BUS601: Financial Management

At some point in time, we all have to look into the future.  In our personal lives, this might include considering the purchase of our first home. There is a need to consider the down payment, monthly mortgage costs, insurance premiums, taxes, and maintenance (investment). Our analysis will most likely include some expectation of the value of this home appreciating over time (return on investment), and this will be included in the decision-making process.  Businesses engage in the same process, whether it is considering the launch of a new company or expanding an existing business.  

For the sake of this discussion, let us assume that we are interested in making some investments to expand the business.  To be effective in this process, there are a few key components that must be included.  

• Review the past.  How has the firm been performing over the last few years?  Are there any significant trends that can be identified?

• What is the value of the investment to be made?  How will it be financed?  If this investment is paid, what are the projected results?

• In considering the future state, what factors in the business environment must be considered (economic, social/culture, legal, competition, etc.)?

Trend Analysis

When we are analyzing a financial package and comparing year-over-year performance, we need a way to interpret how increases and decreases in the various accounts really affect our business.  For example, sales can increase from $3,432,000 (year 1) to $5,834,400 (year 2).  Cost of goods sold (COGS) has also increased from $2, 864,000 (year 1) to $4,980,000 (year 2).  This, in itself, is not really surprising as you would expect to spend more on materials and labor as you sell more products.  But how well are we doing given this performance?

To evaluate our year-over-year performance and determine if any changes are required, we will need to common-size our financials.  This step will restate each account on the income statement, or the balance sheet, as a percentage of our sales.  These percentages help to understand the size of the changes presented in the financial statements.  Let us consider the following section of a simple income statement:

Our Company
Income Statement
Years Ending 2017 through 2019

A review of the numbers shows that our sales increased substantially, as did the COGS and S, G & A.  However, we notice that although sales increased, our operating margin has decreased.  This is where common sizing can help us to make sense of the numbers.

The formula for common sizing is:

(Expense Account / Sales) * 100 = % of Sales

With this new information, we can look in more detail at what occurred in our business.  For example, COGS decreased per sales dollar in 2019 versus 2018.  Specifically, you spent seventy cents of every dollar in sales on COGS, versus the almost 73 cents per dollar that you spent in 2018.  You should determine why this cost went down.  Was it due to better price negotiations or perhaps a change in materials?

S, G & A increased almost 3.5%.  You are spending more of every dollar received to cover administrative salaries, marketing activities, business insurance, etc.  Are there areas where you can improve efficiencies, or better control these increasing expenses?

Bottom line is that you worked harder, found more customers, and increased your sales, but ended up earning approximately 2.4% less in net earnings as a percent of sales.  Look, sometimes, despite our best efforts, we will realize a loss.  The question to be answered is…could this have been prevented?

Pro Forma Financials

Now that you have reviewed where you have been, it’s important to see where you’re going!  Understanding where you want your business to be over the next 2-, 3- or 5-year period is part of the preparation work for helping you make the necessary decisions required to support your future plans.

Now, let me be honest here. This is where things can get to be a bit challenging.  The forecasting process requires a great deal of homework. You will need to do your homework on the market, trends, competition, consumers, legislation, suppliers, and much more.  The better informed you are about what is taking place in the business environment, the better your position to plan for the future.

Finally, for our analysis to be as effective as possible, we need to do a comparative analysis that looks outside the business as well as inside.

• Internal – evaluates the business' performance over time, and highlights areas for review.
• External – evaluates the financial performance of the business against the performance of other, similar firms in our market.

Let us make the following forecast for the year 2020:

• Sales will increase by 5.0% - based on the addition of two new product offerings and the opening of three new sales offices.

• COGS sold will be reduced to 68.0% of sales – based on supplier negotiations and the identification of three new preferred suppliers.

• S, G & A will be reduced to 10.0% of sales – re-evaluating marketing expenses, negotiating lower insurance rates, and eliminating underutilized warehouse space.

• Depreciation expense will be held constant at 1.5% of sales.

• Interest expense will be held constant at 2.0%of sales.

As a result, the pro forma income statement for 2020 would be:

The company will, of course, need to provide a forecast for each of the statements contained in the financial package.  This means that there will be a proforma Income Statement, Statement of Retained Earnings, Balance Sheet, and Statement of Cash Flows.  Remember what this process involves.  The company started with a review of how the company performed in the past, and the use of trend analysis to determine if there are significant patterns in revenue generation, operating costs, profits, and losses.  This was followed by a comprehensive review of what critical factors the firm could identify that will have an effect on future performance.  They must consider the external business environment that the firm operates in, including competition, cultural and demographic changes, consumer wants/needs, and government regulations.

When all of this information is available to the firm, they can then evaluate internal factors that can impact future performance.  Factors such as capital investments, required skill sets, productivity measures, plant expansions, and any number of additional decisions that management is making must also be included in the discussion.  Finally, the company will create the pro forma financial package which becomes the basis for developing the operating budgets for the business.

One final note about forecasts.  This must be a dynamic process.  By that, I mean that historical trends are not necessarily predictors of future outcomes.  In addition, the internal and external factors that we used to prepare our forecast can, and most probably will, change.  That is why it is important to conduct regular reviews of our progress against these budgets, but to determine if changes should be made to the budget itself due to changes in the business environment. 

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Source: Saylor Academy
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