Financial Analysis and Forecasting
The most important type of financial analysis is basic ratio analysis. Every financial executive has to have a very good understanding of accounting. This is where some academic finance programs have fallen down: Collectively we have de-emphasized accounting and have emphasized economics. As Enron has reminded us, financial executives and financial academics have to have a very good understanding of accounting, both for corporate finance and for what is needed in value equity shares. The most important aspects of security analysis and of corporate finance are to understand financial analysis, which is to go through the basic Dupont formulas to understand where the profitability of a firm comes from, and then further to read the notes to the financial statements.
Generally, there is too much functional fixation on earnings per share, and not enough time is spent reading the notes to the financial statements to understand the quality of the underlying information that goes into the earnings per share calculation. Financial analysis is overwhelmingly the most important thing – apart from the time value of money – that people get out of a finance course. Financial analysis is what finance professionals need to know. Unfortunately, it is not being emphasized as much it should be in most finance textbooks.
It is critically important to be able to read a set of financial statements and realize that the earnings per share have increased simply because the company triggered the sale of an unwanted asset, rather than through increased sales; or that the sales themselves were made only through generous financing indicated by the increase in accounts receivable; or that the increased earnings per share only came about because the firm hid some expenses either through using executive stock options instead of bonuses as compensation or by stretching out depreciation schedules. WorldCom has alerted us all again that changing expenses into assets not only reduces expenses and thus increases earnings per share, but also increases the tangible asset value per share.
After financial analysis, you need to go through basic financial forecasting. Financial analysis tells us what has happened, but good financial forecasting can tip us off as to what might happen in the future. Here it is important to check cash flow from operations with net income to assess the quality of a firm’s financial statements. Profitability shortfalls that have been covered through triggering asset sales or stretching out depreciation schedules become apparent in a five-year forecast as the firm’s ability to generate cash flow dries up.
The great value of financial forecasting is in the ability to build a spreadsheet model and do “what if” analysis. We can do this in spreadsheets very easily. What tends to happen is that professionals vary the sales levels by plus or minus 2 or 3 percent. They change the cost of goods sold or the fixed cost and then assess the impact on cash flow and earnings. The hidden flaw in much of this analysis is a failure to understand the linkages between different spreadsheet variables. There is too much extrapolation, simply because spreadsheets allow you to extrapolate, and not enough smart modeling.
The key idea that has been rediscovered in finance is what is now called real options. The insights of Black and Scholes into pricing derivatives have been very important, but their insights have also reemphasized that in any spreadsheet, you can’t simply extrapolate numbers. You have to consider that if certain numbers change significantly – say, sales increase by 5 or 10 or 15 percent – then there may be other changes that are going on, as well. For example, the increase in sales may cause scale economies to lower unit costs or increase the gross margin. Similarly, if sales decline by 5 or 10 or 15 percent, the firm may change some of its actions and actually change the underlying cash flows. This is actually an old message in finance. We used to talk about it in terms of decision trees. For example, a price decline of 20 percent may cause the gross margin to turn negative, forcing the firm to close that line of business to avoid incurring more losses. Similarly, a price increase may cause the firm to switch production from one line to another. In either case, a simple extrapolation in a spreadsheet doesn’t fully capture the dynamism of the firm’s response to certain situations. The incorporation of the idea of real options into spreadsheet design offers the benefit of more accurate and realistic financial forecasting.
