Financial Management

Prospective Analysis
Airish Mae I. Danganan
Rose Ann dela Cruz-Valdez

Prospective Analysis
It is the forecasting of the future financial information. It is the central to security
valuation where both free cash flow and residual income models require estimates of future
financial statements.

Two Techniques in Prospective Analysis

1. Financial Statement Forecasting
2. Valuation

In prospective analysis, we make prospective financial statements which encompasses

financial forecasts and financial projections.

Two Broad Stages of Financial Prospective Analysis

1. Long term Forecasting – analysis of past data and forecasting of financial statements
2. Implementation – use of forecast to value common stock or to accomplish any other
objective for which the forecast was carried out.

Importance of Prospective Analysis

1. Security Valuation – residual income model requires estimates of future financial
statements
2. Management and Assessment – examine viability of company’s strategic plan.
3. Assessment of solvency – ability to meet company’s debt obligation.
4. Predictions of future performance.

In projecting financial statements, it must begin with projecting the income statement
followed by projecting the balance sheet or the statement of financial position.

Projecting Income Statement

Begins by estimating sales, thus sales estimate can be tested for plausibility in fou different
context which are:
1. Past sales trends
2. Market share implied by the sales estimate
3. Its relation to planned marketing efforts
4. Production capacity
Then, followed by projecting cost of goods sold or cost of sales. Cost of goods sold or cost of
sales are all cost that is directly linked to sales. These are always projected as percentage of sales
and their assumption can be affected by a variety of factors both external and internal to the
company.
The last step in projecting income statement is the projecting operating expenses,
depreciation and interest expense. Operating expenses are not directly linked to sales and are
projected on item by item basis. Meanwhile, projecting depreciation and interest expense
requires a look ahead to the projected balance sheet. Past interest expense will be analysed as a
percentage of past debt balances and trend extended into the future.
Financial Management
Prospective Analysis
Airish Mae I. Danganan
Rose Ann dela Cruz-Valdez

Example of Projecting Income Statement

Projecting Balance Sheet

These are the following steps in projecting balance sheet:
1. Project current assets other than cash, using projected sales or cost of goods sold and
appropriate turnover ratios as described below.
2. Project PP&E increases with capital expenditures estimate derived from historical trends
or information obtained in the MD&A section of the annual report.
3. Project current liabilities other than debt, using projected sales or cost of goods sold and
appropriate turnover ratios as described below
4. Obtain current maturities of long-term debt from the long-term debt footnote.
5. Assume other short-term indebtedness is unchanged from prior year balance unless they
have exhibited noticeable trends.
Example of Projecting Balance Sheet
Financial Management
Prospective Analysis
Airish Mae I. Danganan
Rose Ann dela Cruz-Valdez

Results in Projecting Balance Sheet

Sensitivity Analysis
Sensitivity Analysis varies in the projection assumptions to find those with the greatest
effect on projected profits and cash flows. It examines the influential variable closely. It also
prepare expected, optimistic and pessimistic scenarios to develop a range of possible outcomes.

The Residual Income Valuation Model

It defines equity value at time “t” as the sum of current book value and the present value
of all future expected residual income.

Where: BVt is book value at the end of period t, RIt + n is residual income in period t + n,
and k is cost of capital. Residual income at time t is defined as comprehensive net income minus
a charge on beginning book value, that is, RIt = NIt - (k x BVt - 1).

Application of Prospective Analysis in the Residual Income Valuation Model

In its simplest form, we can perform a valuation by projecting the following parameters:
 Sales growth
 Net profit margin (Net income/Sales)
 Net working capital turnover (Sales/Net WC)
 Fixed-Asset turnover (Sales/Fixed Asset)
 Financial Leverage (Operating Assets/Equity)
 Cost of equity capital
Financial Management
Prospective Analysis
Airish Mae I. Danganan
Rose Ann dela Cruz-Valdez

Advantages of Residual Income Model

1. It makes use of data readily available from a firm’s financial statements and can be used
well with firms who do not pay dividends or do not generate positive free cash flow.
2. It looks at the economic profitability of a firm rather than just its accountability
profitability.

Thus, its only drawback in using residual income model is the fact that it relies so heavily on
forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to
psychological biases or historic misrepresentation of a firms financial statements.

Trends in Value Drivers

The Residual Income valuation model defines residual income as:

RIt = NIt – (k X BVt-1)
= (ROEt – k) X BVt-1
Where ROE = NI/BVt-1
- Stock price is only impacted so long as ROE ≠ k
- Shareholder value is created so long as ROE > k
- ROE is a value driver as are its components
- Net Profit Margin
- Asset Turnover
- Financial leverage
Two relevant observations:
- ROEs tend to revert to a long-run equilibrium.
- The reversion is incomplete.

Sources:

DAC 115 Corporate Financial Reporting and Analysis

Financial Statements Analysis by Dina Trisnawati
Fundamentals of Investments (Valuation and Management) 7th Edition By Bradford Jordan,
Thomas W. Miller Jr., Steven D. Dolvin, CPA 2015