Chapter-3: Financial Statement Analysis and Financial Model Ratio Analysis Financial Planning Percentage of Sales Growth VS External Financing Determinants of Growth
Ratio Analysis • Ratios are relationship between two items of financial statements. • Different ratios help to find different characteristics of the firm • The various categories of ratios are: Liquidity, Long-term Solvency, Asset management, Profitability, Market value
Ratio Analysis • Du Pont Identity • ROE is affected by 3 things • Operating efficiency (Profit Margin) • Asset use efficiency (Asset Turnover) • Financial Leverage (Equity Multiplier)
Ratio Analysis • Enterprise Value = (Market Capitalization) + (Market value of all interest bearing outstanding debt) – (Cash) This is entire firm’s market value, which might be necessary during acquisition decisions
Financial Planning • Financial Planning models forecasts financial statements • Known as “pro-forma” statements • There are several models used to forecast • In this section we will learn the Percentage to Sales method • This model takes “Sales” as the comparison base and forecasts that most of the items on the financial statement changes at the same rate as the sales. • i.e. the ratio with sales of most items remain constant
Percentage of Sales: Example • We will be looking at the steps of percentage of sales model of financial planning when applied on Rosengarten Corporation: Income Statement Balance Sheet
Percentage of Sales: Example • Step 1: Separate Income Statement and Balance Sheet accounts into two groups: those that vary with sales, those that don’t.
Percentage of Sales: Example • Step 2: Forecast a sales growth rate. Several ways this can be done: • Finding a trend from previous growth • Discussion with the sales and production team about their targets and capabilities • In this example Rosengarten projected a 25% increase in sales the coming year
Percentage of Sales: Example • Step 3: Create Pro-forma Income statement using the forecasted sales growth rate. • At 25% growth Rosengarten’s projected sales will be $1000 X 1.25 = $1250
Percentage of Sales: Example • Step 4: Calculate projected dividend and additions to retained earnings • Net Income = Dividends + Retained Earnings • Payout Ratio = Dividend / Net Income • Retention Ratio (Plowback Ratio) = • Retained Earnings / Net Income • OR (1 – Payout Ratio) • For Rosengarten: • Payout ratio = $44/$132 = 33.33% • Plowback ratio = $88/$132 = 66.67% • So projected dividend = $165 X 33.33% = $55 • Projected retained earnings = $165 X 66.67% = $110
Percentage of Sales: Example • Step 5: Create a partial pro-forma balance sheet to calculate EFN • Start with forecasted total asset as asset/sales ratio will remain constant • This is the capital intensity ratio (reciprocal of Total asset turnover) • Higher the ratio the more capital intensive is the company • Rosengarten’s capital intensity ratio is 300%
Percentage of Sales: Example • External Fund Needed (EFN) = $565
Percentage of Sales: Example • Step 6: Decide on the way to raise the EFN and use it to complete the Pro-forma Balance sheet • External financing decisions are taken by top management. They can choose among three decisions: • 100% EFN raised through debt (short-term & long-term) • 100% EFN raised through common stocks • Optimal debt-equity ratio used to raise EFN through a combination of both debt and equity sources.
Percentage of Sales: Example • Rosengarten used 100% debt & kept the same NWC
Growth VS External Financing • Internal Growth Rate: The growth rate a firm can maintain without the requirement of any external financing (only internal financing i.e. Retained earnings) • Represented by the point where the two graphs cross (in the previous slide) • At this point required increase in assets is exactly equal to the additions of retained earnings. • where“b” = retention ratio
Growth VS External Financing • Sustainable Growth Rate: It is the maximum growth rate a firm can achieve with no external equity financing while maintaining a constant debt-equity ratio • Firms prefer raising fund through debt than equity because: • Equity issuance has higher transaction cost • Shareholders want to avoid diluted ownership • Firm wants to attain financial leverage in terms of ROE • Where “b” = retention ratio
Determinants of Sustainable Growth • Since ROE is a prominent factor for calculating sustainable growth, thus determinants of ROE and Sustainable Growth are same • ROE = Profit margin X Total asset turnover X Equity Multiplier • So determinants of sustainable growth are: • Profit margin: Increase in PM will increase firm’s ability to generate funds internally (R.E) • Dividend Policy: Decrease in dividend payout ratio increases retention ratio thus internal funds increase • Financial Policy: Increase in debt-equity ratio makes additional debt financing available through increased leverage • Total asset turnover: Increase in total asset turnover decreases firm’s need for new assets as less assets produce more sales.