,022 / ($790,625/91) = 32 days.

Actually, customers are paying sooner! Credit sales have increased faster than Accounts receivable so the DSO has fallen. We don’t need to worry about this aspect of the business.

We can also use financial ratios to make forecasts. Suppose we project credit sales for the first quarter of 2002 to be $905,000. Can we make a prediction of the accounts receivable balance for March 31, 2002?

Absent a change in credit policy, a reasonable approach might be to predict 2002 DSO will be between 35 and 32 days, an average of 33.5 days.

Projected credit sales per day = $905,000 / 91 days = $9,945.

Projected accounts receivable = $9,945 * 33.5 = $333,159.

We could use this amount as our estimate of accounts receivable on a pro forma March 31, 2002 balance sheet, assuming that we anticipate no changes in our credit policy or the payment behavior of our customers. See the discussion of “percent of sales forecasting” below.

II. Pro Forma Financial Statements

Pro forma income statements and balance sheets are the building blocks of a financial plan. Pro forma statements are projected, or future, financial statements. These statements show the firm’s projected income and the forecast for...
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