Techniques for

Financial Analysis,
Modeling and
Forecasting

414 pages 22 Chapters 22 Quizzes 1 Online Final

Techniques for Financial Analysis,

Modeling and Forecasting
Written by Jae K. Shim
MBA, Ph.D.
This comprehensive course gives the student every sales and financial
forecasting formula and modeling technique needed to analyze their
operation both as a whole and by segment. This course provides proven
techniques that help to identify and solve problem areas. The course also
covers analysis techniques that help the student to evaluate proposals for
profit potential, proven methods that improve the accuracy of your short
and long-term forecasting, analysis tools that help the student to better
manage working capital, cash, and accounts receivable, plus much more.
The student will also receive dozens of worked-out models and modeling
techniques that simplify the most difficult business decisions and are easy
to adapt to any computer spreadsheet program. This course supplies
company accountants, treasurers, and CFOs with all the forecasting
techniques needed to financially analyze a business as a whole or by
segment.
Upon completion of this course, the student should be able to
Give examples of alternative economic systems.
Characterize and explain the concepts associated with
contemporary business.
Define sole proprietorships.
Explain and give an example of a partnership.
Outline the requirements of a limited partnership.
Identify the requirements of a Subchapter S corporation.
Define the concepts of management.
Implement human relation strategies.
Discuss the history of the labor movement.
Outline the processes of production and manufacturing.
Understand and explain the purchasing function.
Select and evaluate location sites of manufacturing facilities and
retail facilities.
Interpret and analyze financial statements.
Understand what business finance involves.
Techniques for Financial Analysis, Modeling & Forecasting Page 2

This course includes:

22 Chapters
22 Review Exercises with Answer Keys
An Online Final Exam
Glossary

Techniques for Financial Analysis, Modeling & Forecasting Page 3

Disclaimer: The material presented within this course is for

informational and educational purposes only. It should not be used to
provide guidance to your customers or clients in lieu of competent,
certified legal advice. All parties involved in the development of this
course shall not be liable for any inappropriate use of this information
beyond the purpose stated above. As a student, you should understand
that it is your responsibility to adhere to the laws and regulations
pertaining to any aspect of this course and the materials presented
within.

Techniques for Financial Analysis, Modeling & Forecasting Page 4

Table of contents
CHAPTER 1: BREAK-EVEN AND CONTRIBUTION MARGIN ANALYSIS

CHAPTER 2: UNDERSTANDING AND APPLYING THE TIME VALUE

OF MONEY CONCEPT

33

CHAPTER 3: HOW TO ASSESS CAPITAL EXPENDITURE PROPOSALS

FOR STRATEGIC DECISION MAKING

53

CHAPTER 4: ANALYZING FINANCIAL STATEMENTS FOR FINANCIAL

FITNESS

73

CHAPTER 5: ANALYZING QUALITY OF EARNINGS

97

CHAPTER 6: ANALYSIS OF VARIANCE ANALYSIS FOR COST CONTROL

104

CHAPTER 7: ANALYSIS OF SEGMENTAL PERFORMANCE AND PROFIT

VARIANCE

118

CHAPTER 8: EVALUATING DIVISIONAL PERFORMANCE

132

CHAPTER 9: ANALYZING WORKING CAPITAL

142

CHAPTER 10: CORPORATE INVESTMENTS

171

CHAPTER 11: OBTAINING FUNDS: SHORT-TERM AND LONG-TERM

FINANCING

201

CHAPTER 12: ANALYZING MERGERS AND ACQUISITIONS

219

CHAPTER 13: FORECASTING AND FINANCIAL PLANNING

236

CHAPTER 14: FORECASTING METHODOLOGY

246

CHAPTER 15: FORECASTING WITH REGRESSION AND MARKOV

METHODS

262

CHAPTER 16: FINANCIAL FORECASTING AND BUDGETING TOOLS

295

Techniques for Financial Analysis, Modeling & Forecasting Page 5

CHAPTER 17: FORECASTING CASH FLOWS

323

CHAPTER 18: HOW TO USE CORPORATE PLANNING MODELS

334

CHAPTER 19: FINANCIAL MODELING FOR "WHAT-IF" ANALYSIS

346

CHAPTER 20: USING OPTIMIZATION TECHNIQUES TO BUILD

OPTIMAL BUDGETS

360

CHAPTER 21: USING SPREADSHEET AND FINANCIAL MODELING

PACKAGES

372

CHAPTER 22: USING MANAGEMENT GAMES FOR EXECUTIVE

TRAINING

387

REFERENCES AND ADDITIONAL READINGS

402

GLOSSARY

405

Techniques for Financial Analysis, Modeling & Forecasting Page 6

PREFACE
Financial analysis is necessary in evaluating internal operations and
activities to optimize profit and efficiency while at the same time reducing
the risk. Problem areas must be identified so that corrective, timely action
may be taken.
Break-even analysis determines what level of sales of a product line is
necessary to cover costs. Contribution margin evaluation indicates what
selling price to charge given a special order situation.
To determine where funds should be expended in the business, capital
budgeting techniques are provided including present value, internal rate of
return and payback. Applications of various types of investment
opportunities are addressed.
Analyzing the balance sheet, income statement and overall financial
structure shows you the companys financial strengths and deficiencies and
problem areas are noted for management attention. How the business is
viewed financially by investors and creditors affects the firms chances of
financing, cost of capital and the market price of its stock.
Knowing how to evaluate segmental performance is essential in recognizing the relative performance of divisions within the firm. Also,
comparisons can be made to similar divisions in competing companies.
Measures of performance include return on investment and residual
income.
The management of current assets and liabilities positively affects the
bottom-line and reduces risk. Some examples of this are accelerating cash
inflow, delaying cash outflow, inventory planning and investment portfolio
management. By acquiring other companies, diversification and earning
power may be enhanced. Selecting the right financing instrument to obtain
funds is critical; it affects both cost of capital and restrictiveness of funds.
Financial planning models are used to generate pro-forma financial
statements and financial ratios. These are the basic tools for budgeting and
profit planning. There are user-oriented computer software systems
specifically designed for corporate planners and executives. Due to
technological advances in computers, such as networking and data base
management systems, more companies are using modeling. A model is
Techniques for Financial Analysis, Modeling & Forecasting Page 7

necessary for making day-to-day operational and strategic planning

decisions. Financial planning models, which are one functional branch of a
general corporate model, may be used for many purposes. Among these
applications are
Financial forecasting Risk analysis
Budgeting
Cash management
Tax planning
Merger and acquisition
Profit planning
analysis
Capital budgeting
New venture analysis
Supported by the expanded capabilities provided by models, many
companies are increasingly successful in including long-term strategic
considerations in their business plans, thus enabling them to investigate
the possible impact of their current decisions on future profitability and
cash flow. For example, companies are able to examine the effects of
proposed mergers and acquisitions with much more certainty and to
estimate with more confidence the potential profits from new markets.
The applications of and benefits deriving from the use of well-designed and
sophisticated planning models are unlimited. The model is, in short, a
technique for risk analysis and what-if experiments. Modeling allows
for strategic planning and for accomplishing operational and tactical
decisions for immediate planning problems.
With the ever-increasing technology in the areas of spreadsheets, data
base management systems, graphics and the like, businesspeople will have
no choice but to utilize financial models more effectively. Using the
applications found throughout this course, you will be able to use modeling
for analytical decisions without having to know programming.
The course shows you:
How to develop a new model
How to select the best user-oriented planning package to meet the
specific needs and resources available
How to use your spreadsheet program on a microcomputer for various
modeling purposes
How to tie the financial model to the overall management information
system framework
This is your guide for more effective financial management. Use it often,
to keep continuous tabs on your companys financial health.
Techniques for Financial Analysis, Modeling & Forecasting Page 8

CHAPTER 1
BREAK-EVEN AND CONTRIBUTION MARGIN ANALYSIS
LEARNING OBJECTIVES
After studying the material in this chapter,
1.
2.
3.
4.

You will be able to define Cost-Volume-Profit (CVP) analysis.

You will be able to describe operating leverage.
You will be able to analyze sale mix.
You will be able to give examples of contribution margin analysis.

Before your business can realize "profit," you must first understand the concept of
breaking even. To break even on your company's product lines and/or services, you must
be able to calculate the sales volume needed to cover your costs and how to use this
information to your advantage. You must also be familiar with how your costs react to
changes in volume. Break-even analysis (cost-volume-profit analysis or CVP) allows you
to answer many planning questions. Operating leverage is the degree to which fixed costs
exist in a company's cost structure. Operating leverage measures operating risk arising
from high fixed costs. Contribution margin analysis is useful in your decision making with
respect to pricing strategy and which product lines to push.
WHAT IS COST-VOLUME-PROFIT ANALYSIS?
Cost-volume-profit (CVP) analysis relates to the way profit and costs change with a
change in volume. CVP analysis examines the impact on earnings of changes in such
factors as variable cost, fixed cost, selling price, volume and product mix. CVP
information helps you to predict the effect of any number of contemplated actions and to
make better planning decisions. More specifically, CVP analysis tries to answer the
following questions:
1. What sales volume is required to break even? How long will it take to reach that
sales volume?
2. What sales volume is necessary to earn a desired profit?
3. What profit can be expected on a given sales volume?
4. How would changes in selling price, variable costs, fixed costs and output affect
profits?
5. How would a change in the mix of products sold affect the break-even and target
volume and profit potential?
WHAT AND WHY OF BREAK-EVEN SALES
Break-even analysis, which is part of CVP analysis, is the process of calculating the sales
needed to cover your costs so that there is zero profit or loss. The break-even point that is
arrived at by such analysis is important to the profit planning process. Such knowledge
allows managers to maintain and improve operating results. It is also important when
introducing a new product or service, modernizing facilities, starting a new business, or
appraising production and administrative activities.
Techniques for Financial Analysis, Modeling & Forecasting Page 9

Break-even analysis can also be used as a screening device, such as the first
attempt to determine the economic feasibility of an investment proposal.
Also, pricing may be aided by knowing the break-even point for a product. What
other situations can you think of where break-even analysis is useful?
The assumptions of break-even analysis follow:

Selling price is constant, which in turn requires the following assumptions:

Demand elasticity is very high for selling price to remain the same when sales
volume increases
Selling price is stable over the income period
Tip: In practice, neither assumption is likely to hold, making it difficult to forecast
selling price
There is only one product or a constant sales mix.
Manufacturing efficiency is constant.
Inventories do not significantly change from period to period.
Variable cost per unit is constant.
Fixed cost and variable cost are properly separated, identified and quantified
The only factor affecting variable cost is volume

Note: Cost-volume profit relationships that are curvilinear may be analyzed linearly by
considering only a relevant range of volume.
The guidelines for breaking even are:
An increase in selling price lowers break-even sales.
An increase in variable cost increases break-even sales.
An increase in fixed cost increases break-even sales.
Your objective of course is not just to break even, but to earn a profit. In deciding
which products to push, continue, or discontinue, the break-even point is not the only
important factor. Economic conditions, supply and demand and the long-term impact on
customer relations must also be considered. You can extend break-even analysis to
concentrate on a desired profit objective.
The break-even sales can be determined using the graphic, equation and formula
approaches. Using the graphic approach (see Figure 1.1), revenue, total cost and fixed
cost are plotted on a vertical axis and volume is plotted on a horizontal axis. The
break-even point occurs at the intersection of the revenue line and the total cost line.
Figure 1.1 also depicts profit potentials over a wide range of activity. It shows how profits
increase with increases in volume.
The equation approach uses the following equation:
S

VC

FC

S VC = FC
Where S = sales, VC = variable cost, (S VC) = contribution margin and FC = fixed cost.
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Note: At the breakeven point, the contribution margin equals total fixed cost.
This approach allows you to solve for break-even sales or for other unknowns as
well. An example is selling price. If you want a desired before-tax profit, solve for P in the
following equation:
S

VC

FC

EXAMPLE 1.1
A product has a fixed cost of $270,000 and a variable cost of 70% of sales. The point of
break-even sales can be calculated as follows:
S
1S
0.3S
S

=
=
=
=

FC
$270,000
$270,000
$900,000

+
+

VC
.7S

If the selling price per unit is $100, break-even units are 9,000 ($900,000/$100). If desired
profit is $40,000, the sales needed to obtain that profit (P) can be calculated as follows:
S
1S
0.3S
S

=
=
=
=

FC
$270,000
$310,000
$1,033,333

+
+

VC
0.7S

+
+

P
$40,000

FIGURE 1.1
BREAK-EVEN CHART

EXAMPLE 1.2
If the selling price per unit is $30, the variable cost per unit is $20 and the fixed cost is
Techniques for Financial Analysis, Modeling & Forecasting Page 11

$400,000, the break-even units (U) can be calculated as follows:

S
$30U
$10U
U

=
=
=
=

FC
$400,000
$400,000
40,000

+
+

VC
$20U

The break-even dollar amount is:

40,000

units

$30

$1,200,000

EXAMPLE 1.3
You sell 800,000 units of an item. The variable cost is $2.50 per unit. Fixed cost totals
$750,000. The selling price (SP) per unit should be $3.44 to break even:
S
800,000SP
800,000SP
SP

=
=
=
=

FC
$750,000
$2,750,000
$3.44

+
+

VC
($2.50 x 800,000)

EXAMPLE 1.4
Assume your selling price is $40, your sales volume is 20,000 units, your variable cost is
$15 per unit, your fixed cost is $120,000, your after-tax profit is $60,000 and your tax rate
is 40%. To determine how much you have available to spend on research (R), consider
this equation:
S
=
($40 x 20,000) =

VC
+
($15 x 20,000) +

FC
$120,000

$280,000

* After-tax profit:

$ 60,000

+
+

P
$ 100,000*

+
+

R
R

0. 6

before-tax profit

$ 60,000
.6

before-tax profit

$100,000

before-tax profit

EXAMPLE 1.5
Assume your selling price is $40, your variable cost is $24, your fixed cost is $150,000,
Techniques for Financial Analysis, Modeling & Forecasting Page 12

your after-tax profit is $240,000 and your tax rate is 40%. To determine how many units
you must sell to earn the after-tax profit, consider the following equation:
S
$40 U
$16 U
U

=
=
=
=

*0.6
0.6

FC
$150,000
$550,000
34,375

+
+

VC
$24 U

before-tax profit
x

before-tax profit

Before-tax profit

+
+

P
$400,000*

after-tax
profit
=

$240,000
0.6

$240,000
=

$400,000

EXAMPLE 1.6
Assume your selling price is $50 per unit, your variable cost is $30 per unit, your sales
volume is 60,000 units, your fixed cost is $150,000 and your tax rate 30%. To determine
the after-tax profit, use the following equation:
S
($50 x 60,000)

=
=

FC
150,000
1,050,000

After-tax profit

+
+

VC
($30 x 60,000)

$1,050,000

+
+

P
P

P
x

0.70 =

$735,000

EXAMPLE 1.7
You are considering making a product presently purchased outside for $0.12 per unit. The
fixed cost is $10,000 and the variable cost per unit is $0.08. Use the following equation to
determine the number of units you must sell so that the annual cost of your machine
equals the outside purchase cost.
$0.12 U
$0.04 U
U

=
=
=

$10,000
$ 10,000
250,000

$0.08 U

THE FORMULA APPROACH

In order to compute the break-even point and perform various CVP analyses, note the
Techniques for Financial Analysis, Modeling & Forecasting Page 13

following important concepts.

CONTRIBUTION MARGIN (CM). The contribution margin (CM) is the excess of sales (S)
over the variable costs (VC) of the product or service. It is the amount of money available
to cover fixed costs (FC) and to generate profit. Symbolically, CM = S - VC
UNIT CM. The unit CM is the excess of the unit selling price (p) less the unit variable cost
(v). Symbolically, unit CM = p v.
CM RATIO. The CM ratio is the contribution margin as a percentage of sales, i.e.,
CM Ratio =

CM
(S VC)
VC
=
=1S
S
S

Note: The CM ratio is 1 minus the variable cost ratio. For example, if variable costs are
70% of sales, then the variable cost ratio is 70% and the CM ratio is 30%
The three major formulas for break-even and CVP analysis are:
Break-even sales in units (U) =

Fixed Costs
FC
=
(p v)
Unit CM

Break-even point in dollars (S) =

Target income sales volume =

Fixed Costs
CM Ratio

Fixed Costs + Target Income

Unit CM (or CM ratio)

EXAMPLE 1.8
A product has a fixed cost of $270,000 and a variable cost of 70% of sales. The CM ratio
is then 30%. The break-even sales in dollars (S) can be calculated as follows:
Break-even point in dollars (S) =

Fixed Costs $270,000

=
= $900,000
CM Ratio
.3

If target profit is $40,000, the sales in dollars (S) needed to obtain that profit can be
calculated as follows:
$270,000 + $40,000
$310,000
=
= $1,033,333
.3
.3

WHAT IS MARGIN OF SAFETY?

The margin of safety is a risk indicator that stipulates the amount by which sales may
Techniques for Financial Analysis, Modeling & Forecasting Page 14

decline before losses are experienced.

Margin of safety

Budget sales - Break-even sales

Budget sales

The lower the ratio, the greater the risk of reaching the break-even point.

EXAMPLE 1.9
If budget sales are $40,000 and break-even sales are $34,000, what is your margin of
safety?
Margin of safety

$40,000 - $34,000
$40,000

15%

CASH BREAK-EVEN POINT

If you have a minimum of available cash, or if the opportunity cost of holding excess cash
is high, you may want to know the volume of sales that will cover all cash expenses during
a period. This is known as the cash break-even point.
Not all fixed costs involve cash payments. For example, depreciation expense is a
noncash charge. To find the cash break-even point, the noncash charges, such as
depreciation and prepaid expenses, must be subtracted from total fixed costs. Therefore,
the cash break-even point is lower than the usual break-even point. The cash break-even
point equation is as follows:
S

VC

FC (after deducting
depreciation)

EXAMPLE 1.10
If the selling price is $25 per unit, the variable cost is $15 per unit and total fixed cost is
$50,000, which includes depreciation of $2,000, the cash break-even point is:
$25U
$10U
U

=
=
=

$15U
$48,000
4,800

$48,000

You must sell 4,800 units at $25 each to meet your break-even point.
WHAT IS OPERATING LEVERAGE?
Operating leverage is the degree to which fixed costs exist in your cost structure. It is the
extent to which you commit yourself to high levels of fixed costs other than interest
payments in order to leverage profits during good times. However, high operating
leverage means risk because fixed costs cannot be decreased when revenue drops in the
short run.
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A high ratio of fixed cost to total cost over time may cause variability in profit. But a
high ratio of variable cost to total cost indicates stability. It is easier to adjust variable cost
than fixed cost when demand for your products decline.
EXAMPLE 1.11
Assume that fixed costs were $40,000 in 20X0 and $55,000 in 20X1 and that variable
costs were $25,000 in 20X0 and $27,000 in 20X1. The operating leverage in 20X1
compared to 20X0 was higher, as indicated by the increase in the ratio of fixed costs to
total costs. Hence, there is greater earnings instability.
$55,000
$82,000

67.1 % for 20X1

$40,000
$65,000

61.5% for 20X0

EXAMPLE 1.12
Assume that your selling price is $30 per unit, your variable cost is $18 per unit, your fixed
cost is $40,000 and your sales volume is 8,000 units. You can determine the extent of
operating leverage as follows:
(Selling price - Variable cost) (Units)
(Selling price - Variable Cost) (Units) - Fixed
cost
($30-$18)(8,000)
($30-$18)(8,000) $40,000

=
=

$96,000
$56,000

1.71

This means that for every 1% increase in sales above the 8,000-unit volume,
income will increase by 1.71 %. If sales increase by 10%, net income will rise by 17.1%.

EXAMPLE 1.13
You are evaluating operating leverage. Your selling price is $2 per unit, your fixed cost is
$50,000 and your variable cost is $1.10 per unit, The first example assumes a sales
volume of 100,000 units; the second assumes a sales volume of 130,000 units.
Sales Volume (in dollars)
(100,000 x $2)
(130,000 x $2)

Fixed Cost
$50,000
$50,000

Variable Cost
$110,000
$143,000

=
=
=

Net Income
$40,000
$67,000

The ratio of the percentage change in net income to the percentage change in sales
volume is as follows:
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Change in net income

Net Income
Change in quantity
Quantity

=
=

$67,000 - $40,000
$40,000
130,000 - 100,000
100,000
=

=
=

$27,000
$40,000
30,000
100,000

67.5%

30.0%

2.25

If fixed cost remains the same, the 2.25 figure tells you that for every 1% increase
in sales above the 100,000-unit volume there will be a 2.25% increase in net income.
Thus, a 10% jump in sales will boost net income 22.5%. The same proportionate
operating leverage develops regardless of the size of the sales increase above the
100,000-unit level.
The opportunity to magnify the increase in earnings that arises from any increase
in sales suggests that you should use a high degree of operating leverage. Presumably,
fixed operating costs should constitute a larger proportion of the total cost at a particular
sales level so as to enhance the gains realized from any subsequent rise in sales. While a
high degree of operating leverage is sometimes a desirable objective, there is the risk of
financial damage caused by a drop in sales. It should also be noted that the more
unpredictable sales volume is, the more desirable it is to have a high degree of operating
leverage. Remember: Fixed costs magnify the gain or loss from any fluctuation in sales.
If you have a high degree of operating leverage, you should not simultaneously
use a high degree of financial leverage (debt) because the combination makes the risk
associated with your operations too severe for a volatile economic environment.
Alternatively, if you have a low degree of operating leverage you can often take on a
higher level of financial leverage. The lower risk of operating leverage balances the higher
risk of financial leverage (debt position). The tradeoffs determine how much financial and
operating leverage to use.
One example of an operating leverage question you may face is whether to buy
buildings and equipment or rent them. If you buy them, you incur fixed costs even if
volume declines. If there is a rental with a short-term lease, the annual cost is likely to be
more, but it is easier to terminate the fixed cost in a business downturn. Another operating
leverage decision involves whether to purchase plant and facilities and manufacture all
components of the product or to subcontract the manufacturing and just do assembly.
With subcontracting, contracts can be terminated when demand declines. If plant and
equipment is bought, the fixed cost remains even if demand declines.
Operating leverage is an issue that directly impacts line managers. The level of
operating leverage selected should not be made without input from the production
managers. In general, newer technology has a higher fixed cost and lower variable cost
than older technology. Managers must determine whether the risks associated with
higher fixed costs are worth the potential returns.
SALES MIX ANALYSIS
Break-even analysis requires some additional considerations when your company
produces and sells more than one product. Different selling prices and different variable
Techniques for Financial Analysis, Modeling & Forecasting Page 17

costs result in different unit contribution margins. As a result, break-even points vary with
the relative proportions of the products sold, called the sales mix. In break-even analysis,
it is necessary to predetermine the sales mix and then compute a weighted average
contribution margin (CM). It is also necessary to assume that the sales mix does not
change for a specified period.
The break-even formula for the company as a whole is:
Break-even sales in units (or in dollars) =

Fixed Costs
Weighted Average Unit CM
(or CM Ratio)

EXAMPLE 1.14
Your company has fixed costs of $76,000 and two products with the following contribution
margin data:

Selling price
Less: Variable cost
Unit CM

Product A
$15
12
$3

Product B
$10
5
$5

Sales mix

60%

40%

The weighted average unit contribution margin is:

$3(.6)

$5(.4)

$3.80

Your company's break-even point in units is:

$76,000/$3.80

20,000
units

which is divided as follows:

Product A: 20,000 units x 60% = 12,000 units
Product B: 20,000 units x 40% = 8,000 units

EXAMPLE 1.15
Your company has total fixed costs of $18,600 and produces and sells three products:
Techniques for Financial Analysis, Modeling & Forecasting Page 18

Product A
Sales
$30,000
Less: Variable cost
24,000
Contribution margin $6,000
Contribution margin
ratio
Sales Mix

Product B
$60,000
40,000
$20,000

Product C
$10,000
5,000
$ 5,000

Total
$100,000
69,000
$ 31,000

20%

331/3%

50%

31%

30%

60%

10%

100%

Since the contribution margin ratio for your company is 31%, the break-even point in
dollars is:
$18,600/.31

$60,000

Which will be split in the mix ratio of 3:6:1 to give us the following break-even points for the
individual products A, B and C:
Product A:
Product B:
Product C:

$60,000
$60,000
$60,000

x
x
x

30%
60%
10%

=
=
=

$18,000
$36,000
$ 6,000
$60,000

One important assumption in a multiproduct company is that the sales mix will not change
during the planning period. If the sales mix does change, however, the break-even point
will also change.
CONTRIBUTION MARGIN ANALYSIS
Contribution margin analysis is used to evaluate the performance of the manager and
activity. Contribution margin equals sales less variable cost. The contribution margin
income statement looks at cost behavior. It shows the relationship between variable cost
and fixed cost, irrespective of the functions a given cost item is associated with. When
analyzing the manufacturing and/or selling functions of your company, you are faced with
the problem of choosing between alternative courses of action. Examples are:

Whether to accept or reject a special order

Whether to sell or process further
Whether to make or buy
Whether to add or drop a certain product line
How to utilize scarce resources

Illustrative Contribution Margin Income Statement

Techniques for Financial Analysis, Modeling & Forecasting Page 19

Sales
Less variable cost of sales
Manufacturing contribution margin
Less variable selling and administrative expenses
Contribution margin
Less fixed cost
Net income
Advantages of Contribution Margin Income Statement

Aids in decision making, such as whether to drop or push a product line

Aids in deciding whether to ask a selling price that is below the normal price
Tip: When idle capacity exists, an order should be accepted at below the normal selling
price as long as a contribution margin is earned, since fixed cost will not change.
Disadvantages of Contribution Margin Income Statement

Not accepted for financial reporting or tax purposes

Ignores fixed overhead as a product cost

Difficult to segregate fixed cost and variable cost

ACCEPTING OR REJECTING A SPECIAL ORDER
You may receive a special order for your products at a lower price than usual. Normally,
you may refuse such an order since it will not yield a satisfactory profit. However, if sales
are slumping, such an order should be accepted if the incremental revenue obtained from
it exceeds the incremental costs involved. The company should accept this price since it
is better to receive some revenue than to receive nothing at all. A price that is lower than
the regular price is called a contribution price. This contribution approach to pricing is
most appropriate when: (1) there is a distressing operating situation where demand has
fallen off, (2) there is idle capacity, or (3) there is sharp competition or a competitive
bidding situation.
EXAMPLE 1.16
Your company has a 100,000-unit capacity. You are producing and selling only 90,000
units of a product each year at a regular price of $2. If the variable cost per unit is $1 and
the annual fixed cost is $45,000, the income statement follows:
Sales (90,000
units)
Less: Variable
costs
(90,000 units)
Contribution margin
Less: Fixed cost
Net income

Total
$180,000

Per Unit
$2.00

90,000
$90,000
45,000
$45,000

1.00
$1.00
0.50
$0.50

The company received an order calling for 10,000 units at $1.20 per unit, for a total of
$12,000. The buyer will pay the shipping expenses. Although the acceptance of this order
Techniques for Financial Analysis, Modeling & Forecasting Page 20

will not affect regular sales, you are reluctant to accept it because the $1.20 price is below
the $1.50 factory unit cost ($1.50 = $1.00 + $0.50). You must consider, however, that you
can add to total profits by accepting this special order even though the price offered is
below the unit factory cost. At a price of $1.20, the order will contribute $0.20 per unit
(contribution margin per unit = $1.20 - $1.00 = $0.20) toward fixed cost and profit will
increase by $2,000 (10,000 units x $0.20). Using the contribution approach to pricing, the
variable cost of $1 will be a better guide than the full unit cost of $1.50. Note that the fixed
costs will not increase.

Per
Unit
$2.00
1.00

Sales
Less: Variable
costs
Contribution margin $1.00
Less-. Fixed cost
0.50
Net income
$0.50

Without
Special
Order
(90,000
Units)
$180,000
90,000

With
Special
Order
(100,000
Units)
$192,000
100,000

$ 90,000
45,000
$45,000

$ 92,000
45,000
$47,000

Difference
$12,000
10,000
$ 2,000
$2,000

ANALYZING THE MAKE-OR-BUY DECISION

Deciding whether to produce a component part internally or to buy it from a supplier is
called a make-or-buy decision. This decision involves both qualitative factors (e.g..
product quality and long-term business relationships with subcontractors) and
quantitative factors (e.g., cost). The quantitative effects of the make-or-buy decision are
best seen through incremental analysis.
EXAMPLE 1.17
You have prepared the following cost estimates for manufacture of a subassembly
component based on an annual product of 8,000 units:
Direct material
Direct labor
Variable factory overhead
applied
Fixed factory overhead applied
(150% of direct labor cost)
Total Cost

Per Unit
$5
4
4

Total
$40,000
32,000
32,000

$48,000

$19

$152,000

A supplier offers the subassembly at a price of $16 each. Two-thirds of fixed

factory overhead, which represent executive salaries, rent, depreciation, taxes, continue
regardless of the decision. To determine whether to make or buy the product, you must
evaluate the relevant costs that change between the alternatives. Assuming productive
capacity will be idle if not used to produce the subassembly, the analysis is as follows:
Per Unit
Make

Buy

Total of 8,000 Units

Make
Buy

Techniques for Financial Analysis, Modeling & Forecasting Page 21

Purchase price
Direct material
Direct Labor
Variable overhead
Fixed overhead that can
be avoided by not making
Total relevant costs
Difference in favor of
making

16
$5
4
4
2
$15
$1

128,000
$40,000
32,000
32,000
16,000

$16

$120,000 $128,000
$ 8,000

The make-or-buy decision must be evaluated in the broader perspective of considering

how best to utilize available facilities. The alternatives include:
1. Leaving facilities idle
2. Renting out idle facilities
3. Using idle facilities for other products
DETERMINING WHETHER TO SELL OR PROCESS FURTHER
When two or more products are produced simultaneously from the same input by a joint
process, these products are called joint products. The term joint costs is used to describe
all the manufacturing costs incurred prior to the point at which the joint products are
identified as individual products that is, the split-off point. At the split-off point some of the
joint products are in final form and can be sold to the consumer, whereas others require
additional processing. In many cases, however, you might have an option: you can sell
the goods at the split-off point or process them further in the hope of obtaining additional
revenue. Joint costs are considered irrelevant to this sell-or-process-further decision,
since the joint costs have already been incurred at the time of the decision and, therefore,
represent sunk costs. The decision will rely exclusively on additional revenue compared
to the additional costs incurred due to further processing.
EXAMPLE 1.18
Your company produces products A, B and C from a joint process. Joint production costs
for the year are $120,000. Product A may be sold at the split-off point or processed further.
The additional processing requires no special facilities and all additional processing costs
are variable. The sales value at the split-off point of 3,000 units is $60,000. The sales
value for 3,000 units after further processing is $90,000 and the additional processing
cost is $25,000.
Incremental sales revenue
Incremental costs of additional processing
Incremental gain or CM of additional
processing

$30,000
25,000
5,000

It is profitable for product A to be processed further. Keep in mind that the joint
production cost of $120,000 is not included in the analysis. Since it is a sunk cost, it is
irrelevant to the decision.
ADDING OR DROPPING A PRODUCT LINE
Deciding whether to drop an old product line or add a new one requires an evaluation of
Techniques for Financial Analysis, Modeling & Forecasting Page 22

both qualitative and quantitative factors. However, any final decision should be based
primarily on the impact on contribution margin or net income.
EXAMPLE 1.19
Your company has three major product lines: A, B and C. You are considering dropping
product line B because it is being sold at a loss. The income statement for these product
lines follows:
Sales
Less: Variable costs
Contribution margin
Less: Fixed costs
Direct
Allocated
Total
Net Income

Product A
$10,000
6,000
$ 4,000

Product B
$15,000
8,000
$ 7,000

Product C
$25,000
12,000
$13,000

Total
$50,000
26,000
$24,000

$ 2,000
1,000
$ 3,000
$ 1,000

$ 6,500
1,500
$ 8,000
$(1,000)

$ 4,000
2,500
$ 6,500
$ 6,500

$12,500
5,000
$17,500
$ 6,500

Direct fixed costs are identified directly with each of the product lines, whereas
allocated fixed costs are common fixed costs allocated to the product lines using some
base (e.g., space occupied). Common fixed costs typically continue regardless of the
decision and thus cannot be saved by dropping the product line to which they are
distributed.
The following calculations show the effects on your company with and without product
line B.

Sales
Less: Variable cost
Contribution margin
Less: Fixed costs
Direct
Allocated
Total
Net Income

Keep
Product B
$50,000
26,000
24,000

Drop
Product B
$35,000
18,000
17,000

$12,500
5,000
$17,500
$ 6,500

$ 6,000
5,000
$11,000
$ 6,000

Difference
$(15,000)
(8,000)
(7,000)
$ (6,500)
$ (6,500)
$ 500

Alternatively, if product line B were dropped, the incremental approach would show
the following:
Sales revenue
lost

$15,000

Gains:
Techniques for Financial Analysis, Modeling & Forecasting Page 23

Variable cost avoided

Directed fixed costs
avoided
Increase (decrease) in net
income

$8,000
6,000

14,500

$ (500)

Both methods demonstrate that by dropping product line B your company will lose
an additional $500. Therefore, product line B should be kept. One of the great dangers in
allocating common fixed costs is that such allocations can make a product line look less
profitable than it really is. Because of such an allocation, product line B showed a loss of
$1,000 but it actually contributes $500 ($7,000 - $6,500) to the recovery of common fixed
costs.
UTILIZING SCARCE RESOURCES
In general, the emphasis on products with higher contribution margins maximizes your
companys net income. This is not true, however, when there are constraining factors or
scarce resources. A constraining factor is the factor that restricts or limits the production
or sale of a given product. It may be machine hours, labor hours, or cubic feet of
warehouse space. In the presence of these constraining factors, maximizing profit
depends on getting the highest contribution margin per unit of the factor (rather than the
highest contribution margin per unit of product output).
EXAMPLE 1.20
Your company produces products A and B with the following contribution margins per unit
and an annual fixed cost of $42,000.
Product A
Sales
$8
Less: Variable
6
costs
Contribution margin $2

Product B
$24
20
$4

As is indicated by the contribution margin, product B is more profitable than product A

since it contributes more to your company's profits ($4 versus $2). But assume that your
company has a limited capacity of 10,000 labor hours. Further, assume that product A
requires 2 labor hours to produce and product B requires 5 labor hours. One way to
express this limited capacity is to determine the contribution margin per labor hour.
Contribution margin per unit
Labor hours required per unit
Contribution margin per labor
hour

Product A
$2.00
2
$1.00

Product B
$4.00
5
$0.80

Since product A returns the higher contribution margin per labor hour, it should be
produced and product B should be dropped.
Another way to look at the problem is to calculate the total contribution margin for
Techniques for Financial Analysis, Modeling & Forecasting Page 24

each product.
Product A
Maximum possible
5,000 units*
production
Contribution margin per unit x $2
Total contribution margin
$10,000
*(10,000 hours/2 hours)
**(10,000 hours/5 hours)

Product B
2,000 units**
x $4
$8,000

Again, product A should be produced since it contributes more than product B

($10,000 versus $8,000)
DONT FORGET THE QUALITATIVE FACTORS
In addition to the quantitative factors highlighted by contribution margin analysis,
qualitative factors must also be considered in the decision-making. They include:
1.
2.
3.
4.

Effect on employee morale, schedules and other internal factors

Relationships with and commitments to suppliers
Effect on present and future customers
Long-term future effect on profitability

In some decision-making situations, qualitative factors are more important than

immediate financial benefit.
CONCLUSION
Break-even analysis assists you in making management decisions concerning the
feasibility of introducing products or services. The impact of fixed costs in the cost
structure has to be considered in evaluating corporate operational risk. Contribution
margin analysis tells us whether to accept a below-normal selling price, which products to
emphasize, how to optimize utilization of capacity and how to formulate a bid price on a
contract.

Techniques for Financial Analysis, Modeling & Forecasting Page 25

CHAPTER 1 QUIZ
1. Cost-volume-profit (CVP) analysis allows management to determine the relative
profitability of a product by assigning costs to a product in a manner that maximizes the
contribution margin (CM).
True / False
2. The dollar amount of sales revenues needed to attain a target income is calculated by
dividing the contribution margin (CM) ratio into
A. Fixed cost.
B. Target income.
C. Target income plus fixed costs.
D. Target income less fixed costs.
3. United Industries manufactures three products at its highly automated factory. The
products are very popular, with demand far exceeding the companys ability to supply the
marketplace. To maximize profit, management should focus on each products
contribution margin (CM) per machine hour.
True / False
4. The percentage change in profits associated with the percentage change in sales is the
degree of
A. Operating leverage.
B. Financial leverage.
C. Breakeven point.
D. Combined leverage.
5. Korn Company sells two products, as follows:

Product Y
Product Z

Per unit
Sales Variable
price costs
$120 $ 70
500
200

Fixed costs total $300,000 annually. The expected sales mix in units is 60% for product Y
and 40% for product Z. How much is Korns breakeven sales in units?
A. 857
B. 1,111
C. 2,000
D. 2,459
6. When considering a special order that will enable a company to make use of currently
idle capacity, factory depreciation is irrelevant.
Techniques for Financial Analysis, Modeling & Forecasting Page 26

True / False
7. When an organization is operating above the breakeven point, the degree or amount
that sales may decline before losses are incurred is called the
A. Residual income rate.
B. Marginal rate of return.
C. Margin of safety.
D. Target (hurdle) rate of return.
8. The cash break-even point the volume of sales that will cover all cash expenses during
a period.
True / False
9. Cost relevant to a make-or-buy (outsourcing) decision
A. Depends on whether the company is operating at or below normal volume.
B. Involves an analysis of avoidable costs.
C. Should use absorption (full) costing.
D. Should use activity-based costing.
9. Which of the following qualitative factors favors the buy choice in an insourcing vs.
outsourcing (make or buy) decision?
A. Maintaining a long-run relationship with suppliers is desirable.
B. Quality control is critical.
C. Idle capacity is available.
D. All of the answers are correct.
11. There is a market for both product X and product Y. Which of the following costs and
revenues would be most relevant in deciding whether to sell product X or process it
further to make product Y?
A. Total cost of making X and the revenue from sale of X and Y.
B. Total cost of making Y and the revenue from sale of Y.
C. Additional cost of making Y, given the cost of making X and additional revenue
from Y.
D. Additional cost of making X, given the cost of making Y and additional revenue
from Y.
12. In joint-product costing and analysis, which one of the following costs is relevant when
deciding the point at which a product should be sold to maximize profits?
A. Separable costs after the split-off point.
B. Joint costs to the split-off point.
C. Sales salaries for the period when the units were produced.
Techniques for Financial Analysis, Modeling & Forecasting Page 27

D. Purchase costs of the materials required for the joint products.

13. In calculating the breakeven point for a multiproduct company, which of the following
assumptions are commonly made when variable costing is used?
I. Sales volume equals production volume.
II. Variable costs are constant per unit.
III. A given revenue (sales) mix is maintained for all volume changes.
A.
B.
C.
D.

I and II.
I and III.
II and III.
I, II and III.

Techniques for Financial Analysis, Modeling & Forecasting Page 28

CHAPTER 1 ANSWER KEY

1. (F) is correct. Cost-volume-profit (CVP) analysis relates to the way profit and costs
change with a change in volume. CVP analysis examines the impact on earnings of
changes in such factors as variable cost, fixed cost, selling price, volume and product mix.
The contribution margin (CM) is used to project the breakeven point as well as profits at
various levels of sales.
(T) is incorrect. CVP analysis is a means of projecting profitability at various sales levels
rather than a technique of accounting for costs. The CM is not maximized by simply
assigning costs to a product, but by either increasing the sales price or reducing the cost.
2. (C) is correct. Breakeven analysis treats the target income in the same way as fixed
costs. The CM ratio is divided into the sum of fixed costs plus target profit.
(A) is incorrect. The result would be the break-even point, not the sales needed to earn a
target income.
(B) is incorrect. Fixed costs are left out and must be added to target income.
(D) is incorrect. Fixed costs must be added (not subtracted from) to target income.
3. (T) is correct. When demand far exceeds a companys ability to supply the
marketplace, management will want to maximize its profits per unit of scarce resource. If
the scarce resource is raw materials, the products that provide the greatest contribution
margin per unit of raw materials should be emphasized. If machine hours are the
constraint, profits are maximized by emphasizing the CM per machine hour.
(F) is incorrect. The company can sell as much of each product as it can produce without
limited capacity. If sales are limited by constraints, e.g., machine hours, the company
should seek to maximize its return per unit of the constraint.
4. (A) is correct. Operating leverage is the degree to which fixed costs exist in your cost
structure. Firms may increase fixed costs, such as by automation, to reduce variable
costs. The result is a greater degree of operating leverage (DOL), which is the percentage
change in operating income (earnings before interest and taxes) divided by the
percentage change in sales.
(B) is incorrect. The degree of financial leverage equals the percentage change in net
income divided by the percentage change in operating income.
(C) is incorrect. The breakeven point is the volume at which total sales revenue equals
total costs.

Techniques for Financial Analysis, Modeling & Forecasting Page 29

(D) is incorrect. The degree of total (combined) leverage equals the percentage change in
net income divided by the percentage change in sales.
5. (C) is correct. The weighted-average CM per unit is $150 [(60% x $50) + (40% x $300)]
and the break-even point 2,000 units ($300,000 / $150).
(A) is incorrect. 857 units assume a $350 weighted-average CM.
(B) is incorrect. 1,111 divides fixed costs by the sum of variable costs for Y and Z.
(D) is incorrect. 2,459 divides fixed costs by the weighted-average variable costs.
6. (T) is correct. Because factory depreciation will be expensed whether or not the
company accepts the special order, it is irrelevant to the decision. Only the variable costs
are relevant. Fixed costs such as factory depreciation and factory rent tend to stay the
same regardless of the decision.
(F) is incorrect. Only the variable costs, such as materials, direct labor and variable
overhead, are relevant. They need to be covered by the special order at a price lower than
the regular price.
7. (C) is correct. The margin of safety is the excess of budgeted revenues over breakeven
revenues. It is considered in sensitivity analysis.
(A) is incorrect. Residual income is the excess of earnings over an imputed charge for the
given investment base.
(B) is incorrect. A marginal rate of return is the return on the next investment.
(D) is incorrect. A target or hurdle rate of return is the required rate of return. It is also
known as the discount rate of the opportunity cost of capital.
8. (T) is correct. If you have a minimum of available cash, or if the opportunity cost of
holding excess cash is high, you may want to know the volume of sales that will cover all
cash expenses during a period. This is known as the cash break-even point.
(F) is incorrect. Not all fixed costs involve cash payments. For example, depreciation
expense is a noncash charge. To find the cash break-even point, the noncash charges,
such as depreciation and prepaid expenses must be subtracted from total fixed costs.
Therefore, the cash break-even point is lower than the usual break-even point.
9. (B) is correct. Available resources should be used as effectively as possible before
outsourcing. If the total relevant costs of production are less than the cost to buy the item,
Techniques for Financial Analysis, Modeling & Forecasting Page 30

it should be produced in-house. The relevant costs are those that can be avoided.
(A) is incorrect. Whether operations are at normal volume is less important than the
amount of idle capacity. The company is less likely to buy if it has sufficient unused
capacity.
(C) is incorrect. Total costs (absorption costing) are not as important as relevant costs.
(D) is incorrect. Activity-based costing is used to allocate fixed overhead. Fixed overhead
is not relevant in a make-or-outsource decision unless it is avoidable.
10. (A) is correct. The maintenance of long-run relationships with suppliers may become
paramount in a make-or-buy decision. Abandoning long-run supplier relationships may
cause difficulty in obtaining needed parts when terminated suppliers find it advantageous
not to supply parts in the future.
(B) is incorrect. If quality is important, one can ordinary control it better in ones own plant.
(C) is incorrect. The availability of idle capacity more likely favors the decision to make.
(D) is incorrect. The importance of quality control and the availability of idle capacity are
qualitative factors favoring the make choice in an insourcing vs. outsourcing.
11. (C) is correct. Incremental costs are the additional costs incurred for accepting one
alternative rather than another. Questions involving incremental costing (sometimes
called differential costing) decisions are based upon a variable costing analysis. The
typical problem for which incremental cost analysis can be used involves two or more
alternatives, for example, selling or processing further. Thus, the relevant costs and
revenues are the marginal costs and marginal revenues.
(A) is incorrect. The cost of making X is a sunk cost (irrelevant). In addition, only X or Y,
not both, can be sold.
(B) is incorrect. Only the relevant, incremental costs are considered.
(D) is incorrect. Y is made only after X is completed.
12. (A) is correct. Joint products are created from processing a common input. Common
costs are incurred prior to the split-off point and cannot be identified with a particular joint
product. As a result, common costs are irrelevant to the timing of sale. However,
separable costs incurred after the split-off point are relevant because, if incremental
revenues exceed the separable costs, products should be processed further, not sold at
the split-off point.

Techniques for Financial Analysis, Modeling & Forecasting Page 31

(B) is incorrect. Joint costs (common costs) have no effect on the decision as to when to
sell a product.
(C) is incorrect. Sales salaries for the production period do not affect the decision.
(D) is incorrect. Purchase costs are joint costs.
13. (D) is correct. CVP analysis assumes that costs and revenues are linear over the
relevant range. It further assumes that total fixed costs and unit variable costs are
constant. Thus, total variable costs are directly proportional to volume. CVP analysis also
assumes that no material change in inventory occurs (sales = production) and that the
mix of products is constant (or that only one product is produced).
(A) is incorrect. The sales mix is deemed to be constant.
(B) is incorrect. Unit variable cost is assumed to be constant.
(C) is incorrect. The assumption is that inventories do not change.

Techniques for Financial Analysis, Modeling & Forecasting Page 32

CHAPTER 2
UNDERSTANDING AND APPLYING
THE TIME VALUE OF MONEY CONCEPT
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.

Understand the concept of future value.

Distinguish between future value and present value concepts.
Calculate the future value of a single payment and an annuity.
Calculate the present value of a single payment and an annuity.
Explain perpetuities.

You cannot treat todays and tomorrows dollars the same. This chapter looks at the
relationship between present (discounted) and future (compound, amount of) values of
money. Applications of present values and future values include loans, leases, bonds,
sinking fund, growth rates, capital budgeting investment selection and effect of inflation
on the organization. You can solve for many different types of unknowns, such as interest
rate, annual payment, number of periods, present amount and future amount. Present
value and future value calculations have many applications in accounting, financial and
investment decisions.
ASSUMPTIONS OF PRESENT VALUE AND FUTURE VALUE TECHNIQUES

Present value and future value variables (e.g., interest rate, number of periods,
annual cash flows) are known with certainty.
The interest rate is constant.
All amounts in a series are equal.

We will be using the following tables throughout this chapter.

Future Value of $1
Future Value of an Annuity of $1
Present Value of $1
Present Value of an Annuity of
$1

Table 2.1
Table 2.2
Table 2.3
Table 2.4

Future value is sometimes called amount of, sum of, or compound value. Present value is
sometimes called discounted value, year zero value, or current value.
Some rules for using the present and future value tables throughout this chapter
follow.

Techniques for Financial Analysis, Modeling & Forecasting Page 33

Present Value Table

A present value table is used if you want to determine the current amount of
receiving future cash flows.
The Present Value of $1 table is used if you have unequal cash flows each period
or a lump-sum cash flow.
The Present Value of an Annuity of $1 table is used if the cash flows each period
are equal and occur at the end of the period.
The Present Value of an Annuity Due (which requires modification of The Present
Value of an Annuity table) is used if the cash flows each period are equal and occur
at the beginning of the period.
Future Value Table
A Future Value table is used if you want to determine the future (later) amount of
giving cash flows.
The Future Value of $1 table is used if you have unequal cash flows each period or
a lump-sum cash flow.
The Future Value of an Annuity of $1 table is used if the cash flows each period are
equal and occur at the end of the period.
The Future Value of an Annuity Due (which requires modification of The Future
Value of an Annuity table) is used if the cash flows each period are equal and occur
at the beginning of each period.
Both Present Value and Future Value Tables
If you want to determine a total dollar amount either in the present or future, you
have a multiplication problem.
If you want to calculate an annual payment, interest rate, or number of periods, you
have a division problem. In such a case, what you put in the numerator of a fraction
determines which table to use. For example, if you put in the numerator a future
value that involves equal year-end payments, you have to use the Future Value of
an Annuity table.
If you are given a present value amount, it goes in the numerator of the fraction. On
the other hand, if you are given a future value amount, that value goes in the
numerator.
If you are solving for an annual payment, you divide the numerator by the factor
corresponding to the interest rate (i) and the number of periods (n).
If you are solving for an interest rate, divide the numerator by the annual payment
to get a factor. Then, to find the interest rate, find that factor on the table opposite
the number of years. The interest rate will be indicated at the top of the column
where the factor is located.
If you are solving for the number of years, you divide the numerator by the annual
payment to get the factor. Then find the factor in the appropriate interest rate
column. The number of years will be indicated in the far left-hand column.

Now let us look at examples using the different tables.

Techniques for Financial Analysis, Modeling & Forecasting Page 34

FUTURE VALUE OF $1 (TABLE 2.1)

EXAMPLE 2.1
You put $400 in a savings account earning 10 percent interest compounded annually for
six years. You will have accumulated
$400

1.7716

$708.64

EXAMPLE 2.2
You deposit $10,000 in an account offering an annual interest rate of 20 percent. You will
keep the money on deposit for five years. The interest rate is compounded quarterly. The
accumulated amount at the end of the fifth year is
n = 5 x 4 = 20
i=20/4=5%
$10,000 x 2.6533 = $26,533
EXAMPLE 2.3
On 1/1/2001 you deposit $10,000 to earn 10 percent compounded semiannually.
Effective 1/1/2005 the interest rate is increased to 12 percent and at that time you decide
to double your balance. You want to determine how much will be accumulated in your
account on 1/1/2011.
1/1/20011/1/2005
:

1/1/2005:
Double balance
1/1/2005:
Total balance
1/1/2005-1/1/2011:

4x2

10% / 2
$10,000 x
1.4775

=
=

5%
$14,775
$14,775

n
i

=
=

6x2
12% / 2
$29,550 x
2.0122

=
=

$29 550
12
6%
$59,460.51

EXAMPLE 2.4
You want to have $1,000,000 at the end of 15 years. The interest rate is 8 percent. You
have to deposit today the following sum to accomplish your objective:
$1,000,000
= $315,238.63
3.1722

Techniques for Financial Analysis, Modeling & Forecasting Page 35

EXAMPLE 2.5
At an interest rate of 12 percent, you want to know how long it will take for your money to
double.
$2
=2
$1

n = 6 years (falls closer to 6 years)

EXAMPLE 2.6
You want to have $250,000. Your initial deposit is $30,000. The interest rate is 12 percent.
The number of years it will take to reach your goal is

$250,000
= 8.3333
$30,000

n = 18.5 years (approximately). Factor falls about midway between 18 and 19 years.

EXAMPLE 2.7
You agree to pay back $3,000 in six years on a $2,000 loan made today. You are being
charged an interest rate of

$3,000
= 1.5
$2,000

i=7%

EXAMPLE 2.8
Your earnings per share was $1.20 in 20X1 and eight years later it was $3.67. The
compound annual growth rate is

$3.67
= 3.059
$1.20

Growth rate = 15%

Techniques for Financial Analysis, Modeling & Forecasting Page 36

FUTURE VALUE OF AN ANNUITY OF $1 (TABLE 2.2)

EXAMPLE 2.9
You plan to pay $20,000 year-end payments into a sinking fund for the next 15 years. The
fund earns an interest of 8 percent compounded once a year. The accumulated balance
at the end of the fifteenth year is
$20,000 x 27.152 = $543,040

EXAMPLE 2.10
You deposit $30,000 semiannually into a fund for ten years. The annual interest rate is 8
percent. The amount accumulated at the end of the tenth year is calculated as follows:
n = 10 x 2=20
i = 8%/2 = 4%
$30,000 x 29.778 = $893,340

EXAMPLE 2.11
You borrow $300,000 for 20 years at 10 percent. At the end of the 20-year period, you will
have to pay
$300,000 x 6.7275* =
$2,018,250
*Future Value o $1 (Table 2.1)
The interest amount equals
$2,018,250 Maturity value
- 300,000 Principal
$1,718,250 Interest

EXAMPLE 2.12
You want to determine the annual year-end deposit needed to accumulate $100,000 at
the end of 15 years. The interest rate is 12 percent. The annual deposit is
$100.000
= $2,682.48
37.279

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EXAMPLE 2.13
You need a sinking fund for the retirement of a bond 30 years from now. The interest rate
is 10 percent. The annual year-end contribution needed to accumulate $1,000,000 is
$1,000,000
= $6,079.40
164.49

EXAMPLE 2.14
You want to have $600,000 accumulated in your fund. You make four deposits of
$100,000 per year. The interest rate you must earn is
$600,000
=6
$100,000
i = 28% (approximately)

EXAMPLE 2.15
You want to have $500,000 accumulated in a pension plan after nine years. You deposit
$30,000 per year. The interest rate you must earn is
$500,000
= 16.667
$30,000

i= 15% (approximately)

EXAMPLE 2.16
You want $500,000 in the future. The interest rate is 10 percent. The annual payment is
$80,000. The number of years it will take to accomplish this objective is

$500,000
= 6.25
$80,000
n = 5 years (approximately)

FUTURE VALUE OF AN ANNUITY DUE OF $1 (TABLE 2.2. ADJUSTED)

Calculation of the future value of an annuity due of $1 requires a minor adjustment to the
Future Value of an Ordinary Annuity of $1 table. To get the future value of an annuity due,
add 1 to the number of years and then obtain the factor. Then subtract 1 from this factor.

Techniques for Financial Analysis, Modeling & Forecasting Page 38

EXAMPLE 2.17
You make $25,000 payments at the beginning of the year into a sinking fund for 20 years.
The interest rate is 12 percent. The accumulated value of the fund at the end of the
twentieth year is
n =20+1 = 21
Factor
81.698
1.000
Adjusted
80.698
$25,000 x 80.698 = $2,017,450

EXAMPLE 2.18
You want to accumulate $600,000 in an account. You are going to make eight yearly
deposits. The interest rate is 12 percent. The annual deposit is
n =8+ 1=9
$600,000 $600,000
=
= $43,557.17
14.775 1
13.775

Techniques for Financial Analysis, Modeling & Forecasting Page 39

Table 2.1 Future Value of $1

Techniques for Financial Analysis, Modeling & Forecasting Page 40

Table 2.2 Future Value of an Annuity of $1

Techniques for Financial Analysis, Modeling & Forecasting Page 41

PRESENT VALUE OF $1 (TABLE 2.3)

The discount rate ordinarily used in present value calculations is called the cost of capital ,
which is the minimum required rate of return set by the firm.
EXAMPLE 2.19
You have an opportunity to receive $30,000 four years from now. You earn 12 percent on
your investment. The most you should pay for this investment is
$30,000 x 0.6355 = $19,065

EXAMPLE 2.20
You are thinking of starting a new product line that initially costs $30,000. The interest rate
is 10 percent. Your annual net cash inflows are
Year 1
Year 2
Year 3

$8,000
15,000
18,000

The net present value is positive, as indicated in the following calculations.

Year
0
1
2
3
Net present
value

Calculation
-$30,000 x l
8,000 x 0.9091
15,000 x 0.8264
18,000 x 0.7513

Net Present Value

-$30,000.00
7,272.80
12,396.00
13,523.40
$ 3,192.20

You should undertake the new product line.

PRESENT VALUE OF AN ANNUITY OF $1 (TABLE 2.4)

Annuities are often received from pension plans and insurance policies. The Present
Value of $1 table (Table 2.3) can be used to solve an annuity of equal payments by
making separate calculations for each years cash flow (multiplying the cash flow for the
year by the present value of $1 factor) and adding them all up over the length of the
proposals life. But the calculation can be done much faster using a Present Value of an
Annuity of $1 table (Table 2.4) All that is required is to multiply the annual cash payment
by the factor in the table.

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EXAMPLE 2.21
You are trying to determine the price you are willing to pay for a $1,000, five-year U.S.
bond paying $50 interest semiannually, which is sold to yield 8 percent.
i
n

=
=

8% / 2
5x2

=
=

4%
10

Present Value of $1 (Table 2.3) for n = 10, i = 4%:

$1,000 x
0.6756

$675.6
0

Present Value of an Annuity of $1 (Table 2.4) for n= l0,i=4%:

$50 x 8.1109 405.55
Present
$1,081.15
value

EXAMPLE 2.22
You incur the following expenditures to lease an item:
Year 0
$3,000
Year 1
4,000
Year 2
5,000
Years 3-10 12,000*
The interest rate is 10 percent.
For years 1 and 2, use the Present Value of $1 table (Table 2.3).
*You are paying $12,000 each from year 3 to year 10. While you can calculate it using the
Present Value of $1 table, it is significantly faster and more accurate to use the Present
Value of an Annuity table (Table 2.4).
The net present value is
Year
0
1
2
310
Net present
value
*Year 10 factor - year 2 factor.

Calculation
-$3,000 x l
-4,000 x 0.9091
-5,000 x 0.8264
-12,000 x (6.1446 1.7355)*

Present Value
-$3,000.00
- 3,636.40
- 4,132.00
-52,909.20
$63,677.60

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Each loan payment comprises principal and interest. The breakdown is usually shown in
a loan amortization table. The interest is higher in the early years than the later years
because it is multiplied by a higher loan balance.

EXAMPLE 2.23
You borrow $200,000 for five years at an interest rate of 14 percent. The annual year-end
payment on the loan is
$200,000
= $58,256.39
3.4331

EXAMPLE 2.24
You take out a $30,000 loan payable monthly over the next 40 months. The annual
interest rate is 36 percent. The monthly payment is
n = 40
i= 36/12 = 3%
From Table 2.4, 23.1148 for n=40 months and i=3% monthly
$30,000
= $1,297.87
23.1148

EXAMPLE 2.25
You borrow $300,000 payable $70,000 a year. The interest rate is 14 percent. The
number of years you have to pay off the loan is
$300,000
= 4.2857
$70,000

n = 7 years (approximately)

EXAMPLE 2.26
You borrow $20,000 to be repaid in 12 monthly payments of $2,131,04. The monthly
interest rate is
$20,000
= 9.3851
$2,131.04

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Table 2.4 for n=12 months yields i=4%

EXAMPLE 2.27
You borrow $1,000,000 and agree to make payments of $100,000 per year for 18 years.
The interest rate you are paying is
$1,000,000
= 10
$100,000
i= 7 percent (approximately)

EXAMPLE 2.28
You buy a note for $14,000. You will receive annual payments of $2,000 on it for ten years.
Your annual yield is
$14,000
=7
$2,000

i = 7%

EXAMPLE 2.29
When you retire you want to receive an annuity of $80,000 at the end of each year for ten
years. The interest rate is 8 percent. The amount that must be in your retirement account
at the date of retirement is calculated as follows.
Using the Present Value of an Annuity of $1 table (Table 2.4):
$80,000 x 6.7101 = $536,808
You also want to know how much you have to deposit into your pension plan at the end of
each year to have $536,808 if you are going to make 20 annual contributions. The interest
rate is 6 percent.
Using the Future Value of an Annuity of $1 table (Table 2.2):
$536,808
= $14,593.12
36.785

PRESENT VALUE OF AN ANNUITY DUE OF $1 (TABLE 2.4 ADJUSTED)

To get the present value of an annuity due, which refers to equal beginning-of-year
payments, find the present value of an ordinary annuity of $1 for one period less than the
life of the annuity. Then add 1 to this number.
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EXAMPLE 2.30
You will receive ten payments of $5,000 at the beginning of each year. The interest rate is
14 percent. The present value of the cash receipts is
n

10 - 1

Factor
4.9464
Add
1.0000
Adjusted factor 5.9464
$5,000 x
5.9464

$29,732

EXAMPLE 2.31
You owe $800,000 and will make 15 beginning-of-year payments to pay it off. The interest
rate is
n =15 - 1=14 Factor
5.0081
Add
1.0000
Adjusted factor 6.0081
$800,000
=
6.0081

$133153.57

Techniques for Financial Analysis, Modeling & Forecasting Page 46

Table 2.3 Present Value of $1

Techniques for Financial Analysis, Modeling & Forecasting Page 47

Table 2.4 Present Value of an Annuity of $1

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PERPETUITIES
Annuities that go on indefinitely are referred to as perpetuities. An example is preferred
stock having an indefinite constant dollar dividend.
Present value of a perpetuity =

Re ceipt
Discount rate

EXAMPLE 2.32
A perpetual bond has a $50 per year interest payment and the discount rate is 8 percent.
The present value of this perpetuity equals
$50
= $625
0.08

CONCLUSION
The Present Value of $1 table is used when you want to determine the current value of
receiving unequal cash receipts. If the cash flows each year are equal, you use the
Present Value of an Annuity of $1 table. The Future Value of $1 table is employed to find
the compounded amount of making unequal deposits. If the cash deposits are equal each
period, you use the Future Value of an Annuity of $1 table. The present value and future
value tables are used to solve for unknowns such as annual payment, interest rate and
the number of years. They can be used to solve many business-related problems.

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CHAPTER 2 QUIZ
1. Future value is best described as
A. The sum of cash flows discounted to time zero.
B. Future cash inflows discounted to the present.
C. The compound value of cash inflows or cash outflows at a future time.
D. The fair market value.
2. The discount rate ordinarily used in present value calculations is the
A. Federal Reserve rate.
B. Minimum required rate of return set by the firm.
C. Treasury bill rate.
D. Prime rate.
3. On July 1, 2003, a company purchased a new machine that it does not have to pay for
until July 1, 2005. The total payment on July 1, 2005 will include both principal and
interest. Assuming interest at a 10% rate, the cost of the machine would be the total
payment multiplied by what time value of money concept?
A. Present value of annuity of 1.
B. Future amount of annuity of 1.
C. Present value of 1.
D. Future amount of 1.
4. Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce
annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year
3. Present values of an annuity of $1 at 14% are
Period 1
0.88
2
1.65
3
2.32
Using a 14% cost of capital, what is the present value of these future savings?
A.
B.
C.
D.

$49,500
$69,600
$62,900
$69,500

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CHAPTER 2 ANSWER KEY

1. (C) is correct. The future value of a dollar is its value at a time in the future given its
present sum. The future value of a dollar is affected both by the interest rate and the time
at which the dollar is received.
(A) is incorrect. Discounting to time zero is a present value calculation.
(B) is incorrect. The present value is the sum of future cash inflows discounted to the
present.
(D) is incorrect. The fair market value is the value a buyer is willing to pay at arms length.
2. (B) is correct. The discount rate most often used in present value calculations is the
minimum desired rate of return as set by management. The NPV arrived at in this
calculation is a first step in the decision process. It indicates how the projects return
compares with the minimum desired rate of return.
(A) is incorrect. The Federal Reserve rate may be considered; however, the firm will set
its minimum desired rate of return in view of its needs.
(C) is incorrect. The Treasury bill rate is a riskless rate. The firm will set its minimum
desired rate of return in view of the projects risk levels.
(D) is incorrect. The firm will set the prime rate plus risk premium as the discount rate.
3. (C) is correct. The cost of the machine to the company on July 1, 2003 is the present
value of the payment to be made on July 1, 2005. To obtain the present value, i.e.,
today's price, the future payment is multiplied by the present value of $1 for two periods at
10%.
(A) is incorrect. The present value of an annuity determines the value today of a series of
future payments (not merely one payment).
(B) is incorrect. The future value of an annuity determines the amount available at a
specified time in the future after a series of deposits (investments).
(D) is incorrect. The future value of a dollar determines how much will be available at a
specified time in the future based on the single investment (deposit) today.
4. (C) is correct. The present value of future cost savings constitute two present values:
the present value of a 2-year annuity of $30,000 per year and the present value of
$20,000 in year 3. Using a 14% cost of capital and ignoring tax effects, the present value
is $62,900; [$30,000 x 1.65] + [$20,000 (2.32 1.65)] = $49,500 + $$13,400 = $62,900.
Techniques for Financial Analysis, Modeling & Forecasting Page 51

(A) is incorrect. $49,500 equals the present value of a 2-year annuity for $30,000
($20,000 x 1.65).
(B) is incorrect. $69,600 equals the present value of a 3-year annuity for $30,000
($30,000 x 2.32).
(D) is incorrect. $69,500 equals the present value of a 2-year annuity for $30,000, plus
$20,000.

Techniques for Financial Analysis, Modeling & Forecasting Page 52

CHAPTER 3
HOW TO ASSESS CAPITAL EXPENDITURE PROPOSALS
FOR STRATEGIC DECISION MAKING
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.
6.
7.

Describe the types and special features of capital budgeting decisions.

Calculate, interpret and evaluate five capital budgeting techniques.
Select the best mix of projects with a limited capital spending budget.
Describe factors to consider in determining capital expenditures.
Explain types of capital budgeting decisions to be made.
Handle mutually exclusive investments.
Discuss risk analysis in capital budgeting.

Capital budgeting relates to planning for the best selection and financing of long-term
investment proposals. Capital budgeting decisions are not equally essential to all
companies; the relative importance of this essential function varies with company size, the
nature of the industry and the growth rate of the firm. As a business expands, problems
regarding long-range investment proposals become more important. Strategic capital
budgeting decisions can turn the tide for a company.
The types of scarce resources that may be committed to a project include cash, time
of key personnel, machine hours and floor space in a factory. When estimating costs for a
proposed project, the allocation of the company's scarce resources must be converted in
terms of money.
There are two broad categories of capital budgeting decisions, namely, screening
decisions and preference decisions. Screening decisions relate to whether a proposed
project satisfies some present acceptance standard. For instance, your company may have
a policy of accepting cost reduction projects only if they provide a return of, say, 15 percent.
On the other hand, preference decisions apply to selecting from competing courses of
action. For example, your company may be looking at four different machines to replace an
existing one in the manufacture of a product. The selection of which of the four machines is
best referred to as a preference decision.
The basic types of investment decisions are selecting between proposed projects
and replacement decisions. Selection requires judgments concerning future events of which
you have no direct knowledge. You have to consider timing and risk. Your task is to
minimize your chances of being wrong. To help you deal with uncertainty, you may use the
risk-return trade-off method. Discounted cash flow methods are more realistic than are
methods not taking into account the time value of money in appraising investments.
Consideration of the time value of money becomes more essential in inflationary periods.
Capital budgeting can be used in profit and nonprofit settings.
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Planning for capital expenditures requires you to determine the "optimal"

proposal, the number of dollars to be spent and the amount of time required for completion.
An appraisal is needed of current programs, evaluating new proposals and coordinating
interrelated proposals within the company. In planning a project, consideration should be
given to time, cost and quality, which all interact. For control, a comparison should be made
between budgeted cost and time compared to actual cost and time. All future operating
cash savings are considered as well as the tax effects on cash flows of future depreciation
charges. The cash proceeds of future asset disposals are likewise a necessary
consideration. Depreciation expense is a consideration only to the extent that it affects the
cash flows for taxes. Otherwise, depreciation is excluded from the analysis because it is a
noncash expense. Note: Accelerated depreciation results in greater depreciation in the
early years of an assets life compared with the straight-line method. Thus, accelerated
depreciation results in lower income tax expense in the early years of a project and higher
income tax expense in the later years. By effectively deferring taxes, the accelerated
method increases the present value of the depreciation tax shield.
Capital budgeting decisions must conform to your cash position, financing strategy
and growth rate. Will the project provide a return exceeding the long-range expected return
of the business? Projects must be tied into the company's long-range planning, taking into
account corporate strengths and weaknesses. The objectives of the business and the
degree to which they depend on economic variable (e.g., interest rate, inflation), production
(e.g., technological changes) and market factors must be established. Also, the capital
budget may have to be adjusted after considering financial, economic and political concerns.
But consideration should be given to "sunken" and "fixed" costs that are difficult to revise
once the initial decision is made.
Recommendation: Use cost-benefit analysis. Is there excessive effort for the
proposal? Can it be performed internally or must it be done externally (e.g., make or buy)? Is
there a more efficient means and less costly way of accomplishing the end result? Further,
problem areas must be identified. An example is when long-term borrowed funds are used
to finance a project where sufficient cash inflows will not be able to meet debt at maturity.
Suggestion: Measure cash flows of a project using different possible assumed
variation (e.g., change in selling price of a new product). By modifying the assumptions and
appraising the results you can see the sensitivity of cash flows to applicable variables. An
advantage is the appraisal of risk in proposals based on varying assumptions. An increase
in risk should result in a higher return rate.
Taxes have to be considered in making capital budgeting decisions because a
project that looks good on a before-tax basis may not be acceptable on an after-tax basis.
Taxes have an effect on the amount and timing of cash flows.
What-if questions are often the most crucial and difficult with regard to the capital
expenditure budget and informed estimates are needed of the major assumptions.
Spreadsheets can be used to analyze the cash flow implications of acquiring fixed assets.
Once an investment proposal is approved, there has to be an implementation of
controls over expenditures and a reporting system regarding the projects status.
Techniques for Financial Analysis, Modeling & Forecasting Page 54

Expenditures should be traced to the project and controls in place assuring the expenditures
are in conformity with the approved investment proposal. Continuous monitoring should be
done of how well the project is doing relative to the original plan.
FACTORS TO CONSIDER IN DETERMINING CAPITAL EXPENDITURE
* Rate of return
* Budget ceiling
* Probability of success
* Competition
* Tax rate
* Dollar amounts
* Time value of money
* Risk
* Liquidity
* Long-term business strategy
TYPES OF CAPITAL BUDGETING DECISIONS TO BE MADE
* Cost reduction program
* Undertaking an advertising campaign
* Replacing or expanding existing facilities
* Merger analysis
* Refinancing an outstanding debt issue
* New and existing product evaluation
* No profit investments (e.g., health and safety).
This chapter discusses the various capital budgeting methods including payback,
discounted payback, accounting rate of return, net present value, internal rate of return and
profitability index. Consideration is also given to capital rationing and risk analysis in capital
budgeting.
CAPITAL BUDGETING METHODS
PAYBACK PERIOD
The payback period measures the length of time required to recover the amount of initial
investment. It is computed by dividing the initial investment by the cash inflows through
increased revenues or cost savings.
EXAMPLE 3.1
Assume:
Cost of investment
Annual after-tax cash
savings

$18,000
$3,000

Then, the payback period is:

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Payback
period

Initial investment
---------------=

$18,000
---------

Cost savings

$3,000

6 years

Decision rule: Choose the project with the shorter payback period. The rationale behind this
choice is: The shorter the payback period, the less risky the project and the greater the liquidity.
EXAMPLE 3.2
Consider the two projects whose after-tax cash inflows are not even. Assume each project
costs $1,000.
Cash Inflow
Year A($
1
100
2
200
3
300
4
400
5
500
6
600

B($)
500
400
300
100

When cash inflows are not even, the payback period has to be found by trial and error.
The payback period of project A is ($1,000= $100 + $200 + $300 + $400) 4 years. The payback
period of project B is $1,000 = $500 + $400 + $100):

2 years +

$100
-----$300

2 1/3 years

Project B is the project of choice in this case, since it has the shorter payback period.
The advantages of using the payback period method of evaluating an investment
project are that (1) it is simple to compute and easy to understand and (2) it handles investment
risk effectively.
The shortcomings of this method are that (1) it does not recognize the time value of
money and (2) it ignores the impact of cash inflows received after the payback period;
essentially, cash flows after the payback period determine profitability of an investment.
DISCOUNTED PAYBACK PERIOD
You can take into account the time value of money by using the discounted payback period.
The payback period will be longer using the discounted method since money is worth less over
time.
Techniques for Financial Analysis, Modeling & Forecasting Page 56

Discounted payback is computed by adding the present value of each year's cash
inflows until they equal the initial investment.
Discounted
payback

Initial cash outlays

--------------------------

Discounted annual cash

inflows
EXAMPLE 3.3
You invest $40,000 and receive the following cash inflows. The interest rate is 10%. The
discounted payback period is calculated as follows:

Year
1
2
3

T3 factor
@10%
.909
.826
.751

Cash inflows
$15,000
20,000
28,000

Accumulated
Present
value
$13,635
30,155
51,183

Present
value
$13,635
16,520
21,028

Thus,

$30,155 +

$40,000 30,155
-------------------$21,028

2 years

.47

2.47 years

ACCOUNTING RATE OF RETURN

Accounting rate of return (ARR), also called simple or unadjusted rate of return, measures
profitability from the conventional accounting standpoint by relating the required
investment--or sometimes the average investment--to the future annual net income.
Decision rule: Under the ARR method, choose the project with the higher rate of return.
EXAMPLE 3.4
Consider the following investment:
Initial investment
Estimated life
Cash inflows per year
Depreciation per year (using straight
line)

$6,500
20 years
$1,000
$325

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The accounting rate of return for this project is:

ARR

Net income
------------=
Investment

$1,000 - $325
--------------=
$6,500

10.4%

If average investment (usually assumed to be one-half of the original investment) is used,

then:
ARR

$1,000 - $325
------------=
$3,250

20.8%

The advantages of this method are that it is easily understood, simple to compute and
recognizes the profitability factor.
The shortcomings of this method are that it fails to recognize the time value of money
and it uses accounting data instead of cash flow data.
NET PRESENT VALUE
Net present value (NPV) is the excess of the present value (PV) of cash inflows generated by
the project over the amount of the initial investment (I):
NPV = PV I
The present value of future cash flows is computed using the so-called cost of capital
(or minimum required rate of return) as the discount rate. When cash inflows are uniform, the
present value would be
PV = A . T4 (i, n)
where A is the amount of the annuity. The value of T4 is found in Table 2.4 of Chapter 2.
Decision rule: If NPV is positive, accept the project. Otherwise reject it.
EXAMPLE 3.5
Consider the following investment:
Initial investment
Estimated life
Annual cash inflows
Cost of capital (minimum required rate of
return)

$12,950
10 years
$3,000
12%

Techniques for Financial Analysis, Modeling & Forecasting Page 58

Present value of the cash inflows is:

PV

=
=

A.T4(i,n)
$3,000. T4(12%,10
years)
$3,000 (5.650)

=
Initial investment (I)

$16,95
0

12,95
0
$4,00
0

Net present value (NPV = PV-I)

Since the NPV of the investment is positive, the investment should be accepted.
The advantages of the NPV method are that it obviously recognizes the time value of
money and it is easy to compute whether the cash flows from an annuity or vary from period to
period.
INTERNAL RATE OF RETURN
Internal rate of return (IRR), also called time adjusted rate of return, is defined as the rate of
interest that equates I with the PV of future cash inflows.
In other words,
at IRR I = PV or NPV = 0
Decision rule: Accept the project if the IRR exceeds the cost of capital. Otherwise, reject it.
EXAMPLE 3.6
Assume the same data given in Example 3.5 and set the following equality (I = PV):
$12,950

$3,000. T4(i,10 years)

T4(i,10 years) =

$12,950
-----$3,000

4.317

Which stands somewhere between 18 percent and 20 percent in the 10-year line of Table
2.4. The interpolation follows:
PV of An Annuity of $1 Factor
T4(i,10 years)
18%
IRR
20%
Difference

4.494
4.317
_____
0.177

4.494
4.192
0.302

Techniques for Financial Analysis, Modeling & Forecasting Page 59

Therefore,
IRR
=

18%

18%

0.586(2%)

0.177
------0.302

+
=

18%

=
+

(20% - 18%)
1.17%

19.17%

Since the IRR of the investment is greater than the cost of capital (12 percent), accept
the project.
The advantage of using the IRR method is that it does consider the time value of money
and, therefore, is more exact and realistic than the ARR method.
The shortcomings of this method are that (1) it is time-consuming to compute,
especially when the cash inflows are not even, although most financial calculators and PCs
have a key to calculate IRR and (2) it fails to recognize the varying sizes of investment in
competing projects.
Note: Spreadsheet programs can be used in making IRR calculations. For example, Excel has
a function IRR(values, guess). Excel considers negative numbers as cash outflows such as the
initial investment and positive numbers as cash inflows. Many financial calculators have similar
features. As in Example 13, suppose you want to calculate the IRR of a $12,950 investment
(the value --12950 entered in year 0 that is followed by 10 monthly cash inflows of $3,000).
Using a guess of 12% (the value of 0.12), which is in effect the cost of capital, your formula
would be @IRR(values, 0.12) and Excel would return 19.15%, as shown below.
Year 0

2
3,000

3
3,000

4
3,000

5
3,000

6
3,000

7
3,000

8
3,000

9
3,000

3,000

10
3,000

$ (12,950)
IRR =
NPV =

19.15%
$4,000.67

Note: The Excel formula for NPV is NPV (discount rate, cash inflow values) + I, where I is given
as a negative number.
Note: The internal rate of return (IRR) or the net present value (NPV) method are
collectively called discounted cash flow (DCF) analysis.
PROFITABILITY INDEX
The profitability index, also called present value index, is the ratio of the total PV of future
cash inflows to the initial investment, that is, PV/I. This index is used as a means of ranking
projects in descending order of attractiveness.
Decision rule: If the profitability index is greater than 1, then accept the project.
Techniques for Financial Analysis, Modeling & Forecasting Page 60

EXAMPLE 3.7
Using the data in Example 3.5, the profitability index is
PV
---I

$16,950
-------$12,950

1.31

Since this project generates $1.31 for each dollar invested (i.e., its profitability index
is greater than 1), accept the project.
The profitability index has the advantage of putting all projects on the same relative
basis regardless of size.
HOW TO SELECT THE BEST MIX OF PROJECTS WITH A LIMITED BUDGET
Many firms specify a limit on the overall budget for capital spending. Capital rationing is
concerned with the problem of selecting the mix of acceptable projects that provides the
highest overall NPV. The profitability index is used widely in ranking projects competing for
limited funds.
EXAMPLE 3.8
The Westmont Company has a fixed budget of $250,000. It needs to select a mix of
acceptable projects from the following:
Projects
A
B
C
D
E
F

I($)
70,000
100,000
110,000
60,000
40,000
80,000

PV($)
112,000
145,000
126,500
79,000
38,000
95,000

NPV($)
42,000
45,000
16,500
19,000
-2,000
15,000

Profitability Index
1.6
1.45
1.15
1.32
0.95
1.19

Ranking
1
2
5
3
6
4

The ranking resulting from the profitability index shows that the company should select
projects A, B and D.

A
B
D

I
$70,000
100,000
60,000
$230,000

PV
$112,000
145,000
79,000
$336,000

Therefore,
NPV

$336,000

$230,000

$106,000

Techniques for Financial Analysis, Modeling & Forecasting Page 61

HOW TO HANDLE MUTUALLY EXCLUSIVE INVESTMENTS

A project is said to be mutually exclusive if the acceptance of one project automatically
excludes the acceptance of one or more other projects. In the case where one must choose
between mutually exclusive investments, the NPV and IRR methods may result in
contradictory indications. The conditions under which contradictory rankings can occur are:
1. Projects that have different life expectancies.
2. Projects that have different sizes of investment.
3. Projects whose cash flows differ over time. For example, the cash flows of one project
increase over time, while those of another decrease.
The contradictions result from different assumptions with respect to the reinvestment
rate on cash flows from the projects.
1. The NPV method discounts all cash flows at the cost of capital, thus implicitly assuming
that these cash flows can be reinvested at this rate.
2. The IRR method implies a reinvestment rate at IRR. Thus, the implied reinvestment rate
will differ from project to project.
The NPV method generally gives correct ranking, since the cost of capital is a more
realistic reinvestment rate.
EXAMPLE 3.9
Assume the following:
Cash Flows
A
B

0
(1000)
(1000)

1
1200

5
2011.40

Computing IRR and NPV at 10 percent gives the following different rankings:
A
B

IRR
20%
15%

NPV at 10%
90.08
249.10

RISK ANALYSIS IN CAPITAL BUDGETING

Risk analysis is important in making capital investment decisions because of the large
amount of capital involved and the long-term nature of the investments being considered.
Techniques for Financial Analysis, Modeling & Forecasting Page 62

The higher the risk associated with a proposed project, the greater the rate of return that
must be earned on the project to compensate for that risk.
Since different investment projects involve different risks, it is important to
incorporate risk into the analysis of capital budgeting. There are several methods for
incorporating risk, including:
1. Probability distributions
2. Risk-adjusted discount rate
3. Certainty equivalent
4. Simulation
5. Sensitivity analysis
6. Decision trees (or probability trees)
PROBABILITY DISTRIBUTIONS
Expected values of a probability distribution may be computed. Before any capital budgeting
method is applied, compute the expected cash inflows, or in some cases, the expected life
of the asset.
EXAMPLE 3.10
A firm is considering a $30,000 investment in equipment that will generate cash savings
from operating costs. The following estimates regarding cash savings and useful life, along
with their respective probabilities of occurrence, have been made:
Annual Cash
Savings
$6,000
$8,000
$10,000

Probability

Useful Life

Probability

0.2
0.5
0.3

4 years
5 years
6 years

0.2
0.6
0.2

$6,000 (0.2) =
$8,000 (0.5) =
$10,000 (0.3) =

$1,200
4,000
3,000
$8,200

Then, the expected annual saving is:

The expected useful life is:

4 (0.2)
5 (0.6)
6 (0.2)

=
=
=

0.8
3.0
1.2
5

The expected NPV is computed as follows (assuming a 10 percent cost of capital):

Techniques for Financial Analysis, Modeling & Forecasting Page 63

NPV

PV-I

=
=

$8,200
T4(10%,5)-$30,000
$8,200 (3.7908)-$30,000

$31,085-$30,000

$1,085

The expected IRR is computed as follows: By definition, at IRR,

I
$30,000
T4(r,5)

=
=

PV
$8,200 T4 (r,5)

$30,000
-------$8,200

3.6585

which is about halfway between 10 percent and 12 percent in Table 2.4 in Chapter 2, so that
we can estimate the rate to be about 11 percent. Therefore, the equipment should be
purchased, since (1) NPV = $1,085, which is positive and/or (2) IRR = 11 percent, which is
greater than the cost of capital of 10 percent.
RISK-ADJUSTED DISCOUNT RATE
This method of risk analysis adjusts the cost of capital (or discount rate) upward as projects
become riskier, i.e., a risk-adjusted discount rate is the riskless rate plus a risk premium.
Therefore, by increasing the discount rate from 10 percent to 15 percent, the expected cash
flow from the investment must be relatively larger or the increased discount rate will
generate a negative NPV and the proposed acquisition/investment would be turned down.
The expected cash flows are discounted at the risk-adjusted discount rate and then the
usual capital budgeting criteria such as NPV and IRR are applied.
Note: The use of the risk-adjusted discount rate is based on the assumption that investors
demand higher returns for riskier projects.
EXAMPLE 3.11
A firm is considering an investment project with an expected life of 3 years. It requires an
initial investment of $35,000. The firm estimates the following data in each of the next
4 years:
After-Tax Cash Inflow
-$5,000
$10,000
$30,000
$50,000

Probability
0.2
0.3
0.3
0.2

Assuming a risk-adjusted required rate of return (after taxes) of 20 percent is

appropriate for the investment projects of this level or risk, compute the risk-adjusted NPV.
First, the present value is:
PV= -$5,000(0.2) + $10,000(0.3) + $30,000(0.3) + $50,000(0.2)=$21,000
The expected NPV = $21,000 T4(20%,3) - $35,000
= 21,000 (2.107)-$35,000 = $44,247 - $35,000 = $9,247
Techniques for Financial Analysis, Modeling & Forecasting Page 64

CERTAINTY EQUIVALENT APPROACH

The certainty equivalent approach to risk analysis is to convert cash flows from individual
projects into risk adjusted certainty equivalent cash flows. The approach is drawn directly
from the concept of utility theory. This method forces the decision maker to specify at what
point the firm is indifferent to the choice between a certain sum of money and the expected
value of a risky sum.
Under this approach, first determine a certainty equivalent adjustment factor, , as:

Certain sum
------------------Equivalent risky
sum

Once s are obtained, they are multiplied by the original cash flow to obtain the equivalent
certain cash flow. Then, the accept-or-reject decision is made, using the normal capital
budgeting criteria. The risk-free rate of return is used as the discount rate under the NPV
method and as the cutoff rate under the IRR method.
EXAMPLE 3.12
XYZ, Inc., with a 14 percent cost of capital after taxes is considering a project with an
expected life of 4 years. The project requires an initial certain cash outlay of $50,000. The
expected cash inflows and certainty equivalent coefficients are as follows:
Year

After-Tax
Certainty
Cash Flow Equivalent
Adjustment Factor
$10,000
0.95
15,000
0.80
20,000
0.70
25,000
0.60

1
2
3
4

Assuming that the risk-free rate of return is 5 percent, the NPV and IRR are computed as
follows:
First, the equivalent certain cash inflows are obtained as follows:

Year
1
2
3
4

After-Tax
Cash
Inflow
10,000
15,000
20,000
25,000
NPV

0.95
0.80
0.70
0.60
=

Equivalent
Certain
Cash Inflow
$9,500
12,000
14,000
15,000

PV at 5%
0.9524
0.9070
0.8638
0.8227

$44,366 - $50,000 =

PV
$9,048
10,884
12,093
12,341
44,366

-$5,634

Techniques for Financial Analysis, Modeling & Forecasting Page 65

By trial and error, we obtain 4 percent as the IRR. Therefore, the project should be rejected,
since (1) NPV = -$5,634, which is negative and/or (2) IRR = 4 percent is less than the
risk-free rate of 5 percent.
SIMULATION
This risk analysis method is frequently called Monte Carlo simulation. It requires that a
probability distribution be constructed for each of the important variables affecting the
project's cash flows. Since a computer is used to generate many results using random
numbers, project simulation is expensive.
SENSITIVITY ANALYSIS
Forecasts of many calculated NPVs under various alternative functions are compared to
see how sensitive NPV is to changing conditions. It may be found that a certain variable or
group of variables, once their assumptions are changed or relaxed, drastically alters the
NPV. This results in a much riskier asset than was originally forecast.
DECISION TREES
Some firms use decision trees (probability trees) to evaluate the risk of capital budgeting
proposals. A decision tree is a graphical method of showing the sequence of possible
outcomes. A capital budgeting tree would show the cash flows and NPV of the project under
different possible circumstances. The decision tree method has the following advantages:
(1) It visually lays out all the possible outcomes of the proposed project and makes
management aware of the adverse possibilities and (2) the conditional nature of successive
years' cash flows can be expressly depicted. The disadvantages are: (1) most problems are
too complex to permit year-by-year depiction and (2) it does not recognize risk.
EXAMPLE 3.13
Assume XYZ Corporation wishes to introduce one of two products to the market this year.
The probabilities and present values (PV) of projected cash inflows are given below:
Product
A

Initial
investment
$225,000

PV of cash
inflows

Probabilities

$450,000
200,000
-100,000

1.00
0.40
0.50
0.10

320,000
100,000
-150,000

1.00
0.20
0.60
0.20

80,000

A decision tree analyzing the two products is given in Figure 3.1.

FIGURE 3.1
Techniques for Financial Analysis, Modeling & Forecasting Page 66

Expected net present value:

Product A
Product B

$270,000 - $225,000
$ 94,000 - $ 80,000

=
=

$45,000
$14,000

Based on the expected NPV, choose product A over product B.

CONCLUSION
Net present value, internal rate of return and profitability index are equally effective in
selecting economically sound, independent investment proposals. But the payback
method is inadequate since it does not consider the time value of money. For mutually
exclusive projects, net present value, internal rate of return and profitability index
methods are not always able to rank projects in the same order; it is possible to come up
with different rankings under each method. Risk should be taken into account in the
capital budgeting process, such as by using probabilities, simulation and decision trees.

Techniques for Financial Analysis, Modeling & Forecasting Page 67

CHAPTER 3 QUIZ
1. Depreciation expenses are included in discounted cash flow analysis.
True / False
2. The technique that recognizes the time value of money by discounting the after-tax
cash flows for a project over its life to time period zero using the companys minimum
desired rate of return is the
A. Net present value method.
B. Capital rationing method.
C. Payback method.
D. Accounting rate of return method.
3. The net present value (NPV) method of capital budgeting assumes that cash flows are
reinvested at
A. The risk-free rate.
B. The cost of debt.
C. The internal rate of return.
D. The discount rate (cost of capital) used in the analysis.
4. The technique that reflects the time value of money and is calculated by dividing the
present value of the future net after-tax cash inflows that have been discounted at the
desired cost of capital by the initial cash outlay for the investment is the
A. Net present value method
B. Capital rationing method.
C. Accounting rate of return method.
D. Profitability index method.
5. A characteristic of the payback method (before taxes) is that it
A. Neglects total project profitability.
B. Uses accrual accounting inflows in the numerator of the calculation.
C. Uses the estimated expected life of the asset in the denominator of the calculator.
D. Uses the hurdle rate in the calculation.
6. The proper discount rate to use in calculating certainty equivalent net present value is
the
A. Risk-adjustment discount rate.
B. Risk-free rate.
C. Cost of equity capital.
D. Cost of debt.

Techniques for Financial Analysis, Modeling & Forecasting Page 68

7. The use of an accelerated method instead of the straight-line method of depreciation in

computing the net present value of a project has the effect of
A. Raising the discount (hurdle) rate necessary to justify the project.
B. Lowering the net present value of the project.
C. Increasing the present value of the depreciation tax shield.
D. Increasing the cash outflows at the initial point of the project.
8. Net present value (NPV) and internal rate of return (IRR) differ in that
A. NPV assumes reinvestment of project cash flows at the cost of capital, whereas IRR
assumes reinvestment of project cash flows at the internal rate of return.
B. NPV and IRR make different accept or reject decisions for independent projects.
C. IRR can be used to rank mutually exclusive investment projects, but NPV cannot.
D. NPV is expressed as percentage, while IRR is expressed as a dollar amount.

Techniques for Financial Analysis, Modeling & Forecasting Page 69

CHAPTER 3 ANSWER KEY

1. (F) is correct. Depreciation expense is a consideration only to the extent that it affects
the cash flows for taxes. Otherwise, depreciation is excluded from the analysis because it
is a noncash expense.
(T) is incorrect. Discounted cash flow analysis, using either the internal rate of return
(IRR) or the net present value (NPV) method, is based on the time value of cash inflows
and outflows. After tax effects of initial investment, differential cash flows, terminal cash
flow, net working capital changes and relevant opportunity costs should be considered in
a capital budgeting analysis. All future operating cash savings are considered as well as
the tax effects on cash flows of future depreciation charges. The cash proceeds of future
asset disposals are likewise a necessary consideration.
2. (A) is correct. Net present value (NPV) is the excess of the present value (PV) of cash
inflows generated by the project over the amount of the initial investment (I): NPV = PV I. If
NPV>0, the investment is considered to be acceptable.
(B) is incorrect. Capital rationing is not a technique but rather a condition that
characterizes capital budgeting when the limited amount of capital available is insufficient
to fund all profitable investments.
(C) is incorrect. The payback method does not consider the time value of money.
(D) is incorrect. The accounting rate of return method fails to consider the time value of
money. Further, it uses accounting income data rather than cash flows.
3. (D) is correct. The NPV method assumes that cash inflows are reinvested at the
discount rate (cost of capital) used in the NPV calculation. Usually the cost of capital is
risk-free rate plus risk premium.
(A) is incorrect. The NPV method discounts all cash flows at the cost of capital, thus
implicitly assuming that these cash flows can be reinvested at this rate.
(B) is incorrect. The NPV method assumes that cash inflows are reinvested at the
discount rate used in the NPV calculation. The cost of debt is not the cost of capital in
many cases.
(C) is incorrect. The IRR method assumes a reinvestment rate equal to the IRR.
4. (D) is correct. The profitability index, also called present value index, is the ratio of the
total PV of future cash inflows to the initial investment. This index is used as a means of
ranking projects in descending order of attractiveness in a capital rationing situation.
(A) is incorrect. The NPV method does not divide the future cash flows by the cost.
Techniques for Financial Analysis, Modeling & Forecasting Page 70

(B) is incorrect. Capital rationing is not a technique but rather a condition that
characterizes capital budgeting when insufficient capital is available to finance all
profitable investment opportunities.
(C) is incorrect. The accounting rate of return method does not discount cash flows.
5. (A) is correct. The payback period measures the length of time required to recover the
amount of initial investment. It is computed by dividing the initial investment by the cash
inflows through increased revenues or cost savings. If the net cash inflows are not constant,
a cumulative approach is used. The shortcomings of this method are that (1) it does not
recognize the time value of money and (2) it ignores the impact of cash inflows received
after the payback period; essentially, cash flows after the payback period determine
profitability of an investment.
(B) is incorrect. The net investment is the numerator.
(C) is incorrect. The constant expected net cash inflow is the denominator.
(D) is incorrect. No hurdle rate or other interest rate is used in the payback period
calculation.
6. (B) is correct. Rational investors choose projects that yield the best return given some
level of risk. If an investor desires no risk, that is, an absolutely certain rate of return, the
risk-free rate is used in calculating NPV. The risk-free rate is the return on a risk-free
investment such as Treasury bonds.
(A) is incorrect. A risk-adjustment discount rate does not represent an absolutely certain
rate of return. A discount rate is adjusted upward as the investment becomes riskier.
(C) is incorrect. The cost of equity capital does note equate to the certainty equivalence of
a risk-free investments return.
(D) is incorrect. The cost of debt is not a risk-free return.
7. (C) is correct. Accelerated depreciation results in greater depreciation in the early years
of an assets life compared with the straight-line method. Thus, accelerated depreciation
results in lower income tax expense in the early years of a project and higher income tax
expense in the later years. By effectively deferring taxes, the accelerated method
increases the present value of the depreciation tax shield.
(A) is incorrect. The hurdle rate must be set by the decision maker.
(B) is incorrect. The greater depreciation tax shield increases the NPV.
(D) is incorrect. Greater initial depreciation reduces the cash outflows for taxes but has no
Techniques for Financial Analysis, Modeling & Forecasting Page 71

effect on the initial cash outflows.

8. (A) is correct. The NPV method discounts all cash flows at the cost of capital, thus
implicitly assuming that these cash flows can be reinvested at this rate, while The IRR
method implies a reinvestment rate at IRR. Thus, the implied reinvestment rate will differ
from project to project. The cost of capital is the appropriate reinvestment rate because it
represents the opportunity cost for a project at a given level of risk. The problem with the
IRR method is that it assumes a higher discount rate even through a project may not have
a greater level of risk.
(B) is incorrect. NPV and IRR make consistent accept/reject decisions for independent
projects. When NPV is positive, IRR exceeds the cost of capital and the project is
acceptable.
(C) is incorrect. The NPV method can be used to rank mutually exclusive projects,
whereas IRR cannot. The reinvestment rate assumption causes IRR to make faulty
project rankings under some circumstances.
(D) is incorrect. IRR is expressed as a percentage and NPV in dollar terms.

Techniques for Financial Analysis, Modeling & Forecasting Page 72

CHAPTER 4
ANALYZING FINANCIAL STATEMENTS FOR FINANCIAL FITNESS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.
6.

Explain what financial statement analysis is and why it is important.

Compare horizontal analysis and vertical analysis.
List the basic components of ratio analysis.
Distinguish between trend analysis and industry comparison.
Calculate a comprehensive set of financial ratios and interpret them.
Explain the limitations of ratio analysis.

Accounting can be thought of as the art of creating scorecards for business operations. It
translates raw data into a set of objective numbers integrated into financial statements
that provide information about the firms profits, performance, problems and future
prospects. Financial analysis is the study of the relationships among these financial
numbers; it helps users to identify the major strengths and weaknesses of a business
enterprise.
WHO USES FINANCIAL ANALYSIS
The techniques of financial analysis are important to two groups: internal management
and external users, such as investors and banks.
Internal Managers
Internal managers analyze the financial statements to determine whether the company is
earning an adequate return on its assets. They also use financial ratios as flags to
indicate potential areas of strength or weakness. Many financial analysts use
rule-of-thumb measurements for key financial ratios. For example, most analysts feel that
a current ratio (current assets divided by current liabilities) of two to one is acceptable for
most businesses. However, while a company may meet or even surpass this ratio, the
financial statements might indicate that an increasing proportion of the current assets
consist of accounts receivable that have been outstanding for more than 30 days. Slow
payments might require management to change its credit policy by shortening the credit
period or by implementing a more effective cash-collection policy. Internal management
also uses this number-crunching process to decide how much inventory is to be held at
any one time or whether to merge with or acquire another company.
External Users
External uses include investors, creditors, unions and prospective employees. Investors
might use the financial statements to study whether there is an adequate profit margin or
a favorable return on assets. The financial health of the company, as perceived by
investors, will affect the market price of the companys stock, cost of financing and bond
rating. For creditors, financial statements indicate a companys ability to repay a loan. A
Techniques for Financial Analysis, Modeling & Forecasting Page 73

union will study the financial statements to evaluate their wage and pension demands
when their old contract with management expires. Finally, students and other job seekers
might analyze a companys financial statements to determine career opportunities.
Horizontal and Vertical Analysis
Financial statement analysis includes horizontal analysis (percentage change over the
years) and vertical analysis (percentage relationship within one year). Sources of
financial information include a companys annual financial report, SEC filings, financial
reference books put out by such firms as Dun & Bradstreet, trade publications and
financial newspapers such as the Wall Street Journal.
An analyst also studies industry norms. This measurement indicates how a
company is performing in comparison with other companies in the same industry.
Unfortunately, there are limitations to the use of this method. First, one company in the
same industry might be involved in manufacturing and selling a product in large quantities
at the wholesale level, while another enterprise might only sell at the retail level to the
public. Second, each enterprise might use a different accounting method for financial
reporting purposes. For example, one company might value its ending inventory
according to the FIFO method, while a competitor might use LIFO. In addition, the two
companies might use a different accounting method for recording depreciation. The
cumulative effect of the use of different accounting methods might make a comparison of
net income and fixed-asset valuation of little importance.
FINANCIAL STATEMENT ANALYSIS
The financial community uses several methods for evaluating the financial health of an
enterprise. These methods include trend analysis, horizontal and vertical analysis and
ratio analysis.
TREND ANALYSIS
Trend analysis indicates in which direction a company is headed. Trend percentages are
computed by taking a base year and assigning its figures as a value of 100. Figures
generated in subsequent years are expressed as percentages of base-year numbers.
EXAMPLE 4.1
The Hotspot Appliance Corporation showed the following figures for a five-year period:

Net sales
Cost of goods sold
Gross profit

20x5

20x4

20x3

20x2

20x1

$910
573
$337

$875
510
$365

$830
483
$347

$760
441
$319

$775
460
$315

20x2
98
96
101

20x1
100
100
100

A schedule showing trend percentages is given below.

Net sales
Cost of goods sold
Gross profit

20x5
117
125
107

20x4
113
111
116

20x3
107
105
110

Techniques for Financial Analysis, Modeling & Forecasting Page 74

With 20x1 taken as the base year, its numbers are divided into those from subsequent
years to yield comparative percentages. For example, net sales in 20x1 ($775,000) is
divided into 20x5s net-sales figure ($910,000).
Net sales show an upward trend after a downturn in 20x2. Cost of goods sold
shows a sharp increase between 20x4 and 20x5 after a small drop in costs between 20x1
and 20x2. There appears to be a substantial drop in gross profit between 20x4 and 20x5,
which is attributable to the increased cost of goods sold.
Trend percentages show horizontally the degree of increase or decrease, but they
do not indicate the reason for the changes. They do serve to indicate unfavorable
developments that will require further investigation and analysis. A significant change
may have been caused by a change in the application of an accounting principle or by
controllable internal conditions, such as a decrease in operating efficiency.
HORIZONTAL ANALYSIS
Horizontal analysis improves an analysts ability to use dollar amounts when evaluating
financial statements. It is more useful to know that sales have increased 25% than to
know that sales increased by $50,000. Horizontal analysis requires that you: (1) compute
the change in dollars from the earlier base year and (2) divide the dollar amount of the
change by the base period amount.
EXAMPLE 4. 2
The comparative income statement of the Ogel Supply Corporation as of December 31,
20x2, appears as follows:
Net sales
Cost of goods sold
Gross profit
Operating expenses:
Selling expenses
General expenses
Total operating expenses
Income from operations
Interest expense
Income before income
taxes
Income tax expense
Net income

20x2
$990,000
574,000
$416,000

20x1
$884,000
503,000
$381,000

$130,000
122,500
$252,500
163,500
24,000
$139,500

$117,500
120,500
$238,000
143,000
26,000
$117,000

36,360
$103,140

28,030
$ 88,970

The following is a detailed horizontal analysis statement.

Techniques for Financial Analysis, Modeling & Forecasting Page 75

Net sales
Cost of goods sold
Gross profit
Operating expenses:
Selling expenses
General expenses
Total operating expenses
Income from operations
Interest expense
Income before income taxes
Income tax expense
Net income

20x2
$990,000
574,000
416,000

20x1
$884,000
503,000
381,000

Increase
(Decrease)
Amount
$106,000
71,000
35,000

130,000
122,500
252,500
163,500
24,000
139,500
36,360
$103,140

117,500
120,500
238,000
143,000
26,000
117,000
28,030
$ 88,970

12,500
2,000
14,500
20,500
(2,000)
22,500
8,330
$ 14,170

Percent
12.0
14.1
9.2
10.6
1.7
6.1
14.3
(7.7)
19.2
29.7
15.9

EXAMPLE 4.3
The comparative balance sheet of the Ogel Supply Corporation as of December 31,20x2,
appears as follows:
ASSETS
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total currents assets
Property, plant & equipment, net
Total assets
LIABILITIES
Current liabilities:
Notes payable
Accounts payable
Total current liabilities
Long-term debt
Total liabilities
STOCKHOLDERS EQUITY
Common stock, no-par
Retained earnings
Total stockholders equity
Total liabilities &stockholders equity

20x2

20x1

$ 60,000
113,000
107,100
5,700
$285,800
660,000
$945,800

$ 30,000
79,000
106,900
6,100
$222,000
665,000
$887,000

$ 40,000
100,600
$140,600
400,000
$540,600

$ 33,000
57,500
$ 90,500
410,000
$500,500

$200,000
205,200
$405,200
$945,800

$200,000
186,500
$386,500
$887,000

The following is a detailed horizontal analysis statement.

Techniques for Financial Analysis, Modeling & Forecasting Page 76

20x2

20x1

Increase
(Decrease)
Amount

ASSETS
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total current assets
Property, plant, & equipment, net
Total assets

$ 60,000
113,000
107,100
5,700
$285,800
660,000
$945,800

$ 30,000
79,000
106,900
6,100
$222,000
665,000
$887,000

$ 30,000
34,000
200
(400)
$ 63,800
(5,000)
$ 58,800

100.0
43.0
0.0
(7.0)
28.7
.1
6.6

LIABILITIES
Current liabilities:
Note payable
Accounts payable
Total current liabilities
Long-term debt
Total liabilities

$ 40,000
100,600
$140,600
400,000
$540,600

$ 33,000
57,500
$ 90,500
410,000
$500,500

$ 7,000
43,100
$ 50,100
(10,000)
$ 40,100

21.2
75.0
55.4
(2.4)
8.1

200,000
205,200
$405,200
$945,800

$200,000
186,500
$386,500
$887,000

$
18,700
$ 18,700
$ 58,800

0.0
10.0
5.0
6.6

STOCKHOLDERSEQUITY
Common stock, no-par
Retained earnings
Total stockholders equity
Total liabilities & stockholders
equity

Percent

VERTICAL ANALYSIS
Vertical (common-size) analysis shows the percentage relationship of each item on the
financial statement to a total figure representing 100 percent. Each income statement
account is compared to net sales. For example, if net sales is $100,000 and net income
after taxes is $8,000, then the companys net income is $8,000 divided by $100,000, or
8% of the net sales figure.
Vertical analysis also reveals the internal structure of the business. This means
that if total assets are $750,000 and cash shows a year-end balance, then cash
represents 10% of the total assets of the business year-end. Vertical analysis shows the
mix of assets that generate the income as well as the sources of capital provided by either
current or noncurrent liabilities, or by the sale of preferred and common stock.
A companys vertical percentages should be compared to those of its competitors
or to industry averages to determine the companys relative position in the marketplace.
Like horizontal analysis, vertical analysis is not the end of the process. The analyst must
be prepared to examine problem areas indicated by horizontal and vertical analysis.
EXAMPLE 4.4
The comparative income statement of the Ogel Supply Corporation at December
31,20x2, appears as follows:
Techniques for Financial Analysis, Modeling & Forecasting Page 77

Net sales
Cost of goods sold
Gross profit
Operating expenses:
Selling expenses
General expenses
Total operating expenses
Income from operations
Interest expense
Income before income
taxes
Income tax expense
Net income

20x2
$990,000
574,000
$416,000

20x1
$884,000
503,000
$381,000

$130,000
122,500
$252,500
$163,500
24,000
$139,500

$117,500
120,500
$238,000
$143,000
26,000
$117,000

36,360
28,030
$103,140 $ 88,970

The following is a detailed vertical analysis statement.

Net sales
Cost of goods sold
Gross profit
Operating expenses:
Selling expenses
General expenses
Total operating expenses
Income from operations
Interest expense
Income before income
taxes
Income tax expense
Net income

20x2
Amount
$990,000
574,000
$416,000

Percent
100.0
58.0
42.0

20x1
Amount
$884,000
503,000
$381,000

Percent
100.0
57.0
43.0

$130,000
122,500
$252,500
$163,500
24,000
$139,500

13.1
12.4
25.5
16.5
2.4
14.1

$117,500
120,500
$238,000
$143,000
26,000
$117,000

13.3
13.6
26.9
16.1
2.9
13.2

3.7
36,360
$103,140 10.4

28,030
$ 88,970

3.2
10.0

EXAMPLE 4.5
The comparative balance sheet of the Ogel Supply Corporation at December 31, 20x2,
appears as follows:
ASSETS
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total currents assets
Property, plant and equipment, net
Total assets

20x2

20x1

$ 60,000
113,000
107,100
5,700
$285,800
660,000
$945,800

$ 30,000
79,000
106,900
6,100
$222,000
650,000
$887,000

Techniques for Financial Analysis, Modeling & Forecasting Page 78

LIABILITIES
Current liabilities:
Notes payable
Accounts payable
Total current liabilities
Long-term debt
Total liabilities
STOCKHOLDERS EQUITY
Common stock, no-par
Retained earnings
Total stockholders equity
Total liabilities and stockholders
equity

$ 40,000
100,600
$140,600
400,000
$540,600

$ 33,000
57,500
$ 90,500
410,000
$500,500

$200,000
205,200
$405,200
$945,800

$200,000
186,500
$386,500
$887,000

Prepare a detailed vertical analysis statement.

ASSETS
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total currents assets
Property, plant and
equipment, net
Total assets
LIABILITIES
Current liabilities:
Notes payable
Accounts payable
Total current liabilities
Long-term debt
Total liabilities
STOCKHOLDERS EQUITY
Common stock, no-par
Retained earnings
Total stockholders equity
Total liabilities and
stockholders equity

20x2
Amount

Percent

20x1
Amount

Percent

$ 60,000
113,000
107,100
5,700
$285,800

6.3
11.9
11.3
0.6
30.1

$ 30,000
79,000
106,900
6,100
$222,000

3.4
8.9
12.1
.7
25.1

660,000
$945,800

69.9
100.0

665,000
$887,000

74.9
100.0

$ 40,000
100,600
$140,600
400,000
$540,600

4.2
10.6
14.8
42.3
57.1

$ 33,000
57,500
$ 90,500
410,000
$500,500

3.7
6.5
10.2
46.2
56.4

$200,000
205,200
$405,200

21.1
21.7
42.8

$200,000
186,500
$386,500

22.6
21.0
43.6

$945,800

100.0

$887,000

100.0

After completing the statement analysis, the financial analyst will consult with
management to discuss problem areas, possible solutions and the companys prospects
for the future.

Techniques for Financial Analysis, Modeling & Forecasting Page 79

RATIO ANALYSIS
Ratios provide a convenient and useful way of expressing a relationship between
numbers. For example, management is always interested in its ability to pay its current
liabilities as they become due.
LIQUIDITY ANALYSIS
Ratios used to determine the debt-paying ability of the company include the current ratio
and the acid-test or quick ratio. A term also frequently used in financial statement analysis
is working capital.
Current Ratio
The current ratio is a valuable indicator of a companys ability to meet its current
obligations as they become due. The ratio is computed by using the following formula:
Current Assets
Current Liabilities
EXAMPLE 4.6
Assume that in Example 4.3 the Ogel Supply Corporation showed the following current
assets and current liabilities for the years ended December 31, 20x2 and December 31,
20x1:
ASSETS
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total currents assets
LIABILITIES
Current liabilities:
Notes payable
Accounts payable
Total current liabilities

20x2

20x1

$ 60,000
113,000
107,100
5,700
$285,800

$ 30,000
79,000
106,900
6,100
$222,000

$ 40,000
100,600
$140,600

$ 33,000
57,500
$ 90,500

The current ratios for 20x2 and 20x1 are:

20x2
Total current assets
$285,800
Total current liabilities $140,600 = 2.0

20x1
$222,000
$90,500 = 2.5

The change from 2.5 to 2.0 indicates that Ogel has a diminished ability to pay its
current liabilities as they mature. However, a current ratio of 2.0 to 1 is still considered a
secure indicator of a companys ability to meet its current obligations incurred in
operating the business.

Techniques for Financial Analysis, Modeling & Forecasting Page 80

Acid-Test or Quick Ratio

Unlike the current ratio, the acid-test or quick ratio places emphasis on the relative
convertibility of the current assets into cash. The ratio places greater emphasis on
receivables than on inventory, since the inventory may not be readily convertible into cash.
This method also assumes that prepaid expenses have minimal resale value. The ratio is
computed by using the following formula:
Cash + Short-Term Investments + Accounts Receivable, Net
Current Liabilities

EXAMPLE 4.7
Assumed that in Example 4.3 the Ogel Supply Corporation showed the following current
assets and current liabilities for the years ended December 31, 20x2 and December 31,
20x1:
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total currents assets
Current liabilities:
Notes payable
Accounts payable
Total current liabilities

20x2

20x1

$ 60,000
113,000
107,100
5,700
$285,800

$ 30,000
79,000
106,900
6,100
$222,000

$ 40,000
100,600
$140,600

$ 33,000
57,500
$ 90,500

The acid-test or quick ratios for 20x2 and 20x1 are:

Current assets:
Cash
Accounts receivable, net
Total currents assets
Current liabilities:
Notes payable
Accounts payable
Total current liabilities

Total acid-test assets

Total current liabilities

20x2

20x1

$ 60,000
113,000
$173,000

$ 30,000
79,000
$109,000

$ 40,000
100,600
$140,600

$ 33,000
57,500
$ 90,500

20x2

20x1

$173,000
$140,600 =1.2

$109,000
$90,500 = 1.2

The ratios are unchanged. This shows that, despite a significant increase in both the
acid-test or quick assets and current liabilities, Ogel still maintains the same ability to
meet its current obligations as they mature.

Techniques for Financial Analysis, Modeling & Forecasting Page 81

Working Capital
Working capital is the excess of current assets over current liabilities.
Working capital items are those that are flowing through the business in a regular
pattern and may be diagrammed as follows:

Inventory

Accounts
Receivable

Accounts
Payable

Cash

EXAMPLE 4.8
Assume that in Example 4.3 the Ogel Supply Corporation showed the following current
assets and current liabilities for the years ended December 31, 20x2 and December 31,
20x1:
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total currents assets
Current liabilities:
Notes payable
Accounts payable
Total current liabilities

20x2

20x1

$ 60,000
113,000
107,100
5,700
$285,800

$ 30,000
79,000
106,900
6,100
$222,000

$ 40,000
100,600
$140,600

$ 33,000
57,500
$ 90,500

Working capital for 20x2 and 20x1 is:

20x2
Total currents assets $285,800
Total current liabilities $140,600
Working capital
$145,200

20x1
$222,000
$ 90,500
$131,500

The change from $131,500 to $145,200 indicates that Ogel has increased its
working capital, which Ogel must now decide whether it is making effective use of. For
example, should any excess working capital be used to purchase short-term
income-producing investments?
Techniques for Financial Analysis, Modeling & Forecasting Page 82

Accounts-Receivable Ratios
Accounts-receivable ratios are composed of the accounts receivable turnover and the
collection period, which is the number of days the receivables are held.
Accounts-Receivable Turnover
The accounts-receivable turnover is the number of times accounts receivable are
collected during the year. The turnover equals net credit sales (if not available, then total
sales) divided by the average accounts receivable. Average accounts receivable is
usually determined by adding the beginning accounts receivable to the ending accounts
receivable and dividing by two. However, average accounts receivable may be arrived at
with greater accuracy on a quarterly or monthly basis, particularly for a seasonal business.
Unfortunately, this information is typically known only to management. Using data for the
shortest time period will provide the most reliable ratio.
The higher the accounts-receivable turnover, the more successfully the business
collects cash. However, an excessively high ratio may signal an excessively stringent
credit policy, with management not taking advantage of the potential profit by selling to
customers with greater risk. Note that here, too, before changing its credit policy,
management has to consider the profit potential versus the inherent risk in selling to more
marginal customers. For example, bad debt losses will increase when credit policies are
liberalized to include riskier customers.
The formula for determining the accounts-receivable turnover is expressed as
follows:
Net Credit Sales
Average Net Accounts
Receivable

EXAMPLE 4.9
Assume that in Example 4.3 the Ogel Supply Corporation showed the following
accounts-receivable totals for the years ended December 31, 20x2 and December 31,
20x1:
Current assets:
Accounts receivable,
net

20x2

20x1

113,000

79,000

Assuming sales of $990,000 for 20x2, calculate the accounts-receivable turnover for
20x2.
Average accounts
receivable

($113,000+$79,000) /2

Sales
Average accounts receivable

$990,000
$96,000

$96,000

10.3

Techniques for Financial Analysis, Modeling & Forecasting Page 83

Day-Sales-in-Receivables
The days-sales-in-receivables (average collection period) determine how many days
sales remain in accounts receivable. The determination is a two-step process. First,
divide the net sales by 365 days to determine the sales amount for an average day. Then
divide this figure into the average net accounts receivable.
EXAMPLE 4.10
In Example 4.9 it was determined that the Ogel Supply Corporations accounts receivable
turnover was 10.3. Use this figure to calculate the days-sales-in-receivables for 20x2.
Step one:
Net sales
=
365 days

$990,000
365

$2,712

Step two:
$96,000

Average net accounts

receivable
One days sales

35.4 days

$2,712

Inventory Ratios
A company with excess inventory is tying up funds that could be invested elsewhere for a
return. Inventory turnover is a measure of the number of times a company sells its
average level of inventory during the year. A high turnover indicates an ability to sell the
inventory, while a low number indicates an inability. A low inventory turnover may lead to
inventory obsolescence and high storage and insurance costs. The formula for
determining inventory turnover is:
Cost of Goods sold
Average Inventory

EXAMPLE 4.11
Assume that in Example 4.3 the Ogel Supply Corporation showed the following inventory
amounts for the years ended December 31, 20x2 and December 31, 20x1:
Current assets:
Inventories

20x2

20x1

107,100

106,900

If cost of goods sold is $574,000 for 20x2, calculate the inventory turnover for 20x2.
Average
inventories

($107,100 + $106,900) / 2

Cost of goods sold

Average inventories

$574,000
$107,000

$107,000

5.4

Techniques for Financial Analysis, Modeling & Forecasting Page 84

Operating Cycle
The operating cycle is the time needed to turn cash into inventory, inventory into
receivables and receivables back into cash. For a retailer, it is the time from purchase of
inventory to collection of cash. Thus, the operating cycle of a retailer is equal to the sum of
the number of days sales in inventory and the number of days sales in receivables. The
days sales in inventory equals 365 (or another period chosen by the analyst) divided by
the inventory turnover. The days sales in receivables equals 365 (or other number)
divided by the accounts receivable turnover.
Interrelationship of Liquidity and Activity to Earnings
There is a trade-off between liquidity risk and return. Liquidity risk is reduced by holding
more current assets than noncurrent assets. There will be less of a return, however,
because the return rate on current assets (i.e., marketable securities) is usually less than
the return rate on productive fixed assets. Further, excessive liquidity may mean that
management has not been aggressive enough in finding attractive capital-investment
opportunities. There should be a balance between liquidity and return.
High profitability does not automatically mean a strong cash flow. Cash problems
may exist even with a high net income due to maturing debt and the need for asset
replacement, among other reasons. For instance, it is possible that a growth business
may have a decline in liquidity because cash is needed to finance an expanded sales
base.
MEASURING A COMPANYS ABILITY TO PAY ITS LONG-TERM DEBT
A corporation with a large amount of debt runs a greater risk of insolvency than one with a
large amount of preferred or common stock outstanding. The reason is that payment of
interest is mandatory, while the payment of dividends is discretionary with the
corporations board of directors. Individuals and banks that purchase the long-term notes
and bonds issued by an enterprise take a special interest in a businesss ability to repay
its debt plus interest. Two key methods used to measure a companys ability to pay its
legal obligations as they become due are the debt ratio and the times-interest-earned
ratio.
Debt Ratio
The debt ratio indicates how much of the companys assets were obtained by the
issuance of debt. If the ratio is 1, it means that all of the firms assets were financed by the
issuance of debt. If the ratio is 0.6, it means that 60% of the companys assets were
financed by debt. The formula for the debt ratio is:
Total Liabilities
Total Assets
EXAMPLE 4.12
Assume that in Example 4.3 the Ogel Supply Corporation showed the following total
assets and total liabilities for the years ended December 31, 20x2 and December 31,
20x1:
Techniques for Financial Analysis, Modeling & Forecasting Page 85

20x2

20x1

ASSETS
Current assets:
Cash
Accounts receivable, net
Inventories
Prepaid expenses
Total currents assets
Property, plant and equipment, net
Total assets

$ 60,000
113,000
107,100
5,700
$285,800
660,000
$945,800

$ 30,000
79,000
106,900
6,100
$222,000
665,000
$887,000

LIABILITIES
Current liabilities:
Notes payable
Accounts payable
Total current liabilities
Long-term debt
Total liabilities

$ 40,000
100,600
$140,600
400,000
$540,600

$ 33,000
57,500
$ 90,500
410,000
$500,500

The debt ratios for 20x2 and 20x1 are:

Total liabilities
Total assets

20x2

20x1

$540,600
$945,800 = 0.57

$500,500
$887,000 = 0.56

The ratios indicate that Ogel debt position has increased.

Times-Interest-Earned Ratio
The times-interest-earned ratio measures a companys ability to pay its interest
obligations. For example, a times-interest-earned ratio of 5 means that the company
earned enough to pay its annual interest obligation five times.
EXAMPLE 4.13
Assume that in Example 4.2 the Ogel Supply Corporation showed the following income
from operations and interest expense for the years ended December 31, 20x2 and
December 31, 20x1:

Interest expense
Income from
operations

20x2

20x1

$ 24,000
163,500

$ 26,000
143,000

The times-interest-earned ratios for 20x2 and 20x1 are:

Income from operations

Interest expense

20x2

20x1

$163,500
$ 24,000 = 6.8

$143,000
$ 26,000 = 5.5

Techniques for Financial Analysis, Modeling & Forecasting Page 86

The ratios indicate that Ogel will have little difficulty paying its interest obligations.
Ogel might even consider borrowing more money.
PROFITABILITY RATIOS
These ratios measure the profitability of the company. The primary ratios are rate of
return on net sales, rate of return on total assets and rate of return on total stockholders'
equity.
Rate Of Return On Net Sales
The formula for calculating the rate of return on net sales is as follows:
Net Income
Net Sales

This ratio reveals the profit margin of the business. It tells how much earnings are
associated with each sales dollar.
EXAMPLE 4.14
Assume that in Example 4.2 the Ogel Supply Corporation showed the following net
income and net sales figures for the years ended December 31, 20x2 and December 31,
20x1:

Net sales
Net income

20x2

20x1

$990,000
103,140

$884,000
88,970

The rates of return on net sales for 20x2 and 20x1 are:

Net income
Net sales

20x2

20x1

$103,140
$990,000 =
10.4%

$ 88,970
$884,000 =
10.1%

The increase in the rate of return indicates that the company is more profitable on
each sales dollar obtained.
Rate Of Return On Total Assets
The rate of return measures the ability of the company to earn a profit on its total assets.
In making the calculation, interest expense must be added back to the net income, since
both creditors and investors have financed the companys operations. The formula is:
Net Income + Interest
Expense
Average Total Assets

Where average total assets = total assets (beginning) + total assets (ending) / 2
Techniques for Financial Analysis, Modeling & Forecasting Page 87

EXAMPLE 4.15
Assume that in Example 4.2 the Ogel Supply Corporation showed the following net
income, interest expense and total assets figures for the years ended December 31, 20x2
and December 31, 20x1:

Net income
Interest expense
Total assets

20x2

20x1

$103,140
24,000
945,800

$ 88,970
26,000
887,000

The rate of return on total assets for 20x2 is:

Average total
assets

$103,140 + $24,000
($945,800 + $887,000) / 2

$127,140
$916,400 = 13.9%

Rate Of Return On Common Stockholders' Equity

The rate of return on common stock shows the relationship between net income and the
common stockholders investment in the company. To compute this rate, preferred
dividends must be subtracted from net income. This leaves net income available to the
common shareholders. The formula for computing the rate of return on common stock is:
Net Income - Preferred Dividends
Average Common Stockholders
Equity

EXAMPLE 4.16
Assume that in Examples 4.2 and 4.3 the Ogel Supply Corporation showed the following
net income for 20x2 and total stockholders equity for the years ended December 31,
20x2 and December 31, 20x1:

Net income
Total stockholders'
equity

20x2

20x1

$103,140
405,200

$ 88,970
386,500

The rate of return on total common stockholders' equity for 20x2 is:
Average common stockholders'
equity

Net income
Average common stockholders'
equity

($405,200 + $386,500) / 2

=
$395,850

$103,140 - 0
=
$395,850

26.1%

The return on the common stockholders equity is 26.1%, which is 12.2% higher
than the return on assets, which is 13.9%. The company is borrowing at a lower rate to
earn a higher rate. The practice is called trading on equity, or leverage and is directly
Techniques for Financial Analysis, Modeling & Forecasting Page 88

related to the debt ratio. However, should revenues drop, the interest on debt must still be
paid. Thus, in times of operating losses, excessive debt can hurt profitability.
Earnings per Share
Earnings per share (EPS) is computed by dividing net income less the preferred
dividends by the number of common shares outstanding. The preferred-share dividend
must be subtracted because it represents a prior claim to dividends that must be paid
before any payments of dividends can be made to the common shareholders. If there is
no preferred stock, earnings per share equals net income divided by common shares
outstanding.
EXAMPLE 4.17
Assume that in Examples 4.2 and 4.3 the Ogel Supply Corporation showed the following
net income for 20x2 and 20x1 and that 10,000 common shares were outstanding for
the years ended December 31, 20x2 and December 31, 20x1:

Net income

20x2

20x1

$103,140

$ 88,970

Calculate the earnings per share for 20x2 and 20x1.

Net income
Common shares
outstanding

20x2
$103,140 - 0
10,000

$10.31

20x1
$88,970 - 0
10,000

$8.90

EVALUATING STOCK AS AN INVESTMENT

Investors purchase stock to earn a return on their investment. This return consists of both
gains from the sale of appreciated stock and from dividends. Two ratios used to analyze
the value of a stock include the price-earnings ratio and the book value per share of stock.
Price-Earnings Ratio
The price-earnings ratio equals the market price per share divided by the earnings per
share. A high price-earnings ratio is generally favorable because it indicates that the
investing public looks at the company in a positive light. However, too high a
price-earnings ratio could mean a poor investment because the stock may be overvalued,
while a low price-earnings ratio stock could be a good investment if its a case of the stock
being undervalued.
EXAMPLE 4.18
Assume that for the years 20x2 and 20x1 the market price per share of common stock for
Ogel Corporation was as follows:
Market price per
share

20x2
$130.00

20x1
$95.00

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Using the earnings per share of $10.31 for 20x2 (from Example 4.17) and $8.90 for 20x1,
the price/earnings ratio for each year can be calculated as follows.
Market price per share
Earnings per share of common
stock

20x2
$130.00
$10.31

12.6

20x1
$95.00
$8.9

10.7

The increase in the price-earnings multiple indicates that the stock market had a
higher opinion of the business in 20x2, possibly due to the companys increased
profitability.
Book Value Per Share
The book value per share equals the net assets available to common stockholders
divided by the shares outstanding. Net assets equals stockholders equity minus
preferred stock. The comparison of book value per share to market price per share
provides a clue as to how investors regard the firm. The formula for calculating book value
per share is as follows:
Total Stockholders Equity - Preferred Equity
Number of Shares of Common Stock
Outstanding

EXAMPLE 4.19
Assume that for the year's 20x2 and 20x1 the stockholders equity of Ogel Corporation
was as follows:
20x2
$405,200

Total stockholders'
equity

20x1
$386,500

If there are 10,000 shares of common stock outstanding at December 31 of each year, the
book value per share for each year would be:

Total stockholders' equity

Common shares
outstanding

20x2
$405,200
10,000

$40.52

20x1
$386,500
10,000

$38.65

LIMITATIONS OF RATIO ANALYSIS

Some of the limitations of ratio analysis are as follows:
(1)

Many large businesses are involved with multiple lines of business, making it
difficult to identify the industry to which a specific company belongs. A
comparison of its ratios with other corporations may thus be meaningless.
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(2)

Accounting and operating practices differ among companies, which can distort
the ratios and make comparisons meaningless. For example, the use of
different inventory-valuation methods would affect inventory and
asset-turnover ratios.

(3)

Industry averages published by financial advisory services are only

approximations. Therefore the company may have to look at the ratios of its
major competitors if such ratios are available.

(4)

Financial statements are based on historical costs and do not consider

inflation.

(5)

Management may hedge or exaggerate its financial figures. Hence certain

ratios will not be accurate indicators.

(6)

A ratio does not describe the quality of its components. For example, the
current ratio may be high but inventory may consist of obsolete merchandise.

(7)

Ratios are static and do not take into account future trends.

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CHAPTER 4 QUIZ
1. In financial statement analysis, expressing all financial statement items as a
percentage of base-year amounts is called
A. Horizontal common-size analysis.
B. Vertical common-size analysis.
C. Trend analysis.
D. Ratio analysis.
2. In assessing the financial prospects for a firm, financial analysts use various
techniques. An example of vertical, common-size analysis is
A. An assessment of the relative stability of a firms level of vertical integration.
B. Advertising expense for the current year is 2% of sales.
C. A comparison in financial ratio form between two or more firms in the same
industry.
D. Advertising expense is 2% greater compared with the previous year.
3. A firms average collection period is equal to
A. The length of time it takes to collect receivables.
B. The inventory conversion period.
C. The cash conversion cycle.
D. The inventory divided by average daily sales.
4. LIFO inventory cost flow assumption will result in a higher inventory turnover ratio in an
inflationary economy.
True / False
5. Return on investment (ROI) may be calculated by dividing net income by
A. Average collection period.
B. Average total assets.
C. Debt ratio.
D. Fixed-charge coverage.
6. To determine the operating cycle for a retail department store, which one of the
following pairs of items is needed?
A. Days sales in accounts receivable and average merchandise inventory.
B. Cash turnover and net sales.
C. Days sales in inventory and days sales in receivables.
D. Asset turnover and return on sales.

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7. If a company is profitable and is effectively using leverage, return on total assets is

likely to be the largest.
True / False
8. Which one of the following ratios would provide the best measure of liquidity?
A. Sales minus returns to total debt.
B. Total assets minus goodwill to total equity.
C. Current assets minus inventories to current liabilities.
D. Current liabilities to long-term debt.

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CHAPTER 4 ANSWER KEY

1. (A) is correct. Expressing financial statement items are percentages of corresponding
base-year figures is a horizontal form of common-size (percentage) analysis that is useful
for evaluating trends. The base amount is assigned the value of 100% and the amounts
for other years are denominated in percentages compared to the base year.
(B) is incorrect. Vertical common-size (percentage) analysis presents figures for a single
year expressed as percentages of a base amount on the balance sheet (e.g., total assets)
and on the income statement (e.g., sales).
(C) is incorrect. The term trend analysis is most often applied to the quantitative
techniques used in forecasting to fit a curve to given data.
(D) is incorrect. Ratio analysis is a general term covering both horizontal and vertical
analyses.
2. (B) is correct. Vertical, common-size analysis compares the components within a set of
financial statements. A base amount is assigned a value of 100%. For example, total
assets on a common-size income statement are valued at 100%. Common-size
statements permit evaluation of the efficiency of various aspects of operations. An analyst
who states that advertising expense is 2% of sales is using vertical, common-size
analysis.
(A) is incorrect. Vertical integration occurs when a corporation owns one or more of its
suppliers or customers.
(C) is incorrect. Vertical, common-size analysis restates financial statements amounts as
percentages.
(D) is incorrect. A statement that advertising expense is 2% greater than in the previous
year results form horizontal analysis.
3. (A) is correct. The average collection period may be stated as the accounts receivable
balance divided by average credit sales per day or as days in the year divided by the
receivables turnover. It is the average time required to convert the enterprise's
receivables into cash.
(B) is incorrect. The inventory conversion period (days of inventory) is the average time
required to convert materials into finished goods and then to sell them. This process
typically occurs before the receivables collection period and the amount of time in one
period does not necessarily bear any relationship to the other.
(C) is incorrect. The cash conversion cycle equals the inventory conversion period, plus
the receivables collection period, minus the payables deferral period (average time
between resource purchases and payment of cash for them). It estimates the time
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between when the enterprise makes payments and when it receives cash inflows.
(D) is incorrect. The inventory divided by the sales per day is the inventory conversion
period (days of inventory).
4. (T) is correct. The inventory turnover ratio equals the cost of goods sold divided by the
average inventory. LIFO assumes that the last goods purchased are the first goods sold
and that the oldest goods purchased remain in inventory. The result is a higher cost of
goods sold and a lower average inventory than under other inventory cost flow
assumptions if prices are rising. Because cost of goods sold (the numerator) will be higher
and average inventory (the denominator) will be lower than under other inventory cost
flow assumptions, LIFO produces the highest inventory turnover ratio.
(F) is incorrect. When prices are rising, LIFO results in a higher cost of goods sold and a
lower average inventory than under other inventory cost flow assumptions such as FIFO,
weighted average, or specific identification.
5. (B) is correct. The rate of return measures the ability of the company to earn a profit on
its total assets.
(A) is incorrect. ROI cannot be determined using this ratio. Average collection period
represents the number of days it takes to collect on receivables, equal to 365 days divided
by accounts receivable turnover.
(C) is incorrect. ROI cannot be determined using this ratio. The debt ratio compares total
liabilities to total assets. It shows the percentage of total funds obtained from creditors.
(D) is incorrect. ROI cannot be determined using this ratio. The fixed-charge coverage
reflects the number of times before-tax earnings cover fixed expense.
6. (C) is correct. The operating cycle is the time needed to turn cash into inventory,
inventory into receivables and receivables back into cash. For a retailer, it is the time from
purchase of inventory to collection of cash. Thus, the operating cycle of a retailer is equal
to the sum of the number of days sales in inventory and the number of days sales in
receivables. The days sales in inventory equals 365 (or another period chosen by the
analyst) divided by the inventory turnover. The days sales in receivables equals 365 (or
other number) divided by the accounts receivable turnover.
(A) is incorrect. The cost of sales must be known to calculate days sales in inventory.
(B) is incorrect. Cash sales and net sales are insufficient to permit determination of the
operating cycle. They are only different sales figures.
(D) is incorrect. Asset turnover and return on sales are two components of ROI. They are
insufficient to permit determination of the operating cycle.
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7. (F) is correct. The purpose of leverage is to use creditor capital to earn income for
shareholders. If the return on the resources provided by creditors exceeds the cost of
debt, leverage is used effectively and the return to common equity will be higher than the
other measures. The reason is that common equity provides a smaller proportion of the
investment than in an unleveraged company.
(T) is incorrect. Effective use of leverage will enhance stockholders returnreturn on
common equity. Return on total assets will be lower than the return on common equity if
the firm is profitable and using leverage effectively.
8. (C) is correct. Liquidity is the degree to which assets can be converted to cash in the
short run to meet maturing obligations. The usual measures of liquidity are the current ratio
and the quick (acid-test) ratio. The quick ratio is the best measure of short-term liquidity
because it uses only the most liquid assets (cash, marketable securities and receivables)
in the calculation; inventories are not included because they are two steps away from cash
(they have to be sold and then the receivable has to be collected).
(A) is incorrect. This does not refer to expenses that have to be paid out of the sales
dollars. Also, the sales revenue available to pay liabilities is indeterminable. Thus, sales
minus debt service are not a liquidity measure.
(B) is incorrect. Fixed assets are included in the numerator of the ratio; hence, this ratio is
not a measure of liquidity.
(D) is incorrect. Using only liabilities in the calculation ignores the assets available to pay
the liabilities.

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CHAPTER 5
ANALYZING QUALITY OF EARNINGS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.

Define quality of earnings.

Analyze discretionary costs.
Describe what accounting estimates can do.
Construct a guide for internal control and management honesty.
Compare and explain auditor relations and reports.

You should be familiar with the accounting factors that are involved in analyzing the
income statement, including the nature of the accounting policies used, the degree of
certainty in accounting estimates, discretionary costs, tax reporting and verifiability of
earnings. It is your task to adjust net income to derive an earnings figure that is most
relevant to your needs.
QUALITY OF EARNINGS
Quality of earnings is relative, not absolute. It is a comparison of the favorable and
unfavorable characteristics of the net incomes of competing companies. It involves
looking at quantitative (e.g., ratio analysis) and qualitative factors (e.g., pending litigation).
Reported earnings are adjusted to make them relevant to the user for his analytical
purposes. Data in the footnotes will assist in the restatement process.
Earnings quality relates to the degree to which net income is overstated or
understated, as well as to the stability of income statement elements. Earnings quality
affects the price-earnings ratio, bond rating, effective interest rate, compensating balance
requirement, availability of financing and desirability of the firm as either an acquirer or
acquiree. Earnings quality attributes exist in different proportions and intensifies in the
earnings profiles of companies. You have to be very careful of the quality of earnings of
high-accounting-risk companies, including a company in a high-risk environment or one
that shows glamour, such as one with consistently strong growth.
Unwarranted accounting changes (principles and estimates) lower earnings
quality and distort the earnings trend. Justification for an accounting change is present in
a new FASB statement, AICPA Industry Audit Guide and IRS regulations.
EXAMPLE 5.1
An asset was acquired for $12,000 on 1/1/X1. The life is eight years and has a salvage
value of $2,000. On l/8/X4, the company unrealistically changed the original life to ten
years, with a salvage value of $3,000.

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The adjustment required to 20X4s net income is as follows:

Depreciation expense after change in estimate
Original cost
Less accumulated depreciation ($1,250 x 3)
Book value (12/31/X3)
New salvage value
Amount to be depreciated
New remaining life (10 3) 7 years
Recorded depreciation expense ($5,250/7) = $750
Depreciation expense should be
Downward adjustment to l9X4 net income

$750
$12,000
3,750
$ 8,250
3,000
$ 5,250
1,250
$ 500

Income smoothing lowers the quality of earnings. Examples are:

Future revenue is reported in the current period.

Income is transferred from good years to bad years.
Expenses are shifted among the years.

A weak relationship between revenue and reported earnings may point to the
existence of earnings management.
EXAMPLE 5.2
The ratio of net income to revenue for the period 20X1 to 20X4 was
20X1
14%

20X2
2%

20X3
22%

20X4
(4)%

The weak association implies the existence of income management.

The immediate recognition of revenue without the rendering of substantial services
imparts lower earnings quality. An example is a health spa, which reflects income, as
membership fees are collected at the beginning of the earnings cycle. On the other hand,
the belated recognition of revenue results in understated earnings. Also watch out for the
reversal of previously recorded items, such as profits or a prior write-off of an asset.
The underaccrual or overaccrual of expenses or losses results in poor earnings
quality. For example, by underaccruing for warranty expense, net income is overstated.
What to Watch Out for: The reduction of expenses for exaggerated expected recoveries
of excess costs under contracts causing an overstatement in earnings. Also, is there a
higher expense provision in the current year because of an inadequate provision in a
previous year? This distorts the earnings trend. Be on Guard Against: A company taking a
financial bath by writing down overstated assets all of a sudden and providing for
expense and loss provisions that realistically apply to the future. This sometimes occurs
when new management takes over and wants to reduce earnings, blaming old
management for a bad year, or when the current management feels that since operations
are so bad anyway, a further decrease in earnings will not have a material negative effect
on the market price. What to Watch Out for: Deferring items to an asset that should
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preferably be expensed. An example is advertising.

ANALYSIS OF DISCRETIONARY COSTS
Discretionary costs can be changed at managements will. What to Do: Examine the
current level of discretionary costs relative to previous years and to future requirements.
An index number may be used to compare the current-year discretionary cost to the base
amount. A reduction in discretionary costs lowers earnings quality if their absence will
have a detrimental effect on the future (e.g., advertising, research, repairs).
Recommendation: Analyze the trend in the following ratios: (1) discretionary costs to
sales and (2) discretionary costs to assets. If in connection with a cost-reduction program
material cuts are made in discretionary costs, earnings quality has declined. However,
cost control is warranted when (1) in prior years discretionary expenditures were
excessive and (2) competition has decreased. A material increase in discretionary costs
in a given year may have a significant positive impact on corporate earning power and
future growth. Income smoothing is indicated when discretionary costs as a percentage of
revenue fluctuate each year.
EXAMPLE 5.3
The following data are supplied:
Sales
Research

20X1
$95,000
9,000

20X2
$125,000
14,000

20X3
$84,000
3,000

The most representative year (base year) is 20Xl. After 20X4, you believe that research is
essential for the companys success because of technological factors in the industry.
Research to sales

20X1
9.5%

20X2
11.2%

20X3
3.6%

Looking in base dollars, 20X1 represents 100. 20X2 is 156 ($14,000/$9,000). 20X3 has
an index of 33 ($3,000/$9,000).
A red flag is posted for 20X3. Research is lower than in previous periods. There should
have been a boost in research in light of the technological updating needed for 20X4.
ACCOUNTING ESTIMATES
The greater the degree of subjective accounting estimates in the income measurement
process, the lower the quality of earnings. What to Do: Examine the difference between
actual experience and the estimates employed. The wider the difference, the lower the
quality of earnings. Look at the variation over time between a loss provision and the actual
loss. A continually understated loss provision means inaccurate estimates and/or intent to
overstate earnings. Sizable gains and losses on the sale of assets may infer inaccurate
depreciation estimates.
Examine the trend in the following ratios:

High estimation assets (e.g., fixed assets) to total assets

Cash expenses to revenue
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Estimated expenses to revenue

Cash revenue to revenue
Estimated revenue to revenue
Estimated expenses to net income
Estimated revenue to net income

Higher estimation is indicated by long-term construction work using the

percentage-of-completion contract method and a material amount of estimated liability
provisions.
EXAMPLE 5.4
The following information applies to a company:
Cash and near-cash
revenue
Non-cash revenue items
Total revenue
Cash and near-cash
expenses
Non-cash expenses
Total expenses
Net income

20X1
$ 98,000

20X2
$107,000

143,000
$241,000

195,000
$302,000

20X1
$ 37,000

20X2
$ 58,000

67.000
$104,000
$137,000

112.000
$170000
$132,000

Estimation-related ratios can now be calculated.

Estimated revenue to total
revenue
Estimated revenue to net income
Estimated expenses to total
expenses
Estimated expenses to total
revenue
Estimated expenses to net income

20X1
59%

20X2
65%

104%
64%

148%
66%

28%

37%

49%

85%

In every case, there was greater estimation involved in the income measurement process
in 20X2 relative to 20X1. The higher degree of estimation resulted in lower earnings
quality.
INTERNAL CONTROL AND MANAGEMENT HONESTY
Deficient internal control casts doubt upon the integrity of the earnings stream. Look at the
trend in audit fees and in audit time over the years. Increasing trends may point to internal
control and audit problems. Examine disclosure of errors that cast doubt upon the
integrity of financial reporting. Are there any indicators of a dishonest management, such
as corporate bribes, payoffs, or hiding of defective merchandise?

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AUDITOR RELATIONS AND REPORTS

You should examine the turnover rate in auditors. High turnover rates as a result of
accounting disagreements reflect negatively on earnings quality. When a conflict of
opinion regarding an accounting change results in a change in auditors, determine the
effect on net income if the new auditor agrees to the policy change; compare the net
income computed under the new policy with that computed under the old policy. Examine
the type of audit opinion rendered (unqualified, qualified, disclaimer, or adverse) and
consider why that format was selected. Questions to be asked are

What is the subject of a qualified opinion?

Why was a disclaimer opinion called for?
What uncertainties are present?
Is there adequate footnote disclosure?
Is there a significant subsequent event?
Are there related party transactions?

CONCLUSION
Quality of earnings involves those factors that would influence investors or creditors
considering investing or giving credit to firms exhibiting the same reported earnings.
Specifically, two firms in a given industry may report identical earnings, but may be quite
different in terms of operational performance. This is because identical earnings may
possess different degrees of quality. The key in evaluating a companys earnings quality
is to compare its earnings profile (the mixture and degree of favorable and unfavorable
characteristics associated with reported results) with the earnings profile of other
companies in the same industry. Analysts attempt to assess earnings quality in order to
render the earnings comparable and to determine what valuation should be placed upon
them.
You must address the problem of evaluating earnings of competitive companies
that report substantially different net incomes. The earnings quality of the firm reporting
higher net income may in fact be inferior if the firm is burdened with more undesirable
characteristics in earnings than its low-income competitor.
When two competitive companies use alternative accounting policies, you should
adjust their net incomes to a common basis in order to reduce the diversity in accounting
that exists. The best basis for adjusting earnings for comparative purposes is to derive net
income figures, assuming that realistic accounting policies were used.
Quality of earnings can be looked at only in terms of accounting and financial
characteristics that have an effect on the earning power of a firm, as shown in its net
income figure. These characteristics are complex and interrelated and are subject to wide
varieties of interpretation depending upon your own analytical objective.

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CHAPTER 5 QUIZ
1. Quality of earnings:
A. Is absolute.
B. Is relative
C. Ignores the favorable and unfavorable characteristics of the net incomes of
competing companies.
D. Looks at quantitative (e.g., ratio analysis).
2. Earnings quality relates to the degree to which assets is inflated.
True / False

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CHAPTER 5 ANSWER KEY

1. (B) is correct. Quality of earnings is relative, not absolute. It is a comparison of the
favorable and unfavorable characteristics of the net incomes of competing companies. It
involves looking at quantitative (e.g., ratio analysis) and qualitative factors (e.g., pending
litigation). Reported earnings are adjusted to make them relevant to the user for his
analytical purposes. Data in the footnotes will assist in the restatement process.
(A) is incorrect. Quality of earnings is relative.
(C) is incorrect. Quality of earnings is a comparison of the favorable and unfavorable
characteristics of the net incomes of competing companies.
(D) is incorrect. Quality of earnings involves looking at quantitative (e.g., ratio
analysis) and qualitative factors (e.g., pending litigation).
2. (F) is correct. Earnings quality relates to the degree to which net income is overstated
or understated, as well as to the stability of income statement elements.
(T) is incorrect. Earnings quality affects the price-earnings ratio, bond rating, effective
interest rate, compensating balance requirement, availability of financing and
desirability of the firm as either an acquirer or acquiree.

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CHAPTER 6
ANALYSIS OF VARIANCE ANALYSIS FOR COST CONTROL
LEARNING OBJECTIVES
After studying the material in this chapter, you will able to:
1. Explain responsibility accounting and appreciate how important it is for
managerial control.
2. Distinguish among three types of responsibility centers and see how they
are evaluated.
3. Calculate different types of variances for manufacturing costs--direct
materials, direct labor and manufacturing overhead.
4. Explain the managerial significance of these variances.
5. Prepare a flexible budget and explain its advantage over the static budget
format.
6. List non-financial performance measures.
Responsibility accounting is the system for collecting and reporting revenue and cost
information by areas of responsibility. It operates on the premise that managers should be
held responsible for their performance, the performance of their subordinates and all
activities within their responsibility center. Responsibility accounting, also called
profitability accounting and activity accounting, has the following advantages:
(1) It facilitates delegation of decision making.
(2) It helps management promote the concept of management by
objective. In management by objective, managers agree on a set of
goals. The manager's performance is then evaluated based on his or
her attainment of these goals.
(3) It provides a guide to the evaluation of performance and helps to
establish standards of performance which are then used for
comparison purposes.
(4) It permits effective use of the concept of management by exception,
which means that the manager's attention is concentrated on the
important deviations from standards and budgets.
Responsibility Accounting and Responsibility Center
For an effective responsibility accounting system, the following three basic conditions are
necessary:
a) The organization structure must be well defined. Management responsibility
and authority must go hand in hand at all levels and must be clearly
established and understood.
b) Standards of performance in revenues, costs and investments must be
properly determined and well defined.

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c) The responsibility accounting reports (or performance reports) should

include only items that are controllable by the manager of the responsibility
center. Also, they should highlight items calling for managerial attention.
A well-designed responsibility accounting system establishes responsibility
centers within the organization. A responsibility center is defined as a unit in the
organization which has control over costs, revenues and/or investment funds.
Responsibility centers can be one of the following types:
Cost center. A cost center is the unit within the organization which is responsible only
for costs. Examples include production and maintenance departments of a manufacturing
company.
Variance analysis based on standard costs and flexible budgets would be a typical
performance measure of a cost center.
Profit center. A profit center is the unit which is held responsible for the revenues
earned and costs incurred in that center. Examples might include a sales office of a
publishing company, an appliance department in a retail store and an auto repair center in a
department store. The contribution approach to cost allocation is widely used to measure
the performance of a profit center. This topic is covered in Chapter 7.
Investment center. An investment center is the unit within the organization which is
held responsible for the costs, revenues and related investments made in that center. The
corporate headquarters or division in a large decentralized organization would be an
example of an investment center. This topic is covered in Chapter 8.
STANDARD COSTS AND VARIANCE ANALYSIS
One of the most important phases of responsibility accounting is establishing standard costs
and evaluating performance by comparing actual costs with the standard costs. Standard
costs are costs that are established in advance to serve as targets to be met and after the
fact, to determine how well those targets were actually met. The standard cost is based on
physical and dollar measures: it is determined by multiplying the standard quantity of an
input by its standard price.
The difference between the actual costs and the standard costs, called the variance,
is calculated for individual cost centers. Variance analysis is a key tool for measuring
performance of a cost center.
The performance reports based on the analysis of variances must be prepared for
each cost center, addressing the following questions:
1. Is it favorable (F) or unfavorable (U)?
2. If it is unfavorable, is it significant enough for further investigation? For
example, a 5% over the standard is a redflag. The decision to
investigate is based on the companys policy in terms of the standard
plus or minus an allowable control limit. Current practice sets the
control limits subjectively, based on judgment and past experience
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3.
4.
5.
6.

rather than any formal identification of limits. About 45 to 47 percent of

the firms surveyed used dollar or percentage control limits.
If it is significant, is it controllable? For example, it may be due to a
strike on the part of the supplier. A material shortage and the ensuing
price hike may not be within the control of the production manager.
If it is controllable, then who is responsible for what portion of the total
variance?
What are the causes for an unfavorable variance?
What is the remedial action to take?

The whole purpose of variance analysis is to determine what happened, what

the causes are and make sure the same thing does not happen again. The
report is useful in two ways: (1) in focusing attention on situations in need of
management action and (2) in increasing the precision of planning and control of
costs. The report should be produced as part of the overall standard costing and
responsibility accounting system.
Figure 6.1 takes you, step by step, through variance analysis.

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FIGURE 6.1
USING VARIANCE ANALYSIS TO CONTROL COSTS

Compute Variance

Yes

Is the Variance
Favorable (F)?

No Action is Needed

No
No

Is It Significant?

No Action is Needed

Yes
No

Is It Controllable?

No Action is Needed

Yes
What Are the Causes?

Take Corrective
Action

GENERAL MODEL FOR VARIANCE ANALYSIS

Two general types of variances can be calculated for most cost items: a price (rate,
spending) variance and a quantity (usage, efficiency) variance.
The price variance is calculated as follows:
Price
Variance

=
=
=

Actual Quantity *(Actual price - Standard

price)
AQ * (AP - SP)
(AQ * AP) - (AQ * SP)

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The quantity variance is calculated as follows:

Quantity

Actual Standard
Standard
= (Quantity - Quantity)* Price

Variance
=
=

(AQ - SQ) * SP
(AQ * SP) - (SQ * SP)

It is important to note four things:

1. A price variance and a quantity variance can be calculated for all three variable cost
items -- direct materials, direct labor and the variable portion of factory overhead. The
variance is not called by the same name, however. For example, a price variance is
called a materials price variance in the case of direct materials, but a labor rate variance
in the case of direct labor and a variable overhead spending variance in the case of
variable factory overhead.
2. A cost variance is unfavorable (U) if the actual price AP or actual quantity AQ
exceeds the standard price SP or standard quantity SQ; a variance is favorable (F) if the
actual price or actual quantity is less than the standard price or standard quantity.
3. The standard quantity allowed for output -- item (3) -- is the key concept in variance
analysis. This is the standard quantity that should have been used to produce actual
output. It is computed by multiplying the actual output by the number of input units
allowed.
4. Variances for fixed overhead are of questionable usefulness for control purposes,
since these variances are usually beyond the control of the production department.
We will now illustrate the variance analysis for each of the variable manufacturing cost
items.
MATERIALS VARIANCES
A materials purchase price variance is isolated at the time of purchase of the material. It
is computed based on the actual quantity purchased. The purchasing department is
responsible for any materials price variance that might occur. The materials quantity
(usage) variance is computed based on the actual quantity used. The production
department is responsible for any materials quantity variance.
Unfavorable price variances may be caused by: inaccurate standard prices,
inflationary cost increases, scarcity in raw material supplies resulting in higher prices and
purchasing department inefficiencies. Unfavorable material quantity variances may be
explained by poorly trained workers, by improperly adjusted machines, or by outright
waste on the production line.
EXAMPLE 6.1
Mighty Kings Corporation uses a standard cost system. The standard variable costs for
product J are as follows:
Techniques for Financial Analysis, Modeling & Forecasting Page 108

Materials: 2 pounds per unit at $3 per pound ($6 per unit of Product J)
Labor: 1 hour per unit at $5 per hour ($5 unit of Product J)
Variable overhead: 1 hour per unit at $3 per hour ($3 per unit of Product J)

During March, 25,000 pounds of material were purchased for $74,750 and 20,750
pounds of material were used in producing 10,000 units of finished product. Direct labor
costs incurred were $49,896 (10,080 direct labor hours) and variable overhead costs
incurred were $34,776.
It is important to note that the amount of materials purchased (25,000 pounds)
differs from the amount of materials used in production (20,750 pounds). The materials
purchase price variance was computed using 25,000 pounds purchased, whereas the
materials quantity (usage) variance was computed using the 20,750 pounds used in
production. A total variance cannot be computed because of the difference.
We can compute the materials variances as follows:
Materials purchase price
variance

AQ (AP - SP)

=
=

(AQ * AP) - (AQ * SP)

(25,000 pounds)
($2.99 - $3.00)
$74,750 - $75,000
$250 (F)

=
=
Materials quantity (usage)
variance

(AQ - SQ) SP

(20,750 pounds - 20,000 pounds)

($3.00)
$62,250 - $60,000
$2,250 (U)

=
=

LABOR VARIANCES
Labor variances are isolated when labor is used for production. They are computed in a
manner similar to the materials variances, except that in the 3-column model the terms
efficiency and rate are used in place of the terms quantity and price. The production
department is responsible for both the prices paid for labor services and the quantity of
labor services used. Therefore, the production department must explain why any labor
variances occur.
Unfavorable rate variances may be explained by an increase in wages, or the use
of labor commanding higher wage rates than contemplated. Unfavorable efficiency
variances may be explained by poor supervision, poor quality workers, poor quality of
materials requiring more labor time, machine breakdowns and employee unrest.

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EXAMPLE 6.2
Using the same data given in Example 6.1, the labor variances can be calculated as:
Labor rate
variance

AH (AR - SR)

=
=

(AH * AR) - (AH * SR)

(10,080 hours)
($4.95 - $5.00)
$49,896 - $50,400
$504 (F)

=
=
Labor efficiency
variance

(AH - SH) SR

(10,080 hours - 10,000 hours) *

$5.00
$50,400 - $50,000
$400 (U)

=
=

VARIABLE OVERHEAD VARIANCES

The variable overhead variances are computed in a way very similar to the labor
variances. The production department is usually responsible for any variable overhead
variance.
Unfavorable variable overhead spending variances may be caused by a large
number of factors: acquiring supplies for a price different from the standard, using more
supplies than expected, waste and theft of supplies. Unfavorable variable overhead
efficiency variances might be caused by such factors as: poorly trained workers,
poor-quality materials, faulty equipment, work interruptions, poor production scheduling,
poor supervision, employee unrest and so on.
When variable overhead is applied using direct labor hours, the efficiency
variance will be caused by the same factors that cause the labor efficiency variance.
However, when variable overhead is applied using machine hours, inefficiency in
machinery will cause a variable overhead efficiency variance.
EXAMPLE 6.3
Using the same data given in Example 6.1, the variable overhead variances can be
computed as follows:
Variable overhead spending
variance

AH (AR - SR)

=
=

(AH * AR) - (AH * SR)

(10,080 hours)
($3.45 - $3.00)
$34,776 - $30,240
$4,536 (U)

=
=

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Variable overhead efficiency

variance

(AH - SH) SR

(10,080 hours - 10,000 hours) *

$3.00
$30,240 - $30,000
$240 (U)

=
=

FLEXIBLE BUDGETS AND PERFORMANCE REPORTS

A flexible budget is a tool that is extremely useful in cost control. The flexible budget is
characterized as follows:
1. It is geared toward a range of activity rather than a single level of activity.
2. It is dynamic in nature rather than static. By using the cost-volume formula (or flexible
budget formula), a series of budgets can be easily developed for various levels of activity.
The static (fixed) budget is geared for only one level of activity and has problems
in cost control. Flexible budgeting distinguishes between fixed and variable costs, thus
allowing for a budget which can be automatically adjusted (via changes in variable cost
totals) to the particular level of activity actually attained. Thus, variances between actual
costs and budgeted costs are adjusted for volume ups and downs before differences due
to price and quantity factors are computed.
The primary use of the flexible budget is to accurately measure performance by
comparing actual costs for a given output with the budgeted costs for the same level of
output.
EXAMPLE 6.4
To illustrate the difference between the static budget and the flexible budget, assume that
the Assembly Department of Omnis Industries, Inc. is budgeted to produce 6,000 units
during June. Assume further that the company was able to produce only 5,800 units. The
budget for direct labor and variable overhead costs is as follows:
OMNIS INDUSTRIES, INC.
The Direct Labor and Variable Overhead Budget
Assembly Department
For the Month of June
Budgeted production
6,000 units
Actual production
5,800 units
Direct labor
Variable overhead costs:
Indirect labor
Supplies
Repairs

$39,000

6,000
900
300
$46,200
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If a static budget approach is used the performance report will appear as follows:

OMNIS INDUSTRIES, INC.

Direct Labor and Variable Overhead
Static Budget Versus Actual
Assembly Department
For the Month of June
Production in units
Direct labor
Variable overhead costs:
Indirect labor
Supplies
Repairs

Budget
6,000
$39,000

Actual*
5,800
$38,500

Variance (U or F)**
200U
$500F

6,000
900
300
$46,200

5,950
870
295
$45,615

50F
30F
5F
$585F

*Given.
**A variance represents the deviation of actual cost from the standard or budgeted cost. U and F
stand for
"unfavorable" and "favorable," respectively.

These cost variances are useless, in that they are comparing oranges with apples.
The problem is that the budget costs are based on an activity level of 6,000 units,
whereas the actual costs were incurred at an activity level below this (5,800 units).
From a control standpoint, it makes no sense to try to compare costs at one
activity level with costs at a different activity level. Such comparisons would make a
production manager look good as long as the actual production is less than the budgeted
production. Using the cost-volume formula and generating the budget based on the
5,800 actual units gives the following performance report:

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OMNIS INDUSTRIES, INC.

Performance Report Assembly Department
Flexible Budget Versus Actual
For the Month of June

Budgeted production
Actual production

Direct labor
Variable
overhead:
Indirect labor
Supplies
Repairs

6,000 units
5,800 units

Cost-volume Flexible Budget

formula
5,800 units
$6.50 per
$37,700
unit

Actual
5,800 units
$38,500

Variance
(U or F)
$800U

1.00
0.15
0.05
$7.70

5,950
870
295
$45,615

150U
0
5U
$955U

5,800
870
290
$44,660

Notice that all cost variances are unfavorable (U), as compared to the favorable cost
variances on the performance report based on the static budget approach.
NONFINANCIAL PERFORMANCE MEASURES
Standard costs are widely used in manufacturing, service and not-for-profit organizations.
The list of companies using standards as a method for controlling costs and measuring
performance continues to grow. For a firm to improve, managers should encompass
nonfinancial (or operational) measures as well as financial measures, especially those
that track factors required for world-class status. In an automated environment, labor is a
smaller proportion of product cost, often less than 5%. Thus, traditional labor variances
are of little value to management. Also, the manufacturing process is more reliable in an
automated environment and the traditional variances tend to be minimal.
The new performance measures tend to be nonfinancial and more subjective than
standard costs. Table 1 presents five sets of nonfinancial performance measures. They
include statistics for activities such as quality control, on-time delivery, inventory, machine
downtime and material waste. Measures such as quality control and delivery performance
are customer oriented. These are useful performance measures in all organizations,
particularly service organizations in which the focus is on services, not goods. A general
model for measuring the relative success of an activity compares number of successes
with total activity volume. For example, delivery performance could be measured as
follows.

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Number of on-time
deliveries
---------------------------

delivery success
rate

Total delivery made

The percentage of external failures may be monitored for quality control.

Others may be production oriented. Reducing material waste, inventory and
machine downtime have been shown to improve quality and efficiency. These
nonfinancial performance measures and measures of performance using standard costs
are not mutually exclusive. Reducing materials waste would eliminate an unfavorable
materials usage variance, for example. Measures such as inventory turnover and days of
inventory can be used, however. Table 6.1 illustrates nonfinancial performance
measures.
TABLE 6.1
NONFINANCIAL PERFORMANCE MEASURES
Task
Inventory:
Inventory levels
Number of inventoried items

Objective
Decrease inventory levels
Curtail number of different
items

Quality control:
Number of customer complaints
Number of defects

Reduce complaints
Reduce defects

Delivery performance:
Delivery success rate

Increase on-time deliveries

Materials waste:
Scrap and waste as a percentage of total
cost
Machine downtime:
Percentage of machine downtime

Decrease scrap and waste

Reduce downtime

CONCLUSION
Variance analysis is essential in the organization for the appraisal of all aspects of the
business. This chapter was concerned with the control of cost centers through standard
costs. It discussed the basic mechanics of how the two major variances --the price
variance and the quantity variance--are calculated for direct materials, direct labor,
variable overhead and fixed overhead. The idea of flexible budgeting was emphasized in
an attempt to correctly measure the efficiency of the cost center. We noted that fixed
overhead volume variance has a limited usefulness at the level of a cost center, since
only top management has the power to expand or contract fixed facilities.
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CHAPTER 6 QUIZ
1. In a standard cost system, the materials price variance is obtained by multiplying the
A. Actual price by the difference between actual quantity purchased and standard
quantity used.
B. Actual quantity purchased by the difference between actual price and standard price.
C. Standard price by the difference between standard quantity purchased and standard
quantity used.
D. Standard quantity purchased by the difference between actual price and standard
price.
2. An unfavorable price variance occurs because of
A. Price increases for raw materials.
B. Price decreases for raw materials.
C. Less-than-anticipated levels of waste in the manufacturing process.
D. More-than-anticipated levels of waste in the manufacturing process.
3. Under a standard cost system, the materials price variances are usually the
responsibility of the production manager.
True / False
4. How is labor rate variance computed?
A. The difference between standard and actual rates, times standard hours.
B. The difference between standard and actual hours, times actual rate.
C. The difference between standard and actual rates, times actual hours.
D. The difference between standard and actual hours, times the difference between
standard and actual rates.
5. If a manufacturing company uses responsibility accounting, depreciation on equipment
is least likely to appear in performance report for a manager of an assembly line?
A. Supervisory salaries.
B. Materials.
C. Repairs and maintenance.
D. Depreciation on equipment.

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CHAPTER 6 ANSWER KEY

1. (B) is correct. The materials price variance measures the difference between the
amount actually paid for the materials purchased and the standard amount allowed for the
materials purchased. Thus, it equals the difference between actual price and standard
price, multiplied by the actual quantity purchased. This question assumes that price
variances are isolated at the time of purchase.
(A) is incorrect. The materials price variance measures the difference between the actual
price and standard price for the materials purchased.
(C) is incorrect. Multiplying the standard price by the difference between standard
quantity purchased and standard quantity used gives the standard change in inventories.
(D) is incorrect. The actual quantity must be used to determine the materials price
variance.
2. (A) is correct. Unfavorable price variances may be caused by: inaccurate standard
prices, inflationary cost increases, scarcity in raw material supplies resulting in higher
prices and purchasing department inefficiencies.
(B) is incorrect. A decrease in price would result in a favorable price variance.
(C) is incorrect. Less waste would result in a favorable materials quantity (usage)
variance.
(D) is incorrect. More waste would result in an unfavorable materials quantity variance.
3. (F) is correct. The materials price variance is the difference between the standard price
and the actual price paid for materials. This variance is usually the responsibility of the
purchasing department. Thus, the purchasing manager has an incentive to obtain the
best price possible.
(T) is incorrect. The production manager has no control over the price paid for materials
because he/she does not handle material purchases.
4. (C) is correct. The labor rate variance is computed by finding the difference between
the standard and the actual rates and then multiplying by actual hours; (AR SR) x AH.
(A) is incorrect. The actual hours must be used to determine the labor rate variance.
(B) is incorrect. This formula gives no useful variances.
(D) is incorrect. The difference between standard and actual hours, times the difference
between standard and actual rates, is not the correct formula.
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5. (T) is correct. Responsibility accounting stresses that managers should be held

responsible for only those factors under their control. Costs are classified as controllable
and noncontrollable to assign responsibility, which implies that some revenues and costs
can be changed through effective management. For example, depreciation on equipment
is ordinarily outside control of an assembly line manager and should not appear on his/her
performance report.
(F) is incorrect. Depreciation on equipment is ordinarily outside control of an assembly
line manager and should not appear on his/her performance report. Costs such as
supervisory salaries, materials and repairs and maintenance are costs controllable by an
assembly line manager.

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CHAPTER 7
ANALYSIS OF SEGMENTAL PERFORMANCE AND PROFIT VARIANCE
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1. Explain Segmental Reporting for Profit Centers.
2. Give examples of Profit Variance Analysis.
3. Analyze and evaluate sales mix.
Segmental reporting is the process of reporting activities of profit centers such as divisions,
product lines, or sales territories. The contribution approach is valuable for segmented
reporting because it emphasizes the cost behavior patterns and the controllability of costs
that are generally useful for profitability analysis of various segments of an organization.
SEGMENTAL REPORTING FOR PROFIT CENTERS
The contribution approach is based on the thesis that:
(1) Fixed costs are much less controllable than variable costs.
(2) Direct fixed costs and common fixed costs must be clearly distinguished. Direct fixed
costs are those fixed which can be identified directly with a particular segment of an
organization, whereas common fixed costs are those costs that cannot be identified directly
with the segment.
(3) Common fixed costs should be clearly identified as unallocated in the contribution
income statement by segments. Any attempt to allocate these types of costs, on some
arbitrary basis, to the segments of the organization can destroy the value of responsibility
accounting. It would lead to unfair evaluation of performance and misleading managerial
decisions.
The following concepts are highlighted in the contribution approach:
1. Contribution margin: Sales minus variable costs
2. Segment margin: Contribution margin minus direct (traceable) fixed costs. Direct fixed
costs include discretionary fixed costs such as certain advertising, R & D, sales promotion
and engineering and traceable and committed fixed costs such as depreciation, property
taxes, insurance and the segment managers' salaries.
3. Net income: Segment margin less unallocated common fixed costs.

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Segmental reporting can be made by:

Division.
Product or product line.
Sales territory.
Service center.
Sales person.
Store or branch office.
Domestic or foreign operations.

EXAMPLE 7.1
Figure 7.1 illustrates two levels of segmental reporting:
(1) By segments defined as divisions.
(2) By segments defined as product lines of a division.
FIGURE 7.1
SEGMENTAL INCOME STATEMENT
(1)

Segments Defined as Divisions:

Sales
Less: Variable costs:
Manufacturing
Selling and admin.
Total variable costs
Contribution margin
Less: Direct fixed costs
Divisional segment margin
Less: Unallocated common fixed
costs
Net income
(2)

SEGMENTS
Total Company Division 1
$150,000
$90,000
40,000
20,000
60,000
$90,000
70,000
$20,000
$10,000

30,000
14,000
44,000
$46,000
43,000
$3,000

Division 2
$60,000
10,000
6,000
16,000
$44,000
27,000
$17,000

$10,000

Segments Defined as Product Lines of Division 2

Division 2
$60,000

SEGMENTS
Deluxe Model
$20,000

Regular Model
$40,000

Sales
Less: Variable costs
Manufacturing
10,000
5,000
5,000
Selling and administrative
6,000
2,000
4,000
Total variable costs
16,000
7,000
9,000
Contribution margin
$44,000
$13,000
$31,000
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Less: Direct fixed cost

Product line margin
Less: Unallocated common
fixed costs
Divisional segment margin

26,500
$17,500

9,500
$3,500

17,000
$14,000

$500
$17,000

The segment margin is the best measure of the profitability of a segment. Unallocated
fixed costs are common to the segments being evaluated and should be left unallocated in
order not to distort the performance results of segments.
Profit Variance Analysis
Profit variance analysis, often called gross profit analysis, deals with how to analyze the
profit variance that constitutes the departure between actual profit and the previous year's
income or the budgeted figure. The primary goal of profit variance analysis is to improve
performance and profitability in the future.
Profit, whether it is gross profit in absorption costing or contribution margin in direct
costing, is affected by at least three basic items: sales price, sales volume and costs. In
addition, in a multi-product firm, if not all products are equally profitable, profit is affected by
the mix of products sold.
The difference between budgeted and actual profits is due to one or more of the following:
(1) Changes in unit sales price and cost, called sales price and cost price variances,
respectively. The difference between sales price variance and cost price variance is
often called a contribution-margin-per-unit variance or a gross-profit-per-unit variance,
depending upon what type of costing system being referred to, that is, absorption
costing or direct costing. Contribution margin is considered, however, a better
measure of product profitability because it deducts from sales revenue only the
variable costs that are controllable in terms of fixing responsibility. Gross profit does
not reflect cost-volume-profit relationships. Nor does it consider directly traceable
marketing costs.
(2) Changes in the volume of products sold summarized as the sales volume variance
and the cost volume variance. The difference between the two is called the total
volume variance.
(3) Changes in the volume of the more profitable or less profitable items referred to as the
sales mix variance.
Detailed analysis is critical to management when multi-products exist. The volume
variances may be used to measure a change in volume (while holding the mix constant) and
the mix may be employed to evaluate the effect of a change in sales mix (while holding the
quantity constant). This type of variance analysis is useful when the products are substituted
for each other, or when products which are not necessarily substitutes for each other are
marketed through the same channel.
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Types of Standards in Profit Variance Analysis

To determine the various causes for a favorable variance (an increase) or an
unfavorable variance (a decrease) in profit we need some kind of yardsticks to compare
against the actual results. The yardsticks may be based on the prices and costs of the
previous year, or any year selected as the base periods. Some companies are summarizing
profit variance analysis data in their annual report by showing departures from the previous
year's reported income. However, one can establish a more effective control and budgetary
method rather than the previous year's data. Standard or budgeted mix can be determined
using such sophisticated techniques as linear and goal programming.
Single Product Firms
Profit variance analysis is simplest in a single product firm, for there is only one sales price,
one set of costs (or cost price) and a unitary sales volume. An unfavorable profit variance
can be broken down into four components: a sales price variance, a cost price variance, a
sales volume variance and a cost volume variance.
The sales price variance measures the impact on the firm's contribution margin (or
gross profit) of changes in the unit selling price. It is computed as:
Sales price
variance

(actual price - budget price)

actual sales

If the actual price is lower than the budgeted price, for example, this variance is unfavorable;
it tends to reduce profit. The cost price variance, on the other hand, is simply the summary
of price variances for materials, labor and overhead. (This is the sum of material price, labor
rate and factory overhead spending variances). It is computed as:
Cost price
variance

(actual cost - budget cost) x

actual sales

If the actual unit cost is lower than budgeted cost, for example, this variance is favorable; it
tends to increase profit. We simplify the computation of price variances by taking the sales
price variance less the cost price variance and call it the gross-profit-per-unit variance or
contribution-margin-per-unit variance.
The sale volume variance indicates the impact on the firm's profit of changes in the
unit sales volume. This is the amount by which sales would have varied from the budget if
nothing but sales volume had changed. It is computed as:
Sales volume
variance

(actual sales - budget sales)

x budget price

If actual sales volume is greater than budgeted sales volume, this is favorable; it tends to
increase profit. The cost volume variance has the same interpretation. It is:
(Actual sales - budget sales)

budget cost per unit.

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The difference between the sales volume variance and the cost volume variance is called
the total volume variance.
Multi-Product Firms
When a firm produces more than one product, there is a fourth component of the profit
variance. This is the sales mix variance, the effect on profit of selling a different
proportionate mix of products than the one that has been budgeted. This variance arises
when different products have different contribution margins. In a multi-product firm, actual
sales volume can differ from that budgeted in two ways. The total number of units sold could
differ from the target aggregate sales. In addition, the mix of the products actually sold may
not be proportionate to the target mix. Each of these two different types of changes in
volume is reflected in a separate variance.
The total volume variance is divided into the two: the sales mix variance and the
sales quantity variance. These two variances should be used to evaluate the marketing
department of the firm. The sales mix variance shows how well the department has done in
terms of selling the more profitable products while the sales quantity variance measures
how well the firm has done in terms of its overall sales volume. They are computed as:
Sales Mix Variance
(Actual Sales at budget mix - Actual Sales at actual
mix)

Budget CM (or gross profit / unit)

Sales Quantity Variance

(Actual Sales at budget mix - Budget Sales at budget
mix)

Budget CM (or gross profit /

unit)

Sales Volume Variance

(Actual Sales at actual mix - Budget Sales at budget
mix)

Budget CM (or gross profit /

unit)

EXAMPLE 7.2
The Lake Tahoe Ski Store sells two ski models -- Model X and Model Y. For the years 20x1
and 20x2, the store realized a gross profit of $246,640 and only $211,650, respectively. The
owner of the store was astounded since the total sales volume in dollars and in units was
higher for 20x2 than for 20x1 yet the gross profit achieved actually declined. Given below
are the store's unaudited operating results for 20x1 and 20x2. No fixed costs were included
in the cost of goods sold per unit.
Selling
YEAR
1
2

Price
$150
160

Model X
Costs of
Goods
Sold per unit
$110
125

Sales in

Sales

Selling

Units
2,800
2,650

Revenue
$420,000
424,000

Price
$172
176

Model Y
Costs of
Goods
Sold per unit
$121
135

Sales
in
Units
2,640
2,900

Sales
Revenue
$454,080
510,400

Explain why the gross profit declined by $34,990. Include a detailed variance analysis of
price changes and changes in volume both for sales and cost. Also subdivide the total
volume variance into change in price and changes in quantity.
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Sales price and sales volume variances measure the impact on the firm's CM (or GM) of
changes in the unit selling price and sales volume. In computing these variances, all costs
are held constant in order to stress changes in price and volume. Cost price and cost
volume variances are computed in the same manner, holding price and volume constant. All
these variances for the Lake Tahoe Ski Store are computed below.
Sales Price Variance
Actual sales for 20x2:
Model X 2,650
Model Y 2,900

x
x

$160
176

$150
172

=
=

=
=

$424,000
510,400
$934,400

Actual 20x2 sales at 20x1 prices:

Model X 2,650
Model Y 2,900

x
x

$397,500
498,800
896,300
$38,100 F

Sales Volume Variance

Actual 20x2 sales at 20x1 prices: $896,300

Actual 20x1 sales (at 20x1 prices):
Model X 2,800
Model Y 2,640

x
x

$150
172

=
=

$420,000
454,080
874,080
$22,220 F

Cost Price Variance

Actual cost of goods sold for 20x2:

Model X 2,650
Model Y 2,900

x
x

$125
135

$110
121

=
=

=
=

$331,250
391,500
$722,750

Actual 20x2 sales at 20x1 costs:

Model X 2,650
Model Y 2,900

x
x

$291,500
350,900
642,400
$80,350 U

Cost Volume Variance

Actual 20x2 sales at 20x1 costs: $642,400

Actual 20x1 sales (at 20x1 costs):

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Model X 2,800
Model Y 2,640

x
x

$110
121

=
=

$308,000
319,440
627,440
$14,960 U

Total volume
variance

=
=

sales volume
variance
$22,220 F

cost volume
variance
$14,960 U

$7,260 F

The total volume variance is computed as the sum of a sales mix variance and a sales
quantity variance as follows:
Sales Mix Variance

Model X
Model Y

20x2 Actual
Sale at
20x1 Mix*
2,857
2,693
5,550

20x1 Actual
Sale at
20x2 Mix
2,650
2,900
5,550

Diff.
207 U
207 F

20x1 Gross
Profit
Per Unit
$40
51

Variance
($)
$8,280 U
10,557 F
$2,277 F

*This is the 20x1 mix (used as standard or budget) proportions of 51.47% (or 2,800/5,440 =
51.47%) and 48.53% (or 2,640/5,440 = 48.53%) applied to the actual 20x2 sales figure of
5,550 units.
Sales Quantity Variance

Model X
Model Y

20x2 Actual
Sale at
20x1 Mix*
2,857
2,693
5,550

20x2 Actual
Sale at
20x2 Mix
2,800
2,640
5,440

Diff.
57 F
53 F

20x1 Gross
Profit
Variance
Per Unit
($)
$40
$2,280 F
51
2,703 F
$4,983 F

A favorable total volume variance is due to a favorable shift in the sales mix (that is from
Model X to Model Y) and also to a favorable increase in sales volume (by 110 units) which is
shown as follows.
Sale mix
variance
Sales quantity

$2,277 F
4,983 F
$7,260F

However, there remains the decrease in gross profit. The decrease in gross profit of
$34,990 can be explained as follows.

Techniques for Financial Analysis, Modeling & Forecasting Page 124

Gains
Losses
$38,100 F

Gain due to increased sales

price
Loss due to increased cost
Gain due to increase in units
sold
Gain due to shift in sales mix

Hence, net decrease in gross

profit

80,350U
4,983 F
2,277 F
$45,360 F $80,350U
$80,350 $45,360

$34,990U

Despite the increase in sales price and volume and the favorable shift in sales mix, the Lake
Tahoe Ski Store ended up losing $34,990 compared to 20x1. The major reason for this
comparative loss was the tremendous increase in cost of gods sold, as costs for both Model
X and Model Y went up quite significantly over 20x1. The store has to take a close look at
the cost picture, even though only variable and fixed costs should be analyzed in an effort to
cut down on controllable costs. In doing that, it is essential that responsibility be clearly fixed
to given individuals. In a retail business like the lake Tahoe Ski Store, operating expenses
such as advertising and payroll of store employees must also be closely scrutinized.
EXAMPLE 7.3
Shim and Siegel, Inc. sells two products, C and D. Product C has a budgeted unit CM
(contribution margin) of $3 and Product D has a budgeted Unit CM of $6. The budget for a
recent month called for sales of 3,000 unit of C and 9,000 units of D, for a total of 12,000
units. Actual sales totaled 12,200 units, 4,700 of C and 7,500 of D. Compute the sales
volume variance and break this variance down into the (a) sales quantity variance and (b)
sales mix variance.
Shim and Siegel's sales volume variance is computed below. As we can see, while total unit
sales increased by 200 units, the shift in sales mix resulted in a $3,900 unfavorable sales
volume variance.
Sale Volume Variance

Product C
Product D

Actual
Sales at
Actual Mix
4,700
7,500
12,200

Standard
Sales at
Budgeted Mix
3,000
9,000
12,000

Difference
1,700 F
1,500 U

Budgeted
CM per Unit
$3
6

Variance
($)
$5,100 F
9,000 U
$3,900 U

In multiproduct firms, the sales volumes variance is further divided into a sales
quantity variance and a sales mix variance. The computations of these variances are shown
on the next page.

Techniques for Financial Analysis, Modeling & Forecasting Page 125

Sales Quantity Variance

Product C
Product D

Standard
Sales at
Budgeted Mix

Actual
Sales at
Budgeted Mix
3,050
9,150
12,200

3,000
9,000
12,000

Actual
Sales at
Budgeted Mix
3,050

Actual
Sales at
Actual Mix
4,700

9,150

7,500

12,200

12,200

Diff.
50 F
150 F

Budgeted
CM per Unit

$3
6

Variance
($)
$ 150 F
900 F
$1,050 F

Sale Mix Variance

Product
C
Product
D

Difference
1,650 F

Standard
CM per Unit
$3

Variance
($)
$4,950 F

1,650 U

9,900 U
$4,950 U

The sales quantity variance reflects the impact on the CM or GM (gross margin) of
deviations from the standard sales volume, whereas the sales mix variance measures the
impact on the CM of deviations from the budgeted mix. In the case of Shim and Siegel, Inc.,
the sales quantity variance came out to be favorable, i.e., $1,050 F and the sales mix
variance came out to be unfavorable, i.e., $4,950 U. These variances indicate that while
there was favorable increase in sales volume by 200 units, it was obtained by an
unfavorable shift in the sales mix, that is, a shift from Product D, with a high margin, to
Product C, with a low margin.
Note that the sales volume variance of $3,900 U is the algebraic sum of the following
two variances.
Sales quantity variance
Sales mix variance

$1,050 F
4,950 U
$3,900 U

In conclusion, the product emphasis on high margin sales is often a key to success for
multiproduct firms. Increasing sales volume is one side of the story; selling the more
profitable products is another.
Managerial Planning and Decision Making
In view of the fact that Shim and Siegel, Inc. experienced an unfavorable sales volume
variance of $3,900 due to an unfavorable (or less profitable) mix in the sales volume, the
company is advised to put more emphasis on increasing the sale of Product D.
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In doing that the company might wish to:

(a)

Increase the advertising budget for succeeding periods to boost Product D

sales;

(b)

Set up a bonus plan in such a way that the commission is based on quantities
sold rather than higher rates for higher margin items such as Product D or
revise the bonus plan to consider the sale of product D;

(c)

Offer a more lenient credit term for Product D to encourage its sale;

(d)

Reduce the price of Product D enough to maintain the present profitable mix
while increasing the sale of product. This strategy must take into account the
price elasticity of demand for Product D.

SALES MIX ANALYSIS

Many product lines include a lower-margin price leader model and often a high-margin
deluxe model. For example, the automobile industry includes in its product line
low-margin energy-efficient small cars and higher-margin deluxe models. In an attempt to
increase over-all profitability, management would wish to emphasize the higher-margin
expensive items, but salesmen might find it easier to sell lower-margin cheaper models.
Thus, a salesman might meet his unit sales quota with each item at its budgeted price, but
because of mix shifts he could be far short of contributing his share of budgeted profit.
Management should realize that
1. Greater proportions of more profitable products mean higher profits.
2. Higher proportions of lower margin sales reduce overall profit despite the
increase in overall sales volume. That is to say that an unfavorable mix may
easily offset a favorable increase in volume and vice versa.
Performance Reports
Profit variance analysis aids in fixing responsibility by separating the causes of the change
in profit into price, volume and mix factors. With responsibility resting in different places, the
segregation of the total profit variance is essential. The performance reports based on the
analysis of profit variances must be prepared for each responsibility center, indicating the
following:
1.
2.
3.
4.
5.
6.

Is it controllable?
Is it favorable or unfavorable?
If it is unfavorable, is it significant enough for further investigation?
Who is responsible for what portion of the total profit variance?
What are the causes for an unfavorable variance?
What is the remedial action to take?

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The performance report must address these types of questions. The report is
useful in two ways: (1) in focusing attention on situations in need of management action and
(2) in increasing the precision of planning and control of sales and costs. The report should
be produced as part of the overall standard costing and responsibility accounting system. A
responsibility accounting system should have certain controls that provide for feedback
reports indicating deviations from expectations. Management may then focus on those
deviations (exceptions) for reinforcement for correction.
CONCLUSION
The contribution approach attempts to measure the performance of segments of an
organization. It classifies costs as being either direct (traceable) or common to the segments.
Only those costs that are directly identified with the segments are allocated; costs that are
not direct to the segments are treated as common costs and are not allocated.
Under the contribution approach we deduct variable costs from sales to arrive at a
contribution margin. The direct fixed costs are then deducted from the contribution margin,
yielding a segment margin. The segment margin is a measure of a segment success that is
also useful for long-term planning and mix decision making.
This chapter has also been concerned with the analysis and evaluation of profit
performances. If the responsibility is to be fixed for a profit center, comparisons of targets
and attainments must be made, with the differences fully accounted for. Changes in income
traceable to volume must be separated from changes due to prices. The effect of volume
changes must be further divided to reveal the quantity factor and the mix factor.

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CHAPTER 7 QUIZ
1. The sales volume variance equals:
A. (Actual price - budget price) x actual sales.
B. (Actual cost - budget cost) x actual sales.
C. (Actual sales - budget sales) x budget cost per unit.
D. (Actual sales - budget sales) x budget price.

2. In a responsibility accounting system, a feedback report that focuses on the difference

between budgeted amounts and actual amounts is an example of
A. Management by exception.
B. Assessing blame.
C. Granting rewards to successful managers.
D. Ignoring other variables for which the budgeted goals were met.
3. For a company that produces more than one product, the sales volume variance can be
divided into sales quantity variance and sales mix variance.
True / False
4. The sales mix variance equals
A. (Actual Sales at budget mix - Actual Sales at actual mix) x Budget CM (or gross
profit / unit)
B. (Actual Sales at budget mix - Budget Sales at budget mix) x Budget CM (or gross
profit / unit)
C. Budgeted market share percentage x (actual market size in units - budgeted
market size in units) x budgeted weighted-average CM.
D. (Actual market share percentage - budgeted market share percentage) x actual
market size in units x budgeted weighted-average CM.
5. The sales volume variance equals
A. The difference between actual and budgeted volume times budget price.
B. Actual operating income minus flexible budget operating income.
C. Actual unit price minus budgeted unit price, times the actual units produced.
D. Budgeted unit price times the difference between actual inputs and budgeted
inputs for the actual activity level achieved.

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CHAPTER 7 ANSWER KEY

1. (D) is correct. The sale volume variance indicates the impact on the firm's profit of
changes in the unit sales volume. This is the amount by which sales would have varied from
the budget if nothing but sales volume had changed.
(A) is incorrect. This formula gives sales price variance.
(B) is incorrect. (Actual cost - budget cost) x actual sales is the formula for cost price
variance.
(C) is incorrect. This formula is cost volume variance.
2. (A) is correct. A responsibility accounting system should have certain controls that
provide for feedback reports indicating deviations from expectations. Management may
then focus on those deviations (exceptions) for reinforcement for correction.
(B) is incorrect. The responsibility accounting system should not be used exclusively to
assess blame. It should be used to grant rewards to high-achieving managers.
(C) is incorrect. The responsibility accounting system should not be used exclusively to
give rewards. It should be used to address red flag areas and reinforce for remedial
actions.
(D) is incorrect. Feedback reports concentrate on deviations, but not to the total exclusion
of other budgeted variables.
3. (T) is correct. The total volume variance is divided into the two: the sales mix variance
and the sales quantity variance. These two variances should be used to evaluate the
marketing department of the firm. The sales mix variance shows how well the department
has done in terms of selling the more profitable products while the sales quantity variance
measures how well the firm has done in terms of its overall sales volume. The sales
quantity variance is the change in contribution margin caused by the difference between
actual and budgeted volume, assuming that budgeted sales mix, unit variable costs and
unit sales prices are constant. Thus, it equals the sales volume variance when the sales
mix variance is zero. In a multiproduct case, a sales mix variance occurs when the sales
mix differs from that budgeted. For example, an unfavorable sales mix variance can be
caused by greater sales of a low-contribution product at the expense of lower sales of a
high-contribution product.
(F) is incorrect. The sales quantity variance is the change in contribution margin caused
by the difference between actual and budgeted volume, assuming that budgeted sales
mix, unit variable costs and unit sales prices are constant. Thus, it equals the sales
volume variance when the sales mix variance is zero.

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4. (A) is correct. When a firm produces more than one product, there is a fourth component
of the profit variance. This is the sales mix variance, the effect on profit of selling a different
proportionate mix of products than the one that has been budgeted. This variance arises
when different products have different contribution margins. For each product in the mix,
the difference between actual units sold and its budgeted percentage of the actual total
unit sales is multiplied by the budgeted CM for the product. The results are added to
determine the mix variance. An alternative is to multiply total actual units sold by the
difference between the budgeted weighted-average CM for the planned mix and that for
the actual mix.
(B) is incorrect. This formula is the sales quantity variance.
(C) is incorrect. This equation defines how the actual market size deviates from the
planned market size.
(D) is incorrect. This equation defines the market share variance.
5. (A) is correct. The sale volume variance indicates the impact on the firm's profit of
changes in the unit sales volume. This is the amount by which sales would have varied from
the budget if nothing but sales volume had changed.
(B) is incorrect because actual operating income minus flexible budget operating income
is the definition of the flexible budget variance (actual result - flexible budget amount for
the actual activity) for operating income.
(C) is incorrect because actual unit price minus budgeted unit price, times the actual units
produced, is the price variance.
(D) is incorrect because budgeted unit price times the difference between actual inputs
and budgeted inputs for the actual activity level achieved is an efficiency variance.

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CHAPTER 8
EVALUATING DIVISIONAL PERFORMANCE
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1. Compute return on investment (ROI) by means of the Du Pont formula and
show how changes in sales, expenses and assets affect the investment
center's performance.
2. Calculate the residual income (RI) and explain how it differs from ROI in
measuring divisional performance.
3. Explain how ROI and RI measures affect the division's investment decision.
The primary difference between centralization and decentralization is in the degree of
freedom of decision making by managers at many levels. In decentralization, decision
making is at as low a level as possible. The premise is that the local manager can make
more informed decisions than a centralized manager. Centralization assumes decision
making must be consolidated so that activities throughout the organization may be more
effectively coordinated. In most organizations, a mixture of these approaches is best.
The ability to measure performance is essential in developing management
incentives and controlling the operation toward the achievement of organizational goals.
A typical decentralized subunit is an investment center which is responsible for an
organization's invested capital (operating assets) and the related operating income.
There are two widely used measurements of performance for the investment center: the
rate of return on investment (ROI) and residual income (RI).
RATE OF RETURN ON INVESTMENT (ROI)
ROI relates net income to invest capital. Specifically,

ROI

Operating
income
-----------------OPERATING
ASSETS

EXAMPLE 8.1
Consider the following financial data for a division:
Operating assets
Operating income

$100,000
$18,000

ROI = $18,000/$100,000 = 18%

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The problem with this formula is that it only indicates how a division did and how well it
fared in the company. Other than that, it has very little value from the standpoint of profit
planning.
The Breakdown of ROI -- Du Pont Formula
In the past, managers have tended to focus only on the margin earned and have ignored
the turnover of assets. It is important to realize that excessive funds tied up in assets can
be just as much of a drag on profitability as excessive expenses.
The Du Pont Corporation was the first major company to recognize the importance
of looking at both margin and asset turnover in assessing the performance of an
investment center. The ROI breakdown, known as the Du Pont formula, is expressed as a
product of these two factors, as shown below.

ROI

Operating
income
---------------------Operating assets

Operating
income
---------------------Sales

Margin

Sales
x

--------------------Operating
assets

Asset
turnover

The Du Pont formula combines the income statement and balance sheet into this
otherwise static measure of performance. Margin is a measure of profitability or operating
efficiency. It is the percentage of profit earned on sales. This percentage shows how
many cents attach to each dollar of sales. On the other hand, asset turnover measures
how well a division manages its assets. It is the number of times by which the investment
in assets turns over each year to generate sales.
The breakdown of ROI is based on the thesis that the profitability of a firm is
directly related to management's ability to manage assets efficiently and to control
expenses effectively.
EXAMPLE 8.2
Assume the same data as in Example 8.1. Also assume sales of $200,000.

Then, ROI

Operating
income
----------------Operating assets

$18,000
=

--------$100,000

18%

Alternatively,

Margin

Operating
income
-----------------Sales

$18,000
=

------$200,000

9%

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Turnover

Sales
--------------Operating
assets

$200,000
-------$100,000

2 times

Therefore,
ROI

Margin

Turnover

9%

2 times

The breakdown provides a lot of insights to division managers on how to improve

profitability of the investment center.
Specifically, it has several advantages over the original formula for profit planning. They
are:
(1) Focusing on the breakdown of ROI provides the basis for integrating many of the
management concerns that influence a division's overall performance. This will help
managers gain an advantage in the competitive environment.
(2) The importance of turnover as a key to overall return on investment is emphasized in
the breakdown. In fact, turnover is just as important as profit margin in enhancing overall
return.
(3) The importance of sales is explicitly recognized, which is not there in the original
formula.
(4) The breakdown stresses the possibility of trading one off for the other in an attempt to
improve the overall performance of a company. The margin and turnover complement
each other. In other words, a low turnover can be made up for by a high margin; and vice
versa.
EXAMPLE 8.3
The breakdown of ROI into its two components shows that a number of combinations of
margin and turnover can yield the same rate of return, as shown below:
Margin
(1) 9%
(2) 6
(3) 3
(4) 2

x
x
x
x
x

Turnover
2 times
3
6
9

= ROI
= 18%
= 18
= 18
= 18

ROI AND PROFIT PLANNING

The breakdown of ROI into margin and turnover gives divisional managers insight into
planning for profit improvement by revealing where weaknesses exist: margin or turnover,
or both. Various actions can be taken to enhance ROI. Generally, they can:
Techniques for Financial Analysis, Modeling & Forecasting Page 134

1. Improve margin
2. Improve turnover
3. Improve both
Alternative 1 demonstrates a popular way of improving performance. Margins may
be increased by reducing expenses, raising selling prices, or increasing sales faster than
expenses. Some of the ways to reduce expenses are:
(a)

Use less costly inputs of materials.

(b)

Automate processes as much as possible to increase labor productivity.

(c)

Bring the discretionary fixed costs under scrutiny, with various programs either
curtailed or eliminated. Discretionary fixed costs arise from annual budgeting
decisions by management. Examples include advertising, research and
development and management development programs. The cost-benefit analysis
is called for in order to justify the budgeted amount of each discretionary program.

A division with pricing power can raise selling prices and retain profitability without
losing business. Pricing power is the ability to raise prices even in poor economic times
when unit sales volume may be flat and capacity may not be fully utilized. It is also the
ability to pass on cost increases to consumers without attracting domestic and import
competition, political opposition, regulation, new entrants, or threats of product
substitution. The division with pricing power must have a unique economic position.
Divisions that offer unique, high-quality goods and services (where the service is more
important than the cost) have this economic position.
Alternative 2 may be achieved by increasing sales while holding the investment in
assets relatively constant, or by reducing assets. Some of the strategies to reduce assets
are:
(a)

Dispose of obsolete and redundant inventory. The computer has been extremely
helpful in this regard, making perpetual inventory methods more feasible for
inventory control.

(b)

Devise various methods of speeding up the collection of receivables and also

evaluate credit terms and policies.

(c)

See if there are unused fixed assets.

(d)

Use the converted assets obtained from the use of the previous methods to repay
outstanding debts or repurchase outstanding issues of stock. The division may
release them elsewhere to get more profit, which will improve margin as well as
turnover.

Alternative 3 may be achieved by increasing sales or by any combinations of

alternatives 1 and 2.
Techniques for Financial Analysis, Modeling & Forecasting Page 135

EXAMPLE 8.4
Assume that management sets a 20 percent ROI as a profit target. It is currently making
an 18 percent return on its investment.

ROI

Operating
income
-------Sales

Operating
income
--------Operating assets

Sales
x

--------Operating
assets

Present situation:
18%

18,000
-------200,000

200,000
-------100,000

The following are illustrative of the strategies which might be used (each strategy is
independent of the other).
Alternative 1: Increase the margin while holding turnover constant. Pursuing this strategy
would involve leaving selling prices as they are and making every effort to increase
efficiency, so as to reduce expenses. By doing so, expenses might be reduced by $2,000
without affecting sales and investment to yield a 20% target ROI, as follows:
20%

20,000
------200,000

200,000
-------100,000

Alternative 2: Increase turnover by reducing investment in assets while holding net profit
and sales constant. Working capital might be reduced or some land might be sold,
reducing investment in assets by $10,000 without affecting sales and net income to yield
the 20% target ROI as follows:
20%

18,000
------200,000

200,000
-------90,000

Alternative 3: Increase both margin and turnover by disposing of obsolete and redundant
inventories or through an active advertising campaign. For example, trimming down
$5,000 worth of investment in inventories would also reduce the inventory holding charge
by $1,000. This strategy would increase ROI to 20%.

20%

19,000
------200,000

200,000
------95,000

Excessive investment in assets is just as much of a drag on profitability as excessive

expenses. In this case, cutting unnecessary inventories also helps cut down expenses of
carrying those inventories, so that both margin and turnover are improved at the same
Techniques for Financial Analysis, Modeling & Forecasting Page 136

time. In practice, alternative 3 is much more common than alternative 1 or 2.

RESIDUAL INCOME (RI)
Another approach to measuring performance in an investment center is residual income
(RI). RI is the operating income that an investment center is able to earn above some
minimum rate of return on its operating assets. RI, unlike ROI, is an absolute amount of
income rather than a specific rate of return. When RI is used to evaluate divisional
performance, the objective is to maximize the total amount of residual income, not to
maximize the overall ROI figure.
RI

Operating
income

(Minimum required rate of return x Operating

assets)

EXAMPLE 8.5
In Example 8.1, assume the minimum required rate of return is 13 percent. Then the
residual income of the division is:
$18,000

(13% x $100,000)

$18,000 - $13,000

$5,000

RI is regarded as a better of measure of performance than ROI because it

encourages investment in projects that would be rejected under ROI. A major
disadvantage of RI, however, is that it cannot be used to compare divisions of different
sizes. RI tends to favor the larger divisions due to the larger amount of dollars involved.
Residual Income and Economic Value Added
Residual income is better known as economic value added (EVA). Many firms are
addressing the issue of aligning division managers' incentives with those of the firm by
using EVA as a measure of performance. EVA encourages managers to focus on
increasing the value of the company to shareholders, because EVA is the value created
by a company in excess of the cost of capital for the investment base. Improving EVA can
be achieved in three ways:
(a)
(b)
(c)

Invest capital in high-performing projects.

Use less capital.
Increase profit without using more capital.

INVESTMENT DECISIONS UNDER ROI AND RI

The decision whether to use ROI or RI as a measure of divisional performance affect
financial managers' investment decisions. Under the ROI method, division managers
tend to accept only the investments whose returns exceed the division's ROI; otherwise,
the division's overall ROI would decrease. Under the RI method, on the other hand,
division managers would accept an investment as long as it earns a rate in excess of the
minimum required rate of return. The addition of such an investment will increase the
division's overall RI.
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EXAMPLE 8.6
Consider the same data given in Examples 8.1 and 8.2:
Operating assets
$100,000
Operating income
$18,000
Minimum required rate of return 13%
ROI = 18% and RI = $5,000
Assume that the division is presented with a project that would yield 15 percent on a
$10,000 investment. The division manager would not accept this project under the ROI
approach since the division is already earning 18 percent. Acquiring this project will bring
down the present ROI to 17.73 percent, as shown below:
Present
Operating assets (a) $100,000
Operating income
18,000
(b)
ROI (b / a)
18%

New Project
$10,000
1,500*
15%

Overall
$110,000
19,500
17.73%

*$10,00 x 15% = $1,500

Under the RI approach, the manager would accept the new project since it
provides a higher rate than the minimum required rate of return (15 percent vs. 13
percent). Accepting the new project will increase the overall residual income to $5,200, as
shown below:

Operating assets (a)

Operating income (b)
Minimum required income at 13%(c)
RI (b-c)

Present
$100,000
18,000
13,000
$5,000

New Project Overall

$10,000
$110,000
1,500
19,500
1,300*
14,300
$200
$5,200

*$10,000 x 13% = $1,300

CONCLUSION
Return on investment (ROI) and residual income (RI) are two most widely used measures
of divisional performance. Emphasis was placed on the breakdown of the ROI formula,
commonly referred to as the Du Pont formula. The breakdown formula has several
advantages over the original formula in terms of profit planning. The choice of evaluation
systems--ROI or RI--will greatly affect a division's investment decisions.

Techniques for Financial Analysis, Modeling & Forecasting Page 138

CHAPTER 8 QUIZ
1. Residual income (RI) is a performance evaluation that is used in conjunction with, or
instead of, return on investment (ROI). In many cases, residual income is preferred to ROI
because.
A. Residual income is a measure over time, while ROI represents the results for one
period.
B. Residual income concentrates on maximizing absolute dollars of income rather
than a percentage return as with ROI.
C. The imputed interest rate used in calculating residual income is more easily
derived than the target rate that is compared to the calculated ROI.
D. Average investment is employed with residual income while year-end investment
is employed with ROI.
2. The primary difference between centralization and decentralization is
A. Separate offices for all managers.
B. Geographical separation of divisional headquarters and central headquarters.
C. The extent of freedom of decision making by many levels of management.
D. The relative size of the firm.
3. Decentralized firms can delegate authority and yet retain control and monitor managers
performance by structuring the organization into responsibility centers. Which one of the
following organizational segments is most like an independent business?
A. Revenue center.
B. Profit center.
C. Cost center.
D. Investment center.
4. Residual income is a better measure for performance evaluation of an investment center
manager than return on investment (ROI) because
A. The problems associated with measuring the asset base are eliminated.
B. Desirable investment decisions will not be neglected by high-return divisions.
C. Only the gross book value of assets needs to be calculated.
D. The arguments about the implicit cost of interest are eliminated.
5. Economic value added (EVA) is a measure of managerial performance. EVA equals
A. Operating income after interest (weighted-average cost of capital x operating assets).
B. Operating income - (minimum required rate of return x operating assets)
C. Earnings before interest and taxes residual income.
D. Operating income divided by operating assets.

Techniques for Financial Analysis, Modeling & Forecasting Page 139

CHAPTER 8 ANSWER KEY

1. (B) is correct. Residual income (RI) is the operating income that an investment center is
able to earn above some minimum rate of return on its operating assets. RI, unlike ROI, is
an absolute amount of income rather than a specific rate of return. If performance is
evaluated using ROI, a manager may reject a project that exceeds the minimum return if
the project will decrease overall ROI. For example, given a target rate of 20%, a project
with an ROI of 22% might be rejected if the current ROI is 25%.
(A) is incorrect. Both RI and ROI represent the results for a single period.
(C) is incorrect. The target rate for ROI is the same as the imputed interest rate used in
the residual income calculation.
(D) is incorrect. The same investment base should be employed by both methods.
2. (C) is correct. The primary distinction is in the degree of freedom of decision making by
managers at many levels. In decentralization, decision making is at as low a level as
possible. The premise is that the local manager can make more informed decisions than a
centralized manager. Centralization assumes decision making must be consolidated so
that activities throughout the organization may be more effectively coordinated. In most
organizations, a mixture of these approaches is best.
(A) is incorrect. Whether all managers have separate offices is a trivial issue.
(B) is incorrect. Geographical separation is possible in a centralized environment.
(D) is incorrect. Relative size is a secondary factor in determining whether to centralize.
3. (D) is correct. An investment center is the organizational type most like an independent
business because it is responsible for its own revenues, costs incurred and capital
invested. The other types of centers do not incorporate all three elements.
(A) is incorrect. A revenue center is responsible only for revenue generation, not for costs
of capital investment.
(B) is incorrect. A profit center is responsible for revenues and costs but not for invested
capital.
(C) is incorrect. A cost center is evaluated only on the basis of costs incurred. It is not
responsible for revenues or investment capital.
4. (B) is correct. Residual income is the excess of the amount of the ROI over a targeted
amount equal to an imputed interest charge on investment capital. The advantage of
using residual income rather than percentage ROI is that the former emphasizes
Techniques for Financial Analysis, Modeling & Forecasting Page 140

maximizing a dollar amount instead of a percentage. Managers of divisions with a high

ROI are encouraged to accept projects with returns exceeding the cost of capital even if
those projects reduce the departments ROI.
(A) is incorrect. Residual income and return on investment employ the same asset base.
(C) is incorrect. Both residual income and return on investment use the same asset base
such as the gross book value of assets.
(D) is incorrect. Use of the residual income method requires knowledge of the cost of
capital; thus arguments about the implicit cost of interest may escalate with use of the
residual income method.
5. (B) is correct. Economic value added (EVA) is also called residual income. EVA
represents the business units true economic profit, that is, the return that could have
been obtained on the best alternative investment of similar risk. Hence, the EVA
measures the managerial benefit obtained by using resources in a particular way. It is
useful for determining whether a segment of a business is increasing shareholder value.
(A) is incorrect. Interest should not be subtracted twice. The weighted-average cost of
capital includes interest.
(C) is incorrect. EVA is residual income.
(D) is incorrect. Operating income divided by operating assets is return on assets (ROA).

Techniques for Financial Analysis, Modeling & Forecasting Page 141

CHAPTER 9
ANALYZING WORKING CAPITAL
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.

Evaluate working capital.

Give examples and explain cash management.
Manage accounts receivable.
Describe how to plan and control inventory.

Effective management of working capital (current assets less current liabilities) improves
returns and minimizes the risk that the company will run short of cash. By optimally
managing cash, receivables and inventory, a company can maximize its rate of return and
minimize its liquidity and business risk. The amount invested in each current asset may
change daily and should be monitored carefully to ensure that funds are used in the most
productive way possible. Large account balances may also indicate risk; for example,
inventory may not be salable and/or accounts receivable may not be collectible. On the
other hand, maintaining inadequate current asset levels may be costly; business may be
lost if inventory is too low.
Cash refers to currency and demand deposits; excess funds may be invested in
marketable securities. Cash management involves accelerating cash inflow and delaying
cash outflow. Accounts receivable management involves selecting customers with good
credit standing and speeding up customer collections. Inventory management involves
having the optimal order size at the right time.
EVALUATING WORKING CAPITAL
Working capital equals current assets less current liabilities. If current assets are
$6,500,000 and current liabilities are $4,000,000, working capital equals $2,500,000.
Managing working capital--regulating the various types of current assets and current
liabilities--requires making decisions on how assets should be financed (e.g., by
short-term debt, long-term debt, or equity); net working capital increases when current
assets are financed through noncurrent sources.
Managing working capital is also evaluating the trade-off between return and risk.
If funds are transferred from fixed assets to current assets, liquidity risk is reduced,
greater ability to obtain short-term financing is enhanced and the company has greater
flexibility in adjusting current assets to meet changes in sales volume. However, it also
receives reduced return, because the yield on fixed assets exceeds that of current assets.
Financing with noncurrent debt carries less liquidity risk than financing with current debt
because the former is payable over a longer time period. However, long-term debt often
has a higher cost than short-term debt because of its greater uncertainty.
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Liquidity risk may be reduced by using the hedging approach to financing, in which
assets are financed by liabilities with similar maturity. When a company needs funds to
purchase seasonal or cyclical inventory, it uses short-term financing, which gives it
flexibility to meet its seasonal needs within its ability to repay the loan. On the other hand,
the companys permanent assets should be financed with long-term debt. Because the
assets last longer, the financing can be spread over a longer time, helping to ensure the
availability of adequate funds with which to meet debt payments.
The less time it takes between purchase and delivery of goods, the less working
capital needed. For example, if the company can receive a raw material in two weeks, it
can maintain a lower level of inventory than if two months' lead time is required. You
should purchase material early if significantly lower prices are available and if the
material's cost savings exceed inventory carrying costs.
CASH MANAGEMENT
The goal of cash management is to invest excess cash for a return and at the same time
have adequate liquidity. A proper cash balance, neither excessive nor deficient, should
exist; for example, companies with many bank accounts may be accumulating excessive
balances. Proper cash forecasting is particularly crucial in a recession and is required to
determine (1) the optimal time to incur and pay back debt and (2) the amount to transfer
daily between accounts. A daily computerized listing of cash balances and transaction
reporting can let you know the up-to-date cash balance so you can decide how best to
use the funds. You should also assess the costs you are paying for banking services,
looking at each account's cost.
When cash receipts and cash payments are highly synchronized and predictable,
your company may keep a smaller cash balance; if quick liquidity is needed, it can invest
in marketable securities. Any additional cash should be invested in income producing
securities with maturities structured to provide the necessary liquidity.
Financially strong companies that are able to borrow at favorable rates, even in
difficult financial markets, can afford to keep a lower level of cash than companies that are
highly leveraged or considered poor credit risks.
At a minimum, a company should hold in cash the greater, of (1) compensating
balances (deposits held by a bank to compensate it for providing services) or (2)
precautionary balances (money held for emergency purposes) plus transaction balances
(money to cover checks outstanding). It must also hold enough cash to meet its daily
requirements. Compensating balances are either (1) an absolute minimum balance or (2)
a minimum average balance that bank customers must keep at the bank. These are
generally required by the bank to compensate for the cost of services rendered.
Maintaining compensating balances will not accelerate a company's cash inflows
because less cash will be available even though the amount of cash coming in remains
unchanged.
A number of factors go into the decision on how much cash to hold, including the
company's liquid assets, business risk, debt levels and maturity dates, ability to borrow on
short notice and on favorable terms, rate of return, economic conditions and the
Techniques for Financial Analysis, Modeling & Forecasting Page 143

possibility of unexpected problems, such as customer defaults.

Acceleration of Cash Inflow
To improve cash inflow, you should evaluate the causes of and take corrective action for
delays in having cash receipts deposited. Ascertain the origin of cash receipts, how they
are delivered and how cash is transferred from outlying accounts to the main corporate
account. Also investigate banking policy regarding availability of funds and the length of
the time lag between when a check is received and when it is deposited.
The types of delays in processing checks are: (1) "mail float," the time required for
a check to move from debtor to creditor; (2) "processing float," the time needed for the
creditor to enter the payment; and (3) "deposit collection float," the time it takes for a
check to clear.
You should try out all possible ways to accelerate cash receipts, including the use
of lockboxes, pre-authorized debits (PADs), wire transfers and depository transfer
checks.
-- Lockbox. A lockbox represents a way to place the optimum collection point near
customers. Customer payments are mailed to strategic post office boxes geographically
situated to reduce mailing and depositing time. Banks make collections from these boxes
several times a day and deposit the funds to the corporate account. They then prepare a
computer listing of payments received by account and a daily total, which is forwarded to
the corporation.
To determine the effectiveness of using a lockbox, you should determine the
average face value of checks received, the cost of operations eliminated, reducible
processing overhead and the reduction in "mail float" days. Because per-item processing
costs for lockboxes is typically significant, it makes the most sense to use one for
low-volume, high-dollar collections. However, businesses with high-volume, low-dollar
receipts are using them more and more as technological advances lower their per-item
cost.
Wholesale lockboxes are used for checks received from other companies. As a rule, the
average dollar cash receipts are large and the number of cash receipts is small. Many
wholesale lock boxes result in mail time reductions of no more than one business day and
check-clearing time reductions of only a few tenths of one day. They are therefore most
useful for companies that have gross revenues of at least several million dollars and that
receive large checks from distant customers.
A retail lockbox is the best choice if the company deals with the public (retail customers
as distinguished from companies). Retail lockboxes typically receive many transactions of
nominal amounts. The lockbox reduces float and transfers workload from the company to
the bank, resulting in improved cash flow and reduced expenses.
-- Return Envelopes. Providing return envelopes can accelerate customer remissions. On
the return envelope, you can use bar codes, nine-digit code numbers, or post office box
numbers. Another option is Accelerated Reply Mail (ARM), in which a unique "truncating"
ZIP code is assigned to payments such as lockbox receivables. The coded remittances
are removed from the postal system and processed by banks or third parties.
Techniques for Financial Analysis, Modeling & Forecasting Page 144

-- Pre-Authorized Debits. Cash from customers may be collected faster if you obtain
permission from customers to have pre-authorized debits (PADs) automatically charged
to the customers bank accounts for repetitive charges. This is a common practice among
insurance companies, which collect monthly premium payments via PADs. These debits
may take the form of paper pre-authorized checks (PACs) or paperless automatic
clearing house entries. PADs are cost-effective because they avoid the process of billing
the customer, receiving and processing the payment and depositing the check. Using
PADs for variable payments is less efficient because the amount of the PAD must be
changed each period and the customer generally must be advised by mail of the amount
of the debit. PADs are most effective when used for constant, relatively nominal periodic
payments.
-- Wire Transfers. To accelerate cash flow, you may transfer funds between banks by wire
transfers through computer terminal and telephone. Such transfers should be used only
for significant dollar amounts because wire transfer fees are assessed by both the
originating and receiving banks. Wire transfers are best for intraorganization transfers,
such as transfers to and from investments, deposits to an account made the day checks
are expected to clear and deposits made to any other account that requires immediate
availability of funds. They may also be used to fund other types of checking accounts,
such as payroll accounts. In order to avoid unnecessarily large balances in the account,
you may fund it on a staggered basis. However, to prevent an overdraft, you should make
sure balances are maintained in another account at the bank.
There are two types of wire transfers--preformatted (recurring) and free-form
(nonrepetitive). Recurring transfers do not involve extensive authorization and are
suitable for ordinary transfers in which the company designates issuing and receiving
banks and provides its account number. Nonrecurring transfers require greater control,
including written confirmations instead of telephone or computer terminal confirmations.
-- Depository Transfer Checks (DTCs). Paper or paperless depository checks may be
used to transfer funds between the company's bank accounts. They do not require a
signature, since the check is payable to the bank for credit to the company's account.
DTCs typically clear in one day. Manual DTCs are preprinted checks that include all
information except the amount and date; automated DTCs are printed as needed. It is
usually best to use the bank's printer since it is not cost-effective for the company to
purchase a printer. Automatic check preparation is advisable only for companies that
must prepare a large number of transfer checks daily.
There are other ways to accelerate cash inflow. You can send bills to customers
sooner than is your practice, perhaps immediately after the order is shipped. You can also
require deposits on large or custom orders or submit progress billings as the work on the
order progresses. You can charge interest on accounts receivable that are past due and
offer cash discounts for early payment; you can also use cash-on-delivery terms. In any
event, you should deposit checks immediately.
EXAMPLE 9.1
C Corporation obtains average cash receipts of $200,000 per day. It usually takes five
days from the time a check is mailed until the funds are available for use. The amount tied
up by the delay is:
Techniques for Financial Analysis, Modeling & Forecasting Page 145

5 days

$200,000

1,000,000

You can also calculate the return earned on the average cash balance.
EXAMPLE 9.2
A company's weekly average cash balances are as follows:
Week
1
2
3
4
Total

Average Cash
Balance
$12,000
17,000
10,000
15,000
$54,000

The weekly average cash balance is:

$54,000
= $13,500
4
If the annual interest rate is approximately 12 percent, the monthly return earned on the
average cash balance is:
0.12
= $135
$13,500 x
12
If you are thinking of establishing a lockbox to accelerate cash inflow, you will need to
determine the maximum monthly charge you will incur for the service.
EXAMPLE 9.3
It takes Travis Corporation about seven days to receive and deposit payments from
customers. Therefore, it is considering establishing a lockbox system. It expects the
system to reduce the float time to five days. Average daily collections are $500,000. The
rate of return is 12 percent.
The reduction in outstanding cash balances arising from implementing the lockbox
system is:
2 days x $500,000 = $1,000,000
The return that could be earned on these funds in a year is:
$1,000,000 x 0.12 = $120,000
The maximum monthly charge the company should pay for this lockbox arrangement is
therefore:

$120,000
= $10,000
12
Techniques for Financial Analysis, Modeling & Forecasting Page 146

You should compare the return earned on freed cash to the cost of the lockbox
arrangement to determine if using the lockbox is financially advantageous.
EXAMPLE 9.4
A company's financial officer is determining whether to initiate a lockbox arrangement that
will cost $150,000 annually. The daily average collections are $700,000. Using a lockbox
will reduce mailing and processing time by two days. The rate of return is 14%.
Annual return on freed cash (14% x 2 x $700,000) $196,000
Annual cost
$150,000
Net advantage of lockbox system
$46,000

Sometimes you need to determine whether to switch banks in order to lower the overall
costs associated with a lockbox arrangement.
EXAMPLE 9.5
You now have a lockbox arrangement in which Bank A handles $5 million a day in return
for an $800,000 compensating balance. You are thinking of canceling this arrangement
and further dividing your western region by entering into contracts with two other banks.
Bank B will handle $3 million a day in collections with a compensating balance of
$700,000 and Bank C will handle $2 million a day with a compensating balance of
$600,000. Collections will be half a day quicker than they are now. Your return rate is
12%.
Accelerated cash receipts
($5 million per day x 0.5 day)
Increased compensating
balance
Improved cash flow
Rate of return
Net annual savings

$2,500,000
500,000
$2,000,000
x 0.12
$240,000

Delay of Cash Outlay

Delaying cash payments can help your company earn a greater return and have more
cash available. You should evaluate the payees and determine to what extent you can
reasonably stretch time limits without incurring finance charges or impairing your credit
rating.
There are many ways to delay cash payments, including centralizing payables,
having zero balance accounts and paying by draft.
-- Centralize Payables. You should centralize your company's payable operation--that is,
make one center responsible for making all payments--so that debt may be paid at the
most profitable time and so that the amount of disbursement float in the system may be
ascertained.
-- Zero Balance Account (ZBA). Cash payments may be delayed by maintaining zero
balance accounts in one bank in which you maintain zero balances for all of the
Techniques for Financial Analysis, Modeling & Forecasting Page 147

company's disbursing units with funds being transferred in from a master account as
needed. The advantages of ZBAs are that they allow better control over cash payments
and reduced excess cash balances in regional banks. Using ZBAs is an aggressive
strategy that requires the company to put funds into its payroll and payables checking
accounts only when it expects checks to clear. However, watch out for overdrafts and
service charges.
-- Drafts. Payment drafts are another strategy for delaying disbursements. With a draft,
payment is made when the draft is presented for collection to the bank, which in turn goes
to the issuer for acceptance. When the draft is approved, the company deposits the funds
to the payee's account. Because of this delay, you can maintain a lower checking balance.
Banks usually impose a charge for drafts and you must endure the inconveniences of
formally approving them before payment. Drafts can provide a measure of protection
against fraud and theft because they must be presented for inspection before payment.
-- Delay in Mail. You can delay cash payment by drawing checks on remote banks (e.g., a
New York company might use a Texas bank), thus ensuring that checks take longer to
clear. You may also mail checks from post offices that offer limited service or at which
mail must go through numerous handling points. If you utilize the mail float properly, you
can maintain higher actual bank balances than book balances. For instance, if you write
checks averaging $200,000 per day and they take three days to clear, you will have
$600,000 ($200,000 x 3) in your checking account for those three days, even though the
money has been deducted in your records.
-- Check Clearing. You can use probability analysis to determine the expected date for
checks to clear. Probability is defined as the degree of likelihood that something will
happen and is expressed as a percentage from 0 to 100. For example, it's likely that not
all payroll checks are cashed on the payroll date, so you can deposit some funds later and
earn a return until the last minute.
-- Delay Payment to Employees. You can reduce the frequency of payments to
employees (e.g., expense account reimbursements, payrolls); for example, you can
institute a monthly payroll rather than a weekly one. In this way, you have the use of the
cash for a greater time period. You can also disburse commissions on sales when the
receivables are collected rather than when sales are made. Finally, you can utilize
noncash compensation and remuneration methods (e.g., distribute stock instead of
bonuses).
Other ways exist to delay cash payments. Instead of making full payment on an
invoice, you can make partial payments. You can also delay payment by requesting
additional information about an invoice from the vendor before paying it. Another strategy
is to use a charge account to lengthen the time between when you buy goods and when
you pay for them. In any event, never pay a bill before its due date.
EXAMPLE 9.6
Every two weeks the company disburses checks that average $500,000 and take three
days to clear. You want to find out how much money can be saved annually if the transfer
of funds is delayed from an interest-bearing account that pays 0.0384 percent per day
Techniques for Financial Analysis, Modeling & Forecasting Page 148

(annual rate of 14 percent) for those three days.

$500,000

(0.000384 x 3)

$576

The savings per year is $576 x 26 (yearly payrolls)

14,976
=

CASH MODELS
A number of mathematical models have been developed to assist the financial manager
in distributing a company's funds so that they provide a maximum return to the company.
A model developed by William Baumol can determine the optimum amount of cash for a
company to hold under conditions of certainty. The objective is to minimize the sum of the
fixed costs of transactions and the opportunity cost (return forgone) of holding cash
balances that do not yield a return. These costs are expressed as
F*

(T )
(C )
+i
C
2
where F
T

=
=

i
C
C*

=
=
=

the fixed cost of a transaction

the total cash needed for the time period
involved
the interest rate on marketable securities
cash balance
optimal level of cash

The optimal level of cash is determined using the following formula:

C* =

2FT
i

EXAMPLE 9.7
You estimate a cash need for $4,000,000 over a one-month period during which the cash
account is expected to be disbursed at a constant rate. The opportunity interest rate is 6
percent per annum, or 0.5 percent for a one-month period. The transaction cost each time
you borrow or withdraw is $100.
The optimal transaction size (the optimal borrowing or withdrawal lot size) and the
number of transactions you should make during the month follow:

C* =

2FT
2(100)(4,000,000)
=
= $400,000
i
0.005

The optimal transaction size is $400,000.

Techniques for Financial Analysis, Modeling & Forecasting Page 149

The average cash balance is:

C*
2

$400,000
2

$200,000

The number of transactions required is:

4,000,000
$400,000

10 transactions during the

month.

There is also a model for cash management when cash payments are uncertain. The
Miller-Orr model places upper and lower limits on cash balances. When the upper limit is
reached, a transfer of cash to marketable securities is made; when the lower limit is
reached, a transfer from securities to cash occurs. No transaction occurs as long as the
cash balance stays within the limits.
Factors taken into account in the Miller-Orr model are the fixed costs of a securities
transaction (F), assumed to be the same for buying as well as selling; the daily interest
rate on marketable securities (i); and the variance of daily net cash flows (2 )--( is
sigma). The objective is to meet cash requirements at the lowest possible cost. A major
assumption of this model is the randomness of cash flows. The control limits in the Miller-Orr model are "d" dollars as an upper limit and zero dollars at the lower limit. When the
cash balance reaches the upper level, d less z dollars (optimal cash balance) of securities
are bought and the new balance becomes z dollars. When the cash balance equals zero,
z dollars of securities are sold and the new balance again reaches z. Of course, in
practice the minimum cash balance is established at an amount greater than zero
because of delays in transfer; the higher minimum in effect acts as a safety buffer.
The optimal cash balance z is computed as follows:
2
3 3F
Z = 4i

The optimal value for d is computed as 3z.

(z + d )
The average cash balance approximates
.
3
EXAMPLE 9.8
You wish to use the Miller-Orr model. The following information is supplied:
Fixed cost of a securities transaction
Variance of daily net cash flows
Daily interest rate on securities
(10%/360)

$10
$50
0.000277

The optimal cash balance, the upper limit of cash needed and the average cash
balance follow:

Techniques for Financial Analysis, Modeling & Forecasting Page 150

3(10)(50)
=
4(0.000277)
= $108

z=

3(10)(50) 3 1,500
=
=
0.001108
0.001108

1,353,790

The optimal cash balance is $108; the upper limit is $324 (3 x $108); and the
($108 + $324)
average cash balance is $144
.
3
When the upper limit of $324 is reached, $216 of securities ($324 - $108) will be
purchased to bring the account to the optimal cash balance of $108. When the lower limit
of zero dollars is reached, $108 of securities will be sold to again bring it to the optimal
cash balance of $108.
MANAGEMENT OF ACCOUNTS RECEIVABLE
Accounts receivable management directly impacts the profitability of the firm. It includes
determining discount policy and credit policy for marginal customers, investigating ways
of speeding up collections and reducing bad debts and setting terms of sale to assure
ultimate collection.
As part of accounts receivable management, you should appraise order entry,
billing and accounts receivable activities to be sure that proper procedures are being
followed from the time an order is received until ultimate collection. Among the points to
consider is how the average time lag between completing the sales transaction and
invoicing the customer can be reduced. You should also consider the opportunity cost of
holding receivables, that is, the return lost by having funds tied up in accounts receivable
instead of invested elsewhere.
Accounts receivable management involves two types of float--invoicing and mail.
Invoicing float is the number of days between the time goods are shipped to the customer
and the time the invoice is sent out. Obviously, the company should mail invoices on a
timely basis. Mail float is the time between the preparation of an invoice and the time it is
received by the customer. Mail float may be reduced by decentralizing invoicing and
mailing, coordinating outgoing mail with post office schedules, using express mail
services for large invoices, enforcing due dates and offering discounts for early payment.
Credit Policies
A key concern in accounts receivable management is determining credit terms to be
given to customers, which affects sales volume and collections. For example, offering
longer credit terms will probably increase sales. Credit terms have a direct bearing on the
costs and revenue generated from receivables. If credit terms are tight, the company will
have a lower investment in accounts receivable and incur fewer bad-debt losses, but it
may also experience lower sales, reduced profits and adverse customer reaction. On the
other hand, if credit terms are lax, the company may enjoy higher sales and gross profit,
but it risks increased bad debts and a higher opportunity cost of carrying the investment in
accounts receivable because marginal customers take longer to pay. Receivable terms
should be liberalized when you want to get rid of excessive inventory or obsolete items or
if you operate in an industry in which products are sold in advance of retail seasons (e.g.,
swimsuits). If your products are perishable, you should impose short receivable terms and
Techniques for Financial Analysis, Modeling & Forecasting Page 151

possibly require payment on delivery.

In evaluating a potential customer's ability to pay, consider the customer's integrity,
financial soundness and collateral. A customer's credit soundness may be appraised
through quantitative techniques such as regression analysis, which examines the change
in a dependent variable that occurs as an independent (explanatory) variable changes.
Such techniques are particularly useful when you need to evaluate a large number of
small customers. You should be able to estimate bad debt losses reliably if your company
sells to many customers and has not changed its credit policies for a long time.
Keep in mind that extending credit involves additional expenses--the
administrative costs of operating the credit department; computer services; and fees paid
to rating agencies.
You may find it useful to obtain references from retail credit bureaus and
professional credit reference services as part of your customer credit evaluation. Dun and
Bradstreet (D&B) reports contain information about a company's nature of business,
product line, management, financial statements, number of employees, previous
payment history as reported by suppliers, current debts, including any past due, terms of
sale, audit opinion, lawsuits, insurance coverage, leases, criminal proceedings, banking
relationships and account information (e.g., current bank loans), location and seasonal
fluctuations, if applicable.
Monitoring Receivables
There are many ways to maximize profitability from accounts receivable and keep losses
to a minimum. These include proper billing, factoring and evaluating the customers'
financial health.
-- Billing. Cycle billing, in which customers are billed at different time periods, can smooth
out the billing process. In such a system, customers with last names starting with A may
be billed on the first of the month, those with last names beginning with B on the second
day and so on. Customer statements should be mailed within twenty-four hours of the
close of the billing period.
To speed up collections, you can send invoices to customers when their order is
processed at the warehouse instead of when the merchandise is shipped. You can also
bill for services at intervals when work is performed over a period of time or charge a
retainer, rather than receiving payment when the work is completed. In any event, you
should bill large sales immediately.
When business is slow, seasonal datings, in which you offer delayed payment
terms to stimulate demand from customers who are unable to pay until later in the season,
can be used.
-- Customer Evaluation Process. Before giving credit, carefully analyze customer financial
statements and obtain ratings from financial advisory services. Try to avoid high-risk
receivables, such as customers who are in a financially troubled industry or region. Be
careful of customers who have been in business less than one year since about 50
Techniques for Financial Analysis, Modeling & Forecasting Page 152

percent of businesses fail within the first two years. As a rule, consumer receivables carry
a greater risk of default than do corporate receivables. You should modify credit limits and
accelerate collections based on changes in a customer's financial health; you may want
to withhold products or services until payments are made and ask for collateral in support
of questionable accounts (the collateral value should equal or exceed the account
balance). If necessary, you can use outside collection agencies to try to collect from
recalcitrant customers.
You should age accounts receivable (that is, rank them by the time elapsed since
they were billed) to spot delinquent customers and charge interest on late payments. After
you compare current aged receivables to those of prior years, industry norms and the
competition's, you can prepare a Bad Debt Loss Report showing cumulative bad debt
losses by customer, terms of sale and size of account and then summarized by
department, product line and type of customer (e.g., industry). Bad debt losses are
typically higher for smaller companies than for larger ones.
-- Insurance Protection. You may want to have credit insurance to guard against unusual
bad debt losses. In deciding whether to acquire this protection, consider expected
average bad debt losses the company's financial ability to withstand the losses and the
cost of insurance.
-- Factoring. Factor (sell) accounts receivable if that results in a net savings. However,
you should realize that confidential information may be disclosed in a factoring
transaction. (Factoring is discussed in Chapter 13.)
Credit Policy
In granting trade credit, you should consider your competition and current economic
conditions. In a recession, you may want to relax your credit policy in order to stimulate
additional business. For example, the company may not rebill customers who take a cash
discount even after the discount period has elapsed. On the other hand, you may decide
to tighten credit policy in times of short supply, because at such times your company as
the seller has the upper hand.
DETERMINING THE INVESTMENT IN ACCOUNTS RECEIVABLE
To determine the dollar investment tied up in accounts receivable, use a computation that
takes into account the annual credit sales and the length of time receivables are
outstanding.
EXAMPLE 9.9
A company sells on terms of net/30, meaning payment is required within 30 days. The
accounts are on average 20 days past due. Annual credit sales are $600,000. The
investment in accounts receivable is:
50
x $600,000 = $83,333.28
360
The investment in accounts receivable represents the cost tied up in those
receivables, including both the cost of the product and the cost of capital.
Techniques for Financial Analysis, Modeling & Forecasting Page 153

EXAMPLE 9.10
The cost of a product is 30 percent of selling price and the cost of capital is 10 percent of
selling price. On average, accounts are paid four months after sale. Average sales are
$70,000 per month.
The investment in accounts receivable from this product is
Accounts receivable (4 months x $70,000)

$280,000

Investment in accounts receivable [$280,000 x (0.30 + 0.10)]

112,000

EXAMPLE 9.11
Accounts receivable are $700,000. The average manufacturing cost is 40% of the selling
price. The before-tax profit margin is 10%. The carrying cost of inventory is 3% of selling
price. The sales commission is 8% of sales. The investment in accounts receivable is:
$700,000 (0.40 + 0.03 + 0.08) = $700,000 (0.51) = $357,000
The average investment in accounts receivable may be computed by multiplying
the average accounts receivable by the cost/selling price ratio.
EXAMPLE 9.12
If a company's credit sales are $120,000, the collection period is 60 days and the cost is
80% of sales price, what is (a) the average accounts receivable balance and (b) the
average investment in accounts receivable?
360
=6
Accounts receivable turnover =
60
Average accounts receivable =

Credit sales $120,000

=
= $20,000
Turnover
6

Average invest in account receivable

$20,000 x 0.8 = $16,000

DISCOUNT POLICY
In order to determine if customers should be offered a discount on the early payment of
account balances, the financial manager has to compare the return on freed cash
resulting from customers paying sooner to the cost of the discount.
EXAMPLE 9.13
The following data are provided:
Current annual credit sales
Collection period
Terms
Minimum rate of return

$14,000,000
3 months
net/30
15%

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The company is considering offering a 3/10, net/30 discount (that is, if the
customer pays within 10 days of the date of sale, the customer will receive a 3% discount.
If payment is made after l0 days, no discount is offered. Total payment must be made
within 30 days.) The company expects 25 percent of the customers to take advantage of
the discount. The collection period will decline to two months.
The discount should be offered, as indicated in the following calculations:
Advantage of discount
Increased profitability:
Average account receivable balance before a change in policy
Credit sales
$14,000,000
= $3,500,000
Accounts receivable turnover 12 3 = 4
Average accounts receivable balance after change in policy
$14,000,000
Credit sales
= $2,333,333
Average receivable turnover 12 2 = 6
Reduction in average accounts receivable
balance
Rate of return
Return

$1,116,667
x .15
$ 175,000

Disadvantage of discount
Cost of the discount 0.03 x 0.25 x
$14,000,000
Net advantage of discount

$ 105,000
$ 70,000

Changing Credit Policy

To decide whether the company should give credit to marginal customers, you need to
compare the earnings on the additional sales obtained to the added cost of the
receivables. If the company has idle capacity, the additional earnings is the contribution
margin on the new sales, since fixed costs are constant. The additional cost of the
receivables results from the likely increase in bad debts and the opportunity cost of tying
up funds in receivables for a longer time period.
EXAMPLE 9.14
Sales price per unit
Variable cost per
unit
Fixed cost per unit
Annual credit sales
Collection period
Minimum return

$120
80
15
$600,000
1 month
16%

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If you liberalize the credit policy, you project that

-- Sales will increase by 40%.
-- The collection period on total accounts will increase to two months.
-- Bad debts on the increased sales will be 5%.
Preliminary calculations:
Current units
($600,000/$120)

5,000

Additional units (5,000 x 0.4) 2,000

Advantage of the change in policy

Additional profitability:
Incremental sales volume 2,000
units

Contribution margin per unit

(Selling price - variable cost)

$120 - $80

$40

Incremental profitability $80,000

Disadvantage of the change in policy
Incremental bad debts:
Incremental units x Selling price (2,000 x
$120)
Bad debt percentage
Additional bad debts

$240,000
x 0.05
$ 12,000

The first step in determining the opportunity cost of the investment tied up in accounts
receivable is to compute the new average unit cost as follows:
Current units
Additional units
Total

New average unit cost =

Units
5,000
2,000
7,000

x
x
x

Unit Cost
$95
$80

=
=
=

Total Cost
$475,000
160,000
$635,000

Total cost
$635,000
=
= $90.71
Units
7 ,000

Note that at idle capacity, fixed cost remains constant; therefore, the incremental cost is
only the variable cost of $80 per unit. Therefore, the average unit cost will drop.
We now compute the opportunity cost of funds placed in accounts receivable:
Average investment in accounts receivable after change in policy:
Techniques for Financial Analysis, Modeling & Forecasting Page 156

Credit sales
-------Accounts receivable
turnover
$840,000@
-----x
6
@7,000 units x

Unit cost
---------Selling price

$90.71
----$120

$105,828

$120

$840,000

Current average investment in accounts receivable:

$600,000
-----12

$95
--$120

39,583

Additional investment in accounts

receivable
Minimum return
Opportunity cost of funds tied up

$66,245
x 0.16
$10,599

Net advantage of relaxation in credit standards:

Additional earnings

$80,000

Less:
Additional bad debt
losses
Opportunity cost
Net savings

$12,000
10,599

-22,599
$57,401

The company may have to decide whether to extend full credit to presently limited
credit customers or no-credit customers. Full credit should be given only if net profitability
occurs.
EXAMPLE 9.15
Category Bad Debt
Percentage
X
2%
Y
5%
Z
30%

Collection
Period
30 days
40 days
80 days

Credit
Policy
Unlimited
Restricted
No credit

Increase in Annual Sales if

Credit Restrictions are Relaxed
$80,000
600,000
850,000

Gross profit is 25 percent of sales. The minimum return on investment is 12%.

As you decide whether credit standards should be loosened, consider the gross
profit on increased sales versus the opportunity cost associated with higher receivable
balances and collection expenses.
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EXAMPLE 9.16
You are considering liberalizing the credit policy to encourage more customers to
purchase on credit. Currently, 80 percent of sales are on credit and there is a gross
margin of 30 percent. The return rate on funds is 10 percent. Other relevant data are:

Sales
Credit sales
Collection expenses
Accounts receivable turnover

Currently
$300,000
240,000
4% of credit sales
4.5

Proposal
$450,000
360,000
5% of credit sales
3

An analysis of the proposal yields the following results:

Gross profit:
Expected increase in credit sales $360,000 - $240,000
Gross profit rate
Increase in gross profit
Opportunity cost:
Average accounts receivable balance
(credit sales/accounts receivable turnover)
Expected average accounts receivable $360,000/3
Current average accounts receivable $240,000/4.5
Increase in average accounts receivable
Return rate
Opportunity cost of funds tied up in accounts receivable
Collection expenses:
Expected collection expenses 0.05 x $360,000
Current collection expenses 0.04 x $240,000
Increase in collection expenses
You would profit from a more liberal credit policy as
follows:
Increase in gross profit
Opportunity cost in accounts receivable
Increase in collection expenses
Net advantage

$120,000
x .30
$36,000

$120,000
53,333
$66,667
x 10%
$6,667
$18,000
9,600
$8,400
$36,000
(6,667)
(8,400)
$20,933

To determine whether it is advantageous to engage in a sales campaign, you

should consider the gross margin earned, the sales discount and the opportunity cost of
higher receivable balances.
EXAMPLE 9.17
The company is planning a sales campaign in which it will offer credit terms of 3/10,
net/45. It expects the collection period to increase from sixty days to eighty days.
Relevant data for the contemplated campaign follow:

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Cash sales
Payment from (in
days)
1-10
11-100

Percent of Sales
Before
Campaign
40%

Percent of Sales
During
Campaign
30%

25
35

55
15

The proposed sales strategy will probably increase sales from $8 million to $10
million. There is a gross margin rate of 30%. The rate of return is 14%. Sales discounts
are given on cash sales.

The company should undertake the sales campaign, because earnings will
increase by $413,889 ($2,527,222 - $2,113,333).
INVENTORY MANAGEMENT
The purpose of inventory management is to develop policies that will achieve an optimal
inventory investment. This level varies among industries and among companies in a
given industry. Successful inventory management minimizes inventory, lowers cost and
improves profitability.
As part of this process, you should appraise the adequacy of inventory levels,
which depend on many factors, including sales, liquidity, available inventory financing,
production, supplier reliability, delay in receiving new orders and seasonality. In the event
you have slow-moving products, you may wish to consider discarding them at lower
prices to reduce inventory carrying costs and improve cash flow.
You should try to minimize the lead time in your company's acquisition,
manufacturing and distribution functions--that is, how long it takes to receive the
merchandise from suppliers after an order is placed. Depending upon lead times, you
may need to increase inventory or alter the purchasing pattern. Calculate the ratio of the
value of outstanding orders to average daily purchases to indicate the lead time for
receiving orders from suppliers; this ratio indicates whether you should increase the
inventory balance or change your buying pattern.
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You must also consider the obsolescence and spoilage risk of inventory. For
example, technological, perishable, fashionable, flammable and specialized goods
usually have high salability risk, which should be taken into account in computing desired
inventory levels.
Inventory management involves a trade-off between the costs of keeping inventory
and the benefits of holding it. Different inventory items vary in profitability and the amount
of space they take up and higher inventory levels result in increased costs for storage,
casualty and theft insurance, spoilage, property taxes for larger facilities, increased
staffing and interest on funds borrowed to finance inventory acquisition. On the other
hand, an increase in inventory lowers the possibility of lost sales from stockouts and the
production slowdowns caused by inadequate inventory. Additionally, large volume
purchases result in greater purchase discounts.
Inventory levels are also affected by short-term interest rates. As short-term
interest rates increase, the optimum level of holding inventory is reduced.
You may have to decide whether it is more profitable to sell inventory as is or to sell
it after further processing. For example, assume inventory can be sold as is for $40,000 or
for $80,000 if it is put into further processing costing $20,000. The latter should be
selected because the additional processing yields a $60,000 profit, compared to $40,000
for the current sale.
Quantity Discount
You may be entitled to a quantity discount when purchasing large orders. The discount
reduces the cost of materials.
EXAMPLE 9.18
A company purchases 1,000 units of an item having a list price of $10 each. The quantity
discount is 5 percent. The net cost of the item is:
Acquisition cost (1,000 x $10)
Less: Discount (0.05 x
$10,000)
Net cost

$10,000
500
$ 9,500

Investment in Inventory
You should consider the average investment in inventory, which equals the average
inventory balance times the per unit cost.
EXAMPLE 9.19
Savon Company places an order for 5,000 units at the beginning of the year. Each unit
costs $10. The average investment is:
Average inventory
(a)
Unit cost, $
Average investment

2,500 units
x $10
$25,000

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(a)

Quantity(Q) 5,000
=
2
2

To get an average, add the beginning balance and the ending balance and then divide by
2. This gives the mid-value.
The more frequently a company places an order, the lower the average investment.
Determining Carrying and Ordering Costs
You want to determine the costs for planning, financing, record keeping and control
associated with inventory. Once inventory costs are known, you can compute the amount
of timeliness of financing.
Inventory carrying costs include warehousing, handling, insurance, property taxes
and the opportunity cost of holding inventory. A provisional cost for spoilage and
obsolescence should also be included in the analysis. The more the inventory held, the
greater the carrying cost. Carrying cost equals:
Q
xC
Carrying Cost =
2
Where

represents average quantity and C is the carrying cost per unit.

A knowledge of inventory carrying costs will help you determine which items are
worth storing.
Inventory ordering costs are the costs of placing an order and receiving the
merchandise. They include freight and the clerical costs incurred in placing the order. To
minimize ordering you should enter the fewest number of orders possible. In the case of
produced items, ordering cost also includes scheduling cost. Ordering cost equals:
S
Ordering Cost =
xP
Q
Where S = total usage, Q = quantity per order and P = cost of placing an order.
The total inventory cost is therefore:
QC SP
+
2
C
A knowledge of ordering costs helps you decide how many orders you should
place during the period to suit your needs.
A tradeoff exists between ordering and carrying costs. A large order quantity
increases carrying costs but lowers ordering cost.
The economic order quantity (EOQ) is the optimum amount of goods to order each
time to minimize total inventory costs. EOQ analysis should be applied to every product
that represents a significant proportion of sales.
EOQ =

2SP
C

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The EOQ model assumes:

-- Demand is constant and known with certainty.
-- Depletion of stock is linear and constant.
-- No discount is allowed for quantity purchases.
-- Lead time, the time interval between placing an order and receiving delivery, is a
constant (that is, stockout is not possible).
The number of orders for a period is the usage (S) divided by the EOQ.
In the next two examples, we compute for a product the EOQ, the number of
orders and the number of days that should elapse before the next order is placed.
EXAMPLE 9.20
You want to know how frequently to place orders to lower your costs. The following
information is provided:
S
P
C

EOQ =

=
=
=

500 units per month

$40 per order
$4 per unit

2SP
2(500)(40)
=
= 10,000 =100 units
C
4

The number of orders each month is:

S
500
=
=5
EOQ 100

Therefore, an order should be placed about every six days (31/5).

EXAMPLE 9.21
A company is determining its frequency of orders for product X.
Each product X
costs $15. The annual carrying cost is $200. The ordering cost is $10. The company
anticipates selling 50 product Xs each month. Its desired average inventory level is 40.
S = 50 x 12 = 600
P = $10
C=

Purchase price x carrying cost $15x$200

=
= $5
Average investment
40x$15

EOQ =

2SP
=
C

2( 600)(10)
=
5

12,000
=
5

2,400 = 49 (rounded)

Techniques for Financial Analysis, Modeling & Forecasting Page 162

The number of orders per year is:

600
S
=
= 12 orders (rounded)
49
EOQ
The company should place an order about every thirty days (365/12).
The Reorder Point
The reorder point (ROP) is a signal that tells you when to place an order. Calculating the
reorder point requires a knowledge of the lead time between order and receipt of
merchandise. It may be influenced by the months of supply or total dollar ceilings on
inventory to be held or inventory to be ordered.
Reorder point is computed as follows:
ROP = lead time x average usage per unit of time
This reveals the inventory level at which a new order should be placed. If a safety
stock is needed, add to the ROP.
You have to know at what inventory level you should place an order to reduce
inventory costs and have an adequate stock of goods with which to satisfy customer
orders.
EXAMPLE 9.22
A company needs 6,400 units evenly throughout the year. There is a lead time of one
week. There are 50 working weeks in the year. The reorder point is:
1 week x

6,400
= 1 128 = 128 units
50 weeks

When the inventory level drops to 128 units, a new order should be placed.
An optimal inventory level can be based on consideration of the incremental
profitability resulting from having more merchandise compared to the opportunity cost of
carrying the higher inventory balances.
EXAMPLE 9.23
The current inventory turnover is 12 times. Variable costs are 60 percent of sales. An
increase in inventory balances is expected to prevent stockouts, thus increasing sales.
Minimum rate of return is 18 percent. Relevant data include:
Sales
$800,000
890,000
940,000
980,000

Turnover
12
10
8
7

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(3)
[(1)/(2)]
Average
Inventory
Balance
$66,667

(4)
Opportunity Cost of
Carrying Incremental
Inventory (a)
----

(1)
(2)
Sales
Turnover
$800,00 12
0
890,000 10
89,000
$4,020
940,000 8
117,500
5,130
980,000 7
140,000
4,050
(a) Increased inventory from column 3 x 0.18
(b) Increased sales from column 1 x 0.40

(5)
Increased
Profitability
(b)
----

(6)
[(5)-(4)]
Net Savings
----

36,000
20,000
16,000

14,870
14,870
11,950

The optimal inventory level is $89,000, because it results in the highest net
savings.
Control of Stockouts
It is desirable to minimize both the cost of carrying safety stock and the costs of running
out of an item, i.e., of stockouts. Safety stock is the amount of extra stock that is kept to
guard against stockouts. It is the inventory level at the time of reordering minus the
expected usage while the new goods are in transit. Delivery time, usage rate and level of
safety stock are therefore considerations in controlling stockouts.
Safety stocks protect against the losses caused by stockouts. These can take
the form of lost sales or lost production time. Safety stock is necessary because of the
variability in lead time and usage rates. As the variability of lead time increases, that is, as
the standard deviation of the probability distribution of lead times increases, the risk of a
stockout increases and a company will tend to carry larger safety stocks.
CONCLUSION
To maximize cash flow, cash collections should be accelerated and cash payments
delayed. Accounts receivable management requires decisions on whether to give credit
and to whom, the amount to give and the terms. The proper amount of investment in
inventory may change daily and requires close evaluation. Improper inventory
management occurs when funds tied up in inventory can be used more productively
elsewhere. A buildup of inventory may carry risk, such as obsolescence. On the other
hand, an excessively low inventory may result in reduced profit through lost sales.

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CHAPTER 9 QUIZ
1. A typical firm doing business nationally cannot expect to accelerate its cash inflow by
A. Establishing multiple collection centers throughout the country.
B. Employing a lockbox arrangement.
C. Initiating controls to accelerate the deposit and collection of large checks.
D. Maintaining compensating balances rather than paying cash for bank services.
2. With regard to inventory management, an increase in the frequency of ordering will
normally
A. Reduce the total ordering costs.
B. Have no impact on total ordering costs.
C. Reduce total carrying costs.
D. Have no impact of total carrying costs.
3. One of the elements included in the economic order quantity (EOQ) formula is
A. Safety stock.
B. Annual demand (usage).
C. Selling price of item.
D. Lead time for delivery.
4. The one item listed below that would warrant the least amount of consideration in credit
and collection policy decisions is the
A. Quality of accounts accepted.
B. Quantity discount given.
C. Cash discount given.
D. Level of collection expenditures.
5. The economic order quantity (EOQ) formula assumes that
A. Purchase costs per unit differ because of quantity discounts.
B. Costs of placing an order vary with quantity ordered.
C. Periodic demand for the good is known.
D. Erratic usage rates are cushioned by safety stocks.
6. For inventory management, ignoring safety stocks, which of the following is a valid
computation of the reorder point?
A. The economic order quantity.
B. The economic order quantity times the anticipated demand during lead time.
C. The anticipated demand per day during lead time times in days.
D. The square root of the anticipated demand during the lead time.

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7. What are the three factors a manager should consider in controlling stockouts?
A. Carrying costs, quality costs and physical inventories.
B. Economic order quality, annual demand and quality costs.
C. Time needed for delivery, rate of inventory usage and safety stock.
D. Economic order quantity, production bottlenecks and safety stock.
8. The elapsed time between placing an order for inventory and receiving the order is
stocking time.
True / False
9. In inventory management, the safety stock will tend to increase if the
A.
Carrying cost increases.
B.
Cost of running out of stock decreases.
C.
Variability of the lead time increases.
D.
Fixed order cost decreases.
10. A lock-box system
A.
Reduces the need for compensating balances.
B.
Provides security for late night deposits.
C.
Reduces the risk of having checks lost in the mail.
D.
Accelerates the inflow of funds.

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CHAPTER 9 ANSWER KEY

1. (D) is correct. Compensating balances are either (1) an absolute minimum balance or
(2) a minimum average balance that bank customers must keep at the bank. These are
generally required by the bank to compensate for the cost of services rendered.
Maintaining compensating balances will not accelerate a company's cash inflows
because less cash will be available even though the amount of cash coming in remains
unchanged.
(A) is incorrect. Multiple collection centers throughout the country will reduce the time
required to receive cash in the mail. For example, California customers of a New York firm
would make payment to a West Coast center. Thus, the company would receive the cash
two or three days sooner.
(B) is incorrect. Direct deposit by customers into a lock-box also speeds cash into
company accounts.
(C) is incorrect. Special handling of large checks is a cost-effective way to deposit large
amounts.
2. (C) is correct. Inventory carrying costs can sometimes be transferred to suppliers. If a
seller has good enough control of demand schedules to know exactly when goods are
needed, orders can be placed so that goods arrive no earlier than when actually needed.
This practice relies on a supplier who is willing to take the responsibility for storing this
needed inventory and shipping it to arrive on time. Suppliers are more willing to provide
this service when they have many competitors.
(A) is incorrect. Total ordering costs will increase with more orders.
(B) is incorrect. Total ordering costs will increase because total ordering costs is ordering
cost per order times number of orders.
(D) is incorrect. Total carrying costs are reduced.
3. (B) is correct. The basic EOQ formula is
2(annualdemand )(ordering cos t per order)
EOQ =
carrying cos t per unit
(A) is incorrect. The safety stock is not included in the basic EOQ formula.
2(annualdemand )(ordering cos t per order)
EOQ =
carrying cos t per unit
(C) is incorrect. The selling price of the item is not included in the basic EOQ formula. (D)
is incorrect. The lead time for delivery is not included in the basic EOQ formula.
Techniques for Financial Analysis, Modeling & Forecasting Page 167

EOQ =

2(annualdemand )(ordering cos t per order)

carrying cos t per unit

4. (B) is correct. A quantity discount is an attempt to increase sales by reducing the unit
price on bulk purchases. It concerns only the price term of an agreement, not the credit
term and thus is unrelated to credit and collection policy.
(A) is incorrect. The quality of accounts is important to credit policy since it is inversely
related to both sales and bad debts.
(C) is incorrect. Offering a cash discount improves cash flow and reduces receivables and
the cost of extending credit.
(D) is incorrect. The level of collection expenditures must be considered when
implementing a collection policy. The marginal cost of a credit and collection policy should
not exceed its revenue.
5. (C) is correct. The EOQ model makes some strong assumptions. They are:
1.
Demand is fixed and constant throughout the year.
2.
Lead time is known with certainty.
3.
No quantity discounts are allowed.
4.
No shortages are permitted.
(A) is incorrect. The EOQ model makes the strong assumption that no quantity discounts
are allowed.
(B) is incorrect. Costs of placing an order do vary with quantity ordered, but the EOQ
model's assumptions are not based on this fact.
(D) is incorrect. Safety stock provide for the variation in lead time demand to determine
the reorder point. If average demand and lead time are both certain, no safety stock is
necessary and should be dropped from the formula.
6. (C) is correct. Reorder point is computed as follows: ROP = lead time in days x average
usage per day.
(A) is incorrect. The EOQ is used to determine the most economic quantity to order.
(B) is incorrect. The EOQ times the anticipated demand during lead time is an irrelevant
number.
(D) is incorrect. The squares root of the anticipated demand during the lead time is an
irrelevant number.

Techniques for Financial Analysis, Modeling & Forecasting Page 168

7. (C) is correct. It is desirable to minimize both the cost of carrying safety stock and the
costs of running out of an item, i.e., of stockouts. Safety stock is the amount of extra stock
that is kept to guard against stockouts. It is the inventory level at the time of reordering
minus the expected usage while the new goods are in transit. Delivery time, usage rate
and level of safety stock are therefore considerations in controlling stockouts.
(A) is incorrect. Carrying costs, quality costs and physical inventories are
inventory-related concepts that do not pertain directly to stockouts.
(B) is incorrect. The order quantity, annual demand and quality costs are not direct
concerns.
(D) is incorrect. Production bottlenecks result from a stockout; they are not a method of
control. Also, EOQ is irrelevant to stockouts.
8. (F) is correct. The time between placing an order and receiving that order is the lead
time. The basic EOQ formula assumes immediate replenishment, but in practice time will
elapse between ordering inventory and its arrival. Lead time must therefore be
considered in determining the order point (level of inventory at which a new order should
be made).
(T) is incorrect. Stocking time is the length of time to transfer inventory to the shelves or to
its place of use once it has been received by the purchaser.
9. (C) is correct. Safety stocks protect against the losses caused by stockouts. These can
take the form of lost sales or lost production time. Safety stock is necessary because of
the variability in lead time and usage rates. As the variability of lead time increases, that
is, as the standard deviation of the probability distribution of lead times increases, the risk
of a stockout increases and a company will tend to carry larger safety stocks.
(A) is incorrect. Increased carrying costs make safety stocks less economical. Thus,
safety stocks would be reduced.
(B) is incorrect. If the cost of stockouts declines, the incentive to carry large safety stocks
is reduced.
(D) is incorrect. Lower ordering costs encourage more frequent orders, which in turn will
reduce the need for large safety stocks.
10. (D) is correct. A lock-box system accelerates the inflow of funds. A company
maintains mail boxes, often in numerous locations around the country, to which
customers send payments. A bank checks these mailboxes several times a day and
funds received are immediately deposited to the company's account without first being
processed by the company's accounting system, thereby hastening availability of the
funds.
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(A) is incorrect. A lock-box system is not related to compensating balances; a

compensating balance may be required by a covenant in a loan agreement that requires
a company to maintain a specified balance during the term of the loan.
(B) is incorrect. A lock-box system is a process by which payments are sent to a bank's
mailbox, which is checked during normal post office hours.
(C) is incorrect. The use of a lock-box system entails sending checks through the mail to a
post office box. Thus, it does not reduce the risk of losing checks in the mail.

Techniques for Financial Analysis, Modeling & Forecasting Page 170

CHAPTER 10
CORPORATE INVESTMENTS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.

Explain accounting aspects of an investment portfolio.

Outline analytical implications.
Describe how to obtain investment information.
Compare risk versus return.
List financial assets.
List and explain real assets.
Outline how to perform portfolio analysis.
Explain features of mutual funds.
Distinguish between fundamental analysis and technical analysis.

Investment analysis is concerned with evaluating the quality of an existing portfolio as

well as determining what and when to buy or sell financial and real assets. Appropriate
sources of investment information must be searched out and evaluated for optimal
decision making. A risk-return analysis is required to achieve a proper mix of securities in
the portfolio. The types of financial assets and real assets to invest in must be known,
along with their respective advantages and disadvantages. Diversification by investing in
mutual funds is also addressed. Fundamental and technical analyses are discussed to
assist you in selecting the right securities at the right time. Microcomputers greatly aid in
the investment analysis process.
ACCOUNTING ASPECTS
As per FASB No. 12, an investment portfolio is recorded at aggregate cost or market
value, whichever is lower. For marketable securities (short-term investments), the
unrealized loss is shown in the income statement. For noncurrent investments (long-term
securities), the unrealized loss is shown as a separate item in the stockholders equity
section, thus bypassing the income statement. While a security transferred between
categories must be transferred at the lower of cost or market value, with a realized loss
recognized in the income statement, category switching allows for corporate flexibility in
reporting future earnings. Warning: Be on guard for frequent and questionable
reclassifications, because earnings quality may be adversely affected.
EXAMPLE 10.1
On November 1, 20X2, a company reclassified a security from current to noncurrent that
had a cost of $28,000 and a market value of $24,000. It therefore reported a realized loss
of $4,000.
If you conclude that the real motivation behind the switch was to avoid reflecting expected
future unrealized losses against income, you should downwardly adjust net income in
future years for such decline, even though such losses are reported as a contra to
stockholders equity.
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ANALYTICAL IMPLICATIONS
An investment portfolio with a market value higher than cost constitutes an undervalued
asset. For example, if a portfolio has a cost of $400,000 and a market value of $460,000,
it will be reported in the balance sheet at $400,000, but the realistic value for analytical
purposes is $460,000.
Special Note: Debt securities may be retained at cost, even though their market value is
less. For analytical purposes, value the debt investments at market.
Be on Guard: Watch for declines in portfolio market values not fully reflected in the
accounts. An indication of fair value is the revenue (interest income, dividend income)
generated by the portfolio. A declining trend in the percentage of earnings on investments
to carrying value may point to higher asset realization risk. If there has been a subsequent
event disclosure in the annual report applicable to unrealized losses that have occurred
on the securities portfolio, downwardly adjust the investment to account for the decline.
EXAMPLE 10.2
A company reports the following information.
Investments
Income from investments (dividends and
interest)

20X1
$30,000
4,000

20X2
$33,000
3,200

The 20X2 annual report has a footnote titled Subsequent Events, which indicates that
there was a $5,000 decline in the investment portfolio as of March 3, 20X3.
The ratio of investment income to total investments went down from 13.3 percent
($4,000/$30,000) in 20X1 to 9.7 percent ($3,200/$33,000) in 20X2, pointing to higher
realization risk in the portfolio. Further, the post-balance sheet disclosure of a reduction in
value of $5,000 in the portfolio should make you downwardly adjust the realizability of the
year-end portfolio.
Indicators of Riskiness in a Portfolio

Volatile securities. Diversify the portfolio by industry and economic sector.

However, volatile securities can be more profitable in a bull market.
Positively correlated securities. Try to have securities that are negatively
correlated to each other in order to add price stability to the portfolio. With
negatively correlated securities, some securities will go up in value while others go
down in value.
Variability in rate of return. Determine the standard deviation of the rate of return
on the investment portfolio.

Considerations in Selecting an Investment

Liquidity needs.
Desired rate of return.
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Risk. Rule: The higher the risk, the higher the rate of return must be.
Tax rate. If one is in a high tax bracket, tax-free securities may be preferred (e.g.,
municipal bonds).
Rate of change in price.
Annual income.
Future prospects.
Maturity period. A longer maturity period means a greater chance of price
fluctuation.
Amount of available funds.

OBTAINING INFORMATION
Prior to making an investment decision, you should be familiar with economic conditions,
political environment, market status, industry surroundings and corporate performance.
Investment information is either descriptive or analytical. Descriptive information reveals
prior performance of the economy, politics, market and specific investment. Analytical
information consists of current data, including forecasts and recommendations as to
specific securities. Both types of investment information assist you in assessing the risk
and return of a particular choice and enable you to see whether the investment satisfies
your objectives. Almost free information is contained in newspapers and magazines.
You will have to pay for additional information from a financial advisory service
publication like Value Line. Other sources of investment data include market information
and indexes, economic and current events and industry and company data.
Market Information and Indexes
Market price information provides past, present and prospective prices of securities. Data
on current and recent price behavior of stocks are contained in price quotations.
The Dow Jones Industrial Average is an average of the market prices of the 30
industrial stocks having wide ownership and volume activity as well as significant market
value. Dow Jones calculates separate averages for public utilities, transportation and the
composite.
Standard & Poors has five common stock indexes. The S&P Index compares the
present price of a group of stocks to the base prices from 1941 to 1943. The S&P indexes
are industrial (400 companies), financial (40 companies), transportation (20 companies),
public utility (40 companies) and composite (500 companies). S&P also has indexes for
consumer and capital goods companies as well as low-grade and high-grade common
stocks.
The New York Stock Exchange Index includes all the stocks on the exchange. The
American Stock Exchange Index reflects the price changes of its stocks. The National
Association of Security Dealers Automated Quotation (NASDAQ) Index reflects activity in
the over-the-counter market. Its composite index consists of about 2,300 companies
traded on the NASDAQ system.
Barrons has a 50-stock average as well as the average price of the 20 most active
and 20 lowest-priced stocks. Other averages and indexes are published by some
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financial advisory services. For example, Value Line has a composite of 1,700 companies
as an indication of the overall behavior of the stock market.
There are also indicators of bond performance. Bond yields are typically quoted for a
group of bonds of similar type and quality. Some sources of bond yield information are the
Federal Reserve, Standard & Poors, Moodys and Barrons.
Economic and Political Events
The analysis of economic and political events provides information in forecasting national
and international economic trends. Recommendation: Read the financial section of a
good newspaper (e.g., Barrons) and business magazines (e.g., Forbes).
The Federal Reserve Bulletin provides data on the performance of the national
economy. Included are a summary of business conditions; statistics on employment and
retail prices; the Federal Reserve Board Index of industrial production; and information
about gross national product, national income, interest rates and yields.
The U.S. Department of Commerce issues monthly the Survey of Current Business
and Business Conditions Digest. The Survey has a monthly update by industry of
business information about exports, inventories, personal consumption and labor market
statistics. The Digest publishes cyclical indicators of economic activity, including leading,
coincident and lagging.
Subscription services publish data of economic and corporate developments. They
also publish forecasts of business trends and detailed economic information and analysis.
An example is the Kiplinger Washington Letter.
Industry and Company Analysis
You should select an industry that looks good before picking a particular company. You
can obtain industry data from reading an industry trade publication such as the Public
Utilities Fortnightly. Financial advisory reports on companies, such as Standard & Poors
and Moodys, may be helpful as well. Financial advisory reports typically present and
analyze a companys financial history, current financial position and future expectations.
For example, Dun and Bradstreet issues Key Business Ratios and Billion Dollar Directory.
Brokerage research reports also provide useful analyses and recommendations on
industries and companies.
Microcomputers and Electronic Data Bases
With the use of a microcomputer, you have instant access to business data and
immediate analytical ability (e.g., comparing data to predetermined criteria) and you can
compute a rating of all your investments. Software exists for record keeping (shares, cost,
selling price, revenue), graphics for plotting prices, timing buys and sells and portfolio
management. Some programs enable you to perform sophisticated fundamental and
technical analysis and contain price and dividend history as well. Investment selection
software aids in determining whether to buy or sell a stock. Investment monitoring
software permits you to keep track of your portfolio by using investment information in
data bases. You can add new prices to the files or modify old ones. Dividend information
Techniques for Financial Analysis, Modeling & Forecasting Page 174

is also available. Tax investment software enables you to consider the tax aspects of
certain securities. Investment programs can accommodate and track stocks, bonds,
treasury securities, options, warrants, mutual funds and commodities.
Dow Jones News/Retrieval contains many data bases, including current and
historical Dow Jones Quotes, Corporate Earnings Estimator (earnings per share or EPS
estimates), Disclosure II (corporate financial statements and footnote data), Media
General Financial Services (stock performance related ratings; comparisons to market
indicators; bond, mutual fund and money market information), Merrill Lynch Research
Service, Weekly Economic Survey and Update (economic data, trends and analysis) and
Wall Street Highlights. The Dow Jones Spreadsheet Link obtains financial information,
such as stock prices from Dow Jones News/Retrieval and puts them on a data disk. The
data are then transferred to a spreadsheet for financial analysis calculations.
Numerous Internet services, such as MSN, AOL, Yahoo and CNBC, provide financial
data on companies, economic information and projections, money market trends and
earnings results and forecasts. Included are Value Line and Standard and Poors
information.
Most investment programs communicate through computer with other outside data
bases and various brokerage firms (via stock bulletin board services). To access them
you need a modem and telecommunications software (e.g., Crosstalk).
Standard & Poors CompuStat tapes provide 20 years of annual financial data for
more than 3,000 companies.
RISK VERSUS RETURN
Return from an investment comes from current income and appreciation in market value.
The expected return rate on a security is the weighted average of possible returns,
weights being probabilities. The holding period return is the total return you earn from
holding an investment for a specified period of time and equals

Holding period return =

Current income + Capital gain (or Loss)

----------------------------------------------Purchase price

EXAMPLE 10.3
You invest $100 in a security, sell it for $107 and earn a cash dividend of $13.
The holding period return is
$13 + $7
--------$100

$20
-------- =
$100

20%

Risk is the variability of possible returns applicable to an investment. Greater return is

required to compensate for higher risk. Risk can be measured by the standard deviation,
which is a measure of the dispersion of the probability distribution of possible returns. The
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higher the standard deviation, the wider the distribution and thus the greater is the
investment risk.
Special Note: Be careful using the standard deviation to compare risk, since it is only an
absolute measure of dispersion (risk) and does not consider the dispersion of outcomes
in relation to an expected return. Recommendation: In comparing securities with differing
expected returns, you should use the coefficient of variation. The coefficient of variation
equals the standard deviation for a security divided by its expected value. The higher the
coefficient, the riskier the security.
EXAMPLE 10.4
Stock X has a standard deviation of 14.28 percent and an expected value of 19 percent.
The coefficient of variation equals
14.28%
19%

0.75

Types of Risk
Business risk is due to earnings variability, which may be caused by variability in
demand, selling price and cost. It is the uncertainty surrounding the basic
operations of the entity.
Liquidity risk is the possibility that an asset may not be able to be sold for its market
value on short notice.
Default risk is the risk that the borrower will not be able to pay interest or principal
on debt.
Market risk applies to changes in stock price caused by changes in the stock
market as a whole, regardless of the fundamental change in a companys earning
power.
Interest rate risk applies to fluctuation in the value of the asset as interest rate,
money market and capital market conditions change. Interest rate risk applies to all
investment instruments, such as fixed income securities. For example, a decline in
interest rates will result in an increase in bond and stock prices.
Purchasing power risk applies to the possibility that you will receive less in
purchasing power than originally invested. Bonds in particular are affected by this
risk, since the issuer will be paying back in cheaper dollars during an inflationary
period. However, the return on common stock tends to move with the inflation rate.
Systematic risk is nondiversifiable, resulting in situations beyond managements
control and is thus not unique to the particular security. Examples are interest
rates, purchasing power and market risks.
Unsystematic risk is the portion of the securitys risk that is controlled through
diversification. It is the risk unique to a given security. Examples are liquidity,
default and business risks. Most of the unsystematic risk can be diversified away in
an efficiently constructed portfolio.
FINANCIAL ASSETS
Investments may be in the form of financial assets or real assets. The former comprise all
intangible investments representing equity ownership of a company, providing evidence
that someone owes you debt, or your right to buy or sell an ownership interest at a later
date. Financial assets include common stock, preferred stock, bonds, options and
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warrants, mutual funds, certificates of deposit, treasury bills, commercial paper,

commodity and financial futures, savings accounts and money market funds. Real assets
are those that physically can be touched, including precious metals and real estate. Real
assets are discussed in the next section.
Short-term securities (to be held one year or less) have minimal risk and provide
liquidity. Long-term securities (to be held for more than one year) usually are invested in
for capital appreciation and annual income.
Common Stock
Common stock is the equity investment representing ownership of a company. The
margin requirement is 50 percent for common stock. Advantages of owning common
stock are voting rights, appreciation in stock price, receipt of dividends and a better hedge
against inflation than fixed-income obligations. Disadvantages of common stock
ownership are a decline in stock price in bearish markets, lack of sizable dividends and
higher risk than debt securities and preferred stock, since you are the last to be paid in
corporate liquidation.
Types of Common Stock
Blue chip stock. This is common stock of high-quality companies with a long record
of earnings and dividends. They are typically held for a long term, have low risk
and generate modest but dependable return. An example is IBM.
Growth stocks. These have a long record of higher-than-average earnings.
Typically there is a low dividend payment, since funds are retained for expansion.
They grow faster than the economy and industry. An example is high-tech firms.
Income stocks. These stocks are suitable for those wishing higher current income
instead of future capital gains with minimal risk. These are above-average returns
and dividend payouts. Examples are utility stocks.
Cyclical stocks. These are stocks that fluctuate in price depending on economic
changes. An example is airlines.
Defensive stocks. These are basically not affected by downswings in the business
cycle; they are recession-resistant. An example is consumer products.
Speculative stocks. These do not have a track record of high earnings and
dividends. While profits are uncertain, they do have the potential for providing a
substantial return. Speculative stocks are for you if you are willing to accept
substantial risk in return for potentially high return. An example is cancer-related
pharmaceuticals.
Penny stocks. This refers to some over-the-counter stocks of high risk and low
quality that nevertheless have potential for high return. Some are on the way
toward failure, while others have just entered the market and are barely surviving.
Preferred Stock
Preferred stock is a hybrid of common stock and bonds. It is an equity investment (with no
voting rights), but has many characteristics of a bond issue. The amount of dividend is
typically fixed.

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There is an 80 percent dividend exclusion for dividends received on stock.

Preferred stock is riskier than bonds and as such has a higher return. Preferred
stockholders take precedence over common stockholders in the receipt of dividends and
in the event of liquidation. There is no maturity date, but preferred stock is often
convertible into common stock. Preferred stock may be callable at the companys option
and it generally provides only dividend income rather than significant appreciation in
price.
Preferred dividend yield =

Annual stated dividend income

Preferred stock price

Bonds
A bond represents a long-term obligation to pay by a corporation or government. Bonds
are typically in $1,000 denominations. You can buy or sell a bond before maturity at a
price other than face value. Investment in bonds can provide you with both interest
income and capital gains. Interest rates and bond prices move in opposite directions. A
decrease in interest rate will result in an increase in bond price. Bonds are good for fixed
income.
Corporate bonds have more risk than government bonds because companies can fail.
A tax disadvantage to bonds is that interest income is fully taxed, while there is an 80
percent dividend exclusion. Recommendation: If you want stability in principal, buy
variable rate bonds, since the interest rate is changed to keep the bonds at par.
Disadvantages of bond investment are constancy of interest income over the life of the
bond, decrease in purchasing power during an inflationary period, sensitivity of prices to
interest rate swings and less marketability in the secondary market compared to stocks.
Convertible Securities
Convertible securities may be converted into common stock at a later date. Two
examples of these securities are convertible bonds and convertible preferred stock.
These securities provide fixed income in the form of interest (convertible bonds) or
dividends (convertible preferred stock). You also benefit from the appreciation value of
the common stock.
Warrants
A warrant permits you to purchase a given number of shares at a specified price during a
given time period. Warrants are typically good for several years. They are often given as
sweeteners for a bond issue. Warrants are not frequently issued and are not available for
all securities. There are no dividend payments or voting rights. A warrant permits you to
take part indirectly in price appreciation of common stock and to derive a capital gain.
When the price per common share rises, you may either sell the warrant (because it
also increases in value) or exercise it to obtain stock. Trading in warrants is speculative
because of the possibility of variability in return, but the potential for high return exists.
EXAMPLE 10.5
A warrant in ABC Company stock permits you to buy one share at $10. If the stock rises in
price prior to the expiration date, the warrant increases in value. If the stock drops below
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$10, the warrant loses value.

The warrants exercise price is typically constant over its life. But the price of some
warrants may increase as the expiration date becomes closer. Exercise price is adjusted
for stock splits and stock dividends.

Return on a
warrant

Selling price Purchase price

Years
----------------------------------------

Average investment

EXAMPLE 10.6
You bought a warrant for $18 and sold it for $30 after three years. Your return rate is:
$30 - $18
3
---------------($30 + $18)/2

$4/$24

16.7%

Warrants are a speculative investment because their value depends on the price of
common stock they may be exchanged for. The value of a warrant varies as the related
stocks price varies.
Value of a warrant = (Market price of common stock - Exercise price of warrant) x Number
of common shares bought for one warrant
EXAMPLE 10.7
The exercise price of a warrant is $40. Two warrants equal one share. The stock has a
market price of $58.
Value of a warrant = ($58 - $40) x 0.5 = $9
Options
An option allows for the purchase of a security (or property) at a certain price during a
specified time period. An option is neither debt nor equity. It is an opportunity to take
advantage of an expected change in the price of a security. The option holder has no
guaranteed return. The option may not be attractive to exercise, since the market price of
the underlying common stock has not risen, for example, or the option time period may
elapse. If this occurs, you will lose your investment. Thus, options involve considerable
risk.
A call is an option to buy, whereas a put is an option to sell, a security at a specified
price by a given date. Calls and puts can be bought in round lots, typically 100 shares.
They are usually written for widely held and actively traded stock. Calls and puts are an
alternative investment to common stock. They provide leverage opportunity and are
speculative. You do not have to exercise a call or put to earn a return. You can trade them
in the secondary market for their value at the time.
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In purchasing a call you have the opportunity to make a substantial gain from a small
investment, but you risk losing your entire investment if the stock price does not increase.
Calls are in bearer form, with a life of one to nine months. Calls have no voting rights,
ownership interest, or dividend income. However, option contracts are adjusted for stock
splits and stock dividends. The value of a call rises as the underlying common stock
increases in market price.
Value of call = (Market price of stock - Exercise price of call) x 100
EXAMPLE 10.8
The market price of a stock is $60, with an exercise price of $53.
Value of call = ($60 - $53) x 100 = $700
EXAMPLE 10.9
You have a three-month call option permitting you to buy 700 shares of a companys
stock at $15 per share. Within the time period, you exercise the option when the market
price is $23. The gain is $5,600 ($8 X 700). If the price had declined or remained at $15
per share you would not have been able to exercise the call option and would have lost
the entire cost of the option.
In purchasing a call you buy common stock for a fraction of the cost of purchasing
regular shares. Calls are bought at a much lower price than common stock. Leverage
exists, since a little change in common stock price can result in a significant change in the
call options price. Part of the percentage gain in the call price is the speculative premium
applicable to the remaining time period on the call. Calls let you control 100 shares of
stock without making a significant dollar investment.
EXAMPLE 10.10
A stock has a price of $35. You can for $300 purchase a call that permits the acquisition of
100 shares at $35 each. The stock price goes to $57, at which time you exercise the call.
The profit is $22 on each of the 100 shares of stock in the call, or a total of $2,200, on an
investment of only $300. The net return is 633 percent [($2,200 - $300)/$300].
As previously mentioned, your return on a put comes when stock price declines.
Value of put = (Exercise price of put - Market price of stock) x 100
EXAMPLE 10.11
Stock price is $40. You acquire a put to sell 100 shares of stock at $40. The cost of the put
is $250. When stock price goes to $27, you exercise the put. The profit is $1,300 ($13 X
100). Your net gain is $1,050 ($1,300 - $250). Your net return is 420 percent
($1,050/$250).
Investment strategies with calls and puts include hedging, straddles and spreads. If you
own a call and put option you can hedge by holding on to two or more securities to lower
risk and at the same time earn a profit. It may involve purchasing a stock and later buying
an option on it. For instance, a stock may be acquired along with writing a call on it.
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Further, a holder of a security that has increased in price may acquire a put to bring about
downside risk protection.
Straddling integrates a call and put on the identical security with the same exercise
price and exercise date. It is employed by a speculator trading on both sides of the market.
The speculator looks to a significant change in stock price in one direction in order to earn
a gain exceeding the cost of both options. But if the large change in prices does not occur,
there is a loss equal to the cost of the options. A straddle holder can increase risk and
earning potential by closing one option prior to closing the other.
With a spread, you buy an option (long position) and write an option (short position) in
the same security using call options. There is high risk and a potential for high return. With
a spread, you buy one call and sell another. The net profit from a spread position depends
on the change between two option prices as the stock price increases or decreases.
Straddles and spreads are not traded on listed exchanges, but rather must be bought
through brokerage houses and members of the Put and Call Brokers and Dealers
Association.
Futures Contracts
In the futures market you can trade in commodities and financial instruments. A future is a
contract to buy or sell a specified amount of an item for a certain price by a given date.
The seller of a futures contract agrees to deliver the item to the buyer of the contract, who
agrees to buy the item. In the contract are specified the amount, valuation, method,
quality, expiration date, manner of delivery and exchange to be traded in.
Commodity contracts are assurances by a seller to deliver a commodity (e.g., wheat).
Financial contracts are seller agreements to deliver a financial instrument (e.g., Treasury
bill) or a given amount of foreign currency. Futures are high-risk investments partly
because they depend on international economic conditions and the volatile nature of
prices.
A long position is buying a contract in the hope that the price will increase. A short
position is selling a contract with the expectation that the price will decline. The position
may be terminated by reversing the transaction. For example, the long buyer may
subsequently become a short seller of the same amount of the commodity or financial
instrument. Practically all futures are offset prior to delivery.
A futures contract can be traded in the futures market. Trading is accomplished
through specialized brokers and some commodity firms deal only in futures. Fees depend
on the contract amount and the price of the item.
Commodities futures
Commodity contracts may last up to one year. There are standardized unit sizes of some
commodity contracts (e.g., 50,000 pounds for cotton). You can invest in a commodity
directly, indirectly through a mutual fund, or by a limited partnership involved in
commodity investments. The latter is more conservative, because risk is spread among
many owners and professional management runs the limited partnership. You may look
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to commodity trading for high rates of return and as an inflation hedge. Recommendation:
To reduce your risk, diversify your portfolio.
Commodity and financial futures are traded in the Chicago Board of Trade, which is the
largest exchange. There are other exchanges, some specializing in given commodities
(e.g., New York Cotton Exchange).
The return on futures contracts is in the form of capital gain because no current
income is earned. There is high return potential due to price volatility of the commodity
and leverage effects from low margin requirements. But if things go the opposite way, the
entire investment in the form of margin can be lost rapidly.
Return on commodity
contract

Selling price Purchase price

Margin deposit

EXAMPLE 10.12
You buy a commodity contract for $30,000 giving a margin deposit of $6,000. You sell the
contract for $32,000.
Return on commodity
contract

$32,000 $30,000
------------------------ -

$2,000
---------- =

$6,000

$6,000

0.33

The margin on a commodity contract is low, typically from 5 percent to 10 percent of the
contracts value.
Financial futures
Financial futures may relate to interest rate futures, foreign currency futures and
stock-index futures. As a result of instability in interest and exchange rates, financial
futures can be used to hedge. They can also be used to speculate, because of the
possibility of major price changes. There is a lower margin requirement with financials
than with commodities. For example, the margin on a U.S. Treasury bill is about 2 percent.
For the most part, financial futures are for fixed-income debt securities to hedge or
speculate on interest rate changes and foreign currency.
With an interest rate futures contract, you have the right to a certain amount of the
applicable debt security at a subsequent date (typically no more than three years).
Examples are Treasury bills and notes, certificates of deposit and commercial paper.
The value of interest rate futures contracts is directly linked to interest rates. For
instance, as interest rates decrease, the contracts value increases. As the price or quote
of the contract increases, the buyer of the contract gains, while the seller loses.
If you are a speculator, financial futures are attractive because of the possibility of a
significant return on a small investment. But there is much risk to interest futures because
of their volatility, along with significant gain or loss potential.
With a currency futures contract you have the right to a certain amount of foreign
currency at a later date. The contracts are standardized; no secondary markets exist.
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Currency futures are expressed in dollars or cents per unit of the related foreign currency.
The delivery period is usually no more than one year. There are standardized trading
units for different currencies (e.g., the British pound has a 25,000 trading unit).
EXAMPLE 10.13
Assume a standardized contract of $100,000. In March you buy a currency futures
contract for delivery in July. The contract price is $1, or 2. The total value of the contract
is $50,000 and the margin requirement is $6,000. The pound strengthens until 1.8 equal
$1. Thus, the value of your contract rises to $55,556, providing you with a return of 92.6
percent. However, if there was a weakening in the pound, you would have incurred a loss
on the contract.
A stock-index futures contract is tied to a broad stock market index (e.g., S&P 500
Stock Index, New York Stock Exchange Composite Stock Index). They permit you to take
part in the general change in the entire stock market. You are in effect purchasing and
selling the market as a whole instead of a specific security. When to Use: If you believe
there will be a bull market but are uncertain as to which individual stock will increase, buy
(long position) a stock-index future. There is high risk involved, however.
REAL ASSETS
Real (tangible) assets are those that physically exist (e.g., can be touched). They include
real estate, precious metals, gems, collectibles, common metals and oil. We will discuss
here only the first two, since they are relevant for corporate investors.
Real property can be used to diversify a portfolio, since it typically increases in value
when financial assets are decreasing in value. Disadvantages of tangible assets are that
there is less liquidity (a secondary market does not always exist), dealer commission
rates are higher than with financial assets, there may be storage and insurance costs, a
substantial capital investment is required and no current income is provided (except for
rental real estate).
Real Estate
Real estate ownership can take the form of residential property, commercial property, raw
land, limited partnership in a real estate syndicate and ownership of shares in a real
estate investment trust (REIT).
Real estate generates capital appreciation potential. Some types of real estate
investment property (residential and commercial) provide annual income. Advantages of
investing in real estate are building equity, high yield, inflation hedge and leverage
opportunity. Leverage improves earnings when the return earned on borrowed funds is
greater than the after-tax interest cost. Disadvantages of investing in real estate are
possible governmental regulation (e.g., building codes), high property taxes, possible
losses if property declines in value and limited marketability.
Commercial and industrial properties have differing degrees of risk depending on the
tenants. There are also significant operating expenses.
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Raw land has the highest risk but possesses the greatest return potential. There is no
annual income; return is from appreciation in value.
REITs issue shares to obtain investment, which along with borrowed funds is put into
long-term mortgages and real estate projects. REITs are similar to mutual funds and are
traded on the exchanges or over the counter. Real estate investment trusts have liquidity
because of the existence of a secondary market.
A limited partnership (real estate syndicate) is a tax-sheltered investment with capital
gain potential. The general partner (decision maker) sells participation units to limited
partners (whose obligations are typically limited to their investments). Besides making
cash investments, the partnership often incurs debt in the acquisition of properties. The
advantage of a limited partnership is the greater and more diversified holdings.
Disadvantages of a limited partnership are that limited partners have minimal control over
activities, high fees are charged by the general partner, foreclosure can occur if borrowed
amounts are not paid and there is no secondary market, which precludes their sale.
Considerations in a Real Estate Arrangement

Possible lawsuits against the partnership

Prior performance
Previous delays in paying limited partners
Where funds are invested (e.g., identifiable or nonidentifiable property)
Whether the limited partnership investment is publicly or privately traded

Precious Metals
Precious metals (e.g., gold and silver) are volatile investments, but they do furnish a
hedge against inflation. The price of precious metals typically increases during troubled
times because of investor uncertainty and decreases during stable, predictable periods.
When interest rates are high, it is expensive to invest in gold or silver. Precious metals are
liquid (have international markets) and are not periodically taxed.
Gold
Gold acts as an inflation hedge and is a good investment when there is a depreciation in
paper currency and when interest rates are low. Gold typically reacts opposite to the way
in which common stock does. Gold may be acquired directly or indirectly (e.g., shares in a
gold mine). Investment in shares of gold mines does provide portfolio diversification.
Disadvantages of gold investment are high storage cost, high transaction costs, no
dividend revenue, price volatility and the fact that some types of gold are in bearer form.
An advantage to owning gold is the possibility of large appreciation in price.
Silver
The return from silver comes from capital appreciation. While silver is much lower in price
than gold, there is a relatively higher carrying cost. You may also buy stock in silver
mining companies.

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PORTFOLIO ANALYSIS
The investment portfolio should be diversified into many different types of securities in
different industry groups as well as international markets. A balanced portfolio contains
stocks, bonds, real estate, money market (e.g., commercial paper), precious metals and
options. There is a trade-off of return and risk. Portfolio risk can be minimized by
diversifying. The degree of reduction in portfolio risk depends on the correlation between
the assets being combined.
EXAMPLE 10.14
A portfolio has a risk-free rate of 10 percent, market portfolio return of 14 percent and beta
of 0.9. The expected rate of return is
10% + 0.9(14% - 10%) = 13.6%
Note: A feasible portfolio that offers the highest expected return for a given risk or the
least risk for a given expected return is called an efficient portfolio.
MUTUAL FUNDS
Mutual funds represent investment in a professionally managed portfolio of securities.
You receive shares of stock in a mutual fund investment company. Advantages are
diversification, excellent management, more informed decisions, size (e.g., bid buys may
influence the price of a stock up), ownership in many securities with minimal capital
investment, dividend reinvestment, check writing options and easy record keeping (it is
done by the fund). Disadvantages are commission charges and professional
management fees. Generally, mutual fund performance has not materially done better
than the market as a whole. However, certain mutual funds are well known for excellent
performance over the years, as rated by independent sources like Forbes and Money
magazine.
Mutual funds may be classified by type depending on organization, fees charged,
methods of trading funds and investment purpose. With open-end funds, you can
purchase from and sell shares back to the fund itself. On the other hand, closed-end
funds have a fixed number of shares outstanding. These shares are traded similarly to
common stock in secondary markets. All open-and closed-end funds charge
management fees. Load funds charge sales commissions while no-load funds do not.
There are also specialized mutual funds (e.g., money market fund). Mutual funds may
have different investment purposes: growth, safety and income, capital appreciation and
growth plus income, for instance. You may invest in index funds to control portfolio risk
and assure market performance. An index fund follows the change in a selected broad
market index (e.g., Standard & Poors 500) by holding investment commitments in the
same proportion as those that comprise the index itself.
Types of Mutual Funds
Growth. The purpose is capital appreciation. The stocks invested in have growth
potential, but greater risk.
Income. The objective is to obtain current income (e.g., dividends, interest
income). Typically, the portfolio comprises high-dividend common stock, preferred
stock and debt securities. Generally, high-quality securities are bought.
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Balanced. These funds provide capital gains and current income. A high
percentage of the portfolio is in high-quality common stock to achieve capital
appreciation with a lower percentage in fixed income securities. There is a safe
return with minimal risk. It is a hybrid between growth and income funds.
Bonds. An investment is made in different types and qualities of bonds. Interest
income is the paramount concern. The funds provide liquidity, safety and
diversification. Some bond funds invest only in municipal securities to obtain
tax-free income.
Money market. These funds invest in short-term money market securities such as
commercial paper, so there is liquidity with low risk. Usually the return on the fund
exceeds what can be earned on a bank account.

A fund may invest in only one industry (e.g., Fidelity Select) or a group of industries.
They try to maximize the rate of return, but higher risk is usually involved.
The return from mutual funds comes in the form of dividends, capital gain and change
in capital or net asset value (NAV) of the fund.
Holding Period
Return

Dividends + Capital Gain Distribution + Change in Net Asset Value

Beginning Net Asset Value

FUNDAMENTAL ANALYSIS
Fundamental analysis evaluates a stock by analyzing the companys financial statements.
It considers overall financial health, economic and political conditions, industry factors
and future outlook of the company. It tries to determine whether stock is overpriced,
underpriced, or correctly priced. Financial statement analysis provides you with much of
the data you require to forecast earnings, dividends and selling price.
You have to look at economic risk. What is the effect of business cycles on the firm?
Business cycles arise from three conditions: (1) changes in demand; (2) diversification of
customer base; and (3) product diversification. The greater the changes in product
demand, the more the company is affected by the business cycle and thus the greater the
profit variability.
Fundamental analysis is discussed in detail in Chapters 4 and 5.
TECHNICAL ANALYSIS
According to technical analysis, the market can be predicted in terms of direction and
magnitude. You can evaluate the stock market by employing numerous indicators,
including studying economic factors within the marketplace.
Stock prices tend to move with the market because they react to numerous
demand and supply forces. You may attempt to forecast short-term price changes to
properly time purchase and sale of securities. You try to recognize a recurring pattern in
prices or a relationship between stock price changes and other market data. You can also
employ charts and graphs of internal market data, such as price and volume.
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The two major techniques of technical analysis are key indicators and charting.
Key Indicators
Key indicators of market and stock performance include trading volume, market breadth,
Barrons Confidence Index, mutual fund cash position, short selling, odd-lot theory and
the Index of Bearish Sentiment.
Trading volume
A reflection of the health of the stock market is the number of shares traded. Price follows
volume. For instance, increased price usually occurs with increased volume. Trading
volume is based on supply-demand relationships and indicates market strength or
weakness. A strong market occurs when volume rises as prices increase. A weak market
occurs when volume increases as prices decrease. If the demand of new stock offerings
exceeds the supply, stock prices will increase. Note: Supply-demand evaluation is more
concerned with the short term than the long term.
Volume is closely tied into stock price change. A bullish market occurs when there
is a new high on heavy volume. But a new high with light trading volume is considered
temporary. A new low with light volume is deemed significantly better than one with high
volume, since fewer investors are involved. A bearish situation occurs when there is high
volume with the new low price.
Watch out for a selling climax, when prices decrease for a long period at an
increased rate, coupled with increased volume. Subsequent to the climax, we expect
prices to increase and the low at the point of climax is not anticipated to be violated for a
long time. A selling climax usually happens at the end of a bear market.
When prices have been going up for several months, a low price increase coupled
with high volume is a bearish indicator.
An upside-downside index shows the difference between advances and
decreases in stock volume typically based on a 10-day or 30-day moving average. The
index assists in predicting stock market turning points. A bull market continues only where
buying pressures continue to be strong.
The final stage of a major increase in stock price is referred to as the exhaustion
move. It takes place when there is a rapid decline in volume and price. A trend reversal is
indicated.
Market breadth
Market breadth refers to the dispersion of a general price increase or decrease. You can
use it as an advance reflection of major stock price declines or advances. It can be used
to analyze the prime turning points of the market on the basis of stock market cycles. A
bull market is a long time period in which securities approach their highs slowly, with the
individual peaks increasing as market averages approach a turning point. In a bear
market, many stock prices decrease materially in a short time period. Market weakness
occurs when many stocks are decreasing in prices while the averages increase. In
forecasting the end of a bear market, the degree of stock selling is considered.
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A breadth measure looks at the activity of a broader range of securities than does
a market average (e.g., Dow Jones Industrial). The Dow Jones stocks are not
representative of the whole market, since the average is weighted toward large
companies. Hence, all stocks on an exchange may be analyzed by considering advances
and declines.
The Breadth Index computes on a daily basis the net advances or declining issues
on the New York Stock Exchange. Net advances is a positive sign. The amount of
strength depends on the spread between the number of advances and declines.
Recommendation: Look at relevant figures in The Wall Street Journal.
Breadth index

Net advances or declines

Number of securities traded

Advances less declines typically move in the same direction as a popular market
average. However, they may go in the opposite direction at a market peak or bottom.
Breadth analysis concentrates on change instead of level. Suggestion: Chart the Breadth
Index against a market average (e.g., Dow Jones Industrial). In most cases they move
together. Caution: In a bull market, carefully watch an extended divergence between the
Breadth Index, such as where it drops gradually, to new lows and the Dow Jones, such as
where it goes to new highs. Recommendation: Compare the Breadth Index for the current
period to a base year. When the Breadth Index and Dow Jones Industrial Average are
both dropping, it points to market weakness.
EXAMPLE 10.15
Net declines are 24 on securities traded of 1,160. The Breadth Index is -2.1percent
(-24/1,160).
A possible sign to the end of a bull market is when the Dow Jones Industrial
Average is rising but the number of daily declines exceeds the number of daily advances
on a continual basis. This possibly reflects that conservative investors are purchasing
blue chip stocks, but do not have confidence in the overall market. A market upturn is
pointed to when the Dow Jones Industrial Average is dropping, but advances continually
lead declines.
Market breadth can be applied to individual securities as well. Net volume (rises in price
minus decreases in price) should be computed.
EXAMPLE 10.16
Sixty thousand shares are traded in Company X for one day. Forty-five thousand are on
the upside (rising in price), 10,000 are on the downside (decreasing in price) and 5,000
have no change. The net volume difference is 35,000, traded on upticks. You have to
appraise any sign of divergence between the price trend and the net volume for the
company. If there is a divergence, you may expect a reversal in the price trend.
Accumulation occurs when price decreases and net volume increases.

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Barrons Confidence Index

Barrons Confidence Index evaluates the trading pattern of bond investors. It helps in
deciding when to buy and sell stocks. The assumption used is that bond traders have
more knowledge than stock traders and hence spot trends more quickly. If you know what
bond traders are doing today, you can predict what stock traders will be doing next.
Barrons Confidence Index is calculated as follows:
Yield on Barrons 10 top-grade corporate bonds
Yield on Dow Jones 40-bond average

EXAMPLE 10.17
The Dow Jones yield is 15 percent and the Barrons yield is 14 percent. Barrons
Confidence Index = 93.3% (14%/15%)
The numerator has a lower yield relative to the denominator since it contains
higher-quality bonds. Lower risk means lower return. Obviously, the index will always be
less than 100 percent. In the case where bond investors are bullish, there will be a small
yield difference between high-grade and low-grade bonds (probably around 95 percent).
In bearish times, bond investors will look to high-quality issues. If investors continue to
place money in lower-quality bonds, they will demand a higher yield to compensate for the
increased risk. The Confidence Index will now be lower because of an increasing
denominator. If confidence is high, investors will buy lower-grade bonds. Consequently,
the yield on high-grade bonds will decrease while the yield on low-grade bonds will
increase.
Mutual fund position
The buying pattern of mutual funds reflects the purchasing potential of large institutional
investors. Recommendation: Look at the Investment Company Institutes monthly ratio of
mutual fund cash and cash equivalents to total assets. A change in the ratio points to
changes in institutional investor opinions.
Typically, the ratio is between 5 and 25 percent. When a mutual funds cash
position is 15 percent of assets or higher, you can assume the fund represents significant
purchasing power, which points to a possible market upturn. The higher the cash position
of the fund, the more bullish is the general market outlook. The investment of this cash will
cause a rise in stock prices. On the other hand, a low ratio is a bearish indicator.
Short selling
You can engage in short selling when you believe stock prices will go down. In effect, you
sell high and buy low. In a short sale you make a profit if the market price of the security
drops. To make a short sale, your broker borrows the security from someone else and
then sells it for you to another. Subsequently, you buy the shares back. Of course, if
market price goes up, you have a loss. You sell short against the box when you sell
short shares you actually own.

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EXAMPLE 10.18
You sell short 100 shares of Company Y stock, which has a market price of $60 per share.
You later buy them back for $48 per share. Your profit is $1,200 ($12 per share x 100
shares).
Technical analysts evaluate the number of shares sold short. They also examine
the ratio of latest reported short interest position for the month to the daily average volume
for the month. Short interest refers to the number of shares sold short in the market at any
given time. A high ratio is bullish and a low ratio is bearish. Typically, the ratio for all
stockholders on the New York Stock Exchange has been between 1.0 and 1.75. A short
interest ratio of 2.0 or greater indicates a market low.
The examination of short sales is an example of a contrary opinion rule. Some
analysts are of the opinion that a rise in the number of short sellers points to a bullish
market. It is believed that short sellers overreact. Further, the short seller will
subsequently buy the short-sold stock back, resulting in an increased market demand.
However, some analysts believe that increased short selling points to a downward and
technically weak market, which results from investor pessimism.
The Wall Street Journal publishes the amount of short interest on the New York
Stock Exchange and the American Stock Exchange. By monitoring short interests you
can forecast future market demand and determine whether the current market is
optimistic or pessimistic.
Advice: A significant short interest in a stock should make you question the securitys
value.
Why not also look at odd-lot short sales? Many odd-lotters are uninformed. An
odd-lotter ratio of 3.0 or more reflects pessimism.
Specialists make markets in various securities and are deemed smart money
investors. Recommendation: Look at the ratio of specialists short sales to the total
number of short sales on an exchange.
Odd-lot theory
An odd lot is a transaction in which less than 100 shares of a security are involved.
Odd-lot trading is indicative of popular opinion. It rests on the theory of contrary opinion.
Guideline: Determine what losers are doing and then do the opposite. In essence,
sophisticated investors should sell when small traders are buying and buy when they are
selling. Refer to The Wall Street Journal for odd-lot trading information. Volume is
typically expressed in shares instead of dollars. But some technical analysts employ the
SEC Statistical Bulletin where volume is expressed in dollars.
Odd-lot index

Odd-lot purchases
Odd-lot sales

The ratio typically is between 0.40 and 1.60.

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You may also examine the ratio of odd-lot short sales to total odd-lot sales and the
ratio of total odd-lot volume (buys and sells) to round-lot volume on the New York Stock
Exchange. These figures act to substantiate the conclusions reached by evaluating the
ratio of odd-lot selling volume to odd lot buying volume.
As per the odd-lot theory, the small trader is right most of the time but does not
recognize key market turns. For instance, odd-lot traders correctly begin selling part of
their portfolios in an upward market trend, but as the market continues to rise, small
traders try to make substantial profits by becoming significant net buyers. However, this
precedes a market fall.
Index of Bearish Sentiment
Investors Intelligences Index of Bearish Sentiment is based on the opposite of the
recommendations of investment advisory services; it is a contrary opinion rule. For
example, if investment advisory services say buy, you should sell. According to Investors
Intelligence, when 42 percent or more of the advisory services are bearish, the market will
go up. On the other hand, when 17 percent or fewer of the services are bearish, the
market will drop.
Index of Bearish
Sentiment

Bearish services
Total number of services giving an opinion

When the ratio goes toward 10 percent, it means the Dow Jones Industrial Average is
about to move from bullish to bearish. When the index approaches 60 percent, the Dow
Jones Industrial Average is about to go from bearish to bullish. The reasoning of the
theory is that advisory services are trend followers instead of anticipators.
Puts and calls
You may look toward option trading activity to forecast market trends.
Put-call ratio

Put volume
Call volume

The index increases when there is more put activity because of pessimism around market
bottom. The ratio goes down when there is more call activity because investors are
optimistic around the market peak.
Option buy call
percentage

Option buy call transactions

Total call volume

A high ratio points to investor optimism.

Charting
Charts are useful in analyzing market conditions and price behavior of individual
securities. Reference can be made to Standard & Poors Trendline, which provides
charting data on companies. Chart interpretation requires the ability to evaluate
formations and identify buy and sell indicators. The major types of charts are line (Figure
10.1), bar (Figure 10.2) and point-and-figure.
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A chart provides information about resistance levels (points). A breakout from the
resistance level notes market direction. The longer the sideways movement prior to a
break, the more stock can increase in price.
Benefits of the chart are they help you to ascertain whether there is a major market
upturn or downturn and whether the trend will reverse. You can further appraise what
price may be achieved by a given stock or market average. Also, these charts help in
forecasting the magnitude of a price swing.
Moving average
Moving averages assist in analyzing intermediate and long-term stock movements. By
evaluating the trend in current prices relative to the long-term moving average of prices,
you can predict a reversal in a major uptrend in price of a companys stock or of the
general market. The underlying direction and degree of change in volatile numbers are
depicted in a moving average.

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Moving average computation:

Step 1:
Step 2:
Step 3:

Average a portion of the series

Add the following number to the numbers already averaged, omitting the first
number
Obtain a new average

Typically, a 200-day moving average of daily ending prices is used. The average is
usually graphed to spot directions. What to Do: Buy when the 200-day average line
becomes constant or increases after a decline and when the daily price of stock moves
beyond the average line.
EXAMPLE 10.19
Day

Index

1
2
3
4

115
126
119
133

Three-Day
Moving Total

Three-Day
Moving
Average

360 (days 13) 120 (360/3)

378 (days 24) 126 (378/3)

Suggestion: Buy when stock price surpasses the 200-day line, then goes down toward it
but not through it and then goes up again.
Relative strength analysis
Appraisal of relative strength assists in predicting individual stock prices.
Relative strength (method 1)

Monthly average stock price

=
Monthly average market index (or industry group
index)

Relative strength (method 2)

Specific industry group price index

=
Total market index

What to Watch Out for: When a stock or industry group outperforms the market, that stock
or industry is considered favorably because it should become even stronger. Some
analysts distinguish between relative strength in a declining market and relative strength
in an increasing market. When a stock does better than a major stock average in an
advance, it may shortly turn around. However, when the stock is superior to the rest of the
market in a decline, the stock will typically remain strong.
Support and resistance levels
A support level is the lower end of a trading range, while the resistance level is the upper
end (see Figure 10.3). Support may happen when a security goes to a lower trading level,
since new investors may now desire to buy it. If such is the case, there will be new
demand in the market. Resistance occurs when a stock goes to the high side of the
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normal trading range. If you purchase on an earlier high, you may see this as an
opportunity to sell the security at a gain. When market price is higher than the resistance
point or less than the support point, you may assume the stock is trading in a new range
and that higher or lower trading values are imminent.

Dow theory
Dow Theory applies to individual stocks and to the overall market. It is based on the
movements of the Dow Jones Industrial Average and the Dow Jones Transportation
Average. Stock market direction has to be confirmed by both averages. According to the
theory, price trend in the overall market points to the termination of both bull and bear
markets. It confirms when a reversal has taken place. The following three movements in
the market are assumed to occur simultaneously:

Primary. A primary trend can be either bullish or bearish and typically lasts 28 to 33
months.
Secondary. A secondary trend goes counter to the primary movement and typically
lasts three weeks to three months.
Day-to-day. This variability makes up the first two movements of the market.

Secondary movements and daily fluctuations reflect a long-term primary movement

trend.
A major primary rise in market averages coexists with intermediate secondary
downward reactions, eliminating a material amount of the previous increase. At the
culmination of each reaction, a price recovery occurs that falls short of the previous rise. If,
subsequent to an unsuccessful recovery, a downward reaction goes below the low point
of the last prior reaction, it is inferred that the market is in a primary downturn. (See Figure
10.4.)

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According to the Dow Theory, there is an upward market when the cyclical movements of
the market averages increase over time and the successive market lows become higher.
There is a downward market when the successive highs and successive lows in the
market are lower than the previous highs and lows.
CONCLUSION
Portfolio investment analysis is needed to achieve maximum return on investments at
minimal risk. A determination must be made of which investment vehicle is best under
certain circumstances. Proper timing of buys and sells is also essential. Diversification is
a must to guard against unusual price changes in one particular market.

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CHAPTER 10 QUIZ
1. A call option on a common share is more valuable when there is a lower
A. Market value of the underlying share.
B. Exercise price on the option.
C. Time to maturity on the option
D. Variability of market price on the underlying share.
2. A feasible portfolio that offers the highest expected return for a given risk or the least
risk for a given expected return is a(n)
A. Optimal portfolio.
B. Desirable portfolio.
C. Efficient portfolio.
D. Effective portfolio.
3. A major use of warrants in financing is to:
A. Lower the cost of debt.
B. Avoid dilution of earnings per share.
C. Maintain managerial control.
D. Permit the buy-back of bonds before maturity.
4. P/E ratio is a tool for technical analysis.
True / False
5. Preferred and common stock differ in that
A. Failure to pay dividends on common stock will not force the firm into bankruptcy
while failure to pay dividends on preferred stock will force the firm into bankruptcy.
B. Preferred stock has a higher priority than common stock with regard to earnings
and assets in the event of bankruptcy.
C. Common stock dividends are a fixed amount while preferred stock dividends are
not.
D. Preferred stock dividends are deductible as an expense for tax purposes while
common stock dividends are not.
6. A forward contract involves
A. A commitment today to purchase a product on a specific future date at a price to be
determined some time in the future.
B. A commitment today to purchase a product some time during the current day at its
present price.
C. A commitment today to purchase a product on a specific future date at a price
determined today.
D. A commitment today to purchase a product only when its price increases above its
current exercise price.
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7. REITs are not as liquid as stocks and bonds.

True / False
8. Types of mutual funds include U.S. treasury funds.
True / False

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CHAPTER 10 ANSWER KEY

1. (B) is correct. The lower the exercise price, the more valuable the call option. The
exercise price is the price at which the call holder has the right to purchase the underlying
share.
(A) is incorrect. A call option is the right to buy a common share at a set price for a
specified time period. If the underlying share has a lower market value, the call option is
less, not more, valuable.
(C) is incorrect. A call option is less, not more, valuable given less time to maturity. When
the option has less time to maturity, the chance that the share price will rise is smaller.
(D) is incorrect. A call option is less -- not more-- valuable if the price of the underlying
share is less variable. Less variability means a lower probability of a price increase.
2. (C) is correct. A feasible portfolio that offers the highest expected return for a given risk
or the least risk for a given expected return is called an efficient portfolio.
(A) is incorrect. An optimal portfolio is a portfolio selected from the efficient set of
portfolios because it is tangent to the investors highest indifference curve.
(B) is incorrect. A desirable portfolio is a nonsense term.
(D) is incorrect. There is no such thing as an effective portfolio.
3. (A) is correct. Warrants are often given as sweeteners for a debt issue. Warrants are
long-term options that give holders the right to buy common stock in the future at a
specific price. If the market price goes up, the holders of warrants will exercise their rights
to buy stock at the special price. If the market price does not exceed the exercise price,
the warrants will lapse. The investor then has the security of fixed-return debt plus the
possibility for large gains if stock prices increase significantly. If warrants are attached,
debt can sell at an interest rate slightly lower than the market rate.
(B) is incorrect. Outstanding warrants dilute earnings per share. They are included in the
denominator of the EPS calculation even if they have not been exercised.
(C) is incorrect. Warrants can, if exercised, result in a dilution of management's holdings.
(D) is incorrect. A call provision in a bond indenture, not the use of warrants, permits the
buyback of bonds.
4. (F) is correct. P/E ratio is a ratio used for fundamental analysis.

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(T) is incorrect. Technical analysts believe the market can be predicted in terms of direction
and magnitude. They study the stock market by way of charting and using various indicators
to project future market movements. Stock prices of companies tend to move with the
market because they react to various demand and supply forces. The technical analysts try
to predict short-term price changes and then recommend the timing of a purchase and sale.
Market breadth, relative strength analysis and moving averages are some of the tools used
for technical analysis.
5. (B) is correct. In the event of bankruptcy, the claims of preferred shareholders must be
satisfied before common shareholders receive anything. The interests of common
shareholders are secondary to those of all other claimants.
(A) is incorrect. Failure to pay dividends will not force the firm into bankruptcy, whether the
dividends are for common or preferred stock. Only failure to pay interest will force the firm
into bankruptcy.
(C) is incorrect. Preferred dividends are fixed.
(D) is incorrect. Neither common nor preferred dividends are tax deductible.
6. (C) is correct. A futures (forward) contract is an executory contract in which the parties
involved agree to the terms of a purchase and a sale, but performance is deferred.
Accordingly, a forward contract involves a commitment today to purchase a product on a
specific future date at a price determined today.
(A) is incorrect. The price of a future contract is determined on the day of commitment, not
some time in the future.
(B) is incorrect. Performance is deferred in a future contract and the price of the product is
not necessarily its present price. The price can be any price determined on the day of
commitment.
(D) is incorrect. A forward contract is a firm commitment to purchase a product. It is not
based on a contingency. Also, a forward contract does not involve an exercise price
(exercise price is in an option contract).
7. (F) is correct. Real estate investment trusts have liquidity because of the existence of a
secondary market.
(T) is incorrect. REITs are similar to mutual funds and are traded on the exchanges or
over the counter. Real estate investment trusts have liquidity because of the existence of
a secondary market.

Techniques for Financial Analysis, Modeling & Forecasting Page 199

8. (F) is correct. U.S. treasury funds are not mutual funds.

(T) is incorrect. Mutual funds may be categorized as follows:
Money market funds.
Growth funds
Aggressive growth (capital appreciation) funds
Income funds

Techniques for Financial Analysis, Modeling & Forecasting Page 200

CHAPTER 11
OBTAINING FUNDS: SHORT-TERM AND LONG-TERM FINANCING
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.

Explain what financial planning involves.

Distinguish between short-term and intermediate-term financing sources
Compare short-term to long-term financing
List long-term financing sources.
Identify and compute each source of cost of capital.

You can finance short-term (less than one year), intermediate-term (one to five years), or
long-term (in excess of five years) . Each has its own merits and deficiencies. Under what
circumstances is one better than the other? Are you able to adjust your financing strategy
to meet changing times? Do you know the changing impact that economic, political and
industry conditions have on the entitys flow of funds? What is the degree of internally
generated funds?
FINANCIAL PLANNING
After you have decided on the length of the financing, the proper type within the category
must be chosen. In selecting a given financing instrument, you have to consider the
following:

Cost.
Effect on financial ratios.
Effect on credit rating (some sources of short-term financing may negatively impact
the company's credit rating, such as factoring accounts receivable).
Risk (reliability of the source of funds for future borrowing). If your company is
materially affected by outside forces, it will need more stable and reliable financing.
Restrictions, such as requiring a minimum level of working capital.
Flexibility.
Expected money market conditions (e.g., future interest rates) and availability of future
financing.
Inflation rate.
Company profitability and liquidity positions, both of which must be favorable if the
company is to be able to pay its near term obligations.
Stability and maturity of operations.
Tax rate.

SHORT-TERM FINANCING
Short-term financing may be used to meet seasonal and temporary fluctuations in funds
position as well as to meet long-term needs. For example, short-term financing may be
used to provide additional working capital, finance current assets (such as receivables
and inventory), or provide interim financing for a long-term project (such as the acquisition
Techniques for Financial Analysis, Modeling & Forecasting Page 201

of plant and equipment) until long-term financing is arranged. (Long-term financing may
not always be appropriate because of perceived long-term credit risk or excessively high
cost.)
When compared to long-term financing, short-term financing has several advantages. It
is usually easier to arrange and less expensive and has more flexibility. The drawbacks of
short-term financing are that it is subject to greater fluctuations in interest rates,
refinancing is frequently required, there is greater risk of default because the loan comes
due sooner and any delinquency may damage the company's credit rating.
The sources of short-term financing include trade credit, bank loans, bankers'
acceptances, finance company loans, commercial paper, receivable financing and
inventory financing. One particular source may be more appropriate than another in a
given circumstance; some are more desirable than others because of interest rates or
collateral requirements.
Using Trade Credit
Trade credit (accounts payable) are balances owed by your company to suppliers. It is a
spontaneous (recurring) financing source for creditworthy companies since it comes from
normal operations. Trade credit is the least expensive form of financing inventory. Its
benefits are that it is readily available, since suppliers want business; it requires no
collateral; there is no interest charge or else a minimal one; it is convenient; and it is likely
to be extended if the company gets into financial trouble. If the company has liquidity
difficulties, it may be able to stretch (extend) accounts payable; however, the company
will be required to give up any cash discount offered and accept a lower credit rating. The
company should prepare a report analyzing accounts payable in terms of lost discounts,
aged debit balances, aged unpaid invoices and days to pay.
EXAMPLE 11.1
The company purchases $500 worth of merchandise per day from suppliers. The terms of
purchase are net/60 and the company pays on time. The accounts payable balance is:
$500 per day x 60 days = $30,000
The company should typically take advantage of a cash discount offered for early
payment because failing to do so results in a high opportunity cost. The cost of not taking
a discount equals:
(

Discount Lost
360
)(
)
Dollar Proceeds You Have
Number of Days You have Use of
Use of by Not Taking the

the Money by Not Taking the

Discount

Discount

Bank Loans
Even though other institutions, such as savings and loan associations and credit unions,
provide banking services, most banking activities are conducted by commercial banks.
Commercial banks allow the company to operate with minimal cash and still be confident
Techniques for Financial Analysis, Modeling & Forecasting Page 202

of planning activities even in uncertain conditions.

Commercial banks favor short-term loans since they like to get their money back within
one year. If the company is large, a group of banks may form a consortium to furnish the
desired level of capital.
The prime interest rate is a benchmark for the short-term loan interest rate banks
charge creditworthy corporate borrowers. Good companies with strong financial strength
can get terms below prime. Your company's interest rate may be higher depending upon
the risk the bank believes it is taking.
Bank financing may take the following forms:
-- Unsecured loans
-- Secured loans
-- Lines of credit
-- Letters of credit
-- Revolving credit
-- Installment loans
-- Unsecured Loans. Most short-term unsecured (uncollateralized) loans are
self-liquidating. This kind of loan is recommended if the company has an excellent credit
rating. It is usually used to finance projects having quick cash flows and is appropriate if
the company has immediate cash and can either repay the loan in the near future or
quickly obtain longer-term financing. Seasonal cash shortfalls and desired inventory
buildups are among the reasons to use an unsecured loan. The disadvantages of this
kind of loan are that it carries a higher interest rate than a secured loan since there is no
collateral and that a lump sum payment is required.
-- Secured Loans. If the company's credit rating is deficient, the bank may lend money
only on a secured basis. Collateral can take many forms, including inventory, marketable
securities, or fixed assets. Even if the company is able to obtain an unsecured loan, it may
be better off taking a collateralized loan at a lower interest rate.
-- Lines of Credit. Under a line of credit, the bank agrees to lend money up to a
specified amount on a recurring basis. The bank typically charges a commitment fee on
the amount of the unused credit line. Credit lines are typically established for a one-year
period and may be renewed annually. You can determine if the preferred line of credit is
adequate for your company's present and immediate future needs by considering the
current and expected cash requirements of the business.
The advantages of a line of credit are that it offers easy and immediate access to funds
during tight money market conditions and it enables the company to borrow only as much
as it needs and to repay immediately when cash is available. You should use a line of
credit if the company is working on large individual projects for a long time period and will
obtain minimal or no payments until the job is completed. The disadvantages of lines of
credit relate to the collateral requirements and the additional financial information that
must be presented to the bank. Banks also may place restrictions on the company, such
Techniques for Financial Analysis, Modeling & Forecasting Page 203

as setting a ceiling on capital expenditures or requiring a minimum level of working

capital.
When the company borrows under a line of credit, it may be required to maintain a
compensating balance (a noninterest-bearing account) with the bank. The compensating
balance is stated as a percentage of the loan and effectively increases the cost of the loan.
A compensating balance may also be placed on the unused portion of a line of credit, in
which case the interest rate is reduced.
A line of credit is typically decided upon prior to the actual borrowing. In the days
between the arrangement for the loan and the actual borrowing, interest rates may
change. Therefore, the agreement will stipulate the loan is at the prime interest rate
prevailing when the loan is extended plus a risk premium. (The prime interest rate will not
be known until you actually borrow the money since market interest rates may change
from the time you contract for a loan and the time you receive the funds.)
The bank may test the company's financial capability by requiring it to "clean up," that is,
repay the loan for a brief time during the year (e.g., for one month). The payment shows
the bank that the loan is actually seasonal rather than permanent. If the company is
unable to repay a short-term loan, it should probably finance with long-term funds.
-- Letters of Credit. A letter of credit is a document issued by a bank guaranteeing the
payment of a customer's drafts up to a specified amount for a designated time period. In
effect, the bank's credit is substituted for that of the buyer, minimizing the seller's risk.
Payment may be made on submission of proof of shipment or other performance. Letters
of credit are used primarily in international trade.
There are different types of letters of credit. A commercial letter of credit is typically
drawn in favor of a third party. A confirmed letter of credit is provided by a correspondent
bank and guaranteed by the issuing bank.
The advantages of letters of credit are that the company does not have to pay cash in
advance of shipment, using funds that could be used elsewhere in the business.
-- Revolving Credit. A revolving credit is an agreement between the bank and the
borrower in which the bank contracts to make loans up to a specified ceiling within a
prescribed time period. With revolving credit, notes are short term (typically ninety days).
When part of the loan is paid, an amount equal to the repayment may again be borrowed
under the terms of the agreement. Advantages are the readily available credit and few
restrictions compared to line-of-credit agreements. A major disadvantage may be
restrictions imposed by the bank.
-- Installment Loans. An installment loan requires monthly payments of interest and
principal. When the principal on the loan decreases sufficiently, you may be able to
refinance at a lower interest rate. The advantage of this kind of loan is that it may be
tailored to satisfy seasonal financing needs.

Techniques for Financial Analysis, Modeling & Forecasting Page 204

Interest
Interest on a loan may be paid either at maturity (ordinary interest) or in advance
(discounting the loan). When interest is paid in advance, the loan proceeds are reduced
and the effective (true) interest rate is increased.
Commercial Finance Loans
When credit is unavailable from a bank, the company may have to go to a commercial
finance company, which typically charges a higher interest rate than the bank and
requires collateral.
Typically, the value of the collateral is greater than the balance of the loan and may
consist of accounts receivable, inventories and fixed assets. Commercial finance
companies also finance the installment purchases of industrial equipment. A portion of
their financing is sometimes obtained through commercial bank borrowing at wholesale
rates.
Commercial Paper
Commercial paper is a short-term unsecured obligation with a maturity ranging from two
to 270 days, issued by companies to investors with temporarily idle cash. Commercial
paper can be issued only if the company possesses a very high credit rating; therefore,
the interest rate is less than that of a bank loan typically one-half percent below the prime
interest rate. Commercial paper is sold at a discount (below face value), with the interest
immediately deducted from the face of the note by the creditor; however, the company
pays the full face value. Commercial paper may be issued through a dealer or directly
placed to an institutional investor (a dealer is a company that buys securities and then
sells them out of its own inventory, while an institutional investor is an entity that buys
large volumes of securities, such as banks and insurance companies).
The benefits of commercial paper are that no security is required, the interest rate is
typically less than that required by banks or finance companies and the commercial paper
dealer often offers financial advice. The drawbacks are that commercial paper can be
issued only by large, financially sound companies and that commercial paper dealings
are impersonal. Commercial paper is usually backed by a bank letter of credit.
We now look at an example that determines whether the amount of commercial paper
issued by a company is excessive.
EXAMPLE 11.2
The company needs $300,000 for the month of November. Its options are:
l. Obtaining a one-year line of credit for $300,000 with a bank. The commitment fee is
0.5% and the interest charge on the used funds is 12%.
2. Issuing two-month commercial paper at 10% interest. Because the funds are needed
only for one month, the excess funds ($300,000) can be invested in 8% marketable
securities for December. The total transaction fee for the marketable securities is
0.3%.

Techniques for Financial Analysis, Modeling & Forecasting Page 205

The line of credit costs:

Commitment fee for unused period (0.005) (300,000)
(11/12)
Interest for one month (0.12) (300,000) (1/12)
Total cost

$1,375
3,000
$4,375

The commercial paper costs:

Interest charge (0.10) (300,000) (2/12)
Transaction fee (0.003) (300,000)
Less interest earned on marketable securities (0.08) (300,000)
(1/12)
Total cost

$5,000
900
(2,000)
$3,900

Since $3,900 is less than $4,375, the commercial paper arrangement is the better
option.
Using Receivables for Financing
In accounts receivable financing, the accounts receivable serve as security for the loan as
well as the source of repayment.
Financing backed by accounts receivable generally takes place when:
-- Receivables are at least $25,000.
-- Sales are at least $250,000.
-- Individual receivables are at least $100.
-- Receivables apply to selling merchandise rather than rendering services.
-- Customers are financially strong.
-- Sales returns are low.
-- The buyer receives title to the goods at shipment.
Receivable financing has several advantages. It eliminates the need to issue bonds or
stock to obtain a recurring cash flow. Its drawback is the high administrative costs of
monitoring many small accounts.
Accounts receivable may be financed under either a factoring agreement or an
assignment (pledging) arrangement. Factoring is the outright sale of accounts receivable
to a bank or finance company without recourse; the purchaser takes all credit and
collection risks. The proceeds received by the seller are equal to the face value of the
receivables less the commission charge, which is usually 2 to 4 percent higher than the
prime interest rate. The cost of the factoring arrangement is the factor's commission for
credit investigation, interest on the unpaid balance of advanced funds and a discount from
the face value of the receivables if there is high credit risk. Remissions by customers are
made directly to the factor.
The advantages of factoring are that it offers immediate cash, it reduces overhead
because the credit examination function is no longer needed, it provides financial advice,
Techniques for Financial Analysis, Modeling & Forecasting Page 206

it allows for receipt of advances as required on a seasonal basis and it strengthens the
company's balance sheet position.
The disadvantages of factoring include both the high cost and the negative impression
left with customers as a result of the change in ownership of the receivables. Factors may
also antagonize customers by their demanding methods of collecting delinquent
accounts.
In an assignment (pledging) arrangement, ownership of the accounts receivable is not
transferred. Instead, receivables are given to a finance company with recourse. The
finance company usually advances between 50 and 85 percent of the face value of the
receivables in cash; your company is responsible for a service charge, interest on the
advance and any resulting bad debt losses and continues to receive customer
remissions.
The assignment of accounts receivable has the advantages of providing immediate
cash, making cash advances available on a seasonal basis and avoiding negative
customer feelings. The disadvantages include the high cost, the continuing of administrative costs and the bearing of all credit risk.
Financial managers must be aware of the impact of a change in accounts receivable
policy on the cost of financing receivables. When accounts receivable are financed, the
cost of financing may rise or fall. For example, when credit standards are relaxed, costs
rise; when recourse for defaults is given to the finance company, costs decrease; and
when the minimum invoice amount of a credit sale is increased, costs decline.
Using Inventories for Financing
Financing inventory, which typically takes place when the company has completely used
its borrowing capacity on receivables, requires the existence of marketable,
nonperishable and standardized goods that have quick turnover and that are not subject
to rapid obsolescence. Good collateral inventory can be easily sold. However, you should
consider the price stability of the merchandise and the costs of selling it when deciding on
a course of action.
The cash advance for financed inventory is high when there is marketable inventory. In
general, the financing of raw materials and finished goods is about 75 percent of their
value; the interest rate is approximately 3 to 5 points over the prime interest rate.
The drawbacks of inventory financing include the high interest rate and the restrictions it
places on inventory.
Types of inventory financing include floating (blanket) liens, warehouse receipts and
trust receipts. With a floating lien, the creditor's security lies in the aggregate inventory
rather than in its components. Even though the company sells and restocks, the lender's
security interest continues. With a warehouse receipt, the lender receives an interest in
the inventory stored at a public warehouse; the fixed costs of this arrangement are high.
There may be a field warehouse arrangement in which the warehouse sets up a secured
area directly at the company's location; the company has access to the goods but must
Techniques for Financial Analysis, Modeling & Forecasting Page 207

continually account for them. With a trust receipt loan, the creditor has title to the goods
but releases them to the company to sell on the creditor's behalf; as goods are sold, the
company remits the funds to the lender. The drawback of the trust receipt arrangement is
that a trust receipt must be given for specific items.
A collateral certificate guaranteeing the existence of pledged inventory may be issued
by a third party to the lender. The advantage of a collateral certificate is its flexibility;
merchandise need not be segregated or possessed by the lender.
Financing with Other Assets
Assets other than inventory and receivables may be used as security for short-term bank
loans. Possibilities include real estate, plant and equipment, cash surrender value of life
insurance policies and securities. Lenders are also usually willing to advance a high
percentage of the market value of bonds or to make loans based on a third-party
guaranty.
Short-term financing is easier to arrange, has lower cost and is more flexible than
long-term financing. However, short-term financing leaves the borrower more vulnerable
to interest-rate swings, requires more frequent refinancing and requires earlier payment.
As a rule, you should use short-term financing to provide additional working capital, to
finance short-lived assets, or to serve as interim financing on long-term projects.
Long-term financing is more appropriate for the financing of long-term assets or
construction projects.
INTERMEDIATE-TERM FINANCING: TERM LOANS AND LEASING
We now consider the use of intermediate-term loans, primarily through banks and leases,
to meet corporate financing needs. Examples are bank loans, insurance company term
loans and equipment financing.
Purposes of Intermediate-term Bank Loans
Intermediate-term loans are loans with a maturity of more than one year but less than five
years. They are appropriate when short-term unsecured loans are not, such as when a
business is acquired, new fixed assets are purchased, or long-term debt is retired. If a
company wants to float long-term debt or issue common stock but market conditions are
unfavorable, it may seek an intermediate loan to bridge the gap until conditions improve.
A company may use extendable debt when it will have a continuing financing need,
reducing the time and cost required for repeated debt issuance.
The interest rate on intermediate-term loans is typically higher than that for short-term
loans because of the longer maturity period and varies with the amount of the loan and
the company's financial strength. The interest rate may be either fixed or variable.
Ordinary intermediate-term loans are payable in periodic equal installments except for
the last payment, which may be higher (a balloon payment). The schedule of loan
payments should be based on the company's cash flow position to satisfy the debt. The
periodic payment in a term loan equals:

Techniques for Financial Analysis, Modeling & Forecasting Page 208

Periodic Payment =

Amount of loan
Present value factor

TYPES OF LONG-TERM DEBT

Different types of debt instruments are appropriate in different circumstances. The
amount of debt a company may have depends largely on its available collateral. Sources
of long-term debt include mortgages and bonds.
Mortgages
Mortgages are notes payable that are secured by real assets and that require periodic
payments. Mortgages can be issued to finance the purchase of assets, the construction of
a plant, or the modernization of facilities. Banks require that the value of the property
exceed the mortgage on that property and usually lend up to between 70 percent and 90
percent of the value of the collateral. Mortgages may be obtained from a bank, life insurance company, or other financial institution. As a rule, it is easier to obtain mortgage loans
for multiple-use real assets than for single-use real assets.
There are two types of mortgages: senior mortgages, which have first claim on assets
and earnings and junior mortgages, which have subordinate liens.
A mortgage may have a closed-end provision that prevents the company from issuing
additional debt of the same priority against the specific property. If the mortgage is
open-ended, the company can issue additional first-mortgage bonds against the property.
Mortgages have a number of advantages, including favorable interest rates, fewer
financing restrictions than bonds, extended maturity dates for loan repayment and easy
availability.
Bonds
Long-term corporate debt usually takes the form of bonds payable and loans payable. A
bond is a certificate indicating that the company has borrowed money and agrees to
repay it. A written agreement, called an indenture, describes the features of the bond
issue (e.g., payment dates, call price should the issuer decide to reacquire the bonds,
conversion privileges and any restrictions).
The indenture is a contract between the company, the bondholder and the trustee, who
makes sure that the company meets the terms of the bond contract (in many instances,
the trustee is the trust department of a commercial bank). Although the trustee is an agent
for the bondholder, it is selected by the issuing company prior to the issuance of the
bonds. If a provision of the indenture is violated, the bonds are in default. (Covenants in
the indenture should be flexible enough to allow companies to respond quickly to changes
in the financial world.) The indenture may also have a negative pledge clause, which
precludes the issuance of new debt that takes priority over existing debt in the event of
liquidation. The clause can apply to assets currently held as well as to assets that may be
purchased in the future.
The price of a bond depends on several factors, including its maturity date, interest rate
and collateral. In selecting a maturity period for long-term debt, you should structure the
Techniques for Financial Analysis, Modeling & Forecasting Page 209

debt repayment schedule so that not all of the debt comes due close together. It is best to
spread out the payments to avoid possibility that the cash flow will be inadequate to meet
the debt payment. Also, if you expect your company's credit rating to improve in the near
term, you should issue short-term debt and then refinance later at a lower interest rate.
Note: A call provision allows the issuer of a bond to redeem the bond (call it in) earlier than
the specified maturity date. This provision is an advantage to the issuer but not the
investor. It provides the issuer with flexibility if interest rates decline and refinancing
becomes appropriate.
Bond prices and market interest rates are inversely related. As market interest rates
increase, the price of existing bonds falls because investors can invest in new bonds
paying higher interest rates. The price of a bond on the open market depends on several
factors such as its maturity value, interest rate and collateral.
Interest. Bonds are issued in $1,000 denominations; many have maturities of 10 to 30
years. The interest payment to the bondholder is called nominal interest, which is the
interest on the face of the bond and which is equal to the coupon (nominal) interest rate
times the face value of the bond. Although the interest rate is stated on an annual basis,
interest on a bond is usually paid semiannually. Interest expense incurred by the issuer is
tax deductible.
COST OF CAPITAL
The cost of capital is defined as the rate of return that is necessary to maintain the market
value of the firm (or price of the firm's stock). Financial managers must know the cost of
capital (the minimum required rate of return) in (1) making capital budgeting decisions, (2)
helping to establish the optimal capital structure and (3) making decisions such as leasing,
bond refunding and working capital management. The cost of capital is used either as a
discount rate under the NPV method or as a hurdle rate under the IRR method in Chapter 3.
The cost of capital is computed as a weighted average of the various capital components,
which are items on the right-hand side of the balance sheet such as debt, preferred stock,
common stock and retained earnings.
COMPUTING INDIVIDUAL COSTS OF CAPITAL
Each element of capital has a component cost that is identified by the following:
ki
kd
kp
ks
ke
ko

=
=
=
=
=
=

before-tax cost of debt

ki (1-t) = after-tax cost of debt, where t = tax rate
cost of preferred stock
cost of retained earnings (or internal equity)
cost of external equity, or cost of issuing new common stock
firm's overall cost of capital, or a weighted average cost of
capital

COST OF DEBT
The before-tax cost of debt can be found by determining the internal rate of return (or yield
to maturity) on the bond cash flows.
Techniques for Financial Analysis, Modeling & Forecasting Page 210

However, the following short-cut formula may be used for approximating the yield to
maturity on a bond:
ki =

I + (M - V) / n
(M + V) / 2

Where
I
M
V
n

=
=
=
=

annual interest payments in dollars

par or face value, usually $1,000 per bond
market value or net proceeds from the sale of a bond
term of the bond n years

Since the interest payments are tax-deductible, the cost of debt must be stated on an
after-tax basis.
The after-tax cost of debt is:
kd = ki (1 - t)
Where t is the tax rate.
EXAMPLE 11.3
Assume that the Carter Company issues a $1,000, 8%, 20-year bond whose net proceeds
are $940. The tax rate is 40%. Then, the before-tax cost of debt, ki, is:
I + (M - V) / n
(M + V) / 2

ki =

$80 + ($1,000 $940) / 20 $83

=
= 8.56%
($1,000 + $940) / 2
$970

Therefore, the after-tax cost of debt is:

kd = ki (1 - t)
= 8.56% (1-0.4) = 5.14%
COST OF PREFERRED STOCK
The cost of preferred stock, kp, is found by dividing the annual preferred stock dividend, dp,
by the net proceeds from the sale of the preferred stock, p, as follows:
kp =

dp
p

Since preferred stock dividends are not a tax-deductible expense, these dividends are
paid out after taxes. Consequently, no tax adjustment is required.

Techniques for Financial Analysis, Modeling & Forecasting Page 211

EXAMPLE 11.4
Suppose that the Carter company has preferred stock that pays a $13 dividend per share
and sells for $100 per share in the market. The flotation (or underwriting) cost is 3 percent,
or $3 per
share. Then the cost of preferred stock is:
dp
kp =
p
$13
=
= 13.4%
$97
COST OF EQUITY CAPITAL
The cost of common stock, ke, is generally viewed as the rate of return investors require on
a firm's common stock. Two techniques for measuring the cost of common stock equity
capital are widely used:
1. the Gordon's growth model and
2. the capital asset pricing model (CAPM) approach.
The Gordon's Growth Model. The Gordon's model is:
P0 =
Where
P0
D1
r
g

=
=
=
=

value (or market price) of common stock

dividend to be received in 1 year
Investor's required rate of return
rate of growth (assumed to be constant over
time)

Solving the model for r results in the formula for the cost of common stock:
r=

D1
P0

+ g or ke =

D1

+g

P0

Note that the symbol r is changed to ke to show that it is used for the computation of cost of
capital.
EXAMPLE 11.5
Assume that the market price of the Carter Company's stock is $40. The dividend to be paid
at the end of the coming year is $4 per share and is expected to grow at a constant annual
rate of 6 percent. Then the cost of this common stock is:
$4
D1
ke =
+g=
+ 6% = 16%
$40
P0
Techniques for Financial Analysis, Modeling & Forecasting Page 212

The cost of new common stock, or external equity capital, is higher than the cost of
existing common stock because of the flotation costs involved in selling the new common
stock. Flotation costs, sometimes called issuance costs, are the total costs of issuing and
selling a security that include printing and engraving, legal fees and accounting fees.
If f is flotation cost in percent, the formula for the cost of new common stock is:
ke =

D1
+g
P0 (1 f)

EXAMPLE 11.6
Assume the same data as in Example 11.5, except the firm is trying to sell new issues of
stock A and its flotation cost is 10 percent.
Then:
D1
ke =
+g
P0 (1 f)
$4
$4
=
+ 6% =
+ 6% = 11.11% + 6% = 17.11%
$40(1 0.1)
$36
The Capital Asset Pricing Model (CAPM) Approach. An alternative approach to measuring
the cost of common stock is to use the CAPM, which involves the following steps:
1. Estimate the risk-free rate, rf, generally taken to be the United States Treasury bill rate.
2. Estimate the stock's beta coefficient, b, which is an index of systematic (or
nondiversifiable market) risk.
3. Estimate the rate of return on the market portfolio, rm, such as the Standard & Poor's
500 Stock Composite Index or Dow Jones 30 Industrials.
4. Estimate the required rate of return on the firm's stock, using the CAPM equation:
ke = rf + b(rm - rf)
EXAMPLE 11.7
Assuming that rf is 7 percent, b is 1.5 and rm is 13 percent, then:
ke = rf + b(rm - rf) = 7% + 1.5(13% - 7%) = 16%.
This 16 percent cost of common stock can be viewed as consisting of a 7 percent risk-free
rate plus a 9 percent risk premium, which reflects that the firm's stock price is 1.5 times more
volatile than the market portfolio to the factors affecting nondiversifiable, or systematic, risk.
COST OF RETAINED EARNINGS
The cost of retained earnings, ks, is closely related to the cost of existing common stock,
since the cost of equity obtained by retained earnings is the same as the rate of return
investors require on the firm's common stock. Therefore,
ke = ks

Techniques for Financial Analysis, Modeling & Forecasting Page 213

MEASURING THE OVERALL COST OF CAPITAL

The firm's overall cost of capital is the weighted average of the individual capital costs, with
the weights being the proportions of each type of capital used. Let ko be the overall cost of
capital.
ko = (percentage of the total capital structure supplied by each source of capital x cost of
capital for each source)
= wd kd + wp kp + we ke + ws ks
Where
wd
wp
we
ws

=
=
=
=

% of total capital supplied by debts

% of total capital supplied by preferred stock
% of total capital supplied by external equity
% of total capital supplied by retained earnings (or internal equity)

The weights can be historical, target, or marginal.

HISTORICAL WEIGHTS
Historical weights are based on a firm's existing capital structure. The use of these weights
is based on the assumption that the firm's existing capital structure is optimal and therefore
should be maintained in the future. Two types of historical weights can be used - book value
weights and market value weights.
Book Value Weights. The use of book value weights in calculating the firm's weighted cost
of capital assumes that new financing will be raised using the same method the firm used for
its present capital structure. The weights are determined by dividing the book value of each
capital component by the sum of the book values of all the long-term capital sources. The
computation of overall cost of capital is illustrated in the following example.

EXAMPLE 11.8
Assume the following capital structure and cost of each source of financing for the Carter
Company:
Bonds ($1,000 par)
$20,000,000
Preferred stock ($100 par) 5,000,000
Common stock ($40 par)
20,000,000
Retained earnings
5,000,000
Total
$50,000,000

Cost
5.14% (from Example 11.3)
13.40% (from Example 11.4)
17.11% (from Example 11.6)
16.00% (from Example 11.6)

Source

Book Value

Weights

Cost

Debt
Preferred stock
Common stock

$20,000,000
5,000,000
20,000,000

40%(a)
10
40

5.14%
13.40%
17.11%

Weighted
Cost
2.06%(b)
1.34
6.84

Techniques for Financial Analysis, Modeling & Forecasting Page 214

Retained
earnings

5,000,000

10

$50,000,000

16.00%

100%

1.60
11.84%

Overall cost of capital = ko = 11.84%

(a) $20,000,000/$50,000,000 = .40 = 40%
(b) 5.14% x 40% = 2.06%

Market Value Weights. Market value weights are determined by dividing the market value of
each source by the sum of the market values of all sources. The use of market value
weights for computing a firm's weighted average cost of capital is theoretically more
appealing than the use of book value weights because the market values of the securities
closely approximate the actual dollars to be received from their sale.
EXAMPLE 11.9
In addition to the data from Example 11.8, assume that the security market prices are as
follows:
Mortgage bonds
Preferred stock
Common stock

=
=
=

$1,100 per bond

$90 per share
$80 per share

The firm's number of securities in each category is:

Mortgage bonds =

$20,000,000
= 20,000
$1,000

Preferred stock =

$5,000,000
= 50,000
$100

Common stock =

$20,000,000
= 500,000
$40

Therefore, the market value weights are:

Source
Debt
Preferred
stock
Common
stock

Number of
Securities
20,000
50,000
500,000

Price

Market Value

$1,100
$90

$22,000,000
4,500,000

$80

40,000,000
$66,500,000

The $40 million common stock value must be split in the ratio of 4 to 1 (the $20 million
common stock versus the $5 million retained earnings in the original capital structure), since
the market value of the retained earnings has been impounded into the common stock.
Techniques for Financial Analysis, Modeling & Forecasting Page 215

The firm's cost of capital is as follows:

Source

Market Value

Weights

Cost

Debt
Preferred stock
Common stock
Retained
earnings

$22,000,000
4,500,000
32,000,000
8,000,000

33.08%
6.77
48.12
12.03

5.14%
13.40%
17.11%
16.00%

$66,500,000

100.00%

Overall cost of capital

ko

Weighted
Average
1.70%
0.91
8.23
1.92
12.76%

12.76%

CONCLUSION
Cost of capital is an important concept within financial management. It is the rate of return
that must be achieved in order for the price of the stock to remain unchanged. Therefore, the
cost of capital is the minimum acceptable rate of return for the company's new investments.
The chapter discussed how to calculate the individual costs of financing sources, various
ways to calculate the overall cost of capital and how the optimal budget for capital spending
can be constructed. Financial officers should be thoroughly familiar with the ways to
compute the costs of various sources of financing for financial, capital budgeting and capital
structure decisions.

Techniques for Financial Analysis, Modeling & Forecasting Page 216

CHAPTER 11 QUIZ
1. A company has made the decision to finance next years capital projects through debt
rather than additional equity. The benchmark cost of capital for these projects should be
the weighted-average cost of capital.
True / False
2. A call provision
A. Allows bondholders to require the organization to retire the bond before original maturity.
B. Lowers the investors' required rate of return.
C. Provides organization flexibility in financing if interest rates fall.
D. Protects investors against margin calls.
3. A measure that describes the risk of an investment project relative to other investments
in general is the
A. Coefficient of variation.
B. Beta coefficient.
C. Standard deviation.
D. Expected return.

CHAPTER 11 ANSWER KEY

Techniques for Financial Analysis, Modeling & Forecasting Page 217

1. (T) is correct. The cost of capital is used either as a discount rate under the NPV method
or as a hurdle rate under the IRR method. The cost of capital is computed as a weighted
average of the various capital components, which are items on the right-hand side of the
balance sheet such as debt, preferred stock, common stock and retained earnings. When a
firm achieves its optimal capital structure, the weighted-average cost of capital is
minimized.
(F) is incorrect. The cost of capital is a composite, or weighted average, of all financing
sources in their usual proportions. The cost of capital should also be calculated on an
after-tax basis.
2. (C) is correct. A call provision allows the issuer of a bond to redeem the bond (call it in)
earlier than the specified maturity date. This provision is an advantage to the issuer but
not the investor. It provides the issuer with flexibility if interest rates decline and
refinancing becomes appropriate.
(A) is incorrect. The early retirement option is solely at the discretion of the issuer.
(B) is incorrect. A call provision will either not affect the rate of return or cause the investor
to require a higher rate to compensate for the possibility that the contract rate will not
continue until maturity.
(D) is incorrect. A margin call by a broker who holds stock purchased on credit (on
margin) is a demand for additional money from investors. A margin call is likely when
prices decline and margin requirements, stated as a percentage of price, are
inadequately covered.
3. (B) is correct. The required rate of return on equity capital in the Capital Asset Pricing
Model (CAPM) is the risk-free rate, plus the product of the market risk premium times the
beta coefficient. The market risk premium is the amount above the risk-free rate that will
induce investment in the market. The beta coefficient of an individual share is the
correlation between the volatility (price variation) of the stock market and that of the price
of the individual share. For example, if an individual share goes up 15% and the market
only 10%, beta is 1.5.
(A) is incorrect. The coefficient of variation compares risk with expected return (standard
deviation expected return).
(C) is incorrect. Standard deviation measures dispersion (risk) of asset returns.
(D) is incorrect. Expected return does not describe risk.

Techniques for Financial Analysis, Modeling & Forecasting Page 218

CHAPTER 12
ANALYZING MERGERS AND ACQUISITIONS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.

Define and explain mergers.

Decide on acquisition terms.
Describe how to acquire another business.
Identify the impact of merger on earnings per share and market price per
share.
5. Identify risk factors.
6. Describe uses of a holding company.
External growth occurs when a business purchases the existing assets of another entity
through a merger. You are often required to appraise the suitability of a potential merger
as well as participate in merger negotiations. Besides the growth aspect, a merger may
enable the reduction of corporate risk through diversification. The three common ways of
joining two or more companies are a merger, consolidation, or a holding company.
In a merger, two or more companies are combined into one, where only the
acquiring company retains its identity. Generally, the larger of the two companies is the
acquiring company.
With a consolidation, two or more companies combine to create a new company.
None of the consolidation firms legally survive. For example, companies A and B give all
their assets, liabilities and stock to the new company, C, in return for Cs stock, bonds, or
cash.
A holding company owns sufficient shares of common stock to possess voting
control of one or more other companies. The holding company comprises a group of
businesses, each operating as a separate entity. By possessing more than 50 percent of
the voting rights through common stock, the holding company has effective control of
another company with a smaller percent of ownership, such as 25 percent. The holding
company is referred to as the parent and each company controlled is termed a subsidiary.
Depending on the intent of the combination, there are three common ways in which
businesses get together so as to obtain advantages in their market. They are

Vertical merger. This occurs when a company combines with a supplier or customer.
An example is when a wholesaler combines with retailers.

Horizontal merger. This occurs when two companies in a similar business combine.
An example is the combining of two airlines.
Techniques for Financial Analysis, Modeling & Forecasting Page 219

Conglomerate merger. This occurs when two companies in unrelated industries

combine, such as where an electronics company joins with an insurance company.

MERGERS
A merger of two companies may be achieved in one of two ways. The acquirer may
negotiate with the management of the prospective acquired company, which is the
preferred approach. If negotiations are not successful, the acquirer may make a tender
offer directly to the stockholders of the targeted company. A tender offer represents a
cash offer for the common shares held by stockholders. The offer is made at a premium
above the current market price of the stock. In some cases, the tender may be shares in
the acquiring company rather than cash. Usually an expiration date exists for the tender.
Note:
1.

A good takeover candidate includes a cash-rich business, a company with a

low debt-to-equity ratio and a company with significant growth potential.

2.

In a two-tier offer, better terms are offered to shareholders who sell early. For
example, early sellers may receive cash and late sellers, bonds.

3.

Leverage buyout (LBO) is used as a defensive tactic against a hostile

takeover by tender offer. A leveraged buyout (LBO) entails the company
going private. A small group of investors, usually including senior
management purchases the publicly owned shares. The shares will then be
delisted because they will no longer be traded. Thus, an LBO competes with
a hostile tender offer as alternative.

In negotiating with management, the acquiring company usually makes a stock

offer based on a specified exchange ratio. The merger may occur if the acquired company
receives an offer at an acceptable premium over the current market price of stock.
Sometimes contingent payments are also given, such as stock warrants.
There are various financing packages that buyers may use for mergers, such as
common stock, preferred stock, convertible bonds, debt, cash and warrants. A key
consideration in choosing the final package is its effect on current earnings per share
(EPS).
If common stock is exchanged, the sellers stock is given in exchange for the
buyers stock, resulting in a tax-free exchange. The drawback is that the stock issuance
reduces earnings per share because the buyers outstanding shares are increased. When
an exchange of cash for common stock occurs, the selling companys stockholders
receive cash, resulting in a taxable transaction. This type of exchange may increase
earnings per share since the buying company is obtaining new earnings without
increasing outstanding shares.
There are many reasons why a business might prefer external growth through
mergers instead of internal growth.

Techniques for Financial Analysis, Modeling & Forecasting Page 220

Advantages of a Merger

Aids in diversification, such as reducing cyclical and operational effects.

Achieves a synergistic effect, which means that the results of a combination are greater than the sum of the parts. For example, greater profit
may be derived from the combined entity than would occur from each
individual company because of increased efficiency and cost savings. A
greater probability of synergy exists with a horizontal merger because of the
elimination of duplicate facilities.
Provides a missed attribute; that is, a company gains something it
lacked. For example, superior management quality or research capability
may be obtained.
Aids in the companys ability to raise funds when it combines with
another possessing highly liquid assets and low debt.
Enhances the market price of stock in certain cases, resulting in a higher
PE ratio for the stock. For instance, the stock of a larger company may be
perceived to be more marketable, stable and secure.
Aids the company in financing an acquisition that would not otherwise be
possible to obtain, such as where acquiring a company by exchanging stock
is less costly than constructing new capital facilities, which would require a
substantial outlay of cash. For example, a company may be unable to finance
significant internal expansion but can accomplish it by buying a business
already having such capital facilities.
Generates a good return on investment when the market value of the
acquired company is materially less than its replacement cost.
Obtains a tax loss carry-forward benefit if the acquired company has
been operating at a net loss. The acquirer may utilize the tax loss
carry-forward benefit to offset its own profitability, thus lowering its taxes. The
tax loss may be carried forward 15 years to reduce the acquiring companys
future earnings. In essence, the government is financing part of the
acquisition.

EXAMPLE 12.1
Harris Company is evaluating whether to buy Stone Company. Stone has a tax loss of
$500,000. The company expects pretax earnings of $400,000 and $300,000 for the next
two years. The tax rate is 46 percent.
The taxes to be paid by Harris follow.
Year 1
Year 2

$400,000 $400,000
$300,000 $100,000

$200,000 x 46%

$92,000

Techniques for Financial Analysis, Modeling & Forecasting Page 221

Disadvantages of a Merger

Adverse financial effects because expected benefits were not forthcoming.

For example, anticipated cost reductions did not occur.
Problems are caused by dissenting minority stockholders.
Government antitrust action delays or prevents the proposed merger.

Note: A proxy fight is an attempt by dissident shareholders to gain control of the

corporation, or at least gain influence, by electing directors. A proxy is a power of attorney
given by a shareholder that authorizes the holder to exercise the voting rights of the
shareholder. The proxy is limited in its duration, usually for a specific occasion like the
annual shareholders meeting. The issuer of a proxy statement must file a copy with the
SEC ten days prior to mailing it to shareholders all material information concerning the
issues. A form that indicates the shareholders agreement or disagreement must be
provided. Also, if the purpose is for voting for directors, proxies must be accompanied by
an annual report.
Appraisal of a potential merger must consider its effect on the financial performance of the
company, including:

Earnings per share. The merger should result in higher earnings or improve its
stability.

Dividends per share. The dividends before and after the merger should be
maintained to stabilize the market price of stock.

Market price per share. The market price of the stock should be higher or at least
the same after the merger.

Risk. The merged business should have less financial and operating risk than
before.

DECIDING ON ACQUISITION TERMS

When determining acquisition terms, you should consider the following:

Earnings in terms of absolute dollars and percentage change

Dividends
Market price of stock
Book value per share
Net working capital per share

The weight of each of the aforementioned elements on a merger varies depending upon
the circumstances involved.

Techniques for Financial Analysis, Modeling & Forecasting Page 222

Earnings
In determining the value of earnings in a merger, you should consider expected future
earnings and projected P-E ratio. A rapidly growing company is anticipated to have a
higher P-E multiple.
Dividends
Dividend receipts are desirable to stockholders. However, the more a companys growth
rate and earnings, the less is the impact of dividends on market price of stock. On the
other hand, if earnings are dropping, the greater is the effect of dividends on per share
price.
Market Price of Stock
The price of a security considers projected earnings and dividends. The value assigned to
the company in the acquisition will most likely be greater than the present market price in
the following cases:

The business is in a depressed industry.

The acquired company is of greater value to the acquirer (e.g., has high-quality
management, aids diversification) than to the stock market in general.
A higher market price than the current one is offered to induce existing
stockholders to give up their shares.

Book Value per Share

Since book value is based on historical cost rather than current value, it is not an
important factor to consider. However, when book value is greater than market value,
there may be an expectation that market price will go up after the merger because of
improved circumstances (e.g., superior management).
Net Working Capital per Share
If the acquired business has a very low debt position or very liquid assets, the acquirer
may borrow the funds for the acquisition by using the acquired companys strong liquidity
position.
Factors to Consider in Determining the Price to Be Paid for a Business

Financial analysis of the acquired company, such as the quality of earnings and
growth rate.
Future expected rate of return on assets and sales along with the probability of
achieving those expected returns.
Tax effects, such as unused tax credits.
Management quality, such as experienced and dynamic management.
Marketing position, such as favorable marketing image and market share.
Degree of competition.
Employee relations, such as the absence of unionization.
Political environment, such as the absence of stringent governmental regulation
and operations in politically unstable areas.
Risk level, such as having sufficient insurance coverage for assets.
Economic environment, including recession-resistant business.
Techniques for Financial Analysis, Modeling & Forecasting Page 223

Corporate characteristics, including having negatively correlated product lines.

Industry characteristics, such as being in a growing industry rather than a declining
one.
Structure of the arrangement, making it taxable or nontaxable.
Effect of the acquisition on the acquiring companys financial strength and
operating performance (e.g., liquidity, solvency).
Enhancement of integration and/or diversification.
Legal implications, such as the likelihood of stockholder liability suits.
Possible attack for antitrust violation.

Be Careful: Detailed financial planning and analysis are required in the acquisition
process.
ACQUISITION OF ANOTHER BUSINESS
Should stock or assets be given in the acquisition?
Advantages of Giving Stock
Quick.
Simple in terms of document preparation. There is a transfer of stock certificates in
exchange for immediate or deferred payment.
Typically, stockholder votes authorizing the purchase or sale are not required.
Minority stockholders may not have appraisal rights.
Disadvantages of Giving Stock
The acquirer in buying stock of the target company assumes its liabilities, whether
disclosed or not.
If the target is liquidated after acquisition, much work is required in conveying the
target companys assets as part of the liquidation.
Advantages of Giving Assets
Acquirer has full control over the assets it buys and the liabilities it assumes.
Typically, no acquiring company stockholder vote is needed.
Disadvantages of Giving Assets
Difficult to determine the fair value of each asset.
Target companys stockholders must approve.
State transfer taxes must be paid.
Creditor agreement may be required for certain transfers and assignments.
Must conform to bulk sales laws.
In evaluating whether to buy another business, capital budgeting techniques may be used.
Also, the effect of the new capital structure on the entitys overall cost of capital has to be
projected.
EXAMPLE 12.2
Weiss Corporation is considering buying Poczter Corporation for $95,000. Weiss current
cost of capital is 12 percent. Poczters estimated overall cost of capital after the
Techniques for Financial Analysis, Modeling & Forecasting Page 224

acquisition is 10 percent. Projected cash inflows from years one through eight are
$13,000.
The net present value is:
Year
0(-$95,000 x 1)
1-8 (13,000 x 5.334926)
Net present value

Present Value
-$95,000
+ 69,354*
-$25,646

*Using 10 percent as the discount rate.

The acquisition is not feasible because of the negative net present value.
EXAMPLE 12.3
Charles Company desires to purchase certain fixed assets of Blake Company. However,
the latter wants to sell out its business. The balance sheet of Blake Company follows.
Assets
Cash
Accounts receivable
Inventory
Equipment 1
Equipment 2
Equipment 3
Building
Total assets

$4,000
8,000
10,000
16,000
28,000
42,000
110,000
$218,000

Liabilities and Stockholders

Equity
Total liabilities
Total equity
Total liabilities and equity

$80,000
138,000
$218 000

Charles wants only equipment 1 and 2 and the building. The other assets, excluding cash,
can be sold for $24,000. The total cash received is thus $28,000 ($24,000 + $4,000 initial
cash balance). Blake desires $50,000 for the entire business. Charles will therefore have
to pay a total of $130,000, which is $80,000 in total liabilities and $50,000 for its owners.
The actual net cash outlay is therefore $102,000 ($130,000 - $28,000). It is anticipated
that the after-tax cash inflows from the new equipment will be $27,000 per year for the
next five years. The cost of capital is 8 percent.
The net present value of the acquisition is
Year
0(-$102,000 x 1)
1-5 (27,000 x 3.992710)
Net present value

Present Value
-$102,000
107,803
$ 5,803

The positive net present value indicates that the acquisition should take place.
Techniques for Financial Analysis, Modeling & Forecasting Page 225

A company may be bought by exchanging stock in accord with a predetermined ratio. The
acquirer typically offers more for each share of the acquired company than the current
market price of stock. The exchange ratio equals
Amount paid per share of the acquired company
Market price of the acquiring companys shares
EXAMPLE 12.4
Travis Company buys Boston Company. Travis Companys stock sells for $75 per share
while Bostons stock sells for $45. According to the merger negotiations, Travis offers $50
per share. The exchange ratio is 0.667 ($50/$75).
Travis exchanges 0.667 shares of its stock for one share of Boston.
IMPACT OF MERGER ON EARNINGS PER SHARE
AND MARKET PRICE PER SHARE
A merger can have a positive or negative effect on net income and market price per share
of common stock.
EXAMPLE 12.5
The following information applies:
Company A
$50,000
5,000

Net income
Outstanding
shares
EPS
P-E ratio
Market price

Company B
$84,000
12,000

$10
7
$70

$7
10
$70

Company B acquires Company A and exchanges its shares for As shares on a

one-for-one basis. The effect on EPS follows.

A stockholders
B stockholders
Total

B Shares
Owned After
Merger
5,000
12,000
17,000

EPS Before
Merger

EPS After
Merger

$10
$7

$7.88*
$7.88*

*Total net income is determined as:

5,000 shares x $10
12,000 shares x $7

Net income
Total
shares

$134,000
17,000

$50,000
84,000
$134,000
7.88 (rounded)
=

Techniques for Financial Analysis, Modeling & Forecasting Page 226

EPS goes down by $2.12 for A stockholders and up by $0.88 for B stockholders.
The effect on market price is not clear. Assuming the combined entity has the same P-E
ratio as Company B, the market price per share will be $78.80 (10 x $7.88). The
stockholders experience a higher market value per share. The increased market value
arises because net income of the combined entity is valued at a P-E ratio of 10, the same
as Company B, while prior to the merger, Company A had a lower P-E multiple of 7. But if
the combined entity is valued at Company As multiplier of 7, the market value would be
$55.16 (7 x $7.88). In this case, the stockholders in each firm experience a reduction in
market value of $14.84 ($70.00 -- $55.16).
Because the impact of the merger on market value per share is not clear, the key
consideration is EPS.
EXAMPLE 12.6
The following situation exists:
Market price per share of acquiring
company
Market price per share of acquired
company

Price per share

offered

$100

$ 20

$ 24

The exchange ratio equals

Shares
Market price

$24/$100
$24/$20

=
=

0.24
1.20

EXAMPLE 12.7
Mart Company wants to buy James Company by issuing its shares. Relevant data follow.
Net income
Outstanding
shares

Mart
$40,000
20,000

James
$26,000
8,000

The exchange ratio is 2 to 1. The EPS based on the original shares of each company
follows.
EPS of combined
entity

Combined net
income
Total Shares

Techniques for Financial Analysis, Modeling & Forecasting Page 227

$66,000
20,000 + (8,000 x 2)

$1.83
(rounded)

EPS of Mart
EPS of
James

$66,000
36,000
shares

$1.83

$1.83 x 2

$3.66

EXAMPLE 12.8
OConnor Corporation wants to buy Phil Corporation by exchanging 1.8 shares of its
stock for each share of Phil. OConnor expects to have the same P-E ratio subsequent to
the merger as prior to it. Applicable data follow.
Net income
Shares
Market price per share

OConnor
$500,000
225,000
$50

Phil
$150,000
30,000
$60

The exchange ratio of market price equals

Offer price
=
Market price of Phil

$50 x 1.8
$60

$90
$60

1.5

EPS and P-E ratios for each company are

EPS
P-E ratio

OConnor
$500,000/225,000 = $2.22
(rounded)
$50/$2.22 = 22.5 (rounded)

Phil
$150,000/30,000

$5

$60/$5

12

The P-E ratio used in obtaining Phil is

1.8 x $50
$5

$90
$5

18 times

The EPS of OConnor subsequent to the acquisition is

$650,000
=
225,000 + (30,000 x 1.8)

$650,000
279,000

2.33 (rounded)

The expected market price per share of the combined entity is $2.33 x 22.5 times =
$52.43 (rounded)

Techniques for Financial Analysis, Modeling & Forecasting Page 228

RISK
In evaluating the risk associated with an acquisition, a scenario analysis may be used,
looking at best case, worst case and most likely case. Operating scenarios consider
assumptions as to variables, including sales, volume, cost, competitive reaction,
customer perception and government interference. You derive the probability for each
scenario on the basis of experience. Sensitivity analysis may also be used to indicate how
sensitive the projects returns are to variances from expected values of essential
variables. For instance, you may undertake a sensitivity analysis on selling prices
assuming they are, for example, 8 or 12 percent higher or lower than expected. The
theory behind sensitivity analysis is to adjust key variables from their expected values in
the most likely case. The analysis can be performed assuming one purchase price or all
possible purchase prices. What is the impact, for example, of a 2 percent change in the
gross profit rate on projected returns?
What price should you pay for a target company? You should pay an amount
resulting in a cutoff return given the most likely operating scenario.
Warning: It is difficult to accomplish successful unrelated diversification. Examples are
General Electrics acquisition of Utah International and RCAs acquisition of CIP. Both
firms have divested their acquisitions. Recommendation: Acquisition of companies
operating in related fields usually have a higher success rate.
HOLDING COMPANY
A holding company is one whose only purpose is owning the stock of other businesses.
To obtain voting control of a business, the holding company may make a direct market
purchase or a tender offer. A company may decide to become a holding company if its
basic business is in a state of decline and it decides to liquidate its assets and uses the
funds to invest in companies with high growth potential.
Because the operating companies owned by the holding company are separate
legal entities, the obligations of one are isolated from the others. If one goes bankrupt, no
claim exists on the assets of the other companies. Recommendation: A loan officer
lending to one company should attempt to obtain a guarantee by the other companies.
Advantages of a Holding Company
Ability to obtain a significant amount of assets with a small investment. In essence,
the holding company can control more assets than it could acquire through a
merger.
Risk protection, in that the failure of one company does not result in the failure of
another or of the holding company. If the owned company fails, the loss of the
holding company is limited to its investment in it.
Ease of obtaining control of another company; all that is involved is buying
sufficient stock in the marketplace. Unlike a merger, in which stockholder or
management approval is required, no approval is necessary for a holding
company.
Ability to obtain a significant amount of control with a small investment by getting
voting control in a company for a minimal amount and then using that firm to gain
voting control in another and so on.
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Disadvantages of a Holding Company

Multiple tax because the income the holding company receives is in the form of
cash. Prior to paying dividends, the subsidiary must pay taxes on the earnings.
When profit is distributed to the holding company as dividends, it must pay tax on
the dividends received less an 80 percent dividend exclusion. But if the holding
company owns 80 percent or more of the subsidiarys shares, a 100 percent
dividend exemption exists. No multiple tax exists for a subsidiary that is part of a
merged company.
More costly to administer than a single company emanating from a merger
because economies of scale are not achieved.
Possibility that the U.S. Department of Justice will deem the holding company a
near monopoly and require dissolution of some of the owned companies.
Incurrence of increased debt because the acquisition may magnify variability in
earnings, thus subjecting the holding company to greater risk.
EXAMPLE 12.9
A holding company owns 70 percent of another firm. Dividends received are $20,000. The
tax rate is 46 percent. The tax paid on the dividends follows.
Dividend
Dividend exclusion
(80%)
Dividend subject to tax
Tax rate
Tax

$20,000
16,000
$ 4,000
x 46%
$ 1,840

The effective tax rate is 9.2% ($l,840/ $20,000).

CONCLUSION
In analyzing a potential merger and acquisition, many considerations must be taken into
account, such as the market price of stock, earnings per share, dividends, book value of
assets, risk and tax considerations. A detailed evaluation of the target company is
necessary to ensure that the price paid is realistic given the particular circumstances.

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CHAPTER 12 QUIZ
1. A vertical merger occurs when
A. An enterprise combines with one of its suppliers or customers.
B. Two firms that produce the same type of good or service combine.
C. Enterprises in two different countries combine.
D. Unrelated enterprises combine.
2. In a two-tier merger offer, shareholders receive a higher amount per share if they
tender their share later.
True / False
3. Which of the following is a defensive tactic against a hostile takeover by tender offer?
A. Leverage buyout (LBO).
B. Acquisition.
C. Conglomerate merger.
D. Saturday night special.
4. Which type of acquisition does not require shareholders to have a formal vote to
approve?
A. Merger.
B. Acquisition of stock.
C. Acquisition of all of the firms assets.
D. Consolidation.
5. When firm B merges with firm C to create firm BC, what has occurred?
A. A tender offer.
B. An acquisition of assets.
C. An acquisition of stock.
D. A consolidation.
6. Which of the following is a combination involving the absorption of one firm by another?
A. Merger.
B. Consolidation.
C. Proxy fight.
D. Acquisition.
7. The merger of Gap and Limited would be categorized as a
A. Diversifying merger.
B. Horizontal merger.
C. Conglomerate merger.
D. Vertical merger.
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8. An attempt to replace management in which a group of shareholders try to solicit votes

is a
A. Tender offer.
B. Takeover.
C. Proxy fight.
D. Leveraged buyout.
9. The merger of an oil refinery by a chain of gasoline stations is an example of a
A. Conglomerate merger.
B. White knight.
C. Vertical merger.
D. Horizontal merger.

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CHAPTER 12 ANSWER KEY

1. (A) is correct. Vertical merger occurs when a company combines with a supplier or
customer. An example is when a wholesaler combines with retailers.
(B) is incorrect. When two firms producing the same type of good or service combine, the
merger is classified as horizontal.
(C) is incorrect. A multinational merger may or may not be vertical.
(D) is incorrect. When two unrelated enterprises combine, the merger is classified as
conglomerate.
2. (F) is correct. In a two-tier offer, different prices are offered depending on when shares
are tendered. Better terms are usually offered to early sellers and debt securities may or
may not be involved.
(T) is incorrect. In a two-tier offer, better terms are offered to shareholders who sell early.
For example, early sellers may receive cash and late sellers, bonds.
3. (A) is correct. A leveraged buyout (LBO) entails the company going private. A small
group of investors, usually including senior management purchases the publicly owned
shares. The shares will then be delisted because they will no longer be traded. Thus, an
LBO competes with a hostile tender offer as alternative.
(B) is incorrect. Acquisition is the purchase of all of another firms assets or a controlling
interest in its shares.
(C) is incorrect. A conglomerate merger is a combination of two unrelated firms in different
industries.
(D) is incorrect. A Saturday night special is direct solicitation of shareholders through
advertisements or general mailing.
4. (B) is correct. An acquisition of stock does not require a formal vote of the firms
shareholders. Thus, management and the board of directors cannot influence
shareholders. If the acquisitions firms offer is rejected, a tender offer is usually made to
the shareholders to obtain a controlling interest.
(A) is incorrect. A merger is a transaction in which an acquiring firm absorbs a second firm
and the acquiring firm is a combination of the two merger companies. A merger is not a
type of acquisition.
(C) is incorrect. An acquisition of all of the firms assets requires a vote from the
shareholders.
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(D) is incorrect. A consolidation is similar to a merger, but a new company is formed and
neither of the merging companies survives. Thus, consolidation is not a type of
acquisition.
5. (D) is correct. A consolidation is a business transaction in which an acquiring firm
absorbs a second firm. An entirely new company is formed and neither of the merging
companies survives. Firm B merges with firm C to form an entirely new company called
BC and neither B nor C survives. Therefore, this is a consolidation.
(A) is incorrect. A tender offer is used in an acquisition by a firm to the shareholders of
another firm to tender their shares for a specified price.
(B) is incorrect. An acquisition of assets results in the ending of the existence of the
acquired firm with the acquiring firm remaining in existence.
(C) is incorrect. An acquisition of stock results in the ending of the existence of the
acquired firm with the acquiring firm remaining in existence.
6. (A) is correct. A merger is business combination in which an acquiring firm absorbs
another firm. In a merger, two or more companies are combined into one, where only the
acquiring company retains its identity. Generally, the larger of the two companies is the
acquiring company. However, approval of the merger is required by votes of the
shareholders of each firm.
(B) is incorrect. A consolidation merges two companies and forms a new company in
which neither of the tow merging firms survives. It is similar to a merger, but one firm is not
absorbed by another.
(C) is incorrect. A proxy fight is an attempt by dissident shareholders to gain control of the
corporation by electing directors.
(D) is incorrect. An acquisition involves the purchase of all another firms assets or a
controlling interest in its stock.
7. (B) is correct. A horizontal merger occurs when two firms in the same industry combine.
Gap and Limited are both in the clothing industry. A merger of these two companies would
be horizontal merger.
(A) is incorrect. A diversifying merger brings together companies in different industries.
(C) is incorrect. A conglomerate merger is a combination of two firms in unrelated
industries.

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(D) is incorrect. A vertical merger is a combination of a firm with one of its suppliers or
customers.
8. (C) is correct. A proxy fight is an attempt by dissident shareholders to gain control of the
corporation, or at least gain influence, by electing directors.
(A) is incorrect. A tender offer is a general invitation by an individual or corporation to all
shareholders of another corporation to tender (sell) their shares for a specified price.
(B) is incorrect. A takeover is an attempt by one corporation to take control over another
by purchasing a majority of common stock.
(D) is incorrect. A leveraged buyout is a largely debt-financed acquisition of a firms
publicly owned stock.
9. (C) is correct. A vertical merger is the combination of a firm with one or more of its
suppliers or customers. The acquiring firm remains in business but is a combination of the
two merged firms. The chain of gasoline stations is acquiring an oil refinery, which is a
supplier. The chain of gasoline stations will keep its name and identity. Therefore, this is a
vertical merger.
(A) is incorrect. A conglomerate merger involves the combination of two firms in unrelated
industries.
(B) is incorrect. A white knight is a firm form which the target firm seeks a competitive offer
to avoid being acquired by a less desirable suitor.
(D) is incorrect. Horizontal mergers combine companies in the same industry.

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CHAPTER 13
FORECASTING AND FINANCIAL PLANNING
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.
6.

Explain who uses forecasts.

List and describe each of forecasting methods.
Select a forecasting method.
Define the qualitative approach.
Describe common features and assumptions inherent in forecasting.
Illustrate the steps in the forecasting process.

Financial management in both private and public organizations typically operate under
conditions of uncertainty or risk. Probably the most important function of business is
forecasting. A forecast is a starting point for planning. The objective of forecasting is to
reduce risk in decision making. In business, forecasts are the basis for capacity planning,
production and inventory planning, manpower planning, planning for sales and market
share, financial planning and budgeting, planning for research and development and top
management's strategic planning. Sales forecasts are especially crucial aspects of many
financial management activities, including budgets, profit planning, capital expenditure
analysis and acquisition and merger analysis.
Figure 13.1 illustrates how sales forecasts relate to various managerial functions
of business.
FIGURE 13.1
SALE FORECASTS AND MANAGERIAL FUNCTIONS

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WHO USES FORECASTS?

Forecasts are needed for marketing, production, purchasing, manpower and financial
planning. Further, top management needs forecasts for planning and implementing
long-term strategic objectives and planning for capital expenditures. More specifically,
marketing managers use sales forecasts to determine 1) optimal sales force allocations,
2) set sales goals and 3) plan promotions and advertising. Other things such as market
share, prices and trends in new product development are required.
Production planners need forecasts in order to:
.Schedule production activities
.Order materials
.Establish inventory levels
.Plan shipments
Some other areas which need forecasts include material requirements (purchasing and
procurement), labor scheduling, equipment purchases, maintenance requirements and
plant capacity planning.
As shown in Figure 13.1, as soon as the company makes sure that it has enough
capacity, the production plan is developed. If the company does not have enough
capacity, it will require planning and budgeting decisions for capital spending for capacity
expansion.
On this basis, the financial manager must estimate the future cash inflow and
outflow. He must plan cash and borrowing needs for the company's future operations.
Forecasts of cash flows and the rates of expenses and revenues are needed to maintain
corporate liquidity and operating efficiency. In planning for capital investments,
predictions about future economic activity are required so that returns or cash inflows
accruing from the investment may be estimated.
Forecasts must also be made of money and credit conditions and interest rates so
that the cash needs of the firm may be met at the lowest possible cost. The finance and
accounting functions must also forecast interest rates to support the acquisition of new
capital, the collection of accounts receivable to help in planning working capital needs and
capital equipment expenditure rates to help balance the flow of funds in the organization.
Sound predictions of foreign exchange rates are increasingly important to financial
managers of multinational companies (MNCs).
Long-term forecasts are needed for the planning of changes in the company's
capital structure. Decisions as to whether to issue stock or debt in order to maintain the
desired financial structure of the firm require forecasts of money and credit conditions.
The personnel department requires a number of forecasts in planning for human
resources in the business. Workers must be hired and trained and for these personnel
there must be benefits provided that are competitive with those available in the firm's
labor market. Also, trends that affect such variables as labor turnover, retirement age,
absenteeism and tardiness need to be forecast as input for planning and decision making
in this function.
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Managers of nonprofit institutions and public administrators must also make

forecasts. Hospital administrators face the problem of forecasting the health care needs
of the community. In order to do this efficiently, a projection has to be made of:
.The growth in absolute size of population
.The changes in the number of people in various age groupings
.The varying medical needs these different age groups will have.
Universities forecast student enrollments, cost of operations and in many cases,
what level of funds will be provided by tuition and by government appropriations.
The service sector which today account for 2/3 of the U.S. gross domestic product
(GDP), including banks, insurance companies, restaurants and cruise ships, need
various projections for their operational and long-term strategic planning. Take a bank, for
example. The bank has to forecast:
.Demands of various loans and deposits
.Money and credit conditions so that it can determine the cost of money it lends
FORECASTING METHODS
There is a wide range of forecasting techniques which the company may choose from.
There are basically two approaches to forecasting: qualitative and quantitative. They are
as follows:
1. Qualitative approach - forecasts based on judgment and opinion.
.Executive opinions
.Delphi technique
.Sales force polling
.Consumer surveys
.Techniques for eliciting experts' opinions - PERT derived
2. Quantitative approach
a) Forecasts based on historical data
.Naive methods
.Moving averages
.Exponential smoothing
.Trend analysis
.Decomposition of time series
.Box-Jenkins
b) Associative (Causal) forecasts
.Simple regression
.Multiple regression
.Econometric modeling
c) Forecasts based on consumer behavior - Markov approach
d) Indirect methods
.Market surveys
.Input-output analysis
.Economic indicators
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Figure 13.2 summarizes the forecasting methods.

Quantitative models work superbly as long as little or no systematic change in the
environment takes place. When patterns or relationships do change, by themselves, the
objective models are of little use. It is here where the qualitative approach based on
human judgment is indispensable. Because judgmental forecasting also bases forecasts
on observation of existing trends, they too are subject to a number of shortcomings. The
advantage, however, is that they can identify systematic change more quickly and
interpret better the effect of such change on the future. We will discuss the qualitative
method here in this chapter, while various quantitative methods along with their
illustrations will be taken up in subsequent chapters.
SELECTION OF FORECASTING METHOD
The choice of a forecasting technique is significantly influenced by the stage of the
product life cycle and sometimes by the firm or industry for which a decision is being
made.
In the beginning of the product life cycle, relatively small expenditures are made for
research and market investigation. During the first phase of product introduction, these
expenditures start to increase. In the rapid growth stage, considerable amounts of money
are involved in the decisions; therefore a high level of accuracy is desirable. After the
product has entered the maturity stage, the decisions are more routine, involving
marketing and manufacturing. These are important considerations when determining the
appropriate sales forecast technique.
After evaluating the particular stages of the product and firm and industry life
cycles, a further probe is necessary. Instead of selecting a forecasting technique by using
whatever seems applicable, decision makers should determine what is appropriate.
Some of the techniques are quite simple and rather inexpensive to develop and use,
whereas others are extremely complex, require significant amounts of time to develop
and may be quite expensive. Some are best suited for short-term projections, whereas
others are better prepared for intermediate- or long-term forecasts.
What technique or techniques to select depends on the following criteria:
1. What is the cost associated with developing the forecasting model compared with
potential gains resulting from its use? The choice is one of benefit-cost trade-off.
2. How complicated are the relationships that are being forecasted?
3. Is it for short-run or long-run purposes?
4. How much accuracy is desired?
5. Is there a minimum tolerance level of errors?
6. How much data are available? Techniques vary in the amount of data they require.
THE QUALITATIVE APPROACH
The qualitative (or judgmental) approach can be useful in formulating short-term
forecasts and also can supplement the projections based on the use of any of the
qualitative methods. Four of the better known qualitative forecasting methods are
Executive Opinions, the Delphi Method, Sales Force Polling and Consumer Surveys.
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EXECUTIVE OPINIONS
The subjective views of executives or experts from sales, production, finance, purchasing
and administration are averaged to generate a forecast about future sales. Usually this
method is used in conjunction with some quantitative method such as trend extrapolation.
The management team modifies the resulting forecast based on their expectations.
The advantage of this approach is that the forecasting is done quickly and easily,
without need of elaborate statistics. Also, the jury of executive opinions may be the only
feasible means of forecasting in the absence of adequate data. The disadvantage,
however, is that of "group think." This is a set of problems inherent to those who meet as
a group. Foremost among these problems are high cohesiveness, strong leadership and
insulation of the group. With high cohesiveness, the group becomes increasingly
conforming through group pressure which helps stifle dissension and critical thought.
Strong leadership fosters group pressure for unanimous opinion. Insulation of the group
tends to separate the group from outside opinions, if given.
THE DELPHI METHOD
It is a group technique in which a panel of experts is individually questioned about their
perceptions of future events. The experts do not meet as a group in order to reduce the
possibility that consensus is reached because of dominant personality factors. Instead,
the forecasts and accompanying arguments are summarized by an outside party and
returned to the experts along with further questions. This continues until a consensus is
reached by the group, especially after only a few rounds. This type of method is useful
and quite effective for long-range forecasting.
The technique is done by "questionnaire" format and thus it eliminates the
disadvantages of group think. There is no committee or debate. The experts are not
influenced by peer pressure to forecast a certain way, as the answer is not intended to be
reached by consensus or unanimity. Low reliability is cited as the main disadvantage of
the Delphi Method, as well as lack of consensus from the returns. Table 13.1 shows how
effective this method can be.

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TABLE 13.1

SALES-FORCE POLLING
Some companies use as a forecast source sales people who have continual contacts with
customers. They believe that the sales forces that are closest to the ultimate customers
may have significant insights regarding the state of the future market. Forecasts based on
sales-force polling may be averaged to develop a future forecast. Or they may be used to
modify other quantitative and/or qualitative forecasts that have been generated internally
in the company. The advantages to this way of forecast are that (1) it is simple to use and
understand, (2) it uses the specialized knowledge of those closest to the action, (3) it can
place responsibility for attaining the forecast in the hands of those who most affect the
actual results and (4) the information can be easily broken down by territory, product,
customer or salesperson.
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The disadvantages include salespeople being overly optimistic or pessimistic

regarding their predictions and inaccuracies due to broader economic events that are
largely beyond their control.
TABLE 13.1
AN EXAMPLE OF THE USE OF THE DELPHI METHOD

CONSUMER SURVEYS
Some companies conduct their own market surveys regarding specific consumer
purchases. Surveys may consist of telephone contacts, personal interviews, or
questionnaires as a means of obtaining data. Extensive statistical analysis is usually
applied to survey results in order to test hypotheses regarding consumer behavior.
PERT-DERIVED FORECASTS
A technique known as PERT (Program Evaluation and Review Technique) has been
useful in producing estimates based on subjective opinions such as executive opinions or
sales force polling. The PERT methodology requires that the expert provide three
estimates: (1) pessimistic (a), (2) the most likely (m) and (3) optimistic (b). The theory
suggests that these estimates combine to form an expected value, or forecast, as follows:
EV = (a + 4m +b)/6
With a standard deviation of

= (b - a)/6

Where EV = expected value (mean) of the forecast

= standard deviation of the forecast
For example, suppose that management of a company believes that if the
economy is in recession, the next year's sales will be $300,000 and if the economy is in
prosperity $330,000. Their most likely estimate is $310,000. The PERT method
generates an expected value of sales as follows:
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EV

= ($300,000+4($310,000) + $330,000)/6=$311,667

With a standard deviation of

= ($330,000 - $300,000)/6 =$5,000

There are two distinct advantages to this method:
(1) It is often easier and more realistic to ask the expert to give optimistic,
pessimistic and most likely estimates than a specific forecast value.
(2) The PERT method includes a measure of dispersion (the standard deviation),
which makes it possible to develop probabilistic statements regarding the
forecast. For example, in the above example the forecaster is 95 percent
confident that the true value of the forecasted sales lies between plus or minus
two standard deviations from the mean ($311,667). That is the true value can
be expected between $301,667 and $321,667.
COMMON FEATURES AND ASSUMPTIONS INHERENT IN FORECASTING
As pointed out, forecasting techniques are quite different from each other. But
there are certain features and assumptions that underlie the business of forecasting.
They are:
1. Forecasting techniques generally assume that the same underlying causal
relationship that existed in the past will continue to prevail in the future. In other words,
most of our techniques are based on historical data.
2. Forecasts are very rarely perfect. Therefore, for planning purposes, allowances
should be made for inaccuracies. For example, the company should always maintain
a safety stock in anticipation of stockouts.
3. Forecast accuracy decreases as the time period covered by the forecast (that is, the
time horizon) increases. Generally speaking, a long-term forecast tends to be more
inaccurate than a short-term forecast because of the greater uncertainty.
4. Forecasts for groups of items tend to be more accurate than forecasts for individual
items, since forecasting errors among items in a group tend to cancel each other out.
For example, industry forecasting is more accurate than individual firm forecasting.
STEPS IN THE FORECASTING PROCESS
There are six basic steps in the forecasting process. They are:
1. Determine the what and why of the forecast and what will be needed. This will
indicate the level of detail required in the forecast (for example, forecast by region,
forecast by product, etc.), the amount of resources (for example, computer hardware
and software, manpower, etc.) that can be justified and the level of accuracy desired.
2. Establish a time horizon, short-term or long-term. More specifically, project for the
next year or next 5 years, etc.
3. Select a forecasting technique. Refer to the criteria discussed before.
4. Gather the data and develop a forecast.
5. Identify any assumptions that had to be made in preparing the forecast and using it.
6. Monitor the forecast to see if it is performing in a manner desired. Develop an
evaluation system for this purpose. If not, go to step 1.
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CHAPTER 13 QUIZ
1. Production planners need sales forecasts in order to order materials.
True / False
2. Which one of the following is a sales forecasting technique?
A. Linear programming (LP).
B. Queuing theory.
C. Sales force polling
D. EOQ.

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CHAPTER 13 ANSWER KEY

1. (T) is correct. Production planners need forecasts in order to plan and schedule
production activities so that they can order materials, establish inventory levels, hire
factory labor and plan shipments
(F) is incorrect. Production planners need demand forecasts in order to develop a master
production schedule so that they can decide on how much and when to order proper
amount of materials to support production.
2. (C) is correct. Some companies use as a forecast source sales people who have
continual contacts with customers. They believe that the sales force that is closest to the
ultimate customers may have significant insights regarding the state of the future market.
Forecasts based on sales-force polling may be averaged to develop a future forecast. Or
they may be used to modify other quantitative and/or qualitative forecasts that have been
generated internally in the company.
(A) is incorrect. LP is a method of minimizing or maximizing a function given certain
constraints.
(B) is incorrect. Queuing theory is a method of determining the appropriate number of
service stations (such as teller windows or cash registers) to minimize the sum of service
and waiting costs.
(D) is incorrect. EOQ stands for economic order quantity.

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CHAPTER 14
FORECASTING METHODOLOGY
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1. Identify and explain naive models.
2. Give examples of smoothing techniques
3. Describe step by step the forecasting method using decomposition of time series
This chapter discusses several forecasting methods that fall in the quantitative approach
category. The discussion includes naive models, moving averages and exponential
smoothing methods. Time series analysis and regressions are covered in future chapters.
The qualitative methods were described in the previous chapter.
NAIVE MODELS
Naive forecasting models are based exclusively on historical observation of sales or other
variables such as earnings and cash flows being forecast. They do not attempt to explain
the underlying causal relationships, which produce the variable being forecast.
Naive models may be classified into two groups. One group consists of simple
projection models. These models require inputs of data from recent observations, but no
statistical analysis is performed. The second group are made up of models, while naive,
are complex enough to require a computer. Traditional methods such as classical
decomposition, moving average and exponential smoothing models are some examples.
Advantages: It is inexpensive to develop, store data and operate.
Disadvantages: It does not consider any possible causal relationships that underlie
the forecasted variable.
1. A simplest example of a naive model type would be to use the actual sales of the
current period as the forecast for the next period. Let us use the symbol Y't+1 as the
forecast value and the symbol Yt as the actual value. Then, Y't+1 = Yt
2. If you consider trends, then
Y't+1 = Yt + (Yt - Yt-1)
This model adds the latest observed absolute period-to-period change to the most
recently observed level of the variable.
3. If you want to incorporate the rate of change rather than the absolute amount,
then

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Example 14.1
Consider the following sales data:

Month
1
2
3
4
5
6
7
8
9
10
11
12

20X1
Monthly
Sales of
Product
$3,050
2,980
3,670
2,910
3,340
4,060
4,750
5,510
5,280
5,504
5,810
6,100

We will develop forecasts for January 20X2 based on the aforementioned three models:
1. Y't+1 = Yt = $6,100
2. Y't+1 = Yt + (Yt - Yt-1) = $6,100 + ($6,100 - $5,810) = $6,100 + $290= $6,390
3.
Y
Y't+1 = Yt t
Yt 1
= $6,100 x

$6,100
= $6,100 (1.05) = $6,405
$5,810

The naive models can be applied, with very little need of a computer, to develop
forecasts for sales, earnings and cash flows. They must be compared with more
sophisticated models such as the regression and Box-Jenkins methods for forecasting
efficiency.
SMOOTHING TECHNIQUES
Smoothing techniques are a higher form of naive models. There are two typical forms:
moving average and exponential smoothing. Moving averages are the simpler of the two.
MOVING AVERAGES
Moving averages are averages that are updated as new information is received. With the
moving average, a manager simply employs the most recent observations to calculate an
average, which is used as the forecast for the next period.
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Example 14.2
Assume that the marketing manager has the following sales data.
Date
Jan.1
2
3
4
5
6
7

Actual Sales (Yt)

46
54
53
46
58
49
54

In order to predict the sales for the seventh and eighth days of January, the
manager has to pick the number of observations for averaging purposes. Let us consider
two cases: one is a six-day moving average and the other is a three-day average.
Case 1
46 + 54 + 53 + 46 + 58 + 49
Y'7 =
6
= 51
Y'8 =

54 + 53 + 46 + 58 + 49 + 54
6
= 52.3

Where Y' = predicted

Case 2
46 + 58 + 49
3
= 51
Y'7 =
Y'8 =

58 + 49 + 54
3 = 53.6

Techniques for Financial Analysis, Modeling & Forecasting Page 248

Predicted Sales(Y't)
Date

Actual Sales

Jan. 1

46

54

53

46

58

49

54

Case 1

Case 2

51
53.6
51
52.3

Figure 14.1 summarizes the results of Cases 1 and 2 above.

In terms of weights given to observations, in case 1, the old data received a weight
of 5/6 and the current observation got a weight of 1/6. In case 2, the old data received a
weight of only 2/3 while the current observation received a weight of 1/3.
Thus, the marketing manager's choice of the number of periods to use in a moving
average is a measure of the relative importance attached to old versus current data.
ADVANTAGES AND DISADVANTAGES
The moving average is simple to use and easy to understand. However, there are two
shortcomings.

It requires you to retain a great deal of data and carry it along with you from forecast
period to forecast period.
All data in the sample are weighted equally. If more recent data are more valid than
older data, why not give it greater weight?

The forecasting method known as exponential smoothing gets around these

disadvantages.
EXPONENTIAL SMOOTHING
Exponential smoothing is a popular technique for short-run forecasting by financial
managers. It uses a weighted average of past data as the basis for a forecast. The
procedure gives heaviest weight to more recent information and smaller weights to
observations in the more distant past. The reason for this is that the future is more
dependent upon the recent past than on the distant past. The method is known to be
effective when there is randomness and no seasonal fluctuations in the data. One
Techniques for Financial Analysis, Modeling & Forecasting Page 249

disadvantage of the method, however, is that it does not include industrial or economic
factors such as market conditions, prices, or the effects of competitors' actions.
THE MODEL
The formula for exponential smoothing is:
Y't+1 = Yt + ( 1 - ) Y't
or in words,
Y'new = Y old + (1 - ) Y'old
where Y'new = Exponentially smoothed average to be used as the forecast.
Yold = Most recent actual data.
Y'old = Most recent smoothed forecast.
= Smoothing constant.
The higher the , the higher the weight given to the more recent information.
Example 14.3
The following data on sales are given below.
Time period (t)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Actual sales
(1000)(Yt)
$60.0
64.0
58.0
66.0
70.0
60.0
70.0
74.0
62.0
74.0
68.0
66.0
60.0
66.0
62.0

To initialize the exponential smoothing process, we must have the initial forecast. The first
smoothed forecast to be used can be
1. First actual observations.
2. An average of the actual data for a few periods
For illustrative purposes, let us use a six-period average as the initial forecast Y'7 with a
smoothing constant of = 0.40.
Then Y'7 = (Y1 + Y2 + Y3+ Y4 + Y5 + Y6)/6
= (60 + 64 + 58 + 66 + 70 + 60)/6 = 63
Techniques for Financial Analysis, Modeling & Forecasting Page 250

Note that Y7 = 70. Then Y'8 is computed as follows:

Y'8 = Y7 + (1 - ) Y'7
= (0.40)(70) + (0.60)(63)
= 28.0 + 37.80 = 65.80
Similarly,
Y'9 = Y8 + (1 - ) Y'8
= (0.40)(74) + (0.60)(65.80)
= 29.60 + 39.48 = 69.08
and
Y'10 = Y9 + (1 - )Y'9
= (0.40)(62) + (0.60)(69.08)
= 24.80 + 41.45 = 66.25
By using the same procedure, the values of Y'11, Y'12, Y'13, Y'14 and Y'15 can be
calculated. The following table shows a comparison between the actual sales and
predicted sales by the exponential smoothing method.
Due to the negative and positive differences between actual sales and predicted
sales, the forecaster can use a higher or lower smoothing constant (), in order to adjust
his/her prediction as quickly as possible to large fluctuations in the data series. For
example, if the forecast is slow in reacting to increased sales, (that is to say, if the
difference is negative), he/she might want to try a higher value. For practical purposes,
the optimal may be picked by minimizing what is known as the mean squared error
(MSE), which will be discussed in more detail in a later chapter.
MSE = (Yt - Y't)2/ (n - i)
Where i = the number of observations used to determine the initial forecast (in our
example, i=6).

Techniques for Financial Analysis, Modeling & Forecasting Page 251

TABLE 14.1
COMPARISON OF ACTUAL SALES AND PREDICTED SALES
Time period (t)

Actual sales

Predicted Difference
sales (Y't) (Yt - Y't)

Difference2

63.00
65.80
69.08
66.25
69.35
68.81
67.69
64.61
65.17

49.00
67.24
50.13
60.06
1.82
7.90
59.14
1.93
10.05
307.27

(Yt - Y't)2

(Yt)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

$60.0
64.0
58.0
66.0
70.0
60.0
70.0
74.0
62.0
74.0
68.0
66.0
60.0
66.0
62.0

7.00
8.20
-7.08
7.75
-1.35
-2.81
-7.69
1.39
-3.17

In our example,
MSE = 307.27 / (15 - 6) = 307.27 / 9 = 34.14
The idea is to select the that minimizes MSE, which is the average sum of the
variations between the historical sales data and the forecast values for the corresponding
periods.
The Computer and Exponential Smoothing
As a manager, you will be confronted with complex problems requiring large sample data.
You will also need to try different values of for exponential smoothing. Virtually all
forecasting software has an exponential smoothing routine.
FORECASTING USING DECOMPOSITION OF TIME SERIES
When sales exhibit seasonal or cyclical fluctuation, we use a method called classical
decomposition, for dealing with seasonal, trend and cyclical components together. Note
that the classical decomposition model is a time series model. This means that the
method can only be used to fit the time series data, whether it is monthly, quarterly, or
annually. The types of time series data the company deals with include sales, earnings,
cash flows, market share and costs.
We assume that a time series is combined into a model that consists of the four
components - trend (T), cyclical (C), seasonal (S) and random (R). We assume the model
is of a multiplicative type, i.e
Yt = T x C x S x R
In this section, we illustrate, step by step, the classical decomposition method by
working with the quarterly sales data.
Techniques for Financial Analysis, Modeling & Forecasting Page 252

The approach basically involves the following four steps:

1. Determine seasonal indices, using a four-quarter moving average.
2. Deseasonalize the data.
3. Develop the linear least squares equation in order to identify the trend
component of the forecast.
4. Forecast the sales for each of the four quarters of the coming year.
The data we are going to use are the quarterly sales data for the video set over the
past four years. (See Table 14.2) We begin our analysis by showing how to identify the
seasonal component of the time series.
Step 1: Use moving average to measure the combined trend-cyclical (TC) components of
the time series. This way we eliminate the seasonal and random components, S and R.
More specifically, Step 1 involves the following sequences of steps:
TABLE 14.2
QUARTERLY SALES DATA FOR VCRS OVER THE PAST 4 YEARS
Year
1

Quarter
1
2
3
4
1
2
3
4
1
2
3
4
1
2
3
4

Sales
5.8
5.1
7.0
7.5
6.8
6.2
7.8
8.4
7.0
6.6
8.5
8.8
7.3
6.9
9.0
9.4

a) Calculate the 4-quarter moving average for the time series, which we discussed
in the above.
However, the moving average values computed do not correspond directly to the original
quarters of the time series.
b) We resolve this difficulty by using the midpoints between successive
moving-average values. For example, since 6.35 corresponds to the first half of quarter 3
and 6.6 corresponds to the last half of quarter 3, we use (6.35+6.6)/2 = 6.475 as the
moving average value of quarter 3.
Techniques for Financial Analysis, Modeling & Forecasting Page 253

Similarly, we associate (6.6+6.875) /2 = 6.7375 with quarter 4. A complete summary of

the moving-average calculation is shown in Table 14.3.
TABLE 14.3
MOVING AVERAGE CALCULATIONS FOR THE VCRS SALES TIME SERIES

Year
1

Quarter
1

Sales
5.8

5.1

Four-Quarter Centered
Mov. Av.
Mov. Ave.

6.35
3

7.0

6.475
6.6

7.5

6.7375
6.875

6.8

6.975
7.075

6.2

7.1875
7.3

7.8

7.325
7.35

8.4

7.4
7.45

7.0

7.5375
7.625

6.6

7.675
7.725

8.5

7.7625
7.8

8.8

7.8375
7.875

7.3

7.9375
8

6.9

8.075
8.15

9.0

9.4

c) Next, we calculate the ratio of the actual value to the moving average value for
each quarter in the time series having a 4-quarter moving average entry. This ratio in
effect represents the seasonal-random component, SR=Y/TC. The ratios calculated this
Techniques for Financial Analysis, Modeling & Forecasting Page 254

way appear in Table 14.4.

TABLE 14.4
SEASONAL RANDOM FACTORS FOR THE SERIES

Year Quarter
1
1
2

Sales
5.8

Four-Quarter
Mov. Av.

Centered
Mov. Av.
TC

Sea.-Rand.
SR=Y/TC

6.475

1.081

6.738

1.113

6.975

0.975

7.188

0.863

7.325

1.065

7.400

1.135

7.538

0.929

7.675

0.860

7.763

1.095

7.838

1.123

7.938

0.920

8.075

0.854

5.1
6.35

7.0
6.6

7.5
6.875

6.8
7.075

6.2
7.3

7.8
7.35

8.4
7.45

7.0
7.625

6.6
7.725

8.5
7.8

8.8
7.875

7.3
8

6.9
8.15

9.0

9.4

d) Arrange the ratios by quarter and then calculate the average ratio by quarter in
order to eliminate the random influence.
Techniques for Financial Analysis, Modeling & Forecasting Page 255

For example, for quarter 1

(0.975+0.929+0.920)/3=0.941
e) The final step, shown below, adjusts the average ratio slightly (for example, for
quarter 1, 0.941 becomes 0.940), which will be the seasonal index.
Step 2: After obtaining the seasonal index, we must first remove the effect of season from
the original time series. This process is referred to as deseasonalizing the time series. For
this, we must divide the original series by the seasonal index for that quarter. This is
shown in Table 14.5.
Step 3: Looking at the graph in Figure 14.1, we see the time series seem to have an
upward linear trend. To identify this trend, we develop the least squares trend equation.
This procedure is shown in Table 14.6, which was discussed in a previous chapter.
TABLE 14.5
SEASONAL COMPONENT CALCULATIONS
Quarter
1

Sea.Rand.
SR
0.975
0.929
0.920
0.863
0.860
0.854
1.081
1.065
1.095
1.113
1.135
1.123

Seasonal
Factor S

Adjusted
S

0.941

0.940

0.859

0.858

1.080

1.079

1.124
4.004

1.123
4.000

Techniques for Financial Analysis, Modeling & Forecasting Page 256

TABLE 14.6
DESEAONALIZED DATA
Year Quarter
1
1
2
3
4
2
1
2
3
4
3
1
2
3
4
4
1
2
3
4

Sales
5.8
5.1
7.0
7.5
6.8
6.2
7.8
8.4
7.0
6.6
8.5
8.8
7.3
6.9
9.0
9.4

t-bar=

8.5

b=

0.1469

a=

6.1147

Seas. S
0.940
0.858
1.079
1.123
0.940
0.858
1.079
1.123
0.940
0.858
1.079
1.123
0.940
0.858
1.079
1.123

Des. Data
6.17
5.94
6.49
6.68
7.23
7.23
7.23
7.48
7.45
7.69
7.88
7.84
7.76
8.04
8.34
8.37
117.82

t
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
136

y-bar=

7.3638

tY
6.17
11.89
19.46
26.72
36.17
43.35
50.59
59.86
67.01
76.91
86.64
94.07
100.94
112.57
125.09
133.98
1051.43

t2
1
4
9
16
25
36
49
64
81
100
121
144
169
196
225
256
1496

which means y = 6.1147 + 0.1469 t for the forecast periods:

t=

17
18
19
20

Step 4: Develop the forecast using the trend equation and adjust these forecasts to
account for the effect of season. The quarterly forecast, as shown in Table 14.7, can be
obtained by multiplying the forecast based on trend times the seasonal factor.

Techniques for Financial Analysis, Modeling & Forecasting Page 257

TABLE 14.7
QUARTER-TO-QUARTER SALES FORECASTS FOR YEAR 5
Trend
Seasonal
Quarterly
Year
Quarter
Forecast
Factor
Forecast
5
1
8.6128
(a) 0.940
8.0971
2
8.7598
0.858
7.5170
3
8.9067
1.079
9.6121
4
9.0537
1.123
10.1632
Note: (a) y = 6.1147 + 0.1469 t = 6.1147 + 0.1469 (17) = 8.6128
FIGURE 14.1
ACTUAL VERSUS DESEASONALIZED DATA

CONCLUSION
Various quantitative forecasting methods exist. Naive techniques are based solely on
previous experience. Smoothing approaches include moving average and exponential
smoothing. Moving averages and exponential smoothing employs a weighted average of
past data as the means of deriving the forecast. The classical decomposition method is
utilized for seasonal and cyclical situations.
Techniques for Financial Analysis, Modeling & Forecasting Page 258

CHAPTER 14 QUIZ
1. To facilitate planning and budgeting, management of a travel service company wants
to develop forecasts of monthly sales for the next 24 months. Based on past data,
management had observed an upward trend in the level of sales. There are also seasonal
variations with high sales in June, July and August and low sales in January, February
and March. An appropriate technique for forecasting the companys sales is
A.
Time series analysis.
B.
Queuing theory.
C.
Linear programming (LP).
D.
Sensitivity analysis.
2. The four components of a time series are: trend, cyclical, seasonal and repetitive.
True / False
3. The four components of time series data are secular trend, cyclical variation,
seasonality and random variation. The seasonality in the data can be removed by
A.
Multiplying the data by a seasonality factor.
B.
Ignoring it.
C.
Taking the weighted average over four time periods.
D.
Subtracting a seasonality factor from the data.
4. The moving-average method of forecasting
A.
Is a cross-sectional forecasting method.
B.
Regresses the variable of interest on a related variable to develop a forecast.
C.
Derives final forecasts by adjusting the initial forecast based on the smoothing
constant.
D.
Includes each new observation in the average as it becomes available and
discards the oldest observation.
5. As part of a risk analysis, an auditor wishes to forecast the percentage growth in next
months sales for a particular plant using the past 30 months sales results. Significant
changes in the organization affecting sales volumes were made within the last 9 months.
The most effective analysis technique to use would be
A.
Unweighted moving average.
B.
Exponential smoothing.
C.
Queuing theory.
D.
Linear regression analysis.

Techniques for Financial Analysis, Modeling & Forecasting Page 259

CHAPTER 14 ANSWER KEY

1. (A) is correct. In time series analysis, the dependent variable is regressed on time (the
independent variable). The secular trend is the long-term change that occurs in the
series. It is represented by a straight line or curve on a graph. A variety of methods
include seasonal variations in this forecasting model, but most adjust date by a seasonal
index.
(B) is incorrect. Queuing theory is used to minimize the sum of the costs of waiting in line
and servicing waiting lines.
(C) is incorrect. LP optimizes a given objective function subject to constraints.
(D) is incorrect. Sensitivity analysis studies the effects of changes in one or more
variables on the results of a decision model.
2. (F) is correct. Time series analysis or trend analysis relies on past experience.
Changes in the value of a variable (e.g., unit sales of a product) may have several
possible components. In time series analysis, the dependent variable is regressed on
time (the independent variable). The secular trend is the long-term change that occurs in
a series. It is represented by a straight line or curve on a graph. Seasonal variations are
common in many businesses. A variety of methods include seasonal variations in a
forecasting model, but most methods adjust data by a seasonal index. Cyclical
fluctuations are variations in the level of activity in business periods. Whereas some of
these fluctuations are beyond the control of the firm, they need to be considered in
forecasting. They are usually incorporated as index numbers. Irregular or random
variations are any variations not included in the tree categories above. Business can be
affected by random happenings, e.g., weather, strikes, or fires.
(T) is incorrect. Repetitive is not meaningful terms in a time series context. Irregular or
random variations are any variations not included in the three categoriestrend, cyclical
and seasonal. Business can be affected by random happenings, e.g., weather, strikes, or
fires.
3. (C) is correct. Seasonal variations are common in many businesses. A variety of
methods exist for including seasonal variations in a forecasting model, but most methods
divide by a seasonal index. Alternatively, seasonal variations can be removed from data
by using a weighted average of several time periods instead of data from individual
periods.
(A) is incorrect. Adding or subtracting a seasonality factor to a forecast based on trend
analysis is a means of adjusting for seasonality.
(B) is incorrect. Seasonality factors cannot be ignored; they are reflected in the data and
must be considered for a model to be accurate.
Techniques for Financial Analysis, Modeling & Forecasting Page 260

(D) is incorrect. The seasonality adjustment for a single seasons data may be an
increase or a decrease.
4. (D) is correct. The moving-average method is a smoothing technique that uses the
experience of the past N periods (through time period t) to forecast a value for the next
period. Thus, the average includes each new observation and discards the oldest
observation. The forecast formula for the next period (for time period t = 1) is the sum of
the last N observations divided by N.
(A) is incorrect. Cross-sectional regression analysis examines relationships among large
amounts of data (e.g., many or different production methods or locations) at a particular
moment in time.
(B) is incorrect. Regression analysis relates the forecast to changes in particular
variables.
(C) is incorrect. Under exponential smoothing, each forecast equals the sum of the last
observation times the smoothing constant, plus the last forecast times one minus the
constant.
5. (B) is correct. Under exponential smoothing, each forecast equals the sum of the last
observation times the smoothing constant, plus the last forecast times one minus the
constant. Thus, exponential means that greater weight is placed on the most recent data
with the weights of all data falling off exponentially as the data ages. This feature is
important because of the organizational changes that affected sales volume.
(A) is incorrect. An unweighted average will not give more importance to more recent
data.
(C) is incorrect. Queuing theory is used to minimize the cost of waiting lines.
(D) is incorrect. Linear regression analysis determines the equation for the relationship
among variables. It does not give more importance to more recent data.

Techniques for Financial Analysis, Modeling & Forecasting Page 261

CHAPTER 15
FORECASTING WITH REGRESSION AND MARKOV METHODS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.
6.
7.

Explain the least-squares method.

Discuss regression statistics.
Identify statistics to look for in multiple regressions.
Evaluate forecasting performance.
Outline checklists on how to choose the best forecasting equation.
Select and use a computer statistical package for multiple regression.
Explain forecasting sales using the Markov model.

Regression analysis is a statistical procedure for estimating mathematically the average

relationship between the dependent variable and the independent variable(s). Simple
regression involves one independent variable, price or advertising in a demand function,
whereas multiple regression involves two or more variables, that is price and advertising
together.
In this chapter, we will discuss simple (linear) regression to illustrate the
least-squares method, which means that we will assume the Y = a + bX relationship.
THE LEAST-SQUARES METHOD
The least-squares method is widely used in regression analysis for estimating the
parameter values in a regression equation. The regression method includes all the
observed data and attempts to find a line of best fit. To find this line, a technique called the
least-squares method is used.
To explain the least-squares method, we define the error as the difference
between the observed value and the estimated one and denote it with u. Symbolically,
u = Y - Y'
where Y = observed value of the dependent variable
Y' = estimated value based on Y' = a + bX
The least-squares criterion requires that the line of best fit be such that the sum of
the squares of the errors (or the vertical distance in Figure 15.1 from the observed data
points to the line) is a minimum, i.e.,
Minimum: u2 = (Y-a-bX)2

Techniques for Financial Analysis, Modeling & Forecasting Page 262

Figure 15.1
Y AND Y'

Using differential calculus we obtain the following equations, called normal equations:
Y = na + bX
XY = aX + bX2

Solving the equations for b and a yields

n XY - ( X)( Y)
b=
n X 2 ( X) 2
a = Y bX

where Y =

Y
n

and X =

X
n

Example 15.1
To illustrate the computations of b and a, we will refer to the data in Table 15.1. All the
sums required are computed and shown below.

Techniques for Financial Analysis, Modeling & Forecasting Page 263

Table 15.1
Computed Sums
Advertising X
(000)

Sales Y
(000)

XY

X2

Y2

$9
19
11
14
23
12
12
22
7
13
15
17
$174

15
20
14
16
25
20
20
23
14
22
18
18
$225

135
380
154
224
575
240
240
506
98
286
270
306
3,414

81
361
121
196
529
144
144
484
49
169
225
289
2,792

225
400
196
256
625
400
400
529
196
484
324
324
4,359

From the table above:

X = 174; Y = 225; XY = 3,414; X2 = 2,792.
X = X/n = 174/12 = 14.5;

Y = Y/n = 225/12 = 18.75.

Substituting these values into the formula for b first:

b=

n XY - ( X)( Y)
n X ( X)
2

(12)(3,414) - (174)(225)
1,818
=
= 0.5632
2
(12)(2,792) - (174)
3,228

a = Y - b X = 18.75 - (0.5632)(14.5) = 18.75 - 8.1664 = 10.5836

Thus, Y' = 10.5836 + 0.5632 X
Example 15.2
Assume that the advertising of $10 is to be expended for next year; the projected sales for
the next year would be computed as follows:
Y' = 10.5836 + 0.5632 X
= 10.5836 + 0.5632 (10)
= $16.2156
Note that Y2 is not used here but rather is computed for r-squared (R2).
TREND ANALYSIS
Trends are the general upward or downward movements of the average over time. These
movements may require many years of data to determine or describe them. They can be
Techniques for Financial Analysis, Modeling & Forecasting Page 264

described by a straight line or a curve. The basic forces underlying the trend include
technological advances, productivity changes, inflation and population change. Trend
analysis is a special type of simple regression. This method involves a regression
whereby a trend line is fitted to a time series of data.
The linear trend line equation can be shown as
Y=a+bt
where t = time.
The formula for the coefficients a and b are essentially the same as the cases for
simple regression. However, for regression purposes, a time period can be given a
number so that t = 0. When there is an odd number of periods, the period in the middle is
assigned a zero value. If there is an even number, then -1 and +1 are assigned the two
periods in the middle, so that again t = 0.
With t = 0, the formula for b and a reduces to the following:
b=

a=

n tY
n t 2

Y
n

EXAMPLE 15.3
Case 1 (odd number)
t=

20X1
-2

20X2
-1

20X3
0

20X4
+1

20X5
+2

Case 2 (even number)

t=

20X1
-3

20X2
-2

20X3
-1

20X4
+1

20X5
+2

20X6
+3

In each case t = 0.

Techniques for Financial Analysis, Modeling & Forecasting Page 265

Example 15.4
Consider ABC Company, whose historical sales follows.
Year
20X1
20X2
20X3
20X4
20X5

Sales (in millions)

$ 10
12
13
16
17

Since the company has five years' data, which is an odd number, the year in the middle is
assigned a zero value.

b=

a=

Year

20X1
20X2
20X3
20X4
20X5

-2
-1
0
+1
+2
0

Sales(in
millions)(Y)
$ 10
12
13
16
17
68

tY

-20
-12
0
16
34
18

4
1
0
1
4
10

100
144
169
256
289
958

(5)(18)
= 90/50 =1.8
5(10)
68
= 13.6
5

Therefore, the estimated trend equation is

Y' = $13.6 + $1.8 t
To project 20X6 sales, we assign +3 to the t value for the year 20X6.
Y' = $13.6 + $1.8 (3)
= $19
Table 15.1 contains a summary of the more commonly used forecasting methods
discussed thus far.

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Techniques for Financial Analysis, Modeling & Forecasting Page 268

REGRESSION STATISTICS
Regression analysis is a statistical method. Hence, it uses a variety of statistics to tell
about the accuracy and reliability of the regression results. They include:
1. Correlation coefficient (R) and coefficient of determination(R2)
2. Standard error of the estimate (Se) and prediction confidence interval
3. Standard error of the regression coefficient (Sb) and t-statistic
Each of these statistics is explained below.
1. Correlation coefficient (R) and coefficient of determination (R2)
The correlation coefficient R measures the degree of correlation between Y and X. The
range of values it takes on is between -1 and +1. More widely used, however, is the
coefficient of determination, designated R2 (read as r-squared). Simply put, R2 tells us
how good the estimated regression equation is. In other words, it is a measure of
"goodness of fit" in the regression. Therefore, the higher the R2, the more confidence we
have in our estimated equation.
More specifically, the coefficient of determination represents the proportion of the
total variation in Y that is explained by the regression equation. It has the range of values
between 0 and 1.
Example 15.5
The statement "Sales is a function of advertising expenditure with R2 = 70 percent," can
be interpreted as "70 percent of the total variation of sales is explained by the regression
equation or the change in advertising and the remaining 30 percent is accounted for by
something other than advertising, such as price and income."
The coefficient of determination is computed as
R2 = 1 -

(Y - Y' )
(Y - Y)

In a simple regression situation, however, there is a short-cut method available:

R2 =

[n XY - ( X)( Y)]2
[n X 2 ( X) 2 ][n Y 2 - ( Y) 2 ]

Comparing this formula with the one for b, we see that the only additional information we
need to compute R2 is Y2.

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Example 15.6
To illustrate the computations of various regression statistics, we will refer to the data in
Table 15.1.
Using the shortcut method for R2,
R2 =

(1,818) 2
3,305,124
3,305,124
=
=
2
[3,228][(12)(4,359) - (225) ] [3,228][52,308 - 50,625] (3,228)(1,683)

3,305,124
5,432,724

= 0.6084 = 60.84%

This means that about 60.84 percent of the total variation in sales is explained by
advertising and the remaining 39.16 percent is still unexplained. A relatively low R2
indicates that there is a lot of room for improvement in our estimated forecasting formula
(Y' = $10.5836 + $0.5632X). Price or a combination of advertising and price might
improve R2.
2. Standard Error of the Estimate (Se) and Prediction Confidence Interval
The standard error of the estimate, designated Se, is defined as the standard
deviation of the regression. It is computed as:
Se =

(Y - Y' )

n-2

- a Y - b XY
n-2

This statistic can be used to gain some idea of the accuracy of our predictions.
Example 15.7
Going back to our example data, Se is calculated as :

Se =

- a Y - b XY
n-2

4,359 - (10.5836)(225) - (0.5632)(3,414)

=
12 - 2

54.9252
=
10

2.3436

Suppose you wish to make a prediction regarding an individual Y value--such as a

prediction about the sales when an advertising expense = $10. Usually, we would like to
have some objective measure of the confidence we can place in our prediction and one
such measure is a confidence (or prediction) interval constructed for Y.
A confidence interval for a predicted Y, given a value for X, can be constructed in the
following manner.
Techniques for Financial Analysis, Modeling & Forecasting Page 270

Y' t Se

1
1+ +
n

(X p X) 2

X2 -

( X) 2
n

where Y' = the predicted value of Y given a value for X;

Xp = the value of independent variable used as the basis for prediction.
Note: t is the critical value for the level of significance employed. For example, for a
significant level of 0.025 (which is equivalent to a 95% confidence level in a two-tailed
test), the critical value of t for 10 degrees of freedom is 2.228 (See Table 15.3). As can be
seen, the confidence interval is the linear distance bounded by limits on either side of the
prediction.
Example 15.8
If you want to have a 95 percent confidence interval of your prediction, the range for the
prediction, given an advertising expense of $10 would be between $10,595.10 and
$21,836.10, as determined as follows: Note that from Example 15.2, Y' = $16.2156
The confidence interval is therefore established as follows:
$16.2156 (2.228)(2.3436) 1 +

1
+
12

(10 - 14.5) 2
(174) 2
2,792
12

= $16.2156 (2.228)(2.3436) (1.0764)

= $16.2156 5.6205
which means the range for the prediction, given an advertising expense of $10 would be
between $10.5951 and $21.8361. Note that $10.5951 = $16.2156 - 5.6205 and $21.8361
=$16.2156 + 5.6205.
3. Standard Error of the Regression Coefficient (Sb) And t-Statistic
The standard error of the regression coefficient, designated Sb and the t-statistic are
closely related. Sb is calculated as:
Se
Sb =
(X - X) 2
or in short-cut form
Se
Sb =
X 2 - X X)

Sb gives an estimate of the range where the true coefficient will "actually" fall.

Techniques for Financial Analysis, Modeling & Forecasting Page 271

t-statistics (or t-value) is a measure of the statistical significance of an independent

variable X in explaining the dependent variable Y. It is determined by dividing the
estimated regression coefficient b by its standard error Sb. It is then compared with the
table t-value (See Table 15.3). Thus, the t-statistic measures how many standard errors
the coefficient is away from zero.
Rule of thumb: Any t-value greater than +2 or less than -2 is acceptable. The
higher the t-value, the greater the confidence we have in the coefficient as a predictor.
Low t-values are indications of low reliability of the predictive power of that coefficient.
Example15.9
The Sb for our example is:
Sb =

Se
X 2 - X X)

2.3436
=
2,792 (14.5)(174)

Thus, t-statistic =

b
Sb

2.3436
= 0.143
2,792 - 2,523

0.5632
= 3.94
0.143

Since, t = 3.94 > 2, we conclude that the b coefficient is statistically significant. As was
indicated previously, the table's critical value (cut-off value) for 10 degrees of freedom is
2.228 (from Table 15.3 at the end of the chapter).
To review:
(1) t-statistic is more relevant to multiple regressions which have more than one b's.
(2) R2 tells you how good the forest (overall fit) is while t-statistic tells you how good an
individual tree (an independent variable) is.
In summary, the table t value, based on a degree of freedom and a level of significance, is
used:
(1) To set the prediction range -- upper and lower limits -- for the predicted value of the
dependent variable.
(2) To set the confidence range for regression coefficients.
(3) As a cutoff value for the t-test.

Figure 15.3 shows an Excel regression output that contains the statistics we discussed so
far.

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FIGURE 15.3
EXCEL REGRESSION OUTPUT
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations

0.77998
0.60837
0.56921
2.34362
12

(R )
(Se)

ANOVA
Regression
Residual
Total

df
1
10
11

SS
85.32434944
54.92565056
140.25

MS
Significance F
85.3243 0.002769
5.49257

Intercept
Advertising

Coefficients
10.5836
0.5632

Standard Error (Sb) t Stat

Lower 95%
2.17960878
4.85575 5.727171
0.142893168
3.94139 0.244811

Upper 95% Upper 95.0%

15.4401
15.4401
0.88158
0.88158

(1) R-squared (R2) = .608373 = 60.84%

(2) Standard error of the estimate (Se) = 2.343622
(3) Standard error of the coefficient (Sb) = 0.142893
(4) t-value = 3.94
All of the above are the same as the ones manually obtained.
Note: Linear regression makes several assumptions: that errors are normally distributed
with a mean of zero, that the variance of the errors is constant (constant variance or
homoscedasticity) and that the independent variables are not correlated with each other.
STATISTICS TO LOOK FOR IN MULTIPLE REGRESSIONS
In multiple regressions that involve more then one independent (explanatory) variable,
managers must look for the following statistics:

t-statistics

R-bar squared ( R ) and F-statistic

Multicollinearity
Autocorrelation (or serial correlation)

t-Statistics
The t-statistic was discussed earlier, but is taken up again here since it is more
valid in multiple regressions than in simple regressions. The t-statistic shows the
significance of each explanatory variable in predicting the dependent variable. It is
desirable to have as large (either positive or negative) a t-statistic as possible for each
independent variable. Generally, a t-statistic greater than +2.0 or less than -2.0 is
acceptable. Explanatory variables with low t-value can usually be eliminated from the
Techniques for Financial Analysis, Modeling & Forecasting Page 273

regression without substantially decreasing R2 or increasing the standard error of the

regression. In a multiple regression situation, the t-statistic is defined as
t-statistic =

bi
Sb i

where i = ith independent variable

2

R-bar Squared ( R ) and F-Statistic

2

A more appropriate test for goodness of fit for multiple regressions is R-bar squared ( R ):
2

R = 1 - (1 - R2)

n 1
nk

where n = the number of observations

k = the number of coefficients to be estimated
An alternative test of the overall significance of a regression equation is the F-test.
Virtually all computer programs for regression analysis show an F-statistic.
The F-statistic is defined as
(Y ' Y ) 2 / k
Explained variation/k
F=
=
2
(Y Y ' ) /(n k 1) Unexplained variation/(n - k - 1)

If the F-statistic is greater than the table value, it is concluded that the regression equation
is statistically significant in overall terms.
Multicollinearity
When using more than one independent variable in a regression equation, there is
sometimes a high correlation between the independent variables themselves.
Multicollinearity occurs when these variables interfere with each other. It is a pitfall
because the equations with multicollinearity may produce spurious forecasts.
Multicollinearity can be recognized when

The t-statistics of two seemingly important independent variables are low

The estimated coefficients on explanatory variables have the opposite sign
from that which would logically be expected

There are two ways to get around the problem of multicollinearity:

One of the highly correlated variables may be dropped from the regression
The structure of the equation may be changed using one of the following
methods:

Techniques for Financial Analysis, Modeling & Forecasting Page 274



Divide both the left and right-hand side variables by some series that
will leave the basic economic logic but remove multicollinearity
Estimate the equation on a first-difference basis
Combine the collinear variables into a new variable, which is their
weighted sum

Autocorrelation (Serial Correlation)

Autocorrelation is another major pitfall often encountered in regression analysis. It
occurs where there is a correlation between successive errors. The Durbin-Watson
statistic provides the standard test for autocorrelation. Table 15.2 at the end of the
chapter provides the values of the Durbin-Watson statistic for specified sample sizes and
explanatory variables. Table 15.2 gives the significance points for dL and dU for tests on
the autocorrelation of residuals (when no explanatory variable is a lagged endogenous
variable). The number of explanatory variables, K excludes the constant term.
Generally speaking,
Durbin-Watson
Statistic
Between 1.5 and 2.5
Below 1.5
Above 2.5

Autocorrelation
No autocorrelation
Positive Autocorrelation
Negative
Autocorrelation

Autocorrelation usually indicates that an important part of the variation of the dependent
variable has not been explained. Recommendation: The best solution to this problem is to
search for other explanatory variables to include in the regression equation.
CHECKLISTS--HOW TO CHOOSE THE BEST FORECASTING EQUATION
Choosing among alternative forecasting equations basically involves two steps. The first
step is to eliminate the obvious losers. The second is to select the winner among the
remaining contenders.
HOW TO ELIMINATE LOSERS
1. Does the equation make sense? Equations that do not make sense intuitively or from
a theoretical standpoint must be eliminated.
2. Does the equation have explanatory variables with low t-statistics? These equations
should be reestimated or dropped in favor of equations in which all independent
variables are significant. This test will eliminate equations where multicollinearity is a
problem.
2

3. How about a low R ? The R can be used to rank the remaining equations in order to
2

select the best candidates. A low R could mean:

A wrong functional was fitted
An important explanatory variable is missing
Other combinations of explanatory variables might be more desirable
Techniques for Financial Analysis, Modeling & Forecasting Page 275

HOW TO CHOOSE THE BEST EQUATION

1. Best Durbin-Watson statistic. Given equations that survive all previous tests, the
equation with the Durbin-Watson statistic closest to 2.0 can be a basis for selection.
2. Best forecasting accuracy. Examining the forecasting performance of the equations is
essential for selecting one equation from those that have not been eliminated. The
equation whose prediction accuracy is best in terms of measures of forecasting errors,
such as MAD, MSE, RMSE, or MPE (to be discussed in detail in a later chapter)
generally provides the best basis for forecasting.
It is important to note that neither Lotus 1-2-3 nor Quattro Pro calculate many statistics
2

such as R-bar squared ( R ), F-statistic and Durbin-Watson statistic. You have to go to

regression packages such as Statistical Analysis System (SAS), STATPACK and
Statistical Packages for Social Scientists (SPSS), to name a few. These packages do all
have PC versions.
USE OF A COMPUTER STATISTICAL PACKAGE FOR MULTIPLE REGRESSION
Example 15.10
Stanton Consumer Products Corporation wishes to develop a forecasting model for its
dryer sale by using multiple regression analysis. The marketing department has prepared
the following sample data.
Sales of Disposable
Sales of
Washers Income
Savings Dryers
(Y)
Month
(X1)
(X2)
(X3)
January
$45,000 $16,000
$71,000 $29,000
February
42,000
14,000
70,000
24,000
March
44,000
15,000
72,000
27,000
April
45,000
13,000
71,000
25,000
May
43,000
13,000
75,000
26,000
June
46,000
14,000
74,000
28,000
July
44,000
16,000
76,000
30,000
August
45,000
16,000
69,000
28,000
September 44,000
15,000
74,000
28,000
October
43,000
15,000
73,000
27,000

The computer statistical package called SPSS was employed to develop the regression
model. Figure 15.4 contains the input data and output that results using three explanatory
variables. To help you understand the listing, illustrative comments are added whenever
applicable.

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FIGURE 15.4
SPSS REGRESSION OUTPUT
Variables Entered/Removedb
Model
1

Variables
Entered
SAVINGS,
sales, a
INCOME

Variables
Removed

Method
.

Enter

a. All requested variables entered.

b. Dependent Variable: SALESDRY

Model Summaryb

Model
1

R
.992a

R Square
.983

Adjusted R
Square
.975

Std. Error
of the
Estimate
286.1281

Durbin-Watson
2.094

a. Predictors: (Constant), SAVINGS, sales, INCOME

b. Dependent Variable: SALESDRY

Coefficientsa

Model
1

(Constant)
sales
INCOME
SAVINGS

Unstandardized
Coefficients
B
Std. Error
-45796.3
4877.651
.597
.081
1.177
.084
.405
.042

Standardi
zed
Coefficien
ts
Beta
.394
.752
.508

t
-9.389
7.359
13.998
9.592

Sig.
.000
.000
.000
.000

a. Dependent Variable: SALESDRY

1. The forecasting equation. From the SPSS output we see that

Y' = -45,796.35 + 0.597X1 + 1.177X2 + 0.405X3
Suppose that in November the company expects
X1
X2

=
=

X3

sales of washers
disposable
income
Savings

=
=

$43,000
$15,000

$75,000

Techniques for Financial Analysis, Modeling & Forecasting Page 277

Then the forecast sales for the month of November would be

Y' = -45,796.35 + 0.597(43,000) + 1.177(15,000) + 0.405(75,000)
= -45,796 + 25,671 + 17,655 + 30,375
= $27,905.35
2. The coefficient of determination. Note that the SPSS output gives the value of R, R2
and R2 adjusted. In our example, R = 0.992 and R2 = 0.983
In the case of multiple regression, R2 is more appropriate, as was discussed previously.
2

R = 1 - (1 - R2)

n 1
nk
10 1
= 1 - 0.017 (9/7)
10 3
= 1 - 0.025 = 0.975

= 1 - (1 - 0.983)

This tells us that 97.5 percent of total variation in sales of dryers is explained by the
three explanatory variables. The remaining 2.2 percent was unexplained by the estimated
equation.
3. The standard error of the estimate (Se). This is a measure of dispersion of actual sales
around the estimated equation. The output shows Se = 286.1281.
4. Computed t. We read from the output

X1
X2
X3

t-Statistic
7.359
13.998
9.592

All t values are greater than a rule-of-thumb table t value of 2.0. (Strictly speaking, with n
- k - 1 = 10 - 3 - 1 = 6 degrees of freedom and a level of significance of, say, 0.01, we see
from Table 15.3 that the table t value is 3.707.) For a two-sided test, the level of
significance to look up was .005. In any case, we conclude that all three explanatory
variables we have selected were statistically significant.
4. F-test. From the output, we see that
F=

29.109 / 3
( Y ' Y ) 2 / k
Explained variation/k
=
=
2
0.491 / 6
( Y Y ' ) /( n k 1) Unexplained variation/(n - k - 1)

= 9.703/0.082 = 118.517 (which is given in the printout.)

At a significance level of 0.01, our F-value is far above the value of 9.78 (which is
from Table 15.4), so we conclude that the regression as a whole is highly significant.
6. Conclusion. Based on statistical considerations, we see that:
The estimated equation had a good fit
All three variables are significant explanatory variables
The regression as a whole is highly significant
Techniques for Financial Analysis, Modeling & Forecasting Page 278

The model developed can be used as a forecasting equation with a great degree of
confidence

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MEASURING ACCURACY OF FORECASTS

The performance of a forecast should be checked against its own record or against that of
other forecasts. There are various statistical measures that can be used to measure
performance of the model. Of course, the performance is measured in terms of
forecasting error, where error is defined as the difference between a predicted value and
the actual result.
Error (e) = Actual (A) - Forecast (F)
MAD and MSE
Two commonly used measures for summarizing historical errors are the mean absolute
deviation (MAD) and the mean squared error (MSE). The formulas used to calculate MAD
and MSE are
MAD = |e| / n
MSE = e2 / (n - 1)
The following example illustrates the computation of MAD and MSE.
Example 15.11
Sales data of a microwave oven manufacturer are given below.
Period

Actual (A)

1
2
3
4
5
6
7
8

217
213
216
210
213
219
216
212

Forecast
(F)
215
216
215
214
211
214
217
216

e (A-F)

|e|

2
-3
1
-4
2
5
-1
-4
-2

2
3
1
4
2
5
1
4
22

4
9
1
16
4
25
1
16
76

Using the figures,

MAD = |e| /n = 22/8 = 2.75
MSE = e2 / (n - 1)= 76/7 = 10.86
One way these measures are used is to evaluate forecasting ability of alternative
forecasting methods. For example, using either MAD or MSE, a forecaster could compare
the results of exponential smoothing with alphas and elect the one that performed best in
terms of the lowest MAD or MSE for a given set of data. Also, it can help select the best
initial forecast value for exponential smoothing.
THE U STATISTIC AND TURNING POINT ERRORS
There is still a number of statistical measures for measuring accuracy of the forecast. Two
standards may be identified. First, one could compare the forecast being evaluated with a
Techniques for Financial Analysis, Modeling & Forecasting Page 284

naive forecast to see if there are vast differences. The naive forecast can be anything like
the same as last year, moving average, or the output of an exponential smoothing
technique. In the second case, the forecast may be compared against the outcome when
there is enough to do so. The comparison may be against the actual level of the variable
forecasted, or the change observed may be compared with the change forecast.
The Theil U Statistic is based upon a comparison of the predicted change with the
observed change. It is calculated as:
U=

(1 / n ) (F A) 2
(1 / n ) F2 + (1 / n ) A 2

As can be seen, U=0 is a perfect forecast, since the forecast would equal actual
and F - A = 0 for all observations. At the other extreme, U=1 would be a case of all
incorrect forecasts. The smaller the value of U, the more accurate the forecasts. If U is
greater than or equal to 1, the predictive ability of the model is lower than a naive
no-change extrapolation. Note: Many computer software packages routinely compute the
U Statistic.
CONTROL OF FORECASTS
It is important to monitor forecast errors to insure that the forecast is performing well. If the
model is performing poorly based on some criteria, the forecaster might reconsider the
use of the existing model or switch to another forecasting model or technique. The
forecasting control can be accomplished by comparing forecasting errors to
predetermined values, or limits. Errors that fall within the limits would be judged
acceptable while errors outside of the limits would signal that corrective action is desirable.
Forecasts can be monitored using either tracking signals or control charts.
A tracking signal is based on the ratio of cumulative forecast error to the
corresponding value of MAD.
Tracking signal = (A - F) / MAD
The resulting tracking signal values are compared to predetermined limits. These
are based on experience and judgment and often range from plus or minus 3 to plus or
minus 8. Values within the limits suggest that the forecast is performing adequately. By
the same token, when the signal goes beyond this range, corrective action is appropriate.
Example 15.12
Going back to Example 15.11, the deviation and cumulative deviation have already
been computed:
MAD = |A - F| / n = 22 / 8 = 2.75
Tracking signal = (A - F) / MAD = -2 / 2.75 = - 0.73
A tracking signal is as low as - 0.73, which is substantially below the limit (-3 to -8).
It would not suggest any action at this time.
Techniques for Financial Analysis, Modeling & Forecasting Page 285

Note: Plot the errors and see if all errors are within the limits, so that the forecaster
can visualize the process and determine if the method being used is in control.
Example 15.13
For the sales data below, using the naive forecast, we will determine if the forecast
is in control. For illustrative purposes, we will use 2 sigma control limits.

Year
1
2
3
4
5
6
7
8
9
10

Sales
320
326
310
317
315
318
310
316
314
317

Forecasts Error

Error

320
326
310
317
315
318
310
316
314

36
256
49
4
9
64
36
4
9
467

6
-16
7
-2
3
-8
6
-2
3
-3

First, compute the standard deviation of forecast errors.

Sf = e2 / (n - 1) = 467/(9 - 1) = 7.64
Two sigma limits are then plus or minus 2(7.64) = -15.28 to +15.28
Note that the forecast error for year 3 is below the lower bound, so the forecast is not in
control. The use of other methods such as moving average, exponential smoothing, or
regression would possibly achieve a better forecast.
FORECASTING SALES WITH THE MARKOV MODEL
The forecasting methods we have discussed to date were, for the most part, based on the
use of historical data. They did not consider aspects of consumer behavior in making purchase decisions in the marketplace. In this section, we will present a model based on
learned behavior, called the Markov model. We operate on the thesis that consumption is
a form of learned behavior. That is, consumers tend to repeat their past consumption
activities. Some consumers become loyal to certain product types as well as specific
brands. Others seek other brands and products. In general, there is a great degree of
regularity about such behavior. The Markov model is developed so as to predict market
share by considering consumer brand loyalty and switching behaviors.
The model has the following objectives:
1. To predict the market share that a firm will have at some point in the future.
2. To predict whether some constant or level market share will be obtained in
the future. Most Markov models will result in a final constant market share
where changes in market share will no longer result with the passage of
time.
3. To investigate the impact of the company's marketing strategies and
promotional efforts, such as advertising, on gain or loss in market share.
Techniques for Financial Analysis, Modeling & Forecasting Page 286

To answer these questions, we need to compute what is called transition probabilities

for all the companies involved in the market. Transition probabilities are nothing more
than the probabilities that a certain seller will retain, gain and lose customers. To
develop this, we need sample data of past consumer behavior. Let us assume that
there are three battery manufacturers, A, B and C. Each of the firms know that consumers switch from one firm to another over time because of advertising,
dissatisfaction with service and other sales promotion efforts. We assume that each
firm maintains records of consumer movements for a specified time period, like one
month. We further assume that no new customers enter and no old customers leave
the market during this period.
Table 15.5 provides data on the flows among all the firms.

Jan. 1
Firms Customer
s
A
300
B
600
C
400

From

Table 15.5
Flow of Customers
Gains
Losses
A
B
C
To A
B

0
30
30

30
15
0

45
0
15

35
20
0

0
45
35

30
0
20

This table can be converted into a matrix form as shown in Table 15.6.
Table 15.6
Retention, Gain and Loss
Retention and Loss to
Firms
A
B
C
Retention
A
240
30
30
And
B
45
540
15
Gain
C
35
20
345
Total
320
590
390

Feb.1
Customer
s
320
590
390

Total
300
600
400
1300

Table 15.7 is a matrix of the same sizes as the one in Table 15.6 illustrating exactly how
each probability was determined

Probability of
Customers
being
Retained or
gained

Firms
A
B
C

Table 15.7
Transition Probability Matrix
Probability of Customers Being Retained or Lost
A
B
C
240/300=.80
30/300=.10
30/300=.10
45/600=.075
540/600=.9
15/600=.025
35/400=.0875
20/400=.05
345/400=.8625

The rows in this matrix show the probability of the retention of customers and the loss of
customers; the columns represent the probability of retention of customers and the gain of
Techniques for Financial Analysis, Modeling & Forecasting Page 287

customers. For example, row 1 indicates that A retains .8 of its customers (30) to C. Also,
column 1, for example, indicates that A retains .8 of its customers (240), gains .075 of Bs
customers (45) and gains .0875 of Cs customers (35).
The original market share a January 1 was:
(300A 600B 400C)=(.2308A .4615B .3077C)
With this, we will be able to calculate market share, using the transition matrix we
developed in Table 15.7.
To illustrate, Company A held 23.08 percent of the market at January 1. Of this, 80
percent was retained, Company A gained 10 percent of Company Bs 46.15 percent of
the market and another 10 percent of Company Cs 30.77 percent.
The February 1 market share of Company A is, therefore, calculated to be:
Retention
Gain from B
Gain from C

.8 x .2308=.1846
.1 x .4615=.0462
.1 x .3077=.0308
.2616*

Similarly, Company Bs market share is as follows:

Gain from A
Retention
Gain from C

.075 x .2308=.0173
.9 x .4615=.4154
.025 x .3077=.0077
.4404*

Company Cs market share is:

Gain from A
Gain from B
Retention

.0875 x .2308=.0202
.05 x .4615=.0231
.8625 x .3077=.2654
.3087*

*These numbers do not add up to exactly 100 percent due to rounding errors.
In summary, the February 1 market share came out to be approximately:
26% for Company A
44% for Company B
30% for Company C
The market share forecasts may then be used to generate a specific forecast of
sales. For example, if industry sales are forecast to be, say, $10 million, obtained through
regression analysis, input-output analysis, or some other technique, the forecast of sales
for A is $2.6 million ($100 million x .26).
If the company wishes to forecast the market share for March, then, the procedure
is exactly the same as before, except using the February 1 forecasted market share as a
Techniques for Financial Analysis, Modeling & Forecasting Page 288

basis. The forecaster must be careful when using the Markov casting market shares in the
near future. Distant forecasts, after many time periods, generally are not very reliable
forecasts by this method. Even in short-term forecasts, constant updating of the transition
matrix is needed for accuracy of projection.
At least in theory, most Markov models will result in a final constant market share in
which market share will no longer change with the passage of time. However, this market
share and its derivation will not be discussed here. In effect, this model has very little
practical application because the constant or level condition assumes no changes in
competitive efforts of the firms within the industry.
CONCLUSION
Regression analysis is the examination of the effect of a change in independent variables
on the dependent variable. It is a popularly used method to forecast sales. This chapter
discussed the well-known estimation technique, called the least-squares method.
To illustrate the method, we assume a simple regression, which involves one
independent variable in the form of Y = a + bX. In an attempt to obtain a good fit, we
discussed various regression statistics. These statistics tell you how good and reliable
your estimated equation is and help you set the confidence interval for your prediction.
Most importantly, we discussed how to utilize spreadsheet programs such as
Excel to perform regressions, step by step. The program calculates not only the
regression equation, but also all the regression statistics discussed in this chapter.
Multiple regression analysis is the examination of the effect of a change in explanatory
variables on the dependent variable. For example, various financial ratios bear on a firm's
market price of stock. Many important statistics that are unique to multiple regression
analysis were explained with computer illustrations. An emphasis was placed on how to
pick the best forecasting equation.
There is always a cost associated with a failure to predict a certain variable
accurately. Because all forecasts tend to be off the mark, it is important to provide a
measure of accuracy for each forecast. Several measures of forecast accuracy and a
measure of turning point error can be calculated.
These quite often are used to help
managers evaluate the performance of a given method as well as to choose among
alternative forecasting techniques. Control of forecasts involves deciding whether a
forecast is performing adequately, using either a control chart or a tracking signal.
Selection of a forecasting method involves choosing a technique that will serve its
intended purpose at an acceptable level of cost and accuracy.
The Markov model can be used to take into account learned behavior, such as
consumer spending patterns.

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CHAPTER 15 QUIZ
1. Violation of autocorrelation (serial correlation) among several assumptions underlying
regression analysis is most prevalent in time series analysis.
True / False
2. Forecasting sales with the Markov model:
A. Assumes that consumption is a form of learned behavior.
B. Assumes that the probabilities of an event are dependent on all previous events.
C. Is useful if sequencing of related decisions is necessary.
D. Is used to assess the implications of decisions in a competitive environment
based on trend analysis.
3. Correlation is a term frequently used in conjunction with regression analysis and is
measured by the value of the coefficient of correlation, r. The best explanation of the
value r is that it
A.
B.
C.
D.

Interprets variances in terms of the independent variable.

Ranges in size from negative infinity to positive infinity.
Is a measure of the relative relationship between two variables.
Is positive only for downward-sloping regression lines.

4. In regression analysis, the coefficient of determination is a measure of

A. The amount of variation in the dependent variable explained by the independent
variables.
B. The amount of variation in the dependent variable unexplained by the
independent variables.
C. The slope of the regression line.
D. The predicted value of the dependent variable.
5. Autocorrelation or serial correlation
A.
Defines the proportion of the variance explained by the independent variable.
B.
Means that observations are not independent.
C.
Means that independent variables are correlated with each other.
D.
Is the failure of random samples to represent the population.
6. Multicollinearity occurs when
A.
A proportion of the variance is explained by the independent variable.
B.
Observations are not independent.
C.
Independent variables are correlated with each other.
D.
A random sample fails to represent the population.

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7. In a simple linear regression model, the standard error of the estimate of Y represents
A. A measure of variability of the actual observations from the regression line.
B. A range of values constructed from the regression equation results for a specified
level of probability.
C. A variability about the least squares line that is uniform for all values of the
independent variable in the sample.
D. The proportion of the variance explained by the independent variable.
8. Certainty is one of the assumptions underlying the validity of linear regression output.
True / False
9. Constant variance means
A. A measure of variability of the actual observations from the least squares line.
B. A range of values constructed from the regression equation results for a specified
level of probability.
C. A variability about the regression line that is uniform for all values of the
independent variable in the sample.
D. The underlying assumptions of the regression equation that are not met.
10. If the error term is normally distributed about zero, then
A. The parameter estimates of the Y-intercept and slope also have a normal
distribution.
B. The estimate of the slope can be tested using a t-test.
C. The probability that the error term is greater than zero is equal to the probability
that it is less than zero for any observation.
D. All of the answers are correct.

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CHAPTER 15 ANSWER KEY

1. (T) is correct. Time series analysis is a regression model in which the independent
variable is time. In time series analysis, the value of the next time period before that.
Hence, the error terms are usually correlated or dependent on the prior period; i.e., they
are characterized by autocorrelation (serial correlation).
(F) is incorrect. When autocorrelation exists, the standard errors of the regression
coefficients are seriously underestimated. The other three major requirements of
regression analysis constant variance of the error term, normal distribution of the error
term and an expected value of the error term equal to zeroare usually met.
2. (A) is correct. The Markov model operates on the thesis that consumption is a form of
learned behavior. That is, consumers tend to repeat their past consumption activities.
(B) is incorrect. Markov processes eventually reach a steady state; earlier probabilities
are less important.
(C) is incorrect. Past consumption patterns, not sequencing, are important in a Markov
process.
(D) is incorrect. Earlier trends are weighted less than later trends.
3. (C) is correct. The coefficient of correlation (r) measures the strength of the linear
relationship between the dependent and independent variables. The magnitude of r is
independent of the scales of measurement of x and y. The coefficient lies between -1.0
and +1.0. A value of zero indicates no linear relationship between the x and y variables. A
value of +1.0 indicates a perfectly direct relationship and a value of -1.0 indicates a
perfectly inverse relationship.
(A) is incorrect. The coefficient relates the two variables to each other.
(B) is incorrect. The size of the coefficient varies between -1.0 and +1.0.
(D) is incorrect. A downward-sloping regression line indicates a negative correlation. A
downward slope means that y decreases as x increases.
4. (A) is correct. Squaring the coefficient of correlation gives the coefficient of
determination, which is a measure of the amount of variation in a dependent variable that
can be explained by independent variables.
(B) is incorrect. The complement of the coefficient of determination is the unexplained
variation.

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(C) is incorrect. The slope is the change in the dependent variable in relation to the
change in independent variable.
(D) is incorrect. The predicted value of the dependent variable is calculated by the
regression formula (y=a + bx for simple regression).
5. (B) is correct. Autocorrelation and serial correlation are synonyms meaning that the
observations are not independent. For example, certain costs may rise with an increase in
volume but not decline with a decrease in volume.
(A) is incorrect. It is the definition of the coefficient of determination.
(C) is incorrect. It is the definition of multicollinearity.
(D) is incorrect. This is the definition of bias.
6. (C) is correct. Multicollinearity occurs when independent variables are correlated with
each other.
(A) is incorrect. This is the definition of the coefficient of determination.
(B) is incorrect. It is the definition of autocorrelation.
(D) is incorrect. It is the definition of bias.
7. (A) is correct. The standard error of the estimate represents the variance of actual
observations from the regression line. It is computed as:

(Y - Y' )

n-2
(B) is incorrect. This statistic describes a confidence interval. It can be used to gain some
idea of the accuracy of our predictions.
(C) is incorrect. It defines constant variance.
(D) is incorrect. The proportion of the variance explained by the independent variable is a
measure of goodness-of-fit, known as the coefficient of determination.
8. (F) is correct. Linear regression makes several assumptions: that errors are normally
distributed with a mean of zero, that the variance of the errors is constant and that the
independent variables are not correlated with each other. However, regression is only a
means of predicting the future; certainty cannot be achieved.
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(T) is incorrect. Implied assumptions of the regression model are that the errors are
normally distributed and their mean is zero, that the variance of the errors is constant and
that the independent variables are not correlated with each other.
9. (C) is correct. Constant variance signifies a uniform deviation of points from the
regression line. This uniformity is based on the assumption that the distribution of the
observations and errors is not affected by the values of the independent variable (s).
(A) is incorrect. It describes the standard error of the estimate.
(B) is incorrect. It describes a confidence interval. This statistic can be used to gain some idea
of the accuracy of our predictions.
(D) is incorrect. Constant variance is one of the basic assumptions underlying regression
analysis.
10. (D) is correct. All three statements are true. This ideal situation permits t-test (based
on the t-distribution) to be performed to evaluate the significance of the estimates. For
example, a confidence interval may be constructed around the estimate of the slope (b) of
the regression line using the critical value of the t-statistic (based on the specified
confidence level, sample size and degrees of freedom) and the standard error of b. If this
interval does not include zero, one may conclude that the true slope is not zero and that
the estimate is statistically significant (not affected solely by random factors).
(A) is incorrect. The parameters, a and b in the regression equation y = a + bx, are
assumed to be normally distributed.
(B) is incorrect. The t-distribution may be used in hypothesis testing of the estimate of b.
(C) is incorrect. The mean of the error term is assumed to be zero.

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CHAPTER 16
FINANCIAL FORECASTING AND BUDGETING TOOLS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.

Forecast external financing needs with the percent-of-sales method.

Describe how budgeting and financial planning works.
Give examples of how the budget works.
Discuss zero-base budgeting.
Outline the certified public accountants involvement and responsibility with
prospective financial statements.

Financial forecasting, an essential element of planning, is the basis for budgeting

activities. It is also needed when estimating future financing requirements. The company
may look either internally or externally for financing. Internal financing refers to cash flow
generated from the company's normal operating activities. External financing refers to
capital provided by parties external to the company. You need to analyze how to estimate
external financing requirements. Basically, forecasts of future sales and related expenses
provide the firm with the information to project future external financing needs. The
chapter discusses (1) the percent-of-sales method to determine the amount of external
financing needed, (2) budgeting and financial planning, (3) zero-base budgeting and (4)
the CPA's involvement in prospective financial statements.
FORECASTING EXTERNAL FINANCING NEEDS
THE PERCENT-OF-SALES METHOD
Percentage of sales is the most widely used method for projecting the company's financing
needs. Financial officers need to determine the next year's fund requirements, the portion of
which has to be raised externally. This way they can have a head start for arranging a
least-cost financing plan.
This method involves estimating the various expenses, assets and liabilities for a
future period as a percent of the sales forecast and then using these percentages, together
with the projected sales, to construct pro forma balance sheets.
Basically, forecasts of future sales and their related expenses provide the firm with
the information needed to project its future needs for financing.
The basic steps in projecting financing needs are:
1. Project the firm's sales. The sales forecast is the initial most important step.
Most other forecasts (budgets) follow the sales forecast.
2. Project additional variables such as expenses.
3. Estimate the level of investment in current and fixed assets that are required to
support the projected sales.
4. Calculate the firm's financing needs.
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The following example illustrates how to develop a pro forma balance sheet and determine
the amount of external financing needed.
EXAMPLE 16.1
Assume that sales for 20X0 = $20, projected sales for 20X1 = $24, net income = 5% of sales
and the dividend payout ratio = 40%.
The steps for the computations are outlined as follows:
Step 1. Express those balance sheet items that vary directly with sales as a
percentage of sales. Any item such as long-term debt that does not vary directly with
sales is designated "n.a." or "not applicable."
Step 2. Multiply these percentages by the 20X1 projected sales = $24 to obtain the
projected amounts as shown in the last column.
Step 3. Simply insert figures for long-term debt, common stock and paid-in-capital
from the 20X0 balance sheet.
Step 4. Compute 20X1 retained earnings as shown in (b).
Step 5. Sum the asset accounts, obtaining a total projected assets of $7.2 and also
add the projected liabilities and equity to obtain $7.12, the total financing provided.
Since liabilities and equity must total $7.2, but only $7.12 is projected, we have a
shortfall of $0.08 "external financing needed."
Although the forecast of additional funds required can be made by setting up pro
forma balance sheets as described above, it is often easier to use the following formula:
External
funds
needed
(EFN)
EFN

Required
Increase

Spontaneous
increase in

Increase in
retained

in assets
(A/S)S

liabilities
(L/S)S

earnings
(PM)(PS)(1-d)

Where:
A/S

L/S

S
PM
PS
d

=
=
=
=

Assets that increase spontaneously with

sales as a percentage of sales.
Liabilities that increase spontaneously
with sales as a percentage of sales.
Change in sales.
Profit margin on sales.
Projected sales
Dividend payout ratio.

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EXAMPLE 16.2
In Example 16.1,
A/S
L/S
S
PM

=
=
=
=

PS
d

=
=

$6/$20
$2/$20
($24 - $20)
5% on
sales
$24
40%

=
=
=

30%
10%
$4

Plugging these figures into the formula yields:

EFN = 0.3($4) - 0.1($4) - (0.05)($24)(1 - 0.4)
= $1.2 - $0.4 - $0.72 = $0.08
Thus, the amount of external financing needed is $800,000, which can be raised by
issuing notes payable, bonds, stocks, or any combination of these financing sources.
The major advantage of the percent-of-sales method of financial forecasting is that it
is simple and inexpensive to use. To obtain a more precise projection of the firm's future
financing needs, however, the preparation of a cash budget is required. One important
assumption behind the use of the method is that the firm is operating at full capacity. This
means that the company has no sufficient productive capacity to absorb a projected
increase in sales and thus requires additional investment in assets.
BUDGETING AND FINANCIAL PLANNING
A comprehensive (master) budget is a formal statement of management's expectation
regarding sales, expenses, volume and other financial transactions of an organization for
the coming period. Simply put, a budget is a set of pro forma (projected or planned) financial
statements. It consists basically of a pro forma income statement, pro forma balance sheet
and cash budget. A budget is a tool for both planning and control. At the beginning of the
period, the budget is a plan or standard; at the end of the period it serves as a control device
to help management measure its performance against the plan so that future performance
may be improved.
It is important to realize that with the aid of computer technology, budgeting can be
used as an effective device for evaluation of "what-if" scenarios. This way management
should be able to move toward finding the best course of action among various alternatives
through simulation. If management does not like what they see on the budgeted financial
statements in terms of various financial ratios such as liquidity, activity (turnover), leverage,
profit margin and market value ratios, they can always alter their contemplated decision and
planning set.

Techniques for Financial Analysis, Modeling & Forecasting Page 297

FIGURE 16.1
PRO FORM BALANCE SHEET
(IN MILLIONS OF DOLLARS)

The budget is classified broadly into two categories:

1. Operating budget, reflecting the results of operating decisions.
2. Financial budget, reflecting the financial decisions of the firm.
The operating budget consists of:
Sales budget
Production budget
Techniques for Financial Analysis, Modeling & Forecasting Page 298

 Direct materials budget

Direct labor budget
Factory overhead budget
Selling and administrative expense budget
Pro forma income statement

The financial budget consists of:

Cash budget
Pro forma balance sheet

The major steps in preparing the budget are:

1. Prepare a sales forecast.
2. Determine expected production volume.
3. Estimate manufacturing costs and operating expenses.
4. Determine cash flow and other financial effects.
5. Formulate projected financial statements.
Figure 16.2 shows a simplified diagram of the various parts of the comprehensive (master)
budget, the master plan of the company.

Techniques for Financial Analysis, Modeling & Forecasting Page 299

FIGURE 16.2
MASTER BUDGET

HOW THE BUDGET WORKS: AN EXAMPLE

To illustrate how all these budgets are put together, we will focus on a manufacturing
company called the Putnam Company, which produces and markets a single product. We
will make the following assumptions:

Techniques for Financial Analysis, Modeling & Forecasting Page 300

The company uses a single material and one type of labor in the manufacture of
the product.
It prepares a master budget on a quarterly basis.
Work in process inventories at the beginning and end of the year are negligible
and are ignored.
The company uses a single cost driverdirect labor hours (DLH)--as the
allocation base for assigning all factory overhead costs to the product.

THE SALES BUDGET

The sales budget is the starting point in preparing the master budget, since estimated sales
volume influences nearly all other items appearing throughout the master budget. The sales
budget should show total sales in quantity and value. The expected total sales can be
break-even or target income sales or projected sales. It may be analyzed further by product,
by territory, by customer and, of course, by seasonal pattern of expected sales.
Generally, the sales budget includes a computation of expected cash collections
from credit sales, which will be used later for cash budgeting.
EXAMPLE 16.3
THE PUTNAM COMPANY
Sales Budget
For the Year Ended December 31, 20B
QUARTER
Expected
sales in
units*
Unit sales
price*
Total sales
*Given.

Year as a
Whole

1000

1800

2000

1200

6000

x $150
$150,000

x $150
$270,000

x $150
$300,000

x $150
$180,000

x $150
$900,000

SCHEDULE OF EXPECTED CASH COLLECTIONS

Accounts
receivable
12/31/20A

Total cash
collections

100,000+
60,000++

$160,000

$ 90,000+++
108,000
$162,000
120,000
$180,000
72,000
$198,000

$100,000
150,000
270,000
300,000
72,000

$282,000 $252,000 $892,000

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+ All of the $100,000 accounts receivable balance is assumed to be collectible in the first quarter.
++ 40 percent of a quarter's sales are collected in the quarter of sale.
+++ 60 percent of a quarter's sales are collected in the quarter following.

Monthly Cash Collections from Customers

Frequently, there are time lags between monthly sales made on account and their related
monthly cash collections. For example, in any month, credit sales are collected as follows:
15% in month of sale, 60% in the following month, 24% in the month after and the
remaining 1 percent are uncollectible.

Credit
sales

April-Actual

May-Actual

June-Budgeted

$320

200

300

July-Budgete
d
280

The budgeted cash receipts for June and July are computed as follows:
For June:
From April sales
$320 x .24 $ 76.80
From May sales
200 x .6
120.00
From June sales
300 x .15
45.00
Total budgeted collections in June
$241.80
For July:
From May sales
$200 x .24 $ 48
From June sales
300 x .6
180
From July sales
280 x .15
42
Total budgeted collections in July
$270
THE PRODUCTION BUDGET
After sales are budgeted, the production budget can be determined. The production budget
is a statement of the output by product and is generally expressed in units. It should take
into account the sales budget, plant capacity, whether stocks are to be increased or
decreased and outside purchases. The number of units expected to be manufactured to
meet budgeted sales and inventory requirements is set forth in the production budget.
Expected Production Volume
=

Desired
Planned
sales inventory

+ ending - Beginning
inventory

The production budget is illustrated as follows:

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INVENTORY PURCHASES MERCHANDISING FIRM

Putnam Company is a manufacturing firm, so it prepares a production budget, as shown
in Example 16.4. If it were a merchandising (retailing or wholesaling) firm, then instead of
a production budget, it would develop a merchandise purchase budget showing the
amount of goods to be purchased from its suppliers during the period. The merchandise
purchase budget is in the same basic format as the production budget, except that it
shows goods to be purchased rather than goods to be produced, as shown below:
Budgeted cost of goods sold (in units or dollars)
Add: Desired ending merchandise inventory
Total needs
Less: Beginning merchandise inventory
Required purchases (in units or in dollars)

$500,000
120,000
$620,000
(90,000)
$530,000

THE DIRECT MATERIAL BUDGET

When the level of production has been computed, a direct material budget should be
constructed to show how much material will be required for production and how much
material must be purchased to meet this production requirement.
The purchase will depend on both expected usage of materials and inventory levels.
The formula for computation of the purchase is:
Purchase in units = Usage + Desired ending material inventory units - Beginning
inventory units
The direct material budget is usually accompanied by a computation of expected cash
payments for materials.

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SCHEDULE OF EXPECTED CASH DISBURSEMENTS

Accounts
payable,
12/31/20A
1st quarter
purchases
($11,900)
2d quarter
purchases
($18,450)
3d quarter
purchases
($17,850)
4th quarter
purchases
($12,950)
Total
disbursement
s
*
**
***
****
+
++

$6,275+

$ 6,275

5,950++ 5,950++

11,900

9,225

9,225
8,925

$12,225

$15,175

$18,150

18,450
8,925

17,850

6,475

6,475

$15,400

$60,950

Given.
nd
25 percent of the next quarter's units needed for production. For example, the 2 quarter
production needs are 3,640 lbs. Therefore, the desired ending inventory for the 1st quarter would
be 25% x 3,640 lbs. = 910 lbs.
st
Assume that the budgeted production needs in lbs. for the 1 quarter of 20B = 2,080 lbs. So, 25% x
2,080 lbs. = 520 lbs.
The same as the prior quarter's ending inventory.
All of the $6,275 accounts payable balance (from the balance sheet, 20A) is assumed to be paid in the
first quarter.
50 percent of a quarter's purchases are paid for in the quarter of purchase; the remaining 50% are paid
for in the following quarter.

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THE DIRECT LABOR BUDGET

The production requirements as set forth in the production budget also provide the starting
point for the preparation of the direct labor budget. To compute direct labor requirements,
expected production volume for each period is multiplied by the number of direct labor hours
required to produce a single unit. The direct labor hours to meet production requirements is
then multiplied by the (standard) direct labor cost per hour to obtain budgeted total direct
labor costs.
EXAMPLE 16.6
THE PUTNAM COMPANY
Direct Labor Budget
For the Year Ended December 31, 20B
QUARTER
Units to be
produced
(Example 16.4)
Direct labor
hours per unit*
Total hours
Direct labor cost
per hour*
Total direct labor
cost

Year as
a Whole

980

1,820

1,920

1,380

6,100

x5
4,900

x5
9,100

x5
9,600

x5
6,900

x5
30,500

x $10

x $10

x $10

x $10

x $10

$49,000

$91,000

$96,000

$69,000

$305,000

*Both are given.

THE FACTORY OVERHEAD BUDGET
The factory overhead budget should provide a schedule of all manufacturing costs other
than direct materials and direct labor. Using the contribution approach to budgeting requires
the cash budget. We must remember that depreciation does not entail a cash outlay and
therefore must be deducted from the total factory overhead in computing cash disbursement
for factory overhead.
EXAMPLE 16.7
To illustrate the factory overhead budget, we will assume that:
Total factory overhead budgeted = $18,300 fixed (per quarter), plus $2 per hour of
direct labor. This is one example of a cost-volume (or flexible budget) formula (y = a +
2
bx), developed via the regression (least-squares) method with a high R .
Depreciation expenses are $4,000 each quarter.
Overhead costs involving cash outlays are paid for in the quarter incurred.
Techniques for Financial Analysis, Modeling & Forecasting Page 305

THE PUTNAM COMPANY

Factory Overhead Budget
For the Year Ended December 31, 20B
QUARTER
Budgeted direct labor
hours
(Example 16.6)
Variable overhead rate
Variable overhead
budgeted
Fixed overhead budgeted
Total budgeted overhead
Less: Depreciation*
Cash disbursements for
factory overhead

Year as
a Whole

4,900
x $2

9,100
x $2

9,600
x $2

6,900
x $2

30,500
x $2

9,800
18,300
28,100
4,000

18,200
18,300
36,500
4,000

19,200
18,300
37,500
4,000

13,800
18,300
32,100
4,000

61,000
73,200
134,200
16,000

$24,100

$32,500

$33,500

$28,100

$118,200

*Depreciation does not require a cash outlay.

THE ENDING FINISHED GOODS INVENTORY BUDGET
The ending finished goods inventory budget provides us with the information required for
the construction of budgeted financial statements. After completing Examples 16.3-16.7,
sufficient data will have been generated to compute the per-unit manufacturing cost of
finished product. This computation is required for two reasons: (1) to help compute the
cost of goods sold on the budgeted income statement; and (2) to give the dollar value of
the ending finished goods inventory to appear on the budgeted balance sheet.
EXAMPLE 16.8
THE PUTNAM COMPANY
Ending Finished Goods Inventory Budget
For the Year Ended December 31, 20B
Ending Inventory Units
300 units (Ex. 16.4)

Unit Product Cost

$82*

Total
$24,600

*The unit product cost of $82 is computed as follows:

Unit Cost

Units

Total

Direct materials
$ 5 per lbs. 2 pounds $10
Direct labor
10 per hr.
5 hours
50
Factory
4.40 per hr. 5 hours
22
overhead**
Unit product cost
$82
** Predetermined factory overhead applied rate = Budgeted annual factory
overhead/budgeted annual activity units = $134,200/30,500 DLH = $4.40.
Techniques for Financial Analysis, Modeling & Forecasting Page 306

THE SELLING AND ADMINISTRATIVE EXPENSE BUDGET

The selling and administrative expense budget lists the operating expenses involved in
selling the products and in managing the business. Just as in the case of the factory
overhead budget, this budget can be developed using the cost-volume (flexible budget)
formula in the form of y = a + bx.
If the number of expense items is very large, separate budgets may be needed for
the selling and administrative functions.
EXAMPLE 16.9
THE PUTNAM COMPANY
Selling and Administrative Expense Budget
For the Year Ended December 31, 20B
QUARTER
Year as
Expected sales in units
Variable selling and
administrative expense
per unit*
Budgeted variable
expense
Fixed selling and
administrative
expense**:
Advertising
Insurance
Office salaries
Taxes
Total budgeted selling
and administrative
expenses***

1
1,000

2
1,800

3
2,000

4
1,200

a Whole
6,000

x $3

x $3

x $3

x $3

x $3

$3,000

$5,400

$6,000

$3,200

$18,000

20,000

20,000

20,000

40,000

20,000
12,600
40,000

40,000

40,000
7,400

80,000
12,600
160,000
7,400

$63,000

$78,000

$66,000

$71,000

$278,000

*Assumed. It includes sales agents' commissions, shipping and supplies.

**Scheduled to be paid.
***Paid for in the quarter incurred.

THE CASH BUDGET

The cash budget is prepared for the purpose of cash planning and control. It presents the
expected cash inflow and outflow for a designated time period. The cash budget helps
management keep cash balances in reasonable relationship to its needs. It aids in avoiding
unnecessary idle cash and possible cash shortages. The cash budget consists typically of
four major sections:
1. The cash receipts section, which is a cash collection from customers and other cash
receipts such as royalty income and investment income.
2. The cash disbursements section, which comprises all cash payments made by
purpose.
3. The cash surplus or deficit section, which simply shows the difference between the
Techniques for Financial Analysis, Modeling & Forecasting Page 307

total cash available and the total cash needed including a minimum cash balance if
required. If there is surplus cash, loans may be repaid or temporary investments
made.
4. The financing section, which provides a detailed account of the borrowings,
repayments and interest payments expected during the budgeting period.
The investments section, which encompasses investment of excess cash and
liquidation of investment of surplus cash.
EXAMPLE 16.10
To illustrate, we will make the following assumptions:
Putnam Company has an open line of credit with its bank, which can be used as
needed to bolster the cash position.
The company desires to maintain a $10,000 minimum cash balance at the end of
each quarter. Therefore, borrowing must be sufficient to cover the cash shortfall and
to provide for the minimum cash balance of $10,000
All borrowings and repayments must be in multiples of $1,000 amounts and interest
is 10 percent per annum.
Interest is computed and paid on the principal as the principal is repaid.
All borrowings take place at the beginning of a quarter and all repayments are made
at the end of a quarter.
No investment option is allowed in this example. The loan is self-liquidating in the
sense that the borrowed money is used to obtain resources that are combined for
sale and the proceeds from sales are used to pay back the loan.
Note: To be useful for cash planning and control, the cash budget must be prepared on a
monthly basis.
Note the following:
Cash balance, beginning
Add receipts:
Total cash available before financing (a)
Deduct disbursements:
Total cash disbursements (b)
+ Minimum cash balance desired
Total cash needed (c)
Cash surplus or deficit (a) (c)
Financing:
Borrowing (at beginning)
Repayment (at end)
Interest
Total effects of financing (d)
Cash balance, ending [(a) (b) + (d)]

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THE PUTNAM COMPANY

Cash Budget
For the Year Ended December 31, 20B

Cash balance,
beginning
Add: Receipts:
Collections from
customers
Total cash
available (a)
Less:
Disbursements:
Direct materials
Direct labor
Factory
overhead
Selling and
Admin.
Equipment
purchase
Dividends
Income tax
Total
disbursements
(b)
Minimum cash
balance
Total cash
needed (c)
Cash surplus
(deficit) (a) (c)
Financing:
Borrowing
Repayment
Interest effects
of financing (d)
Total
Cash balance,
ending
[(a)(b) + (d)]

*
**

***

From
Example

QUARTER
1
2
$19,000* 10,675

3
10,000

4
10,350

Year as
a Whole
19,000

16.3

160,000

198,000

282,000

252,000

892,000

179,000

208,675

292,000

262,350

911,000

16.5
16.6
16.7

12,225
49,000
24,100

15,175
91,000
32,500

18,150
96,000
33,500

15,400
69,000
28,100

60,950
305,000
118,200

16.9

63,000

78,000

66,000

71,000

278,000

Given

30,000

12,000

42,000

Given
16.12

5,000
15,000
198,325

5,000
15,000
248,675

5,000
15,000
233,650

5,000
15,000
203,500

20,000
60,000
884,150

10,000

10,000

10,000

10,000

10,000

208,325

258,675

243,650

213,500

894,150

(29,325)

(50,000)

48,350

48,850

16,850

30,000**
0
0

50,000
0
0

0
(45,000)
(3,000)**

0
(35,000)
(2,625)+

80,000
(80,000)
(5,625)

30,000
$10,675

50,000
10,000

(48,000)
10,350

(37,625)
21,225

(5,625)
$21,225

$19,000 (from the balance sheet 20A).

The company desires to maintain a $10,000 minimum cash balance at the end of
each quarter. Therefore, borrowing must be sufficient to cover the cash shortfall of
$19,325 and to provide for the minimum cash balance of $10,000, for a total of
$29,325.
The interest payments relate only to the principal being repaid at the time it is
repaid. For example, the interest in quarter 3 relates only to the interest due on the
$30,000 principal being repaid from quarter 1 borrowing and on the $15,000
principal being repaid from quarter 2 borrowing. Total interest being paid is $3,000,
shown as follows:

Techniques for Financial Analysis, Modeling & Forecasting Page 309

$30,000 x 10% x

$2,250

$15,000 x 10% x 2/4

+ $35,000 x 10% x 3/4

=
=

750
$2,625

THE BUDGETED INCOME STATEMENT

The budgeted income statement summarizes the various component projections of revenue
and expenses for the budgeting period. However, for control purposes the budget can be
divided into quarters or even months depending on the need.
EXAMPLE 16.11
THE PUTNAM COMPANY
Budgeted Income Statement
For the Year Ended December 31, 20B
From Example
Sales (6,000 units @ $150)
Less: Cost of goods sold
Beginning finished goods inventory
Add: Cost of goods manufactured
(6,100 units @$82)
Cost of goods available for sale
Less: Ending finished goods inventory
Gross margin
Less: Selling and administrative
expense
Operating income
Less: Interest expense
Net income before taxes
Less: Income taxes
Net income after taxes

16.3

$900,000

16.12

$16,400

500,200
516,600
(24,600)

16.10
16.11
16.10

$492,000
$408,000
278,000
130,000
5,625
124,375
60,000*
$64,375

*Estimated.
THE BUDGETED BALANCE SHEET
The budgeted balance sheet is developed by beginning with the balance sheet for the year
just ended and adjusting it, using all the activities that are expected to take place during the
budgeting period. Some of the reasons why the budgeted balance sheet must be prepared
are:
It could disclose some unfavorable financial conditions that management might want
to avoid.
It serves as a final check on the mathematical accuracy of all the other schedules.
It helps management perform a variety of ratio calculations.
Techniques for Financial Analysis, Modeling & Forecasting Page 310

 It highlights future resources and obligations.

We can construct the budgeted balance sheet by using:
The December, 20A balance sheet (Example 16.12)
The cash budget (Example 16.10)
The budgeted income statement (Example 16.11).
Putnams budgeted balance sheet for December 31, 20B, is presented below.
Supporting calculations of the individual statement accounts are also provided.

EXAMPLE 16.12
To illustrate, we will use the following balance sheet for the year 20A.
THE PUTNAM COMPANY
Balance Sheet
December 31, 20A
ASSETS
Current assets:
Cash
Accounts receivable
Materials inventory (490 lbs.)
Finished goods inventory (200 units)
Total current assets
Plant and equipment:
Land
Buildings and equipment
Accumulated depreciation
Plant and equipment, net
Total assets

$ 19,000
100,000
2,450
16,400
$137,850
30,000
250,000
(74,000)
206,000
$343,850

LIABILITIES AND STOCKHOLDERS EQUITY

Current liabilities
Accounts payable (raw materials)
Income tax payable
Total current liabilities
Stockholders equity:
Common stock, no par
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity

$ 6,275
60,000
$66,275
$200,000
77,575
277,575
$343,850

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THE PUTNAM COMPANY

Balance Sheet
December 31, 20B
Assets
Cash
Accounts receivable
Materials inventory (520 lbs.)
Finished goods inventory (300 units)
Total current assets
Plant and equipment:
Land
Buildings and equipment
Accumulated depreciation
Plant and equipment, net
Total assets
Current liabilities
Accounts payable (raw materials)
Income tax payable
Total current liabilities
Stockholders equity:
Common stock, no par
Retained earnings
Total stockholders equity
Total liabilities and stockholders
equity

$ 21,225
108,000
2,600
24,600

(a)
(b)
(c)
(d)
$156,425

30,000
292,000
(90,000)

(e)
(f)
(g)
232,000
$388,425

$ 6,475
60,000

(h)
(i)
$66,475

$200,000
121,950

(j)
(k)
321,950
$388,425

Supporting computations:
(a) From Example16.10 (cash budget).
(b) $100,000 (Accounts receivable, 12/31/20A) + $900,000 (Credit sales from Example
th
1) - $892,000(Collections from Example 16.3) = $108,000, or 60% of 4 quarter credit
sales, from Example 16.3 ($180,000 x 60% = $108,000).
(c) Direct materials, ending inventory = 520 pounds x $ 5 = $2,600 (From Example 16.5)
(d) From Example 16.8 (ending finished goods inventory budget).
(e) From the 20A balance sheet and Example 16.10 (no change).
(f) $250,000 (Building and Equipment, 12/31/20A) + $42,000 (purchases from Example
16.10) = $292,000.
(g) $74,000 (Accumulated Depreciation, 12/31/20A) + $16,000 (depreciation expense from
Example 16.7) = $90,000.
(h) Note that all accounts payable relate to material purchases.
$6,275 (Accounts payable, 12/31/20A) + $61,150 (credit purchases from Example 16.5)
- $60,950 (payments for purchases from Example 16.5) = $6,475,
or 50% of 4th quarter purchase = 50% ($12,950) = $6,475.
(i) From Example 16.11.
(j) From the 20A balance sheet and Example 16.10(no change).
Techniques for Financial Analysis, Modeling & Forecasting Page 312

(k) $77,575 (Retained earnings, 12/31/20A) + $64,375 (net income for the period, Example
16.11) $20,000 (cash dividends from Example 16.10) = $121,950.
SOME FINANCIAL CALCULATIONS
To see what kind of financial condition the Putnam Company is expected to be in for the
budgeting year, a sample of financial ratio calculations are in order: (Assume 20A after-tax
net income was $45,000)
Current ratio:
(Current assets/ current liabilities)
Return on total assets:
(Net income after taxes / total
assets)

20A

20B

$137,850/$66,275
=2.08

$156,425/$66,475
=2.35

$45,000/$343,850

$64,375/$388,425

=13.08%

=16.57%

Sample calculations indicate that the Putnam Company is expected to have better
liquidity as measured by the current ratio. Overall performance will be improved as
measured by return on total assets. This could be an indication that the contemplated plan
may work out well.
COMPUTER-BASED AND SPREADSHEET MODELS FOR BUDGETING
More and more companies are developing computer-based models for financial planning
and budgeting, using powerful, yet easy-to-use, financial modeling languages such as
BudgetMastro and Up Your Cash Flow. The models help not only build a budget for profit
planning but answer a variety of what-if scenarios. The resultant calculations provide a
basis for choice among alternatives under conditions of uncertainty. Furthermore, budget
modeling can also be accomplished using spreadsheet programs such as Microsofts Excel.
This is covered in greater detail in Chapter 21.
ZERO BASE BUDGETING
The traditional budgeting techniques involve adding or subtracting a given percentage
increase or decrease to the preceding periods budget and arriving at a new budget. The
prior periods costs are considered to be basic and the emphasis is usually placed on what
upward revisions are to be made for the upcoming year. The traditional method focuses on
inputs rather than outputs related to goal achievement and as such never calls for the
evaluation of corporate activities from a cost/benefit perspective.
Zero-Base Budgeting (ZBB) can generally be described as a technique, which
requires each manager to justify his entire budget request in detail from a base of zero and
as such asks for an analysis of the output values of each activity of a particular
cost/responsibility center. This approach requires that all activities under scrutiny be defined
in decision packages, which are to be evaluated and ranked in order of importance at
various levels. As an end product, a body of structured data is obtained that enables
management to allocate funds confidently to the areas of greatest potential gain.
Techniques for Financial Analysis, Modeling & Forecasting Page 313

ZBB is most applicable in planning service and support expenses rather than direct
manufacturing expenses. This technique is best suited to operations and programs over
which management has some discretion. For example, it can be used to develop:

Administrative and General Support

Marketing
Research
Engineering
Manufacturing Support
Capital Budgets

It should not be used for:

Direct labor
Direct material
Factory overhead

Which are usually budgeted through various methods discussed in the previous section.
Figure 16.2 helps our understanding of ZBB by indicating the key differences between ZBB
and traditional (incremental) budgeting systems.
FIGURE 16.2
DIFFERENCES BETWEEN TRADITIONAL AND ZERO BASE BUDGETING
Traditional

Zero Base

Starts from existing base

Examines cost/benefit for new
activities
Starts with dollars

Starts with base zero

Examines cost/benefit for
all activities
Starts with purposes and
activities
Explicitly examines new
approaches
Results in a choice of
several levels of service
and cost

Does not examine new ways of

operating as integral part of process
Results in a non-alternative budget

THE CERTIFIED PUBLIC ACCOUNTANT'S INVOLVEMENT AND RESPONSIBILITY

WITH PROSPECTIVE FINANCIAL STATEMENTS
The American Institute of Certified Public Accountants (AICPA) in Statement of Position
45-4 provides guidelines for business enterprises, which publish financial forecasts.
Improved financial forecasting should be of concern to the AICPA and the Securities and
Exchange Commission as a basis for financial decision making, security analysis and in
affecting the future market value of securities through investor expectations. There are
three types of functions that CPAs can perform with respect to prospective financial
Techniques for Financial Analysis, Modeling & Forecasting Page 314

statements that will be relied upon by third parties: examination, compilation and
application of agreed-upon procedures. CPAs must prepare prospective financial
statements according to AICPA standards. There must be disclosure of the underlying
assumptions.
Prospective financial statements may be for general use or limited use. General
use is for those not directly dealing with the client. The general user may take the deal or
leave it. Limited use is for those having a direct relationship with the client.
Prospective financial statements may be presented as a complete set of financial
statements (balance sheet, income statement and statement of cash flows). However, in
most cases, it is more practical to present them in summarized or condensed form. At a
minimum, the financial statement items to be presented are:
Sales
Gross margin
Nonrecurring items
Taxes
Income from continuing operations
Income from discontinued operations
Net income
Primary and fully diluted earnings per share
Material changes in financial position
Not considered prospective financial statements are pro-forma financial
statements and partial presentations.
The American Institute of CPA's Code of Professional Ethics includes the following
guidelines regarding prospective financial statements:
Cannot vouch for the achievability of prospective results.
Must disclose assumptions.
Accountant's report must state the nature of the work performed and the degree of
responsibility assumed.
CPAs are not permitted to furnish services on prospective financial statements if
the statements are solely appropriate for limited use but are distributed to parties not
involved directly with the issuing company. They are not allowed to use plain-paper
services on prospective financial statements for third-party use.
A prospective financial statement may be classified as either a forecast or a
projection.
FINANCIAL FORECAST
A financial forecast presents management's expectations and there is an expectation that
all assumptions will take place. Management is usually responsible for assumptions
underlying prospective financial statements. However, the responsible party may be a
party outside the entity, such as a possible acquirer. Note: A financial forecast
encompasses a presentation that management expects to occur, but that is not
necessarily most probable. A financial forecast may be most useful to general users,
since it presents the client's expectations. A financial forecast and not a financial
projection may be issued to passive users, or those not negotiating directly with the client.
Techniques for Financial Analysis, Modeling & Forecasting Page 315

A financial forecast may be given a single monetary amount based on the best
estimate, or as a reasonable range. Caution: This range must not be chosen in a
misleading manner.
Irrespective of the accountant's involvement, management is the only one who has
responsibility for the presentation because only management knows how it plans to run
the business and accomplish its plans.
FINANCIAL PROJECTION
A financial projection presents a "what-if" scenario that management does not necessarily
expect to occur. However, a given assumption may actually occur if management moves
in that direction. A financial projection may be most beneficial for limited users, since they
may seek answers to hypothetical questions based on varying assumptions. These users
may wish to alter their scenarios based on anticipated changing situations. A financial
projection, like a forecast, may contain a range.
A financial projection may be presented to general users only when it supplements
a financial forecast. Financial projections are not permitted in tax shelter offerings and
other general-use documents.
TYPES OF ENGAGEMENTS
The following five types of engagements may be performed by the CPA in connection with
prospective financial statements:
Plain paper
The CPA's name is not associated with the prospective statements. This service can only
be conducted if all of the following conditions are satisfied:
The CPA is not reporting on the presentation.
The prospective statements are on paper not identifying the accountant.
The prospective financial statements are not shown with historical financial
statements that have been audited, reviewed, or compiled by the CPA.
Internal use
The prospective financial statements are only assembled, meaning mathematical and
clerical functions are performed. Assembling financial data is permitted if the following
two criteria exist:
Third parties will not use the statements.
The CPA's name is associated with the statement.
Note that assembling prospective financial statements is limited only to internal use.
Appropriate language on the statements might be "For Internal Use Only."
Compilation
This is the lowest level of service performed for prospective financial statements directed
for third parties. The compilation engagement involves:
Assembling prospective data.
The conduct of procedures to ascertain whether the presentation and assumptions
are appropriate.
Techniques for Financial Analysis, Modeling & Forecasting Page 316

Preparation of a compilation report.

With a compilation, no assurance is given regarding the presentation or assumptions,
but rather it serves to identify obvious matters to be investigated further. Working papers
have to be prepared to show there was proper planning and supervision of the work, as
well as compliance with required compilation procedures. The CPA must also obtain a
management letter from the client regarding representations given to him.
Warning: A compilation should not be made when the forecasted financial
statements exclude disclosure of the significant assumptions or when the financial
projections exclude the hypothetical assumptions.
Agreed-upon procedures
This relates to applying procedures agreed to or requested by specific users and issuing a
report. The report identifies the procedures undertaken, gives the accountant's findings
and restricts distribution of the report to the particular parties. The specified users have to
participate in establishing the nature and procedures. Also, the procedures undertaken
must be more than just reading the prospective data.
Examination
The CPA appraises the preparation underlying the supporting assumptions and the
presentation of prospective financial information in accordance with AICPA standards. A
report is then issued on whether AICPA guidelines have been adhered to and whether the
assumptions are reasonable. It is the highest level of assurance. An adverse opinion must
be given if there is a failure to disclose a material assumption or if disclosed assumptions
are unreasonable. For example, there may not be reasonable expectation that the actual
figure will fall within the range of assumptions presented in a forecast having a range. A
disclaimer opinion is necessary in the event of a scope limitation, such as when a required
examination procedure cannot be performed because of client restrictions or
inappropriate circumstances.
CONCLUSION
A budget is a detailed quantitative plan outlining the acquisition and use of financial and
other resources of an organization over some given time period. It is a tool for planning. If
properly constructed, it is used as a control device. This chapter showed, step-by-step, how
to formulate a master budget. The process begins with the development of a sales budget
and proceeds through a number of steps that ultimately lead to the cash budget, the
budgeted income statement and the budgeted balance sheet. In recent years
computer-based models and spreadsheet software have been utilized for budgeting in an
effort to speed up the budgeting process and allow managerial accountants to investigate
the effects of changes in budget assumptions. Zero-base budgeting (ZBB) has received
considerable attention recently as a new approach to budgeting, particularly for use in
nonprofit, governmental and service-type organizations. The chapter discussed the pros
and cons of ZBB. A CPA's involvement with prospective financial statements may be in the
form of an examination, compilation, or agreed-upon procedures.

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CHAPTER 16 QUIZ
1. The master (comprehensive) budget
A. Shows the forecasted and actual results.
B. Reflects controllable costs only.
C. Can be used to determine manufacturing cost variances.
D. Contains both financial and operating budgets.
2. Which one the following statements regarding selling and administrative budgets is
most accurate?
A. Selling and administrative budgets are usually optional.
B. Selling and administrative budgets need to be detailed in order that the key
assumptions can be better understood.
C. Selling and administrative budgets are fixed in nature.
D. Selling and administrative budgets are difficult to allocate by month and are best
presented as one number for the entire year.
3. Various budgets are included in the master budget cycle. One of these budgets is the
production budget. Which one of the following best describes the production budget?
A. It is calculated from the desired ending inventory and the sales forecast.
B. It includes required direct labor hours.
C. It includes required material purchases.
D. It aggregates the monetary details of the operating budget.
4. Cost of goods soled budget is the last schedule to be prepared in the normal budget
preparation process.
True / False
5. Pro forma financial statements are part of the budgeting process. Normally, the last pro
forma statement prepared is the
A. Income statement.
B. Statement of cost of goods sold.
C. Balance sheet.
D. Statement of manufacturing costs.
6. A financial forecast consists of prospective financial statements that present an entity's
expected financial position, results of operations and cash flows. A forecast
A. Is based on the most conservative estimates.
B. Presents estimates given one or more hypothetical assumptions.
C. Unlike a projection, may contain a range.
D. Is based on assumptions reflecting conditions expected to exist and courses of
action expected to be taken.
Techniques for Financial Analysis, Modeling & Forecasting Page 318

7. The party responsible for assumptions identified in the preparation of prospective

financial statements is usually a third-party lending institution.
True / False
8. Given one or more hypothetical assumptions, a responsible party may prepare, to the
best of its knowledge and belief, an entity's expected financial position, results of
operations and cash flows. Such prospective financial statements are known as
A. Pro forma financial statements.
B. Financial projections.
C. Partial presentations.
D. Financial forecasts.
9. Prospective financial information presented in the format of historical financial
statements that omit either gross profit or net income is deemed to be a partial
presentation.
True / False
10. Which of the following is a prospective financial statement for general use upon which
an accountant may appropriately report?
A. Financial forecast.
B. Financial projection.
C. Partial presentation.
D. Pro forma financial statement.

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CHAPTER 16 ANSWER KEY

1. (D) is correct. All other budgets are subsets of the master budget. Thus, quantified
estimates by the management from all functional areas are contained in the master budget.
These results are then combined in a formal quantitative model recognizing the
organizations objectives, inputs and outputs.
(A) is incorrect. The master budget does not contain actual results.
(B) is incorrect. The master budget reflects all applicable expected costs, whether or not
controllable by individual managers.
(C) is incorrect. The master is not structured to allow determination of manufacturing cost
variances, which requires using the flexible budget and actual results.
2. (B) is correct. Sales and administrative budgets are prepared after the sales budget.
They are among the components of the operating budget process, which culminates in a
budgeted (pro forma) income statement. Like the other budgets, they constitute
prospective information based on the preparer's assumptions about conditions expected
to exist and actions expected to be taken.
(A) is incorrect. Selling and administrative budgets are no more optional than any other
component of the master budget.
(C) is incorrect. Selling and administrative budgets have both variable and fixed
components.
(D) is incorrect. Selling and administrative budgets should be prepared on the same basis
as the remainder of the budget, typically on at least a monthly basis.
3. (A) is correct. A production budget is based on sales forecasts, in units, with
adjustments for beginning and ending inventories. It is used to plan when items will be
produced. After the production budget has been completed, it is used to prepare materials
purchases, direct labor and factory overhead budgets.
(B) is incorrect. The direct labor budget is prepared after the production budget.
(C) is incorrect. The materials purchases budget is prepared after the production budget
and the material usage budget.
(D) is incorrect. The production budget is normally not prepared in monetary terms.
4. (F) is correct. The budget preparation process normally begins with the sales budget
and continues through the preparation of pro forma financial statements. The last
schedule prepared before the financial statements is the cash budget. The cash budget is
Techniques for Financial Analysis, Modeling & Forecasting Page 320

a schedule of estimated cash collections and payments. The various operating budgets
and the capital budget are inputs to the cash budgeting process.
(T) is incorrect. The various operating budgets, including the cost of goods sold budget
and the capital budget are inputs to the cash budgeting process.
5. (C) is correct. The balance sheet is usually the last of the listed items prepared. All
other elements of the budget process must be completed before it can be developed.
(A) is incorrect. The income statement must be prepared before the statement of cash
flows, which reconciles net income and net operating cash flows.
(B) is incorrect. The cost of goods sold is included in the income statement, which is an
input to the statement of cash flows.
(D) is incorrect. The statement of manufacturing costs must be prepared before either the
income statement or the statement of cash flows.
6. (D) is correct. A financial forecast consists of prospective financial statements "that
present, to the best of the responsible party's knowledge and belief, an entity's expected
financial position, results of operations and cash flows." A forecast is based on "the
responsible party's assumptions reflecting conditions it expects to exist and the course of
action it expects to take."
(A) is incorrect. The information presented is based on expected (most likely) conditions
and courses of action rather than the most conservative estimate.
(B) is incorrect. A financial projection (not a forecast) is based on assumptions by the
responsible party reflecting expected conditions and courses of action, given one or more
hypothetical assumptions (a condition or action not necessarily expected to occur).
(C) is incorrect. Both forecasts and projections may be stated either in point estimates or
ranges.
7. (F) is correct. Management is usually responsible for assumptions underlying
prospective financial statements. However, the responsible party may be a party outside
the entity, such as a possible acquirer.
(T)) is incorrect. A third-party lending institution assumes no responsibility in preparation
of prospective financial statements because it has little specific knowledge about a
borrowers business. Management is usually the responsible party.
8. (B) is correct. Prospective statements include forecasts and projections. The difference
between a forecast and a projection is that only the latter is based on one or more
Techniques for Financial Analysis, Modeling & Forecasting Page 321

hypothetical assumptions, which are conditions or actions not necessarily expected to

occur.
(A) is incorrect. Pro forma statements are essentially historical, not prospective,
statements.
(C) is incorrect. Partial presentations are not prospective statements. They do not meet
the minimum presentation guidelines.
(D) is incorrect. Forecasts are based on assumptions about conditions the responsible
party expects to exist and the course of action it expects to take.
9. (T) is correct. Under the minimum presentation guidelines, prospective financial
statements may take the form of complete basic statements or be limited to certain
minimum items (when the items would be presented for the period's historical statements).
A presentation is partial if it omits one or more of the following: (1) sales or gross
revenues, (2) gross profit or cost of sales, (3) unusual or infrequently occurring items, (4)
provision for income taxes, (5) discontinued operations or extraordinary items, (6) income
from continuing operations, (7) net income, (8) primary and fully diluted earnings per
share, (9) significant cash flows.
(F) is incorrect. Prospective information in the form of financial statements includes more
than a balance sheet even if it omits gross profit or net income.
10. (A) is correct. Prospective financial statements are for general use if they are for use
by persons with whom the responsible party is not negotiating directly, e.g., in an offering
statement of the party's securities. Only a report based on a financial forecast is
appropriate for general use.
(B) is incorrect. A projection is appropriate only for limited use.
(C) is incorrect. A presentation not in compliance with minimum guidelines is not
appropriate for general use.
(D) is incorrect. Pro forma statements are essentially historical, not prospective,
statements.

Techniques for Financial Analysis, Modeling & Forecasting Page 322

CHAPTER 17
FORECASTING CASH FLOWS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1. Define the Markov Approach.
2. Illustrate the Lagged Regression Approach.
A forecast of cash collections and potential writeoffs of accounts receivable is essential in
cash budgeting and in judging the appropriateness of current credit and discount policies.
The critical step in making such a forecast is estimating the cash collection and bad debt
percentages to be applied to sales or accounts receivable balances. This chapter
discusses several methods of estimating cash collection rates (or payment proportions)
and illustrates how these rates are used for cash budgeting purposes.
The first approach, which is based on the Markov model, involves the use of a
probability matrix based on the estimates of what is referred to as transition probabilities.
This method is described on a step-by-step basis using an illustrative example. The
second approach involves a simple average. The third approach, empirically tested and
improved by the author, offers a more pragmatic method of estimating collection and bad
debt percentages by relating credit sales and collection data. This method employs
regression analysis. By using these approaches, a financial planner should be able to
-Estimate future cash collections from accounts receivable
-Establish an allowance for doubtful accounts
-Provide a valuable insight into better methods of managing accounts receivable
MARKOV APPROACH
The Markov (probability matrix) approach has been around for a long time. This approach
has been successfully applied by Cyert and others to accounts receivable analysis,
specifically to the estimation of that portion of the accounts receivable that will eventually
become uncollectible. The method requires classification of outstanding accounts
receivable according to age categories that reflect the stage of account delinquency, e.g.,
current accounts, accounts one month past due, accounts two months past due and so
forth. Consider the following example. XYZ department store divides its accounts
receivable into two classifications: 0 to 60 days old and 61 to 120 days old. Accounts that
are more than 120 days old are declared uncollectible by XYZ. XYZ currently has $10,000
in accounts receivable: $7,000 from the 0-60-day-old category and $3,000 from the
61-120-day-old category. Based on an analysis of its past records, it provides us with
what is known as the matrix of transition probabilities. The matrix is given as shown in
Table 17.1.

Techniques for Financial Analysis, Modeling & Forecasting Page 323

TABLE 17.1
PROBABILITY MATRIX

Transition probabilities are nothing more than the probability that an account receivable
moves from one age stage category to another. We noted three basic features of this
matrix. First, notice the squared element, 0 in the matrix. This indicates that $1 in the
0-60-day-old category cannot become a bad debt in one months time. Now look at the
two circled elements. Each of these is 1, indicating that, in time, all the accounts
receivable dollars will either be paid or become uncollectible. Eventually, all the dollars do
wind up either as collected or uncollectible, but XYZ would be interested in knowing the
probability that a dollar of a 0-60-day-old or a 61-120-day-old receivable would eventually
find its way into either paid bills or bad debts. It is convenient to partition the matrix of
transition probabilities into four submatrices, as follows.
I O
R Q

so that
1 0
I =

0 1

0 0
O =

0 0

.3 0
.5 .2
R=
Q =

.5 .1
.3 .1
Now we are in a position to illustrate the procedure used to determine:
-Estimated collection and bad debt percentages by age category
-Estimated allowance for doubtful accounts
Step-by-step, the procedure is as follows:
Step 1. Set up the matrix [I - Q].
1 0
.5 .2
.5 .2
[I - Q] =
-
=

0 1
.3 .1
.3 .9

Techniques for Financial Analysis, Modeling & Forecasting Page 324

Step 2. Find the inverse of this matrix, denoted by N.

2.31 .51
N = [I - Q]-1 =

.77 1.28
Note: The inverse of a matrix can be readily performed by spreadsheet programs such as
Lotus 1-2-3, Microsoft's Excel, or Quattro Pro.
Step 3. Multiply this inverse by matrix R.
2.31 .51
NR =

.77 1.28

.3 0
.95 .05
.5 .1 = .87 .13

NR gives us the probability that an account will eventually be collected or become

a bad debt. Specifically, the top row in the answer is the probability that $1 of XYZ's
accounts receivable in the 0-60-day-old category will end up in the collected and bad debt
category will be paid and a .05 probability that it will eventually become a bad debt.
Turning to the second row, the two entries represent the probability that $1 now in the
61-120-day-old category will end up in the collected and bad debt categories. We can see
from this row that there is a .87 probability that $1 currently in the 61-120-day-category
will be collected and a .13 probability that it will eventually become uncollectible.
If XYZ wants to estimate the future of its $10,000 accounts receivable ($7,000 in
the 0-60 day category and $3,000 in the 61-120 day category), it must set up the following
matrix multiplication:
[7,000 3,000]

.95 .05
.87 .13

= [9,260 740]

Hence, of its $10,000 in accounts receivable, XYZ expects to collect $9,260 and to
lose $740 to bad debts. Therefore, the estimated allowances for the collectible accounts
is $740.
The variance of each component is equal to
A = be(cNR - (cNR)sq) 2
where ci = bi / bi and e is the unit vector.
i=1

In our example, b = (7,000 3,000), c = (.7 .3). Therefore,

1
.95 .05
.95 .05
[
]
A = [7,000 3,000] [.7 .3]
.7
.3

.87 .13
1
.87 .13

sq
= 10,000 [ [.926 .074] - [.857476 .005476] ]
= [685.24 685.24]
Techniques for Financial Analysis, Modeling & Forecasting Page 325

Which makes the standard deviation equal to $26.18 ( $685.24 ). If we want to be 95

percent confident about our estimate of collections, we would set the interval estimate at
$9,260 + 2(26.18), or $9,207.64 -$9,312.36, assuming t = 2 as a rule of thumb. We would
also be able to set the allowance to cover the bad debts at $740 + 2(26.18), or $79,236.
SIMPLE AVERAGE
The most straightforward way to estimate collection percentages is to compute the
average value realized from past data, i.e.,
P'i = AVE (Ct+i/St)
=

1 N Ct+i
, i = 0,1,2..
N t=1 St

where P't = an empirical estimate of collection percentages,

Ct+i = cash collection in month t+i from credit sales in month t,
St = credit sales in month t and
N = the number of months of past data to compute the average.
LAGGED REGRESSION APPROACH
A more scientific approach to estimating cash collection percentages (or payment
proportions) is to utilize multiple regression. We know that there is typically a time lag
between the point of a credit sale and realization of cash. More specifically, the lagged
effect of credit sales and cash inflows is distributed over a number of periods, as follows:
Ct = blSt-1 + b2St-2 + ...biSt-I
where Ct = cash collection in month t
St = credit sales made in period t
b1,b2,...bi = collection percentages (the same as P'i,) and
i = number of periods lagged
By using the regression method discussed previously, we will be able to estimate
these collection rates. We can utilize Excel or special packages such as SPSS, SAS, or
Minitab.
It should be noted that the cash collection percentages, (b1, b2,...,bi) may not add
up to 100 percent because of the possibility of bad debts. Once we estimate these
percentages by using the regression method, we should be able to compute the bad debt
percentage with no difficulty.
Table 17.2 shows the regression results using actual monthly data on credit sales
and cash inflows for a real company. Equation I can be written as follows:
Ct = 60.6%(St-1) + 19.3%(St-2) + 8.8%(St-3)
This result indicates that the receivables generated by the credit sales are collected at the
following rates: first month after sale, 60.6 percent; second month after sale, 19.3 percent;
Techniques for Financial Analysis, Modeling & Forecasting Page 326

and third month after sale, 8.8 percent. The bad debt percentage is computed as 6.3
percent (100-93.7%).
It is important to note, however, that these collection and bad debt percentages are
probabilistic variables; that is, variables whose values cannot be known with precision.
However, the standard error of the regression coefficient and the 5-value permit us to
assess the probability that the true percentage is between specified limits. The
confidence interval takes the following form:
b t Sb
Where Sb = standard error of the coefficient.
TABLE 17.2
REGRESSION RESULTS FOR CASH COLLECTION (CT)
Independent
Variables

Equation
I

St-1

0.606
b
(0.062)
a
0.193
(0.085)
0.088
(0.157)

0.596
(0.097)
0.142
(0.120)
0.043
(0.191)
0.136
(0.800)

0.754
c
2.52
11.63

0.753
c
2.48
16.05

St-2
St-3

St-4
2

R
Durbin-Watson
Standard Error
of the estimate(Se)
Number of
monthly
observations
Bad debt
percentages

Equation II
a

21

20

0.063

0.083

a Statistically significant at the 5% significance level.

b This figure in the parentheses is the standard error of the e estimate for the coefficient
(Sb).
c No autocorrelation present at the 5% significance level.

Techniques for Financial Analysis, Modeling & Forecasting Page 327

Example 17.1
To illustrate, assuming t = 2 as a rule of thumb at the 95 percent confidence level, the true
collection percentage from the prior month's sales will be
60.6% 2(6.2%) = 60.6% 12.4%
Turning to the estimation of cash collections and allowance for doubtful accounts,
the following values are used for illustrative purposes:
St-1 = $77.6, St-2 = $58.5, St-3 = $76.4 and forecast average monthly net credit sales =
$75.2
Then, (a) the forecast cash collection for period t would be
Ct = 60.6%(77.6) + 19.3%(58.5) + 8.8%(76.4) = $65.04
If the financial manager wants to be 95 percent confident about this forecast value, then
the interval would be set as follows:
Ct t Se
Where Se = standard error of the estimate.
To illustrate, using t = 2 as a rule of thumb at the 95 percent confidence level, the true
value for cash collections in period t will be
$65.04 2(11.63) = $65.04 23.26
(b) the estimated allowance for uncollectible accounts for period t will be
6.3% ($75.2) = $4.74
By using the limits discussed so far, financial planners can develop flexible (or
probabilistic) cash budgets, where the lower and upper limits can be interpreted as
pessimistic and optimistic outcomes, respectively. They can also simulate a cash budget
in an attempt to determine both the expected change in cash collections for each period
and the variation in this value.
In preparing a conventional cash inflow budget, the financial manager considers
the various sources of cash, including cash on account, sale of assets, incurrence of debt
and so on. Cash collections from customers are emphasized, since that is the greatest
problem in this type of budget.

Techniques for Financial Analysis, Modeling & Forecasting Page 328

Example 17.2
The following data are given for Erich Stores:

Cash sales
Credit
sales
Total sales

September
Actual
$ 7,000

October November
Actual
Estimated
$ 6,000 $ 8,000

December
Estimated
$ 6,000

50,000
$57,000

48,000 62,000
$54,000 $70,000

80,000
$86,000

Past experience indicates net collections normally occur in the following pattern:

No collections are made in the month of sale

80% of the sales of any month are collected in the following month
19% of sales are collected in the second following month
1% of sales are uncollectible

We can project total cash receipts for November and December as follows:
November December
Cash receipts
Cash sales
Cash collections
September sales
50,000 (19%)
October sales
48,000 (80%)
48,000 (19%)
November sales
62,000 (80%)
Total cash
receipts

$ 8,000

$ 6,000

9,500
38,400
9,120
$55,900

49,600
$64,720

IS CASH FLOW SOFTWARE AVAILABLE?

Computer software allows for day-to-day cash management, determining cash balances,
planning and analyzing cash flows, finding cash shortages, investing cash surpluses,
accounting for cash transactions, automating accounts receivable and payable and
dial-up banking. Computerization improves availability, accuracy, timeliness and
monitoring of cash information at minimal cost. Daily cash information aids in planning
how to use cash balances. It enables the integration of different kinds of related cash
information such as collections on customer accounts and cash balances and the effect of
cash payments on cash balances.
Spreadsheet program software such as Microsoft's Excel, Lotus 1-2-3 and Quattro
Pro can assist you in developing cash budgets and answering a variety of "what-if"
questions. For example, you can see the effect on cash flow from different scenarios (e.g.,
Techniques for Financial Analysis, Modeling & Forecasting Page 329

the purchase and sale of different product lines).

There are computer software packages specially designed for cash management.
Three popular ones are briefly described below.
1. Quicken (Intuit, Inc., 800-246-8848, www.quicken.com)
This program is a fast, easy to use, inexpensive accounting program that can help
a small business manage its cash flow. Bills can be recorded as postdated transactions
when they arrive; the program's Billminder feature automatically reminds the payer when
bills are due. Then, checks can be printed for due bills with a few mouse and/or
keystrokes. Similarly, he/she can record invoices and track aged receivables. Together,
these features help maximize cash on hand.
2. Up Your Cash Flow (Granville Publications Software, 10960 Wilshire Blvd., Suite 826,
Los Angeles, CA 90024, (800) 873-7789)
This program contains automatically prepared spreadsheets for profit/loss
forecasts, cash flow budgets, projected balance sheet, payroll analysis, term loan
amortization schedule, sales/cost of sales by product, ratio analysis and graphs. It is a
menu-driven system and can be customized to forecasting needs.
3. Cash Flow Analysis (Superior Software, 16055 Ventura Blvd., Suite 725, Encino, CA
91436, (800) 421-3264)
This software provides projections of cash inflow and cash outflow. Data are input
into eight categories: sales, cost of sales, general and administrative expenses, long-term
debt, other cash receipts, inventory build-up/reduction, capital expenditures (acquisition
of long-term assets such as store furniture) and income tax. The program allows changes
in assumptions and scenarios and provides a complete array of reports.
Telecommunications software may be used to link up your personal computer via
modem and telephone lines to the bank so as to execute cash payments, transfers
between accounts and obtain current cash balance information. Software available from
banks aid in managing cash collections, payments, investment and borrowing. An
example is JP Morgan/Chase's InfoCash software package which includes modules for:
Cash Reporter - provides account information up to the close of the previous day.
Information available includes checks cleared and money transfers.
Current Day Reporter - provides information on current day transactions.
Regional Bank Reporter - provides information on checking accounts held at other
banks.
Money Transfer Input - enables the transfer of funds between accounts.
CONCLUSION
Two methods of estimating the expected collectible and uncollectible patterns were
presented. One advantage of the Markov model is that the expected value and standard
deviation of these percentages can be determined, thereby making it possible to specify
probabilistic statements about these figures. We have to be careful about these results,
however, since the model makes some strong assumptions. A serious assumption is that
Techniques for Financial Analysis, Modeling & Forecasting Page 330

the matrix of transition probabilities is constant over time. We do not expect this to be
perfectly true. Updating of the matrix may have to be done, perhaps through the use of
such techniques as exponential smoothing and time series analysis.
The regression approach is relatively inexpensive to use in the sense that it does not
require a lot of data. All it requires is data on cash collections and credit sales.
Furthermore, credit sales values are all predetermined; we use previous months' credit
sales to forecast cash collections, that is, there is no need to forecast credit sales. The
model also allows you to make all kinds of statistical inferences about the cash collection
percentages and forecast values.
Extensions of these models can be made toward setting credit and discount policies.
Corresponding to a given set of policies, there are

An associated transition matrix in the Markov model

Associated collection percentages in the regression model

By computing long-term collections and bad debts for each policy, an optimal
policy can be chosen that maximizes expected long-run profits per period.

Techniques for Financial Analysis, Modeling & Forecasting Page 331

CHAPTER 17 QUIZ
1. A firm is attempting to estimate the reserves for doubtful accounts. The probabilities of
these doubtful accounts follow a transition process over time. They evolve from their
starting value to a changed value. As such, the most effective technique to analyze the
problem is
A.
Markov chain analysis.
B.
Econometric theory.
C.
Monte Carlo analysis.
D.
Dynamic programming.
2. Up Your Cash Flow is capital budgeting software.
True / False

Techniques for Financial Analysis, Modeling & Forecasting Page 332

CHAPTER 17 ANSWER KEY

1. (A) is correct. A Markov chain is a series of events in which the probability of an event
depends on the immediately preceding event. An example is the game of blackjack in
which the probability of certain cards being dealt. In the analysis of bad debts, preceding
events, such as collections, credit policy changes and writeoffs, affect the probabilities of
future losses.
(B) is incorrect. Econometrics forecasts the impact of different economic policies and
conditions.
(C) is incorrect. Monte Carlo analysis is a simulation technique that uses random-number
procedures to create values for probabilistic components.
(D) is incorrect. Dynamic programming is a problem-solving approach that breaks a large
mathematical model into a number of smaller, manageable problems.
2. (F) is correct. This is a cash budgeting software package.
(T) is incorrect. This program contains automatically prepared spreadsheets for profit/loss
forecasts, cash flow budgets, projected balance sheet, payroll analysis, term loan
amortization schedule, sales/cost of sales by product, ratio analysis and graphs. It is a
menu-driven system and can be customized to forecasting needs.

Techniques for Financial Analysis, Modeling & Forecasting Page 333

CHAPTER 18
HOW TO USE CORPORATE PLANNING MODELS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.
5.
6.

Identify the types of analysis.

Explain typical questions addressed via corporate modeling
Identify types of corporate planning models
Outline current trends in modeling
Discuss the relationships among mis, dss, eis and personal computers
Describe the future of corporate planning models

Today, more and more companies are using, developing, or experimenting with some form
of corporate planning model. This is primarily due to development of planning and modeling
software packages that make it possible to develop the model without much knowledge of
computer coding and programming. For the accountant and financial analyst, the attractive
features of corporate modeling are the formulation of budgets, budgetary planning and
control and financial analyses that can be used to support management decision making.
However, corporate modeling involves much more than the generation of financial
statements and budgets. Depending on the structure and breadth of the modeling activity, a
variety of capabilities, uses and analyses are available.
A corporate planning model is an integrated business planning model in which
marketing and production models are linked to the financial model. More specifically, a
corporate model is a description, explanation and interrelation of the functional areas of a
firm (accounting, finance, marketing, production and others) expressed in terms of a set of
mathematical and logical relationships so as to produce a variety of reports including
financial statements. The ultimate goals of a corporate planning model are to improve
quality of planning and decision making, reduce the decision risk and, more importantly,
influence or even to shape the future environment.
Generally speaking, a corporate model can be used to:
1.
2.
3.
4.

Simulate an alternative strategy by evaluating its impact on profits.

Help establish corporate and divisional goals.
Measure the interactive effect of parts with the firm.
Help management better understand the business and its functional relationships and
help improve decision making ability.
5. Link the firm's goals and strategies to its master budgets.
6. Assess critically the assumptions underlying environmental constraints.

Techniques for Financial Analysis, Modeling & Forecasting Page 334

TYPES OF ANALYSIS
The type of corporate model management is looking for would depend on what types of
analysis it wishes to perform. There are typically three types of model investigations.
The first type of questions to be raised is "What is" or "what has been" questions
such as the relationship between variables of the firm and external macroeconomic
variables such as GNP or inflation. The goal of this type of model investigation is to obtain a
specific answer based on the stipulated relationship. For example, what is or has been the
firm's profit when the price of raw material was $12.50?
The second type of investigation focuses on "what-if" questions. This is done through
simulation or sensitivity analysis. This analysis often takes the following form: "What
happens under a given set of assumptions if the decision variable(s) is changed in a
prescribed manner?" For example, "What is going to happen to the company's cash flow
and net income if it is contemplating a reduction of the price by 10% and an increase in
advertising budget by 25%?"
The third type of question that can be addressed by way of corporate planning
modeling takes the following form: "What has to be done in order to achieve a particular
objective?" This type of analysis is often called "goal seeking." It usually requires the use of
optimization models such as linear programming and goal programming.
TYPICAL QUESTIONS ADDRESSED VIA CORPORATE MODELING
The following is a list of questions management addresses itself using corporate modeling.

What are the effects of different pricing policies?

What is the effect of different interest rates and current exchange rates on the
income statement and balance sheet of the firm?
What will be the demand for the end products of the firm at various locations and
different times?
What is and will be the unit contribution margin for certain production, transportation
and sales allocations?
What will the absence and turnover rates of the employees of the firm be and what
effect will they have?
What is the effect of advertising and distribution expenditures on sales?
What marketing strategy can and should the firm follow?
What do price-demand or supply relations on the output or input side of the firm look
like?
What are the effects of price/cost changes on sales?
How do certain states of the national or world economy influence sales of the firm on
the one side and purchase price of the production factors on the other?
What is the nature of the conditions that must be fulfilled if the total sales of the firm at
a certain time are supposed to be higher than a certain budget value?
Should the firm produce and sell a certain product, purchase and sell the product, or
not get involved at all?
In what range will the return on investment on various projects and units lie?
Techniques for Financial Analysis, Modeling & Forecasting Page 335

How will the income statement, the balance sheet and the cash flow statement
develop for several operating divisions? What will their contributions be?
What effects with respect to the financial position of the firm could an acquisition or
merger with another firm have?
Benefits derived from the corporate planning models include:

The ability to explore more alternatives

Better quality decision making
More effective planning
A better understanding of the business
Faster decision making
More timely information
More accurate forecasts
Cost savings

TYPES OF MODELS
Corporate planning models can be categorized according to two approaches: simulation
and optimization. Simulation models are attempts to mathematically represent the
operations of the company or of the conditions in the external economic environment. By
adjusting the values of controllable variables and assumed external conditions, the future
implications of present decision making can be estimated. Probabilistic simulation models
incorporate probability estimates into the forecast sequence, while deterministic models do
not. Optimization models are intended to identify the best decision, given specific
constraints.
HISTORY OF MODELS
The rudiments of corporate modeling can be placed in the early 1960s with the large,
cumbersome simulation models developed by major corporations such as AT&T, Wells
Fargo Bank, Dow Chemical, IBM, Sun Oil and Boise Cascade. Most of the models were
written in one of the general programming languages (GPLs) such as FORTRAN and were
used for generating pro forma financial statements. The models typically required several
man-years to develop and, in some cases, never provided benefits sufficient to outweigh the
costs of development. Planning models were considered an untested concept, suitable only
for those corporations large enough to absorb the costs and risks of development.
Important advancements in computer technology in the early 1970s provided the
means for greater diversity and affordability in corporate modeling. Interactive computing
facilities allowed for faster and more meaningful input/output sequences for modelers;
trial-and-error adjustments of inputs and analyses were possible while on-line to the central
computer or to an outside timesharing service. The advent of corporate simulation
languages enabled analysts with little experience with GPLs to write modeling programs in
an English-like programming language-- for example, Comshares IFPS/PLUS, Planning
and Decision and Encore Plus. In addition, a number of spreadsheet programs such as
Microsofts Excel became available for use by corporate planning modelers. Currently,
virtually every Fortune 1000 company is using a corporate simulation model. This statistic
will definitely increase to cover small and medium size firms.
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As companies gained experience in developing basic, deterministic simulations,

renewed effort was directed toward consolidating and integrating smaller models into the
larger corporate models. Furthermore, certain companies were attempting the more difficult
optimization models and were increasing predictive power by using econometric models to
link their simulations with product markets and the external economy. Early successes with
the simpler models led to a boom in modeling, but an increasing number of failures in more
ambitious projects soon moderated the general enthusiasm. As the economy entered a
recession and became more unstable (less predictable), the weaknesses in the rationale
underlying many corporate models were revealed. Managers realized that the purpose of a
model must be well defined and that the end users should be involved in its development.
Although the bad experiences of the mid 1970s have prejudiced some executives against
models to the present day, most veterans of the period have developed a realistic attitude
toward the capabilities of models and are employing recent advancements in techniques to
construct more serviceable models.
CURRENT TRENDS IN MODELING
Among the reasons cited by corporations for using planning models were
* Economic uncertainty
* Shortages of resources
* Diminishing increase in productivity
* International competition
* Tight money and inflation
* Political upheavals (affecting foreign operations)
* Environmental problems
* New business opportunities
There was general agreement that models enabled managers to run alternative analyses
and to adjust decision variables, while reducing the time needed for report writing. The
many possible applications of corporate planning models are listed in Table 18.1. Financial
forecasting and pro-forma balance sheet statements were the most common applications of
most companies. The models proved to be useful tools in "what-if" analysis, sensitivity
analysis, simulations, best/worst case scenarios, goal seeking, optimization and report
preparation.

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Table 18.1
APPLICATIONS OF CORPORATE PLANNING MODELS
Financial forecasting
Pro-forma financial
statements
Capital budgeting
Market decision-making
Merger and acquisition
analysis
Lease versus purchase
decisions
Production scheduling
New venture evaluation
Manpower planning
Profit planning
Sales forecasting
Investment analysis

Construction scheduling
Tax planning
Energy requirements
Labor contract negotiation
fees
Foreign currency analysis
Utilities
Load forecasting
Rate cases
Generation planning

The end users of the models were usually strategic planning groups, the treasurer's
department and the controller's department.
Despite the growing diversity of modeling
techniques available, the vast majority of corporate models encountered in the surveys
were basic, deterministic simulations. Probabilistic considerations were seldom
incorporated into the models by any but the largest corporations. Not many firms appear to
use optimization models as a planning tool. Evidently, the accuracy of optimization models,
as well as their clarity to upper management, must improve before they receive significant
use.
ATTITUDES AND PROBLEMS
The reluctance of many firms to experiment with corporate planning models derives chiefly
from a fear of the unknown. Confusion over what models are and how they are used
precludes serious investigation of their potential benefits. Myths that discourage managers
from considering models include the following:

Models are complicated. On the contrary, most effective models are fairly simple
structures, incorporating only the essential processes of the problem under
investigation. The math involved is often basic algebra and modeling languages
reduce complex terminology.
The company is not large enough. Models do not consist solely of
comprehensive simulations. Some of the most frequently used models center on
a limited number of key relationships.
We do not have any modelers. Modern planning languages have so simplified
the modeling process that even a novice quickly becomes competent. Outside
consultants are also available for assistance.

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The growing acceptance of planning models has enabled managers and technicians
to identify areas requiring improvement and to formulate criteria for success. Optimization
models are one technique in need of refinement. Note: Optimization models are inscrutable
"black boxes" to those managers who have had no part in the modeling effort. Naturally, top
management has little confidence in forecasts produced by a model they cannot understand.
The need to monitor several financial and nonfinancial variables precludes the construction
of simple optimization models.
The reasons for discontinuation of corporate planning models are listed in Table 18.2.
The common justifications were model deficiencies and human problems in implementation.
Three of the prevalent reasons (inflexibility, lack of management support, excessive input
data requirements) are familiar shortcomings, as discussed earlier. The need for
management's support for successful model making cannot be overemphasized; its role as
champion of the effort is essential for companywide acceptance of the final product. It is
interesting to note that excessive development time and costs were not often a basis for
rejection.
Table 18.2
REASONS FOR DISCONTINUED MODELS
Lack of sufficient flexibility
Lack of adequate management support
Excessive amounts of input data required
Replaced by a better model
The need no longer existed
The model did not perform as expected
New management de-emphasized
planning
Poor documentation
Lack of user interest
Excessive development costs
Excessive operating costs
Excessive development time required
STATE-OF-THE-ART AND RECOMMENDED PRACTICE
The acceptance of corporate planning models has resulted in many firms' establishing
planning departments responsible for developing and implementing planning models. The
structure of the typical corporate financial model is an integration of smaller modules used
by each department or business unit for planning purposes. Figure 18.1 shows that
marketing, production and financial models from each business unit can be consolidated to
drive a comprehensive model used by upper management.

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Optimal procedures for assembling effective models are still largely at the discretion
of the individual planning department, but useful guidelines have been published.
1. Determine which process(es) can be modeled effectively
2. Decide whether to use a model
3. Formalize the specifications of the model (e.g., inputs and outputs, structure, etc.)
4. Prepare a proposal
5. Conduct modeling and data gathering concurrently
6. Debug the model
7. Educate the prospective users
8. Have users validate the model
9. Put model to use
10. Update and modify the model as needed
Table 18.3 is a list of prerequisites for modeling and control factors for success.
Table 18.3
SUCCESS FACTORS IN MODELING
Uncontrollable Prerequisites
Operations understood, data plentiful
Relevant data accessible
Budgets, plans and control systems are well defined,
understood
Modelers have management's support
Management scientists accept responsibility for
implementation
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Similar innovative techniques used in the past

Manager and modeler share status and background
Controllable Factors
Involve potential users in development process
Define model's goals explicitly
Input and output are in familiar formats
Company procedures are modified little at first
Look for common management problems to model
Start simple and keep it simple
Allow for ample judgmental inputs
Be realistic about planning time and expected results
Put a manager (not a modeler) in charge
Define roles clearly
Demonstrate part of model early on
Build model within users' organization
Develop expertise to manage and update model
Provide ample documentation
The anatomy of the contemporary financial model is composed of five parts: the
documentation supporting the calculations; input assumptions regarding future periods; the
projections and decision points leading to the forecasted values; managerial (financial)
ratios; and graphics displaying information from decision points. The forecasting systems
utilized depend upon the breadth and planning horizon of the model; typical methods
include market research and Etc method, time trends, moving averages, Box-Jenkins and
various casual methods, such as leading indicators, life cycle analysis and regression.
Forecasting methods should be reviewed periodically by an independent party to
ensure that the techniques have not become outdated. This can be determined only by
maintaining a current management information system (MIS), which provides data to
econometric models of the external environment. Note: The critical importance of external
data in determining company strategy is the central theorem of MIS. Thus, planners make
assumptions about the business environment for a particular planning horizon, based upon
the output from the MIS. The information is combined with internal data to prepare demand
forecasts and the results can be input to a planning model or used to check the validity of
forecasts produced by current techniques.
Planning and modeling languages (PMLs) have been a major incentive in involving
higher management in modeling. General programming languages, such as FORTRAN,
are seldom used in current models; oddly, COBOL, the "business language," has never
been used extensively in modeling. The advantages of PMLs are steadily edging out GPLs:
with PMLs, models are built more easily, with shorter development and data processing, are
more easily understood by upper management and are periodically updated with
enhancement from the vendor.
Today more than 70 PMLs are available at reasonable cost, including IFPS, Encore
Plus and Venture. A further convenience offered to companies looking into modeling is
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premade planning packages sold by software vendors. The packages have often been
criticized for their inflexibility, but the newer models allow for more user specificity. Analytical
portfolio models are commercial packages that tell a conglomerate how to distribute
resources across the portfolio of profit centers. Boston Consulting Group, Arthur D. Little
and McKinsey have developed models that categorize investments into a matrix of profit
potentials and recommended strategies.
A model for Profit Impact of Market Strategy (PIMS) is offered by the Strategic
Planning Institute. The package is a large multiple regression model used to identify the
optimal strategy in a given business environment. Similar packages will likely proliferate in
the future as more companies are forced to use decision models to remain competitive.
Furthermore, more spreadsheet-based add-ins and templates for budgeting are being
developed for Lotus 1-2-3, Microsoft' Excel and Quattro Pro.
MIS, DSS, EIS AND PERSONAL COMPUTERS
The analytic and predictive capabilities of corporate planning models depend in large part
upon the supporting data base. Information technology has advanced to the point that data
bases consist of logic-mathematical models and highly integrated collections of data,
derived from both inside and outside the firm. The data bases are called Management
Information Systems (MISs), Decision Support Systems (DSSs), or Executive Information
Systems (EISs). They store the data and decision tools utilized by management.
A primary value of the MIS, DSS and EIS are their large storage capacity for data
and the potential to more accurately model the external economy and to forecast business
trends. Managers are finding that effective long-range planning depends primarily upon a
thorough understanding of their competitors and the forces in the marketplace. A
considerable body of data is required to develop insight into the competitive environment.
Note: Information derived from within the company has little strategic value for those
purposes, thus the collection of external data should be emphasized.
As a result, the relevance of information to future conditions is the standard by which
input of data to the MIS is controlled.
Once the strategic data have been stored in the mainframe computer system,
managers need quick access to the data base and a means for inputting alternative data
sets and/or scenarios into the econometric models. Only recently have such activities been
made possible by the development of communication links between mainframe systems
and PCs. Many of the applications of the mainframe-PC connection involve rather basic
analyses, such as accounts payable, receivables, general ledger and the like. However,
internal financial planning packages (e.g., Comshares Planning for a single user and
Decision for a multiple user) are currently available, as are external time-sharing services,
such as Dow Jones and The Source.
The outlook for the next few years indicates increasing integration of the PC with the
mainframe and the Web. Corporate planning software packages for PCs are already
proliferating. Applications range from cash flow analysis and budget projections to
regressions, time series analysis and probabilistic analysis. The trend in PC technology is
aimed toward incorporating as many mainframe, analytical capabilities into the
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microcomputer as the market will support.

THE FUTURE OF CORPORATE PLANNING MODELS
The interest in obtaining corporate models is likely to continue. The concept of the strategic
business unit (SBU) as an object of analysis may prove to be unviable. There has been no
consistent definition of SBU and most models treat them as independent of one another,
even though this may not be accurate. The SBU is typically forced into short-term profit
making (rather than long-term development), eventually sapping its vitality. Consequently,
an improved rationale may cause models to be built around a different grouping of profit
centers.
We can expect to see an increased linking of portfolio models with corporate
simulation and optimization models. Modeling software will become more modular in order
to perform limited analyses or comprehensive projections. More software will be written for
microcomputers, graphics will improve and modeling languages will become more user
friendly. The future of modeling is somewhat assured because it is intimately linked with the
continued expansion of the computer market. As a matter of fact, PC networks begin to oust
mainframes in some companies. Though shakeouts may frequently occur among hardware
manufacturers, planning models will always have a market, as software writers improve
their understanding of the planner's needs and produce more efficient decision-making
tools.
Many models will fully integrate with today's faster Windows operating systems
and support Microsoft Office so users can easily prepare reports and graph data using
Excel. They can be deployed as either stand-alone or LAN/WAN connected. Interfaces to
common data sources will be a standard--not an option-- to develop and maintain. Further,
planning models will function on either Web or client/server platforms and require no
installation on the user's PC beyond the Java-enabled Web browser. All information is
stored in a centralized database, for consistency and easy deployment of data
enterprise-wide and in multiple locations. They will support all of the world's leading
multidimensional databases, including Microsoft SQL Server OLAP (OnLine Analytical
Processing) Services, IBM DB2 OLAP Server, Hyperion Essbase and OLE DB for OLAP
compliant databases.
CONCLUSION
In the face of uncertainty about the future, management is particularly interested in following
the best possible course of action under a given circumstance. The corporate planning
model is used as a tool to help minimize risk and uncertainty and to develop the best course
of action for the company. For example, management is able to examine the effects of
proposed mergers and acquisitions with much less uncertainty and to estimate with more
confidence the potential profits from new markets.

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CHAPTER 18 QUIZ
1. Corporate planning models can be categorized according to deterministic simulation and
optimization.
True / False
2. What-if analysis is one of the three model investigations.
True / False

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CHAPTER 18 ANSWER KEY

1. (F) is correct. Corporate planning models can be categorized according to two
approaches: simulation and optimization. Simulation models are attempts to mathematically
represent the operations of the company or of the conditions in the external economic
environment. By adjusting the values of controllable variables and assumed external
conditions, the future implications of present decision making can be estimated.
Probabilistic simulation models incorporate probability estimates into the forecast sequence,
while deterministic models do not. Optimization models are intended to identify the best
decision, given specific constraints.
(T) is incorrect. Corporate planning models can also be probabilistic simulation. Probabilistic
simulation models incorporate probability estimates into the forecast sequence, while
deterministic models do not.
2. (T) is correct. This is done through simulation or sensitivity analysis. This analysis often
takes the following form: "What happens under a given set of assumptions if the decision
variable(s) is changed in a prescribed manner?" For example, "What is going to happen to
the company's cash flow and net income if it is contemplating a reduction of the price by
10% and an increase in advertising budget by 25%?"
(F) is incorrect. The other two are what is or what has been and What has to be done in
order to achieve a particular objective?" This type of analysis is often called "goal seeking."

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CHAPTER 19
FINANCIAL MODELING FOR "WHAT-IF" ANALYSIS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1.
2.
3.
4.

Define a financial model.

Apply and use financial models.
Put financial modeling into practice.
List and explain each of the quantitative techniques used in financial
models.
5. Develop financial models.
6. Identify model specification.
This section introduces financial modeling. We begin with a review of:
.What is a financial model?
.What are some typical uses of financial model?
.What are the types of financial modeling?
.How widespread is the use of financial modeling in practice?
.How do we go about building a financial model?
A FINANCIAL MODEL
A financial model, narrowly called a budgeting model, is a system of mathematical
equations, logic and data which describes the relationships among financial and operating
variables. A financial model can be viewed as a subset of broadly defined corporate
planning models or a stand-alone functional system that attempts to answer a certain
financial planning problem.
A financial model is one in which:
(1) one or more financial variables appear (expenses, revenues, investment, cash flow,
taxes, earnings, etc.);
(2) the model user can manipulate (set and alter) the value of one or more financial
variables; and
(3) the purpose of the model is to influence strategic decisions by revealing to the decision
maker the implications of alternative values of these financial variables.
Types of Financial Models
Financial models fall into two types: simulation better known as what-if models and
optimization models. What-if models attempt to simulate the effects of alternative
management policies and assumptions about the firm's external environment. They are
basically a tool for management's laboratory. Optimization models are the ones in which the
goal is to maximize or minimize an objective such as present value of profit or cost.
Multi-objective techniques such as goal programming are being experimented.
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Models can be deterministic or probabilistic. Deterministic models do not include any

random or probabilistic variables whereas probabilistic models incorporate random
numbers and/or one or more probability distributions for variables such as sales, costs, etc.
Financial models can be solved and manipulated computationally to derive from it the
current and projected future implications and consequences. Due to technological
advances in computers (such as spreadsheets, financial modeling languages, graphics,
data base management systems and networking), more companies are using modeling.
APPLICATIONS AND USES OF FINANCIAL MODELING
Basically, a financial model is used to build a comprehensive budget (that is, projected
financial statements such as the income statement, balance sheet and cash flow statement).
Such a model can be called a budgeting model, since we are essentially developing a
master budget with such a model. Applications and uses of the model, however, go beyond
developing a budget. They include:
Financial forecasting and analysis
Capital expenditure analysis
Tax planning
Exchange rate analysis
Analysis for mergers and acquisitions
Labor contract negotiations
Capacity planning
Cost-volume-profit analysis
New venture analysis
Lease/purchase evaluation
Appraisal of performance by segments
Market analysis
New product analysis
Development of long-term strategy
Planning financial requirements
Risk analysis
Cash flow analysis
Cost and price projections

PUTTING FINANCIAL MODELING INTO PRACTICE

The use of financial modeling, especially a computer-based financial modeling system is
rapidly growing. The reason is quite simple: the growing need for improved and quicker
support for management decisions as a decision support system (DSS) and wide and easy
availability of computer hardware and software.
Some of the functions currently served by financial models are:

Projecting financial results under a given set of assumptions; to evaluate the

financial impact of various assumptions and alternative strategies; and to
prepare long range financial forecasts.

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Computing income, cash flow and ratios for five years by months; also energy
sales, revenue, power generation requirements, operating and manufacturing
expenses, manual or automatic financing and rate structure analysis.
Providing answers to insights into financial 'what-if'? questions and to produce
financial scheduling information.
Forecast of balance sheet and income statement with emphasis on
alternatives for the investment securities portfolio.
Projecting operating results and various financing needs, such as plant and
property levels
and financing requirements.
Computing manufacturing profit, given sales forecasts and any desired
processing sequence through the manufacturing facilities; simulate effect on
profits of inventory policies.
Generating profitability reports of various cost centers.
Projecting financial implications of capital investment programs.
Showing the effect of various volume and activity levels on budget and cash
flow.
Forecasting corporate sales, costs and income by division, by month.
Providing: (1) sales revenue for budget; (2) a basis for evaluating actual sales
department performance; and (3) other statistical comparisons.
Determine pro forma cash flow for alternative development plans for real
estate projects.
Analyzing the impact of acquisition on company earnings.
Determining economic attractiveness of new ventures, products, facilities,
acquisitions and so on.
Evaluate alternatives of leasing or buying computer equipment.
Determining corporate taxes as a function of changes in price.
Evaluate investments in additional capacity at each major refinery.
Generating income statements, cash flow, present value and discounted rate
of return for potential ventures, based on production and sales forecasts.

Supported by the expanded capabilities provided by models, many companies are

increasingly successful in including long-term strategic considerations in their business
plans, thus enabling them to investigate the possible impact of their current decisions on the
long term welfare of the organization.
QUANTITATIVE METHODS USED IN FINANCIAL MODELS
In view of the development of sophisticated quantitative models for analysis in business
planning and decision making, there is a rapid growing trend for their use, certainly with the
aid of computer technology. Here is a list of these techniques used by the model builders:
Econometric and statistical methods
Simple and multiple regressions
Econometric modeling
Time series models
Exponential smoothing
Risk analysis
Simulation

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 Optimization models
Linear programming
Goal programming
Integer programming
Dynamic programming

DEVELOPING FINANCIAL MODELS

Development of financial models essentially involves two steps: (1) definition of variables
and input parameters and (2) model specification. As far as model specification goes, we
will concentrate only on the simulation-type model in this section. Generally speaking, the
model consists of three important ingredients:
Variables
Input parameter values
Definitional and/or functional relationships

Definition of Variables and Input Parameters

Fundamental to the specification of a financial model is the definition of the variables to be
included in the model. There are basically three types of variables: policy variables (Z),
external variables (X) and performance variables (Y).
Policy variables: The policy variables (often called control variables) are those management
can exert some degree of control over. Examples of financial variables are cash
management, working capital, debt management, depreciation, tax, merger-acquisition
decisions, the rate and direction of the firm's capital investment programs, the extent of its
equity and external debt financing and the financial leverage represented thereby and the
size of its cash balances and liquid asset position. Policy variables are denoted by the
symbol Z in Figure 19.1.
External variables: The external variables are the environmental variables that are external
to the company and which influence the firm's decisions from outside of the firm, generally
exogenous in nature. Generally speaking, the firm is embedded in an industry environment.
This industry environment, in turn, is influenced by overall general business conditions.
General business conditions exert influences upon particular industries in several ways.
Total volume of demand, product prices, labor costs, material costs, money rates and
general expectations are among the industry variables affected by the general business
conditions. The symbol X represents the external variable in Figure 1.
Performance variables: The performance variables measure the firm's economic and
financial performance, which are usually endogenous. We use the symbol Y in the diagram.
The Y's are often called output variables. The output variables of a financial model would be
the line items of the balance sheet, cash budget, income statement, or statement of cash
flow. How to define the output variables of the firm will depend on the goals and objectives of
management. They basically indicate how management measures the performance of the
organization or some segments of it. Management is likely to be concerned with: (1) the
firm's level of earnings; (2) growth in earnings; (3) projected earnings; (4) growth in sales;
and (5) cash flow.
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Frequently when we attempt to set up a financial model we face risk or uncertainty

associated with particular projections. In a case such as this, we treat some of these
variables such as sales as random variables with given probability distributions. The
inclusion of random variables in the model transforms it from a deterministic model to a risk
analysis model. However, the use of the risk analysis model in practice is rare because of
the difficulty involved in modeling and computation.
MODEL SPECIFICATION
Once we define various variables and input parameters for our financial model, we must
then specify a set of mathematical and logical relationships linking the input variables to the
performance variables. The relationships usually fall into two types of equations: definitional
equations and behavioral equations. Definitional equations take the form of accounting
identities. Behavioral equations involve theories or hypotheses about the behavior of certain
economic and financial events. They must be empirically tested and validated before they
are incorporated into the financial model.
Definitional Equations
Definitional equations are exactly what the term refers to--mathematical or accounting
definitions. For example,
Assets = Liabilities + Equity
Net Income = Revenues - Expenses
These definitional equations are fundamental definitions in accounting for the balance sheet
and income statement, respectively. Two more examples are given on the next page:
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CASH = CASH(-1) + CC + OCR + DEBT - CD - LP

This equation is a typical cash equation in a financial model. It states that ending cash
balance (CASH) is equal to the beginning cash balance (CASH(-1)) plus cash collections
from customers (CC) plus other cash receipts (OCR) plus borrowings (DEBT) minus cash
disbursements (CD) minus loan payments (LP).
INV = INV(-1) + MAT + DL + MO - CGS
This equation states that ending inventory (INV) is equal to the beginning inventory (INV(-1))
plus cost of materials used (MAT) plus cost of direct labor (DL) plus manufacturing
overhead (MO) minus the cost of goods sold (CGS).
Behavioral Equations
Behavioral equations describe the behavior of the firm regarding the specific activities that
are subject to empirical testing and validation. The classical demand function in economics
is:
Q = f (P) or more specifically Q = a - bP
It simply says that the quantity demanded is negatively related to the price. That is to say,
the higher the price the lower is the demand.
However, the firm's sales is more realistically described as follows:
SALES = f (P, ADV., I, GNP, Pc, etc.) or
Assuming linear relationship among these variables, we can specify the model as follows:
SALES = a + bP + cADV + dI + eGNP + fPc
Which says that the sales are affected by such factors as price (P), advertising expenditures
(ADV), consumer income (I), gross national product (GNP), prices of competitive goods (Pc),
etc.
With the data on SALES, P, ADV, I, GNP and Pc, we will be able to estimate
parameter values a, b, c, d, e and f, using linear regression. We can test the statistical
significance of each of the parameter estimates and evaluate the overall explanatory power
of the model, measured by the t-statistic and r-squared, respectively.
This way we will be able to identify most influential factors that affect the sales of a
particular product. With the best model chosen, management can simulate the effects on
sales of alternative pricing and advertising strategies. We can also experiment with
alternative assumptions regarding the external economic factors such as GNP, consumer
income and prices of competitive goods.

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Model Structure
A majority of financial models that have been in use are recursive and/or simultaneous
models. Recursive models are the ones in which each equation can be solved one at a time
by substituting the solution values of the preceding equations into the right hand side of
each equation. An example of a financial model of recursive type is given below:
(1) SALES
(2) REVENUE
(3) CGS
(4) GM
(5) OE
(6) EBT
(7) TAX
(8) EAT

= A - B*PRICE + C*ADV
= SALES*PRICE
= .70*REVENUE
= SALES - CGS
= $10,000 + .2*SALES
= GM - OE
= .46*EBT
= EBT - TAX

In this example, the selling price (PRICE) and advertising expenses (ADV) are given. A,B
and C are parameters to be estimated and
SALES
REVENUE
CGS
GM
OE
EBT
TAX
EAT

= sales volume in
units
= sales revenue
= cost of goods sold
= gross margin
= operating expenses
= earnings before
taxes
= income taxes
= earnings after taxes

Simultaneous models are frequently found in econometric models which require a higher
level of computational methods such as matrix inversion. An example of a financial model of
this type is presented below:
(1) INT
(2) EARN
(3) DEBT
(4) CASH
(5) BOW

= .10*DEBT
= REVENUE - CGS - OE - INT - TAX - DIV
= DEBT(-1) + BOW
= CASH(-1) + CC + BOW + EARN - CD - LP
= MBAL - CASH

Note that earnings (EARN) in equation (2) is defined as sales revenue minus CGS, OE,
interest expense (INT), TAX and dividend payment (DIV). But INT is a percentage interest
rate on total debt in equation (1). Total debt in equation (3) is equal to the previous period's
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debt (DEBT(-1)) plus new borrowings (BOW). New debt is the difference between a
minimum cash balance (MBAL) minus cash. Finally, the ending cash balance in equation
(5) is defined as the sum of the beginning balance (CASH(-1)), cash collection, new
borrowings and earnings minus cash disbursements and loan payments of the existing debt
(LP). Even though the model presented here is a simple variety, it is still simultaneous in
nature, which requires the use of a method capable of solving simultaneous equations. Very
few of the financial modeling languages have the capability to solve this kind of system.
Decision Rules
The financial model may, in addition to the ones previously discussed that are definitional
equations and behavioral equations, include basic decision rules specified in a very general
form. The decision rules are not written in the form of conventional equations. They are
described algebraically using conditional operators, consisting of statements of the type:
"IF...THEN...ELSE." For example, suppose that we wish to express the following decision
rule: "If X is greater than 0, then Y is set equal to X multiplied by 5. Otherwise, Y is set equal
to 0." Then we can express the rule as follows:
Y=IF X GT 0 THEN X*5 ELSE 0
Suppose the company wishes to develop a financing decision problem based upon
alternative sales scenarios. To determine an optimal financing alternative, managers might
want to incorporate some decision rules into the model for a "what-if" or sensitivity analysis.
Some examples of these decision rules are as follows:
The amount of dividends paid is determined on the basis of targeted earnings
available to common stockholders and a maximum dividend payout ratio specified by
management.
After calculating the external funds needed to meet changes in assets as a result of
increased sales, dividends and maturing debt, the amount of long-term debt to be floated is
selected on the basis of a prespecified leverage ratio.
The amount of equity financing to be raised is chosen on the basis of funds needed
which are not financed by new long-term debt, but is constrained by the responsibility to
meet minimum dividend payments.

In the model we have just described, simultaneity is quite evident. A sales figure is used to
generate earnings and this in turn lead to, among other items, the level of long-term debt
required. Yet the level of debt affects the interest expense incurred within the current period
and therefore earnings. Furthermore, as earnings are affected, so are the price at which
new shares are issued, the number of shares to be sold and thus earnings per share.
Earnings per share then "feeds back" into the stock price calculation.

Techniques for Financial Analysis, Modeling & Forecasting Page 353

Lagged Model Structure

Lagged model structure is common in financial modeling. Virtually all balance sheet
equations or identities are of this type. For example,
Capital

capital(-1) + net income + contributions - cash

dividends

More interestingly,
CC

a*SALES + b*SALES(-1) + c*SALES(-2)

where:
CC
a
b
c

=
=
=
=

cash collections from customers

percent received in the month of sale.
percent received in the month following sale.
percent received in the second month following
sale.

This indicates that the realization of cash lags behind credit sales.
COMPREHENSIVE FINANCIAL MODEL
A comprehensive corporate financial model is illustrated in Example 19.1.

Techniques for Financial Analysis, Modeling & Forecasting Page 354

Techniques for Financial Analysis, Modeling & Forecasting Page 355

Techniques for Financial Analysis, Modeling & Forecasting Page 356

CONCLUSION
Financial models comprise a functional branch of a general corporate planning model. They
are essentially used to generate pro forma financial statements and financial ratios. These
are the basic tools for budgeting and profit planning. Also, the financial model is a technique
for risk analysis and "what-if" experiments. The financial model is also needed for
day-to-day operational and tactical decisions for immediate planning problems.
In recent years, spreadsheet software and computer-based financial modeling
software have been developed and utilized for budgeting and planning in an effort to speed
up the budgeting process and allow budget planners to investigate the effects of changes in
budget assumptions and scenarios.

Techniques for Financial Analysis, Modeling & Forecasting Page 357

CHAPTER 19 QUIZ
1. A financial model is one in which only profits are maximized.
True / False
2. Financial models fall into two types: linear programming (LP) and optimization models.
True / False

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CHAPTER 19 ANSWER KEY

1. (F) is correct. A financial model is one in which (1) one or more financial variables appear
(expenses, revenues, investment, cash flow, taxes, earnings, etc.), (2) the model user can
manipulate (set and alter) the value of one or more financial variables and (3) the purpose of
the model is to influence strategic decisions by revealing to the decision maker the
implications of alternative values of these financial variables.
(T) is incorrect. A financial model is one in which one or more financial variables appear
(expenses, revenues, investment, cash flow, taxes, profits, etc.) as an objective. Profits is
only one performance objective to be maximized.
2. (F) is correct. Financial models fall into two types: simulation better known as what-if
models and optimization models.
(T) is incorrect. Linear programming (LP) is one of optimization models in which the goal is
to maximize or minimize an objective such as present value of profit or cost.

Techniques for Financial Analysis, Modeling & Forecasting Page 359

CHAPTER 20
USING OPTIMIZATION TECHNIQUES TO BUILD OPTIMAL BUDGETS
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1. Explain how linear programming works.
2. Differentiate between linear programming and goal programming.
In the preceding section, we discussed, step by step, how to develop a budget. This section
shows how optimization techniques, such as linear programming or goal programming, can
help develop an optimal budget. For this purpose, we will illustrate with a simple example.
USE OF LINEAR PROGRAMMING
Linear programming (LP) is a mathematical technique designed to determine an optimal
decision (or an optimal plan) chosen from a large number of possible decisions. The
optimal decision is the one that meets the specified objective of the company, subject to
various restrictions or constraints. It concerns itself with the problem of allocating scarce
resources among competing activities in an optimal manner. The optimal decision yields
the highest profit, contribution margin (CM), return on investment (ROI), revenue, or the
lowest cost. A linear programming model consists of two important ingredients:
1. Objective function. The company must define the specific objective to be achieved.
2. Constraints. Constraints are in the form of restrictions on availability of resources or
meeting minimum requirements. As the name linear programming indicates, both the
objective function and constraints must be in linear form.
Applications of LP
Applications of LP are numerous. They include:
1. Selecting least-cost mix of ingredients for manufactured products
2. Developing an optimal budget
3. Determining an optimal investment portfolio (or asset allocation)
4. Allocating an advertising budget to a variety of media.
5. Scheduling jobs to machines
6. Determining a least-cost shipping pattern
7. Scheduling flights
8. Gasoline blending
9. Optimal manpower allocation
10. Selecting the best warehouse location to minimize shipping costs.
For our purposes, we will use this technique first to find the optimal product mix and
then to develop the budget on the optimal program.

Techniques for Financial Analysis, Modeling & Forecasting Page 360

EXAMPLE 20.1
The CSU Company produces and sells two products: snowmobiles (A) and outboard
motors (B). The sales price of A is $900 per unit and that of B $800 per unit. Production
department estimates on the basis of standard cost data are that the capacity required for
manufacturing one unit of A is 10 hours while one unit of product B requires 20 hours. The
total available capacity for the company is 160 hours. The variable manufacturing costs of A
are $300 per unit and they are all paid in cash at the same rate at which the production
proceeds. The variable manufacturing costs of B are $600 per unit. These costs are also
paid in cash.
For simplicity we assume no variable selling costs. Demand forecasts have been
developed: the maximum amount of product A that can be sold is 8 units whereas that of B
is 12 units. Product A is sold with one period credit while one half of the sales of product B is
received in the same period in which the sales are realized. Additional information:
The company has existing loans, which require $2,100 in payment.
The company plans to maintain a minimum balance of $500.
The accounts payable balance of $900 must be paid in cash in this period.
The balance sheet and the fixed overhead budget are given below:
Balance Sheet
Assets
Current assets
Cash
Accounts
Receivable
Inventory
Fixed assets
Total assets

Liabilities
Current liabilities
Accounts
Payable
Short-term loan

$1,000
6,800
6,000

13,800
4,500
$18,300

900
10,000
10,900

Equity
Total Liability &
equity

$18,300

Fixed Overhead Budget

Expenses involving
cash
Accruals
Depreciation

$1,900
800
500
$3,200

Formulation of the LP Model

We begin the formulation of the model by setting up the objective function which is to
maximize the company's total contribution margin(CM). By definition, CM per unit is the
difference between the unit sales price and the variable cost per unit:
Product
A
B
Sales price
$900 $800
Variable cost 300
600
CM per unit $600 $200

Techniques for Financial Analysis, Modeling & Forecasting Page 361

Let us define
A

the number of units of product A to be

produced
the number of units of product B to be
produced

Then the total CM is:

TCM

600A + 200B

Remember that demand forecasts show that there were upper limits of the demand of each
product as follows:
A 6, B 10

The planned use of capacity must not exceed the available capacity. Specifically, we need
the restriction:
10A+ 20B 160

We also need the cash constraint. It is required that the funds tied up in the planned
operations will not exceed the available funds. The initial cash balance plus the cash
collections of accounts receivable are available for the financing of operations. On the other
hand, we need some cash to pay for expenses and maintain a minimum balance. The cash
constraint we are developing involves two stages. In the first stage, we observe the cash
receipts and disbursements that can be considered fixed regardless of the planned
production and sales.
Funds initially available
Beginning cash
balance
Accounts receivable

$1,000

Accounts payable
Repayment of loans
Fixed cash expenses

$900
2,100
1,900

6,800

7,800

Funds to be disbursed

Difference
Minus: Minimum cash balance required
Funds available for the financing of
operations

4,900
2,900
500
$2,400

In the second stage, we observe the cash receipts and disbursements caused by the
planned operations.
First, the total sales revenues:
Product

A 900A
B 800B
Techniques for Financial Analysis, Modeling & Forecasting Page 362

The cash collections from:

product

A
B

(0) 900A
(0.5) 800B

=
=

0
400B

Secondly, the variable manufacturing costs are:

Product

A
B

300A
600B

Therefore, the cash disbursements for:

Product

A
B

(1) 300A
(1) 600B

=
=

300A
600B

Then, the cash constraint is formulated by requiring that the cash disbursements for
planned operations must not exceed the cash available plus the cash collections resulting
from the operations:
300A + 600B 2400 + 0 + 400B

This can be simplified to form the following:

300A + 200B 2400

Using a widely used LP program known as LINDO (Linear Interactive Discrete Optimization)
program, (see Figure 20.1) we obtain the following optimal solution:
A
B
CM

=
=
=

6
3
$4,200

Techniques for Financial Analysis, Modeling & Forecasting Page 363

Techniques for Financial Analysis, Modeling & Forecasting Page 364

Generation of Budgets on the Basis of Optimal Mix

The sales budget would look like:
Sales Budget
Product Price

Quantity

A
B

6
3

$900
800

Revenue
s
$5,400
2,400
$7,800

Similarly, production and cost budgets can be easily developed. We will skip directly to
show the cash budget, budgeted balance sheet and budgeted income statement, as shown
below.
Cash Budget
Beginning cash balance
Accounts receivable
Cash collections from credit
sales

$1,000
6,800
A: (0) 900A =(0)(900)(6)
B: (.5)800B=400B
=400(3)

0
1,200

8,000

Total cash available

Cash disbursements:
Production:

9,000
A: 300A =300(6)
B: 600B =600(3)

1,800
1,800

Accounts payable
balance
Repayment of loan
Fixed expenses

900

3,600

Fixed cash expenses:

2,100
1,900

4,900

Ending cash balance

8,500
$500

Budgeted Income Statement

Sales
Less: Variable costs
Contribution margin (CM)
Less: Fixed expenses

(1)$7,800
(2) 3,600
4,200
Depreciation
Payables in
cash
Accruals

Operating income

500
1,900
800

3,200
$1,000

Techniques for Financial Analysis, Modeling & Forecasting Page 365

Supporting calculations:
(1)
(2)

A
900(6) = 5,400
300(6) = 1,800

B
800(3) =2,400
600(3) =1,800

Total
7,800
3,600

Budgeted Balance Sheet

Assets:
Current assets:
Cash
Accounts
receivable
Inventories

(1) $500
(2) 6,600
(3) 6,000

Total current assets

Fixed assets:

13,100
Beg. balance
Less: Accumulated
Depreciation
Total assets

4,500
(500)

4,000
$17,100

Liabilities:
Current liabilities:
Accounts payable
Short-term debt
Equity
Total liabilities & equity

(4) 800
(5) 7,900

8,700
(6) 8,400
$17,100

Supporting calculations:
(1) from the cash budget
(2) A: 900(6) = 5,400
B: 400(3) = 1,200
6,600
(3) Production and sales were assumed to be equal. This implies there is no change in
inventories.
(4) Accrual of fixed costs
(5) Beginning balance - repayment = $10,000 - 2,100 = 7,900
(6) Beginning balance + net income = $7,400 + 1,000 = 8,400
USE OF GOAL PROGRAMMING (GP)
In the previous section, we saw how we can develop a budget based on an optimal
program (or product mix), using LP. LP, however, has one important drawback in that it is
limited primarily to solving problems where the objectives of management can be stated in
a single goal such as profit maximization or cost minimization. But management must now
deal with multiple goals, which are often incompatible and conflicting with each other. Goal
programming (GP) gets around this difficulty. In GP, unlike LP, the objective function may
consist of multiple, incommensurable and conflicting goals. Rather than maximizing or
minimizing the objective criterion, the deviations from these set goals are minimized, often
based on the priority factors assigned to each goal. The fact that the management will have
multiple goals that are in conflict with each other, means that management will attempt to
satisfy these goals instead of maximize or minimize. In other words, they will look for a
Techniques for Financial Analysis, Modeling & Forecasting Page 366

satisfactory solution rather than an optimal solution.

To illustrate how we can utilize a GP model in order to develop an optimal - more
exactly satisfactory - budget, we will use the same data in the LP problem.
EXAMPLE 20.2
We will further assume that fixed cash receipts include (a) new short-term loan amount of
$1,200, (b) a dividend payment of $700 and (c) a capital expenditure of $500. Now the
company has two goals, income and working capital. In other words, instead of maximizing
net income or contribution margin, the company has a realistic, satisfactory level of income
to achieve. On the other hand, the company wants to have a healthy balance sheet with
working capital at least at a given level. (For example, a lending institution might want to
see that before approving any kind of line of credit).
For illustrative purposes, we will make the following specific assumptions:
The company wants to achieve a return of 20 percent on equity. That means 20 % of
$7,400 = $1,480, which translates into a CM of $1,480 + 3,200 (fixed expenses) = $4,680
The company wants a working capital balance to be at least $3,000. Currently, it is
$2,900 (current assets of $13,800 - current liabilities of $10,900 = $2,900).
These two goals are clearly in conflict. The reason is that we can increase the working
capital by increasing cash funds or the inventory. However, the funds in the form of idle
cash and the goods in the form of unsold inventories will not increase profits.
The first goal can be set up as follows:
600A + 200B + d- - d+

$4,680

Note that working capital balance = beginning balance + net income +

depreciation - dividends - capital expenditures = beginning balance + (sales - variable
costs - fixed costs) - dividend - capital expenditure.
Using this definition, the second goal can be set up as follows:
Sales
Variable costs Fixed expenses
2,900 + 900A + 800B - 300A - 600B -2,700 - 700 -500 > 3,000
This can be simplified to form an inequality:
600A + 200B > 4,000
Then our GP model is as follows:
Min D

d- + d+

subject to A
B
10A + 20B
300A + 200B
600A + 200B
600A + 200B + d- - d+

<6
<10
<160
<2,400
>4,000
= 4,680
all variables > 0

Techniques for Financial Analysis, Modeling & Forecasting Page 367

This particular problem can be easily solved by LINDO.

The GP solution is:

A
B
dd+

=
=
=
=

6
3
480
0

Techniques for Financial Analysis, Modeling & Forecasting Page 368

Which means that the income target was underachieved by $480. Just in the case of LP,
financial executives will be able to develop the budget using this optimal solution in exactly
the same manner as presented in the previous section. More sophisticated GP models can
be developed with "preemptive" priority factors assigned to multiple goals, which is beyond
the scope of this course.
CONCLUSION
Thus far we presented how optimization techniques, such as LP and GP, can help develop
an overall optimal plan for the company. However, in the Naylor study it was found that only
4 percent of the users of corporate planning models employed an optimization type model.
The disadvantage with using optimization models to develop optimal plans for a firm as a
whole is that problems are difficult to define and the firm has multiple objectives. It is not
easy to develop an optimization model that incorporates performance variables such as
ROI, profits, market share and cash flow as well as the line items of the income statement,
balance sheet and cash flow statement. Despite the availability of goal programming that
handles multiple objectives, the possibility of achieving global optimization is very rare at
the corporate level. The usage tends to be limited to sub-models and sub-optimization
within the overall corporate level. Thus, the use of these models in corporate modeling will
probably continue to be focused at the operational level. Production planning and
scheduling, advertising, resource allocation and many other problem areas will continue to
be solved with huge success by these techniques.

Techniques for Financial Analysis, Modeling & Forecasting Page 369

CHAPTER 20 QUIZ
1. An investment company is attempting to allocate its available funds between two
investment alternatives, stocks and bonds, which differ in terms of expected return and
risk. The company would like to minimize its risk while earning an expected return of at
least 10% and investing no more than 70% in either of the investment alternatives. An
appropriate technique for allocating its funds between stocks and bonds is
A.
Linear programming (LP).
B.
Capital budgeting.
C.
Differential analysis.
D.
Queuing theory.
2. Linear programming (LP) is an operating research technique that allocates resources.
Mathematical expressions are used to describe the problem. The measure of
effectiveness that is to be maximized or minimized is the
A.
Constraints.
B.
Set of decision variables.
C.
Objective function.
D.
Derivative of the function.
3. The constraints in a linear programming (LP) model are
A.
Included in the objective function.
B.
Costs.
C.
Scarce resources.
D.
Dependent variables.

Techniques for Financial Analysis, Modeling & Forecasting Page 370

CHAPTER 20 ANSWER KEY

1. (A) is correct. LP is a mathematical technique for planning resource allocation to
optimize a given objective function that is subject to certain constraints, in this case, the
maximum investment is constrained by a 70% limit on either investment choice and a
minimum required return.
(B) is incorrect. Capital budgeting is used to analyze and evaluate long-term capital
investments.
(C) is incorrect. Differential analysis is used for decision making when differences in costs
(revenues) for two or more options are compared.
(D) is incorrect. Queuing theory is used to minimize the sum of the costs of waiting lines
and servicing waiting lines when items arrive randomly and are serviced sequentially.
2. (C) is correct. The objective function in a linear programming model symbolically
represents the outcome to be optimized, e.g., total contribution margin, operating income,
or total cost.
(A) is incorrect. Constraints are the resource limitations and other conditions within which
the objective function is to be optimized.
(B) is incorrect. Variables are the unknowns used to construct the objective function and
constraints.
(D) is incorrect. The derivative of the function is a calculus term, meaning the slope of the
function.
3. (C) is correct. LP models are mathematical techniques in which an objective function is
maximized or minimized subject to constraints. Constraints are mathematical statements
expressed as equalities or inequalities. They describe conditions, usually resource
limitations, to which values of the variables are subject. These constraints must be
specified before a linear programming problem can be solved.
(A) is incorrect. The objective function incorporates the variables to be optimized.
(B) is incorrect. Costs are included in the objective function.
(D) is incorrect. The constraints are given and are independent.

Techniques for Financial Analysis, Modeling & Forecasting Page 371

CHAPTER 21
USING SPREADSHEET AND FINANCIAL MODELING PACKAGES
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1. Use spreadsheet programs.
2. Forecast business failures with Z scores.
3. Be familiar with financial modeling languages.
Financial forecasting and planning can be done using a PC with a powerful spreadsheet
program such as Excel. Or it can be done using a specific financial modeling language such
as Comshare's Planning.
USING SPREADSHEET PROGRAMS
In this section we discuss how we can use spreadsheet programs such as Excel. The
following problems are illustrated:
(1) three examples of projecting an income statement
(2) forecasting financial distress with Z score
EXAMPLE 21.1
Given:
Sales for 1st month = $60,000
Cost of sales = 42% of sales, all variable
Operating expenses = $10,000 fixed plus 5% of sales
Taxes = 30% of net income
Sales increase by 5% each month
(a) Based on this information, Figure 21.1 presents a spreadsheet for the
contribution income statement for the next 12 months and in total.
(b) Figure 21.2 shows the same in (1) assuming that sales increase by 10% and
operating
expenses= $10,000 plus 10% of sales. This is an example of "what-if"
scenarios.

Techniques for Financial Analysis, Modeling & Forecasting Page 372

FIGURE
21.1
PROJECTED INCOME STATEMENT
1
Sales
$60,000
Less: VC
Cost of sales $25,200
Operating
ex.
$3,000
CM
$31,800
Less: FC
Op.
expenses
$10,000
Net income $21,800
Less: Tax
$6,540
NI after tax $15,260

2
3
4
5
$63,000 $66,150 $69,458 $72,930

6
7
$76,577 $80,406

8
9
$84,426 $88,647

10
$93,080

11
12
TOTAL
PERCENT
$97,734 $102,620 $955,028 100%

$26,460 $27,783 $29,172 $30,631

$32,162 $33,770

$35,459 $37,232

$39,093

$41,048 $43,101

$401,112 42%

$3,150 $3,308 $3,473 $3,647

$33,390 $35,060 $36,812 $38,653

$3,829 $4,020
$40,586 $42,615

$4,221 $4,432
$44,746 $46,983

$4,654
$49,332

$4,887 $5,131
$51,799 $54,389

$47,751 5%
$506,165 53%

$10,000
$23,390
$7,017
$16,373

$10,000
$30,586
$9,176
$21,410

$10,000
$34,746
$10,424
$24,322

$10,000
$39,332
$11,800
$27,533

$10,000
$41,799
$12,540
$29,259

$120,000
$386,165
$115,849
$270,315

$10,000
$25,060
$7,518
$17,542

$10,000
$26,812
$8,044
$18,769

$10,000
$28,653
$8,596
$20,057

$10,000
$32,615
$9,785
$22,831

$10,000
$36,983
$11,095
$25,888

$10,000
$44,389
$13,317
$31,072

13%
40%
12%
28%

FIGURE
21.2
PROJECTING INCOME STATEMENT
1
Sales
$60,000
Less: VC
Cost of sales $25,200
Operating
ex.
$6,000
CM
$28,800
Less: FC
Op.
expenses
$10,000
Net income $18,800
Less: Tax
$5,640
NI after tax $13,160

2
3
4
5
$66,000 $72,600 $79,860 $87,846

6
7
8
9
10
11
12
TOTAL
PERCENT
$96,631 $106,294 $116,923 $128,615 $141,477 $155,625 $171,187 $1,283,057 134%

$27,720 $30,492 $33,541 $36,895

$40,585 $44,643

$49,108 $54,018

$59,420

$65,362

$71,899 $538,884

56%

$6,600 $7,260 $7,986 $8,785

$31,680 $34,848 $38,333 $42,166

$9,663 $10,629
$46,383 $51,021

$11,692 $12,862
$56,123 $61,735

$14,148
$67,909

$15,562
$74,700

$17,119 $64,153
$82,170 $615,867

7%
64%

$10,000
$21,680
$6,504
$15,176

$10,000
$36,383
$10,915
$25,468

$10,000
$46,123
$13,837
$32,286

$10,000
$57,909
$17,373
$40,536

$10,000
$64,700
$19,410
$45,290

$10,000
$72,170
$21,651
$50,519

13%
52%
16%
36%

$10,000
$24,848
$7,454
$17,394

$10,000
$28,333
$8,500
$19,833

$10,000
$32,166
$9,650
$22,516

$10,000
$41,021
$12,306
$28,715

$10,000
$51,735
$15,521
$36,215

Techniques for Financial Analysis, Modeling & Forecasting Page 373

$120,000
$495,867
$148,760
$347,107

EXAMPLE 21.2
Delta Gamma Company wishes to prepare a three-year projection of net income
using the following information:
1. 2005 base year amounts are as follows:
Sales revenues
$4,500,000
Cost of sales
2,900,000
Selling and administrative expenses
800,000
Net income before taxes
800,000
2. Use the following assumptions:
Sales revenues increase by 6% in 2006, 7% in 2007 and 8% in 2008.
Cost of sales increase by 5% each year.
Selling and administrative expenses increase only 1% in 2001and will remain at the
2006 level thereafter.
The income tax rate = 46%

Figure 21.3 presents a spreadsheet for the income statement for the next three years.
Figure 21.3
Delta Gamma Company
Three-Year Income Projections (2005-2008)

Sales
Cost of sales
Gross margin

2005
$4,500,000
$2,900,000
$1,600,000

2006
$4,770,000
$3,045,000
$1,725,000

2007
$5,103,900
$3,197,250
$1,906,650

2008
$5,512,212
$3,357,113
$2,155,100

Selling & adm. exp.

Earnings before tax
Tax
Earnings after tax

$800,000
$800,000
$368,000
$432,000

$808,000
$917,000
$421,820
$495,180

$808,000
$1,098,650
$505,379
$593,271

$808,000
$1,347,100
$619,666
$727,434

EXAMPLE 21.3
Based on specific assumptions (see Figure 21.4), develop a budget using Up Your Cash
Flow (Figure 21.5).

Techniques for Financial Analysis, Modeling & Forecasting Page 374

Techniques for Financial Analysis, Modeling & Forecasting Page 375

Techniques for Financial Analysis, Modeling & Forecasting Page 376

FORECASTING FINANCIAL DISTRESS WITH Z SCORE

There has recently been an increasing number of bankruptcies. Will your company go
bankrupt? Will your major customers or suppliers go bankrupt? What warning signs exist
and what can be done to avoid corporate failure?
Prediction models can help in a number of ways: In merger analysis, it can help to
identify potential problems with a merger candidate. Bankers and other business
concerns can use it to determine whether or not to give a new loan (credit) or extend the
old one. Investors can use it to screen out stocks of companies which are potentially risky.
Internal auditors can use such a model to assess the financial health of the company.
Those investing in or extending credit to a company may sue for losses incurred. The
model can help as evidence in a lawsuit.
Financial managers, investment bankers, financial analysts, security analysts and
auditors have been using early warning systems to detect the likelihood of bankruptcy.
But their system is primarily based on financial ratios of one type or the other as an
indication of financial strength of a company. Each ratio (or set of ratios) is examined
independent of others. Plus, it is up to the professional judgment of a financial analyst to
decide what the ratios are really telling.
To overcome the shortcomings of financial ratio analysis, it is necessary to
combine mutually exclusive ratios into a group to develop a meaningful predictive model.
Regression analysis and multiple discriminant analysis (MDA) are two statistical
techniques that have been used thus far.
Z-SCORE MODEL
This section describes the Z-score predictive model which uses a combination of several
financial ratios to predict the likelihood of future bankruptcy. Altman developed a
bankruptcy prediction model that produces a Z score as follows:
Z

1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 0.999*X5

X1
X2
X3
X4

=
=
=
=

X5

Working capital/Total assets

Retained earnings/Total assets
Earnings before interest and taxes (EBIT)/Total assets
Market value of equity/Book value of debt (Net worth for privately-held
firms)
Sales/Total assets

Where:

Altman established the following guideline for classifying firms:

Z score
1.8 or less
3.0 or higher
1.81 - 2.99

Probability of failure
Very high
Unlikely
Not sure

Techniques for Financial Analysis, Modeling & Forecasting Page 377

The Z score is known to be about 90 percent accurate in forecasting business failure one
year in the future and about 80 percent accurate in forecasting it two years in the future.
There are more updated versions of Altman's model.
EXAMPLE 21.4
Navistar International (formerly International Harvester), the maker of heavy-duty trucks,
diesel engines and school buses, continues to struggle. Exhibit 11-7 shows the 23-year
financial history and the Z scores of Navistar. Exhibit 11-8 presents the corresponding
graph.
The graph shows that Navistar International performed at the edge of the
ignorance zone ("unsure area"), for the year 1981. Since 1982, though, the company
started signaling a sign of failure. However, by selling stock and assets, the firm managed
to survive. Since 1985, the company showed an improvement in its Z scores, although the
firm continually scored on the danger zone. Note that the 1991-2003 Z-score are in the
high probability range of <1.81, except the year 1999. In late 2004, the company was in
talks with truck components makers in India about sourcing components in a bid to cut
manufacturing costs.

Techniques for Financial Analysis, Modeling & Forecasting Page 378

NAVISTAR INTERNATIONAL - NAV (NYSE)

Z SCORE - PREDICTION OF FINANCIAL DISTRESS
Balance Sheet

Year

Current
Assets
(CA)

Income Statement

Total Current Total Retained Working

Assets Liability Liability Earnings Capital SALES
(TA)
(CL)
(TL)
(RE)
(WC)

Stock Data

Market Value
EBIT or Net worth
(MKT-NW)

Misc Graph Values

Calculations
WC/
TA
(X1)

RE/
TA
(X2)

EBIT/
TA
(X3)

MKT-NW/ SALES/
Z
TOP BOTTOM
TL
TA
Score GRAY GRAY
(X4)
(X5)

1981
2672
5346
1808
3864
600
864
7018
-16
376
0.1616
0.1122 -0.0030
0.0973 1.3128
1982
1656
3699
1135
3665
-1078
521
4322 -1274
151
0.1408
-0.2914 -0.3444
0.0412 1.1684
1983
1388
3362
1367
3119
-1487
21
3600
-231
835
0.0062
-0.4423 -0.0687
0.2677 1.0708
1984
1412
3249
1257
2947
-1537
155
4861
120
575
0.0477
-0.4731
0.0369
0.1951 1.4962
1985
1101
2406
988
2364
-1894
113
3508
247
570
0.0470
-0.7872
0.1027
0.2411 1.4580
1986
698
1925
797
1809
-1889
-99
3357
163
441 -0.0514
-0.9813
0.0847
0.2438 1.7439
1987
785
1902
836
1259
-1743
-51
3530
219
1011 -0.0268
-0.9164
0.1151
0.8030 1.8559
1988
1280
4037
1126
1580
150
154
4082
451
1016
0.0381
0.0372
0.1117
0.6430 1.0111
1989
986
3609
761
1257
175
225
4241
303
1269
0.0623
0.0485
0.0840
1.0095 1.1751
1990
2663
3795
1579
2980
81
1084
3854
111
563
0.2856
0.0213
0.0292
0.1889 1.0155
1991
2286
3443
1145
2866
332
1141
3259
232
667
0.3314
0.0964
0.0674
0.2326 0.9466
1992
2472
3627
1152
3289
93
1320
3875
-145
572
0.3639
0.0256 -0.0400
0.1738 1.0684
1993
2672
5060
1338
4285
-1588
1334
4696
-441
1765
0.2636
-0.3138 -0.0872
0.4119 0.9281
1994
2870
5056
1810
4239
-1538
1060
5337
233
1469
0.2097
-0.3042
0.0461
0.3466 1.0556
1995
3310
5566
1111
4696
-1478
2199
6342
349
966
0.3951
-0.2655
0.0627
0.2057 1.1394
1996
2999
5326
820
4410
-1431
2179
5754
188
738
0.4091
-0.2687
0.0353
0.1673 1.0804
1997
3203
5516
2416
4496
-1301
787
6371
316
1374
0.1427
-0.2359
0.0573
0.3055 1.1550
1998
3715
6178
3395
5409
-1160
320
7885
515
1995
0.0518
-0.1878
0.0834
0.3688 1.2763
1999
3203
5516
2416
4496
-1301
787
8642
726
2494
0.1427
-0.2359
0.1316
0.5547 1.5667
2000
2374
6851
2315
5409
-143
59
8451
370
2257
0.0086
-0.0209
0.0540
0.4173 1.2335
2001
2778
7164
2273
6037
-170
505
6739
162
2139
0.0705
-0.0237
0.0226
0.3543 0.9407
2002
2607
6957
2407
6706
-721
200
6784
-89
2146
0.0287
-0.1036 -0.0128
0.3200 0.9751
2003
2210
6900
2204
6590
-824
6
7340
149
2118
0.0009
-0.1194
0.0216
0.3214 1.0638
Note: (1) To calculate " Z " score for private firms, enter Net Worth in the MKT-NW column. (For public-held companies, enter Markey Value of Equity).

Techniques for Financial Analysis, Modeling & Forecasting Page 379

1.71
-0.18
0.39
1.13
0.89
0.73
1.40
1.86
2.20
1.60
1.84
1.51
0.76
1.24
1.57
1.41
1.37
1.57
2.17
1.64
1.28
1.01
1.16

2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99
2.99

1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81
1.81

Year

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003

Figure 21.7
"Z" SCORE GRAPH
(NAVISTAR)
3.50
3.00

"Z" SCORE

2.50
2.00
1.50
1.00
0.50
0.00
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
-0.50

YEAR
"Z" SCORE

TOP OF GRAY AREA

BOTTOM OF GRAY AREA

MORE APPLICATIONS OF THE Z SCORE

Various groups of business people can take advantage of this tool for their own purposes.
For example,
1. Merger analysis. The Z score can help identify potential problems with a merger
candidate.
2. Loan credit analysis. Bankers and lenders can use it to determine if they should
extend a loan. Other creditors such as vendors have used it to determine whether to
extend credit.
3. Investment analysis. The Z score model can help an investor in selecting stocks of
potentially troubled companies.
4. Auditing analysis. Internal auditors are able to use this technique to assess whether
the company will continue as a going concern.
5. Legal analysis. Those investing or giving credit to your company may sue for losses
incurred. The Z score can help in your company's defense.
WORDS OF CAUTION
The "Z" score offers an excellent measure for predicting a firm's insolvency. But, like any
other tool, one must use it with care and skill. The "Z" score of a firm should be looked
upon not for just one or two years but for a number of years. Also, it should not be used as
a sole basis of evaluation.
The "Z" score can also be used to compare the economic health of different firms.
Here again extreme care should be exercised. Firms to be compared must belong to the
same market. Also, "Z" scores of the same periods are to be compared.
Techniques for Financial Analysis, Modeling & Forecasting Page 380

BUDGETING AND PLANNING SOFTWARE

In recent years, the focus has been on moving away from spreadsheets to enterprise
budgeting applications in order to make the planning and budgeting process more
efficient and the data more reliable. However the underlying process remains
fundamentally unchanged; it is still about capturing and consolidating line item expenses.
Several popular ones are described briefly.
Adaytum Planning
Adaytum Planning by Adaytum Software (www.adaytum.com) (1-800-262-4445) is a
multi-user budgeting, planning and forecasting system. It gives you the flexibility to:

Update hierarchies directly from General Ledger (G/L).

Combine top-down planning with bottom-up budgeting

Make last minute changes to model structure

Empower end-users to do ad hoc modeling without information system (IS)
support.
Budget Maestro v5.8
Centages Budget Maestro (www.centage.com) is probably the best answer to distributed
budgeting, strategic planning and financial control. Budget Maestro shortens your
budgeting cycle and puts you into control of the process. Its information-driven
environment guides you through budgeting, planning, modeling, forecasting, resource
management, consolidation, analysis and reporting. CFOs and budget managers can
plan, analyze and manage, in ways never before possible. Look at a user's screen and
make changes directly without ever being there. Deliver budget models and deploy
reconfigured software updates to many users at once. Plus manage budgetary
information, even enterprise wide information systems, with a single consistent interface.
Budget Maestro is designed to put CFOs and financial managers in control of all aspects
of managing budgets, creating financial models and building and deploying financial
plans. Budget Maestro allows business managers unparalleled flexibility in analyzing
cash flow and business performance throughout the enterprise. Budget Maestro
significantly shortens your budgeting and planning cycles. It eliminates rekeying and
formatting of data. It increases your data accuracy and integrity. It allows your time to
manage and analyze your business. It is an excellent tool that provides you the ability to
perform:
Budgeting
Forecasting; rolling forecasts
Planning
What-if scenario building
Payroll and Benefits Management
Headcount Planning
Capital Asset Planning
Debt Management
Automatic data consolidation
Management Reports
Extensive drill-down Reporting
Income Statement, Balance Sheet & Statement of Cash Flows
As an alternative to spreadsheets, Budget Maestro automates many of the complex and
Techniques for Financial Analysis, Modeling & Forecasting Page 381

repetitive tasks in the budgeting process while eliminating the need for creating
complicated formulas and manual consolidation of multiple worksheets.
Budget Maestro offers three editions:
Desktop Edition - A single user license that is ideal for the CEO, CFO or Controller of
small to mid-sized organizations that have a centralized budgeting and planning process.
Small Business Edition - This edition supports up to 3 users operating in a collaborative
environment to generate budgets, forecasts and financial reports.
Enterprise Edition - An enterprise-wide application for use by finance executives and
departmental/line managers to foster a more collaborative and participatory planning
environment.
Microsoft Business Solutions for AnalyticsForecaster
This is Web-based budgeting and planning solution from FRx Software
(www.frxsoftware.com/). Many organizations find it difficult to perform the ongoing
budgeting and planning processes necessary to keep business performance on target.
Financial "surprises" are met with panic and more often than not, companies are forced to
make sacrifices in places they cannot afford. The result is a direct, negative impact on
their strategic objectives. But it's not for lack of trying. Finance departments simply don't
have the time it takes to combine multiple spreadsheets submitted from across the
company (Let alone the resources to make sure all line managers understand the
importance of the budgeting and planning process and of submitting well-planned
information on time!). Forecaster puts the systems and processes in place to help you
immediately realize the benefits of an effective budgeting and planning process and make
it an ongoing part of your business strategy.
Host Budget V3.2
(www.hostanalytics.com) HOST BUDGET is an integrated budgeting and planning
software that provides streamlined budgeting, forecasting, reporting and analysis.
Modules are used to automatically manage, consolidate and change information for
planning and replanning. These budgeting, forecasting and planning modules include:
Integration with Hosts Performance Measurement Scorecard
SG&A Budget module
Human Resources Budget module
Sales and Operation Planning (S&OP) module
Sales Forecasting module
Capital Expenditure Budget module and others
HOST BUDGET is architected for the Web so that the individuals involved in budgeting
and planning can use all of the features. All that is needed by the user is a web browser to
access and update the application. Microsoft Excel spreadsheets can be used on-line or
live to the database for queries and updates. Or, if the user prefers to work disconnected
from the central database the user can work off-line and easily upload the Excel file later
or submit via email.
Because of the streamlined effects of HOST BUDGET on an organizations
budgeting process, budgets and forecasts can be refined on an ongoing basis. Managers
can consider what has happened so far and can regularly look into the future aided by
actual versus budgeted information along with current forecast projections in their effort to
Techniques for Financial Analysis, Modeling & Forecasting Page 382

meet financial goals.

Executive Managers can create top down budgets and "push down" the budget to lower
levels of the organization. Line managers and department heads can create budgets from
the bottom up and submit budgets for approval.
Continuous rolling forecasts can easily be created with HOST FORECASTER and
bi-directional data integration allows the detailed budgets to be loaded to or from other
applications.
Based on best practices, HOST FORECASTER provides a rich set of tools to
facilitate sales forecasting using standard methods including:
Statistical forecasting.
Top down forecasting allocated to the SKU level based on prior year history,
current estimate, last two years average sales and other basis.
Bottom up forecasting for product introductions and discontinued products.
Ability to smooth forecasts to eliminate the impact of infrequent sales events.
SRC Systems
SRC Budgeting
Balancing flexibility and control, sophistication and ease-of-use, SRC Budgeting
(www.srcsoftware.com) provides the tools you need to create and execute detailed
budgetstransforming strategic goals into operational plans. SRC Budgeting not only
simplifies the budgeting process, but also streamlines the sharing of data with key
managers. The result is: Greater accuracy, enhanced accountability and increased
ownership by business unitsall while dramatically reducing the time required for the
planning process.
The benefits are:
Increase collaboration while streamlining the budget process.
Model budgets to fit your business.
Align budgets with strategic plans and forecasts.
Create flexible and sophisticated budgets.
SRC Sales Planning
With SRC Sales Planning, all deals can be trackednot just the hot onesand sales
managers can adjust focus, training and incentives to increase sales. Greater visibility
into how leads play out at various points in the sales pipeline improves management
decision-making ability. Understand which leads are working and which ones are not.
Understand which products and services are in demand, identify and investigate changes
and fluctuations and take appropriate actionwhether it means realigning the sales force
or adjusting production and distribution.
The benefits are:
Create a robust sales forecast.
Make more accurate and timely planning decisions.
Align sales, supply chain and operations.
SRC Forecasting
This system allows you to create timely, high-level, dimensionally independent rolling
forecastsdriven by the strategic planand translated into operational targets. SRC
Forecasting streamlines and speeds the forecasting cycle, leverages a sophisticated and
customizable modeling process and helps ensure organizational alignment.
The benefits are:
Techniques for Financial Analysis, Modeling & Forecasting Page 383

Streamline financial forecasting

Customize and model forecasts for accurate planning
Align forecasts with detailed budgets.
CONCLUSION

As was discussed, there is a number of software packages for financial and corporate
modeling. Companies just entering the modeling arena must keep in mind that the
differences that exist between the software packages available in the market can be
substantial. A comparison should be made by examining the software in light of the planning
system, the information system and the modeling activities. The companies also consider
making effective use of in-house computer hardware, micro, mini, or mainframe and data
bases. An effective modeling system does not necessarily imply an outside time-sharing
system or an external economic data base.

Techniques for Financial Analysis, Modeling & Forecasting Page 384

CHAPTER 21 QUIZ
1. The bankruptcy prediction model, such as the Z-score, is useful for stock market
prediction.
True / False
2. An investor has calculated Altman's Z-Score for each of four possible investment
alternatives. Each firm is a public industrial firm. The calculated scores for the four
investments were as follows:
Firm W = 3.89
Firm X = 2.48
Firm Y = 2.00
Firm Z = 1.10
Which statement is true?
A.
B.
C.
D.

W is least risky and Z is most risky.

Z is least risky and W is most risky.
Y is least risky and W is most risky.
X is least risky and W is most risky.

Techniques for Financial Analysis, Modeling & Forecasting Page 385

CHAPTER 21 ANSWER KEY

1. (F) is correct. The "Z" score offers an excellent measure for predicting a firm's
insolvency and is not designed to predict a general stock market or an individual stock
price.
(T) is incorrect. The bankruptcy prediction model can be useful for (1) financial distress
analysis, (2) merger analysis, (3) loan credit analysis, (4) investment analysis, (5) auditing
analysis and (6) legal analysis. For example, the Z-score gives an indication of a
companys financial trouble going forward.
2. (A) is correct. An Altman's Z-Score of 2.90 (2.99 in the original model) or higher for a
public industrial firm is considered an acceptable investment. Scores between 1.20 and
2.90 (1.81 and 2.99) are questionable (in a gray area) and scores less than 1.20 (1.81)
are considered risky.
(B) is incorrect. Z (=1.10) is more risky than W (=3.89).
(C) is incorrect. Y (=2.00) is more risky than W (=3.89).
(D) is incorrect. X (=2.48) is more risky than W (=3.89).

Techniques for Financial Analysis, Modeling & Forecasting Page 386

CHAPTER 22
USING MANAGEMENT GAMES FOR EXECUTIVE TRAINING
LEARNING OBJECTIVES
After studying the material in this chapter, you will be able to:
1. Discuss a variety of executive management games.
2. Validate the game.
3. Outline a new role for computerized executive games.
Management games offer a unique means of teaching business managers and financial
executives financial and managerial concepts and developing their strategic abilities.
More and more companies as well as virtually all MBA programs across the nation are
using management games as a basic teaching tool for industrial training programs.
Games have also found their way into university and corporate executive development
programs. In addition researchers are using games to determine their effectiveness in
teaching strategic thinking skills.

The management game is a form of simulation. The distinction between a game and
a simulation is subtle. Both are mathematical models, but they differ in purpose and mode of
use. As was discussed in the previous chapters, simulation models are designed to simulate
a system and to generate a series of quantitative and financial results regarding system
operations. Games are a form of simulation, except that in games human beings play a
significant part. In games, participants make decisions at various stages; thus games are
distinguished by the idea of play. The major goals of the game play can be summarized as
follows:

Improve decision making and analytical skills

Facilitate participants' understanding of the external environment simulated

Integratively apply the knowledge, concepts and skills acquired in various

business courses

Develop awareness of the need to make decisions without complete information

Improvise appropriately and adapt constructively from previously learned concepts,

theories and techniques

Develop ability to recognize the need for additional factual material

Develop an understanding of the interrelationships of the various functions within

the firm and how these interactions affect overall performance
Techniques for Financial Analysis, Modeling & Forecasting Page 387

Teach the effects of present decisions or future decisions

Develop an understanding of the fact of uncertainty and the impact of the

competitive environment on the firm

Develop an understanding of the necessity for good communications, teamwork

and leadership

Develop an ability to function cooperatively and effectively in a group situation

Management games generally fall into two categories: executive games and
functional games. Executive games are general management games and cover all
functional areas of business and theory interactions and dynamics. Executive games are
designed to train general executives. Functional games, on the other hand, focus on middle
management decisions and emphasize particular functional areas of the firm. They cover
such areas as:
. Resource allocation in general
. Production planning and scheduling
. Manpower requirements and allocation
. Logistics systems
. Material management
. Maintenance scheduling
. Sales management
. Advertising and promotion
. Stock transactions
. Investment analysis
. Research and development management
The objective in playing functional games is usually to minimize cost by achieving
efficient operations or to maximize revenues by allocating limited resources efficiently. With
emphasis on efficiency in specific functional areas, rather than on competition in a
marketplace, which is the case in executive management games, there is no or little
interaction in many functional games between player decisions. From that standpoint,
functional games are very similar to simulation models. Here is a partial list of some well
known functional games:
Name of Functional Games

Areas They Cover

Worldwide Simulation Exercise

The Multinational
Game - MicroVersion
Multinational Management Game
Multinational Business Game
International Operations Simulation
The Business Policy Game

International game

Management Accounting Game

Accounting game

Techniques for Financial Analysis, Modeling & Forecasting Page 388

COMPETE
MARKSTRAT
Marketing Game

Marketing

MICROSIM

Economics game

The Westinghouse Plant Scheduling

Warehouse Simulation Exercise

Distribution and Logistics

Green and Sission's

Materials Inventory Management Game

Inventory planning

Production scheduling
Scheduling Management Game
X-Otol

Production scheduling
Distribution

Interpretive Software'

PharmaSim Brand management

simulation
AutoSim

Marketing laboratory

ServiceSim

Managing customer satisfaction

IBM Production Manpower Decision

Model

Production and manpower

scheduling decisions

FINASIM

Financial management
simulation

PERT-SIM

Project planning and control

A partial list of some well-known executive management games follows.

The Business Strategy Game: A Global Industry Simulation by Arthur A. Thompson

and Gregory J. Stappenbeck (6th edition), Irwin/McGraw-Hill.
(www.mhhe.com/thompson), 1999.
Capstone Business Simulation by Management Simulations, Inc. , Northfield, IL
60093 (1-888-472-7554), 2001.
PriSim Business War Games and Business Simulations by PriSim
(http://www.prisim.com)
The Business Policy Game: An International Simulation, by Richard. V. Cotter and
David J. Fritzsche .
StratSim: The Strategy Simulation by Interpretive Software, Inc. (1-800-SIMUL8R)
(http://www.interpretive.com)
Techniques for Financial Analysis, Modeling & Forecasting Page 389



The Executive Game (XGAME) by R.C. Henshaw, Jr. and J.R. Jackson
MICROMATIC, by A. Strickland.
TEMPOMATIC IV, by O. Embry.
DECIDE, by T. Pary.
The Business Management Laboratory by Ronald L. Jensen
Decision Making Exercise by John E. Van Tassel
Electronic Industry Game by James Francisco
Executive Decision Making Through Simulation By P.R. Cone, et al.
The Executive Simulation by Bernard Keys
Integrated Simulation by W.N. Smith, et al.
The IMAGINIT MANAGEMENT GAME, by R. Barton
COGITATE, by Carnegie Mellon University
Top Management Decision Game, by R. Schrieber
Harvard Business Game, by Harvard University
AIRLINE: A Business Simulation
Alacrity Team Simulation Exercise
CEO: A Business Simulation for Policy and Strategic Management
Collective Bargaining Simulated
COMPETE: A Dynamic Marketing Simulation
The Global Business Game
Corporation: A Global Business Simulation
Entrepreneur: A Business Simulation in Retailing
The Human Resources Management Simulation
INTOPIA: International Operations Simulation/Mark 2000
MANAGEMENT 500: A Business Simulation for Production and Operations
Management
Manager: A Simulation Game
Marketer: A Simulation Game
Marketplace
Multinational Management Game, The
Threshold Competitor: A Management Simulation

EXECUTIVE MANAGEMENT GAMES

Executive (general management) games offer a unique means of teaching the participants
management concepts and developing strategic abilities. Executive games involve
sequential decision making in which the problems at any point in the decision process are at
least partly dependent upon a participant's prior actions. Following the introduction of
management games, their number and use expanded rapidly, so that by 1990 it was
estimated that there were more than 500 games in existence and over 1 million
executives had played them. Robinson (1985) catalogued 100 executive games and their
estimation disclosed that by 2000 virtually all business schools were using management
games.
Management games have been developed by computer manufacturers, educational
institutions and private consulting firms. Some of the most notable ones include PriSim
Business War Games and Business Simulations by PriSim (http://www.prisim.com),
Henshaw and Jackson's Executive Game, Cotters Business Policy Game: An International
Simulation , Thompson and Stappenbecks The Business Strategy game and Stricklands
MICROMATIC. These games differ in the level of sophistication, subject matter, coverage of
Techniques for Financial Analysis, Modeling & Forecasting Page 390

decision variables and so forth, but are typical of general management games.
The Association for Business Simulation and Experiential Learning
(http://www.absel.com) lists some popular simulation and game packages in the market
today and their Websites. They are as follows:

AIRLINE: A Business Simulation

Alacrity Team Simulation Exercise
Business Management Laboratory, The
Business Policy Game, The
BusSim: An Integrated Business Instruction System
CEO: A Business Simulation for Policy and Strategic Management
Collective Bargaining Simulated
COMPETE: A Dynamic Marketing Simulation
The Global Business Game
Corporation: A Global Business Simulation
DEAL: An Entrepreneurship Gaming Simulation
Entrepreneur: A Business Simulation in Retailing
GEO: An International-Business Gaming Simulation
The Human Resources Management Simulation
INFOGAME: Game for Research and Education in Information Systems
INTOPIA: International Operations Simulation/Mark 2000
MAGEUR: A General Business Game
MANAGEMENT 500: A Business Simulation for Production and Operations
Management
Manager: A Simulation Game
Marketer: A Simulation Game
Marketplace
Multinational Management Game, The
Threshold Competitor: A Management Simulation

Management games have been developed by computer manufacturers, educational

institutions and private consulting firms. Some of the most notable ones include Thompson
and Stappenbecks The Business Strategy Game (1999), Henshaw and Jackson's
Executive Game (1986), Schrieber's Top Management Decision Game (1971) and the
Carnegie Tech Management Game (1964). These games differ in the level of sophistication,
subject matter, coverage of decision variables and so forth, but are typical of general
management games.
The game environment is an oligopolistic industry composed of the participating
players who represent companies in the industry. A single product is made by the
companies and this product is sold in a single market. The period of operations covered by
the game is usually assumed to be one quarter of a year. Tip: To be successful, participant
managers need to adopt the top management viewpoint. That is to say, they need to first
define the goals and objectives of the firm they represent. Caution: They must always keep
in mind that they are competing with the management teams of other firms in their industry.
The game simulation model is designed to include general relationships that might exist in
any competitive industry (or, more precisely, any oligopolistic industry). Participants need to
Techniques for Financial Analysis, Modeling & Forecasting Page 391

use, in a small-group setting, their knowledge and experience in order to make certain
deductions about the economy in which they are operating and about general relationships
within the game. These deductions must be combined with knowledge and experience
about the specific relationships with the team's belief about what action the competitors are
likely to take.
A set of quarterly decisions designed to meet the organization's goals and objectives
ideally will be apparent after data are analyzed and forecasting methods are applied. Figure
22.1 is a flowchart of a variety of activities to be performed by the teams involved in
preparing quarterly decisions.
In the course of playing the game, players will encounter a variety of business
situations. It will be necessary to undertake business forecasting, sales forecasting and
profit planning. Cash and capital budgets will have to be formulated. Production planning
and scheduling must be done. Cost analysis, formulation of pricing policies and
development of marketing and advertising programs must be done. The potential effects of
investment and financing decision on the capital structure must be investigated. In addition,
players must prepare and analyze financial statements, cost and sales data and general
informational reports regarding their competitors, industry and economic conditions.
The Executive Game (XGAME) is typical of top management games. The game
environment is an oligopolistic industry composed of the participating players or teams who
represent companies in the industry. A single product is made by the companies and this
product is sold in a single market. The teams manage their companies by making the
following quarterly decisions:
. Price of product
. Marketing budget
. Research and development budget
. Maintenance budget
. Production volume scheduled
. Investment in plant and equipment
. Purchase of materials
. Dividends declared
After decisions have been made they are transmitted via a terminal, along with
historical data summarizing the conditions of the firms at the end of the preceding quarter,
into a computer. The computer, having been programmed to simulate the industry's
operations, generates historical data and prints the following reports for each firm:
.General economic information
.Information on competitors
.Market potential
.Sales volume
.Percent share of industry sales
.Production this quarter
.Inventory, finished goods
.Plant capacity next quarter
.Income statement
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.Cash flow statement

.Balance sheet

For the next quarter, a new set of decisions is made. This set, together with operating
results of the preceding quarter and external economic conditions, are given as input data to
the computer program, which then calculates results of play for the next quarter. The
program prepares a new set of reports, which are returned to the players and the cycle
continues until the end of the game.
Figure 22.2 illustrates the basic structure of a typical executive game. For each play,
data inputs for team decisions, current economic index, status of the game from preceding
plays and parameters of the model functions are built into the game model. Teams'
decisions include price, marketing expenditures, R & D expenditures, production rate,
investment in plant and equipment and the like. The model then simulated interactions
between the simulated environment and the decisions of the participants. At the end of each
simulated period of play, financial statements and summary reports for each company are
Techniques for Financial Analysis, Modeling & Forecasting Page 393

prepared and printed (see Figure 22.3)

.Historical game data for input to the next play are generated
.Data needed for performance evaluation purposes are stored so that the game
administrator is able to rate them, as shown in Figure 22.4
This process is repeated for each firm in the industry.

Techniques for Financial Analysis, Modeling & Forecasting Page 394

Techniques for Financial Analysis, Modeling & Forecasting Page 395

Techniques for Financial Analysis, Modeling & Forecasting Page 396

ADVANTAGES AND DISADVANTAGES OF EXECUTIVE GAMES

Executive games are most useful to individuals seeking expanded business background.
With this goal as a basis for participation, the individuals playing executive games will
receive valuable insight into decision-making environments. The effectiveness of these
games is dependent upon the trade-off between simplicity in model formulation and the
maintenance of realism. Warning: As the complexity of the system grows, the participating
audience loses its attentiveness with the game. It is for these reasons that simplicity is of
major importance in designing an effective and informative executive game. Ease of
understanding, playing and administration are the factors that should be of utmost
consideration to the designer. With this in mind, an optimal model can be designed for the
use intended.
The intended use of executive games is for the participants to draw a basic
understanding of the complexity of a modern-day concern. Players attempt to determine the
effects of various decisions on the specific environment being simulated. The interaction of
several endogenous variables (marketing budget, research and development budget, plant
Techniques for Financial Analysis, Modeling & Forecasting Page 397

maintenance budget, scheduled production volume, plant investment, purchase of raw

materials, declaration of cash dividends, selected by the players with exogenous variables
(economic index, general price index, seasonal demand) formulated by the administrator to
portray prevailing market and economic conditions, allows for excellent simulation of actual
conditions found in today's business world.
VALIDATING THE GAME
A good executive game should be a valid one. Fortunately, the user of simulators is seldom
concerned with proving the truth of a model. Recommendation: A model should be
established on the basis that no one excellent decision or combination of poor decisions by
others should permit one team to capture an overwhelming portion of the market. Built into
the system should be parameters that prohibit high degrees of elasticity from affecting any
one decision. The executive game previously discussed has implemented these controlling
factors along with the controls maintained by the game administrator. The administrator can
change or revise any of the exogenous variables or goals of the game to facilitate proper
play by the participating teams. This executive game uses these controls to magnify its
intended purpose for practical business applications. Removal of controlling factors might
enhance realism, but at the same time would interfere with competition and finally destroy
the executive lessons to be learned.
It is the learning process which the simple executive game wishes to portray,
although for significantly large problems, realism makes the simulation technique highly
preferable to others. Many decisions are made on the basis of simulation results and these
decisions can only prove to be as good as the data employed in the simulation. Thus, strong
statistical inference should be made to test the validity of the data.
While models of this type offer adequate feedback to beginning executives, the more
advanced find drawbacks to an oversimplified model because they lack detailed
relationships in functional areas. The lack of competitive interaction among players is the
prime reason for the deficient descriptiveness in functional areas. Those seeking these
descriptive relationships should make use of functional games that focus their attention on
efficiency rather than competition. It is this competitive nature of executive games that
enhances their appeal to participate. Recommendation: The interaction and competition of
players can be increased by allowing these individuals to actually operate computers.
BENEFITS OF GAME PLAY
.Ability to explore more alternatives
.Better understanding of the interaction of functional areas in business
.Facilitates group interaction
.Provides immediate feedback
.Develops decision-making skills
.Better learning device than case methods
A NEW ROLE FOR COMPUTERIZED EXECUTIVE GAMES
An additional purpose has been found for executive games. Researchers are using the
games in many different ways. The effectiveness of teaching using computerized games;
the effectiveness of changing behaviors, performance and analytical skills are just some of
the research topics academics are pursuing.
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CONCLUSION
Management games are useful in instructing financial managers on how to make good
decisions in various operating scenarios and circumstances. Financial executives should
make decisions in various stages of the process so they can modify their policies as
appropriate. The two types of games are executive games, covering the overall strategic
plan of the firm and functional games, concentrating on specific aspects of the business.
Executive games require adjustment and changes in expectations given the variety of
assumed business situations experienced. Functional games try to reduce cost via efficient
operations or maximize revenue through properly allocating resources.
Academia uses computerized executive games to research the effectiveness of this
teaching tool on changing the behaviors and performance of managers and the
effectiveness of teaching analytical and strategic thinking skills of business students. This
area of study is currently a hot topic open for debate. More research is needed before any
conclusions on the effectiveness of these games can be made.

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CHAPTER 22 QUIZ
1. Games are a form of computer simulation in which computers and statistics play a
significant part.
True / False
2. A typical executive management game produces performance ranking of decision teams.
True / False

Techniques for Financial Analysis, Modeling & Forecasting Page 400

CHAPTER 22 ANSWER KEY

1. (F) is correct. Games are a form of simulation, except that in games human beings play a
significant part.
(T) is incorrect. In games, participants make decisions at various stages; thus games are
distinguished by the idea of play.
2. (T) is correct. At the end of each simulated period of play, financial statements and
summary reports including performance ranking and historical game data for each
company are prepared and printed.
(F) is incorrect. Performance ranking is a vital part of an executive game play because it
will provide a clue how teams fare against each other and how to improve their decision
from one period to another.

Techniques for Financial Analysis, Modeling & Forecasting Page 401

REFERENCES AND ADDITIONAL READINGS

The Association for Business Simulation and Experiential Learning
(http://www.towson.edu/absel/) has the following links to a variety of games.
AIRLINE: A Business Simulation
Alacrity Team Simulation Exercise
Business Management Laboratory, The
Business Policy Game, The
BusSim: An Integrated Business Instruction System
CEO: A Business Simulation for Policy and Strategic Management
Collective Bargaining Simulated
COMPETE: A Dynamic Marketing Simulation
The Global Business Game
Corporation: A Global Business Simulation
DEAL: An Entrepreneurship Gaming Simulation
Entrepreneur: A Business Simulation in Retailing
GEO: An International-Business Gaming Simulation
The Human Resources Management Simulation
INFOGAME: Game for Research and Education in Information Systems
INTOPIA: International Operations Simulation/Mark 2000
MAGEUR: A General Business Game
MANAGEMENT 500: A Business Simulation for Production and Operations
Management
Management Accounting Simulation, The
Manager: A Simulation Game
Marketer: A Simulation Game
Marketplace
Multinational Management Game, The
Threshold Competitor: A Management Simulation
Barker, J. R., Temple, C.S., & Sloan, H. M., III. WORLDWIDE SIMULATION EXERCISE:
User's Manual. (Available from the authors, 33 Hayden Street, Lexington, MA), 1976.
Biggs, W.D. Functional Business Games, Simulation & Games, 18, 242-267, 1987
Burgess, T.F. The Use of Computerized Business Games in Business Studies.
Educational and Training Technology International, 26(3), 226-238, 1989.
Burgess, T.F. The Use of Computerized Management and Business Simulations in the
United Kingdom. Simulation & Games, 22, 174-195, 1991.
Carvalho, Gerard F. Evaluating Computerized Business Simulators for Objective
Learning Validity, Simulation & Games, 22, 328-349, 1990.
Cotter, R., & Fritzsche, D. Modern Business Decisions. Englewood Cliffs, NJ:
Prentice-Hall, 1985.
Cotter, Richard V. and David S. Fritzsche. Business Policy Game-Player's Manual.
Techniques for Financial Analysis, Modeling & Forecasting Page 402

Prentice-Hall, Inc., Englewood Cliffs, N.J. Second Edition, 1986.

Edge, A. G., Keys, B., & Remus, W. Multinational Management Game: User Manual.
Dallas, TX: Business Publications, Inc., 1979.
Edge, A., Keys, B., & Remus, W. The Multinational Game - MicroVersion.. Homewood, IL:
Irwin, 1989.
Elgood, C. Handbook of Management Games (4th ed.). Aldershot:Gower, 1988.
Embry, O., Strickland, A., & Scott, C. TEMPOMATIC IV: A Management Simulation.
Boston: Houghton Mifflin, 1974.
Faria, A. J. A Survey of the Use of Business Games in Academia and Business,
Simulation & Games, 18, 207-224, 1987.
Faria, A., Nulsen, R., & Roussos, D.COMPETE: A Dynamic Marketing Simulation. (3rd
ed.). Dallas, TX: Business Publications, Inc., 1984.
Gold, S., Pray, T., & Dennis, T. MICROSIM A Computerized Microeconomics Simulation.
New York: Macmillan, 1984.
Goosen, Kenneth. Introduction to Management Accounting: A Business Game. Scott
Foresman, Glenview, Ill., 1994.
Hemmasi, M., Graf, L. A., & Kellogg, C. E. A Comparison Of the Performance Behaviors
and Analysis Strategies of MBA Versus BBA Students in A Simulation Environment,
Simulation & Games, 20, 15-30, 1989.
Henshaw, Richard C. and James R. Jackson. The Executive Game. Richard D. Irwin, Inc.,
1986.
Horn, R. E., & Cleaves, A. The Guide To Simulation/Games For Education And Training.
London: Sage, 1989.
Hoskins, W. R. MULTINATIONAL BUSINESS GAME: User Manual. Phoenix, AZ.:
American Graduate School of Business, 1983.
Interpretive Software, Inc. (http://www.interpretive.com) StratSim: The Business
Strategy Simulation, Charlottesville, Virginia, 1997-99.
Interpretive Software, Inc. (http://www.interpretive.com) A Brand Management
Simulation, Charlottesville, Virginia, 1997-99.
Interpretive Software, Inc. (http://www.interpretive.com) AutoSim: The Marketing
Laboratory, Charlottesville, Virginia, 1997-99.
Interpretive Software, Inc. (http://www.interpretive.com) ServiceSim: Managing
Customer Satisfaction, Charlottesville, Virginia, 1997-99.
Techniques for Financial Analysis, Modeling & Forecasting Page 403

Jensen, R., & Cherrington, D. The BUSINESS MANAGEMENT LABORATORY, Dallas,

TX: Business Publications, Inc., 1977
Keys, B. Total Enterprise Business Games, Simulation & Games, 18, 225-241, 1987.
Klein, Ronald D. and Fleck, Jr. Robert A. International Business Simulation/Gaming: An
Assessment and Review, Simulation & Games, 21, 147-165, 1990.
Larreche, J. & Gatignon, H. MARKSTRAT: A Marketing Strategy Game. Scientific Press,
1977.
Mehreg, A. A., Reichel, A., & Olami, R. The Business Game Versus Reality, Simulation
& Games, 18, 488-500, 1987.
Mills, L., & McDowell, D. The BUSINESS GAME. Boston: Little Brown, 1985.
Parasuraman, A. Assessing the Worth of Business Simulation Games: Problems and
Prospects, Simulation & Games, 12, 189-200, 1981.
Pray, T., & Strang, D. DECIDE: A Management Decision Making Simulation. New York.:
Random House, 1980.
Pray, T.F. Management Training: It's All in The Game, Personnel Administrator, 32,
68-72, 1987.
Pray, T. F. and Methe David T. Modeling Radical Changes in Technology Within
Strategy-Oriented Business Simulations, Simulation & Games, 22, 19-35, 1991.
Remus, W., & Jenner, S. Playing Business Games: Expectations and Realities,
Simulation & Games, 12, 480-488, 1981.
Robinson, J. N. Games and Simulation in Management and Economics: A Survey,
Economics, 21 (Winter), 163-171, 1985.
Segev, E. Strategy, Strategy-Making and Performance in The Business Game,
Strategic Management Journal, 8, 565-577, 1987.
Strickland, A., & Scott, T. MICROMATIC - A Management Simulation. Boston: Houghton
Mifflin, 1985.
Thorelli, H.B., & Graves, R.L. INTERNATIONAL OPERATIONS SIMULATION: User's
Manual. New York: Free Press and Macmillan, 1964.
Wolfe, J. The Teaching Effectiveness of Games in Collegiate Business Courses: A
1973-1983 Update, Simulation & Games, 16, 251-288, 1985.
Wolfe, J., & Roberts, C.R. The External Validity of A Business Management Game: A
Five-Year Longitudinal Study, Simulation & Games, 17, 45-59, 1986.
Techniques for Financial Analysis, Modeling & Forecasting Page 404

GLOSSARY
ACID TEST RATIO: (Currents assets - inventories)/current liabilities. This ratio is a more
stringent measure of liquidity than the current ratio in that it subtracts inventories (the
least liquid current asset) from current assets; also called quick ratio.
ANALYSIS OF VARIANCES (VARIANCE ANALYSIS): analysis and investigation of
causes for variances between standard costs and actual costs. A variance is considered
favorable if actual costs are less than standard costs; it is unfavorable if actual costs
exceed standard costs. Unfavorable variances are the ones that need further
investigation for their causes.
BANKERS ACCEPTANCE: Time draft drawn by a business firm whose payment is
guaranteed by the banks acceptance of it. It is especially important in foreign trade,
because it allows the seller of goods to be certain that the buyers draft will actually have
funds behind it.
BETA (COEFFICIENT): A measure of risk based on the sensitivity of an individual
stock's returns to changes in the returns of a broad stock market index; also called
systematic, market, undiversifiable and relative risk. A beta less than 1 means that the
company's stock is less risky than the market.
BREAK-EVEN ANALYSIS: A branch of cost-volume-profit (CVP) analysis that
determines the break-even sales, which is the level of sales where total costs equal total
revenue.
CAPITAL ASSET PRICING MODEL (CAPM): A formula according to which a security's
expected return is equal to the risk free rate plus a risk premium. The model shows the
relationship between an investment's expected (or required) return and its beta. It can be
used to estimate the cost of equity of a firm or a project. capital budget: a budget or plan of
proposed acquisitions and replacements of long-term assets and their financing. A capital
budget is developed using a variety of capital budgeting techniques such as the discount
cash flow method.
CAPITAL STRUCTURE DECISION: Deciding on the amount of debt relative to equity
capital a firm should take on; also called financial structure decision.
CAPITAL STRUCTURE: The mix of long term sources of funds used by the firm; also
called capitalization. The relative total (percentage) of each source of fund is emphasized.
CAPITAL RATIONING: The problem of selecting the mix of acceptable projects that
provides the highest overall net present value (NPV) where a company has a limit on the
budget for capital spending.
CASH BUDGET: A budget for cash planning and control presenting expected cash inflow
and outflow for a designated time period. The cash budget helps management keep its
cash balances in reasonable relationship to its needs. It aids in avoiding idle cash and
possible cash and possible cash shortages.
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CASH FLOW FORECASTING: Forecasts of cash flow including cash collections from
customers, investment income and cash disbursements.
CLASSICAL DECOMPOSITION METHOD: The approach to forecasting that seeks to
decompose the underlying pattern of a time series into cyclical, seasonal, trend and
random sub-patterns. These subpatterns are then analyze individually, extrapolated into
the future and recombined to obtain forecasts of the original series.
COEFFICIENT OF DETERMINATION: A statistical measure of how good the estimated
regression equation is, designated as R2 (read as R-squared). Simply put, it is a measure
of goodness of fit in the regression. Therefore, the higher the
R-squared, the more
confidence we can have in our equation.
CONCENTRATION BANKING: Acceleration of cash collections from customers by
having funds sent to several regional banks and transferred to a main concentration
account in another hank. The transfer of funds can be accomplished electronically.
CONTRIBUTION MARGIN (CM): The difference between sales and the variable costs of
the product or service, also called marginal income. It is the amount of money available to
cover fixed costs and generate profits.
CORRELATION COEFFICIENT (R): A measure of the degree of correlation between two
variables. The range of values it takes is between -1 and +1. A negative value of R
indicates an inverse relationship; a zero value of R indicated that the two variables are
independent of each other; the closer R is to + or -1, the stronger the relationship between
the two variables.
CORRELATION: The degree of relationship between business and economic variables
such as cost and volume. Correlation analysis evaluates cause / effect relationships. It
looks consistently at how the value of one variable changes when the value of the other is
changed. A prediction can be made based on the relationship uncovered. An example is
the effect of advertising on sales. A degree of correlation is measured statistically by the
coefficient of determination (R-squared).
COST OF CAPITAL: The rate that must be earned in order to satisfy the required rate of
return of the firm's investors; also called minimum required rate of return. It also may be
defined as the rate of return on investments at which the price of the firm's common stock
will remain unchanged. The cost of capital is based on the opportunity cost of funds as
determined in the capital markets.
COST-VOLUME-PROFIT (CVP) ANALYSIS: Analysis that deals with how profits and
costs change with a change in volume. It looks at the effects on profits of changes in such
factors as variable costs, fixed costs, selling prices, volume and mix of products sold.
DECISION TREE: A pictorial representation of sequential decisions, states of nature,
probabilities attached to the state of nature and conditional benefits and losses.
DELPHI METHOD: A qualitative forecasting method that seeks to use the judgment of
experts systematically in arriving at a forecast of what future events will be or when they
Techniques for Financial Analysis, Modeling & Forecasting Page 406

may occur. It brings together a group of experts who have access to each others opinions
in an environment where no majority opinion is disclosed.
DEPENDENT VARIABLE: A variable whose value depends on the values of other
variables and constants in some relationship. For example, in the relationship Y = f(X), Y
is the dependent variable influenced by various independent variables, such as earnings
per share, debt / equity ratio and beta (see also Independent Variable).
DESEASONALIZED DATA: Removal of the seasonal pattern in a data series.
Deseasonalizing facilitates the comparison of month-to-month changes.
DIVERSIFICATION: Spreading investments among different companies in different fields.
Diversification is also offered by the securities of many individual companies because of
the wide range of their activities.
DUMMY VARIABLE: Often referred to as a binary variable whose value is either 0 of 1, a
dummy variable frequently is used to quantify qualitative or categorical events. For
example, a peace or war situation could be represented by a dummy variable.
DU PONT FORMULA: The breakdown of return on investment (ROL) into profit margin
and asset turnover.
DURBIN-WATSON STATISTIC: A summary measure of the amount of autocorrelation in
the error terms of the regression. By comparing the computed value of the Durbin-Watson
test with the appropriate values from the table of values of the D-W statistic (Appendix
Table A.4), the significance can be determined (see also Autocorrelation).
EARNINGS FORECAST: Projection of earnings or earnings per share (EPS) frequently
made by management and independent security analysts. Examples of forecast sources
include (1) Lynch, Jones and Ryans Institutional Brokers Estimate System (IBES), (2)
Standard & Poors The Earnings Forecaster and (3) Zacks Investment Researchs Icarus
Service.
ECONOMIC ORDER QUANTITY (EOQ): the order size that should be ordered at one
time to minimize the sum of carrying and ordering costs.
EXPONENTIAL SMOOTHING: A forecasting technique that uses a weighted moving
average of past data as the basis for a forecast. The procedure gives heaviest weight to
more recent information and smaller weights to observations in the more distant past. The
method is effective when there is random demand and no seasonal fluctuations in the
data. The method is popular technique for short-run forecasting by business forecasters.
F-TEST: In statistics the ratio of two mean squares (variances) often can be used to test
the significance of some item of interest. For example, in regression, the ratio of (mean
square due to the regression) to (mean square due to error) can be used to test the
overall significance of the regression model. By looking up F-tables, the degree of
significance of the computed F-value can be determined.

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FINANCIAL MODEL: A system of mathematical equations, logic and data that describes
the relationship among financial and operating variables.
FINANCIAL PROJECTION: An essential element of planning that is the basis for
budgeting activities and estimating future financing needs of a firm. Financial projections
(forecasts) begin with forecasting sales and their related expenses.
FORECAST: 1. A projection or an estimate of future sales revenue, earnings, or costs
(see also Sales Forecasting). 2. A projection of future financial position and operating
results of an organization (see also Financial Projection).
FUNDAMENTAL ANALYSIS: The process of gathering basic financial, accounting and
economic data on a company and determining whether that company is fairly priced by
market standards.
GOODNESS OF FIT: A degree to which a model fits the observed data. In a regression
analysis, the goodness of fit is measured by the coefficient of determination (R-squared).
HOMOSCEDASTICITY: One of the assumptions required in a regression in order to
make valid statistical inferences about population relationships, also known as constant
variance. Homoscedasticity requires that the standard deviation and variance of the error
terms is constant for all Xs and that the error terms are drawn from the same population.
This indicated that there is a uniform scatter or dispersion of data points about the
regression line. If the assumption does not hold, the accuracy of the b coefficient is open
to question.
INDEPENDENT VARIABLE: A variable that may take on any value in a relationship. For
example, in a relationship Y = f(X), X is the independent variable. For example,
independent variables that influence sales are advertising and price (see also Dependent
Variable).
INTERNAL RATE OF RETURN (IRR): The rate of interest that equates the initial
investment with the present value of future cash inflows.
INVESTMENT CENTER: A responsibility center within an organization that has control
over revenue, cost and investment funds. It is a profit center whose performance is
evaluated on the basis of the return earned on invested capital.
JUDGMENTAL (QUALITATIVE) FORECAST: A forecasting method that brings together,
in an organized way, personal judgments about the process being analyzed.
LEAST-SQUARES METHOD: A statistical technique for fitting a straight line through a set
of points in such a way that the sum of the squared distances from the data points to the
line is minimized.
LEVERAGED BUYOUT (LBO): A corporate restructuring where the existing shareholders
sell their shares to a small group of investors. The purchasers of the stock use the firm's
unused debt capacity to borrow the funds to pay for the stock.
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LINEAR PROGRAMMING (LP): A technique used to find an optimal solution to the

resource allocation problem under constrained conditions.
LINEAR REGRESSION: A regression that deals with a straight line relationship between
variables. It is in the form of Y = a + bX whereas nonlinear regression involves curvilinear
relationships such as exponential and quadratic functions (see also Regression
Analysis).
MASTER (COMPREHENSIVE) BUDGET: A plan of activities expressed in monetary
terms of the assets, equities, revenues and costs which will be involved in carrying out
the plans. A set of projected or planned financial statements.
MATERIALS PRICE VARIANCE: The difference between what is paid for a given quantity
of materials and what should have been paid, multiplied by actual quantity of materials
purchased.
MATERIALS QUANTITY (USAGE) VARIANCE: The difference between the actual
quantity of materials used in production and the standard quantity of materials allowed
for actual production, multiplied by the standard price per unit.
MARKOV ANALYSIS: A method of analyzing the current behavior of some variable to
predict the future behavior of that portion of the accounts receivable that will eventually
become uncollectible.
MEAN ABSOLUTE DEVIATION (MAD): The mean or average of the sum of all the
forecast errors with regard to sign.
MEAN ABSOLUTE PERCENTAGE ERROR (MAPE): The mean or average of the sum of
all the percentage errors for a given data set taken without regard to sign. (That is, their
absolute values are summed and the average computed.) It is one measure of accuracy
commonly used in quantitative methods of forecasting.
MEAN SQUARE ERROR (MSE): A measure of accuracy computed by squaring the
individual error for each item in a data set and then finding the average or mean value of
the sum of those squares. The mean squared error gives greater weight to large errors
than to small errors because the errors are squared before being summed.
MOVING AVERAGE (MA): (1) For a time series an average that is updated as new
information is received. With the moving average, the analyst employs the most recent
observations to calculate an average, which is used as the forecast for next period. (2) In
Box-Jenkins modeling the MA in ARIMA stands for moving average and means that the
value of the time series at time t is influenced by a current error term and (possibly)
weighted error terms in the past.
MULTICOLLINEARITY: The condition that exists when the independent variables are
highly correlated with each other. In the presence of multicollinearity, the estimated
regression coefficients may be unreliable. The presence of multicollinearity can be tested
by investigating the correlation between the independent variables.
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MULTIPLE REGRESSION ANALYSIS: A statistical procedure that attempts to assess

the relationship between the dependent variable and two or more independent variables.
For example, sales of Coca-Cola is a function of various factors such as its price,
advertising, taste and the prices of its major competitors. For forecasting purposes, a
multiple regression equation falls into the category of a causal forecasting model (see
also Regression Analysis).
MUTUAL FUND: A company which uses its capital to invest in other companies. There
are two principal types closed-end and open-end. Shares in close-end investment trusts,
are readily transferable in the open market and are bought and sold like other shares.
Capitalization of these companies is fixed. Open-end funds sell their own new shares to
investors, stand ready to buy back their old shares and are not listed. Open-end funds are
so called because their capitalization is not
fixed and they issue more shares as people want them.
NAIVE FORECAST: Forecasts obtained with a minimal amount of effort and data
manipulation and based solely on the most recent information available. One such naive
method would be to use the most recent datum available as the future forecast.
OPERATING LEVERAGE: The responsiveness to sales changes of the firm's earnings
before interest and taxes. This responsiveness arises from the firm's use of fixed
operating costs.
OPTIMAL PARAMETER OR WEIGHT VALUE: Those values that give the best
performance for a given model applied to a specific set of data. It is those optimal
parameters that then are used in forecasting.
PORTFOLIO: Holdings of securities by an individual or institution. A portfolio may contain
bonds, preferred stocks and common stocks of various types of enterprises.
PROCESSING FLOAT: Funds tied up during the time required for the firm to process
remittance checks before they can be deposited in the bank.
PRODUCT LIFE CYCLE: The concept that is particularly useful in forecasting and
analyzing historical data of new products. It presumes that demand for a product follows
an S-shaped curve growing slowly in the early stages, achieving rapid and sustained
growth in the middle stages and slowing again in the mature stage.
PROJECTED (BUDGETED) BALANCE SHEET: A schedule for expected assets,
liabilities and stockholders equity. It projects a companys financial position as of the end
of the budgeting year. Reasons for preparing a budgeted balance sheet follow: (1)
discloses unfavorable financial condition that management may want to avoid; (2) serves
as a final check on the mathematical accuracy of all other budgets; and (3) highlights
future resources and obligations.
PROJECTED (BUDGETED) INCOME STATEMENT: A summary of various component
projections of revenues and expenses for the budget period. It indicates the expected net
income for the period.
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QUANTITATIVE FORECASTING: A technique that can be applied when information

about the past is available - if that information can be quantified and if the pattern included
in past information can be assumed to continue into the future.
R-SQUARED: See Coefficient of Determination.
R-BAR SQUARED (R2 ): R2 adjusted for the degrees of freedom. (See R-Squared.)
RATE OF RETURN ON INVESTMENT (ROI): (1) for the company as a whole, net income
after taxes divided by invested capital. (2) for the segment of an organization, net
operating income divided by operating assets, (3) for capital budgeting purposes. also
called simple accounting, or unadjusted rate of return, expected future net income divided
by initial (or average) investment.
REGRESSION ANALYSIS: A statistical procedure for estimating mathematically the
average relationship between the dependent variable (sales, for example) and one or
more independent variables (price and advertising, for example).
REGRESSION COEFFICIENTS: When a dependent measure Y is regressed against a
set of independent measures X1 through Xk the analyst wishes to estimate the values of
the unknown coefficients by least-squares procedures. For example, in a linear
regression equation Y = a + bX, a and b are regression coefficients. Specifically, a is
called the y-intercept or constant, while b is called a slope. The properties of these
regression coefficients can be used to understand the importance of each independent
variable (as it relates to Y) and the interrelatedness among the independent variables (as
they relate to Y).
REGRESSION EQUATION (MODEL): A forecasting model that relates the dependent
variable (sales, for example) to one or more independent variables (advertising and
income, for example).
RESIDUAL: A synonym for error. It is calculated by subtracting the forecast value from
the actual value to give a residual or error value for each forecast period.
RESIDUAL INCOME (RI): The operating income which an investment center is able to
earn above some minimum return on its assets.
RESPONSIBILITY ACCOUNTING: The collection, summarization and reporting of
financial information about various decision centers (responsibility centers) throughout an
organization. Also called activity accounting or profitability accounting.
RESPONSIBILITY CENTER: A unit in the organization which has control over costs,
revenues, or investment funds. For accounting purposes, responsibility centers are
classified as cost centers, revenue centers, profit centers and investment centers,
depending on what each center is responsible for.

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RISK: (1) A term used to describe a situation in which a firm makes an investment that
requires a known cash outlay without knowing the exact future cash flow the decision will
generate. (2) The chance of losing money. (3) The possible variation associated with the
expected return measured by the standard deviation or coefficient of variation.
RISK ADJUSTED DISCOUNT RATE: A method for incorporating the project's level of risk
into the capital budgeting process, in which the discount rate is adjusted upward to
compensate for higher than normal risk or downward to compensate for lower than
normal risk.
RISK PREMIUM: The additional return expected for assuming risk.
SALES FORECASTING: A projection or prediction of future sales. It is the foundation for
the quantification of the entire business plan and a master budget. Sales forecasts serve
as a basis for planning. They are the basis for capacity planning, budgeting, production
and inventory planning, manpower planning and purchasing planning.
SEGMENT MARGIN: Contribution margin less direct (traceable) fixed costs.
SEGMENTED REPORTING: The process of reporting activities of various segments of
an organization such as divisions, product lines, or sales territories.
SERIAL CORRELATION: See Autocorrelation.
SEASONAL INDEX: A number that indicates the seasonality for a given time period. For
example, a seasonal index for observed values in July would indicate the way in which
that July value is affected by the seasonal pattern in the data. Seasonal indexes are used
to obtain deseaonalized data.
SIMPLE REGRESSION: A regression analysis that involves one independent variable.
For example, the demand for automobiles is a function of its price only (see also Multiple
Regression; Regression Analysis).
SIMULATION MODELS: "What-if" models that attempt to simulate the effects of alternative
management policies and assumptions about the firm's external environment. They are
basically a tool for management's laboratory.
SLOPE: The steepness and direction of the line. More specifically, the slope is the
change in Y for every unit change in X.
SPIN OFF: The separation of a subsidiary from its parent, with no change in the equity
ownership. The management of the parent company gives up operating control over
the subsidiary, but the shareholders maintain their same percentage ownership in both
firms. New shares representing ownership in the averted company are issued to the
original shareholders on a pro rata basis.
STANDARD ERROR OF THE ESTIMATE: The standard deviation of the regression. The
static can be used to gain some idea of the accuracy of our predictions.
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t-STATISTIC: See t-value.

STANDARD ERROR OF THE REGRESSION COEFFICIENT: A measure of the amount
of sampling error in a regression coefficient.
t-TABLE: A table that provides t-values for various degrees of freedom and sample sizes.
The t-table is based on the student t-probability distribution (see also t-value).
t-TEST: In regression analysis, a test of the statistical significance of a regression
coefficient. it involves basically two steps: (1) compute the t-value of the regression
coefficient as follows: t-value = coefficient / standard error of the coefficient; (2) compare
the value with the t-table value. High t-values enhance confidence in the value of the
coefficient as a predictor. Low values (as a rule of thumb, under 2.0) are indications of low
reliability of the coefficient as a predictor (see also t-Value).
t-VALUE: A measure of the statistical significance of an independent variable b in
explaining the dependent variable Y. It is determined by dividing the estimated regression
coefficient b by its standard error.
TEMPLATE: A worksheet or computer program that includes the relevant formulas for a
particular application but not the data. It is a blank worksheet that we save and fill in the
data as needed for a future forecasting and budgeting application.
TENDER OFFER: A bid by an interested party, usually a corporation, for controlling
interest in another corporation.
THEIL U STATISTIC: A measure of the predictive ability of a model based on a
comparison of the predicted change with the observed change. The smaller the value of U,
the more accurate are the forecasts. If U is greater than or equal to 1, the predictive ability
of the model is lower than a naive, no-change extrapolation.
TIME SERIES MODEL: A function that relates the value of a time series to previous
values of that time series, its errors, or other related time series (see ARIMA).
TIME VALUE OF MONEY: value of money at different time periods. As a rule, one dollar
today is worth more than one dollar tomorrow. The time value of money is a critical
consideration in financial decisions.
TIMES INTEREST EARNED RATIO: Earnings before interest and taxes (EBIT)/interest
expense. A ratio that measures the firm's ability to meet its interest payments from its
annual operating earnings.
TOTAL LEVERAGE: A measure of total risk, referring to how earnings per share is
affected by a change in sales. It equals the percentage change in earnings per share
divided by the percentage change in sales. Total leverage at a given level of sales is the
operating leverage multiplied by the financial leverage.

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TRACKING SIGNALS: One way of monitoring how well a forecast is predicting actual
values. The running sum of forecast is predicting actual values. The running sum of
forecast error is divided by the mean absolute deviation (MAD). When the signal goes
beyond a set range, corrective action may be required.
TREND ANALYSIS: A special form of simple regression in which time is the independent
variable (see also Trend Equation).
TREND EQUATION: A special case of simple regression, where the X variable is a time
variable. This equation is used to determine the trend in the variable Y, which can be used
for forecasting.
TREND LINE: A line fitted to sets of data points that describes the relationship between
time and the dependent variable.
TURNING POINT ERROR: Also known as error in the direction of prediction. It
represents the failure to forecast reversals of trends. For example, it may be argued that
the ability to anticipated reversals of interest rate trends is more important than the
precise accuracy of the forecast.
VARIANCE: The difference of revenues, costs and profit from the planned amounts. One of
the most important phases of responsibility accounting is establishing standards in costs,
revenues and profit and establishing performance by comparing actual amounts with the
standard amounts. The differences (variances) are calculated for each responsibility center,
analyzed and unfavorable variances are investigated for possible remedial action.
WHAT-IF ANALYSIS : SIMULATION MODEL.
WEIGHT: The relative importance given to an individual item included in forecasting, such
as alpha in exponential smoothing. In the method of moving averages all of those past
values included in the moving average are given equal weight.
Z-SCORE: A score produced by Altmans bankruptcy prediction model, known to be
about 90 percent accurate in forecasting business failure one year in the future and about
80 percent accurate in forecasting it two years in the future.

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