[MUSIC] We're unpacking several uses for financial analysis techniques this week, including practical applications of horizontal and vertical analysis. One application for this type of analysis is to forecast the future performance of an organization. Whether we're looking to predict the future of our own organization, or to understand a firm that we have invested in, a competitor, or any other institution that we may happen to be an interested stakeholder of. As managers, there are a great deal of benefits we can derive from being able to understand future prospects for our organization, as well as future challenges, and how we might go about addressing them. We're going to focus on techniques that assist us in doing just this. And in particular, to try and translate our understanding of strategy and operations management, for example, into financial outputs. Interestingly, that notion of translation is a useful analogy to understand an application of forecasted financial statements. By attempting to predict the future, we're able to close the loop in our understanding of strengths, weakness, opportunities, and threats. By having a clearer view of what the future might hold for us, we consequently know our present circumstances more intimately. And are able to use this tactically and operationally to generate more value, if our organization can be clever and flexible enough to do so. As an example, suppose we're attempting to predict revenue for next year, and we know that our organization was able to generate $ 800,000 in sales in the current year. So we'll start with the current, And we will express sales over here. Marketing intelligence tells us that we'll be able to generate somewhere between 10 and 15% growth to our revenue in the future. And this is what our stakeholders are expecting our organization to achieve. If we are feeling conservative, then we might go with 10%, and predict that 800,000 will turn into 880,000 next year. This becomes our future prediction then. That's a nice start, but all we have so far is a projection for revenue. What about our expenses? Well, suppose that last year we spent $200,000 on our cost of sales, Or cost of goods sold over here. Then we had $300,000 on staffing costs. For staff, and a further $100,000 on other expenses. Or other. Those of you who are keen to apply the profit formula, will be able to calculate that we made $200,000 d of profit before tax in the most year of operation. Net profit before tax. How should we predict those expenses for the following year though? Can we assume that our expenses will remain the same while we generate more revenue? If only we were so lucky. It's quite likely that we'll incur more expenses in order to generate more revenue. One technique that we can use here is an extrapolation of our vertical analysis for the previous year. Note that our cost of sales, $200,000, can be seen as a proportion of total sales, which was $800,000. If we divide cost of sales by total sales, the output number is that proportion. And in this case it's 25%, or a quarter of total sales. If this proportion remains the same, then a quarter of our new revenue figure of $880,000 would be our prediction for cost of sales. And that figure would be generated by multiplying the proportion, 25% or 0.25, by our new revenue figure of 880,000. This gives us a projected cost of sales of $220,000 for the next year. If we do the same with staffing, we would find that 300,000 is three eighths of 800,000, which can be expressed as 37.5%. That figure multiplied by the new sales of 880,000, yields $330,000 in staffing for the next year. Other expenses of $100,000, would similarly translate into 110,000. You might notice a pattern in each of these outputs. Because revenue has increased by 10% and we're retaining all the same proportions for each of our expense lines, each of these outputs has also increased by 10%. That being the case, the results on our profitability will follow the same lines. We take 220,000, 330,000 and 110,000 away from our 880,000, and we arrive at total expenses of 660,000, and a consequent profit of 220,000. That is 10% more than the 200,000 profit in the most recent period. This shows us the effect of a 10% increase to every line item in our profit and loss. In the real world though, these changes are likely to take place at different levels. For example, what if were able to control our staffing costs so that they only increase by 5% rather than 10%? This would mean that 300,000 from our most recent year would turn into 315,000 for the next year. Can you guess where the extra $15,000 ends up? If you said profit, you'd be right. This is just one example of how our budget for the following year can be informative as to how we can find ways to become more profitable over time. In the event that we can foresee difficulties in the future, such as rising staffing costs, the opposite would be true as well. In this case though, we've been able to increase our profitability to $235,000. Our ability to predict future financial performance accurately depends on a good understanding of changes to our external environment, as well as our internal environment. And how these changes might interact to change circumstances for our firm. Where we can find ways to use these projections to inform our tactical and operational choices, and how these link with our current strategy, we're able to add significant value to our organizations as managers. [MUSIC]