Ratio Analysis to Forecast Earnings

Data on the economy, industry and company are used in deriving forecasts for a company. The results of financial analysis, including common-size and ratio analysis, are integral to this forecasting process.

The forecasts of a company’s growth and expected relationships among financial statement data can be used to build an earnings model that can forecast the company’s future performance.

Modeling and Forecasting Earnings

Pro forma financial statements and budgets are frequently used for financial forecasting within companies. The documents are particularly useful to a company’s board of directors and senior executives. These budgets and forecasts are also used in presentations to credit analysts and others when seeking external financing.

Forecasting usually involves a range of possibilities, and several techniques may be utilized for this purpose. These include:

• sensitivity analysis or “what if” analysis: this provides a range of possible outcomes as specific assumptions are changed;
• scenario analysis: this shows the change in key financial quantities that may result from economic events, such as a loss of funding, loss of a supplier, or a natural disaster. If the list of economic events is mutually exclusive and exhaustive and the events can be assigned probabilities, then a range of outcomes can be evaluated as well as statistical measures such as the mean and median derived for various quantities of interest.
• Simulation: this is a computer-generated sensitivity or scenario analysis that is based on probability models for the factors which drive outcomes. When doing simulations, each event or possible outcome is assigned a probability. After this multiple scenarios are run using probability factors assigned to the possible values of a variable.

Question 1

Which of the following statements is least accurate?

1. Forecasts should be limited to a single point estimate.
2. Scenario analysis shows the change in key financial quantities that may result from given (economic) events.
3. Financial analysis, analyst judgment, and analysis of other information are all integral to the development of forecasts.

Solution

Forecasts should not be limited to a single point estimate. Instead, they  should focus on a range of possibilities.

Both options B and C are accurate statements.

Question 2

Sensitivity analysis:

1. Shows the results of the change of key financial quantities.
2. Makes estimations of how future financial statements should look like.
3. Shows the range of possible outcomes as specific assumptions are changed.

Solution

Sensitivity analysis shows a range of possible outcomes as specific assumptions are changed.

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