Financial Analysis and Planning Chapter 3 Financial Analysis and Planning

Overview of Lecture The Annual Report Ratio Analysis The Du Pont Identity Using Financial Statement Information Financial Planning Models External Financing and Growth

Corporate Finance in the News Insert a current news story here to frame the material you will cover in the lecture.

Statement of Financial Position The Annual Report Statement of Financial Position The Income Statement Statement of Cash Flows

The Statement of Financial Position Also known as The Balance Sheet Assets  Liabilities + Shareholders’ equity Assets represent investments made by company Liabilities and Equity represent how investments are financed

Figure 3.1 The Statement of Financial Position

The Balance Sheet Equation Liabilities Equity Assets

Example 3.1 Building the Statement of Financial Position From British Airways’ 2009 annual report, it had current assets of £2.346 billion, non-current assets of £8.142 billion, current liabilities of £4.142 billion, and non-current liabilities of £4.5 billion. What does British Airways’ statement of financial position or balance sheet look like? What is shareholders’ equity? What is net working capital?

Example 3.1 Building the Statement of Financial Position Net working capital is the difference between current assets and current liabilities, or £2.346 - £4.142 = -£1.796.

Net Working Capital Net Working Capital = Current Assets minus Current Liabilities It is important to ensure that net working capital is positive Positive net working capital means that enough cash will be available to pay off liabilities arising

Accounting Figures drawn from Accounting Standards Market Value Market vs Book Value Book Value Accounting Figures drawn from Accounting Standards Market Value Value based on prices or market valuations

Example 3.2 Market Value versus Book Value Siouxsie plc has non-current assets with a book value of £700 and an appraised market value of about £1,000. Net working capital is £400 on the books, but approximately £600 would be realized if all the current accounts were liquidated. Siouxsie has £500 in long-term debt, both book value and market value. What is the book value of the equity? What is the market value?

Example 3.2 Market Value versus Book Value

Measures performance over a specific period The Income Statement Measures performance over a specific period

The Income Statement Revenues Expenses Income

Three Important Considerations The Income Statement Three Important Considerations Non-Cash Items Time Costs

Average Tax Rates Marginal Tax Rate Taxes Average Tax Rates This is the percentage of income that is paid in taxes Average Tax Rate is the tax bill divided by your taxable income Marginal Tax Rate The tax you would pay if you earn one more unit of currency

Which Tax Rate Should You Use in Financial Decisions? Use the Marginal Tax Rate since that is the rate that you would be taxed on any additional income earned

Cash Flow The most important item to take from financial statements Cash Flow is NOT the same as Net Working Capital Cash Flows from Assets = Cash Flows to Creditors and Equity Investors Total Cash Flow comes from operating activities, investing activities, and financing activities

Work the Web Now is a good time to download a set of company accounts and look through them in detail.

Financial Statement Analysis It is important to be able to analyse a firm’s financial statements and compare them to other firms

Financial Leverage Ratios Ratio Analysis Liquidity Ratios Financial Leverage Ratios Turnover Ratios Profitability Ratios Market Value Ratios

Liquidity or Short-Term Solvency Ratios Current Ratio Quick or Acid Test Ratio Cash Ratio

Short-Term Solvency Ratios

Financial Leverage or Long-Term Solvency Ratios Total Debt Ratio Debt to Equity Ratio Equity Multiplier Times Interest Earned Cash Coverage

Long-Term Solvency Ratios

Asset Management or Turnover Ratios Inventory Turnover Days’ Sales in Inventory Receivables Turnover Days’ Sales in Receivables Total Asset Turnover

Asset Management Ratios

Profitability Ratios Profit Margin Return on Assets Return on Equity

Profitability Ratios

Earnings per Share Price Earnings Ratio Market to Book Ratio Market Value Ratios Earnings per Share Price Earnings Ratio Market to Book Ratio

Market Value Ratios

ROE is Affected By Operating Efficiency Asset Use Efficiency The Du Pont Identity ROE is Affected By Operating Efficiency Asset Use Efficiency Financial Leverage

The Du Pont Identity: Proof

Using Financial Statement Information: Choose a Benchmark Look at the same ratio over a number of years Time Trend Analysis Compare ratio with similar firms Companies in same industry (Check SIC Code) Peer Group Analysis

Financial Statement Analysis: Some Issues Some companies operate in several industries Different Accounting Standards Inappropriate Peers You may want to compare your firm with the best in the industry Choose similar firms at the top of the industry Aspirant Analysis Financial Websites: Yahoo! Finance, Reuters, FT.Com, ADVFN.com, Motley Fool Company Accounts: Download from website Sources of Information

Financial Statements can be used to plan over the long term Financial Planning Financial Statements can be used to plan over the long term The Percentage of Sales approach to Financial Planning External Financing Needed (EFN)

Example: Chute SA Income Statement Sales €1,000 Assets €500 Debt €250 Statement of Financial Position Sales €1,000 Assets €500 Debt €250 Costs 800 Equity 250 Net income € 200 Total Assume that all variables are a constant percentage of sales What happens if sales grow by 20 percent?

Statement of Financial Position Example: Chute SA Income Statement Sales €1,200 Costs 960 Net income € 240 Statement of Financial Position Assets €600 (+100) Debt €300 (+50) Equity 300 Total €600 (+100) How can net income be €240 but equity only increases by €50?

The Percentage of Sales Approach Assume only some variables are tied to sales growth

Bogle plc Income Statement Example: Bogle plc Bogle plc Income Statement Sales £1,000 Costs 800 Taxable income £ 200 Taxes(28%) 56 Net income £ 144 Dividends £48 Addition to retained earnings 96 Costs are a constant percentage of sales (i.e. Constant profit margin) Dividend payout ratio is constant What happens with a 25 percent increase in sales?

Example: Bogle plc (25% increase in Sales) Bogle plc Pro Forma Income Statement Sales (projected) £1,250 Costs (80% of sales) 1,000 Taxable income £ 250 Taxes (28%) 70 Net income £ 180 Dividend payout ratio = Cash dividends / Net income = £48/£144 = 1/3 Projected dividends paid to shareholders = £180  1/3 = £ 60 Projected addition to retained earnings = €180  2/3 = 120 £180

Example: Bogle plc Statement of Financial Position

Example: Bogle plc New Statement of Financial Position

External Financing Needed For Bogle plc:

Bogle plc Possible Scenario

External Financing and Growth: Hoffman AG Income Statement Sales €500 Costs 400 Taxable income €100 Taxes (34%) 34 Net income €66 Dividends €22 Addition to retained earnings 44

External Financing and Growth: Hoffman AG

Financing and Growth: Hoffman AG You forecast sales of €600 next year. What will be the new debt-equity ratio? Sales (projected) €600.0 Costs (80% of sales) 480.0 Taxable income €120.0 Taxes (34%) 40.8 Net income € 79.2 Dividends €26.4 Addition to retained earnings 52.8

Financing and Growth: Hoffman AG Assume Hoffman borrows €47.2, New DE Ratio is £297.2/£302.8 = .98

Growth and Projected EFN for Hoffman AG

Growth and Financing Requirements for Hoffman AG

Financial Policy and Growth The Internal Growth Rate The Sustainable Growth Rate Determinants of Growth

The Internal Growth Rate For Paradise plc:

The Sustainable Growth Rate For Paradise plc:

Determinants of Growth Remember Du Pont! Profit Margin Total Asset Turnover Financial Policy Dividend Policy

Financial Policy and Growth If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy, and total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate.

Financial Planning Models: Some Caveats Financial Planning Models ignore cash flow, risk, and timing Financial Planning should not be a mechanical process Financial Planning Should be an Iterative Process

Overview of Lecture The Annual Report Ratio Analysis The Du Pont Identity Using Financial Statement Information Financial Planning Models External Financing and Growth

Activities for this Lecture Reading Insert here Assignment

Thank You