BUSINESS 020
FREQUENTLY
ASKED QUESTIONS:
FINANCIAL MANAGEMENT
|
|
|
|
|
|
|
|
|
|
|
How do I prepare projected financial statements? What are these statements used for? |
|
|
|
|
|
|
|
|
|
|
|
What Financial Management information will I be required to use again later in the course? |
What is the
format for analyzing a Finance case?
Finance, more than any other segment of Business 020, lends itself well to a relatively structured analysis. In most comprehensive cases, the student is asked to take on the role of a lender assessing the financing requirements and credit worthiness of a customer requesting a loan. While students may often encounter variations on this theme, the general process for assessing a financing request remains basically the same.
In their capacity as outlined in the case, a student must first examine the financial history of the company. By preparing the Statement of Sources and Uses, and analyzing it along with a company's Ratio Sheets, the students will gain an understanding of the performance of the company to date. Using this history as a starting point, the student can now project future performance by preparing projected Income Statements, Statements of Retained Earnings and Balance Sheets. By taking into account both historical performance and management's predictions for the future, these tools are commonly used to assess potential financing requirements, and to help determine if the company will be able to handle any requested debt increases.
Once the student has determined the projected financing needs (plug figure), they must then assess the reasonableness of this amount, and determine if the business' owners should be granted a loan. At this point, a 4Cs analysis can be performed to evaluate any factors affecting the lender's decision that may not have been accounted for already.
Finally, the student must synthesize the knowledge gained from their analysis and determine if the loan request should be granted. A complete, balanced decision and action plan should be prepared to address any concerns the student, in the role of lender, may face from their superiors and/or the customer requesting the loan.
What is a
Statement of Sources and Uses?
Using past balance sheets, this tool allows students to compare where the company is getting its money from (sources) to where the company is spending its financial resources (uses).
When preparing the statements, a student must first compare two historical balance sheets (usually the oldest and newest available), and determine whether the individual accounts represent sources or uses of cash. When assets increase over a given period, they represent a use of cash to a business. When assets decrease, they are a source of cash. In contrast, when liabilities or equity increase they are a source, and when they decrease they are a use.
Once the accounts have been identified, grouped and subtotaled, students can then compare the total sources to total uses to determine whether the company is making good use of its limited financial resources. An effective analysis will identify the major sources and major uses (particularly if these include retained earnings), determine their apparent suitability, and assess whether they are expected to re-occur annually. Overall, the student's analysis should be geared to determining the reasonableness of the cash sources and uses in the business, and the implications these have for the future financial performance of the company.
What is a
Ratio and how do I analyze it?
A financial ratio is nothing more than the restatement of a company's financial statements in fraction form. Often these ratios do not appear as fractions, but rather they are simplified to allow for a more straightforward analysis of how the company is achieving its financial goals. In many cases, the company provides these ratios for the student. However, it remains essential to understand the mechanics behind these numbers for an effective analysis of a company's historical performance.
A ratio analysis generally includes an examination of the five main financial goals (profitability, stability, liquidity, efficiency, and growth). This analysis does not stop with a statement of the magnitude or direction of change, however, but pushes further to understand why these changes have occurred, and whether they have been positive or negative for the business overall. To facilitate such an analysis, it is important to remember that alone any given ratio is of little value, but instead must be compares to industry trends and ratios from other years.
How do I
prepare projected financial statements? What are these statements used for?
In order to prepare projected financial statements, a student must first understand the mechanics of an Income Statement, Statement of Retained Earnings, and Balance Sheet. If you still do not have a firm grasp on the details of how to prepare each statement, it is important to clear up any concerns immediately or you will have considerable difficulty preparing and analyzing projected statements. These statements are critical to an effective financial analysis, and are used to determine the "plug", which represents your best assessment of the projected financing requirements for a company. As such, they represent a significant portion of your financial analysis, are given considerable weight on the financial management exam.
Income Statement
Income projections normally start with a sales estimate, either as provided in the case, or determined by the student using case information. Most costs are then estimated as a % of sales, but some are more appropriately projected using a dollar amount. Generally, those costs that tend to vary along with sales (wages, electricity, etc.) are estimate using the previous year's ratios multiplied by projected sales, while those expenses unrelated to changes in revenue (rent, parking, etc.) are based on the previous year's dollar figures. The difference between income and expenses then calculated, so that tax (if applicable) can be estimated. The final line on a projected Income Statement is often referred to as Net Income, and this amount is used in the preparation of a projected Statement of Retained Earnings.
Statement of Retained Earnings (SRE)
A very straightforward statement, projecting the SRE always begins with the Retained Earnings amount found on the previous year's SRE or on last year's Balance Sheet in the Equity section. Added to this is any projected income (Net Income figure from the projected Income Statement), and subtracted are any dividends the company is projected to declare. The resulting amount represents the current year's Retained Earnings, and is a necessary account for the preparation of the projected Balance Sheet.
Balance Sheet
Unlike the projected Income Statement, which uses ratios in conjunction with projected sales, there is no single account that serves to simplify the preparation of the projected Balance Sheet. Instead, each asset, liability and equity account must be projected independent of one another. In some cases, these are simply calculated using a student's "best guesses", but more often they are based on manager's estimates, age ratios (as discussed in class), or case facts.
If prepared correctly the Balance Sheet must always maintain the balancing relationship "Assets = Liabilities + Equity". However, when projections are being prepared, it is nearly impossible to estimate with such precision, and a "plug figure" is therefore used to ensure this relationship is maintained. In most cases, the plug will be the requested loan amount, and the projected Balance Sheet therefore serves as a tool for estimating how much financing a firm will require, should all the projections made prove true.
While it may at first seem a difficult statement to prepare, frequent practice with the cases throughout this section of the course will expose you to a variety of different Balance Sheet projection methods, and will serve to reduce any uncertainty you may feel going into the exam.
While the general method for projecting statements has each been described above, it is important to note that the specific details for estimating individual accounts can vary significantly from case to case. It is for this reason that students must strive to be well prepared in advance of each class, in order to ensure an understanding of the wide variety of projection techniques. It is also important for students to note both their assumptions and any supporting calculations so that the instructor can follow their logic (essential for part marks!) when work is submitted as either an assignment or an exam.
The plug figure is often a source of confusion for students, but it is really nothing more than an account on the projected Balance Sheet that serves to ensure the statement actually "balances". On any Balance Sheets, the sum of all Assets must always be equal to the sum of all Liabilities and Equities. However, when preparing projected statements, it is often difficult to project with exacting precision, and so one account is left blank until all others have been estimated. Usually, this "plug account" is the requested loan amount, and all that remains is to fill in this account with a figure that ensures the balance is maintained. Once calculated, the plug usually serves as a tool for estimating how much financing a firm will require, should all the projections made prove true.
As important as any financial analysis performed, an assessment of credit risk is an essential part of an effective lending decision. The term "Four Cs of Credit" refers collectively to an assessment of the owners CHARACTER, the business' operating CONDITIONS, its apparent CAPACITY to service debt, and the COLLATERAL available for seizure in the event of bankruptcy. The relative importance of each aspect of analysis often changes from case to case. As a result, the level of detail students provide will vary as case facts permit. This serves to highlight the need for consistent preparation, and an adherence to the suggested methods of analysis as describe in the text and in class.
What is
considered a good decision/action plan?
A good decision should demonstrate that the case analysis has led the student to draw conclusions leading to a specific course of action. The decision should be well supported with the case analysis, should be consistent with the implications/conclusions drawn from the analysis, and should fit well with the firm's goals, objectives, abilities and the external environment in which the firm operates.
An effective financial manager always strives to balance the results of their financial analysis with the qualitative factors affecting a lending decision. A good decision therefore considers the quantitative implications drawn from your analysis in context of the non-financial factors outlined in the case. It explains clearly the reasoning for your decision to grant the loan, deny the request, or offer some alternative amount. In addition, an effective decision specifies a specific implementation plan, including repayment schedules, loan covenants, and/or any collateral liens deemed necessary. Finally, if your decision is to deny the loan, an effective action plan will include an outline of your presentation of this information to the customer, and will outline if and how you plan to maintain a business relationship after delivering what is sure to be unwelcome news.
Overall, your final decision must be proven to be consistent with the results of your analysis. Students must convince each other (and the Instructor) that the decision made and implementation plan devise makes sense and will work.
What Financial Management information will I be required to use again later in the course?
Though the Financial Management unit is complete, some of the tools will be used again throughout the remaining units. You will need to remember how to project statements (particularly the Income Statement) for the General Management unit, and you may find being able to project this statement comes in useful in Marketing. You will also need to remember how to interpret (and perhaps calculate) ratios, and your knowledge of the 4C's of risk may come in handy. We highly recommend that you retain your Financial Management reference sheet for use later on in the course.