Using ratio analysis in financial forecasting – II

So how to go about organizing financial ratios in proforma sheets?

The best way to go about doing this is to divide the ratios into five broad categories and use these categories to classify the core category ratios within each of these classifications. The categories could be:

  • Liquidity Ratios – tells you if the company can pay off its debt and payments falling due within a year
  • Activity Ratios – important for manufacturing companies in order to analyze if the inventories, accounts receivables and account payables are handled efficiently; also tells about whether the asset utilization is appropriate.
  • Solvency Ratios – Debt repayment capacity of the company; could be critical for some of the companies
  • Profitability Ratios – margins earned and return on assets and equity
  • Valuation Ratios – how is the market valuing the company measured largely through relative valuation ratios

Once you have linked ratios sheet in place, you could look at the same from time to time to help you guide if you’re going in the right direction or not. In case, you’re unsure about how to check, always try to take a comparative time series analysis into account and check the performance over the years. In some cases, looking at more than one ratio together could tell loads about the company. For example, looking at the accounts receivable turnover, accounts payable turnover and inventory turnover in conjunction with each other could actually provide insights into the big picture of where the possible issues could be as far as the organizational value chain is concerned.

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.

The Big Picture in financial writing

When you think about creative writing, you think about fancy writing and imaginative use of vocabulary and language to make wonderful masterpieces, but when it comes to financial writing, you don’t need to be a Shakespeare!

What is important is that you make a connection with the reader in a way that the latter doesn’t need to read everything to understand what you are saying. Let me elaborate. When you’re writing a financial report, it usually has an audience that are busy people working in corporations, investors, investment houses, portfolio managers and common people who are not very well-versed in finance. So, you have to convey your point through illustrative means, i.e. pictures, charts and graphs and make it a point to use language that could be understood by others who don’t have a finance background.

The beauty of an analyst report comes when a reader is able to read through the high points of the entire text in less than 2 minutes discerning what is important for the company and finally deciding to read further or not. That essentially is the success of that analyst. You don’t have to come out with a “BUY” or “SELL” recommendation every time you write a report, however, you must be sure about what you are talking. Once you convey things and perspectives on the company in an easy language, but also include further information for the technical/sophisticated investors, you can be expected to be doing a reasonable job. This work could turn into an outstanding one only in the case when there is quality and forethought behind your assumptions.  So always be careful on what you assume, because the results come out of your assumptions only. The assumptions should make sense when you look at the big picture for the business model of the company you’re writing about. Link the assumptions to the big picture to see if those are reasonable.

Analyst report

This is a report I wrote on the same company with two other mates, it is clearly illustrating that scientific writing and financial writing are really worlds apart. I have co-authored research papers in college, two of which were published in very respectable international publications in Aucland, New Zealand and IIM, Ahmedabad, India and can safely say there is a bit of unlearning to do for those who thrive in scientific writing.

Why is it different? What is so different about financial writing? What are the key themes in financial writing that need to be made sure. Is it better to write a small report or a long one? I would also talk about some of the issues in financial writing and how’s and why’s around it. Till then, you can have a look at the report and your feedback on this is most welcomed too 🙂

Investor Presentation

This is an investor presentation pitch that I made in collaboration with two other team mates at the business school. The idea about a good investor presentation goes beyond the color scheme and the number of slides. It is in essence built upon the storyline that you put forward. To build a credible story around your recommendation is very important – you can’t expect everyone to know about the company or industry you’re talking about as much as you do. So, make sure you have everyone’s interest.

Look out for many more tips coming about on how to handle investor pitch/presentations.

Valuation Model for an Oil & Gas E&P Company

This is a valuation model of a leading petroleum company operating in Pakistan, Pakistan Petroleum Limited. You can clearly see how this comprehensive model entails working on each individual component of the business, for instance, production and sales separately eventually building up within the model.

Although many businesses are based on simpler models, and are handled very differently from this one, some analysts focus on the complexity and predicting each individual tiny component so much that they lose sight of the big picture. I will be talking about how to go about modeling in some of the future posts where you will get to learn the to-dos and not-to-dos of the modeling world. It is always best to keep things simple, which can make life easier for everyone and increase utility of the financial model many folds.

Excel-lence

In the world of finance, handling MS Excel is expected to be an individual’s second-nature. When I see a cross-section of new and old graduates in finance, business administration and accounting, it becomes clear that this is one edge to the newer graduates which differentiates them, increases their productivity and improves their decision-making support.

MS Excel might have just grown out a simple spreadsheet system of the 80s, or 90s, but it is not just that anymore. Financial analysis, reporting, critical business operation assessment and financial modeling utilizing debt and equity modeling using proforma statements and financial forecasting, all start and end on Excel.

I’ll try to write, post videos and talk about various tools, approaches and ideas that one could utilize to effectively use Excel to prove their Excellence. So hang on and keep visiting!

Importance of volunteering

In this day and age where everyone seems to be busy with their lives so much that none of us find enough time for everything that we would like to. In many ways, we have overcomplicated many facets of our lives so much that we sometimes lose that touch with reality.

People who are privileged to go through the education system are also trained to prepare themselves for the corporate work life, where no one has time for no one. In this rush, people tend to develop an indifference to many things around them. They tend to develop a sort of one-track mind on most of the issues they are surrounded with.

During this rush, many people don’t recognize the exact opportunity volunteer work offers. The very skills and traits that most people run after to develop – interpersonal skills, confidence, passion and compassion, audacity, vision and a sense of connection with the audience – are all very well developed through volunteering. Some people I have met tell me that it’s such a waste of time that it should be avoided or that we’re always so busy that we can’t just volunteer now. On asking further, I have mostly come to know it is usually those people who have never volunteered themselves for any cause.

When we volunteer for the first time, we have different views on it depending on at which age we start to volunteer, the volunteer opportunity being in our area of interest and our other responsibilities. In my opinion, one should start volunteering with the leading organizations at an early age. Scouting could also be a great start for young ones, as this exposes you the real world in a protected environment. People who have volunteered a lot know about the range of different organization types, organizational hierarchies and functions and they get to connect with people in the same area of interest who also have an urge to share their time and abilities without any commercial end in mind. I would say you could get very good friends and contacts by volunteering since you would meet people from all walks of life and unlike commercial organizations where hierarchies dictate who’s senior, dedication, commitment and hard work differentiates volunteers from the rest in the club. Moreover, one can learn a lot of managerial abilities by volunteering their time – the earlier you start doing it, you would realize the better it turns out to be.

Beyond all these reasons, the most important reason is that the experience where you get to help people, develop compassion and learn to appreciate the diversity and problems of others around you. This is a very humbling experience in itself and I think, it’s a reason enough to volunteer!

The basis of trust

Relationships are often based on trust. In some cultures, mutual trust is of utmost importance, to the extent of even economic loss in the short term. For instance, generally Japanese companies look for mutual trust and put relationships at the forefront of financial matters. Whereas financial numbers are very important, however, they would like to do business joint ventures and partnerships based on compatible relationships. In other cultures, relationships, especially commercial ones develop mostly through economics of the projects.

The question, however, remains what is trust based on?

It is based on performance vis-a-vis expectations. I ask you to do a certain thing and you over-deliver to the extent that I am impressed. The very moment I nurture some more trust on you. So, it would not impress me to the similar extent if you really performed exactly the same task the same way but my expectations were aligned higher there. People love positive surprises, it just sends in an adrenaline rush through the brain that amplifies excitement and happiness together.

How do you make the most out of this simple human psychology? You can benefit out of it by under-committing and over-delivering. This is a daunting task and might look foolish to the short-sighted, but this is the only sure-shot approach to succeeding. Going an extra mile all the time assures competence, professionalism, enthusiasm, drive and commitment all at the same time. So, in the longer term view, such people are sought after – and as per the basic law of demand and supply, the scarce commodity is priced higher than the readily available ones; therefore, you get to charge premium and clients still love to work with you.

Look at the big picture and keep outperforming. Dazzle everyone with your performance to win trust, to nurture relationships that last.

Impact of Entrepreneurship

Entrepreneurship is all about seeing opportunities. It’s also about creating opportunities, where everyone else just sees risks. It’s about perspective. It’s a mindset. After the credit crisis spiral, the world has seen a depression, the worst ever any working person has seen in his lifetime. It was bad. It is bad. Many analysts forecast a turnaround in this year, some skeptics seem unsure of even this suggesting that the remnants of this terrible disaster are going to haunt us for decades to come. As true as that might be, have you noticed that during these crises years, there have been many new millionaires around the world? Howcome people from the emerging markets are making their mark more and more amongst the richest people in this world?

It is about mindset. Once you start developing an ability to see the positives in and around yourself, you start noticing opportunities much faster than others do. Availing those opportunities makes you feel better about yourself and make others feel you’re better than them. What these people have difficulty coming to terms with is that it’s not about risks, it’s about calculated risks. Hence, these could be different for every person. Perhaps someone with a lot of engineering knowledge would find it easier to set up the factory floor operations, whereas someone who has only been associated with accounting might find it very risky. The same accountant could also see opportunity in what many others find risky.

The idea is to intentionally change your approach to looking at things, consciously looking out possible opportunities everywhere. After some time, you won’t have to make a conscious effort on the same and you’d look smarter.

The world out there is changing; for entrepreneurs, this is a blessing in disguise. Tomorrow belongs to those who work on them today.