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© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 3: Evaluating and Forecasting Financial Performance
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© 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.
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© 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
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© 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.
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© 2004 by Nelson, a division of Thomson Canada Limited 5 Types of Ratios Liquidity Asset management Financial leverage Profitability Market-based Dividend policy
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© 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
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© 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
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© 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
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© 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
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© 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.
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© 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.
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© 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.
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© 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.
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© 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.
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© 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).
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© 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.
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© 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).
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© 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.
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© 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.
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© 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.
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© 2004 by Nelson, a division of Thomson Canada Limited 21 Profitability Ratios The relationship between ROI & ROE is expressed in the following formula:
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© 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.
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© 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.
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© 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.
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© 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
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© 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
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© 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.
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© 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
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© 2004 by Nelson, a division of Thomson Canada Limited 29 Relationships Among Ratios Sometimes called the equity multiplier
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© 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.
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© 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
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© 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.
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© 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
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© 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
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© 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
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© 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
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© 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
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© 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
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© 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:
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© 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:
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© 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
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© 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.
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© 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…
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© 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
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© 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
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© 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
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© 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.
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