924 Lecture 7 Essay

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Strategy, accounting, and financial performance analyses provide valuable information that help to shape forecast assumptions.
Forecasts of future performance should be comprehensive, including all condensed financial statements. The starting point for forecasts should be the time series behavior of key measures such as sales growth, earnings, and ROE (and its components).

A projection of future performance of the firm
Strategic Analysis – strategy and competitive performance. Can it be sustained Growth of the company in the long and short run
Accounting Analysis- Past earning or assets overstated or expenses or liabilities understated
Implications for future accounting statements
Financial Analysis – Sources of superior performance. Can it be replicated in future

Typically a few key strategic drivers are critical to forecasting future firm performance.
◦ For example, breakthrough technologies, business alliances, and business line expansions.

A practical approach begins with deriving condensed financial statements that contain key elements of the income statement, balance sheet, and statement of cash flows.
Typically, estimating future sales is the critical first step in arriving at forecasted financial statement information. 

Comprehensive forecast
Earning forecast
Cash flow forecast
Balance Sheet forecast
Identify key drivers - depends on nature of business. Sales forecast, profit margin

Past performance may be used to understand the behavior of key measures such as sales or earnings. ◦ Studying the time series of measures such as earnings can provide insights into trends for future performance. ◦ Measures from prior periods provide benchmarks to compare forecasts against.

Sales is the most used key driver
Growth in sales related to working capital and investment in plant and machinery
Expenses are related to sales – affect profit margin Cash flow forecasts is grounded on accounting numbers – sales, earnings, assets and liabilities
Growth, profitability are related to sales forecast 

Sales Growth Behavior

◦ Growth rates tend to be mean-reverting. See Figure
6-1 on the next slide.

Earnings Behavior

◦ On average, follow a random walk or random walk with drift.
◦ Long-term trends tend to be sustained, on average.

Return on Equity Behavior

◦ ROE behavior is dependent on both earnings and the asset base.
◦ Patterns tend to be mean-reverting. See Figure 6-2 on the next slide.

ROE may be decomposed ultimately to the following components: ROE = NOPAT margin * Operating asset turnover +
Spread *
Net financial leverage

Analyzing the behavior of the components from
1988 – 2005 provided the following insights:

◦ Operating asset turnover and net financial leverage tend to be rather stable
◦ NOPAT margin is the most variable component of ROE, and drives changes in the spread

Preliminary analyses can assist with conducting forecasts.
Using Michael Hill as an example:

◦ Business strategy analysis: Is Michael Hill’s strategy of growth through geographic expansion likely to be profitable?
◦ Accounting analysis: Has Michael Hill overstated earnings or assets, or understated expenses or liabilities? ◦ Financial analysis: What are the sources of superior performance, and is it sustainable?

The impact of changing macroeconomic conditions is sufficiently unpredictable to focus on the firm’s competitive position and strategy
Sales growth has historically met and exceeded investor expectations, but future competition suggests that a slowing trend in the rate of growth is likely.

As a cost leader Michael Hill relies on and can achieve a lower margin.
Its margin have been low recently due to its geographic expansion, and a short term recovery is expected.
In the long run margins are expected to revert to the mean, as a result of increasing competition. 

Working capital to sales – likely to decrease