Chapter 14 Financial Analysis and Long- Term Financial Planning © 2003 John Wiley and Sons

2 Chapter Outcomes n Describe what is meant by financial statement analysis. n Describe the five basic types of financial ratios. n Indicate what is meant by Du Pont analysis and indicate its major components. n Explain the importance of the quality of financial statements.

3 Chapter Outcomes, continued n Describe the link between asset investment requirements and sales growth. n Describe how internally generated financing occurs. n Describe how additional external financing requirements are determined. n Describe cost-volume-profit analysis.

4 Financial Statement Analysis n Why? n Reflects effect of economic and competitive environment n Internal uses by management n External uses –Investors –Suppliers –Lenders

5 Ratio Analysis n Absolute numbers versus ratios n Types of ratio analysis –trend or time series –cross-sectional –industry average

6 Ratio Analysis n Difficulties –GAAP –Multiproduct firms and other differences –Within same industry, ratio characteristics may differ between large/small, domestic/global firms –Ratios may be defined differently by various sources

7 Ratio Analysis n Focus on different ratios depends on user: –Bank loan officer –Long-term lender/bondholder –Equity investor

8 Types of Financial Ratios n Liquidity n Asset Management n Financial Leverage n Profitability n Market Value

9 Liquidity Ratios n Current ratio = Current Assets Current Liabilities n Quick or acid-test ratio = (Cash + Accts. Receivable) Current Liabilities n Average payment period = Accts Payable / (COGS/365)

10 Asset Management n Total Asset Turnover = Net Sales / Total Assets n Fixed Asset Turnover = Net Sales/Fixed Assets

11 More Asset Management n Average collection period = Accts Receivable / (Net Sales/365) n Inventory Turnover = Cost of goods sold Inventory

12 Financial Leverage n Total Debt to Total Assets = Total Liabilities / Total Assets n Total Debt to Equity = Total Liabilities / Stockholder’s Equity n Equity Multiplier = Total Assets / SE

13 Financial Leverage, continued n Interest Coverage = EBIT / Interest expense n Fixed Charge Coverage = Earnings before Fixed Charges Before-tax Fixed Charges n Fixed Charges: interest, rent, lease, sinking fund payments, etc.

14 Profitability n Operating Profit Margin = EBIT / Net Sales n Net Profit Margin = Net Income / Net Sales n Operating Return on Assets = EBIT / Total Assets n Return on Assets (ROA) = Net Income / Total Assets n Return on Equity (ROE) = Net Income / Stockholder’s Equity

15 Market Value n Price / earnings (P/E) ratio n Price / book ratio

16 A Note on Quality Financial Statements n Quality Income Statement n Quality Balance Sheet

17 Ratios and Puzzles n Examine ratios to determine a firm’s strengths, weaknesses n Dig deeper to discover cause of disappointing or deteriorating ratios

18 DuPont Method n ROA = profit margin x TA turnover = NI/Sales x Sales/TA n Indicates there are two ways to earn a given level of ROA: Low PM x High TATO (grocery store) High PM x Low TATO (jewelry store)

19 More DuPont analysis... n ROE = ROA x equity multiplier = (NI / TA) x (TA / equity) Breaking down ROA into its parts: Net income x Sales x Assets Sales Assets Equity

20 Analyzing ROE n ROE can change over time or differ across firms because of differing –profit margins –total asset turnover –financial leverage –some combination of these three reasons

21 Long-Term Financial Planning n Failing to plan is planning to fail n Future growth/asset needs n Future financing arrangements

22 Percent of Sales Technique ASSETS DOLLAR PERCENT AMOUNT OF SALES ($700,000) Cash and m/s $ 25, % Accounts receivable 100, Inventories 125, Total current assets 250, Net plant and equipment 200, Land 50, Total fixed assets 250, Total assets $500,

23 Percent of Sales LIABILITES AND DOLLAR PERCENT EQUITY AMOUNT OF SALES ($700,000) Accounts payable $ 78, % Notes payable 34, Accrued liabilities 30, Total current liabilities 142, Long-term debt 140, Total liabilities 282, Total stockholders’ equity 218, Total liabilities and equity $500,

24 Using this information to forecast financing needs Sales forecast: Forecast asset needs  TA =  Sales x (TA percent of sales) Financing needs  TA =  (TL + SE)

25 Getting the funds... Needed financing can be raised from n internal sources n external sources

26 Internally generated funds Forecasted net income = sales forecast x profit margin Addition to retained earnings = net income forecast - dividends

27 Externally generated financing n Spontaneous financing –Accounts payable –Accruals n External financing needs =  TA -  RE - spontaneous financing

28 Cost-Volume-Profit Analysis n EBIT = Sales less: variable costs less: fixed costs = (Price x Qty) - (VC x Qty) - FC

29 Operating Profit Estimates n Given a unit sales or quantity estimate, we can estimate operating profit, EBIT=(Price x Qty) - (VC x Qty) - FC n A special case: Breakeven n EBIT=0= (Price x Qty) - (VC x Qty) - FC n Qty BE = Fixed Costs (Price - VC)

30 Fixed Costs and Operating Leverage Fixed operating costs result in a larger percentage change in EBIT for a given percentage change in sales Net sales $700,000 Less: variable costs (60% of sales) 420,000 Less: fixed costs 200,000 Earnings before interest and taxes $ 80,000

31 –10% +10% Net sales $630,000 $770,000 Less: variable costs (60% of sales) 378, ,000 Less: fixed costs 200, ,000 EBIT $ 52,000 $108,000 Percent change in EBIT: –35%+35%

32 What happened? n A 10% change in sales is magnified or levered into a 35% change in EBIT n Degree of operating leverage (DOL) = % change in EBIT/ % change in sales = 35% / 10% = 3.5 Another way: DOL = sales - variable costs sales - variable costs- fixed costs

33 As fixed costs rise, the leverage effect rises: use FC = $250,000 PERCENT CHANGE IN SALES –10% base case +10% Net sales $630,000 $700,000 $770,000 Less: variable costs (60% of sales)378, , ,000 Less: FC 250, , ,000 EBIT $ 2,000 $ 30,000 $ 58,000 EBIT % change from base case –93.3%93.3%

34 Degree of operating leverage (DOL) = % change in EBIT / % change in sales = 93.3% / 10% = 9.33

35 Using DOL n Given DOL, we can estimate the change in operating income for a given change in sales n DOL= %change EBIT/% change sales  %change in EBIT= % change in sales x DOL

36 Example Going back to our base case: Net sales $700,000 Less: variable costs (60% of sales) 420,000 Less: fixed costs 200,000 Earnings before interest and taxes $ 80,000 Problem: Forecast EBIT if sales are expected to rise 10 percent

37 Forecasting EBIT n Sales are expected to rise 10 percent n Current EBIT = $80,000 n DOL = 3.5 %change in EBIT= % change in sales x DOL % change in EBIT = 10% x 3.5 = 35% EBIT estimate = $80, ($80,000) EBIT estimate = $108,000