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Snyder Gardens: Summary Points

Snyder Gardens: Summary Points. by Dr. Mike Vetsuypens Professor of Finance SMU Cox School of Business. Lessons from Snyder Gardens. Earnings don’t tell the whole story: We need cash flow analysis Firms can “profitably run out of cash”

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Snyder Gardens: Summary Points

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  1. Snyder Gardens: Summary Points by Dr. Mike Vetsuypens Professor of Finance SMU Cox School of Business

  2. Lessons from Snyder Gardens • Earnings don’t tell the whole story: • We need cash flow analysis • Firms can “profitably run out of cash” • A rough estimate of how much a company needs to support a given sales level is not hard to derive: • use history or your plans as a guide • create pro-forma statements • As long as growth lasts, there will be a need for cash. If the growth is permanent, the company needs permanent, i.e. long-term, capital (LT Debt or Equity) • “Collect faster”, “cut costs”, “stretch payables”, “lower inventory”, “slow growth”: unrealistic and/or harmful!

  3. How fast can a firm afford to grow?The “sustainable growth rate” • The cash that a firm uses must come from somewhere. Therefore, sales growth, debt usage, equity issues, dividend payments and asset utilization ARE INHERENTLY LINKED. You can pick 4 of these variables, but the 5th is then determined by your prior 4 choices. • The sustainable growth rate (G*) is the maximum growth rate in Sales that can be achieved (=financed)…. • Without increasing the debt percentage • Without raising outside equity • Without reducing dividends (if any) • Without increasing asset efficiency (asset turnover)

  4. The “sustainable growth rate” (2) • G*= ROE * (1- dividend payout rate) • G*=(RE/NI)*(NI/Sales)*(Sales/Assets)*(Assets/Equity) • If actual Sales growth > G * then conditions 1,2,3 and/or 4 above will be violated. • Especially dangerous is if fast sales growth is accommodated by increasing leverage (condition 1 above). This may cause liquidity problems and insolvency.

  5. Illustration of sustainable growth(1) Assume that this firm plans Sales growth of 30% next year. What will its balance sheet look like in 1 year? Debt 40 Assets 100 Equity 60

  6. Illustration of sustainable growth(2) With Sales growth = 30% , and constant Asset Turnover, 30 in new Debt and Equity capital is needed. Debt 40 Assets 100 Equity 60 30 30 New Assets New capital

  7. Illustration of sustainable growth(3) With a constant debt proportion, 12 in new Debt and 18 in new Equity capital is needed. Debt 40 Assets 100 Equity 60 New D 12 30 New Assets New E 18

  8. Illustration of sustainable growth(4) With no outside equity, 18 in new internally generated Equity capital is possible only if 18 in reinvested earnings are available. This means that Return on Equity (ROE) must be 30%(=18 in retained earnings/60 beginning equity), the same as the Sales growth. So G=ROE. Debt 40 Assets 100 Equity 60 New D 12 30 New Assets New E 18

  9. A “Solvent” Bankruptcy “Nobody has seriously questioned the company’s solvency. Our problem is liquidity.” C.E.O. of Lomas Financial Corp (upon filing for Chapter 11)

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