Financial Statements and Firm Value 133debt. While sales growth, gross margin expenses and tax rate determine NOPAT, the incremental working
capital investment can be determined by days’ receivable, days’ inventory, and days’ payable. Investors care
about the cash economics of the business because they determine the magnitude, timing and riskiness of
future cash flows. Because New Economy companies like Amazon.com and Yahoo! have dramatically different
cash flows than Old Economy companies like Unilever, we would expect them to have dramatically different
valuations as well. This is indeed the case. Other things being equal: larger the cash inflow from cash
investments, more valuable the company. Conversely, a larger cash outflow from cash investments translates
into lower valuation. Internet companies usually have significantly less investment needs than their Old
Economy counterparts.
Financial Forecasting
Techniques like ratio analysis and funds flow analysis are used to evaluate past performance. Financial fore-
casting involves development of financial models to look into the future. There are three principal components
of financial planning:- Preparing proforma financial statement
- Preparing cash flow estimates
- Preparing cash budgets
We shall discuss the first two, in this section. Financial planning is essential to all companies regardless of
their sizes. Since the common denominator in business is money and money needs to be managed well, it is
imperative for not only the finance manager but also all concerned executives to plan and prepare for the future.
A financial plan is only one part of the story. The other components of the overall plan include marketing
strategy, production plan, etc. A financial plan is supposed to throw light on the capital investment and
financing needs of the firm given its growth objective (and try to match the two). The preparation of proforma
financial statements is one of the most widely used financial forecasting techniques. As the name suggests,
it is the projection of what the financial statements look like at the end of the forecast period, say, 1–5 years.
The projection (of financial statements) involves prediction of each of the variables that you find in the
balance sheet and income statement. The simplest way to forecast financial statement would be to express
all income statement and balance sheet numbers as percentage of sales and given the sales forecast
for the next period find the values of all variables using the historic relationship between the variable and
sales. Obviously, not all variables will have a strict, direct relationship to sales.
For instance, the level of current assets may have a relationship with sales but depreciation may not.
A better strategy is to use a combination of individual forecasting and percentage of sales forecasting. Once
the projected financial statements are ready, a sensitivity analysis could be conducted to test the implication
of variation in sales. It should be noted that when we find the ratio of, say, current assets and sales, we
are assuming that there is a direct, linear relationship between the two. In real life situations, it might be
prudent to generate intensive discussion among concerned executives rather than blindly extrapolate ratios.
The following steps are involved in percent-of-sales forecasting:- Prepare a sales forecast.
- Establish relationship between sales and other relevant financial variables (hence the name percent-of-sales
forecasting) and extrapolate. - Estimate the values of variables that do not have a direct relationship with sales individually.