Financial Statement Analysis and Forecasting

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO

CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Chapter 4 – Financial Statement Analysis Chapter 4 – Financial Statement Analysis and Forecastingand Forecasting

CHAPTER 4CHAPTER 4 Financial Statement Financial Statement

Analysis and ForecastingAnalysis and Forecasting

CHAPTER 4 – Financial Statement Analysis and Forecasting

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Lecture AgendaLecture Agenda

• Learning objectivesLearning objectives• Important termsImportant terms• Consistent financial analysisConsistent financial analysis• Leverage ratiosLeverage ratios• Efficiency ratiosEfficiency ratios• Productivity ratiosProductivity ratios• Liquidity ratiosLiquidity ratios• Valuation ratiosValuation ratios• Financial forecastingFinancial forecasting• Formula forecastingFormula forecasting• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions


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Learning ObjectivesLearning Objectives

1.1. Why return on equity is one of the key financial ratios used for Why return on equity is one of the key financial ratios used for assessing a firm’s performance, and how it can be used to assessing a firm’s performance, and how it can be used to provide information about three areas of a firm’s operationsprovide information about three areas of a firm’s operations

2.2. Why outsiders and insiders are concerned with a company’s Why outsiders and insiders are concerned with a company’s ratios related to leverage, efficiency, productivity, liquidity and ratios related to leverage, efficiency, productivity, liquidity and valuevalue

3.3. How to calculate, interpret, and evaluate the key ratios related How to calculate, interpret, and evaluate the key ratios related to leverage, efficiency, productivity, liquidity, and valueto leverage, efficiency, productivity, liquidity, and value

4.4. Why financial forecasts provide critical information for both Why financial forecasts provide critical information for both management and external partiesmanagement and external parties

5.5. How to prepare financial forecasts by using the percentage of How to prepare financial forecasts by using the percentage of sales approachsales approach

6.6. How external financing requirements are related to sales How external financing requirements are related to sales growth, profitability, dividend payouts, and sustainable growth growth, profitability, dividend payouts, and sustainable growth rates.rates.


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Important Chapter TermsImportant Chapter Terms

• Acid test ratioAcid test ratio• Average collection periodAverage collection period• Average days sales in Average days sales in

inventory inventory • Break-even pointBreak-even point• Cash flow to debt ratioCash flow to debt ratio• Current ratioCurrent ratio• Debt ratioDebt ratio• Debt-equity ratioDebt-equity ratio• Degree of total leverageDegree of total leverage• Dividend payoutDividend payout• Dividend yieldDividend yield

• EBITDA multipleEBITDA multiple• Efficiency ratiosEfficiency ratios• Equity book value per Equity book value per

shareshare• External financing External financing

requirementsrequirements• Financial leverageFinancial leverage• Fixed asset turnoverFixed asset turnover• Forward P/E ratioForward P/E ratio• Gross profit marginGross profit margin• Inventory turnoverInventory turnover• Invested capitalInvested capital


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Important Chapter Terms …Important Chapter Terms …

• Leverage ratioLeverage ratio• LiquidityLiquidity• Market-to-book ratioMarket-to-book ratio• Net operating income (NOI)Net operating income (NOI)• Net profit marginNet profit margin• Off-balance-sheet liabilitiesOff-balance-sheet liabilities• Operating marginOperating margin• Percentage of sales Percentage of sales

methodmethod• Price-earnings (P/E) ratioPrice-earnings (P/E) ratio• Productivity ratios Productivity ratios • Quick ratioQuick ratio

• Receivables turnoverReceivables turnover• Retention (plowback) ratioRetention (plowback) ratio• Return on assets (ROA)Return on assets (ROA)• Return on equity (ROE)Return on equity (ROE)• Spontaneous liabilitiesSpontaneous liabilities• Stock ratiosStock ratios• Sustainable growth rateSustainable growth rate• Times interest earnedTimes interest earned• Total enterprise valueTotal enterprise value• Turnover ratioTurnover ratio• Working capitalWorking capital• Working capital ratioWorking capital ratio

Consistent Financial AnalysisConsistent Financial Analysis

Financial Statement Analysis and Financial Statement Analysis and ForecastingForecasting


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Consistent Financial AnalysisConsistent Financial Analysis

• Your text describes the importance Your text describes the importance of consistent financial analysis of consistent financial analysis across companies, across across companies, across industries, across countriesindustries, across countries

• Morgan Stanley’s ModelWare is a Morgan Stanley’s ModelWare is a start on this.start on this.

• It is up to you, the analyst, to It is up to you, the analyst, to understand the challenges to understand the challenges to comparability and you must comparability and you must attempt to ascertain the financial attempt to ascertain the financial health of the organizations you health of the organizations you study, understanding the study, understanding the limitations inherent in financial limitations inherent in financial accounting practice. accounting practice.


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Consistent Financial AnalysisConsistent Financial AnalysisIntra-Company ComparisonsIntra-Company Comparisons

• GAAP provides considerable latitude for the company.GAAP provides considerable latitude for the company.• Once a firm chooses an acceptable accounting treatment Once a firm chooses an acceptable accounting treatment

for:for:– Revenue recognitionRevenue recognition– Capitalization of expensesCapitalization of expenses– Inventory valuation, etc.Inventory valuation, etc.

then the firm must use these same provisions year after then the firm must use these same provisions year after year.year.

• Any change in accounting principles must be noted in the Any change in accounting principles must be noted in the financial statements and prior years restated to ensure financial statements and prior years restated to ensure there is a common basis of comparison to the present.there is a common basis of comparison to the present.

• Therefore internal comparisons, year over year, are Therefore internal comparisons, year over year, are possible and supported by GAAP.possible and supported by GAAP.


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Consistent Financial AnalysisConsistent Financial AnalysisInter-Company ComparisonsInter-Company Comparisons

• Making comparisons between companies, Making comparisons between companies, even in the same industry are much more even in the same industry are much more difficult because:difficult because:– Widely divergence accounting treatment under GAAPWidely divergence accounting treatment under GAAP– Historical cost-based accounting can seriously affect Historical cost-based accounting can seriously affect

efficiency, leverage and profitability ratios.efficiency, leverage and profitability ratios.


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Analysis of Financial StatementsAnalysis of Financial Statements

• Study the absolute numbers, and the Study the absolute numbers, and the comparative statements for the company to:comparative statements for the company to:– Ascertain trends in the balance sheet, income Ascertain trends in the balance sheet, income

statement and statement of cash flowsstatement and statement of cash flows– Ascertain areas of concernAscertain areas of concern– Ascertain areas of strengthAscertain areas of strength

• Complement your study of the absolute Complement your study of the absolute numbers by using ratios again to:numbers by using ratios again to:– Ascertain trendsAscertain trends– Identify areas of concernIdentify areas of concern– Identify areas of strengthIdentify areas of strength

The DuPont SystemThe DuPont System



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A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE) and DuPont SystemReturn on Equity (ROE) and DuPont System

• The DuPont System gives a framework for the The DuPont System gives a framework for the analysis of financial statements through the analysis of financial statements through the decomposition of the Return on Equity ratiodecomposition of the Return on Equity ratio

(See Figure 4 -2 that illustrates the constituent parts of ROE )(See Figure 4 -2 that illustrates the constituent parts of ROE )

Equity rs'Shareholde

IncomeNet Equity on Return

SE

NIROE

[4-1]


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Framework for Financial AnalysisFramework for Financial AnalysisDu Pont SystemDu Pont System

TA

Sales

Sales

NI

TA

NIROA

4 - 2 FIGURE

GOOD OR BAD?

LEVERAGE RATIOS

EFFICIENCY RATIOS

PRODUCTIVITY RATIOS

ROE

SE

TA


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A Framework for Financial AnalysisA Framework for Financial AnalysisDuPont System and Decomposition of ROEDuPont System and Decomposition of ROE

• As Figure 4 – 2 illustrates, ROE is a function of:As Figure 4 – 2 illustrates, ROE is a function of:– Corporate use of leverage (use of debt)Corporate use of leverage (use of debt)

– Efficiency ratios (ability of the firm to control costs in relationship to Efficiency ratios (ability of the firm to control costs in relationship to sales)sales)

– Productivity ratios (the degree to which the firm can generate sales in Productivity ratios (the degree to which the firm can generate sales in relationship to assets employed)relationship to assets employed)



SE

NIROE

[4-1]


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A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE) and DuPont SystemReturn on Equity (ROE) and DuPont System

• ROE is not a pure ratio because it involves dividing an income ROE is not a pure ratio because it involves dividing an income statement item (flow) by a balance sheet (stock) item.statement item (flow) by a balance sheet (stock) item.

• Instead of using ending SE, many argue you should use Instead of using ending SE, many argue you should use average SE (beginning SE plus ending SE divided by 2) average SE (beginning SE plus ending SE divided by 2) because SE changes over the year as income is earned and because SE changes over the year as income is earned and retained earnings grow.retained earnings grow.



SE

NIROE

[4-1]


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A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE)Return on Equity (ROE)

SE

TA

TA

Sales

Sales

NI

SE

NIROE

[4- 7]

ROA

Leverage

ROE when decomposed shows that it is a function of the return earned on assets and of the leverage used by the firm.


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A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Total AssetsReturn on Total Assets

• ROA shows the ratio of income to assets that ROA shows the ratio of income to assets that have been used to produce them.have been used to produce them.

• ROA can be further decomposed as shown ROA can be further decomposed as shown and the following slideand the following slide

Assets Total

IncomeNet Assetson Return

TA

NIROA

[4-2]


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A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Assets (ROA)Return on Assets (ROA)

• ROA is the product of the net profit margin ROA is the product of the net profit margin and the sales to total asset ratio:and the sales to total asset ratio:

• The sales cancel and we are left with NI / TAThe sales cancel and we are left with NI / TA

TA

Sales

Sales

NI

TA

NIROA [4- 6]


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A Framework for Financial AnalysisA Framework for Financial AnalysisLeverage RatioLeverage Ratio

• If ROA is multiplied by TA and divided by SE, the TA’s If ROA is multiplied by TA and divided by SE, the TA’s cancel out and produces ROE.cancel out and produces ROE.

• TA / SE is the leverage ratioTA / SE is the leverage ratio

• It measures how many dollars of total assets are It measures how many dollars of total assets are supported by each dollar of Shareholders Equity.supported by each dollar of Shareholders Equity.


Assets Total Leverage

Leverage

SE

TA

[4-3]


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DuPont SystemDuPont System

• The DuPont system provides a good starting point for The DuPont system provides a good starting point for any financial analysisany financial analysis– It shows that financial strength comes from many sources It shows that financial strength comes from many sources

(profitability, asset utilization, leverage)(profitability, asset utilization, leverage)– It reinforces the concept that good financial analysis requires It reinforces the concept that good financial analysis requires

looking at each ratio in the context of the otherlooking at each ratio in the context of the other– Whenever you are presented with financial statements it is Whenever you are presented with financial statements it is

important that you look at a sample of ratios from each major important that you look at a sample of ratios from each major category to identify areas of strength and weaknesscategory to identify areas of strength and weakness

(Table 4 -1 illustrates E-Trade Canada’s ROE analysis of Rothmans)(Table 4 -1 illustrates E-Trade Canada’s ROE analysis of Rothmans)


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A Framework for Financial AnalysisA Framework for Financial AnalysisReturn on Equity (ROE) and the DuPont SystemReturn on Equity (ROE) and the DuPont System

Return on Equity 3/31/2006 3/31/2005 3/31/2004 3/31/2003(1) Net Sales 652,271 636,771 620,104 575,469(2) Pretax Income 274,829 261,345 252,683 240,197(3) Net Income 99,464 92,997 90,277 86,678(4) Total assets 449,075 528,528 496,757 429,965(5) Shareholders' equity 113,860 193,708 168,497 130,537Pretax margin % (2/1) 42.13% 41.04% 40.75% 41.74%× Tax retent % (3/2) 36.19% 35.58% 35.73% 36.09%=profit margin % (3/1) 15.25% 14.60% 14.56% 15.06%× Asset Utilization % (1/4) 145.25% 120.48% 124.83% 133.84%= ROA % (3/4) 22.15% 17.60% 18.17% 20.16%× Leverage % (4/5) 394.41% 272.85% 294.82% 329.38%=ROE % (3/5) 87.36% 48.01% 53.58% 66.40%

Source: Data from E-Trade Canada

Table 4-1 E-Trade Canada's Rothman's Dupont ROE Analysis


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Interpreting RatiosInterpreting Ratios

• A ratio is just one number over another A ratio is just one number over another number – by itself, there is little ‘information’number – by itself, there is little ‘information’

• To judge whether a ratio is ‘good’ or ‘bad’ To judge whether a ratio is ‘good’ or ‘bad’ requires that it be compared to something requires that it be compared to something else such as:else such as:– The company’s own ratios over time to ascertain The company’s own ratios over time to ascertain

trendstrends– Other comparable companies or industry averagesOther comparable companies or industry averages

(Table 4 -2 illustrates Rothmans DuPont ratios over time)(Table 4 -2 illustrates Rothmans DuPont ratios over time)


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A Framework for Financial AnalysisA Framework for Financial AnalysisInterpreting RatiosInterpreting Ratios

Rothmans (March 31)

2004 2005 2006

ROE 0.5358 0.4801 0.8736ROA 0.1817 0.1760 0.2215Net profit margin 0.1456 0.1460 0.1525Turnover 1.2483 1.2048 1.4525Leverage 2.9482 2.7285 3.9441

Table 4-2 Rothman's Dupont Ratios

Do you see trends here?

What factors are driving the trend in ROE?


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A Framework for Financial AnalysisA Framework for Financial AnalysisInterpreting RatiosInterpreting Ratios

Altria (December 31)

2003 2004 2005

ROE 0.3670 0.3066 0.2922ROA 0.0957 0.0926 0.0967Net profit margin 0.1132 0.1051 0.1066Turnover 0.8455 0.8816 0.9065Leverage 3.8352 3.3095 3.0232

Table 4-3 Altria's Dupont Ratios

Do you see trends here?

What factors are driving the trend in ROE?

How do these results compare to Rothmans on the previous slide?

Leverage RatiosLeverage Ratios



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LeverageLeverage

• Leverage = magnificationLeverage = magnification• Financial leverage occurs when a firm uses Financial leverage occurs when a firm uses

sources of financing that carry a fixed cost sources of financing that carry a fixed cost (such as long-term debt), and uses this to (such as long-term debt), and uses this to generate greater returns that result in generate greater returns that result in magnified returns to shareholders.magnified returns to shareholders.

• Leverage means magnification of either Leverage means magnification of either profits or losses.profits or losses.


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Leverage RatiosLeverage Ratios

• Include:Include:– Debt ratioDebt ratio– Debt to equity ratioDebt to equity ratio– Times interest earned ratioTimes interest earned ratio– Cash flow to debt ratioCash flow to debt ratio


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Leverage RatiosLeverage RatiosDebt RatioDebt Ratio

• Is a stock ratio indicating the proportion of Is a stock ratio indicating the proportion of total assets financed by debt at a particular total assets financed by debt at a particular point in time (the balance sheet date)point in time (the balance sheet date)

Assets Total

sLiabilitie Total ratioDebt TA

TL[4- 8]


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Leverage RatiosLeverage RatiosDebt-Equity RatioDebt-Equity Ratio

• Is a stock ratio indicating the proportion that Is a stock ratio indicating the proportion that total debt represents in relationship to the total debt represents in relationship to the shareholders equity (common stock and shareholders equity (common stock and retained earnings) at the balance sheet date.retained earnings) at the balance sheet date.


Debt Total ratioy Debt/Equit SE

D[4- 9]


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Leverage RatiosLeverage RatiosTimes Interest Earned (TIE)Times Interest Earned (TIE)

• Is an income statement (flow) ratio indicating Is an income statement (flow) ratio indicating the number of times the firm’s pre-tax income the number of times the firm’s pre-tax income exceeds its fixed financial obligations to its exceeds its fixed financial obligations to its lenders (debt holders)lenders (debt holders)

ExpenseInterest

Taxes andInterest Before Earnings

EarnedInterest Times

TIE

I

EBIT

[4- 10]


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Leverage RatiosLeverage RatiosCash Flow to Debt RatioCash Flow to Debt Ratio

• Measures how long it would take to payoff a Measures how long it would take to payoff a firm’s debt (D)firm’s debt (D)

Debt Total

Operations from FlowCash /

ratiodebt toflowCash

DCF

D

CFO

[4- 11]


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Leverage RatiosLeverage RatiosCash Flow to Debt RatioCash Flow to Debt Ratio

2004 2005 2006 2003 2004 2005

Leverage 2.9482 2.7285 3.9441 3.8352 3.3095 3.0232Debt ratio 0.6608 0.6335 0.7465 0.7393 0.6978 0.6692D/E ratio 0.8902 0.7729 1.3152 0.9785 0.7482 0.6703TIE 46.7842 36.1270 42.7356 13.7035 12.9082 14.3405Cash flow to debt 1.5037 1.0823 1.2235 0.4408 0.4739 0.4621

Table 4-4 Leverage Ratios

Rothmans (March 31) Altria (December 31)

Which firm exhibits greater use of leverage?

Which exhibits greater capacity to take on and service debt?

Efficiency RatiosEfficiency Ratios



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Efficiency ratios measure how efficiently a Efficiency ratios measure how efficiently a dollar of sales is turned into profits.dollar of sales is turned into profits.

• Gives insight to the firm’s cost structure Gives insight to the firm’s cost structure • Whether problems exist with variable costs or fixed costs Whether problems exist with variable costs or fixed costs

(overhead) or both(overhead) or both


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• Include:Include:– Degree of total leverageDegree of total leverage– Break-even pointBreak-even point– Gross profit marginGross profit margin– Operating marginOperating margin


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Efficiency RatiosEfficiency RatiosInterpreting RatiosInterpreting Ratios

Sales 120 132 108Contribution margin (40%) 48 53 43Fixed cost 31 51 31Interest 5 5 5Tax 6 8.5 3.5Net income 6 8.5 3.5

Net profit margin 5.0% 6.4% 3.2%

Table 4-5 Profit Margin and Sales Variability

The focus of efficiency ratios is with the income statement. This example demonstrates the leverage effect of using fixed costs in lieu of variable costs in the cost structure.

Sales varied by +/- of 10% yet profits varied by +/- 40%.


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Efficiency RatiosEfficiency RatiosDegree of Total Leverage RatioDegree of Total Leverage Ratio

• An income statement ratio that measures the An income statement ratio that measures the exposure of profits to changes in sales.exposure of profits to changes in sales.

• The greater the DTL, the greater leverage The greater the DTL, the greater leverage effect.effect.

Taxes Before Earnings

Marginon Contributi

Leverage Total of Degree

DTL

EBT

CM

[4- 12]


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Efficiency RatiosEfficiency RatiosBreak Even PointBreak Even Point

• Estimates the volume of units that must be produced Estimates the volume of units that must be produced and sold in order for the firm to cover all costs both and sold in order for the firm to cover all costs both fixed and variable.fixed and variable.

• The break even point tends to increase as the use of The break even point tends to increase as the use of fixed costs increases.fixed costs increases.

Marginon Contributi

Costs Fixed

Point Even Break

BEP

CM

FC

[4- 13]


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Efficiency RatiosEfficiency RatiosGross Profit MarginGross Profit Margin

• Demonstrates the percentage of sales that are Demonstrates the percentage of sales that are available to cover fixed (period) costs and financing available to cover fixed (period) costs and financing expenses after variable costs have been paid.expenses after variable costs have been paid.

• A declining gross profit margin raises concerns about A declining gross profit margin raises concerns about the firm’s ability to control variable costs such as the firm’s ability to control variable costs such as direct materials and direct labour.direct materials and direct labour.

Sales

Sold Goods ofCost -Sales

Margin Profit Gross

GPM

S

CGSS

[4- 14]


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Efficiency RatiosEfficiency RatiosOperating MarginOperating Margin

• Operating margin measures the cumulative Operating margin measures the cumulative effect of both variable and period costs on the effect of both variable and period costs on the ability of the firm to turn sales into operating ability of the firm to turn sales into operating profits to cover, interest, taxes, depreciation profits to cover, interest, taxes, depreciation and amortization (EBITDA).and amortization (EBITDA).

Sales

Income OperatingNet

Margin Operating

OM

Sales

NOI

[4- 15]


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Efficiency RatiosEfficiency RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Net profit margin 0.1456 0.1460 0.1525 0.1132 0.1051 0.1066Gross profit margin 0.4261 0.4305 0.4426 0.3519 0.3348 0.3286Operating margin 0.4102 0.4155 0.4263 0.1938 0.1867 0.1696

Table 4-6 Efficiency Ratios


Which firm is able to produce a greater percentage of sales as profits?

Which firm is able to produce strong and consistent profitability?

Productivity RatiosProductivity Ratios



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• Measure the ability of the firm to generate Measure the ability of the firm to generate sales from the assets that it employs.sales from the assets that it employs.

• Excessive investment in assets with little or Excessive investment in assets with little or no increase in sales reduces the rate of return no increase in sales reduces the rate of return on both assets and equity (ROA) and (ROE)on both assets and equity (ROA) and (ROE)


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• Include:Include:– Receivables turnoverReceivables turnover– Average collection period (ACP)Average collection period (ACP)– Inventory turnoverInventory turnover– Average days sales in inventory (ADSI)Average days sales in inventory (ADSI)– Fixed asset turnoverFixed asset turnover


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Productivity RatiosProductivity RatiosReceivables TurnoverReceivables Turnover

• Measures the sales generated by every dollar Measures the sales generated by every dollar of receivables.of receivables.

Receivable Accounts

Sales

turnover sReceivable

RT

AR

S

[4- 16]


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Productivity RatiosProductivity RatiosAverage Collection PeriodAverage Collection Period

• Estimates the number of days it takes a firm to collect Estimates the number of days it takes a firm to collect on its accounts receivable.on its accounts receivable.

• If ACP is 40 days, and the firm’s credit policy is net 30, If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen quality of the firm’s customers, and what might happen if economic conditions deteriorate.if economic conditions deteriorate.

turnoversReceivable

AR

Turnover sReceivable

365 Period Collection Average

ACP

ADS

AR

[4- 17]


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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover

• Estimates the number of times, ending inventory was Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.‘turned over’ (sold) in the year.

• A ratio that involves both ‘stock’ and ‘flow’ valuesA ratio that involves both ‘stock’ and ‘flow’ values• Is strongly a function of ending inventory value…Is strongly a function of ending inventory value…

managers often try to improve this ratio as they managers often try to improve this ratio as they approach year end through inventory reduction approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, strategies (cash and carry sales/inventory clearance, etc.) etc.)

Turnover Inventory INV

CGS

[4- 18]


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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover

• When Cost of Goods Sold is not available, it may be When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.necessary to estimate inventory turnover using sales.

• Use of the sales figure is less valid than Cost of Goods Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on inventoried cost, but Sales includes a profit margin on top of inventoried cost.top of inventoried cost.

Turnover Inventory INV

Sales

[4- 19]


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Productivity RatiosProductivity RatiosAverage Days Sales in Inventory (ADSI)Average Days Sales in Inventory (ADSI)

• Estimates the number of days of sales tied up Estimates the number of days of sales tied up in inventory (based on ending inventory in inventory (based on ending inventory values)values)

turnoverInventory

ADS

INV

365

(ADSI)inventory in sales days Average

[4- 20]


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Productivity RatiosProductivity RatiosFixed Asset TurnoverFixed Asset Turnover

• Estimates the number of dollars of sales Estimates the number of dollars of sales produced by each dollar of net fixed assets.produced by each dollar of net fixed assets.

AssetsFixedNet

SalesNFA

S

Turnover Asset Fixed [4- 21]


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Productivity RatiosProductivity RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Turnover 1.2483 1.2048 1.4525 0.8455 0.8816 0.9065Receivables turnover 19.3825 19.8254 55.3006 NA 15.5735 18.2529ACP 18.8314 18.4108 6.6003 NA 23.4372 19.9968Inventory turnover (using sales) 3.1170 3.0349 3.1597 8.5241 8.9244 9.2455ADSI 117.0988 120.2692 115.5165 42.8197 40.8991 39.4788Fixed asset turnover 11.0158 9.2087 8.5490 5.0613 5.4959 5.8673

Table 4-7 Productivity Ratios


Which firm has been improving its efficiency ratios to a greater degree?

Liquidity RatiosLiquidity Ratios



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Liquidity RatiosLiquidity Ratios

• Measure the ability of the firm to meet its Measure the ability of the firm to meet its maturing financial obligations through liquid maturing financial obligations through liquid (cash and near cash) resources(cash and near cash) resources

• Include:Include:– Working capital ratioWorking capital ratio– Current ratioCurrent ratio– Quick (acid-test) ratioQuick (acid-test) ratio


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Liquidity RatiosLiquidity RatiosWorking Capital RatioWorking Capital Ratio

• Measures the percentage of total assets that Measures the percentage of total assets that is invested in current assets.is invested in current assets.

• Helps to analyze capital intensity as well as Helps to analyze capital intensity as well as corporate liquidity.corporate liquidity.

AssetsTotal

AssetsCurrentTA

CA

Ratio Capital Working[4- 22]


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Liquidity RatiosLiquidity RatiosCurrent RatioCurrent Ratio

• Measures the number of dollars of current Measures the number of dollars of current assets for each dollar of current liabilities.assets for each dollar of current liabilities.

• Helps to estimate the capacity of the firm to Helps to estimate the capacity of the firm to meet its maturing financial obligations.meet its maturing financial obligations.

RatioCurrent

sLiabilitieCurrent

AssetsCurrentCL

CA

[4- 23]


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Liquidity RatiosLiquidity RatiosQuick RatioQuick Ratio

• Recognizing that inventories may be less liquid than Recognizing that inventories may be less liquid than other current assets, and in some cases, when other current assets, and in some cases, when liquidated quickly result in cash flows that are less liquidated quickly result in cash flows that are less than book value, the quick ratio gives a clearer than book value, the quick ratio gives a clearer indication of the firm’s ability to meet its maturing indication of the firm’s ability to meet its maturing financial obligations out of current, liquid assets.financial obligations out of current, liquid assets.

RatioQuick

sLiabilitieCurrent

sInventorieAssetsCurrentCL

ARMSC

[4- 24]


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Liquidity RatiosLiquidity RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Current ratio 2.8868 2.9310 2.4756 NA 1.0987 0.9856Quick ratio 1.4981 1.5092 1.0037 NA 0.4877 0.4442Working capital ratio 0.8414 0.8235 0.7800 NA 0.2548 0.2388

Table 4-8 Liquidity Ratios


Which firm has greater liquidity and capacity to meet its financial obligations?


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Estimating Net Liquidation Value per Estimating Net Liquidation Value per ShareShare

• When a firm becomes financially-strained and its When a firm becomes financially-strained and its ability to remain a ‘going concern’ is open to ability to remain a ‘going concern’ is open to question, market values and book values question, market values and book values (accounting) become less valid.(accounting) become less valid.

• As net liquidation value per share begins to As net liquidation value per share begins to influence share price values in the market place influence share price values in the market place you will see share price fall and dividend discount you will see share price fall and dividend discount models for share valuation won’t explain the models for share valuation won’t explain the observable market price.observable market price.


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Estimating Net Liquidation ValueEstimating Net Liquidation ValueNet Liquidation Value Per ShareNet Liquidation Value Per Share

• Net liquidation value per share is always much Net liquidation value per share is always much less than market value per share of a going less than market value per share of a going concern because assets of the company cannot concern because assets of the company cannot usually be converted into an equal amount of usually be converted into an equal amount of cash as the amount stated on the balance sheetcash as the amount stated on the balance sheet – Liquidation takes time and physical deterioration of assets will occur before they Liquidation takes time and physical deterioration of assets will occur before they

can be soldcan be sold– Selling assets costs money – these transactions costs include payments to Selling assets costs money – these transactions costs include payments to

trustees/liquidatorstrustees/liquidators– The market value of many corporate assets such as inventory, plant and The market value of many corporate assets such as inventory, plant and

equipment is usually significantly less than book value because of the liquidators equipment is usually significantly less than book value because of the liquidators need to liquidate quickly, usually at a time in the economic cycle when the need to liquidate quickly, usually at a time in the economic cycle when the economy is not healthyeconomy is not healthy

– Buyers (often called vulture firms) understand the urgency/need to liquidate and Buyers (often called vulture firms) understand the urgency/need to liquidate and they bid very low prices in the hope of obtaining assets at ‘fire-sale’ pricesthey bid very low prices in the hope of obtaining assets at ‘fire-sale’ prices

– Liquidation of corporations involve the courts, court-appointed trustees and there Liquidation of corporations involve the courts, court-appointed trustees and there are costs associated with these processes that reduce the net realizable value of are costs associated with these processes that reduce the net realizable value of the assets.the assets.


4 - 61

Estimating Net Liquidation ValueEstimating Net Liquidation ValueInterpreting RatiosInterpreting Ratios

• Net liquidation values can be estimated by discounting Net liquidation values can be estimated by discounting asset values based on their degree of liquidity, then asset values based on their degree of liquidity, then subtracting the liabilities of the firm to estimate what subtracting the liabilities of the firm to estimate what residual value might be left.residual value might be left.

• The process of estimating net liquidation value is as follows:The process of estimating net liquidation value is as follows:

– Liquid assets are valued close to or the same as book valueLiquid assets are valued close to or the same as book value– Illiquid assets are discounted from book value based on the degree of Illiquid assets are discounted from book value based on the degree of

illiquidityilliquidity– Liabilities are stated in nominal terms because it takes those dollars to Liabilities are stated in nominal terms because it takes those dollars to

satisfy debt obligationssatisfy debt obligations– Preferred stock value is based on residual values (if there is any Preferred stock value is based on residual values (if there is any

estimated residual value following the discounting of assets process)estimated residual value following the discounting of assets process)

(Table 4 – 9 is an example of E-Trade Canada’s Risk Ratings for Rothmans)(Table 4 – 9 is an example of E-Trade Canada’s Risk Ratings for Rothmans)


4 - 62

Estimating Net Liquidation ValueEstimating Net Liquidation ValueInterpreting RatiosInterpreting Ratios

Growth Rates 2006 2005 2004 2003

Net ROA % 22.15% 17.60% 18.17% 20.16%Long-term debt growth (YTY %) 3.00% -0.19% 0.00% N/AAsset growth (YTY %) -15.03% 6.40% 15.53% N/AComponents of Net Liquidated ValueCash @ 100% 130,231 191,995 184,907 113,270Marketable securities @ 98% N/A N/A N/A N/AReceivables @ 90% 10,616 28,907 28,794 75,373Other current assets @ 80% 1,468 1,058 1,698 2,027Inventory @ 50% 103,217 104,910 99,471 76,767Net plant @ 25% 19,075 17,287 14,073 13,654Total Liquid Assets 264,607 344,157 328,943 281,091Current liabilities (100%) 141,496 148,498 144,786 110,964Long-term debt (100%) 149,751 149,708 150,000 150,000Other liabilities (100%) 10,761 0 0 0Net of Liabilities = net liquidation value -37,401 45,951 34,157 20,127Average shares 67,745 67,492 33,610 33,299Net Liquidation Value per Share ($0.55) $0.68 $1.02 $0.60

Source: Data from E-Trade Canada.

Table 4-9 E-Trade Canada's Risk Ratings

Valuation RatiosValuation Ratios



4 - 64

Valuation RatiosValuation Ratios

• Used to assess how the market is valuing the Used to assess how the market is valuing the firm (share price) in relationship to assets and firm (share price) in relationship to assets and current earnings, profits and dividendscurrent earnings, profits and dividends

• Include:Include:– Equity book value per share (BVPS)Equity book value per share (BVPS)– Dividend yieldDividend yield– Dividend payoutDividend payout– Price-earnings (P/E) ratioPrice-earnings (P/E) ratio– Forward (P/E) ratio Forward (P/E) ratio – Market-to-book (M/B) ratioMarket-to-book (M/B) ratio– EBITDA multipleEBITDA multiple


4 - 65

Valuation RatiosValuation RatiosInterpreting Ratios – Book Value per ShareInterpreting Ratios – Book Value per Share

• Expresses shareholders’ equity on a per share Expresses shareholders’ equity on a per share basis.basis.

Shares ofNumber

Equity rs'Shareholde SharePer ValueBook [4- 25]


4 - 66

Valuation RatiosValuation RatiosInterpreting Ratios – Dividend YieldInterpreting Ratios – Dividend Yield

• Expresses dividend payout as a percentage of Expresses dividend payout as a percentage of the current share price.the current share price.

• Can be compared to other investment Can be compared to other investment instruments such bonds (current yield) or with instruments such bonds (current yield) or with other dividend-paying companies.other dividend-paying companies.

Shareper Price

SharePer Dividend Yield Dividend

P

DPS [4- 26]


4 - 67

Valuation RatiosValuation RatiosInterpreting Ratios – Dividend Payout RatioInterpreting Ratios – Dividend Payout Ratio

• Expresses dividends as a percentage of Expresses dividends as a percentage of earnings on a per share basis.earnings on a per share basis.

Shareper Earnings

SharePer Dividend Payout Dividend

EPS

DPS [4- 27]


4 - 68

Valuation RatiosValuation RatiosInterpreting Ratios – Trailing P/E RatioInterpreting Ratios – Trailing P/E Ratio

• Earnings multiple based on the most recent earnings.Earnings multiple based on the most recent earnings.• Often used in estimating the value of a stock.Often used in estimating the value of a stock.

• A stock trading at a P/E multiple of 10 will take ten A stock trading at a P/E multiple of 10 will take ten years at current earnings to recover the price of the years at current earnings to recover the price of the stock.stock.

• A stock trading at a P/E multiple of 100 will take 100 A stock trading at a P/E multiple of 100 will take 100 years at current annual earnings to recover the price of years at current annual earnings to recover the price of the stock.the stock.

Shareper Earnings

Price Share ratio earnings-Price

EPS

P [4- 28]


4 - 69

Valuation RatiosValuation RatiosInterpreting Ratios – Forward P/E RatioInterpreting Ratios – Forward P/E Ratio

• Earnings multiple based on forecast earnings per share.Earnings multiple based on forecast earnings per share.• Often used in estimating the value of a stock especially Often used in estimating the value of a stock especially

with companies with rapid growth in earnings per with companies with rapid growth in earnings per share.share.

• Low P/E shares are regarded as Low P/E shares are regarded as value stocksvalue stocks• High P/E shares are regarded as High P/E shares are regarded as growth stocksgrowth stocks

Shareper Earnings Estimated

Price Share ratio earnings-Price Forward

EEPS

P [4- 29]


4 - 70

Valuation RatiosValuation RatiosInterpreting Ratios – Market to Book RatioInterpreting Ratios – Market to Book Ratio

• Estimates the dollars of Share Price per dollar of book Estimates the dollars of Share Price per dollar of book value per share.value per share.

• Given historical cost accounting as the basis for book Given historical cost accounting as the basis for book value per share, the degree to which market value per value per share, the degree to which market value per share exceeds BVPS indicates the value that has been share exceeds BVPS indicates the value that has been added to the company by management.added to the company by management.

Shareper ValueBook

Price Share ratiobook -to-Market

BVPS

P [4- 30]


4 - 71

Valuation RatiosValuation RatiosInterpreting Ratios – EBITDA MultipleInterpreting Ratios – EBITDA Multiple

• Total enterprise value is an estimate of the total Total enterprise value is an estimate of the total market value of the firm (market value of equity plus market value of the firm (market value of equity plus market value of debt)market value of debt)

• EBITDA multiple expresses total enterprise value for EBITDA multiple expresses total enterprise value for each dollar of operating income (EBITDA)each dollar of operating income (EBITDA)

EBITDA

TEV

onamortizati andon depreciati taxes,interest, before Earnings

Value Enterprise Total multipleEBITDA


4 - 72

Valuation RatiosValuation RatiosInterpreting RatiosInterpreting Ratios

2004 2005 2006 2003 2004 2005

Dividend yield 0.0474 0.0438 0.1333 0.0485 0.0462 0.0410Dividend payout 0.6063 0.7664 1.8621 0.5841 0.6184 0.6132P/E 12.7799 17.5109 13.9655 12.0398 13.3991 14.9739M/B 6.8451 8.3685 12.0682 4.4208 4.0979 4.6319EBITDA multiple 4.8535 6.3545 5.2095 7.8436 8.8194 9.7774Dividend yield (excl. special dividend) N/A N/A 0.0593 N/A N/A N/ADividend payout (excl. special dividend) N/A N/A 0.8276 N/A N/A N/A

Table 4-10 Value Ratios


Can you draw any conclusions for the comparative valuation ratio data summarized in this table?

Financial ForecastingFinancial Forecasting



4 - 74

Financial ForecastingFinancial ForecastingPurposePurpose

Financial managers must produce Financial managers must produce forecasts for the financial results of forecasts for the financial results of corporate plans to:corporate plans to:– Determine whether the corporate plans will require Determine whether the corporate plans will require

additional external financing additional external financing – Determine whether the corporate plans will produce Determine whether the corporate plans will produce

surplus cash resources that could be distributed to surplus cash resources that could be distributed to shareholders as dividendsshareholders as dividends

– Assess the financial forecasts to determine the financial Assess the financial forecasts to determine the financial feasibility of corporate plans – if poor financial results are feasibility of corporate plans – if poor financial results are forecast, this gives management the opportunity to forecast, this gives management the opportunity to reexamine and amend corporate plans to produce better reexamine and amend corporate plans to produce better results before resources and people are committed.results before resources and people are committed.


4 - 75

Financial ForecastingFinancial Forecasting

The basis for all financial forecasts is the sales The basis for all financial forecasts is the sales forecast.forecast.

The most recent balance sheet values are the starting The most recent balance sheet values are the starting point.point.

Pro forma (forecast) balance sheets are projected Pro forma (forecast) balance sheets are projected assuming some relationship with projected sales assuming some relationship with projected sales (constant percentage of sales)(constant percentage of sales)

Current liabilities are usually assumed to rise and fall Current liabilities are usually assumed to rise and fall in a constant percentage with sales – we call them in a constant percentage with sales – we call them ‘‘spontaneous liabilitiesspontaneous liabilities’ because they change without ’ because they change without negotiation with creditors.negotiation with creditors.


4 - 76

Financial ForecastingFinancial ForecastingThe Percentage of Sales MethodThe Percentage of Sales Method

The percentage of sales method involves The percentage of sales method involves the following steps:the following steps:

1.1. Determine which financial policy variables you are Determine which financial policy variables you are interested ininterested in

2.2. Set all the non-financial policy variables as a Set all the non-financial policy variables as a percentage of salespercentage of sales

3.3. Extrapolate the balance sheet based on a percentage Extrapolate the balance sheet based on a percentage of salesof sales

4.4. Estimate future retained earningsEstimate future retained earnings5.5. Modify and re-iterate until the forecast makes sense.Modify and re-iterate until the forecast makes sense.

This process most often results in a balance sheet that This process most often results in a balance sheet that does not balance – a ‘plug’ (balancing) amount is the does not balance – a ‘plug’ (balancing) amount is the external funds required (or surplus funds forecast)external funds required (or surplus funds forecast)


4 - 77


Cash 5 Accruals 5Securities 10 Payables 5Receivables 10 Bank debt 20Inventory 25Current assets 50 Current liabilities 30Net fixed assets 100 Long-term debt 40

Common equity 80

Total assets 150 Total Liabilities 150

Table 4-11 Balance Sheet

The historical balance sheet.

If sales increase,

assets used to produce

those sales must grow.

Spontaneous liabilities

Policy variables requiring decision.


4 - 78


%Sales 120 100.0% 132 145 160

Cash 5 4.2% 5.5 6.0 6.7Securities 10 8.3% 11.0 12.1 13.3Receivables 10 8.3% 11.0 12.1 13.3Inventory 25 20.8% 27.5 30.2 33.3Net fixed assets 100 83.3% 110.0 120.8 133.3Total assets 150 125.0% 165.0 181.3 200.0

Accruals 5 4.2% 5.5 6.0 6.7Payables 5 4.2% 5.5 6.0 6.7Short-term debt 20 16.7% 20.0 20.0 20.0Long-term debt 40 33.3% 40.0 40.0 40.0Equity 80 66.7% 80.0 80.0 80.0Total liabilities and equity 150 125.0% 151.0 152.1 153.3

Cumulative (EFR) 14.0 29.2 46.7

Table 4-12 Initial Forecast

percentages of sales

Sales projections

and the base case

of $120

Balance Sheet Values

calculated as a

percentage of sales.

Naïve increases in balance

sheet accounts in

same proportion

to projected sales

Accounts requiring decision

are assumed to

remain constant on first pass.

First pass funding shortfall

projected.


4 - 79

Percentage of Sale MethodPercentage of Sale MethodImproving the Pro Forma Balance SheetImproving the Pro Forma Balance Sheet

• The prior pro form balance sheet was The prior pro form balance sheet was developed using very naïve assumptions:developed using very naïve assumptions:– Policy variables held constantPolicy variables held constant– Asset growth in all accounts held at the same Asset growth in all accounts held at the same

percentage of salespercentage of sales– Spontaneous liabilities increased at a constant Spontaneous liabilities increased at a constant

percentage of sales.percentage of sales.

• One improvement is to realize that the firm’s One improvement is to realize that the firm’s equity will grow by the amount of retained equity will grow by the amount of retained earnings.earnings.

(See the following income statement)(See the following income statement)


4 - 80


Sales 120Gross operating profit 48Fixed costs 31EBIT 17Interest 5Taxes @ 50% 6Net Income 6

Dividends 3

Table 4-13 Income Statement

Retained earnings = net income less dividends.

Assuming the firm holds this

percentage constant we can project increases in equity on the

balance sheet as 50% of the 5% profit margin or 2.5% of sales.


4 - 81


%Sales 120 100.0% 132 145 160



Cumulative (EFR) 10.7 22.3 35.8

Table 4-14 First Revision of Forecast Equity accounts increased

by projected retained earnings

that increase in proportion to sales.

Notice how the

retained earnings

has reduced

the projected External Funds

Required.


4 - 82

Percentage of Sale MethodPercentage of Sale MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

• Further improvements to the pro forma balance sheet Further improvements to the pro forma balance sheet include:include:– Recognizing that cash balances may not have to rise as a pure Recognizing that cash balances may not have to rise as a pure

constant percentage of salesconstant percentage of sales• Cash balances are required for a variety of reasonsCash balances are required for a variety of reasons

– To support transactionTo support transaction– As a safety cushion against unforeseen cash needsAs a safety cushion against unforeseen cash needs– As a speculative balance to take advantage of unforeseen opportunitiesAs a speculative balance to take advantage of unforeseen opportunities

• Even at low levels of sales, cash balances are required Even at low levels of sales, cash balances are required

• As sales increase, additional cash on hand may be required, but at As sales increase, additional cash on hand may be required, but at a lower percentage of sales. (lower slope to the trend line between a lower percentage of sales. (lower slope to the trend line between cash balances and sales)cash balances and sales)

(See Figure 4 – 3 on the following slide for a more realistic forecast for cash)(See Figure 4 – 3 on the following slide for a more realistic forecast for cash)


4 - 83

Percentage of Sales MethodPercentage of Sales MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

4-3 FIGURE4 - 3 FIGURE

Ca

sh

Sales

14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.0

0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300

Cash Forecast

Linear with constant

Simple %


4 - 84

Percentage of Sale MethodPercentage of Sale MethodSecond Revision the Pro Forma Balance SheetSecond Revision the Pro Forma Balance Sheet

• Further improvements to the pro forma balance sheet Further improvements to the pro forma balance sheet include reexamining asset growth assumptions:include reexamining asset growth assumptions:– Refinement of the cash forecast (as per the previous two slides)Refinement of the cash forecast (as per the previous two slides)– Realization that EFR can be offset by marketable securities that can easily Realization that EFR can be offset by marketable securities that can easily

be liquidated to finance growth needs.be liquidated to finance growth needs.– Reexamine our assumptions about growth in Accounts Receivable and Reexamine our assumptions about growth in Accounts Receivable and

whether we want to change our credit policies in the context of the forecast whether we want to change our credit policies in the context of the forecast macro economic and competitive environmentmacro economic and competitive environment

– Reexamine our inventory management policies taking into account the Reexamine our inventory management policies taking into account the macroeconomic and competitive environment macroeconomic and competitive environment

– Realization that increases in net fixed assets is ‘lumpy’ and not continuously Realization that increases in net fixed assets is ‘lumpy’ and not continuously incremental (if we have excess production capacity, we may not need to incremental (if we have excess production capacity, we may not need to invest any further in fixed assets until we are forecast to exceed that invest any further in fixed assets until we are forecast to exceed that capacity) capacity)

• Further improvements to the pro forma balance sheet Further improvements to the pro forma balance sheet include reexamining assumptions regarding the growth include reexamining assumptions regarding the growth in spontaneous liabilitiesin spontaneous liabilities

(See the effects of these changes on the following slide)(See the effects of these changes on the following slide)


4 - 85


%Sales 120 100.0% 132 145 160



Cumulative (EFR) -10.8 -21.7 -32.6

Table 4-15 Second Revision of Forecast Assuming cash remains constant, we

liquidate marketable

securities and we retain 50% of our profits dramatically affects the forecast.

We now have surplus

resources!


4 - 86

Percentage of Sale MethodPercentage of Sale MethodFinal Revisions to the Pro Forma Income StatementFinal Revisions to the Pro Forma Income Statement

• Given our assumptions about capacity, and there being no Given our assumptions about capacity, and there being no need for further expansion in plant and equipment to support need for further expansion in plant and equipment to support anticipated sales growth, we can reexamine our assumptions anticipated sales growth, we can reexamine our assumptions about the cost structure of the firm.about the cost structure of the firm.

Variable CostsVariable Costs• Variable costs (direct materials and direct labour) will likely grow in proportion Variable costs (direct materials and direct labour) will likely grow in proportion

to sales.to sales.Fixed CostsFixed Costs• Fixed costs, however should remain fixed.Fixed costs, however should remain fixed.• By modifying the income statement for this change in assumptions, we see the By modifying the income statement for this change in assumptions, we see the

net result of this is an increase in forecast net income.net result of this is an increase in forecast net income.DividendsDividends• Most firms do not follow a constant payout ratio, but hold dividends constant Most firms do not follow a constant payout ratio, but hold dividends constant

over multiple years.over multiple years.• Assume that we hold dividends at $3 for the next three years.Assume that we hold dividends at $3 for the next three years.

(See the effects of these changes on the final pro forma income statement on the following slide)(See the effects of these changes on the final pro forma income statement on the following slide)


4 - 87


Sales $120 $132 $145 $160Gross operating profit 48 53 58 64Fixed costs 31 31 31 31EBIT 17 22 27 33Interest 5 5.0 5.0 5.0Taxes @ 50% 6 8.5 11.0 14.0Net Income 6.0 8.5 11.0 14.0

Net profit margin 5.0% 6.4% 7.6% 8.8%

Dividends $3.0 $3.0 $3.0 $3.0Additions to Retained earnings $3.0 $5.5 $8.0 $11.0

Table 4-16 Profit Margin and Sales


4 - 88

Percentage of Sale MethodPercentage of Sale MethodFinal Revisions to the Pro Forma Balance SheetFinal Revisions to the Pro Forma Balance Sheet

• Given our modified income statement and Given our modified income statement and assumptions regarding net profit and cash assumptions regarding net profit and cash dividends we can prepare a final revised balance dividends we can prepare a final revised balance sheetsheet

• This balance sheet now shows that we forecast This balance sheet now shows that we forecast significant surplus cash resources and must make significant surplus cash resources and must make some decisions about how we will manage them:some decisions about how we will manage them:– Investment temporarily in marketable securities in anticipation of further Investment temporarily in marketable securities in anticipation of further

investment opportunities in growing the firm?investment opportunities in growing the firm?– Distribute them in the form of cash dividends?Distribute them in the form of cash dividends?

(See the effects of these changes on the final pro forma balance sheet on the (See the effects of these changes on the final pro forma balance sheet on the following slide)following slide)


4 - 89


%Sales 120 100.0% 132 145 160



Cumulative (EFR) -13.0 -28.3 -46.2

Table 4-17 Final Revision of Forecast

Formula ForecastingFormula Forecasting



4 - 91

Formula ForecastingFormula ForecastingThe Simple Percentage of Sales Forecasting MethodThe Simple Percentage of Sales Forecasting Method

We can express the foregoing percentage of sales method We can express the foregoing percentage of sales method forecasting using equations rather than spreadsheets.forecasting using equations rather than spreadsheets.

When we subtract spontaneous liabilities from total assets we When we subtract spontaneous liabilities from total assets we get the firm’s invested capital or net assets as a percentage get the firm’s invested capital or net assets as a percentage of sales.of sales.

We will denote this by We will denote this by ‘a’‘a’‘‘a’a’ is the treasurer’s financial policy variable because it is the total is the treasurer’s financial policy variable because it is the total

invested capital requirement of the firm as a percentage of sales.invested capital requirement of the firm as a percentage of sales.


4 - 92

Formula ForecastingFormula ForecastingExternal Funds RequiredExternal Funds Required

External Funds Required can now be expressed as a formula External Funds Required can now be expressed as a formula of relationships:of relationships:

Where:Where:‘‘a’ a’ - - treasurer’s financial policy variabletreasurer’s financial policy variablegg -- sales growth ratesales growth rateSS -- current salescurrent salesS S × g× g -- next period’s sales growthnext period’s sales growtha × S × ga × S × g -- incremental capital requiredincremental capital requiredPMPM - - profit margin on salesprofit margin on salesbb -- payout ratiopayout ratio1 – b1 – b - - retention or plowback ratioretention or plowback ratio

)1( EFR SgPMbgSa [4- 32]


4 - 93

Formula ForecastingFormula ForecastingExternal Funds RequiredExternal Funds Required

External Funds Required can also be expressed as a linear External Funds Required can also be expressed as a linear function of the sales growth rate (g) and this can be seen function of the sales growth rate (g) and this can be seen more easily by dividing both sides of Equation 4 – 32 by the more easily by dividing both sides of Equation 4 – 32 by the current sales level and rearranging:current sales level and rearranging:

This line can be graphed to show the relationship between the This line can be graphed to show the relationship between the sales growth rate and External Funds Required.sales growth rate and External Funds Required.

(See Figure 4 -4 found on the following slide)(See Figure 4 -4 found on the following slide)

)( gPMbaPMbS

EFR [4- 33]


4 - 94

External Financing RequirementsExternal Financing Requirements

4-3 FIGURE4 - 4 FIGURE

EF

R /

S

Sales Growth Rate

0.15

0.1

0.05

0.0

-0.05

-0.1

-0.15

-0.2

-0.1

-0.0

8

-0.0

6

-.00

4

-.00

2 0

0.02

0.04

0.06

0.08 0.1

0.12

0.14

0.16

0.18

Sustainable growth rate ( g*)


4 - 95

Formula ForecastingFormula ForecastingThe Sustainable Growth Rate (g*)The Sustainable Growth Rate (g*)

The sustainable growth rate is the sales growth rate at which The sustainable growth rate is the sales growth rate at which the firm neither generates nor needs external financing – the firm neither generates nor needs external financing – that is, it can sustain its own rate of growth through that is, it can sustain its own rate of growth through reinvestment of profits earned.reinvestment of profits earned.

The sustainable growth rate (g*) is the point in Figure 4 – 4 at The sustainable growth rate (g*) is the point in Figure 4 – 4 at which the line crosses the horizontal axis.which the line crosses the horizontal axis.

Using equation 4 – 33 we can rearrange and solve for g*:Using equation 4 – 33 we can rearrange and solve for g*:

)(

*g PMba

PMb

[4- 34]


4 - 96

Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:

– The importance of understanding the sources of a firm’s The importance of understanding the sources of a firm’s profitability or where the challenges to profitability exist.profitability or where the challenges to profitability exist.

– How to calculate and interpret operating, profitability, How to calculate and interpret operating, profitability, liquidity, leverage and efficiency ratiosliquidity, leverage and efficiency ratios

– How to prepare financial forecasts and understand the How to prepare financial forecasts and understand the assumptions underlying the percentage of sales method assumptions underlying the percentage of sales method of financial forecasting.of financial forecasting.

Concept Review QuestionsConcept Review Questions



4 - 98

Concept Review Question 1Concept Review Question 1Ratios and Their InterpretationRatios and Their Interpretation

What useful information do we obtain from What useful information do we obtain from the dividend yield, P/E ratio, M/B ratio, and the dividend yield, P/E ratio, M/B ratio, and EBITDA multiple?EBITDA multiple?


4 - 99

CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.

Economy & Finance

Financial Statement Analysis and Forecasting