© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 3: Evaluating and Forecasting Financial Performance

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter introduces financial statement analysis techniques that are used to evaluate a company’s performance.

© 2004 by Nelson, a division of Thomson Canada Limited 3 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

© 2004 by Nelson, a division of Thomson Canada Limited 4 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.

© 2004 by Nelson, a division of Thomson Canada Limited 5 Types of Ratios  Liquidity  Asset management  Financial leverage  Profitability  Market-based  Dividend policy

© 2004 by Nelson, a division of Thomson Canada Limited 6 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

© 2004 by Nelson, a division of Thomson Canada Limited 7 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

© 2004 by Nelson, a division of Thomson Canada Limited 8 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

© 2004 by Nelson, a division of Thomson Canada Limited 9 Liquidity Ratios  Similar to the current ratio but includes only the most liquid of the current assets  A more conservative measure of liquidity

© 2004 by Nelson, a division of Thomson Canada Limited 10 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.

© 2004 by Nelson, a division of Thomson Canada Limited 11 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.

© 2004 by Nelson, a division of Thomson Canada Limited 12 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.

© 2004 by Nelson, a division of Thomson Canada Limited 13 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.

© 2004 by Nelson, a division of Thomson Canada Limited 14 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.

© 2004 by Nelson, a division of Thomson Canada Limited 15 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).

© 2004 by Nelson, a division of Thomson Canada Limited 16 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.

© 2004 by Nelson, a division of Thomson Canada Limited 17 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).

© 2004 by Nelson, a division of Thomson Canada Limited 18 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.

© 2004 by Nelson, a division of Thomson Canada Limited 19 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.

© 2004 by Nelson, a division of Thomson Canada Limited 20 Profitability Ratios  The ROE indicates the annual percentage return on each dollar of owner’s equity invested in the firm.

© 2004 by Nelson, a division of Thomson Canada Limited 21 Profitability Ratios  The relationship between ROI & ROE is expressed in the following formula:

© 2004 by Nelson, a division of Thomson Canada Limited 22 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.

© 2004 by Nelson, a division of Thomson Canada Limited 23 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.

© 2004 by Nelson, a division of Thomson Canada Limited 24 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.

© 2004 by Nelson, a division of Thomson Canada Limited 25 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

© 2004 by Nelson, a division of Thomson Canada Limited 26 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

© 2004 by Nelson, a division of Thomson Canada Limited 27 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.

© 2004 by Nelson, a division of Thomson Canada Limited 28 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

© 2004 by Nelson, a division of Thomson Canada Limited 29 Relationships Among Ratios Sometimes called the equity multiplier

© 2004 by Nelson, a division of Thomson Canada Limited 30 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.

© 2004 by Nelson, a division of Thomson Canada Limited 31 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

© 2004 by Nelson, a division of Thomson Canada Limited 32 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.

© 2004 by Nelson, a division of Thomson Canada Limited 33 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

© 2004 by Nelson, a division of Thomson Canada Limited 34 Problems in Reporting  Time of revenue recognition  Establishment of reserves  Amortization of intangible assets  Including all losses and debt  “Pro forma” profitability measures

© 2004 by Nelson, a division of Thomson Canada Limited 35 Balance Sheet Quality Issues  Charging off assets  Hidden liabilities  Hidden assets  Off balance sheet financing

© 2004 by Nelson, a division of Thomson Canada Limited 36 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

© 2004 by Nelson, a division of Thomson Canada Limited 37 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

© 2004 by Nelson, a division of Thomson Canada Limited 38 Forecasting Methods  Percent of sales  Cash budgets  Pro forma statement of cash flow  Computerized financial forecasting models  Forecasting with financial ratios

© 2004 by Nelson, a division of Thomson Canada Limited 39 Percent of Sales Forecasting  Used to forecast amount of additional financing required, due increased sales Forecasted Increase in Current Liabilities – Forecasted Increase in Assets = Total Financing Needed Dividends– Forecasted Earnings after Tax = Increase in Retained Earnings  Some portion of the financing will be generated internally, as shown below:

© 2004 by Nelson, a division of Thomson Canada Limited 40 Additional Financing Needed  Difference between total financing needed and internal financing provided is equal to:

© 2004 by Nelson, a division of Thomson Canada Limited 41 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

© 2004 by Nelson, a division of Thomson Canada Limited 42 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.

© 2004 by Nelson, a division of Thomson Canada Limited 43 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…

© 2004 by Nelson, a division of Thomson Canada Limited 44 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

© 2004 by Nelson, a division of Thomson Canada Limited 45 Accuracy of Financial Statements  External auditor  Generally accepted accounting principles  Corporations pose for a financial statement like people pose for a picture

© 2004 by Nelson, a division of Thomson Canada Limited 46 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

© 2004 by Nelson, a division of Thomson Canada Limited 47 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.