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Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth • W. Sean Cleary Chapter 4 – Financial Statement Analysis and Forecasting
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CHAPTER 4 Financial Statement Analysis and Forecasting
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.
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.
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.
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
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The DuPont System Financial Statement Analysis and Forecasting
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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]
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Framework for Financial Analysis Du Pont System 4 - 2 FIGURE GOOD OR BAD? LEVERAGE RATIOS EFFICIENCY RATIOS PRODUCTIVITY RATIOS ROE
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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)
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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]
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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
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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
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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
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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.
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)
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A Framework for Financial Analysis Return on Equity (ROE) and the DuPont System
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)
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A Framework for Financial Analysis Interpreting Ratios Do you see trends here? What factors are driving the trend in ROE?
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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?
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Leverage Ratios Financial Statement Analysis and Forecasting
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.
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.
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)
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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%.
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Efficiency Ratios Degree of Total Leverage Ratio
An income statement ratio that measures the exposure of profits to changes in sales.
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).
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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?
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Productivity Ratios Financial Statement Analysis and Forecasting
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.
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.)
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.
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Productivity Ratios Average Days Sales in Inventory (ADSI)
Estimates the number of days of sales tied up in inventory (based on ending inventory values)
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.
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Liquidity Ratios Interpreting Ratios Which firm has greater liquidity and capacity to meet its financial obligations?
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.
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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.
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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)
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Estimating Net Liquidation Value Interpreting Ratios
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Valuation Ratios Financial Statement Analysis and Forecasting
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.
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Valuation Ratios Interpreting Ratios – Dividend Payout Ratio
Expresses dividends as a percentage of earnings on a per share basis.
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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.
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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
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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.
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.
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.
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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)
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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.
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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.
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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)
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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.
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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.
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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)
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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 %
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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)
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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!
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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)
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Financial Forecasting The Percentage of Sales Method
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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)
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Financial Forecasting The Percentage of Sales Method
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Formula Forecasting Financial Statement Analysis and Forecasting
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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.
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.
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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*:
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