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  • PPT3

    1. 1. Chapter 3: Interpreting Financial Statements Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley Objective Contrast Economic and Accounting Models <=> Value of Accounting Information
    2. 2. Chapter 3 Contents <ul><li>3.1 Functions of Financial Statements </li></ul><ul><li>3.2 Review of Financial Statements </li></ul><ul><li>3.3 Market values v. Book Values </li></ul><ul><li>3.4 Accounting v. Economic Measures of Income </li></ul><ul><li>3.5 Return on Shareholders v. Return on Equity </li></ul><ul><li>3.6 Analysis Using Financial Ratios </li></ul><ul><li>3.7 The Financial Planning Process </li></ul><ul><li>3.8 Constructing a Financial Planning Model </li></ul><ul><li>3.9 Growth & the Need for External Financing </li></ul><ul><li>3.10 Working Capital Mgmt. </li></ul><ul><li>3.11 Liquidity & Cash Mgmt. </li></ul>
    3. 3. 3.1 Functions of Financial Statements <ul><li>Financial Statements: </li></ul><ul><ul><li>Provide information to the owners & creditors of a firm about the current status and past performance </li></ul></ul><ul><ul><li>Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm </li></ul></ul><ul><ul><li>Provide a convenient templates for financial planning </li></ul></ul>
    4. 4. The Balance Sheet <ul><li>Summarizes a firms assets, liabilities, and owner’s equity at a moment in time </li></ul><ul><li>Amounts measured at historical values and historical exchange rates </li></ul><ul><li>Prepared according to GAAP, G enerally A ccepted A ccounting P rinciples </li></ul><ul><ul><li>GAAP modified occasionally by the Financial Accounting Standards Board </li></ul></ul><ul><li>Exchange-listed companies must comply with S ecurities and E xchange C ommission (SEC) rules </li></ul>
    5. 5. The Balance Sheet <ul><li>Major Divisions: </li></ul><ul><ul><li>Assets </li></ul></ul><ul><ul><ul><li>Current assets (less than a year) </li></ul></ul></ul><ul><ul><ul><li>Long-term assets (longer than a year </li></ul></ul></ul><ul><ul><ul><ul><li>Depreciation </li></ul></ul></ul></ul><ul><ul><li>Liabilities and Stockholder’s Equity </li></ul></ul><ul><ul><ul><li>Liabilities </li></ul></ul></ul><ul><ul><ul><ul><li>Current Liabilities </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Long-term debt </li></ul></ul></ul></ul><ul><ul><ul><li>Equity </li></ul></ul></ul>
    6. 7. The Income Statement <ul><li>Summarizes the profitability of a company during a time period </li></ul><ul><li>Major Divisions: </li></ul><ul><ul><li>Revenue & cost of goods sold </li></ul></ul><ul><ul><ul><ul><ul><li>Gross margin </li></ul></ul></ul></ul></ul><ul><ul><li>General administrative and selling expenses (GS&A) </li></ul></ul><ul><ul><ul><ul><ul><li>Operating income </li></ul></ul></ul></ul></ul><ul><ul><li>Debt service </li></ul></ul><ul><ul><ul><ul><ul><li>Taxable income </li></ul></ul></ul></ul></ul><ul><ul><li>Corporate Taxes </li></ul></ul><ul><ul><ul><ul><ul><li>Net income </li></ul></ul></ul></ul></ul>
    7. 8. The Income Statement <ul><li>Important Reminders: </li></ul><ul><ul><li>Retained earnings are not added to the cash balance in the balance sheet, but are added to shareholder’s equity </li></ul></ul><ul><ul><li>Accounts show historical values, not market values </li></ul></ul><ul><ul><ul><li>The shareholder’s equity may be much higher or lower than the market value of the firm </li></ul></ul></ul><ul><ul><ul><ul><li>The value of the firm’s land may have halved or doubled, but this would not be reported in the balance sheet </li></ul></ul></ul></ul>
    8. 10. The Cash-Flow Statement <ul><li>Show the cash that flowed into and from a firm in during a time period </li></ul><ul><ul><li>Focuses attention on a firm’s cash situation </li></ul></ul><ul><ul><ul><li>A firm may be profitable and short of cash </li></ul></ul></ul><ul><ul><li>Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods </li></ul></ul><ul><ul><ul><li>The IRS uses accounting income to compute tax, so accounting rules have a second order effect on cash flows through taxes </li></ul></ul></ul>
    9. 13. 3.3 Market v. Book Values <ul><li>Not all assets and liabilities are included, and others are understate and/or overstated </li></ul><ul><ul><li>Intangible assets such as patents may have some value included, but brand loyalty, technological know-how, or a highly trained loyal workforce will not be valued. Goodwill may be included, but soon loses its connection to market value because of accounting depreciation and market fluctuations </li></ul></ul><ul><ul><li>Some contingent liabilities such as law-suits are not routinely disclosed, or only disclosed in the notes </li></ul></ul><ul><ul><li>Accountants are beginning to mark-to-market the assets of pension funds </li></ul></ul>
    10. 14. Accounting v. Economic Measures of Income: Example <ul><li>GPC’s accounting net income was plus $23,400,000 in 2001 </li></ul><ul><li>Assume the total market value of the stock fell from $200,000,000 to $187,200,000 from year 2xx0 to 2xx1. We saw earlier that the cash dividend to shareholders was $10,000,000. The economic income in year 2xx1 was minus $2,800,000 </li></ul><ul><li>The Accounting and Economic measures of Income may differ substantially </li></ul>
    11. 15. 3.5 Returns to Shareholders v. Return on Equity <ul><li>Recall our definition in Chapter 2 of the holding period return, and compare this with the economic measure of income </li></ul><ul><li>This is the Total Shareholder Return </li></ul>
    12. 16. Returns to Shareholders v. Return on Equity (Continued) <ul><li>Traditionally, corporate performance has been measured by Return on Equity, ROE </li></ul>
    13. 17. Returns to Shareholders v. Return on Equity (Conclusion) <ul><li>Thus, we see that there is no correspondence between a firm's ROE in any year & the total rate of return earned by shareholders on their investment in the company’s stock </li></ul>
    14. 18. 3.6 Analysis using Financial Ratios <ul><li>Despite the differences in accounting and financial principles, the published accounts of a firm yield clues about its financial condition </li></ul><ul><li>Five aspects of a firms performance: </li></ul><ul><ul><ul><li>Profitability </li></ul></ul></ul><ul><ul><ul><li>Asset turnover </li></ul></ul></ul><ul><ul><ul><li>Financial leverage </li></ul></ul></ul><ul><ul><ul><li>Liquidity </li></ul></ul></ul><ul><ul><ul><li>Market value </li></ul></ul></ul>
    15. 19. Profitability
    16. 20. Asset Turnover
    17. 21. Liquidity
    18. 22. Financial Leverage Financial Leverage
    19. 23. Market Value
    20. 24. Ratio Comparisons <ul><li>Establish Your Perspective </li></ul><ul><ul><ul><li>Shareholder </li></ul></ul></ul><ul><ul><ul><li>Employee, Management, or Union </li></ul></ul></ul><ul><ul><ul><li>Creditor </li></ul></ul></ul><ul><ul><ul><li>Predator, Customer, Supplier, Competitor, Trade Association </li></ul></ul></ul><ul><li>Benchmarks </li></ul><ul><ul><ul><li>Other companies ratios </li></ul></ul></ul><ul><ul><ul><li>The firm’s historical ratios </li></ul></ul></ul><ul><ul><ul><li>Data extracted from financial markets </li></ul></ul></ul><ul><li>Sources </li></ul><ul><ul><ul><li>Dun & Bradstreet, Robert Morris, Commerce Department's Quarterly Financial Report, Trade Associations </li></ul></ul></ul>
    21. 25. Relationships Amongst Ratios <ul><li>It is sometimes valuable to decompose ratios into sums, differences, products and quotients of other ratios. Many such schemes start with: </li></ul>
    22. 26. Ratio Analysis Limitations <ul><li>Ratio analysis indicates where you might profitably focus your attention, but it can also mislead you </li></ul><ul><ul><li>Look for collaborating evidence for the hypotheses you form from the ratios </li></ul></ul><ul><li>Sound long-term goals of a firm may cause ratios to look awful. Management-by-ratios may not be in the firms long-term interest </li></ul><ul><li>Companies in the same industry may have very different distribution channels, and accounting methods, leading to markedly different ratios that are none-the-less appropriate to each company </li></ul>
    23. 27. Comment: <ul><li>Always keep in mind that financial statements are prepared according to accounting standards and traditions , and that they do not fully satisfy the needs of a financial analysts </li></ul><ul><li>They do yield useful information if used with care and understanding </li></ul>
    24. 28. Effect of Financial Leverage <ul><li>Financial leverage simply means the use of borrowed money </li></ul><ul><ul><li>Shareholders of a firm use financial leverage to boost their ROE </li></ul></ul><ul><ul><ul><li>This increases the sensitivity of ROE to fluctuations in the firm’s underlying profitability as measured by its ROA </li></ul></ul></ul>
    25. 29. Illustration <ul><li>(Table 3.7 & 3.8 of textbook) </li></ul><ul><ul><li>Consider two firms that are identical except that Nodebt is financed using $1,000,000 of equity and Halfdebt is financed using $500,000 of equity and $500,000 of debt </li></ul></ul><ul><ul><li>further assume that the EBIT of both firms is $120,000 and tax is 40% </li></ul></ul>
    26. 30. Case: Borrow at 10%
    27. 31. Case: Borrow at 10%: Effect of Business Cycle on ROE
    28. 32. Conclusion: <ul><li>From the perspective of </li></ul><ul><ul><li>Creditors: increasing debt is unambiguously harmful, and bond rating agencies will downgrade the firm’s securities </li></ul></ul><ul><ul><li>Shareholders: may benefit, depending on the sign of (ROA-interest rate) and ROA </li></ul></ul>
    29. 33. 3.7 Financial Planning Process <ul><li>This section navigates us through the financial planning process, using the historical financial statements for a manufacturing firm as our embarkation point </li></ul><ul><li>Later, we discuss short-term planning and the management of working capital </li></ul>
    30. 34. The Financial Planning Process <ul><ul><li>Financial planning is a dynamic process that follows a cycle of making plans, implementing them, and revising them in the light of actual results </li></ul></ul>
    31. 35. The Financial Planning Process <ul><ul><li>Starting point is the strategic plan </li></ul></ul><ul><ul><ul><li>Strategy guides the financial planning process by establishing overall business development guidelines and growth targets </li></ul></ul></ul><ul><ul><ul><li>Which businesses does the firm want to </li></ul></ul></ul><ul><ul><ul><ul><li>enter </li></ul></ul></ul></ul><ul><ul><ul><ul><li>expand </li></ul></ul></ul></ul><ul><ul><ul><ul><li>contract </li></ul></ul></ul></ul><ul><ul><ul><ul><li>exit </li></ul></ul></ul></ul><ul><ul><ul><li>and how quickly? </li></ul></ul></ul>
    32. 36. The Financial Planning Process <ul><ul><li>Length of the planning horizon </li></ul></ul><ul><ul><ul><li>The longer the financial plan, the less detailed it should be (in general) </li></ul></ul></ul><ul><ul><ul><li>The revision of a financial plan is generally a function of the length of the planning horizon </li></ul></ul></ul><ul><ul><ul><ul><li>Short-term plans are revised frequently, long-term plans are revised much less frequently </li></ul></ul></ul></ul>
    33. 37. The Financial Planning Process <ul><ul><li>The financial planning horizon may be broken down into several steps: </li></ul></ul><ul><ul><ul><li>Management forecasts the key external factors, including level of economic activity, inflation, interest rates, and the competition’s output and prices </li></ul></ul></ul><ul><ul><ul><li>Based on above, they next forecast revenues, expenses, cash flows, and implied need for external financing </li></ul></ul></ul>
    34. 38. The Financial Planning Process <ul><ul><ul><li>Specific performance targets are generated for the divisions, functions and key individuals of the firm </li></ul></ul></ul><ul><ul><ul><li>Periodic measurements of performance are made, and compared to the plan in order to correct either the plan or performance </li></ul></ul></ul><ul><ul><ul><li>Periodically, key personnel are counseled, rewarded or punished, and a new iteration is instigated </li></ul></ul></ul>
    35. 39. The Financial Planning Process: Notes <ul><ul><li>Some variables must be forecast well in advance because exploitation requires a long lead-time, others may be reacted to immediately </li></ul></ul><ul><ul><li>Some variables are highly volatile, and can’t be forecast effectively, so the best we can do is to plan for the unknown (contingency planning) </li></ul></ul>
    36. 40. The Financial Planning Process: Notes <ul><ul><li>Planning horizons must be appropriate </li></ul></ul><ul><ul><li>For a magazine stand, a two year planning horizon may be far too long </li></ul></ul><ul><ul><li>A pharmaceutical business (with long new-plant construction lead-times, and long drug development/testing/approval procedures) needs a planning horizon that may be as long a ten years </li></ul></ul>
    37. 41. The Financial Planning Process: Notes <ul><ul><li>A plan should always lead to decisions that justify the cost of its preparation </li></ul></ul><ul><ul><ul><li>Proper planning is, in essence, part of the process of decision making. Any part of a plan that does not lead to a decision is probably a waste of managerial resources </li></ul></ul></ul>
    38. 42. 3.8 Constructing a Financial Planning Model <ul><li>The next slide shows the history of GPC </li></ul>
    39. 43. <ul><li>GPC Financial Statements, Years xxx1 - xxx3 </li></ul><ul><li>(Nearest $ Million) </li></ul><ul><li>(Percent of Year's Sales) </li></ul><ul><li>Year </li></ul><ul><li>xxx0 </li></ul><ul><li>xxx1 </li></ul><ul><li>xxx2 </li></ul><ul><li>xxx3 </li></ul><ul><li>xxx1 </li></ul><ul><li>xxx2 </li></ul><ul><li>xxx3 </li></ul><ul><li>Income Statement </li></ul><ul><li>Sales </li></ul><ul><li>200 </li></ul><ul><li>240 </li></ul><ul><li>288 </li></ul><ul><li>100.0% </li></ul><ul><li>100.0% </li></ul><ul><li>100.0% </li></ul><ul><li>Cost of goods sold </li></ul><ul><li>110 </li></ul><ul><li>132 </li></ul><ul><li>158 </li></ul><ul><li>55.0% </li></ul><ul><li>55.0% </li></ul><ul><li>55.0% </li></ul><ul><li>Gross margin </li></ul><ul><li>90 </li></ul><ul><li>108 </li></ul><ul><li>130 </li></ul><ul><li>45.0% </li></ul><ul><li>45.0% </li></ul><ul><li>45.0% </li></ul><ul><li>Selling, general & admin. expenses </li></ul><ul><li>30 </li></ul><ul><li>36 </li></ul><ul><li>43 </li></ul><ul><li>15.0% </li></ul><ul><li>15.0% </li></ul><ul><li>15.0% </li></ul><ul><li>EBIT </li></ul><ul><li>60 </li></ul><ul><li>72 </li></ul><ul><li>86 </li></ul><ul><li>30.0% </li></ul><ul><li>30.0% </li></ul><ul><li>30.0% </li></ul><ul><li>Interest expenses </li></ul><ul><li>30 </li></ul><ul><li>45 </li></ul><ul><li>64 </li></ul><ul><li>15.0% </li></ul><ul><li>18.8% </li></ul><ul><li>22.2% </li></ul><ul><li>Taxes </li></ul><ul><li>12 </li></ul><ul><li>11 </li></ul><ul><li>9 </li></ul><ul><li>6.0% </li></ul><ul><li>4.5% </li></ul><ul><li>3.1% </li></ul><ul><li>Net income </li></ul><ul><li>18 </li></ul><ul><li>16 </li></ul><ul><li>13 </li></ul><ul><li>9.0% </li></ul><ul><li>6.7% </li></ul><ul><li>4.7% </li></ul><ul><li>Dividends </li></ul><ul><li>5 </li></ul><ul><li>5 </li></ul><ul><li>4 </li></ul><ul><li>2.7% </li></ul><ul><li>2.0% </li></ul><ul><li>1.4% </li></ul><ul><li>Change in shareholder's equity </li></ul><ul><li>13 </li></ul><ul><li>11 </li></ul><ul><li>9 </li></ul><ul><li>6.3% </li></ul><ul><li>4.7% </li></ul><ul><li>3.3% </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Assets: </li></ul><ul><li>Cash & equivalents </li></ul><ul><li>10 </li></ul><ul><li>12 </li></ul><ul><li>14 </li></ul><ul><li>17 </li></ul><ul><li>6.0% </li></ul><ul><li>6.0% </li></ul><ul><li>6.0% </li></ul><ul><li>Receivables </li></ul><ul><li>40 </li></ul><ul><li>48 </li></ul><ul><li>58 </li></ul><ul><li>69 </li></ul><ul><li>24.0% </li></ul><ul><li>24.0% </li></ul><ul><li>24.0% </li></ul><ul><li>Inventories </li></ul><ul><li>50 </li></ul><ul><li>60 </li></ul><ul><li>72 </li></ul><ul><li>86 </li></ul><ul><li>30.0% </li></ul><ul><li>30.0% </li></ul><ul><li>30.0% </li></ul><ul><li>Property, Plant & equipment </li></ul><ul><li>500 </li></ul><ul><li>600 </li></ul><ul><li>720 </li></ul><ul><li>864 </li></ul><ul><li>300.0% </li></ul><ul><li>300.0% </li></ul><ul><li>300.0% </li></ul><ul><li>Total Assets </li></ul><ul><li>600 </li></ul><ul><li>720 </li></ul><ul><li>864 </li></ul><ul><li>1037 </li></ul><ul><li>360.0% </li></ul><ul><li>360.0% </li></ul><ul><li>360.0% </li></ul><ul><li>Liabilities: </li></ul><ul><li>Payables </li></ul><ul><li>30 </li></ul><ul><li>36 </li></ul><ul><li>43 </li></ul><ul><li>52 </li></ul><ul><li>18.0% </li></ul><ul><li>18.0% </li></ul><ul><li>18.0% </li></ul><ul><li>Short-term debt </li></ul><ul><li>120 </li></ul><ul><li>221 </li></ul><ul><li>347 </li></ul><ul><li>502 </li></ul><ul><li>110.7% </li></ul><ul><li>144.6% </li></ul><ul><li>174.2% </li></ul><ul><li>Long-term debt </li></ul><ul><li>150 </li></ul><ul><li>150 </li></ul><ul><li>150 </li></ul><ul><li>150 </li></ul><ul><li>75.0% </li></ul><ul><li>62.5% </li></ul><ul><li>52.1% </li></ul><ul><li>Total Liabilities </li></ul><ul><li>300 </li></ul><ul><li>407 </li></ul><ul><li>540 </li></ul><ul><li>704 </li></ul><ul><li>203.7% </li></ul><ul><li>225.1% </li></ul><ul><li>244.3% </li></ul><ul><li>Shareholder's equity </li></ul><ul><li>300 </li></ul><ul><li>313 </li></ul><ul><li>324 </li></ul><ul><li>333 </li></ul><ul><li>156.3% </li></ul><ul><li>134.9% </li></ul><ul><li>115.7% </li></ul>
    40. 44. <ul><li>(Nearest $ Million) </li></ul><ul><li>Year </li></ul><ul><li>xxx0 </li></ul><ul><li>xxx1 </li></ul><ul><li>xxx2 </li></ul><ul><li>xxx3 </li></ul><ul><li>Income Statement </li></ul><ul><li>Sales </li></ul><ul><li>200 </li></ul><ul><li>240 </li></ul><ul><li>288 </li></ul><ul><li>Cost of goods sold </li></ul><ul><li>110 </li></ul><ul><li>132 </li></ul><ul><li>158 </li></ul><ul><li>Gross margin </li></ul><ul><li>90 </li></ul><ul><li>108 </li></ul><ul><li>130 </li></ul><ul><li>Selling, general & admin. expenses </li></ul><ul><li>30 </li></ul><ul><li>36 </li></ul><ul><li>43 </li></ul><ul><li>EBIT </li></ul><ul><li>60 </li></ul><ul><li>72 </li></ul><ul><li>86 </li></ul><ul><li>Interest expenses </li></ul><ul><li>30 </li></ul><ul><li>45 </li></ul><ul><li>64 </li></ul><ul><li>Taxes </li></ul><ul><li>12 </li></ul><ul><li>11 </li></ul><ul><li>9 </li></ul><ul><li>Net income </li></ul><ul><li>18 </li></ul><ul><li>16 </li></ul><ul><li>13 </li></ul><ul><li>Dividends </li></ul><ul><li>5 </li></ul><ul><li>5 </li></ul><ul><li>4 </li></ul><ul><li>Change in shareholder's equity </li></ul><ul><li>13 </li></ul><ul><li>11 </li></ul><ul><li>9 </li></ul>
    41. 46. <ul><li>(Percent of Year's Sales) </li></ul><ul><li>Year </li></ul><ul><li>xxx1 </li></ul><ul><li>xxx2 </li></ul><ul><li>xxx3 </li></ul><ul><li>Income Statement </li></ul>Sales <ul><li>100.0% </li></ul><ul><li>100.0% </li></ul><ul><li>100.0% </li></ul>Cost of goods sold <ul><li>55.0% </li></ul><ul><li>55.0% </li></ul><ul><li>55.0% </li></ul>Gross margin <ul><li>45.0% </li></ul><ul><li>45.0% </li></ul><ul><li>45.0% </li></ul>Selling, general & admin exp. <ul><li>15.0% </li></ul><ul><li>15.0% </li></ul><ul><li>15.0% </li></ul>EBIT <ul><li>30.0% </li></ul><ul><li>30.0% </li></ul><ul><li>30.0% </li></ul>Interest expenses <ul><li>15.0% </li></ul><ul><li>18.8% </li></ul><ul><li>22.2% </li></ul>Taxes <ul><li>6.0% </li></ul><ul><li>4.5% </li></ul><ul><li>3.1% </li></ul>Net income <ul><li>9.0% </li></ul><ul><li>6.7% </li></ul><ul><li>4.7% </li></ul>Dividends <ul><li>2.7% </li></ul><ul><li>2.0% </li></ul><ul><li>1.4% </li></ul>Change in equity <ul><li>6.3% </li></ul><ul><li>4.7% </li></ul><ul><li>3.3% </li></ul>
    42. 48. Constructing a Financial Planning Model <ul><li>Percent-of-sales method </li></ul><ul><ul><li>First examine which items in the income statement have maintained a fixed ratio to sales </li></ul></ul><ul><ul><ul><li>This enables us to decide which items should be forecast on projected sales, and which need to be forecast on another basis </li></ul></ul></ul>
    43. 49. Constructing a Financial Planning Model <ul><li>Percent-of-sales method </li></ul><ul><ul><li>The second step is to forecast sales </li></ul></ul><ul><ul><ul><li>This is a major exercise, but we will assume that sales will continue to grow at 20% next year (as it has in the past) </li></ul></ul></ul>
    44. 50. Constructing a Financial Planning Model <ul><li>Percent-of-sales method </li></ul><ul><ul><li>The third step is to forecast those items that have been assumed to vary with sales </li></ul></ul>
    45. 51. Constructing a Financial Planning Model <ul><li>Percent-of-sales method </li></ul><ul><ul><li>The fourth and final step is to forecast the missing items that have not been assumed to vary with sales </li></ul></ul><ul><ul><li>We need some assumptions: </li></ul></ul>
    46. 52. Constructing a Financial Planning Model <ul><li>Assumptions: </li></ul><ul><ul><li>Interest rate on long-term debt is 8%, and on short-term debt is 15% </li></ul></ul><ul><ul><li>To avoid complexity, we assume that interest is computed on the yearend long- and short-term balances (we can re-address this later) </li></ul></ul><ul><ul><li>interest = 0.08*501.72 + 0.15*150 = 87.26 </li></ul></ul>
    47. 53. Constructing a Financial Planning Model <ul><ul><li>The income statement may now be constructed given the dividend pay-out ratio and tax rate (30% and 40%) </li></ul></ul><ul><ul><li>The change in equity is added to the equity for year xxx3, to give the new balance for year xxx4 </li></ul></ul><ul><ul><li>“Total assets” is available, so the “Total liabilities” may now be computed </li></ul></ul>
    48. 54. <ul><li>134.9% </li></ul><ul><li>115.7% </li></ul><ul><li>N/A </li></ul><ul><li>340 </li></ul>GPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) (Percent of Year's Sales) Year xxx0 xxx1 xxx2 xxx3 xxx1 xxx2 xxx3 F(sales)? xxx4 Income Statement Sales 200 240 288 100.0% 100.0% 100.0% N/A 346 Cost of goods sold 110 132 158 55.0% 55.0% 55.0% Yes 190 Gross margin 90 108 130 45.0% 45.0% 45.0% N/A(Yes) 156 Selling, general & admin. expenses 30 36 43 15.0% 15.0% 15.0% Yes 52 EBIT 60 72 86 30.0% 30.0% 30.0% N/A 104 Interest expenses 30 45 64 15.0% 18.8% 22.2% No 87 Taxes 12 11 9 6.0% 4.5% 3.1% N/A 7 Net income 18 16 13 9.0% 6.7% 4.7% N/A 10 Dividends 5 5 4 2.7% 2.0% 1.4% N/A 3 Change in shareholder's equity 13 11 9 6.3% 4.7% 3.3% 7 Balance Sheet Assets: Cash & equivalents 10 12 14 17 6.0% 6.0% 6.0% Yes 21 Receivables 40 48 58 69 24.0% 24.0% 24.0% Yes 83 Inventories 50 60 72 86 30.0% 30.0% 30.0% Yes 104 Property, Plant & equipment 500 600 720 864 300.0% 300.0% 300.0% Yes 1037 Total Assets 600 720 864 1037 360.0% 360.0% 360.0% N/A(Yes) 1244 Liabilities: Payables 30 36 43 52 18.0% 18.0% 18.0% Yes 62 Short-term debt 120 221 347 502 110.7% 144.6% 174.2% No Long-term debt 150 150 150 150 75.0% 62.5% 52.1% No Total Liabilities 300 407 540 704 203.7% 225.1% 244.3% N/A 904 Shareholder's equity 300 313 324 333 156.3%
    49. 55. Example Completed <ul><ul><li>We complete the balance sheet by recognizing that there are only two accounts that need to be estimated, Short-term debt, and Long-term debt </li></ul></ul><ul><ul><li>The sum is then 904 (Liabilities) - 62 (Payables) = $842 Million </li></ul></ul><ul><ul><li>Assume no change in long-term debt </li></ul></ul><ul><ul><li>Short-term debt =$842 - 150 = $692 million </li></ul></ul>
    50. 58. 3.9 Growth & Need for External Finance <ul><li>In order to grow by 20%, the firm will need an additional 692 - 502 = $190 million in external funding (all short-term funding in the example) </li></ul>
    51. 59. Some Questions: <ul><ul><ul><li>What external funds are required to support a sales growth rate, g, of 30%? </li></ul></ul></ul><ul><ul><ul><li>If I have external funds available equal to $30 million, what level of sales growth does this support? </li></ul></ul></ul>
    52. 61. 3.10 Working Capital Management <ul><li>Many businesses that fail do so because of poor management of working capital, not poor profitability </li></ul><ul><li>Working capital </li></ul><ul><ul><li>Current assets - current liabilities </li></ul></ul>
    53. 62. Efficient Management of Working Capital Principle: <ul><ul><li>Minimize the investment in non-earning assets such as </li></ul></ul><ul><ul><ul><li>receivables </li></ul></ul></ul><ul><ul><ul><li>inventories </li></ul></ul></ul><ul><ul><li>Maximizing the use of free credit such as </li></ul></ul><ul><ul><ul><li>prepayments by customers </li></ul></ul></ul><ul><ul><ul><li>accrued wages </li></ul></ul></ul><ul><ul><ul><li>accounts payable </li></ul></ul></ul>
    54. 63. Cash Cycle Time <ul><li>Cash Cycle Time = Inventory period + receivable period - payables period </li></ul>
    55. 64. 3.11 Liquidity and Cash Budgeting <ul><ul><li>A firm may be profitable, and have a sizable net worth, but if it is illiquid it will be damaged by forced assets sales and by laying-off trained workers </li></ul></ul><ul><ul><li>Banks are much more receptive to funding a planned cash shortfall than funding a shortfall that should have been forecast </li></ul></ul><ul><ul><li>Construct a Cash Budget </li></ul></ul>