Sustainable Growth and Financial Statement Analysis

2007 Forecasts

2007 Pro Forma Income State.Sales 150Costs 135Net Income 15Dividends 6Ret. Earnings 9

2007 Pro Forma Balance SheetLiabilities 150

Assets 300Equity 109

whoops!

2006 Income StatementSales 100Costs 90Net Income 10Dividends 4Ret. Earnings 6

2006 Balance Sheet

Liabilities 100Assets 200

Equity 100

External Funds Needed (EFN)

2007 Pro Forma Income State.

Sales 150

Costs 135

Net Income 15

Dividends 6

Ret. Earnings 9

2007 Pro Forma Balance Sheet

Liabilities 150

Assets 300

Equity 109

Total 300 Total 259

• There is a funding shortfall of 41 (A = 300, L&NW = 259)

• This must be made up by:1. Issuing new equity

2. Allowing the ratio of liabilities/sales to rise

3. Some combination of (1) and (2)

EFN More Generally (Eq. 3.22, p. 70)

)6)(.150(10.)50(1)50(241

))((Pr

besojectedSalPMSalesSales

sLiabilitieSales

Sales

AssetsEFN

PM = Net Profit Margin

b = retention ratio (retained earnings/net income)

Sustainable Growth Rate

• Growth rate in sales = g (i.e., S1 = (1+g)S0 and ΔS = S1 – S0 = gS0

• At what rate can we grow without issuing new equity or allowing liabilities/sales to increase (e.g., EFN = 0)?

ROEb

ROEbgPMbPMb

sales

equityg

PMbPMbsales

liab

sales

assetsg

bSgPMgSsales

liabgS

sales

assetsEFN

1)(

).

(

)1(.

0 000

Dell’s Working Capital

• How did Dell fund 52% growth in sales for 1996?– Use 1995 data to forecast 1996 balance sheet and

compare with 1996 actual

• Can Dell sustain another year of 50% sales growth without issuing new equity or increasing its debt ratio?

• What role does Dell’s cash conversion cycle play in its funding needs?

How Can We Assess and Explain Financial Performance?

Financial Ratio Types

• Market Value

• Profitability

• Asset Management

• Leverage

• Liquidity

Market Value Ratios

• Examples: Market-to-Book; Price-Earnings

• Questions: How do securities markets value the company’s assets? Earnings?

Profitability Ratios

• Examples: Return on assets, equity, invested capital; gross, net profit margin

• Questions: How profitable is the company per dollar invested in the business; per dollar of sales?

Asset Management Ratios

• Examples: asset turnover, days’ sales in receivables, inventory turnover, days’ sales in payables

• Questions: How efficiently does the company use its assets? How long does it take assets or liabilities to turn into cash?

Financial Leverage Ratios

• Examples: Debt/assets; Debt/equity; Interest coverage

• Questions: How much of a burden does debt pose relative to assets, equity or cash flow? How risky is the company?

Liquidity Ratios

• Examples: Current ratio, quick ratio, interval measure

• Questions: How easily can the company meet its immediate cash requirements? How risky is the company?

Financial Ratios Relative to What?

• By themselves, financial ratios have no meaning. We need to compare to:

– Past data for the same company– Data for similar companies (e.g., same

industry)– Other ratios (i.e., DuPont ratios, Cash

Conversion Cycle)

Does One Trend Coincide with Another?

DuPont Ratios

Net Income x Sales x Assets = Net Income

Sales Assets Equity Equity

Net profit X Asset x Equity = ROE

margin turnover multiplier

Like-A-Weed mini-case

• How is Like-A-Weed doing?

• Why is the net profit margin declining?

• Does the company have a financial or an operating problem?

• What should Like-A-Weed do?