Lecture 13 Financial analysis and planning II Corporate Finance Lecturer: Quan, Qi Spring 2014

Financial statements-balance sheet 1)

Financial statements-balance sheet 2) The items in the balance sheet are listed in declining order of liquidity The balance sheet does not show up-to-date market values of these long-term assets, but the original costs less depreciation The balance sheet does not include all the company’s assets. Intangible assets such as patents, reputation, a skilled management, and a well-trained labor force are not included

Financial statements-balance sheet 3) The liability side tells you the where the money used to buy those assets comes from Net working capital=current assets-current liabilities The company’s equity is simply the total value of the net working capital and fixed assets less the long-term liabilities. Part of this equity comes from the sale of shares to investors and the remainder comes from earnings that the company has retained and invested on behalf of the shareholders

Financial statements-income statement

Sources and uses of fund

Financial ratios How much has the company borrowed? Is the amount of debt likely to result in financial distress? How liquid is the company? Can it easily lay its hands on cash if needed? How productively is the company using its assets? Are there any signs that the assets are not being used efficiently? How profitable is the company? How highly is the firm valued by investors? Are investors’ expectations reasonable? Financial ratios help you to ask the right questions, not to answer them

Leverage ratios 1) How much has the company borrowed? The market value includes the value of intangible assets generated by research and development, advertising, staff training, and so on. These assets are not readily salable, and if the company falls on hard times, their value may disappear altogether. So lenders sometimes also insist that the borrower should not allow the book debt ratio to exceed a specified limit 3

Leverage ratios 2) Is the amount of debt likely to result in financial distress? 4

Liquidity ratios 1) How liquid is the company? Can it easily lay its hands on cash if needed? Rapid decreases in the current ratio sometimes signify trouble. However, they can also be misleading. For example, suppose that a company borrows a large sum from the bank and invests it in short-term securities. If nothing else happens, net working capital is unaffected, but the current ratio changes. For this reason it might be preferable to net off the short-term investments and the short-term debt when calculating the current ratio 5

Liquidity ratios 2) 6

Efficiency ratios 1) How productively is the company using its assets? Notice that since assets are likely to change over the course of a year, we use the average of the assets at the beginning and end of the year. Averages are commonly used whenever a flow figure (in this case, sales) is compared with a stock or snapshot figure (total assets) 7

Efficiency Ratios 2) The speed with which a company turns over its inventory is measured by the number of days that it takes for the goods to be produced and sold The average collection period measures how quickly customers pay their bills 8

Profitability ratios 1) 9

Profitability ratios 2) 10

Market value ratios 1) The price–earnings, or P/E, ratio measures the price that investors are prepared to pay for each dollar of earnings A relative high dividend yield indicates that investors are demanding a relatively high rate of return or that they are not expecting rapid dividend growth with consequent capital gains 11

Market value ratios 2) If the market to book ratio is more than 1, it means that the firm is worth more than past and present stockholders have put into it, and vice versa 12

The Dupont system 1) Some of the profitability and efficiency ratios that we described above can be linked in useful ways. These relationships are often referred to as the Dupont system A breakdown of ROE and ROA into component ratios

The Dupont system 2) asset turnover profit margin If the expected return on assets is fixed by competition, firms face a trade-off between the sales-to-assets ratio and the profit margin asset turnover profit margin Firms often seek to increase their profit margins by becoming more vertically integrated; for example, they may acquire a supplier or one of their sales outlets. Unfortunately, unless they have some special skill in running these new businesses, they are likely to find that any gain in profit margin is offset by a decline in the sales-to-assets ratio

The Dupont system 3) leverage ratio asset turnover profit margin debt burden Notice that the product of the two middle terms is the return on assets. This depends on the firm’s production and marketing skills and is unaffected by the financing mix. However, the first and fourth terms do depend on the debt–equity mix. The first term measures the ratio of gross assets to equity, while the last term measures the extent to which profits are reduced by interest. If the firm is leveraged,the first term is greater than 1.0 (assets are greater than equity) and the fourth term is less than 1.0 (part of the profits are absorbed by interest). Thus, leverage caneither increase or reduce the return on equity

Financial planning models 1) To see the financial consequences of a business plan, you need to develop forecasts of future cash flows. If the likely operating cash flow is insufficient to cover both the planned dividend payments and the investment in net working capital and fixed assets, then the firm needs to ensure that it can raise the balance by borrowing or by the sale of additional shares External capital required = operating cash flow -investment in net working capital -investment in fixed assets -dividends

Financial planning models 2) Step 1: Project next year’s operating cash flow

Financial planning models 3) Step2: Project additional investment in net working capital and investment in fixed asset needed to sustain the growth Step3: Calculate the difference between projected operating cashflow and projected uses

Financial planning models 4) Step 4: construct a pro forma balance sheet that incorporates the additional assets and the increase in debt and equity Over the five-year period Executive Paper would need to borrow an additional $1.2 billion and by year 2004 its debt ratio would have increased to 67 percent. What are the alternative ways to finance the plans? 1) To issue a mix of debt and equity, 2) Hold back dividends during this period of rapid growth, 3) More careful control of credit collection could help to economize on capital ( the current collection period is 72 days)

Internal growth rate General relationships between a firm’s growth objectives and its financing needs The growth rate that a company can achieve without external funds is known as the internal growth rate Recall that Executive Paper ended 1999 with fixed assets and net working capitalof $990 million. In 2000 it plans to plow back $39.4 million, so net assets will increase by 39.4/990 or 3.98 percent. Thus Executive Paper can grow by 3.98 percent without needing to raise additional capital. Sustainable growth rate =plowback ratio*return on equity