Sustainable Growth and Financial Statement Analysis
2007 Pro Forma Balance Sheet 2007 Forecasts 2007 Pro Forma Income State. Sales 150 Costs 135 Net Income 15 Dividends 6 Ret. Earnings 9 2007 Pro Forma Balance Sheet Liabilities 150 Assets 300 Equity 109 whoops! 2006 Income Statement Sales 100 Costs 90 Net Income 10 Dividends 4 Ret. Earnings 6 2006 Balance Sheet Liabilities 100 Assets 200 Equity 100
External Funds Needed (EFN) 2007 Pro Forma Income State. Sales 150 Costs 135 Net Income 15 Dividends 6 Ret. Earnings 9 2007 Pro Forma Balance Sheet Liabilities 150 Assets 300 Equity 109 Total 300 Total 259 There is a funding shortfall of 41 (A = 300, L&NW = 259) This must be made up by: Issuing new equity Allowing the ratio of liabilities/sales to rise Some combination of (1) and (2)
EFN More Generally (Eq. 3.22, p. 70) PM = Net Profit Margin b = retention ratio (retained earnings/net income)
Sustainable Growth Rate Growth rate in sales = g (i.e., S1 = (1+g)S0 and ΔS = S1 – S0 = gS0 At what rate can we grow without issuing new equity or allowing liabilities/sales to increase (e.g., EFN = 0)?
Dell’s Working Capital How did Dell fund 52% growth in sales for 1996? Use 1995 data to forecast 1996 balance sheet and compare with 1996 actual Can Dell sustain another year of 50% sales growth without issuing new equity or increasing its debt ratio? What role does Dell’s cash conversion cycle play in its funding needs?
How Can We Assess and Explain Financial Performance?
Financial Ratio Types Market Value Profitability Asset Management Leverage Liquidity
Market Value Ratios Examples: Market-to-Book; Price-Earnings Questions: How do securities markets value the company’s assets? Earnings?
Profitability Ratios Examples: Return on assets, equity, invested capital; gross, net profit margin Questions: How profitable is the company per dollar invested in the business; per dollar of sales?
Asset Management Ratios Examples: asset turnover, days’ sales in receivables, inventory turnover, days’ sales in payables Questions: How efficiently does the company use its assets? How long does it take assets or liabilities to turn into cash?
Financial Leverage Ratios Examples: Debt/assets; Debt/equity; Interest coverage Questions: How much of a burden does debt pose relative to assets, equity or cash flow? How risky is the company?
Liquidity Ratios Examples: Current ratio, quick ratio, interval measure Questions: How easily can the company meet its immediate cash requirements? How risky is the company?
Financial Ratios Relative to What? By themselves, financial ratios have no meaning. We need to compare to: Past data for the same company Data for similar companies (e.g., same industry) Other ratios (i.e., DuPont ratios, Cash Conversion Cycle)
Does One Trend Coincide with Another?
DuPont Ratios Net Income x Sales x Assets = Net Income Sales Assets Equity Equity Net profit X Asset x Equity = ROE margin turnover multiplier
Like-A-Weed mini-case How is Like-A-Weed doing? Why is the net profit margin declining? Does the company have a financial or an operating problem? What should Like-A-Weed do?