When preparing the financial projections of a manufacturing business a useful technique is to analyse the financial statements of a similar business in the manufacturing industry.
By reviewing a set of financial statements it is possible to check whether the assumptions used in the projection are appropriate, and whether the ratios generated are in line with actual results in the industry.
Key Characteristics of a Manufacturing Business
Generally the financial projections of all businesses follow a similar format and are based on a set of key assumptions. These assumptions will vary depending on the type of business involved, and those for a manufacturing business will need to reflect the particular nature of the industry.
Although not a definitive list, some of the more important points to consider when reviewing the financial projections of a manufacturing business are as follows.
Inventory
Unlike retailers who purchase the goods they sell, a manufacturing business takes raw materials and converts them into a finished product using labor and overhead: a manufacturing business will therefore tend to hold significantly more inventory of raw materials, work in process, and finished goods resulting in higher inventory days.
Sales
Sales in a manufacturing business are usually made to be to other businesses such as distributors, and wholesalers rather than direct to consumers. As such they tend to be made on credit terms rather than for cash, resulting in higher accounts receivable days.
Capital Investment
By its nature, a manufacturing business usually needs significant investment in property, plant and equipment. This results in a capital intensive business needing significant amounts of debt and equity financing to fund its operations.
Cost Structure
A manufacturing business tends to have high fixed costs, in particular research and development costs, resulting in lower margins and a high break even point.
Purchases
Purchases are usually significant and on credit terms from suppliers resulting in higher accounts payable days.
Gross Margin
Generally gross margins in a manufacturing business should be between 40% and 50% in order for it to generate the necessary cash to fund its expansion.
Which Financial Statements to Use
Ideally the financial statements used will be of a similar size to that anticipated by the financial projections, however this is not always possible in which case publicly available information for larger manufacturing businesses can be used as a starting point.
Example financial statements are available from a number of sources, including the investor pages of the company’s website or from sources such as Edgar in the US, or Companies House in the UK.
Example Manufacturing Business Review
In order to demonstrate how to estimate the key assumptions to be used in the financial projections of a startup manufacturing business, the financial statements of Mattel, a manufacturer of toys, are used in the calculations below. A copy of Mattel 2015 financial statements can be downloaded here.
Assumptions Calculations
In the financial projections template the key assumptions used are as follows.
- Gross margin %
- Depreciation rate
- Finance costs %
- Income tax rate
- Accounts receivable days
- Inventory days
- Accounts payable days
- Other liability days
The majority of the information used below is obtained from the balance sheet (page 50), income statement (page 51), and cash flow statement (page 53) of the Mattel financial statements, and for ease of use, these three main statements are available for download here.
In the calculations references to the financial statements are shown in brackets as follows.
- Balance sheet statement (B)
- Income statement (I)
- Cash flow statement (C)
Gross margin %
Gross margin % = Gross profit (I) / Net sales (I) Gross margin % = 2,806,358 / 5,702,613 Gross margin % = 49.2%
Depreciation rate
To give an indication of the depreciation rate, it is useful to calculate the depreciation as a percentage of the net book value of long term assets.
Depreciation rate = Depreciation (C) / Property, Plant and Equipment (B) Depreciation rate = 233,025 / 741,147 = 31.4%
Full details of the depreciation rates used can be found on page 55.
Finance Costs %
Finance costs % = Interest expense (I) / Debts (B) Finance costs % = 85,270 / 2,116,914 = 4.0% *Debts = 16,914 + 300,000 + 1,800,000 = 2,116,914 (B)
Income tax rate
Income tax rate = Income tax (I) / Income before tax (I) Income tax rate = 94,499 / 463,915 = 20.4%
Accounts Receivable Days
Accounts receivable days = Accounts receivable (B) x 365 / Revenue (I) Accounts receivable days = 1,145,099 x 365 / 5,702,613 Accounts receivable days = 73 days
Inventory Days
Inventory days = Inventory (B) x 365 / Cost of sales (I) Inventory days = 587,521 x 365 / 2,896,255 Inventory days = 74 days
Accounts Payable Days
Accounts payable days = Accounts payable (B) x 365 / Cost of sales (I) Accounts payable days = 651,681 x 365 / 2,896,255 Accounts payable days = 82 days
Other Liabilities Days
Other liabilities days = Other liabilities x 365 / (Operating expenses - Depreciation + Finance costs + Income tax) Other liabilities days = 676,977 x 365 / 2,212,180 Other liabilities days = 112 days *Other liabilities = 658,225 + 18,752 = 676,977 (B) *Expenses = 717,852 + 1,547,584 - 233,025 + 85,270 + 94,499 = 2,212,180 (I)
The values should now be compared with the assumptions used in the financial projections template and adjustments made as appropriate.
Ratios Calculations
In a similar manner the financial statements of Mattel can be used to calculate ratios for comparison with those generated by the financial projections template.
The main ratios generated in the template are as follows.
- Profitability (Net income / Revenue)
- Efficiency (Revenue / Assets)
- Leverage (Assets / Equity)
- Return on assets (ROA)
- Return on equity (ROE)
- Liquidity (Current assets / Current liabilities)
Using information from the financial statements an estimate of each ratio can be calculated as follows.
Profitability
Profitability = Net income (I) / Net sales (I) Profitability = 369,416 / 5,702,613 = 6.5%
Efficiency
Efficiency = Net sales (I) / Assets (B) Efficiency = 5,702,613 / 6,522,689 = 0.87
Leverage
Leverage = Assets (B) / Equity (B) Leverage = 6,552,689 / 2,633,254 = 2.49
Return on assets (ROA)
Return on assets = Net income (I) / Assets (B) Return on assets = 369,416 / 6,552,689 = 5.6%
Return on equity (ROE)
Return on equity = Net income (I) / Equity (B) Return on equity = 369,416 / 2,633,254 = 14.0%
Liquidity
Liquidity = Current assets (B) / Current liabilities (B) Liquidity = 3,196,863 / 1,645,572 = 1.94
The next step is to see how these ratios compare to those generated by the financial projections for your retail business.
Summary
In summary, using the financial statements of an appropriate business in the same industry assumptions and ratios can be calculated using primarily information from the balance sheet, income statement, and cash flow statement.
In the example above, the financial statements of Mattel were used to represent a manufacturing business revealing the following assumption and ratio values.
| Gross margin % | 49.2% |
| Depreciation rate | 31.4% |
| Finance costs % | 4.0% |
| Income tax rate | 20.4% |
| Accounts receivable days | 73 days |
| Inventory days | 74 days |
| Accounts payable days | 82 days |
| Other liability days | 112 days |
| Profitability | 6.5% |
| Efficiency | 0.87 |
| Leverage | 2.49 |
| Return on assets | 5.6% |
| Return on equity | 14.0% |
| Liquidity | 1.94 |
Obviously the assumptions and ratios calculated from the financial statements of one business are not going to be identical to those of another business. Despite this, it is a worthwhile exercise to find a set of financial statements similar to your proposed business and, together with other information from trade statistics and benchmark reports, use these as the starting point for producing a set of financial projections for a startup manufacturing business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.