CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 3:

Evaluating and Forecasting Financial Performance

INTRODUCTION

This chapter introduces financial statement analysis techniques that are used to evaluate a company’s performance.

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FINANCIAL RATIOS ARE USED BY Management:

Planning and evaluating

Identifying and assessing merger candidates

Credit Managers Estimate the riskiness of potential borrowers

Investors Evaluate corporate securities

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WORDS OF CAUTION Ratios are only as good as the information on which they are

based.

Ratios become most valuable when: Compared to the ratios of a peer group Analyzed over time

Ratios are symptoms, not causes.

Ratios should cause one to ask questions; rarely do they provide answers themselves

When comparing ratios among different firms, ensure the ratios are calculated using the same method.

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TYPES OF RATIOS

Liquidity

Asset management

Financial leverage

Profitability

Market-based

Dividend policy

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MAJOR FINANCIAL STATEMENTS

Balance sheet Shows the firms assets & liabilities as of a certain date (such

as December 31, 200X)

Income statement Measures the flow of revenue and expenses over a reporting

period (such as a year or a quarter)

Cash flow statement A statement of the organization’s sources and uses of cash

resources during a reporting period

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ABBREVIATIONS USED IN THE CHAPTER

EBIT – Earnings Before Interest & Taxes

ROI – Return on Investment

ROE – Return on Equity

P/E Ratio – Price to Earnings Ratio

EAT – Earnings After Tax

r – Return on total capital

k – Cost of capital 7

LIQUIDITY RATIOS

Used to indicate the ability of the firm to fund its liabilities as they come due.

Higher ratio normally preferred to a lower ratio High ratio may indicate poor asset management. Low ratio may indicate difficulty meeting short-term

financial obligations8

Current AssetsCurrent Ratio =

Current Liabilities

LIQUIDITY RATIOS

Similar to the current ratio but includes only the most liquid of the current assets

A more conservative measure of liquidity

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Current Assets - InventoryQuick Ratio =

Current Liabilities

ASSET MANAGEMENT RATIOS

Indicates number of days that, on average, it takes to collect an account receivable.

Long collection period may indicate problems with credit quality or credit granting procedures.

The collection period should always be compared to the firm’s stated credit policy.

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( )÷Accounts Receivable

Collection Period = Annual Credit Sales 365

ASSET MANAGEMENT RATIOS

Shows how many times inventory is turned over during a year.

High ratio is preferred over a low ratio.

Low ratio may indicate stale inventory needing to be sold at discount or poor sales forecasting.

A high ratio may be indicative of lost sales from stock-outs. 11

Cost of SalesInventory Turnover =

Average Inventory

ASSET MANAGEMENT RATIOS

Indicates the number of dollars of sales generated per dollar of fixed assets.

High ratio is often preferred to a low ratio.

High ratio may indicate obsolete fixed assets.

Ratio should be put into context with its industry. 12

SalesFixed Asset Turnover =

Net Fixed Assets

ASSET MANAGEMENT RATIOS

Indicates the number of dollars of sales generated per dollar of total assets.

Similar to the Fixed Asset Turnover Ratio, but the Total Asset Turnover ratio includes both current and fixed assets in the denominator.

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SalesTotal Asset Turnover =

Total Assets

FINANCIAL LEVERAGE RATIOS

The amount of debt per dollar of total assets.

A high number indicates more risk for creditors.

A low number indicates that the assets have been financed mainly by the shareholders.

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Total DebtDebt Ratio =

Total Assets

FINANCIAL LEVERAGE RATIOS

The amount of debt per dollar of equity.

A high ratio indicates that more of the firm is financed by creditors (higher risk of default).

A low ratio indicates that more of the firm is financed by the shareholders (but harder to earn a high return on equity). 15

Total DebtDebt-to-Equity Ratio =

Total Equity

FINANCIAL LEVERAGE RATIOS

Indicates the earnings “cushion” that the firm has before it will not be able to meet its interest payments.

A higher number is preferred to a lower number.

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EBITTimes Interest Earned =

Interest Charges

PROFITABILITY RATIOS

Percentage “Gross Profit” from each $1 of sales.

The Gross Profit Margin must cover all other costs, including profit (the return to the investors).

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Sales - Cost of Goods SoldGross Profit Margin =

Sales

PROFITABILITY RATIOS

The proportion of each dollar of sales that the firm retains as profit, after all expenses, including taxes, have been paid.

A Net Profit Margin of 0.05 indicates that the firm retains $5.00 in profit from each $100 of sales that it makes. 18

Earnings After TaxesNet Profit Margin =

Sales

PROFITABILITY RATIOS

The ROI indicates the annual percentage return on each dollar of capital invested in the firm (by both creditors and shareholders).

Both shareholders & creditors prefer a high ROI.

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Earnings After TaxesROI =

Total Assets

PROFITABILITY RATIOS

The ROE indicates the annual percentage return on each dollar of owner’s equity invested in the firm.

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Earnings After TaxesROE =

Shareholders' Equity

PROFITABILITY RATIOS

The relationship between ROI & ROE is expressed in the following formula:

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×

×

ROE = ROI LeverageAssets

= ROIOwner's Equity

MARKET BASED RATIOS

Indicates how much the market is willing to pay for each $1 of firm earnings.

A high number suggests the firm has excellent growth prospects, is very low risk or both.

Based on accounting earnings, which differ substantially from cash flow over short periods of time.

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Market Price Per ShareP/E Ratio =

Earnings Per Share

MARKET BASED RATIOS

Indicates how much the market is willing to pay for each $1 of Owners’ Equity, as shown on the Balance Sheet.

A high number indicates the firm has hidden or undervalued assets stored on its Balance Sheet.

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Market Price Per ShareMarket to Book Ratio =

Book Value Per Share

DIVIDEND POLICY RATIOS

Indicates the percentage of each $1 of net income that is paid out to its shareholders in the form of a dividend.

High growth firms usually have a low dividend payout ratio.

Slow growth firms have fewer investment opportunities and thus pay out a larger percentage of income to their shareholders.

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Dividends Per SharePayout Ratio =

Earnings Per Share

DIVIDEND POLICY RATIOS

Indicates the percentage of the share price that is paid out annually in the form of a dividend.

A high dividend yield may indicate: A depressed share price A firm with low growth prospects

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Dividends Per ShareDividend Yield =

Market Price Per Share

COMMON –SIZE ANALYSIS Common size balance sheet: a balance sheet in which a

firm’s assets and liabilities are expressed as a percentage of total assets

Common size income statement: an income statement in which a firm’s income and expense items are expressed as a percentage of sales

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TREND ANALYSIS An examination of a firm’s performance over time.

Frequently based on one or more financial ratios over a period of three or more years.

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DUPONT ANALYSIS Used to help identify the source of a problem by “drilling

into” the component parts of a ratio

Example:

See Figure 3.2 (page 84) for an illustration of a Modified DuPont Analysis that analyzes the ROI for the Maple Manufacturing Company

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RELATIONSHIPS AMONG RATIOS

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× =EAT Sales EATROI =

Sales Total Assets Total Assets

× ×EAT Sales Total AssetsROE =

Sales Total Assets Equity

Sometimes called the equity multiplier

FORECASTING WITH FINANCIAL RATIOS

Edward Altman popularized the use of forecasting potential bankruptcy with the use of discriminant analysis.

Uses 5 ratios to generate a “Zeta Score” Net working capital/Total assets Retained earnings/Total assets EBIT/Total assets Market value equity/Book value total debt Sales/Total assets

A number below 2.65 indicated a higher probability of bankruptcy. 30

SOURCES OF FINANCIAL INFORMATION

Dun and Bradstreet

Financial Post

Moody’s

Standard and Poor’s

Annual reports and 10K Filings

Trade associations and journals

Computerized databases31

QUALITY AND FINANCIAL ANALYSIS The quality of a firm’s earnings is positively related to:

the proportion of cash earnings to total earnings the proportion of recurring income to total income.

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QUALITY AND FINANCIAL ANALYSIS The quality of a firm’s balance sheet is:

positively related to the ratio of the market value of the firm’s assets to book value of the assets

inversely related to the amount of its hidden liabilities

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PROBLEMS IN REPORTING

Time of revenue recognition

Establishment of reserves

Amortization of intangible assets

Including all losses and debt

“Pro forma” profitability measures

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BALANCE SHEET QUALITY ISSUES

Charging off assets

Hidden liabilities

Hidden assets

Off balance sheet financing

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PROBLEMS CAUSED BY INFLATION

Inventory profit as a result of timing of price increases

Inventory valuation methods LIFO vs. FIFO

Rising interest rates causing a decline in the value of long-term debt

Differences in the reporting of earnings

Recognition of sales

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ANALYSIS OF A FIRM’S MARKET VALUE

Market value added (MVA) = Market value – Capital The capital market’s assessment of the accumulated NPV of

all of the firm’s past and present projected investment projects

Economic value added (EVA) = (r – k) × Capital The yearly contribution of operations to the creation of MVA

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FORECASTING METHODS

Percent of sales

Cash budgets

Pro forma statement of cash flow

Computerized financial forecasting models

Forecasting with financial ratios

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PERCENT OF SALES FORECASTING Used to forecast amount of additional financing required, due

increased sales

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Forecasted Increase in

Current Liabilities–

Forecasted Increase in

Assets=

TotalFinancingNeeded

Dividends–Forecasted Earnings after Tax

=Increase in Retained Earnings

• Some portion of the financing will be generated internally, as shown below:

ADDITIONAL FINANCING NEEDED

Difference between total financing needed and internal financing provided is equal to:

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( ) ( ) ∆ ∆−

−

Additional (external) Financing Needed =

Assets Sales Current Liabilities Sales

Sales Sales

Earnings After Taxes - Dividends

THE CASH FLOW CONCEPT Accounting income is not the same as cash flow

Cash flow is the relevant source of value

for the firm

After Tax Cash Flow Earnings After Taxes + Noncash charges Noncash charges = Depreciation + Deferred Taxes

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CASH FLOW STATEMENT

Presents the effects of operating, investing, and financing on the cash balance

Direct method presents the effects to net cash provided by operating, investing, and financing.

Indirect method presents the adjustments to net income showing the effects to net cash.

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CASH BUDGETING Forecasts receipts and disbursements over future periods of

time.

Budgeting considerations:

Receipt of credit sales lag projected sales Payments for purchases may precede sales based upon available

credit terms. Other scheduled receipts and disbursements

Long-term loans, capital expenditures, dividend payments, wages, rent…

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PRO FORMA CASH FLOW STATEMENT Measures the increases (and decreases) in cash and cash

equivalents arising from: operations investing activities financing activities

Amounts from operating, investing and financing activities are added to cash and cash equivalents at the start of year

Total of the above should equal the balance of expected cash and cash equivalents at the end of year

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ACCURACY OF FINANCIAL STATEMENTS

External auditor

Generally accepted accounting principles

Corporations pose for a financial statement like people pose for a picture

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FORECASTING AND FINANCIAL PLANNING

Deterministic model Uses single-value forecasts of each financial variable

Probabilistic model Utilize probability distributions for input data

Optimization model Choose the optimal levels of some variables

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MAJOR POINTS

There are a variety of financial ratios analyzing various financial features of a firm (i.e. liquidity, profitability, etc).

Most information for ratio analysis derives from primary financial statements.

Ratios indicate symptoms of problems. Findings should be placed in context with the firm’s historical and industry trends.

Forecasting models help management avoid potential financial problems.

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