Contemporary Financial Management

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.

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

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.

Types of Ratios • Liquidity • Asset management • Financial leverage • Profitability • Market-based • Dividend policy

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

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

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 obligations

Liquidity Ratios • Similar to the current ratio but includes only the most liquid of the current assets • A more conservative measure of liquidity

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.

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.

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.

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.

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.

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).

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.

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).

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.

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.

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

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

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.

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.

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.

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

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

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.

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

Relationships Among Ratios 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.

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 databases

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.

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

Problems in Reporting • Time of revenue recognition • Establishment of reserves • Amortization of intangible assets • Including all losses and debt • “Pro forma” profitability measures

Balance Sheet Quality Issues • Charging off assets • Hidden liabilities • Hidden assets • Off balance sheet financing

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

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

Forecasting Methods • Percent of sales • Cash budgets • Pro forma statement of cash flow • Computerized financial forecasting models • Forecasting with financial ratios

TotalFinancingNeeded = Forecasted Increase in Assets Forecasted Increase in Current Liabilities – Increase in Retained Earnings = Forecasted Earnings after Tax – Dividends Percent of Sales Forecasting • Used to forecast amount of additional financing required, due increased sales • 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:

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

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.

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…

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

Accuracy of Financial Statements • External auditor • Generally accepted accounting principles • Corporations pose for a financial statement like people pose for a picture

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

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.

Contemporary Financial Management