The financial management of a firm deals with questions such as the following on an ongoing basis:
- How are we doing? Are we making or losing money?
- How much cash do we have on hand?
- Do we have enough cash to meet our short-term obligations?
- How efficiently are we utilizing our assets?
- How do our growth and net profits compare to those of our industry peers?
- Where will the funds we need for capital improvements come from?
- Are there ways we can partner with other firms to share risk and reduce the amount of cash we need?
- Overall, are we in good shape financially?
Financial Objectives of a Firm
- Profitability is the ability to earn a profit.
- Liquidity is a company’s ability to meet its short-term financial obligations.
- Efficiency is how productively a firm utilizes its assets relative to its revenue and its profits.
- Stability is the strength and vigor of the firm’s overall financial posture.
The Process of Financial Management
1. Preparation of Historic Financial Statements
- Income statement
- Balance sheet
- Statement of cash flows
2. Preparation of Forecasts
- Income
- Expenses
- Capital expenditures
3. Preparation of Pro Forma Financial Statements
- Pro forma income statement
- Pro forma balance sheet
- Pro forma statement of cash flows
4. Ongoing Analysis of Financial Results
- Ratio analysis
- Measuring results versus plans
- Measuring results versus industry norms
Historical financial statements reflect past performance and are usually prepared on a quarterly and annual basis. Publicly traded firms are required by the Securities and Exchange Commission (SEC) to prepare financial statements and make them available to the public.
Pro forma financial statements are projections for future periods based on forecasts and are typically completed for two to three years in the future. Pro forma financial statements are strictly planning tools and are not required by the SEC.
Historical Financial Statements
Historical financial statements include the income statement, the balance sheet, and the statement of cash flows. The statements are usually prepared in this order because information flows logically from one to the next.
1. Income Statement
The income statement reflects the results of the operations of a firm over a specified period of time. It records all the revenues and expenses for the given period and shows whether the firm is making a profit or is experiencing a loss
2. Balance Sheet
a balance sheet is a snapshot of a company’s assets, liabilities, and owners’ equity at a specific point in time.
The major categories of assets:
- Current assets include cash plus items that are readily convertible to cash, such as accounts receivable, marketable securities, and inventories.
- Fixed assets are assets used over a longer time frame, such as real estate, buildings, equipment, and furniture.
- Other assets are miscellaneous assets, including accumulated goodwill.
- Current liabilities include obligations that are payable within a year, including accounts payable, accrued expenses, and the current portion of long-term debt.
- Long-term liabilities include notes or loans that are repayable beyond one year, including liabilities associated with purchasing real estate, buildings, and equipment.
- Owners’ equity is the equity invested in the business by its owners plus the accumulated earnings retained by the business after paying dividends.
Summarizes the changes in a firm’s cash position for a specified period of time and details of why the change occurred.
The statement of cash flows is divided into three separate activities:
- Operating activities include net income (or loss), depreciation, and changes in current assets and current liabilities other than cash and short-term debt. A firm’s net income, taken from its income statement, is the first line on the corresponding period’s cash flow statement.
- Investing activities include the purchase, sale, or investment in fixed assets, such as real estate, equipment, and buildings.
- Financing activities include cash raised during the period by borrowing money or selling stock and/or cash used during the period by paying dividends, buying back outstanding stock, or buying back outstanding bonds.
To interpret or make sense of a firm’s historical financial statements
The ratios are divided into profitability ratios, liquidity ratios, and overall financial stability ratios.
5. Comparing a Firm’s Financial Results to Industry Norms
helps a firm determine how it stacks up against its competitors and if there are any financial “red flags” requiring attention.
Forecasts
Forecasts are predictions of a firm’s future sales, expenses, income, and capital expenditures. A firm’s forecasts provide the basis for its pro forma financial statements. A well-developed set of pro forma financial statements helps a firm create accurate budgets, build financial plans, and manage its finances in a proactive rather than a reactive manner.
A. Sales Forecast
A projection of a firm’s sales for a specified period
A sales forecast for an existing firm is based on (1) its record of past sales, (2) its current production capacity and product demand, and (3) any factor or factors that will affect its future production capacity and product demand.
B. Forecast of Costs of Sales and Other Items
After completing its sales forecast, a firm must forecast its cost of sales (or cost of goods sold) and the other items on its income statement. The most common way to do this is to use the percent-of-sales method, which is a method for expressing each expense item as a percentage of sales.
Pro Forma Financial Statements
A firm’s pro forma financial statements are similar to its historical financial statements except that they look forward rather than track the past.
A. Pro Forma Income Statement
A financial statement that shows the projected flow of cash into and out of a company for a specific period.
B. Pro Forma Balance Sheet
It provides a firm with a sense of how its activities will affect its ability to meet its short-term liabilities and how its finances will evolve over time. It can also quickly show how much of a firm’s money will be tied up in accounts receivable, inventory, and equipment. The pro forma balance sheet is also used to project the overall financial soundness of a company.
C. Pro Forma Statement of Cash Flows
Shows the projected flow of cash into and out of the company during a specified period.
The important function of the pro forma statement of cash flows is to project whether the firm will have sufficient cash to meet its needs.
Pro forma statement of cash flows is broken into three activities: operating activities, investing activities, and financing activities.
D. Ratio Analysis
The same financial ratios used to evaluate a firm’s historical financial statements should be used to evaluate the pro forma financial statements.
