Prospective Analysis

Introduction

• Future liquidity is as important as past and current

liquidity.
• Company’s future liquidity, solvency, and financial
flexibility is an important aspect to be seen through
financial statements analysis.
 Prospective analysis

• Short-term forecasting
 Cash flow patterns
 Forecasting Sales
 Pro forma analysis
• Long-term forecasting
 Analysis of past data
 Forecasting sources and uses

• Cash flow ratios

 Cash flow adequacy
 Cash reinvestment
 Short term forecasting

• Analysis stresses short-term cash forecasting when company's

ability to meet current obligations is in doubt.

• Short tern cash forecasting is of interest to internal users like-

Managers and Auditors for evaluating a company’s current
and future operating activities.

It is also of interest for external users like-

Short-term creditors they need to assess the a company’s
ability to repay short-term loans.
 Cash flow patterns

• It is very important to review the nature of cash flow patterns

before examining models for cash flow analysis and
projections.
• Holding of cash in the times of increasing prices results in loss
of the purchasing power of the cash.
• Management is responsible for decisions to invest cash in
assets or to immediately pay costs.
• These cash conversions increase risk because the ultimate
recovery of cash from these is less than certain.
• Risk associated with these cash conversion is of various types
and degrees. For exp.
 Risk in converting cash into temporary investment is less than
the risk in committing cash to long-term payout assets like plant
and equipments.
 Investing cash in assets or costs aimed at developing and
marketing new products often carries more serious cash
recovery risks.
• Both short-term liquidity and long-term solvency depend on the
recovery and realizability of cash.
• Cash inflow and outflows are interrelated.
For Exp.
A lapse in sales affects the conversion of finished
goods into receivables and cash, leading to a decline
in cash availability. Company’s inability to replace
this cash from sources like equity, loans , accounts
payable can impede production activities.
• Further, the interrelation between cash flows,
accruals, and profits should be duly recognized.
 Forecasting Sales

• The reliability of cash forecasts depends on the quality of sales

forecasts.

• With few exceptions such as funds from financing or funds

used in investing activities most cash flows relate to and
depend on sales.
Sales forecasting includes consideration of-
• Direction and trends in sales
• Market share
• Industry and economic conditions
• Productive and financial capacity
• Competitive factors
 Cash flow forecasting with Pro forma analysis

• The reasonableness and feasibility of short-term cash forecasts

are usefully checked by means of pro forma financial
statements.
• The assumptions of cash flow forecast are used to prepare pro
forma income statement for forecast period and pro forma
balance sheet for the end of forecast period.
• Then financial ratios and relationships are derived from these
statement and compared to the past data to draw inferences.
• The comparisons must recognize adjustments for factors
expected to affect them during the
 Long-term forecasting

• Short-term cash forecasting using pro forma statements is a

very useful and reliable aid in assessing liquidity.
• However, the reliability and feasibility of cash forecasting
using pro forma statements decline in longer time horizons like
two to three years .
• Long-term cash forecasting instead of focusing on items like
receivables, collections, and payments for labour and materials
etc. focuses on projections of income, operating cash flows,
and other sources and uses of cash.

• It involves two steps-

 Analysis of cash of prior periods using cash flow statements
 Adjustments to cash flow data based on relevant
information and estimates about future uses and sources of
cash to generates our forecasts.
• What-if forecasting of cash flows( unexpected events)
 Cash flow ratios

• Cash flow adequacy Ratio

The cash flow adequacy ratio is a measure of company’s ability
to generate sufficient cash from operations to cover-
 Capital expenditure
 Inventory additions
 Cash dividends
(5 yr sum of cash from operations) / (5 yr sum of capital exp,
inventory additions, and cash dividends)
 Cash reinvestment ratio

• A measure of the percentage of investment in assets

representing operating cash retained and reinvested in the
company.
(Operating cash flow-Dividends)/ (Gross plant+ investment+
other assets+ working capital)
5. Disclosure quality
Are disclosures adequate to analyze the business? Disclosures are
made within the financial statements, in the foot notes, and
management discussion and analysis.
Disclosures like..
Distinguishing core operating profitability from unusual.
Distinguish operating items from financial.
Drivers of core profitability
etc.