PRO FORMA FINANCIAL STATEMENTS
A TEACHING NOTE
I. Financial Analysis and Planning
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, 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.
DSO = Accounts Receivable / Credit Sales per Day.
Suppose a company had credit sales of $687,500