INTRODUCTION TO CORPORATE FINANCE Laurence Booth • W. Sean Cleary Prepared by Ken Hartviksen CHAPTER 4 Financial Statement Analysis and Forecasting Lecture Agenda • • • • • • • • • • • Learning objectives Important terms Consistent financial analysis Leverage ratios Efficiency ratios Productivity ratios Liquidity ratios Valuation ratios Financial forecasting Formula forecasting Summary and Conclusions – Concept Review Questions CHAPTER 4 – Financial Statement Analysis and Forecasting 4-3 Learning Objectives 1. 2. 3. 4. 5. 6. Why return on equity is one of the key financial ratios used for assessing a firm’s performance, and how it can be used to provide information about three areas of a firm’s operations Why outsiders and insiders are concerned with a company’s ratios related to leverage, efficiency, productivity, liquidity and value How to calculate, interpret, and evaluate the key ratios related to leverage, efficiency, productivity, liquidity, and value Why financial forecasts provide critical information for both management and external parties How to prepare financial forecasts by using the percentage of sales approach How external financing requirements are related to sales growth, profitability, dividend payouts, and sustainable growth rates. CHAPTER 4 – Financial Statement Analysis and Forecasting 4-4 Important Chapter Terms • Acid test ratio • Average collection period • Average days sales in inventory • Break-even point • Cash flow to debt ratio • Current ratio • Debt ratio • Debt-equity ratio • Degree of total leverage • Dividend payout • Dividend yield • • • • • • • • • • EBITDA multiple Efficiency ratios Equity book value per share External financing requirements Financial leverage Fixed asset turnover Forward P/E ratio Gross profit margin Inventory turnover Invested capital CHAPTER 4 – Financial Statement Analysis and Forecasting 4-5 Important Chapter Terms … • • • • • • • • • • • Leverage ratio Liquidity Market-to-book ratio Net operating income (NOI) Net profit margin Off-balance-sheet liabilities Operating margin Percentage of sales method Price-earnings (P/E) ratio Productivity ratios Quick ratio • • • • • • • • • • • • Receivables turnover Retention (plowback) ratio Return on assets (ROA) Return on equity (ROE) Spontaneous liabilities Stock ratios Sustainable growth rate Times interest earned Total enterprise value Turnover ratio Working capital Working capital ratio CHAPTER 4 – Financial Statement Analysis and Forecasting 4-6 Consistent Financial Analysis • Your text describes the importance of consistent financial analysis across companies, across industries, across countries • Morgan Stanley’s ModelWare is a start on this. • It is up to you, the analyst, to understand the challenges to comparability and you must attempt to ascertain the financial health of the organizations you study, understanding the limitations inherent in financial accounting practice. CHAPTER 4 – Financial Statement Analysis and Forecasting 4-7 Consistent Financial Analysis Intra-Company Comparisons • GAAP provides considerable latitude for the company. • Once a firm chooses an acceptable accounting treatment for: – Revenue recognition – Capitalization of expenses – Inventory valuation, etc. then the firm must use these same provisions year after year. • Any change in accounting principles must be noted in the financial statements and prior years restated to ensure there is a common basis of comparison to the present. • Therefore internal comparisons, year over year, are possible and supported by GAAP. CHAPTER 4 – Financial Statement Analysis and Forecasting 4-8 Consistent Financial Analysis Inter-Company Comparisons • Making comparisons between companies, even in the same industry are much more difficult because: – Widely divergence accounting treatment under GAAP – Historical cost-based accounting can seriously affect efficiency, leverage and profitability ratios. CHAPTER 4 – Financial Statement Analysis and Forecasting 4-9 Analysis of Financial Statements • Study the absolute numbers, and the comparative statements for the company to: – Ascertain trends in the balance sheet, income statement and statement of cash flows – Ascertain areas of concern – Ascertain areas of strength • Complement your study of the absolute numbers by using ratios again to: – Ascertain trends – Identify areas of concern – Identify areas of strength CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 10 A Framework for Financial Analysis Return on Equity (ROE) and DuPont System • The DuPont System gives a framework for the analysis of financial statements through the decomposition of the Return on Equity ratio ROE NI SE [4-1] Net Income Return on Equity Shareholde rs' Equity (See Figure 4 -2 that illustrates the constituent parts of ROE ) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 11 Framework for Financial Analysis Du Pont System 4 - 2 FIGURE ROE NI ROA TA GOOD OR BAD? TA SE NI Sales LEVERAGE RATIOS EFFICIENCY RATIOS Sales TA PRODUCTIVITY RATIOS CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 12 A Framework for Financial Analysis DuPont System and Decomposition of ROE • As Figure 4 – 2 illustrates, ROE is a function of: – Corporate use of leverage (use of debt) – Efficiency ratios (ability of the firm to control costs in relationship to sales) – Productivity ratios (the degree to which the firm can generate sales in relationship to assets employed) ROE NI SE [4-1] Net Income Return on Equity Shareholde rs' Equity CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 13 A Framework for Financial Analysis Return on Equity (ROE) and DuPont System • ROE is not a pure ratio because it involves dividing an income statement item (flow) by a balance sheet (stock) item. ROE NI SE [4-1] Net Income Return on Equity Shareholde rs' Equity • Instead of using ending SE, many argue you should use average SE (beginning SE plus ending SE divided by 2) because SE changes over the year as income is earned and retained earnings grow. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 14 A Framework for Financial Analysis Return on Equity (ROE) ROA Leverage NI NI Sales TA ROE SE Sales TA SE [4- 7] ROE when decomposed shows that it is a function of the return earned on assets and of the leverage used by the firm. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 15 A Framework for Financial Analysis Return on Total Assets • ROA shows the ratio of income to assets that have been used to produce them. ROA NI TA Return on Assets Net Income Total Assets [4-2] • ROA can be further decomposed as shown and the following slide CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 16 A Framework for Financial Analysis Return on Assets (ROA) • ROA is the product of the net profit margin and the sales to total asset ratio: NI NI Sales ROA TA Sales TA [4- 6] • The sales cancel and we are left with NI / TA CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 17 A Framework for Financial Analysis Leverage Ratio • If ROA is multiplied by TA and divided by SE, the TA’s cancel out and produces ROE. • TA / SE is the leverage ratio Leverage Leverage TA SE [4-3] Total Assets Shareholde rs' Equity • It measures how many dollars of total assets are supported by each dollar of Shareholders Equity. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 18 DuPont System • The DuPont system provides a good starting point for any financial analysis – It shows that financial strength comes from many sources (profitability, asset utilization, leverage) – It reinforces the concept that good financial analysis requires looking at each ratio in the context of the other – Whenever you are presented with financial statements it is important that you look at a sample of ratios from each major category to identify areas of strength and weakness (Table 4 -1 illustrates E-Trade Canada’s ROE analysis of Rothmans) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 19 A Framework for Financial Analysis Return on Equity (ROE) and the DuPont System Table 4-1 E-Trade Canada's Rothman's Dupont ROE Analysis Return on Equity (1) Net Sales (2) Pretax Income (3) Net Income (4) Total assets (5) Shareholders' equity Pretax margin % (2/1) × Tax retent % (3/2) =profit margin % (3/1) × Asset Utilization % (1/4) = ROA % (3/4) × Leverage % (4/5) =ROE % (3/5) 3/31/2006 652,271 274,829 99,464 449,075 113,860 42.13% 36.19% 15.25% 145.25% 22.15% 394.41% 87.36% 3/31/2005 636,771 261,345 92,997 528,528 193,708 41.04% 35.58% 14.60% 120.48% 17.60% 272.85% 48.01% 3/31/2004 620,104 252,683 90,277 496,757 168,497 40.75% 35.73% 14.56% 124.83% 18.17% 294.82% 53.58% 3/31/2003 575,469 240,197 86,678 429,965 130,537 41.74% 36.09% 15.06% 133.84% 20.16% 329.38% 66.40% So urce: Data fro m E-Trade Canada CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 20 Interpreting Ratios • A ratio is just one number over another number – by itself, there is little ‘information’ • To judge whether a ratio is ‘good’ or ‘bad’ requires that it be compared to something else such as: – The company’s own ratios over time to ascertain trends – Other comparable companies or industry averages (Table 4 -2 illustrates Rothmans DuPont ratios over time) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 21 A Framework for Financial Analysis Interpreting Ratios Table 4-2 Rothman's Dupont Ratios Rothmans (March 31) ROE ROA Net profit margin Turnover Leverage 2004 2005 2006 0.5358 0.1817 0.1456 1.2483 2.9482 0.4801 0.1760 0.1460 1.2048 2.7285 0.8736 0.2215 0.1525 1.4525 3.9441 Do you see trends here? What factors are driving the trend in ROE? CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 22 A Framework for Financial Analysis Interpreting Ratios Table 4-3 Altria's Dupont Ratios Altria (December 31) ROE ROA Net profit margin Turnover Leverage 2003 2004 2005 0.3670 0.0957 0.1132 0.8455 3.8352 0.3066 0.0926 0.1051 0.8816 3.3095 0.2922 0.0967 0.1066 0.9065 3.0232 Do you see trends here? What factors are driving the trend in ROE? How do these results compare to Rothmans on the previous slide? CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 23 Leverage • Leverage = magnification • Financial leverage occurs when a firm uses sources of financing that carry a fixed cost (such as long-term debt), and uses this to generate greater returns than result in magnified returns to shareholders. • Leverage means magnification of either profits or losses. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 24 Leverage Ratios • Include: – – – – Debt ratio Debt to equity ratio Times interest earned ratio Cash flow to debt ratio CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 25 Leverage Ratios Debt Ratio • Is a stock ratio indicating the proportion of total assets financed by debt at a particular point in time (the balance sheet date) TL Total Liabilitie s Debt ratio TA Total Assets CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 8] 4 - 26 Leverage Ratios Debt-Equity Ratio • Is a stock ratio indicating the proportion that total debt represents in relationship to the shareholders equity (common stock and retained earnings) at the balance sheet date. D Total Debt Debt/Equit y ratio SE Shareholde rs' Equity CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 9] 4 - 27 Leverage Ratios Times Interest Earned (TIE) • Is an income statement (flow) ratio indicating the number of times the firm’s pre-tax income exceeds its fixed financial obligations to its lenders (debt holders) EBIT I Earnings Before Interest and Taxes TIE Interest Expense Times Interest Earned CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 10] 4 - 28 Leverage Ratios Cash Flow to Debt Ratio • Measures how long it would take to payoff a firm’s debt (D) CFO Cash flow to debt ratio D Cash Flow from Operations CF / D Total Debt CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 11] 4 - 29 Leverage Ratios Cash Flow to Debt Ratio Table 4-4 Leverage Ratios Rothmans (March 31) Leverage Debt ratio D/E ratio TIE Cash flow to debt Altria (December 31) 2004 2005 2006 2003 2004 2005 2.9482 0.6608 0.8902 46.7842 1.5037 2.7285 0.6335 0.7729 36.1270 1.0823 3.9441 0.7465 1.3152 42.7356 1.2235 3.8352 0.7393 0.9785 13.7035 0.4408 3.3095 0.6978 0.7482 12.9082 0.4739 3.0232 0.6692 0.6703 14.3405 0.4621 Which firm exhibits greater use of leverage? Which exhibits greater capacity to take on and service debt? CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 30 Efficiency Ratios Efficiency ratios measure how efficiently a dollar of sales is turned into profits. • Gives insight to the firm’s cost structure • Whether problems exist with variable costs or fixed costs (overhead) or both CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 31 Efficiency Ratios • Include: – – – – Degree of total leverage Break-even point Gross profit margin Operating margin CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 32 Efficiency Ratios Interpreting Ratios Table 4-5 Profit Margin and Sales Variability Sales Contribution margin (40%) Fixed cost Interest Tax Net income 120 48 31 5 6 6 132 53 51 5 8.5 8.5 108 43 31 5 3.5 3.5 Net profit margin 5.0% 6.4% 3.2% The focus of efficiency ratios is with the income statement. This example demonstrates the leverage effect of using fixed costs in lieu of variable costs in the cost structure. Sales varied by +/- of 10% yet profits varied by +/- 40%. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 33 Efficiency Ratios Degree of Total Leverage Ratio • An income statement ratio that measures the exposure of profits to changes in sales. • The greater the DTL, the greater leverage effect. CM EBT Contributi on Margin DTL Earnings Before Taxes Degree of Total Leverage CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 12] 4 - 34 Efficiency Ratios Break Even Point • Estimates the volume of units that must be produced and sold in order for the firm to cover all costs both fixed and variable. FC Break Even Point CM Fixed Costs BEP Contributi on Margin [4- 13] • The break even point tends to increase as the use of fixed costs increases. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 35 Efficiency Ratios Gross Profit Margin • Demonstrates the percentage of sales that are available to cover fixed (period) costs and financing expenses after variable costs have been paid. S CGS S Sales - Cost of Goods Sold GPM Sales Gross Profit Margin [4- 14] • A declining gross profit margin raises concerns about the firm’s ability to control variable costs such as direct materials and direct labour. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 36 Efficiency Ratios Operating Margin • Operating margin measures the cumulative effect of both variable and period costs on the ability of the firm to turn sales into operating profits to cover, interest, taxes, depreciation and amortization (EBITDA). NOI Sales Net Operating Income OM Sales Operating Margin CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 15] 4 - 37 Efficiency Ratios Interpreting Ratios Table 4-6 Efficiency Ratios Rothmans (March 31) Net profit margin Gross profit margin Operating margin Altria (December 31) 2004 2005 2006 2003 2004 2005 0.1456 0.4261 0.4102 0.1460 0.4305 0.4155 0.1525 0.4426 0.4263 0.1132 0.3519 0.1938 0.1051 0.3348 0.1867 0.1066 0.3286 0.1696 Which firm is able to produce a greater percentage of sales as profits? Which firm is able to produce strong and consistent profitability? CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 38 Productivity Ratios • Measure the ability of the firm to generate sales from the assets that it employs. • Excessive investment in assets with little or no increase in sales reduces the rate of return on both assets and equity (ROA) and (ROE) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 39 Productivity Ratios • Include: – – – – – Receivables turnover Average collection period (ACP) Inventory turnover Average days sales in inventory (ADSI) Fixed asset turnover CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 40 Productivity Ratios Receivables Turnover • Measures the sales generated by every dollar of receivables. Receivable s turnover RT S AR [4- 16] Sales Accounts Receivable CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 41 Productivity Ratios Average Collection Period • Estimates the number of days it takes a firm to collect on its accounts receivable. Average Collection Period ACP AR 365 ADS Receivable s Turnover [4- 17] AR Receivable s turnover • If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic conditions deteriorate. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 42 Productivity Ratios Inventory Turnover • Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year. CGS Inventory Turnover INV [4- 18] • A ratio that involves both ‘stock’ and ‘flow’ values • Is strongly a function of ending inventory value…managers often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 43 Productivity Ratios Inventory Turnover • When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales. Sales Inventory Turnover INV [4- 19] • Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 44 Productivity Ratios Average Days Sales in Inventory (ADSI) • Estimates the number of days of sales tied up in inventory (based on ending inventory values) Average days sales in inventory (ADSI) INV ADS [4- 20] 365 Inventory turnover CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 45 Productivity Ratios Fixed Asset Turnover • Estimates the number of dollars of sales produced by each dollar of net fixed assets. Fixed Asset Turnover S NFA [4- 21] Sales Net Fixed Assets CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 46 Productivity Ratios Interpreting Ratios Table 4-7 Productivity Ratios Rothmans (March 31) 2004 2005 2006 Altria (December 31) 2003 Turnover 1.2483 1.2048 1.4525 0.8455 Receivables turnover 19.3825 19.8254 55.3006 NA ACP 18.8314 18.4108 6.6003 NA Inventory turnover 3.1170 3.0349 3.1597 8.5241 (using sales) ADSI 117.0988 120.2692 115.5165 42.8197 Fixed asset turnover 11.0158 9.2087 8.5490 5.0613 2004 2005 0.8816 15.5735 23.4372 0.9065 18.2529 19.9968 8.9244 40.8991 5.4959 9.2455 39.4788 5.8673 Which firm has been improving its efficiency ratios to a greater degree? CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 47 Liquidity Ratios • Measure the ability of the firm to meet its maturing financial obligations through liquid (cash and near cash) resources • Include: – Working capital ratio – Current ratio – Quick (acid-test) ratio CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 48 Liquidity Ratios Working Capital Ratio • Measures the percentage of total assets that is invested in current assets. • Helps to analyze capital intensity as well as corporate liquidity. CA Working Capital Ratio TA Current Assets Total Assets CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 22] 4 - 49 Liquidity Ratios Current Ratio • Measures the number of dollars of current assets for each dollar of current liabilities. • Helps to estimate the capacity of the firm to meet its maturing financial obligations. CA CL Current Assets Current Liabilitie s Current Ratio CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 23] 4 - 50 Liquidity Ratios Quick Ratio • Recognizing that inventories may be less liquid than other current assets, and in some cases, when liquidated quickly result in cash flows that are less than book value, the quick ratio gives a clearer indication of the firm’s ability to meet its maturing financial obligations out of current, liquid assets. C MS AR CL Current Assets Inventories Current Liabilitie s Quick Ratio CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 24] 4 - 51 Liquidity Ratios Interpreting Ratios Table 4-8 Liquidity Ratios Rothmans (March 31) Current ratio Quick ratio Working capital ratio Altria (December 31) 2004 2005 2006 2003 2004 2005 2.8868 1.4981 0.8414 2.9310 1.5092 0.8235 2.4756 1.0037 0.7800 NA NA NA 1.0987 0.4877 0.2548 0.9856 0.4442 0.2388 Which firm has greater liquidity and capacity to meet its financial obligations? CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 52 Estimating Net Realizable Values Interpreting Ratios • When firm’s are financially-strained and no longer a ‘going concern,’ book (accounting) become less valid • Net liquidation values can be estimated by discounting asset values based on their degree of liquidity – Liquid assets are valued close to or the same as book value – Illiquid assets are discounted from book value based on the degree of illiquidity – Liabilities are stated in nominal terms because it takes those dollars to satisfy debt obligations – Preferred stock value is based on residual values (if there is any estimated residual value) (Table 4 – 9 is an example of E-Trade Canada’s Risk Ratings for Rothmans) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 53 Estimating Net Liquidation Value Interpreting Ratios Table 4-9 E-Trade Canada's Risk Ratings Growth Rates Net ROA % Long-term debt growth (YTY %) Asset growth (YTY %) Components of Net Liquidated Value Cash @ 100% Marketable securities @ 98% Receivables @ 90% Other current assets @ 80% Inventory @ 50% Net plant @ 25% Total Liquid Assets Current liabilities (100%) Long-term debt (100%) Other liabilities (100%) Net of Liabilities = net liquidation value Average shares Net Liquidation Value per Share 2006 2005 2004 2003 22.15% 3.00% -15.03% 17.60% -0.19% 6.40% 18.17% 0.00% 15.53% 20.16% N/A N/A 130,231 N/A 10,616 1,468 103,217 19,075 264,607 141,496 149,751 10,761 -37,401 67,745 ($0.55) 191,995 N/A 28,907 1,058 104,910 17,287 344,157 148,498 149,708 0 45,951 67,492 $0.68 184,907 N/A 28,794 1,698 99,471 14,073 328,943 144,786 150,000 0 34,157 33,610 $1.02 113,270 N/A 75,373 2,027 76,767 13,654 281,091 110,964 150,000 0 20,127 33,299 $0.60 So urce: Data fro m E-Trade Canada. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 54 Valuation Ratios • Used to assess how the market is valuing the firm (share price) in relationship to assets and current earnings, profits and dividends • Include: – – – – – – – Equity book value per share (BVPS) Dividend yield Dividend payout Price-earnings (P/E) ratio Forward (P/E) ratio Market-to-book (M/B) ratio EBITDA multiple CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 55 Valuation Ratios Interpreting Ratios – Book Value per Share • Expresses shareholders’ equity on a per share basis. Shareholde rs' Equity Book Value Per Share Number of Shares CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 25] 4 - 56 Valuation Ratios Interpreting Ratios – Dividend Yield • Expresses dividend payout as a percentage of the current share price. Dividend Per Share DPS Dividend Yield Price per Share P [4- 26] • Can be compared to other investment instruments such bonds (current yield) or with other dividend-paying companies. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 57 Valuation Ratios Interpreting Ratios – Dividend Payout Ratio • Expresses dividends as a percentage of earnings on a per share basis. Dividend Per Share DPS Dividend Payout Earnings per Share EPS CHAPTER 4 – Financial Statement Analysis and Forecasting [4- 27] 4 - 58 Valuation Ratios Interpreting Ratios – Trailing P/E Ratio • Earnings multiple based on the most recent earnings. • Often used in estimating the value of a stock. Price - earnings ratio Share Price P Earnings per Share EPS [4- 28] • A stock trading at a P/E multiple of 10 will take ten years at current earnings to recover the price of the stock. • A stock trading at a P/E multiple of 100 will take 100 years at current annual earnings to recover the price of the stock. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 59 Valuation Ratios Interpreting Ratios – Forward P/E Ratio • Earnings multiple based on forecast earnings per share. • Often used in estimating the value of a stock especially with companies with rapid growth in earnings per share. Forward Price - earnings ratio Share Price P Estimated Earnings per Share EEPS [4- 29] • Low P/E shares are regarded as value stocks • High P/E shares are regarded as growth stocks CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 60 Valuation Ratios Interpreting Ratios – Market to Book Ratio • Estimates the dollars of Share Price per dollar of book value per share. Market - to - book ratio Share Price P Book Value per Share BVPS [4- 30] • Given historical cost accounting as the basis for book value per share, the degree to which market value per share exceeds BVPS indicates the value that has been added to the company by management. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 61 Valuation Ratios Interpreting Ratios – EBITDA Multiple • Total enterprise value is an estimate of the total market value of the firm (market value of equity plus market value of debt) • EBITDA multiple expresses total enterprise value for each dollar of operating income (EBITDA) Total Enterprise Value Earnings before interest, taxes, depreciati on and amortizati on TEV EBITDA EBITDA multiple CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 62 Valuation Ratios Interpreting Ratios Table 4-10 Value Ratios Rothmans (March 31) Dividend yield Dividend payout P/E M/B EBITDA multiple Dividend yield (excl. special dividend) Dividend payout (excl. special dividend) Altria (December 31) 2004 2005 2006 2003 2004 2005 0.0474 0.6063 12.7799 6.8451 4.8535 0.0438 0.7664 17.5109 8.3685 6.3545 0.1333 1.8621 13.9655 12.0682 5.2095 0.0485 0.5841 12.0398 4.4208 7.8436 0.0462 0.6184 13.3991 4.0979 8.8194 0.0410 0.6132 14.9739 4.6319 9.7774 N/A N/A 0.0593 N/A N/A N/A N/A N/A 0.8276 N/A N/A N/A Can you draw any conclusions for the comparative valuation ratio data summarized in this table? CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 63 Financial Forecasting Purpose Financial managers must produce forecasts for the financial results of corporate plans to: – Determine whether the corporate plans will require additional external financing – Determine whether the corporate plans will produce surplus cash resources that could be distributed to shareholders as dividends – Assess the financial forecasts to determine the financial feasibility of corporate plans – if poor financial results are forecast, this gives management the opportunity to reexamine and amend corporate plans to produce better results before resources and people are committed. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 64 Financial Forecasting The basis for all financial forecasts is the sales forecast. The most recent balance sheet values are the starting point. Pro forma (forecast) balance sheets are projected assuming some relationship with projected sales (constant percentage of sales) Current liabilities are usually assumed to rise and fall in a constant percentage with sales – we call them ‘spontaneous liabilities’ because they change without negotiation with creditors. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 65 Financial Forecasting The Percentage of Sales Method The percentage of sales method involves the following steps: 1. Determine which financial policy variables you are interested in 2. Set all the non-financial policy variables as a percentage of sales 3. Extrapolate the balance sheet based on a percentage of sales 4. Estimate future retained earnings 5. Modify and re-iterate until the forecast makes sense. This process most often results in a balance sheet that does not balance – a ‘plug’ (balancing) amount is the external funds required (or surplus funds forecast) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 66 Financial Forecasting The Percentage of Sales Method The historical balance sheet. If sales increase, assets used to produce those sales must grow. Spontaneous liabilities Table 4-11 Balance Sheet Cash Securities Receivables Inventory Current assets Net fixed assets 5 10 10 25 50 100 Total assets 150 Accruals Payables Bank debt 5 5 20 Current liabilities Long-term debt Common equity 30 40 80 Total Liabilities CHAPTER 4 – Financial Statement Analysis and Forecasting Policy variables requiring decision. 150 4 - 67 Financial Forecasting The Percentage of Sales Method Table 4-12 Initial Forecast Sales 120 % 100.0% 132 145 160 Cash Securities Receivables Inventory Net fixed assets Total assets 5 10 10 25 100 150 4.2% 8.3% 8.3% 20.8% 83.3% 125.0% 5.5 11.0 11.0 27.5 110.0 165.0 6.0 12.1 12.1 30.2 120.8 181.3 6.7 13.3 13.3 33.3 133.3 200.0 Accruals Payables Short-term debt Long-term debt Equity Total liabilities and equity Cumulative (EFR) 5 5 20 40 80 150 4.2% 4.2% 16.7% 33.3% 66.7% 125.0% 5.5 5.5 20.0 40.0 80.0 151.0 14.0 6.0 6.0 20.0 40.0 80.0 152.1 29.2 6.7 6.7 20.0 40.0 80.0 153.3 46.7 CHAPTER 4 – Financial Statement Analysis and Forecasting Sales Naïve projections increases the inand balance base case sheet of $120 percentages accounts Accounts First passin of sales same requiring funding proportion decision Balance shortfall to are Sheet projected. projected assumed Values to sales remain calculated constant as a on first pass. percentage of sales. 4 - 68 Percentage of Sale Method Improving the Pro Forma Balance Sheet • The prior pro form balance sheet was developed using very naïve assumptions: – Policy variables held constant – Asset growth in all accounts held at the same percentage of sales – Spontaneous liabilities increased at a constant percentage of sales. • One improvement is to realize that the firm’s equity will grow by the amount of retained earnings. (See the following income statement) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 69 Financial Forecasting The Percentage of Sales Method Table 4-13 Income Statement Sales Gross operating profit Fixed costs EBIT Interest Taxes @ 50% Net Income Dividends 120 48 31 17 5 6 6 3 CHAPTER 4 – Financial Statement Analysis and Forecasting Retained earnings = net income less dividends. Assuming the firm holds this percentage constant we can project increases in equity on the balance sheet as 50% of the 5% profit margin or 2.5% of sales. 4 - 70 Financial Forecasting The Percentage of Sales Method Table 4-14 First Revision of Forecast Sales 120 % 100.0% 132 145 160 Cash Securities Receivables Inventory Net fixed assets Total assets 5 10 10 25 100 150 4.2% 8.3% 8.3% 20.8% 83.3% 125.0% 5.5 11.0 11.0 27.5 110.0 165.0 6.0 12.1 12.1 30.2 120.8 181.3 6.7 13.3 13.3 33.3 133.3 200.0 Accruals Payables Short-term debt Long-term debt Equity Total liabilities and equity Cumulative (EFR) 5 5 20 40 80 150 4.2% 4.2% 16.7% 33.3% 66.7% 125.0% 5.5 5.5 20.0 40.0 83.3 154.3 10.7 6.0 6.0 20.0 40.0 86.9 159.0 22.3 6.7 6.7 20.0 40.0 90.9 164.2 35.8 CHAPTER 4 – Financial Statement Analysis and Forecasting Equity Notice how accounts the increased retained by earnings projected has retained reduced earnings the that projected increase Externalin proportion Funds to sales. Required. 4 - 71 Percentage of Sale Method Second Revision the Pro Forma Balance Sheet • Further improvements to the pro forma balance sheet include: – Recognizing that cash balances may not have to rise as a constant percentage of sales • Cash balances are required for a variety of reasons – To support transaction – As a safety cushion against unforeseen cash needs – As a speculative balance to take advantage of unforeseen opportunities • Even at low levels of sales, cash balances are required • As sales increase, additional cash on hand may be required, but at a decreasing percentage of sales. – The following slide illustrates the difference between a simple percentage of sales forecast, and perhaps a more realistic forecast that includes a base amount (constant) and a decreasing percentage of sales CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 72 Percentage of Sales Method Second Revision the Pro Forma Balance Sheet 44-3 - 3FIGURE FIGURE Cash Forecast 14.0 Simple % Cash 12.0 Linear with constant 10.0 8.0 6.0 4.0 2.0 0.0 0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300 Sales CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 73 Percentage of Sale Method Second Revision the Pro Forma Balance Sheet • Further improvements to the pro forma balance sheet include reexamining asset growth assumptions: – Refinement of the cash forecast (as per the previous two slides – Realization that EFR can be offset by marketable securities that can easily be liquidated to finance growth needs. – Reexamine our assumptions about growth in Accounts Receivable and whether we want to change our credit policies in the context of the forecast macro economic and competitive environment – Reexamine our inventory management policies taking into account the macroeconomic and competitive environment – Realization that increases in net fixed assets is ‘lumpy’ and not continuously incremental (if we have excess production capacity, we may not need to invest any further in fixed assets until we are forecast to exceed that capacity) • Further improvements to the pro forma balance sheet include reexamining assumptions regarding the growth in spontaneous liabilities (See the effects of these changes on the pro forma balance sheet on the following slide) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 74 Financial Forecasting The Percentage of Sales Method Table 4-15 Second Revision of Forecast Sales 120 % 100.0% 132 145 160 Cash Securities Receivables Inventory Net fixed assets Total assets 5 10 10 25 100 150 4.2% 8.3% 8.3% 20.8% 83.3% 125.0% 5.0 0.0 11.0 27.5 100.0 143.5 5.0 0.0 12.1 30.2 90.0 137.3 5.0 0.0 13.3 33.3 80.0 131.7 Accruals Payables Short-term debt Long-term debt Equity Total liabilities and equity Cumulative (EFR) 5 5 20 40 80 150 4.2% 4.2% 16.7% 33.3% 66.7% 125.0% 5.5 5.5 20.0 40.0 83.3 154.3 -10.8 6.0 6.0 20.0 40.0 86.9 159.0 -21.7 6.7 6.7 20.0 40.0 90.9 164.2 -32.6 CHAPTER 4 – Financial Statement Analysis and Forecasting Assuming cash remains constant, we liquidate marketable securities and we retain 50% of our profits dramatically affects the forecast. We now have surplus resources! 4 - 75 Percentage of Sale Method Final Revisions to the Pro Forma Income Statement • Given our assumptions about capacity, and there being no need for further expansion in plant and equipment to support anticipated sales growth, we can reexamine our assumptions about the cost structure of the firm. Variable Costs • Variable costs (direct materials and direct labour) will likely grow in proportion to sales. Fixed Costs • Fixed costs, however should remain fixed. • By modifying the income statement for this change in assumptions, we see the net result of this is an increase in forecast net income. Dividends • Most firms do not follow a constant payout ratio, but hold dividends constant over multiple years. • Assume that we hold dividends at $3 for the next three years. (See the effects of these changes on the final pro forma income statement on the following slide) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 76 Financial Forecasting The Percentage of Sales Method Table 4-16 Profit Margin and Sales Sales Gross operating profit Fixed costs EBIT Interest Taxes @ 50% Net Income Net profit margin Dividends Additions to Retained earnings $120 48 31 17 5 6 6.0 5.0% $132 53 31 22 5.0 8.5 8.5 6.4% $145 58 31 27 5.0 11.0 11.0 7.6% $3.0 $3.0 $3.0 $5.5 $3.0 $8.0 CHAPTER 4 – Financial Statement Analysis and Forecasting $160 64 31 33 5.0 14.0 14.0 8.8% $3.0 $11.0 4 - 77 Percentage of Sale Method Final Revisions to the Pro Forma Balance Sheet • Given our modified income statement and assumptions regarding net profit and cash dividends we can prepare a final revised balance sheet • This balance sheet now shows that we forecast significant surplus cash resources and must make some decisions about how we will manage them: – Investment temporarily in marketable securities in anticipation of further investment opportunities in growing the firm? – Distribute them in the form of cash dividends? (See the effects of these changes on the final pro forma balance sheet on the following slide) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 78 Financial Forecasting The Percentage of Sales Method Table 4-17 Final Revision of Forecast Sales 120 % 100.0% 132 145 160 Cash Securities Receivables Inventory Net fixed assets Total assets 5 10 10 25 100 150 4.2% 8.3% 8.3% 20.8% 83.3% 125.0% 5.0 0.0 11.0 27.5 100.0 143.5 5.0 0.0 12.1 30.2 90.0 137.3 5.0 0.0 13.3 33.3 80.0 131.7 Accruals Payables Short-term debt Long-term debt Equity Total liabilities and equity Cumulative (EFR) 5 5 20 40 80 150 4.2% 4.2% 16.7% 33.3% 66.7% 125.0% 5.5 5.5 20.0 40.0 85.5 156.5 -13.0 6.0 6.0 20.0 40.0 93.5 165.6 -28.3 6.7 6.7 20.0 40.0 104.5 177.8 -46.2 CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 79 Formula Forecasting The Simple Percentage of Sales Forecasting Method We can express the foregoing percentage of sales method forecasting using equations rather than spreadsheets. When we subtract spontaneous liabilities from total assets we get the firm’s invested capital or net assets as a percentage of sales. We will denote this by ‘a’ ‘a’ is the treasurer’s financial policy variable because it is the total invested capital requirement of the firm as a percentage of sales. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 80 Formula Forecasting The Per External Funds Required can now be expressed as a formula of relationships: EFR a S g b PM (1 g ) S [4- 32] Where: ‘a’ g S S×g a×S×g PM b 1–b treasurer’s financial policy variable - sales growth rate - current sales - next period’s sales growth - incremental capital required - profit margin on sales - payout ratio - retention or plowback ratio CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 81 Formula Forecasting The Per External Funds Required can also be expressed as a linear function of the sales growth rate (g) and this can be seen more easily by dividing both sides of Equation 4 – 32 by the current sales level and rearranging: EFR b PM (a b PM ) g S [4- 33] This line can be graphed to show the relationship between the sales growth rate and External Funds Required. (See Figure 4 -4 found on the following slide) CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 82 External Financing Requirements 44-3 - 4FIGURE FIGURE 0.15 Sustainable growth rate ( g*) 0.05 0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -.002 -.004 -0.06 -0.05 -0.08 0.0 -0.1 EFR / S 0.1 -0.1 -0.15 Sales Growth Rate -0.2 CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 83 Formula Forecasting The Sustainable Growth Rate (g*) The sustainable growth rate is the sales growth rate at which the firm neither generates nor needs external financing – that is, it can sustain its own rate of growth through reinvestment of profits earned. The sustainable growth rate (g*) is the point in Figure 4 – 4 at which the line crosses the horizontal axis. Using equation 4 – 33 we can rearrange and solve for g*: g* b PM (a b PM ) [4- 34] CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 84 Summary and Conclusions In this chapter you have learned: – The importance of understanding the sources of a firm’s profitability or where the challenges to profitability exist. – How to calculate and interpret operating, profitability, liquidity, leverage and efficiency ratios – How to prepare financial forecasts and understand the assumptions underlying the percentage of sales method of financial forecasting. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 85 Copyright Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein. CHAPTER 4 – Financial Statement Analysis and Forecasting 4 - 86
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