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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 by 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.
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The ability to measure managerial performance is essential in controlling operations toward the achievement of organizational goals. As companies grow or their activities become more complex, they attempt to decentralize decision making as much as possible. They do this by restructuring the firm into several divisions and treating each as an independent business.
ROI can be broken down into two factors--profit margin and asset turnover. The ROI breakdown, known as the Du Pont formula , is expressed as a product of these two factors
Various actions can be taken to enhance ROI.
Generally, a better management performance (i.e., a high or above‑average ROI) produces a higher return to equity holders. However, even a poorly managed company that suffers from a below-average performance can generate an above‑average return on the stockholders' equity, simply called the return on equity (ROE). This is because borrowed funds can magnify the returns a company's profits represent to its stockholders.
Another version of the Du Pont formula, called the modified Du Pont formula reflects this effect. The formula ties together the ROI and the degree of financial leverage (use of borrowed funds). The financial leverage is measured by the equity multiplier.
If the assets in which the funds are invested are able to earn a return greater than the fixed rate of return required by the creditors, the leverage is positive and the common stockholders benefit. The advantage of this formula is that it enables the company to break its ROE into a profit margin portion (net profit margin), an efficiency‑of‑asset‑utilization portion (total asset turnover), and a use‑of‑leverage portion (equity multiplier). It shows that the company can raise shareholder return by employing leverage‑‑taking on larger amounts of debt to help finance growth.
Unfortunately, leverage is a two-edged sword. If assets are unable to earn a high enough rate to cover fixed finance charges, then stockholder suffers. The reason is that part of the profits from the assets which the stockholder has provided to the firm will have to go to make up the shortfall to the long-term creditors, and he/she will be left with a smaller return than otherwise have been earned.
