Applications of FSA: Analyzing Past and Forecasting Future Performance | CFA Level I FSA
PREREQUISITE LESSON
This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.
Today, we’ll dive into the topic of analyzing past performance and forecasting future performance using financial statement analysis.
Evaluating Past Performance
We start the process by breaking down financial statement analysis into a few key segments:
- Evaluation of past performance
- Building a forecasting model based on past performance findings and market projections
- Forecasting future earnings and cash position of the company
Recall the financial statement analysis framework from the topic on financial analysis techniques.
Evaluation of past performance is related to Phases 3 and 4, processing and analyzing data. Common techniques used for this purpose include:
- Common-size analysis
- Graphical analysis
- Regression analysis
- Ratio analysis
EXAMPLE
Let’s evaluate the performance of a furniture manufacturer for the past 3 years using common-size analysis and ratio analysis. Some observations from the analysis include:
- Gross profit margin consistent at around 50-55% for the past 3 years
- Tax expense consistent at around 25% of operating profit
- Increasing operating costs leading to declining operating and net profit margins
Comparing the company’s ratios with the industry average can reveal important aspects of its business strategy. For instance:
- Higher gross profit margin than the industry, indicating a focus on the premium market
- Higher sales, general, and admin expenses than the competition, possibly due to marketing and R&D
Past performance evaluation also allows us to evaluate a firm’s management, and can be used to improve the forecasting model.
Forecasting Future Performance
To forecast future net income and cash flow, start with:
- Forecasting future sales
- Estimating the relationship between GDP growth and industry sales growth
- Including projections of the firm’s market share
Each item on an income statement and balance sheet can be estimated based on separate assumptions about its growth in relation to revenue growth. Multi-period forecasts often use a single estimate of sales growth expected to continue indefinitely.
EXAMPLE
In this example, we project the company’s sales to increase at 5% per year based on the sales forecast. Assumptions include:
- Cost of goods sold at 45% of sales
- Operating expenses at 30% of sales
- Tax expenses at 25% of operating income
To estimate cash flows, make assumptions about future sources and uses of cash. A first-pass model might consider:
- Increases in working capital
- Capital expenditures on new fixed assets
Common assumptions include non-cash working capital as a percentage of sales remaining constant, and fixed capital requirements remaining at a set percentage of sales.
By subtracting the investment in working capital and investment in fixed capital from the net income, we can estimate the change in cash for each year. This allows us to forecast the cash position of the company, excluding the effects of financing cash flows and interest payments.
In our example, we assume that non-cash working capital stays constant at 70% of sales, and fixed capital requirements remain at 10% of sales. This helps us project the investment in working capital and fixed capital for the next 3 years. The forecasted cash position shows an increase each year, indicating a healthy cash position and potentially no need for additional debt to sustain operations.
A second pass can be performed to model the effects of financing cash flows on the forecasted cash position, although it is outside the scope of this topic.
Conclusion
By analyzing past performance and forecasting future performance using financial statement analysis, we can gain valuable insights into a company’s financial health and growth potential. This information can be crucial for investors and financial analysts in making informed decisions about a company’s prospects.
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