CHAPTER 5: Financial Forecasting, e.

Performance Evaluation
Percent of Sales Method,
Sustainable Growth Rate, and - Provides benchmarks for
Financial Planning & Budgeting evaluating actual performance.

A. FINANCIAL FORECASTING 3. Types of Financial Forecasts

1. Definition of Financial Forecasting ● Short-Term Forecasts (1 year

or less)
Financial forecasting refers to the - Used for working capital planning,
process of estimating or predicting future cash budgeting, and operational
financial outcomes based on: expenses.
● Medium-Term Forecasts (1-3
● Historical performance years)
● Current conditions - Guide strategic investment,
● Strategic assumptions marketing, and growth decisions.
Expected market and economic ● Long-Term Forecasts (3-10
trends years)
- Used for capital budgeting, long-
Forecasting allows businesses to project term financial structure, and
revenues, expenses, cash flows, expansion plans.
financing needs, and overall financial
performance. 4. Common Forecasting Methods

2. Objectives of Financial Forecasting ● Historical Growth Trend

Analysis
a. Strategic Planning - Using past data to project future
trends.
- Forecasts help set long-term goals ● Regression and Statistical
and determine the organization's Models
direction. - Using variables that correlate with
financial performance (e.g., GDP,
b. Capital Allocation
prices).
- Enables management to identify ● Econometric Models
investment opportunities and - Advanced models accounting for
allocate capital efficiently. economic and industry-specific
factors.
c. Operational Efficiency ● Percent of Sales Method
- Assumes certain items vary
- Assists in determining production proportionally with sales— simple
levels, staffing, inventory, and but limited.
resource usage.
5. Steps in Financial Forecasting
d. Risk Management
1. Collect and analyze historical
- Predicts potential financial financial data.
challenges, allowing companies to 2. Identify key performance drivers.
prepare contingency plans. 3. Determine forecasting assumptions
(sales growth, cost behavior).
 4. Select the appropriate forecasting - Find each account's percentage
model. relative to sales in the previous
5. Prepare pro forma financial year.
statements.
6. Evaluate forecast results and Step 3: Compute Forecasted Values
adjust assumptions.
7. Monitor forecasts regularly to - Multiply each variable account
reflect actual performance. percentage by the projected sales.

B. THE PERCENT OF SALES Step 4: Prepare Pro Forma Financial

FORECAST METHOD Statements

1. Definition Project:

The Percent of Sales Method is a ● Income Statement

forecasting model that assumes specific ● Balance Sheet
accounts (mainly variable cost current
Step 5: Determine External
assets, and current liabilities) change in
Financing Needed (EFN)
direct proportion to sales.
- If projected total assets exceed
It is widely used because it is simple,
projected total liabilities and
intuitive, and quick to compute.
equity, the difference is EFN.
2. Accounts Typically Assumed to Vary
4. Example Illustration
With Sales
If sales last year were P5,000,000 and
Variable Assets
expected to increase by 20%:
● Accounts Receivable
● Forecasted Sales = 5,000,000 ×
● Inventory
1.20 = P6,000,000
● Cash (sometimes variable)
● Inventory was 20% of sales →
Variable Liabilities 6,000,000 × 20% = P1,200,000
forecasted
● Accounts Payable
● Accrued Expenses Repeat for other variable accounts.

Variable Operating Expenses C. LIMITATIONS OF THE PERCENT OF

SALES METHOD
● Cost of Goods Sold
● Sales and Marketing Although simple and convenient, this
method contains significant limitations
3. Steps in Applying the Percent of Sales that may lead to inaccurate forecasts.
Method
1. Assumes Linear Relationships
Step 1: Determine Forecasted Sales
The method assumes all variable items
- Example: Sales are expected to change proportionally with sales.
increase by 15%.

Step 2: Identify Variable Accounts

Reality: Costs may increase in steps then costs and revenues may no longer
(step costs) or decrease due to follow historical percentages.
economies of scale.
6. Limited Usefulness for Long-Term
2. Ignores Production Capacity Planning
Constraints
The method works best for short-term,
Companies cannot always increase sales stable environments.
without:
For long-term forecasts, dynamic
● Hiring more workers financial models are required.
● Buying new machinery
● Expanding facilities D. SUSTAINABLE GROWTH RATE
(SGR)
The method does not account for these
operational limits. 1. Definition

3. Oversimplifies Working Capital The Sustainable Growth Rate is the

Management maximum annual percentage increase in
sales a company can achieve without:
Working capital needs do not always
scale proportionately with sales. ● Issuing new equity
● Changing financial leverage
Example: ● Altering dividend policy

● Inventory may increase ahead of SGR is based on the firm's ability to

sales. generate earnings internally.
● Accounts receivable may rise if
credit terms change. 2. Formula

4. Assumes Constant Financial SGR = ROE × (1 - Dividend Payout Ratio)

Policies
Where:
The method assumes:
● ROE = Return on Equity
● Same dividend payout ● Dividend Payout Ratio =
● Same leverage level Dividends ÷ Net Income
● Same asset utilization
3. Expanded Formula (DuPont Version)
But financial strategies may change as
the firm grows. ROE = (Net Profit Margin)x (Asset
Turnover)x (Equity Multiplier)
5. Ignores Pricing and Product Mix
Changes Thus, a firm's SGR increases when:

If the business: ● Profit margins improve

● Assets are used more efficiently
● Raises prices, ● Leverage is increased
● Introduces new products, or ● More earnings are retained
● Changes its marketing strategies,
4. Interpretation of SGR
a. Actual Growth > SGR - The starting point for most plans.
b. Capital Investment Plan
The company is growing too fast. - For acquiring new machinery,
buildings, or vehicles.
It may require: c. Operating Expense Plan
- Covers salaries, utilities, supplies,
● More debt and administrative expenses.
● Issuance of equity d. Financing Plan
● Reduction in dividends
Specifies:
b. Actual Growth < SGR
● Capital structure
The company has unused capacity for ● Loans
expansion. ● Equity financing
● Dividend policy
It can:
e. Cash Flow Plan
● Increase marketing - Ensures the business can meet
● Pursue investments short-term obligations.
● Pay more dividends
3. Budgeting as a Tool for Financial
5. Example Calculation Planning

Given: Budgeting is the process of converting

financial plans into numeric form. It
● ROE = 15% provides the quantitative details needed
● Dividend Payout Ratio = 40%. for execution.

SGR = 0.15 × (1 - 0.40) = 0.15 × 0.60 = Types of Budgets

0.09 = 9%
1. Operating Budget
The company can grow sustainably at 9% 2. Sales Budget
per year. 3. Production Budget
4. Cash Budget
E. FINANCIAL PLANNING AND 5. Capital Expenditure Budget
BUDGETING 6. Flexible Budget
7. Master Budget
1. Definition of Financial Planning
4. Importance of Budgeting
Financial planning involves creating a
roadmap for achieving the financial goals a. Control and Accountability
of the business. It ensures the - Budgets establish financial
organization: boundaries and expectations.
b. Performance Measurement
● Is financially stable - Actual results can be compared to
● Can fund its strategic initiatives budgeted amounts.
● Can maintain liquidity c. Resource Allocation
● Can use resources efficiently - Ensures every department receives
the funds needed to operate
2. Components of Financial Planning effectively.
d. Strategic Alignment
a. Sales Forecasts
 - Budgets support the achievement I. INTRODUCTION TO FIRM
of organizational goals. PERFORMANCE EVALUATION
e. Risk Reduction Evaluating firm performance is a
- Through scenario planning,
cornerstone of financial management
budgeting mitigates uncertainty.
because it determines whether a
5. Example: The Budgeting Process company is operating efficiently, using its
resources effectively, and generating
1. Develop sales forecast. returns that satisfy owners, creditors,
2. Create production plan based on
customers, and employees. In general,
forecast.
3. Estimate operating expenses. firm performance evaluation attempts to
4. Prepare capital expenditure answer three fundamental questions:
budget.
1. How well is the company using its
5. Consolidate into master budget.
6. Review and approve at resources?
management level. This includes understanding whether the
7. Implement, monitor, and revise as company is maximizing output from
necessary. available assets, minimizing waste, and
operating within reasonable cost
V. MODULE SUMMARY
structures.
This module covered four major topics 2. Is the business financially healthy
essential to financial management:
and sustainable?
1. Financial Forecasting - Estimating Sustainability refers to the company's
future financial performance using ability to survive and thrive over long
various models. periods, even in the face of economic
2. Percent of Sales Method - A simple downturns, competition, or operational
and widely used forecasting tool,
disruptions.
but one with significant
3. Sustainable Growth Rate (SGR) — Your uploaded material confirms that
An indicator of how fast a company two major approaches are used to
can grow without external equity.
evaluate firms:
4. Financial Planning and Budgeting -
The backbone of financial control, 1. Financial Ratio Analysis
resource allocation, and strategic 2. Stakeholder / Balanced Scorecard
success. Approach

These concepts collectively guide Evaluating Firm's Performance

businesses in making informed,
While financial ratio analysis evaluates
structured, and sustainable financial
decisions. quantitative performance using financial
statements, the Balanced Scorecard
expands this view by integrating
qualitative performance indicators such
CHAPTER 6 - EVALUATING FIRM
as customer satisfaction, internal
PERFORMANCE
processes, and innovation capacity.
Together, these frameworks provide a
holistic understanding of organizational
1. Current Ratio
performance.

II. FINANCIAL RATIO ANALYSIS

Financial ratio analysis uses

mathematical relationships between
Description and Purpose:
financial statement accounts to assess
The current ratio measures the coverage
performance. These ratios provide clear
of short-term liabilities by short-term
insights into areas such as liquidity,
assets. It tells stakeholders whether the
leverage, profitability, efficiency, and
company has enough assets that will be
market valuation.
converted into cash within the year to
Ratios allow comparisons: meet obligations due within the same
✔ Over time (trend analysis) period. This is the most fundamental
✔ Across companies (competitor liquidity indicator.
analysis) In-depth Interpretation:
✔ Against industry standards A commonly accepted “safe” benchmark
(benchmarking) is 2:1, meaning the firm has twice as
A. LIQUIDITY RATIOS many short-term assets as liabilities.
Liquidity ratios measure a firm’s ability to However, this benchmark varies by
meet short-term financial obligations industry. For example:
using short-term assets. These ratios • Retail stores often operate with lower
determine whether a firm can pay its bills ratios because they turn inventory very
when they become due quickly.

Liquidity is essential because firms with • Manufacturing firms require higher

strong profits can still fail due to poor ratios due to longer operating cycles.
cash flow management, inability to pay
Limitations: A high current ratio may
suppliers, or delayed customer
signal inefficiency—excess cash, unused
collections. Liquidity issues often cause:
inventory, or idle receivables. It does not
● Supplier distrust measure quality of assets (e.g., slow-
moving inventory).
● Higher interest rates on loans 2. Quick Ratio (Acid-Test Ratio)

● Difficulty obtaining inventory

● Reputational damage Description and Purpose:

This ratio removes inventory from current
● Bankruptcy
assets because inventory is the least
Below are expanded descriptions of each liquid and may take significant time to
key liquidity ratio. convert into cash. This makes the quick
ratio a superior measure of immediate B. LONG-TERM SOLVENCY /
liquidity, especially relevant for LEVERAGE RATIOS
businesses with slow inventory Your material states that these ratios
movement (e.g., heavy equipment measure how well a company can meet
dealers) its long-term debts and continue
operating in the future.
Interpretation: A quick ratio of 1:1 is ideal
for immediate liquidity. A low quick ratio Leverage ratios reflect financial risk,
means the firm relies too much on selling which increases as debt increases. Debt
inventory to pay bills. is not inherently bad — but mismanaged
debt leads to insolvency.
3. Cash Ratio
1. Debt Ratio

Description and Purpose:

The cash ratio indicates the company’s Description and Purpose:
ability to pay short-term obligations using This ratio shows the percentage of assets
cash on hand and very liquid financed by creditors. A higher ratio
investments. It is the strictest liquidity means more debt funding relative to
measurement. equity.
Interpretation: Interpretation:
∙ Very high cash ratios may indicate poor ∙ High debt ratios ≠ always bad. Debt
investment strategies (too much idle can amplify returns when used
cash). strategically.
∙ Extremely low cash ratios may indicate ∙ But excessive debt makes firms
aggressive working capital policies. vulnerable to interest rate spikes and
4. Net Working Capital downturns.

2. Debt-to-Equity Ratio
Description and Purpose:
NWC is not a ratio but an absolute figure
showing the firm’s short-term financial Description and Purpose:
cushion. Positive NWC means that after This ratio compares the funds supplied by
paying short-term debts, the firm still has creditors versus owners. It is one of the
remaining resources to operate, invest, most important indicators of financial
or handle emergencies. structure.
Interpretation: Interpretation:
Too high NWC may indicate excessive ∙ D/E > 1: creditors fund more assets
funds trapped in working capital than owners → higher risk.
components like receivables and ∙ D/E < 1: firm relies more on equity →
inventory. conservative financing.
3. Equity Multiplier management; low turnover may indicate
overstocking or declining sales.

2. Days Sales in Inventory (DSI)

Description and Purpose:
Shows how much assets each peso of
equity controls. It amplifies ROE through
Shows number of days inventory stays
leverage.
unsold. Firms aim for low DSI.
4. Times Interest Earned (Interest
3. Accounts Receivable Turnover
Coverage Ratio)

Measures how effectively credit sales are

Description and Purpose: collected. Higher turnover = faster
Measures the firm’s ability to pay interest collections.
from operating profits. Low TIE indicates
4. Days Sales Outstanding (DSO)
high insolvency risk.

5. Cash Coverage Ratio

Shows number of days it takes to collect
customer payments.
Description and Purpose:
Adds back depreciation because it’s non- 5. Accounts Payable Turnover
cash—thus giving a better view of ability
to pay interest using cash flow. Shows how fast a firm pays suppliers.
C. ASSET MANAGEMENT / Slow payments improve liquidity but can
EFFICIENCY RATIOS damage relationships.
These ratios measure how efficiently 6. Total Asset Turnover
assets generate sales.
Efficient firms turn inventory faster,
collect receivables quicker, and use fixed Measures how efficiently assets generate
assets productively. revenue.
FULL LIST OF EFFICIENCY RATIOS 7. Fixed Asset Turnover
(Each with long explanations)

1. Inventory Turnover Ratio

Indicates productivity of property, plant,
and equipment.

Description and Purpose: D. PROFITABILITY RATIOS

Shows how many times inventory is These as measures of income relative to
bought and sold during the year. High sales, assets, and equity.
turnover means efficient inventory Profitability ratios answer:
∙ Is the company profitable?
∙ Are resources used effectively? ∙ Dividend Yield
∙ Are investors earning a return ∙ Dividend Payout Ratio
∙ Price-to-Sales Ratio
Profitability Ratio
∙ Price-to-Cash Flow Ratio
1. Gross Profit Margin (GPM)
These ratios assess investor perceptions,
stock valuation, and future earnings
Indicates how efficiently the firm prospects.
produces goods. Higher GPM = better III. METHODS OF PERFORMANCE
cost control. ANALYSIS There are three methods
2. Operating Profit Margin (OPM) below:
✔ Trend analysis
✔ Industry comparison
Measures profitability from core ✔ Competitor comparison
operations without considering financing
Each allows firms to determine whether
or taxes.
performance is improving, lagging, or
3. Net Profit Margin (NPM) outperforming rivals.

IV. THE BALANCED SCORECARD

Shows the ultimate profitability after all This as a non-financial performance

expenses. evaluation tool.

4. Return on Assets (ROA) 1. Customer Perspective

Examines how customers perceive the
company. Measures include satisfaction,
Measures how efficiently assets generate loyalty, retention, service quality,
profit. complaints, delivery reliability, and
perceived value.
5. Return on Equity (ROE)
2. Internal Business Processes
Assesses process efficiency, quality,
Measures profitability for shareholders. production time, safety, waste reduction,
6. Return on Investment (ROI) capacity utilization, and cycle time
improvements.

Measures returns relative to capital 3. Innovation and Learning

invested. Perspective Focuses on training,
employee satisfaction, learning culture,
E. MARKET VALUE RATIOS
innovation, adaptability, and employee
Full list includes: retention.
∙ Earnings Per Share
4. Financial Perspective
∙ Price–Earnings Ratio
Includes profitability, revenue growth,
∙ Market-to-Book Ratio
cost reduction, ROI, and long-term
shareholder value.

V. CONCLUSION

This provides the deepest possible

exploration of firm performance
evaluation, integrating all financial ratios,
explanations, real-world interpretation,
strategic insights, and the Balanced
Scorecard framework, as supported by
your uploaded material.