Financial Planning & Analysis

FINANCIAL PLANNING AND ANALYSIS

Financial Planning and Analysis (FP\&A) is essential to driving sustainable business success. This section provides insight into how businesses assess performance, plan for future growth, and align financial strategies with long-term objectives. Through structured analysis, projections, and budgeting scenarios, organizations can make informed decisions, manage risks effectively, and optimize financial outcomes. Explore the tools and approaches used to evaluate operating measures, forecast performance, and prepare for potential financial challenges in today’s dynamic market landscape.

Operating Measures

Operating measures, also known as operational metrics or key performance indicators (KPIs), are quantifiable metrics utilized to assess and track the efficiency and effectiveness of company’s daily operations. The KPIs provide sights into the operating performance of a company. These measures are essential for understanding how well a business is performing and for identifying areas that require improvement.

Significance of tracking Operational Metrics

Identifying Bottlenecks:helps businesses to spot areas where processes are inefficient and slow.
Resource Allocation: helps businesses to effectively allocate resources based on performance information.
Performance Improvement: provides insights for data-driven decisions to foster performance and efficiency.

Benchmarking: enables comparison pf performance against industry standards or competitors.

Sales Growth

Sales growth is referred to as the increase in a company’s revenue over a specific period, usually measured as a percentage change. Sales growth is a crucial determiner of financial performance and expansion. The data required for assessing sales growth are in the income statement.

Sales growth is calculated comparing current period sales to a previous period’s sales (e.g., month-over-month, quarter-over-quarter, and year-over-year).

Formula for measuring sales growth: (current year / previous year) -1

Gross Margin % of Sales

The gross margin percentage of sales (gross profit margin) is a financial metric that indicates the profitability of a business by computing the percentage of revenue left after accounting for the cost of goods sold (COGS).

Gross Margin Percentage = (gross margin / total revenue or sales) x 100

Operating Income (EBIT) % Sales

Operating income as percentage of sales is a key profitability metric. It indicates how efficiently a company generates profit from its main operations, prior to considering interest and taxes. A higher percentage means better operating efficiency.

Formula for calculating operating income: Operating Income / Sales

Asset Utilization Measures

Asset Utilization Measures

Asset utilization measures how efficiently a company uses its assets to generate revenue or attain its intended purpose. It represents a key performance indicator (KPI) that reflects how well a business utilizes its resources, for example equipment, machinery, and human capital, compared to their potential capacity. Higher asset utilization generally shows signals greater profitability and efficiency

Days Sales Outstanding

Days Sales Outstanding (DSO) is a financial metric that measures the average number of days it takes a company to collect payment after a sale has been made. It indicates how efficiently a company manage its accounts receivable and convert sales into cash. A lower DSO generally in indicates better cash flow and more effective and efficient collections.

Formula for calculating DSO: (Accounts Receivable / Total Credit Sales) x Number of Days

Inventory Turnover

Inventory turnover is an important metric that indicates how efficiently a business manages its inventory. It measures how frequently a company sells and replaces its stock of goods during a specific period, usually a year. A high inventory turnover rate implies efficient inventory management, vital sales, and potentially better cash flow, while a low rate often indicates overstocking or slow sales.

Formula for calculating Inventory Turnover: Cost of goods sold (COGS) / Inventory

Factors Affecting Inventory Turnover:

Product Life Cycle:Turnover rates may vary as products move through their life cycle (growth, maturity, decline).
Seasonality:Demand for certain products may fluctuate based on seasonal patterns.
Industry Benchmarks:Different industries have varying norms for inventory turnover.

Inventory Management Practices: Efficient ordering, storage, and sales strategies can positively impact inventory turnover.

Days Sales in Inventory (DSI)

Days sales in inventory, also known as inventory days outstanding or days sales of inventory, is a financial metric that measures the average number of days it takes a company to sell its inventory. It indicates how efficiently a company manages its inventory and how fast it converts its stock into sales.

Formula for calculating DSI: (Average Inventory / Cost of Goods) x Number of Days

Where:
Average Inventory: (Beginning Inventory + Ending Inventory) / 2
Cost of Goods Sold (COGS): The direct costs associated with producing the goods that wee during the period.
Number of Days: Usually 365 days for a full year.
Interpretation:
Low DSI

As a rule, a lower DSI is preferable as it suggests that a company is efficiently selling its inventory and quickly turning it into revenue.

High DSI

A higher DSI suggests that a company may be holding onto inventory for a longer period, potentially owing to slow sales, overstocking, or other issues with inventory management.

Operating Cash Cycle

Operating Cash Cycle

The operating cash cycle, also known as the cash conversion cycle or net operating cycle, measures the time it takes for a company to convert cash invested in inventory and other resources back into cash from sales. It crucially represents the number of days between paying suppliers and receiving cash from sales. A shorter operating cash cycle generally suggests better working capital management and improved financial health.

Formula for calculating operating cash cycle: DSO + DSI
The Significance Operating Cash Cycle:
Efficiency

A shorter operating cycle indicates that a company is more efficient in managing its inventory and receivables, turning them into cash more quickly.

Liquidity

A shorter cycle signifies the company has more readily available cash to meet its short-term obligations and invest in growth.

Profitability

Effectively and efficiently managing the operating cycle can enhance profitability by decreasing the amount of capital tied up in working capital.

Operating Capital Turnover and Operating Capital % Sales

Operating capital turnover (working capital turnover), measures how efficiently a company utilizes its working capital to generate sales. A higher ratio suggests better management of working capital, while a lower ratio indicates inefficiencies in using short-term assets and liabilities.

Formula for Operating/Working Capital Turnover = Net Sales / Average Working Capital.
- What are it significance:
Higher ratio:indicates efficient use of working capital, meaning the company is generating more revenue with less working capital.

Lower ratio: suggests inefficient use of working capital, likely owing to excessive investment in current assets or slow collection of receivables.

Operating Capital Percentage Sales

The operating capital as a percentage of sales is a ratio that shows how efficiently a company is utilizing its operating working capital to generate sales revenue. It is computed by dividing the operating working capital by the company’s sales. A higher ratio indicates that more cash is tied up in day-to-day operations, potentially suggesting lower liquidity, while a lower ratio indicates more efficient utilization of working capital and higher liquidity.

Formula for Operating Capital % Sales = Operating Working Capital / Sales
- Operating Working Capital = Operating Current Assets – Operating Current Liabilities
- Interpretation:

A high ratio may suggest that a company has sufficient cash tied up in its operations, which could restrain its ability to react to unexpected situations or invest in growth. A lower ratio indicates better management of working capital and potentially more effective and efficient operations.

Capital Asset Intensity (Fixed Asset Turnover)

Capital asset intensity, also known as Fixed Asset Turnover, refers to the amount of a company’s investment in fixed assets, such as property, plant, and equipment) relative to other factors (e.g., labour or revenue). It importantly measures how much capital a company requires to generate a specific level of output or revenue.

A high capital asset intensity suggests a greater reliance on fixed assets, while a low intensity indicates that a company relies on more moderate level of assets

Formula for calculating Capital Asset Intensity: Sales / Net Fixed Assets
Interpretation

A high ratio indicates that the business needs considerable capital investment to generate revenue, for example in manufacturing or utility sector. By contrast, a low ratio indicates that a business can generate more revenue with less capital, for example in software or consulting sector.

Capital Structure/Liquidity Measures

Capital Structure / Liquidity Measures

Current Ratio

The current ratio is a financial metric used to evaluate a company’s ability to meet its short-term financial obligations. It is used to compare a company’s current assets to its liabilities. As a rule, higher current ratio indicates a better ability to pay off debts, while a lower ratio suggests potential liquidity difficulty.

Formula for calculating current ratio: Current Assets / Current Liabilities

Interpretation:

Ratio > 1

Suggests the company has more current assets than current liabilities, indicating it is likely to meet its short-term obligations.

Ratio = 1

Indicates current assets equal current liabilities. The company might pay off its short-term debts but has little margin for error.

Ratio < 1

Indicates current liabilities are more than current assets. The company may have problem in meeting its short-term obligations.

Ideal Ratio

While there is no specifically ideal current ratio, a ratio between 1.5 and 2.0 is usually deemed healthy, suggesting good liquidity without devoid of excessive idle assets. Furthermore, ideal current ratio may vary considerably by industry. Certain industries, such as supermarkets, probably operate lower ratios owing to high inventory turnover.

Quick Ratio

The quick ratio (the acid-test ratio) is a financial metric that evaluates a company’s ability to meet its short-term obligations using its most liquid assets. It is a more conventional measure of liquidity than the current ratio given that it excludes inventory and prepaid expenses, which can be more complex to quickly convert into cash.

The formula for calculating Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivables) / Current Liabilities.

Interpretation:
A quick ratio of 1 or higher usually indicates that a company can easily cover its short-term liabilities with its most liquid assets.

A ratio below 1 suggests the company could thrive to meet its immediate obligations.

A higher quick ratio indicates greater liquidity and a more vital ability to manage short-term debts

Debt to Equity (D/E)

The debt-to-equity ratio is a financial metric that is used to compare a company’s total liabilities to its total shareholders’ equity. It suggests how much a company is using its debt versus equity to finance its assets. A higher D/E ratio indicates a greater reliance on debt, potentially rising financial risk.

The formula for calculating Debt-to-Equity = Debt / Equity
Interpretation:
High D/E ratio:Suggests a company is heavily reliant on debt financing, which can be risky if the company faces financial problems.
Low D/E ratio:Indicates a company is using more equity financing and is less reliant on debt, potentially suggesting lower financial risk.
Industry Variation

The ideal D/E ratio significantly varies across industries. Capital-intensive industries like manufacturing normally have higher ratios compared to service-based industries.

Ideal ratio

As a rule, a ratio below 1.0 is generally deemed healthy, a ratio below 2.0 is usually considered as desirable.

Times Interest Earned (Interest Coverage)

The Times Interest Earned (TIE) ratio, also known as the Interest Coverage Ratio, is a financial metric that suggest a company’s ability to meet its interest obligations on outstanding debt. It measures the number of times a company’s earnings before interest and taxes (EBIT) can cover its interest expense, A higher TIE ratio usually indicates a company is in a stronger financial potion and has stronger capacity to pay its debts.

The formula for calculating Times Interest Earned = EBIT (Operating Income) / Interest Expense

Interpretation:

Higher TIE Ratio

A higher TIE ratio is generally deemed better, indicating a company has large earnings to cover its interest payments and is less possibility to default on its debt.

Lower TIE Ratio

A lower TIE ratio is a company may thrive to meet its interest obligations, potentially bringing about concerns about its financial health and ability to repay its debts. A ratio below 1.5 may create a cause for concern.

TIE Ratio Below 1

Suggests that a company is not earning enough profit to cover its interest expense, which can be a severe warning signal.

Return on Assets (ROA)

Return on Assets is a financial ratio that evaluates how efficiently a company utilizes its assets to generate profit. It suggests how efficiently a company is managing its assets to generate earnings. ROA generally suggests better performance, as it indicates the company is making more profit for each unit of money of assets it owns.

The formula for calculating Return on assets = Net Income / Assets

Interpretation:

A higher ROA suggests that a company is more efficient at utilizing its assets to generate profit.
A lower ROA may suggest that a company is not utilizing its assets effectively or that it has involved in poor capital investments.
It is significant to compare a company’s ROA to its historical ROA, and to the ROA of other companies in the same industry, as ROAs vary considerably between sectors.

Days Sales Outstanding

Formula for calculating DSO: (Accounts Receivable / Total Credit Sales) x Number of Days

Return on Equity (ROE)

Return on Equity is a financial ratio that evaluates a company’s profitability by indicating how much profit a company makes with the money shareholders have invested. ROE is a key metric of a company’s financial performance and its ability to earn profits from shareholders’ investments.

Formula for calculating Return on Equity= Net Income / Equity

Interpretation:

Higher ROE

Generally, a positive sign, indicating greater efficiency in using shareholder investments to generate profits.

Lower ROE

May suggest that a company is not effectively using its equity to generate profits.

Industry Context

ROE should be advisably compared within the same industry, as varied sectors have different profitability norms.

Return on Invested Capital (ROIC)

Return on Invested Capital is a financial indicator that measures how efficient a company generates profits from its invested capital. It suggests how efficiently a company is utilizing its capital to generate value, with a higher ROIC usually showing better performance.

The formula for calculating Return on Invested Capital = EBIAT (Earnings Before Interest and After Tax) / Invested Capital = EBIT (1 – Tax Rate) / Debit + Equity

ROIC = NOPAT / Invested Capital

Importance and Interpretation:

Value Creation

ROIC is a key metric to evaluate whether a company is effectively creating value with its investments. When a company’s ROIC is more than its Weighted Average Cost of Capital (WACC), it is generating returns above its cost of capital, therefore, creating value.

Efficiency

ROIC evaluates how efficiently a company utilizes its capital to generate profits. A higher ROIC indicates better capital allocation and operational efficiency.

Industry Comparison

ROIC is used to compare the performance of companies within the same industry, highlighting which companies are more efficient at using capital.

Long-Term Sustainability

A steadily high ROIC is usually considered as a positive sign for a company’s long-term sustainability, showing its ability to generate returns from its investments.

Investment Decisions

Investors usually use ROIC as a key metric to measure the potential of a company’s investments and its aggregate value.

Self-Financing or Internal Growth Rate (IGR)

The internal Growth Rate is referred to as the maximum growth a company can attain using only its retained earnings, excluding external financing, such as a loan or equity. It is means of self-funded growth potential.

Formula for calculating Internal Growth Rate (IGR) = ROA x Retained Earnings / 1- (ROA x Retained Earnings) >>> IGR = 1- (Dividends and Share Repurchases / Net Income)

IGR = (Retained Earnings / Net Income) x (Net Income / Total Assets)

Advantages of Self-Financing (Internal Growth):

Financial Control

More control over finances and decision-making, as there is no necessity to repay loans or depend on external investors.

Lower Risk

Lower risk of financial distress or bankruptcy compared to depending largely on external debt.

Sustain Values

A company can sustain its own values and culture while avoiding interference from stakeholders.

Economies of Scale

Internal growth can result in lower average costs as production rises.

Disadvantages of Self-Financing (Internal Growth):

Slower Growth

It is mostly likely that companies have limited resources which can slow down the pace of expansion and potentially constrains the company’s ability to effectively compete.

Dependence on Forecasts

A company’s expansion or growth is usually dependent on accurate sales forecasts and the ability to effectively manage resources.

Capital Limitations

A company may need considerable time to effectively accumulate enough retained earnings to fund larger projects.

Financial Ratio Calculations

a). Compound Annual Growth Rates (CAGR) = [(Sales 2025 / Sales 2022)1/n] -1

= [(£102,000 / £89,686)1/3] – 1

= 4.4%

b). Days Sales Outstanding (DSO) = (Receivables x 365) / Sales

= (£21,000 x 365) / £102,000

= 75 days

c). Inventory Turnovers = Cost of Goods Sold (COGS) / Inventory

= £46,000 / £18,800

= 2.5 times

d). Days Sales in Inventory (DSI) = 365 / Inventory Turnovers

= 365 / 2.5

= 146 days

e. Operating Cash Cycle = DSO + DSI

= 75 + 146

= 221 days

f). Return on Invested Capital (ROIC) = EBIT (1 – Tax Rate) / Debt + Equity

= £15,250 (1 – 0.25) / (£11,200 + £54,922) = £11,437.50 / £66,17 = 17.3 %

Business Projections and Plans

Evolution of Financial Projections

Consideration of Outlooks, such as economic, political, technological, and global developments.
The task of predicting the future.
Estimation of specific areas of business interests.

Revenue and gross margins
Operating expenses
Working capital

Updating budgets or reforecasting the expected performance several times each year (check for disproportionate reactions to forecasts).

Types of Financial Projections

Short-term Projections

Short-term financial projections are financial estimates that predict organization’s financial performance over a relatively short period, usually up to one year. They focus on operational activities and assist businesses manage day-to-day financial health. These projections typically include weekly, monthly and quarterly financial breakdowns of projected revenues, expenses, cash flows, and other financial metrics.

Short-term financial projections help businesses make informed decisions related to managing cash flows, budgeting, and spotting potential financial risks. Importantly, financial projections are crucial for maintaining liquidity, optimizing resource allocation, and adapting to market fluctuations over short-term.

2. Long-term Projections

Long-term financial projections are forecast that’s estimate an organization’s financial performance over an extended period, usually three to five years, or even longer. These projections help businesses to make informed decisions related to capital budgeting, strategic planning, and allocation of resource.

Capital Budgeting

Capital budgeting is the process organizations adopt to evaluate and select long-term investments that are in line with their strategic goals and financial limitations. It includes estimation and analysing potential projects, for example procuring new equipment, or expanding operations, to ascertain whether they will add value to the organization. This process brings about effective and efficient allocation of capital resources.

Projection Evaluation

Organizations use different methods to evaluate potential projects, which include:

Net Present Value (NPV): calculating of present value of future cash flows, discounted at cost of capital.
Internal Rate of Return (IRR): determining the discount rate at which the NPV of a project equals zero.
Payback Period: measuring of time it takes for a project to recover its initial investment.

3. Special Purpose Projections

In finance, special purpose projections are financial projections tailored for specific projects or circumstances, typically hypothetical assumptions and scenarios. These projections are different from standard forecasts and used in situations in which general prediction of future financial performance is not sufficient.

Special purpose projects are limited to specific audience or purposes and may not be viably suitable for general use. Some special purpose projects are innovation project evaluation, mergers and acquisitions, product launching planning, etc.

Budgeting Hypothetical Questions

Revenue

How fast is the market growing?
Is our market share expected to rise or decline? Why?
Will we be able to rise prices?
What new products will be brought into the market (by our organization and competitors)?
What products will post falling sales owing to product life cycles or the introduction of competitive product?
What economic assumptions are contemplated in the plan?

Costs and Expenses

What is the general rate of inflation?
What will happen to important costs such as key raw materials, labour, and related expenses such as employee health care?
What rises to headcount will be needed to implement plan?
What operating efficiencies and cost reduction can be achieved?

Asset and Investment Levels