Analyzing Forecasts

When you have completed this section, you will be able to use ratio analysis to assess a firm's performance to compare its performance to itself, its competitors, its industry, and across time. You will learn the categories of ratios, how to compute ratios and how to interpret the numeric values of a ratio as a comment on the firm's performance. Ratio analysis is used to consider the impact of certain financial transactions on a firm.

Modifying inputs such as accounts receivable, inventory, and accounts payable will significantly influence forecasting and business operations.

LEARNING OBJECTIVE

• Explain how modifying different inputs will influence financial forecasts

KEY POINTS

• Accounts receivable has a great effect on a firm's expected cash inflows, and thus modifying this input on a forecast will affect how much cash a company decides to have on hand.
• Because of its prevalence as an expense, modifying the amount of inventory will have far reaching consequences on all forecasted financial statements.
• Accounts payable will influence the current liabilities of a business; therefore, its modification will change a company's perspective on the amount of cash-on-hand needed.

TERMS

• solvency

The state of having enough funds or liquid assets to pay all of one's debts; the state of being solvent.

• liquidity

Availability of cash over short term: ability to service short-term debt.

• forecast

An estimation of a future condition.

EXAMPLE

• For example, 2%,30 Net 31 terms mean that the payer will deduct 2% from the invoice if payment is made within 30 days. If the payment is made on Day 31 then the full amount is paid.

Inputs

The inputs of accounts receivable, inventory, accounts payable, and other line items on financial statements provide important data for financial forecasting. Modifying any one of these inputs can lead to major changes in forecasts. Similarly, drastic differences in expected values and actual values in regard to these inputs can cause problems for a company, possibly even leading to insolvency.

Accounts Receivable

Accounts receivable is money owed to a business by its customers and shown on its balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered. A business must not only anticipate the level of sales that will be made on credit, but it must also anticipate when payment on these accounts will occur and account for the fact that some of these credit accounts will default. Accounts receivable has a great effect on a firm's expected cash inflows, and thus modifying this input on a forecast will affect how much cash a company decides to have on hand.

Inventory

Inventory management is primarily about specifying the scope and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stock of materials. The scope of inventory management concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods, and demand forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an on-going process as the business needs shift and react to the wider environment.

Companies that rely on the sale of physical goods -- i.e., those that must carry inventory -- must manage inventory in such as way as to decrease expenses as much as possible. Since inventory is such a prevalent expense, accurate forecasting is of the utmost importance. Moreover, the modification of this particular input will have expansive effects on all of the financial statements a firm must forecast.

Accounts Payable

Accounts payable is money owed by a business to its suppliers and is shown on its balance sheet as a liability. Commonly, a supplier will ship a product, issue an invoice, and collect payment later, which describes a cash conversion cycle. This is the period of time during which the supplier has already paid for raw materials but hasn't been paid in return by the final customer.

Accounts payable will influence the current liabilities of a business, which will accordingly influence the liquidity of the business. A major requirement for a business to continue its operations is for that business to maintain solvency. Modifying accounts payable will drastically change the amount of cash-on-hand required for a business.