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Financial Statement Analysis and Forecasting

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  • 1. Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth • W. Sean Cleary Chapter 4 – Financial Statement Analysis and Forecasting
  • 2. CHAPTER 4 Financial Statement Analysis and Forecasting
  • 3. Lecture Agenda
    • Learning objectives
    • Important terms
    • Consistent financial analysis
    • Leverage ratios
    • Efficiency ratios
    • Productivity ratios
    • Liquidity ratios
    • Valuation ratios
    • Financial forecasting
    • Formula forecasting
    • Summary and Conclusions
      • Concept Review Questions
  • 4. Learning Objectives
    • 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 provide information about three areas of a firm’s operations
    • Why outsiders and insiders are concerned with a company’s ratios related to leverage, efficiency, productivity, liquidity and value
    • How to calculate, interpret, and evaluate the key ratios related to leverage, efficiency, productivity, liquidity, and value
    • Why financial forecasts provide critical information for both management and external parties
    • How to prepare financial forecasts by using the percentage of sales approach
    • How external financing requirements are related to sales growth, profitability, dividend payouts, and sustainable growth rates.
  • 5. Important Chapter Terms
    • Acid test ratio
    • Average collection period
    • Average days sales in inventory
    • Break-even point
    • Cash flow to debt ratio
    • Current ratio
    • Debt ratio
    • Debt-equity ratio
    • Degree of total leverage
    • Dividend payout
    • Dividend yield
    • EBITDA multiple
    • Efficiency ratios
    • Equity book value per share
    • External financing requirements
    • Financial leverage
    • Fixed asset turnover
    • Forward P/E ratio
    • Gross profit margin
    • Inventory turnover
    • Invested capital
  • 6. Important Chapter Terms …
    • Leverage ratio
    • Liquidity
    • Market-to-book ratio
    • Net operating income (NOI)
    • Net profit margin
    • Off-balance-sheet liabilities
    • Operating margin
    • Percentage of sales method
    • Price-earnings (P/E) ratio
    • Productivity ratios
    • Quick ratio
    • Receivables turnover
    • Retention (plowback) ratio
    • Return on assets (ROA)
    • Return on equity (ROE)
    • Spontaneous liabilities
    • Stock ratios
    • Sustainable growth rate
    • Times interest earned
    • Total enterprise value
    • Turnover ratio
    • Working capital
    • Working capital ratio
  • 7. Consistent Financial Analysis Financial Statement Analysis and Forecasting
  • 8. Consistent Financial Analysis
    • Your text describes the importance of consistent financial analysis across companies, across industries, across countries
    • Morgan Stanley’s ModelWare is a start on this.
    • It is up to you, the analyst, to understand the challenges to comparability and you must attempt to ascertain the financial health of the organizations you study, understanding the limitations inherent in financial accounting practice.
  • 9. Consistent Financial Analysis Intra-Company Comparisons
    • GAAP provides considerable latitude for the company.
    • Once a firm chooses an acceptable accounting treatment for:
      • Revenue recognition
      • Capitalization of expenses
      • Inventory valuation, etc.
    • then the firm must use these same provisions year after year.
    • Any change in accounting principles must be noted in the financial statements and prior years restated to ensure there is a common basis of comparison to the present.
    • Therefore internal comparisons, year over year, are possible and supported by GAAP.
  • 10. Consistent Financial Analysis Inter-Company Comparisons
    • Making comparisons between companies, even in the same industry are much more difficult because:
      • Widely divergence accounting treatment under GAAP
      • Historical cost-based accounting can seriously affect efficiency, leverage and profitability ratios.
  • 11. Analysis of Financial Statements
    • Study the absolute numbers, and the comparative statements for the company to:
      • Ascertain trends in the balance sheet, income statement and statement of cash flows
      • Ascertain areas of concern
      • Ascertain areas of strength
    • Complement your study of the absolute numbers by using ratios again to:
      • Ascertain trends
      • Identify areas of concern
      • Identify areas of strength
  • 12. The DuPont System Financial Statement Analysis and Forecasting
  • 13. A Framework for Financial Analysis Return on Equity (ROE) and DuPont System
    • The DuPont System gives a framework for the analysis of financial statements through the decomposition of the Return on Equity ratio
    • (See Figure 4 -2 that illustrates the constituent parts of ROE )
    [4-1]
  • 14. Framework for Financial Analysis Du Pont System 4 - 2 FIGURE GOOD OR BAD? LEVERAGE RATIOS EFFICIENCY RATIOS PRODUCTIVITY RATIOS ROE
  • 15. A Framework for Financial Analysis DuPont System and Decomposition of ROE
    • As Figure 4 – 2 illustrates, ROE is a function of:
      • Corporate use of leverage (use of debt)
      • Efficiency ratios (ability of the firm to control costs in relationship to sales)
      • Productivity ratios (the degree to which the firm can generate sales in relationship to assets employed)
    [4-1]
  • 16. A Framework for Financial Analysis Return on Equity (ROE) and DuPont System
    • ROE is not a pure ratio because it involves dividing an income statement item (flow) by a balance sheet (stock) item.
    • Instead of using ending SE, many argue you should use average SE (beginning SE plus ending SE divided by 2) because SE changes over the year as income is earned and retained earnings grow.
    [4-1]
  • 17. A Framework for Financial Analysis Return on Equity (ROE) ROE when decomposed shows that it is a function of the return earned on assets and of the leverage used by the firm. [4- 7] ROA Leverage
  • 18. A Framework for Financial Analysis Return on Total Assets
    • ROA shows the ratio of income to assets that have been used to produce them.
    • ROA can be further decomposed as shown and the following slide
    [4-2]
  • 19. A Framework for Financial Analysis Return on Assets (ROA)
    • ROA is the product of the net profit margin and the sales to total asset ratio:
    • The sales cancel and we are left with NI / TA
    [4- 6]
  • 20. A Framework for Financial Analysis Leverage Ratio
    • If ROA is multiplied by TA and divided by SE, the TA’s cancel out and produces ROE.
    • TA / SE is the leverage ratio
    • It measures how many dollars of total assets are supported by each dollar of Shareholders Equity.
    [4-3]
  • 21. DuPont System
    • The DuPont system provides a good starting point for any financial analysis
      • It shows that financial strength comes from many sources (profitability, asset utilization, leverage)
      • It reinforces the concept that good financial analysis requires looking at each ratio in the context of the other
      • Whenever you are presented with financial statements it is important that you look at a sample of ratios from each major category to identify areas of strength and weakness
      • (Table 4 -1 illustrates E-Trade Canada’s ROE analysis of Rothmans)
  • 22. A Framework for Financial Analysis Return on Equity (ROE) and the DuPont System
  • 23. Interpreting Ratios
    • A ratio is just one number over another number – by itself, there is little ‘information’
    • To judge whether a ratio is ‘good’ or ‘bad’ requires that it be compared to something else such as:
      • The company’s own ratios over time to ascertain trends
      • Other comparable companies or industry averages
      • (Table 4 -2 illustrates Rothmans DuPont ratios over time)
  • 24. A Framework for Financial Analysis Interpreting Ratios Do you see trends here? What factors are driving the trend in ROE?
  • 25. A Framework for Financial Analysis Interpreting 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?
  • 26. Leverage Ratios Financial Statement Analysis and Forecasting
  • 27. Leverage
    • Leverage = magnification
    • Financial leverage occurs when a firm uses sources of financing that carry a fixed cost (such as long-term debt), and uses this to generate greater returns that result in magnified returns to shareholders.
    • Leverage means magnification of either profits or losses.
  • 28. Leverage Ratios
    • Include:
      • Debt ratio
      • Debt to equity ratio
      • Times interest earned ratio
      • Cash flow to debt ratio
  • 29. Leverage Ratios Debt Ratio
    • Is a stock ratio indicating the proportion of total assets financed by debt at a particular point in time (the balance sheet date)
    [4- 8]
  • 30. Leverage Ratios Debt-Equity Ratio
    • Is a stock ratio indicating the proportion that total debt represents in relationship to the shareholders equity (common stock and retained earnings) at the balance sheet date.
    [4- 9]
  • 31. Leverage Ratios Times Interest Earned (TIE)
    • Is an income statement (flow) ratio indicating the number of times the firm’s pre-tax income exceeds its fixed financial obligations to its lenders (debt holders)
    [4- 10]
  • 32. Leverage Ratios Cash Flow to Debt Ratio
    • Measures how long it would take to payoff a firm’s debt (D)
    [4- 11]
  • 33. Leverage Ratios Cash Flow to Debt Ratio Which firm exhibits greater use of leverage? Which exhibits greater capacity to take on and service debt?
  • 34. Efficiency Ratios Financial Statement Analysis and Forecasting
  • 35. Efficiency Ratios
    • Efficiency ratios measure how efficiently a dollar of sales is turned into profits.
        • Gives insight to the firm’s cost structure
        • Whether problems exist with variable costs or fixed costs (overhead) or both
  • 36. Efficiency Ratios
    • Include:
      • Degree of total leverage
      • Break-even point
      • Gross profit margin
      • Operating margin
  • 37. Efficiency Ratios Interpreting Ratios 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%.
  • 38. Efficiency Ratios Degree of Total Leverage Ratio
    • An income statement ratio that measures the exposure of profits to changes in sales.
    • The greater the DTL, the greater leverage effect.
    [4- 12]
  • 39. Efficiency Ratios Break Even Point
    • Estimates the volume of units that must be produced and sold in order for the firm to cover all costs both fixed and variable.
    • The break even point tends to increase as the use of fixed costs increases.
    [4- 13]
  • 40. Efficiency Ratios Gross Profit Margin
    • Demonstrates the percentage of sales that are available to cover fixed (period) costs and financing expenses after variable costs have been paid.
    • A declining gross profit margin raises concerns about the firm’s ability to control variable costs such as direct materials and direct labour.
    [4- 14]
  • 41. Efficiency Ratios Operating Margin
    • Operating margin measures the cumulative effect of both variable and period costs on the ability of the firm to turn sales into operating profits to cover, interest, taxes, depreciation and amortization (EBITDA).
    [4- 15]
  • 42. Efficiency Ratios Interpreting Ratios Which firm is able to produce a greater percentage of sales as profits? Which firm is able to produce strong and consistent profitability?
  • 43. Productivity Ratios Financial Statement Analysis and Forecasting
  • 44. Productivity Ratios
    • Measure the ability of the firm to generate sales from the assets that it employs.
    • Excessive investment in assets with little or no increase in sales reduces the rate of return on both assets and equity (ROA) and (ROE)
  • 45. Productivity Ratios
    • Include:
      • Receivables turnover
      • Average collection period (ACP)
      • Inventory turnover
      • Average days sales in inventory (ADSI)
      • Fixed asset turnover
  • 46. Productivity Ratios Receivables Turnover
    • Measures the sales generated by every dollar of receivables.
    [4- 16]
  • 47. Productivity Ratios Average Collection Period
    • Estimates the number of days it takes a firm to collect on its accounts receivable.
    • If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic conditions deteriorate.
    [4- 17]
  • 48. Productivity Ratios Inventory Turnover
    • Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.
    • A ratio that involves both ‘stock’ and ‘flow’ values
    • Is strongly a function of ending inventory value…managers often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.)
    [4- 18]
  • 49. Productivity Ratios Inventory Turnover
    • When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.
    • Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost.
    [4- 19]
  • 50. Productivity Ratios Average Days Sales in Inventory (ADSI)
    • Estimates the number of days of sales tied up in inventory (based on ending inventory values)
    [4- 20]
  • 51. Productivity Ratios Fixed Asset Turnover
    • Estimates the number of dollars of sales produced by each dollar of net fixed assets.
    [4- 21]
  • 52. Productivity Ratios Interpreting Ratios Which firm has been improving its efficiency ratios to a greater degree?
  • 53. Liquidity Ratios Financial Statement Analysis and Forecasting
  • 54. Liquidity Ratios
    • Measure the ability of the firm to meet its maturing financial obligations through liquid (cash and near cash) resources
    • Include:
      • Working capital ratio
      • Current ratio
      • Quick (acid-test) ratio
  • 55. Liquidity Ratios Working Capital Ratio
    • Measures the percentage of total assets that is invested in current assets.
    • Helps to analyze capital intensity as well as corporate liquidity.
    [4- 22]
  • 56. Liquidity Ratios Current Ratio
    • Measures the number of dollars of current assets for each dollar of current liabilities.
    • Helps to estimate the capacity of the firm to meet its maturing financial obligations.
    [4- 23]
  • 57. Liquidity Ratios Quick Ratio
    • Recognizing that inventories may be less liquid than other current assets, and in some cases, when liquidated quickly result in cash flows that are less than book value, the quick ratio gives a clearer indication of the firm’s ability to meet its maturing financial obligations out of current, liquid assets.
    [4- 24]
  • 58. Liquidity Ratios Interpreting Ratios Which firm has greater liquidity and capacity to meet its financial obligations?
  • 59. Estimating Net Liquidation Value per Share
    • When a firm becomes financially-strained and its ability to remain a ‘going concern’ is open to question, market values and book values (accounting) become less valid.
    • As net liquidation value per share begins to influence share price values in the market place you will see share price fall and dividend discount models for share valuation won’t explain the observable market price.
  • 60. Estimating Net Liquidation Value Net Liquidation Value Per Share
    • Net liquidation value per share is always much less than market value per share of a going concern because assets of the company cannot usually be converted into an equal amount of cash as the amount stated on the balance sheet
      • Liquidation takes time and physical deterioration of assets will occur before they can be sold
      • Selling assets costs money – these transactions costs include payments to trustees/liquidators
      • The market value of many corporate assets such as inventory, plant and 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 economy is not healthy
      • 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’ prices
      • Liquidation of corporations involve the courts, court-appointed trustees and there are costs associated with these processes that reduce the net realizable value of the assets.
  • 61. Estimating Net Liquidation Value Interpreting Ratios
    • Net liquidation values can be estimated by discounting asset values based on their degree of liquidity, then subtracting the liabilities of the firm to estimate what residual value might be left.
    • The process of estimating net liquidation value is as follows:
      • Liquid assets are valued close to or the same as book value
      • Illiquid assets are discounted from book value based on the degree of illiquidity
      • Liabilities are stated in nominal terms because it takes those dollars to satisfy debt obligations
      • Preferred stock value is based on residual values (if there is any estimated residual value following the discounting of assets process)
    • (Table 4 – 9 is an example of E-Trade Canada’s Risk Ratings for Rothmans)
  • 62. Estimating Net Liquidation Value Interpreting Ratios
  • 63. Valuation Ratios Financial Statement Analysis and Forecasting
  • 64. Valuation Ratios
    • Used to assess how the market is valuing the firm (share price) in relationship to assets and current earnings, profits and dividends
    • Include:
      • Equity book value per share (BVPS)
      • Dividend yield
      • Dividend payout
      • Price-earnings (P/E) ratio
      • Forward (P/E) ratio
      • Market-to-book (M/B) ratio
      • EBITDA multiple
  • 65. Valuation Ratios Interpreting Ratios – Book Value per Share
    • Expresses shareholders’ equity on a per share basis.
    [4- 25]
  • 66. Valuation Ratios Interpreting Ratios – Dividend Yield
    • Expresses dividend payout as a percentage of the current share price.
    • Can be compared to other investment instruments such bonds (current yield) or with other dividend-paying companies.
    [4- 26]
  • 67. Valuation Ratios Interpreting Ratios – Dividend Payout Ratio
    • Expresses dividends as a percentage of earnings on a per share basis.
    [4- 27]
  • 68. Valuation Ratios Interpreting Ratios – Trailing P/E Ratio
    • Earnings multiple based on the most recent earnings.
    • Often used in estimating the value of a stock.
    • A stock trading at a P/E multiple of 10 will take ten years at current earnings to recover the price of the stock.
    • A stock trading at a P/E multiple of 100 will take 100 years at current annual earnings to recover the price of the stock.
    [4- 28]
  • 69. Valuation Ratios Interpreting Ratios – Forward P/E Ratio
    • Earnings multiple based on forecast earnings per share.
    • Often used in estimating the value of a stock especially with companies with rapid growth in earnings per share.
    • Low P/E shares are regarded as value stocks
    • High P/E shares are regarded as growth stocks
    [4- 29]
  • 70. Valuation Ratios Interpreting Ratios – Market to Book Ratio
    • Estimates the dollars of Share Price per dollar of book value per share.
    • Given historical cost accounting as the basis for book value per share, the degree to which market value per share exceeds BVPS indicates the value that has been added to the company by management.
    [4- 30]
  • 71. Valuation Ratios Interpreting Ratios – EBITDA Multiple
    • Total enterprise value is an estimate of the total market value of the firm (market value of equity plus market value of debt)
    • EBITDA multiple expresses total enterprise value for each dollar of operating income (EBITDA)
  • 72. Valuation Ratios Interpreting Ratios Can you draw any conclusions for the comparative valuation ratio data summarized in this table?
  • 73. Financial Forecasting Financial Statement Analysis and Forecasting
  • 74. Financial Forecasting Purpose
    • Financial managers must produce forecasts for the financial results of corporate plans to:
      • Determine whether the corporate plans will require additional external financing
      • Determine whether the corporate plans will produce surplus cash resources that could be distributed to shareholders as dividends
      • Assess the financial forecasts to determine the financial feasibility of corporate plans – if poor financial results are forecast, this gives management the opportunity to reexamine and amend corporate plans to produce better results before resources and people are committed.
  • 75. Financial Forecasting
    • The basis for all financial forecasts is the sales forecast.
    • The most recent balance sheet values are the starting point.
    • Pro forma (forecast) balance sheets are projected assuming some relationship with projected sales (constant percentage of sales)
    • Current liabilities are usually assumed to rise and fall in a constant percentage with sales – we call them ‘ spontaneous liabilities ’ because they change without negotiation with creditors.
  • 76. Financial Forecasting The Percentage of Sales Method
    • The percentage of sales method involves the following steps:
        • Determine which financial policy variables you are interested in
        • Set all the non-financial policy variables as a percentage of sales
        • Extrapolate the balance sheet based on a percentage of sales
        • Estimate future retained earnings
        • Modify and re-iterate until the forecast makes sense.
    • This process most often results in a balance sheet that does not balance – a ‘plug’ (balancing) amount is the external funds required (or surplus funds forecast)
  • 77. Financial Forecasting The Percentage of Sales Method The historical balance sheet. If sales increase, assets used to produce those sales must grow. Spontaneous liabilities Policy variables requiring decision.
  • 78. Financial Forecasting The Percentage of Sales Method 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.
  • 79. Percentage of Sale Method Improving the Pro Forma Balance Sheet
    • The prior pro form balance sheet was developed using very naïve assumptions:
      • Policy variables held constant
      • Asset growth in all accounts held at the same percentage of sales
      • Spontaneous liabilities increased at a constant percentage of sales.
    • One improvement is to realize that the firm’s equity will grow by the amount of retained earnings.
    • (See the following income statement)
  • 80. Financial Forecasting The Percentage of Sales Method 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.
  • 81. Financial Forecasting The Percentage of Sales Method 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.
  • 82. Percentage of Sale Method Second Revision the Pro Forma Balance Sheet
    • Further improvements to the pro forma balance sheet include:
      • Recognizing that cash balances may not have to rise as a pure constant percentage of sales
        • Cash balances are required for a variety of reasons
          • To support transaction
          • As a safety cushion against unforeseen cash needs
          • As a speculative balance to take advantage of unforeseen opportunities
        • Even at low levels of sales, cash balances are required
        • As sales increase, additional cash on hand may be required, but at a lower percentage of sales. (lower slope to the trend line between cash balances and sales)
      • (See Figure 4 – 3 on the following slide for a more realistic forecast for cash)
  • 83. Percentage of Sales Method Second Revision the Pro Forma Balance Sheet 4-3 FIGURE 4 - 3 FIGURE Cash 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 %
  • 84. Percentage of Sale Method Second Revision the Pro Forma Balance Sheet
    • Further improvements to the pro forma balance sheet include reexamining asset growth assumptions:
      • Refinement of the cash forecast (as per the previous two slides)
      • Realization that EFR can be offset by marketable securities that can easily be liquidated to finance growth needs.
      • Reexamine our assumptions about growth in Accounts Receivable and whether we want to change our credit policies in the context of the forecast macro economic and competitive environment
      • Reexamine our inventory management policies taking into account the macroeconomic and competitive environment
      • Realization that increases in net fixed assets is ‘lumpy’ and not continuously 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 capacity)
    • Further improvements to the pro forma balance sheet include reexamining assumptions regarding the growth in spontaneous liabilities
    • (See the effects of these changes on the following slide)
  • 85. Financial Forecasting The Percentage of Sales Method Assuming cash remains constant, we liquidate marketable securities and we retain 50% of our profits dramatically affects the forecast. We now have surplus resources!
  • 86. Percentage of Sale Method Final Revisions to the Pro Forma Income Statement
    • Given our assumptions about capacity, and there being no need for further expansion in plant and equipment to support anticipated sales growth, we can reexamine our assumptions about the cost structure of the firm.
    • Variable Costs
    • Variable costs (direct materials and direct labour) will likely grow in proportion to sales.
    • Fixed Costs
    • Fixed costs, however should remain fixed.
    • By modifying the income statement for this change in assumptions, we see the net result of this is an increase in forecast net income.
    • Dividends
    • Most firms do not follow a constant payout ratio, but hold dividends constant over multiple 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)
  • 87. Financial Forecasting The Percentage of Sales Method
  • 88. Percentage of Sale Method Final Revisions to the Pro Forma Balance Sheet
    • Given our modified income statement and assumptions regarding net profit and cash dividends we can prepare a final revised balance sheet
    • This balance sheet now shows that we forecast significant surplus cash resources and must make some decisions about how we will manage them:
      • Investment temporarily in marketable securities in anticipation of further investment opportunities in growing the firm?
      • Distribute them in the form of cash dividends?
    • (See the effects of these changes on the final pro forma balance sheet on the following slide)
  • 89. Financial Forecasting The Percentage of Sales Method
  • 90. Formula Forecasting Financial Statement Analysis and Forecasting
  • 91. Formula Forecasting The Simple Percentage of Sales Forecasting Method
    • We can express the foregoing percentage of sales method forecasting using equations rather than spreadsheets.
    • When we subtract spontaneous liabilities from total assets we get the firm’s invested capital or net assets as a percentage of sales.
      • We will denote this by ‘a’
      • ‘ a’ is the treasurer’s financial policy variable because it is the total invested capital requirement of the firm as a percentage of sales.
  • 92. Formula Forecasting External Funds Required
    • External Funds Required can now be expressed as a formula of relationships:
    • Where:
      • ‘ a’ - treasurer’s financial policy variable
      • g - sales growth rate
      • S - current sales
      • S × g - next period’s sales growth
      • a × S × g - incremental capital required
      • PM - profit margin on sales
      • b - payout ratio
      • 1 – b - retention or plowback ratio
    [4- 32]
  • 93. Formula Forecasting External Funds Required
    • External Funds Required can also be expressed as a linear function of the sales growth rate (g) and this can be seen more easily by dividing both sides of Equation 4 – 32 by the current sales level and rearranging:
    • This line can be graphed to show the relationship between the sales growth rate and External Funds Required.
    • (See Figure 4 -4 found on the following slide)
    [4- 33]
  • 94. External Financing Requirements 4-3 FIGURE 4 - 4 FIGURE EFR / S Sales Growth Rate 0.15 0.1 0.05 0.0 -0.05 -0.1 -0.15 -0.2 -0.1 -0.08 -0.06 -.004 -.002 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 Sustainable growth rate ( g* )
  • 95. Formula Forecasting The Sustainable Growth Rate (g*)
    • The sustainable growth rate is the sales growth rate at which the firm neither generates nor needs external financing – that is, it can sustain its own rate of growth through reinvestment of profits earned.
    • The sustainable growth rate (g*) is the point in Figure 4 – 4 at which the line crosses the horizontal axis.
    • Using equation 4 – 33 we can rearrange and solve for g*:
    [4- 34]
  • 96. Summary and Conclusions
    • In this chapter you have learned:
      • The importance of understanding the sources of a firm’s profitability or where the challenges to profitability exist.
      • How to calculate and interpret operating, profitability, liquidity, leverage and efficiency ratios
      • How to prepare financial forecasts and understand the assumptions underlying the percentage of sales method of financial forecasting.
  • 97. Concept Review Questions Financial Statement Analysis and Forecasting
  • 98. Concept Review Question 1 Ratios and Their Interpretation
    • What useful information do we obtain from the dividend yield, P/E ratio, M/B ratio, and EBITDA multiple?
  • 99. Copyright
    • Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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