Using ratio analysis in financial forecasting – I

Most of the people who study or read about ratio analysis don’t realize how powerful it could actually get, especially when you apply it in dynamic context of financial modeling. It serves two clear purposes: firstly, it acts as a sanity check to the model’s sanctity. Sometimes, when financial modeling involves many linkages, some of the linkages are misapplied resulting in a situation where you don’t realize you have made a mistake. As difficult as it is to verify all linkages, it is impractical to keep doing that all the while the model is being constructed.

With financial ratios linked to the proforma forecasting sheets, one can easily make sure that the model is going in the right direction, and any wrong linkage would lead to one of the ratios being out of line with the others or out of line compared to other years. An example in this regard could be a situation where you have prepared the proforma income statements for 5 years, and coming down from the Profit before tax level to Net profit levels, accounting for taxation. If the company is projected to have a loss before taxation in one of the years projected and the formula is subtracting the taxes from profit before tax levels, it would create a mess in your spreadsheet, which could be overlooked.

If you had linked the ratios to the P&L previously, you would see some inconsistency on the net profit margin figure in that particular year compared to other years, and then you can go back to check if how you calculated the figure was correct.

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