Chapter3:ManagingFinancialHealthandPerformanceObjectivesPurpose of Financial PlanningWorking Capital Management1Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallChapter3Contents3.1FunctionsofFinancialStatements3.2ReviewofFinancialStatement3.3Marketvaluesv.BookValues3.4Accountingv.EconomicMeasuresofIncome3.5ReturnonShareholdersv.ReturnonBookEquity3.6AnalysisUsingFinancialRatios3.7TheFinancialPlanningProcess3.8ConstructingaFinancialPlanningModel3.9Growth&theNeedforExternalFinancing3.10WorkingCapitalMgmt.3.11Liquidity&CashMgmt.2Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.1FunctionsofFinancialStatementsFinancialStatements:Provideinformationtotheowners&creditorsofafirmaboutthecurrentstatusandpastperformanceProvideaconvenientwayforowners&creditorstosetperformancetargets&toimposerestrictionsofthemanagersofthefirmProvideaconvenienttemplatesforfinancialplanning3Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.2ReviewofFinancialStatements BalanceSheetsBalanceSheets IncomeStatementsIncomeStatements Cash-FlowStatementsCash-FlowStatements4Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheBalanceSheetSummarizesafirmsassets,liabilities,andownersequityatamoment in timeAmountsmeasuredathistoricalvaluesandhistoricalexchangeratesPreparedaccordingtoGAAP,GenerallyAcceptedAccountingPrinciplesGAAPmodifiedoccasionallybytheFinancialAccountingStandardsBoardExchange-listedcompaniesmustcomplywithSecuritiesandExchangeCommission(SEC)rules5Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheBalanceSheetMajorDivisions: AssetsAssets Currentassets(lessthanayear)Currentassets(lessthanayear) Long-termassets(longerthanayearLong-termassets(longerthanayear DepreciationDepreciation LiabilitiesandStockholdersEquityLiabilitiesandStockholdersEquity LiabilitiesLiabilities CurrentLiabilitiesCurrentLiabilities Long-termdebtLong-termdebtEquity6Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallGPCBalanceSheetonDecember317Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheIncomeStatementSummarizestheprofitabilityofacompanyduring a time periodMajorDivisions:Revenue&costofgoodssoldGrossmarginGeneraladministrativeandsellingexpenses(GS&A)OperatingincomeDebtserviceTaxableincomeCorporateTaxesNetincome8Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheIncomeStatementImportantReminders: RetainedearningsarenotaddedtothecashRetainedearningsarenotaddedtothecashbalanceinthebalancesheet,butareaddedbalanceinthebalancesheet,butareaddedtoshareholdersequitytoshareholdersequity Accountsshowhistoricalvalues,notmarketAccountsshowhistoricalvalues,notmarketvaluesvalues TheshareholdersequitymaybemuchhigherTheshareholdersequitymaybemuchhigherorlowerthanthemarketvalueofthefirmorlowerthanthemarketvalueofthefirmThevalueofthefirmslandmayhavehalvedordoubled,butthiswouldnotbereportedinthebalancesheet9Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall10Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheCash-FlowStatementShowthecashthatflowedintoandfromafirminduring a time period FocusesattentiononafirmscashsituationFocusesattentiononafirmscashsituation AfirmmaybeprofitableandshortofcashAfirmmaybeprofitableandshortofcash UnlikethebalancesheetandincomeUnlikethebalancesheetandincomestatement,cashflowstatementsarestatement,cashflowstatementsareindependentofaccountingmethodsindependentofaccountingmethodsTheIRSusesaccountingincometocomputetax,soaccountingruleshaveasecondordereffectoncashflowsthroughtaxes11Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall12Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall13Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallNotestoFinancialStatementsExplainsaccountingmethodsusedDetailsofassetsandliabilitiesDetailsofequitystructureDocumentschangesinoperationDocumentsoff-balance-sheetitems14Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallReviewingPublishedAccounts UsualorderUsualorder feelqualityofthefeelqualityofthepaper,reviewpicturespaper,reviewpictures readChairsreportreadChairsreport reviewaccountsreviewaccounts readnotesreadnotesproduceestimates CorrectorderCorrectorder produceestimatesproduceestimates readnotesreadnotes compareyourcompareyournumbers&reportsnumbers&reports readChairsreportreadChairsreportcheckpictures,etc.15Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallReasonsforthisOrdering FormyourownunbiasedexpectationsFormyourownunbiasedexpectationsindependentlyofthelatestfinancialreportindependentlyofthelatestfinancialreport NotestoaccountsgivethenumbersmoreNotestoaccountsgivethenumbersmoreprecisemeaningprecisemeaning CompareyournumbersandthefirmstotellCompareyournumbersandthefirmstotellyouwheretofocuswhenreadingthechairsyouwheretofocuswhenreadingthechairsreport.Lookforomissionsandconflictsreport.LookforomissionsandconflictsComparethePR-Departmentspublicimagewithyour(now)informedinvestorsview16Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.3MarketValuesv.BookValuesNotallassetsandliabilitiesareincluded,andothersareunderstateand/oroverstatedIntangible assetssuchaspatentsmayhavesomevalueincluded,butbrandloyalty,technologicalknow-how,orahighlytrainedloyalworkforcewillnotbevalued.Goodwillmaybeincluded,butsoonlosesitsconnectiontomarketvaluebecauseofaccountingdepreciationandmarketfluctuationsSomecontingent liabilitiessuchaslaw-suitsarenotroutinelydisclosed,oronlydisclosedinthenotesAccountantsarebeginningtomark-to-markettheassetsofpensionfunds17Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.4Accountingv.EconomicMeasuresofIncomeEconomistsMeasureofNetIncome NetcashflowtoshareholdersNetcashflowtoshareholderspluschangechangeinmarketvalueofexistingshareholdersinmarketvalueofexistingshareholdersequityequityAccountantsMeasureofNetIncomeRevenueRevenueLessExpensesExpensesLessTaxesTaxes TheabovetwomeasureswouldbeequalifTheabovetwomeasureswouldbeequalifaccountantsmarkedaccountantsmarkedallrelevantassetsandrelevantassetsandliabilitiestomarket(theydont!)18Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallAccountingv.EconomicMeasuresofIncome:ExampleGPCsaccountingnetincomewasplus$23,400,000in2001Assumethetotalmarketvalueofthestockfellfrom$200,000,000to$187,000,000fromyear2xx0to2xx1.Wesawearlierthatthecashdividendtoshareholderswas$10,000,000.Theeconomicincomeinyear2xx1wasminus$2,800,000TheAccountingandEconomicmeasuresofIncomemaydiffersubstantially19Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.5ReturnstoShareholdersv.ReturnonBookEquityRecallourdefinitioninChapter2oftheholdingperiodreturn,andcomparethiswiththeeconomicmeasureofincomeThisistheTotalShareholderReturn20Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallReturnstoShareholdersv.ReturnonBookEquity(Continued)Traditionally,corporateperformancehasbeenmeasuredbyReturnonEquity,ROE21Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallReturnstoShareholdersv.ReturnonBookEquity(Conclusion)Thus,weseethatthereisnocorrespondencebetweenafirmsROEinanyyear&thetotalrateofreturnearnedbyshareholdersontheirinvestmentinthecompanysstock22Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.6AnalysisusingFinancialRatiosDespitethedifferencesinaccountingandfinancialprinciples,thepublishedaccountsofafirmyieldcluesaboutitsfinancialconditionFiveaspectsofafirmsperformance:ProfitabilityAssetturnoverFinancialleverageLiquidityMarketvalue23Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallProfitability24Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallAssetTurnover25Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallFinancialLeverage26Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallLiquidity27Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallMarketValue28Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallRatioComparisonsEstablishYourPerspectiveShareholderEmployee,Management,orUnionCreditorPredator,Customer,Supplier,Competitor,TradeAssociationBenchmarksOthercompaniesratiosThefirmshistoricalratiosDataextractedfromfinancialmarketsSourcesDun&Bradstreet,RobertMorris,CommerceDepartmentsQuarterlyFinancialReport,TradeAssociations29Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallRelationshipsAmongstRatiosItissometimesvaluabletodecomposeratiosintosums,differences,productsandquotientsofotherratios.Manysuchschemesstartwith:30Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallRatioAnalysisLimitationsRatioanalysisindicateswhereyoumightprofitablyfocusyourattention,butitcanalsomisleadyouLookforcollaboratingevidenceforthehypothesesyouformfromtheratiosSoundlong-termgoalsofafirmmaycauseratiostolookawful.Management-by-ratiosmaynotbeinthefirmslong-terminterestCompaniesinthesameindustrymayhaveverydifferentdistributionchannels,andaccountingmethods,leadingtomarkedlydifferentratiosthatarenone-the-lessappropriatetoeachcompany31Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallComment:Alwayskeepinmindthatfinancialstatementsarepreparedaccordingtoaccountingstandards and traditions,andthattheydonotfullysatisfytheneedsofafinancialanalystsTheydoyieldusefulinformationifusedwithcareandunderstanding32Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallEffectofFinancialLeverageFinancialleveragesimplymeanstheuseofborrowedmoney ShareholdersofafirmusefinancialleverageShareholdersofafirmusefinancialleveragetoboosttheirROEtoboosttheirROE ThisincreasesthesensitivityofROEtoThisincreasesthesensitivityofROEtofluctuationsinthefirmsunderlyingfluctuationsinthefirmsunderlyingprofitabilityasmeasuredbyitsROAprofitabilityasmeasuredbyitsROA33Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallIllustration(Table3.7&3.8oftextbook) ConsidertwofirmsthatareidenticalexceptConsidertwofirmsthatareidenticalexceptthatNodebtisfinancedusing$1,000,000ofthatNodebtisfinancedusing$1,000,000ofequityandHalfdebtisfinancedusingequityandHalfdebtisfinancedusing$500,000ofequityand$500,000ofdebt$500,000ofequityand$500,000ofdebt furtherassumethattheEBITofbothfirmsisfurtherassumethattheEBITofbothfirmsis$120,000andtaxis40%$120,000andtaxis40%34Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallCase:Borrowat10%35Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallCase:Borrowat15%36Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallCase:Borrowat10%:EffectofBusinessCycleonROE37Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallConclusion:Fromtheperspectiveof Creditors:increasingdebtisunambiguouslyCreditors:increasingdebtisunambiguouslyharmful,andbondratingagencieswillharmful,andbondratingagencieswilldowngradethefirmssecuritiesdowngradethefirmssecurities Shareholders:maybenefit,dependingontheShareholders:maybenefit,dependingonthesignof(ROA-interestrate)andROAsignof(ROA-interestrate)andROA38Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.7TheFinancialPlanningProcess“Idontgiveastrawberrywhathappens.Iwantyoualltostonewallit.LetthempleadtheFifthAmendment,cover-uporanythingelse,ifitllsaveit,savetheplan.” RichardMilhousNixononPlanning(22RichardMilhousNixononPlanning(22March,1973)March,1973)(Bowdlerizedtoavoidoffendingaccountingstudents)(Bowdlerizedtoavoidoffendingaccountingstudents)39Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallIntroductiontoPlanningThissectionnavigatesusthroughthefinancialplanningprocess,usingthehistoricalfinancialstatementsforamanufacturingfirmasourembarkationpointLater,wediscussshort-termplanningandthemanagementofworkingcapital40Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess FinancialplanningisaFinancialplanningisadynamicdynamicprocessthatprocessthatfollowsacycleofmakingplans,followsacycleofmakingplans,implementingthem,andrevisingthemintheimplementingthem,andrevisingtheminthelightofactualresultslightofactualresults41Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess StartingpointisthestrategicplanStartingpointisthestrategicplan StrategyguidesthefinancialplanningprocessStrategyguidesthefinancialplanningprocessbyestablishingoverallbusinessdevelopmentbyestablishingoverallbusinessdevelopmentguidelinesandgrowthtargetsguidelinesandgrowthtargets WhichbusinessesdoesthefirmwanttoWhichbusinessesdoesthefirmwantto enterenter expandexpand contractcontract exitexit andhowquickly?andhowquickly?42Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess LengthoftheplanninghorizonLengthoftheplanninghorizon Thelongerthefinancialplan,thelessThelongerthefinancialplan,thelessdetaileditshouldbe(ingeneral)detaileditshouldbe(ingeneral) TherevisionofafinancialplanisgenerallyaTherevisionofafinancialplanisgenerallyafunctionofthelengthoftheplanninghorizonfunctionofthelengthoftheplanninghorizon Short-termplansarerevisedfrequently,long-termShort-termplansarerevisedfrequently,long-termplansarerevisedmuchlessfrequentlyplansarerevisedmuchlessfrequently43Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess ThefinancialplanninghorizonmaybeThefinancialplanninghorizonmaybebrokendownintoseveralsteps:brokendownintoseveralsteps: ManagementforecaststhekeyexternalManagementforecaststhekeyexternalfactors,includinglevelofeconomicactivity,factors,includinglevelofeconomicactivity,inflation,interestrates,andthecompetitionsinflation,interestrates,andthecompetitionsoutputandpricesoutputandprices Basedonabove,theynextforecastrevenues,Basedonabove,theynextforecastrevenues,expenses,cashflows,andimpliedneedforexpenses,cashflows,andimpliedneedforexternalfinancingexternalfinancing44Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess SpecificperformancetargetsaregeneratedSpecificperformancetargetsaregeneratedforthedivisions,functionsandkeyindividualsforthedivisions,functionsandkeyindividualsofthefirmofthefirm PeriodicmeasurementsofperformancearePeriodicmeasurementsofperformancearemade,andcomparedtotheplaninordertomade,andcomparedtotheplaninordertocorrecteithertheplanorperformancecorrecteithertheplanorperformance Periodically,keypersonnelarecounseled,Periodically,keypersonnelarecounseled,rewardedorpunished,andanewiterationisrewardedorpunished,andanewiterationisinstigatedinstigated45Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess:Notes SomevariablesmustbeforecastwellinSomevariablesmustbeforecastwellinadvancebecauseexploitationrequiresalongadvancebecauseexploitationrequiresalonglead-time,othersmaybereactedtolead-time,othersmaybereactedtoimmediatelyimmediately Somevariablesarehighlyvolatile,andcantSomevariablesarehighlyvolatile,andcantbeforecasteffectively,sothebestwecandobeforecasteffectively,sothebestwecandoistoplanfortheunknown(contingencyistoplanfortheunknown(contingencyplanning)planning)46Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess:Notes PlanninghorizonsmustbeappropriatePlanninghorizonsmustbeappropriate Foramagazinestand,atwoyearplanningForamagazinestand,atwoyearplanninghorizonmaybefartoolonghorizonmaybefartoolong Apharmaceuticalbusiness(withlongnew-Apharmaceuticalbusiness(withlongnew-plantconstructionlead-times,andlongdrugplantconstructionlead-times,andlongdrugdevelopment/testing/approvalprocedures)development/testing/approvalprocedures)needsaplanninghorizonthatmaybeasneedsaplanninghorizonthatmaybeaslongatenyearslongatenyears47Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess:Notes AplanshouldalwaysleadtoAplanshouldalwaysleadtodecisionsdecisionsthatthatjustifythecostofitspreparationjustifythecostofitspreparation Properplanningis,inessence,partoftheProperplanningis,inessence,partoftheprocessofdecisionmaking.Anypartofaprocessofdecisionmaking.Anypartofaplanthatdoesnotleadtoadecisionisplanthatdoesnotleadtoadecisionisprobablyawasteofmanagerialresourcesprobablyawasteofmanagerialresources48Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheFinancialPlanningProcess: AplanshouldmakereasonabletradeoffsAplanshouldmakereasonabletradeoffsbetweenflexibilityandthecostofflexibilitybetweenflexibilityandthecostofflexibility Recallthatincapitalbudgeting,optionswereRecallthatincapitalbudgeting,optionsweresometimesveryvaluablesometimesveryvaluable49Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.8ConstructingaFinancialPlanningModelThenextslideshowsthehistoryofGPC50Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallGPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) (Percent of Years Sales)Yearxxx0xxx1xxx2xxx3xxx1xxx2xxx3Income StatementSales200240288100.0%100.0%100.0%Cost of goods sold11013215855.0%55.0%55.0%Gross margin9010813045.0%45.0%45.0%Selling, general & admin. expenses30364315.0%15.0%15.0%EBIT60728630.0%30.0%30.0%Interest expenses30456415.0%18.8%22.2%Taxes121196.0%4.5%3.1%Net income1816139.0%6.7%4.7%Dividends5542.7%2.0%1.4%Change in shareholders equity131196.3%4.7%3.3%Balance SheetAssets: Cash & equivalents101214176.0%6.0%6.0% Receivables4048586924.0%24.0%24.0% Inventories5060728630.0%30.0%30.0% Property, Plant & equipment500600720864300.0%300.0%300.0% Total Assets6007208641037360.0%360.0%360.0%Liabilities: Payables3036435218.0%18.0%18.0% Short-term debt120221347502110.7%144.6%174.2% Long-term debt15015015015075.0%62.5%52.1% Total Liabilities300407540704203.7%225.1%244.3%Shareholders equity300313324333156.3%134.9%115.7%51Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall (Nearest $ Million) Yearxxx0xxx1xxx2xxx3Income StatementSales200240288Cost of goods sold110132158Gross margin90108130Selling, general & admin. expenses303643EBIT607286Interest expenses304564Taxes12119Net income181613Dividends554Change in shareholders equity1311952Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall53Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall (Percent of Years Sales)Yearxxx1xxx2xxx3Income StatementSales100.0%100.0%100.0%Cost of goods sold55.0%55.0%55.0%Gross margin45.0%45.0%45.0%Selling, general & admin exp.15.0%15.0%15.0%EBIT30.0%30.0%30.0%Interest expenses15.0%18.8%22.2%Taxes6.0%4.5%3.1%Net income9.0%6.7%4.7%Dividends2.7%2.0%1.4%Change in equity6.3%4.7%3.3%54Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall55Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallConstructingaFinancialPlanningModelPercent-of-salesmethod FirstexaminewhichitemsintheincomeFirstexaminewhichitemsintheincomestatementhavemaintainedafixedratiotostatementhavemaintainedafixedratiotosalessales ThisenablesustodecidewhichitemsshouldThisenablesustodecidewhichitemsshouldbeforecastonprojectedsales,andwhichbeforecastonprojectedsales,andwhichneedtobeforecastonanotherbasisneedtobeforecastonanotherbasis56Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallConstructingaFinancialPlanningModelPercent-of-salesmethod ThesecondstepistoforecastsalesThesecondstepistoforecastsales Thisisamajorexercise,butwewillassumeThisisamajorexercise,butwewillassumethatsaleswillcontinuetogrowat20%nextthatsaleswillcontinuetogrowat20%nextyear(asithasinthepast)year(asithasinthepast)57Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallConstructingaFinancialPlanningModelPercent-of-salesmethod ThethirdstepistoforecastthoseitemsthatThethirdstepistoforecastthoseitemsthathavebeenassumedtovarywithsaleshavebeenassumedtovarywithsales58Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallConstructingaFinancialPlanningModelPercent-of-salesmethod ThefourthandfinalstepistoforecasttheThefourthandfinalstepistoforecastthemissingitemsthathavemissingitemsthathavenotnotbeenassumedbeenassumedtovarywithsalestovarywithsales Weneedsomeassumptions:Weneedsomeassumptions:59Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallConstructingaFinancialPlanningModelAssumptions: Interestrateonlong-termdebtis8%,andInterestrateonlong-termdebtis8%,andonshort-termdebtis15%onshort-termdebtis15% Toavoidcomplexity,weassumethatinterestToavoidcomplexity,weassumethatinterestiscomputedontheyearendlong-andshort-iscomputedontheyearendlong-andshort-termbalances(wecanre-addressthislater)termbalances(wecanre-addressthislater) interest=0.08*501.72+0.15*150=87.26interest=0.08*501.72+0.15*150=87.2660Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallConstructingaFinancialPlanningModel TheincomestatementmaynowbeTheincomestatementmaynowbeconstructedgiventhedividendpay-outratioconstructedgiventhedividendpay-outratioandtaxrate(30%and40%)andtaxrate(30%and40%) ThechangeinequityisaddedtotheequityThechangeinequityisaddedtotheequityforyearxxx3,togivethenewbalanceforforyearxxx3,togivethenewbalanceforyearxxx4yearxxx4 “Totalassets”isavailable,sothe“Total“Totalassets”isavailable,sothe“Totalliabilities”maynowbecomputedliabilities”maynowbecomputed61Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallGPC Financial Statements, Years xxx1 - xxx3 (Nearest $ Million) (Percent of Years Sales)Yearxxx0xxx1xxx2xxx3xxx1xxx2xxx3F(sales)? xxx4Income StatementSales200240288100.0% 100.0% 100.0% N/A346Cost of goods sold11013215855.0%55.0%55.0% Yes190Gross margin9010813045.0%45.0%45.0% N/A(Yes)156Selling, general & admin. expenses30364315.0%15.0%15.0% Yes52EBIT60728630.0%30.0%30.0% N/A104Interest expenses30456415.0%18.8%22.2% No87Taxes121196.0%4.5%3.1% N/A7Net income1816139.0%6.7%4.7% N/A10Dividends5542.7%2.0%1.4% N/A3Change in shareholders equity131196.3%4.7%3.3%7Balance SheetAssets: Cash & equivalents101214176.0%6.0%6.0% Yes21 Receivables4048586924.0%24.0%24.0% Yes83 Inventories5060728630.0%30.0%30.0% Yes104 Property, Plant & equipment500600720864300.0% 300.0% 300.0% Yes1037 Total Assets6007208641037360.0% 360.0% 360.0% N/A(Yes)1244Liabilities: Payables3036435218.0%18.0%18.0% Yes62 Short-term debt120221347502110.7% 144.6% 174.2% No Long-term debt15015015015075.0%62.5%52.1% No Total Liabilities300407540704203.7% 225.1% 244.3%N/A904Shareholders equity300313324333156.3%134.9%115.7%N/A34062Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallExampleCompleted WecompletethebalancesheetbyWecompletethebalancesheetbyrecognizingthatthereareonlytwoaccountsrecognizingthatthereareonlytwoaccountsthatneedtobeestimated,Short-termdebt,thatneedtobeestimated,Short-termdebt,andLong-termdebtandLong-termdebt Thesumisthen904(Liabilities)-62Thesumisthen904(Liabilities)-62(Payables)=$842Million(Payables)=$842Million Assumenochangeinlong-termdebtAssumenochangeinlong-termdebt Short-termdebt=$842-150=$692millionShort-termdebt=$842-150=$692million63Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall64Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall65Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.9Growth&NeedforExternalFinanceInordertogrowby20%,thefirmwillneedanadditional692-502=$190millioninexternalfunding(allshort-termfundingintheexample)Itissometimesusefultobeabletocomputetheexternalfundsneededdirectly:66Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallGrowth&NeedforExternalFinanceLet S S1 1bethesalesinnextyearbethesalesinnextyear S S0 0bethesalesthisyearbethesalesthisyear ASbetheassetsthatvarywithsalesASbetheassetsthatvarywithsales LSbetheliabilitiesthatvarywithsalesLSbetheliabilitiesthatvarywithsales dbethedividendpay-outratiodbethedividendpay-outratio tbethetaxratetbethetaxrate67Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallExternalFundsNeeded68Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallSomeQuestions: HerethesamelogicwasusedtoderiveanHerethesamelogicwasusedtoderiveanequationratherthanasetofaccountsequationratherthanasetofaccounts Theequationsanswerthequestions:Theequationsanswerthequestions: WhatexternalfundsarerequiredtosupportaWhatexternalfundsarerequiredtosupportasalesgrowthrate,g,of20%?salesgrowthrate,g,of20%? IfIhaveexternalfundsavailableequaltoIfIhaveexternalfundsavailableequalto$30million,whatlevelofsalesgrowthdoes$30million,whatlevelofsalesgrowthdoesthissupport?thissupport?69Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall70Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallObservation: SometimesthenewassetsrequiredtoSometimesthenewassetsrequiredtogenerateincomearenotashighasinthisgenerateincomearenotashighasinthisexample,andthecompanymaybeabletoexample,andthecompanymaybeabletosupportalevelofgrowthwithnoexternalsupportalevelofgrowthwithnoexternalfunding(-0.00038inourcase)funding(-0.00038inourcase)71Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallSustainableRateofGrowthAsapracticalmatter,afirmthatdoesnotissuenewequitywillhaveitsdebtconstrainedbythedebtratioSustainableRateofGrowth=(1-d)*ROE72Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.10WorkingCapitalManagementManybusinessesthatfaildosobecauseofpoormanagementofworkingcapital,notpoorprofitabilityWorkingcapital Currentassets-currentliabilitiesCurrentassets-currentliabilities73Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallEfficientManagementofWorkingCapitalPrinciple: Minimizetheinvestmentinnon-earningMinimizetheinvestmentinnon-earningassetssuchasassetssuchas receivablesreceivables inventoriesinventories MaximizingtheuseoffreecreditsuchasMaximizingtheuseoffreecreditsuchas prepaymentsbycustomersprepaymentsbycustomers accruedwagesaccruedwages accountspayableaccountspayable74Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallCashCycleTimeCashCycleTime=Inventoryperiod+receivableperiod-payablesperiod75Copyright2009PearsonEducation,Inc.PublishingasPrenticeHallTheCashFlowCycle76Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall3.11LiquidityandCashBudgeting Afirmmaybeprofitable,andhaveasizableAfirmmaybeprofitable,andhaveasizablenetworth,butifitisilliquiditwillbenetworth,butifitisilliquiditwillbedamagedbyforcedassetssalesandbydamagedbyforcedassetssalesandbylaying-offtrainedworkerslaying-offtrainedworkers BanksaremuchmorereceptivetofundingaBanksaremuchmorereceptivetofundingaplannedplannedcashshortfallthanfundingacashshortfallthanfundingashortfallthatshouldhavebeenforecastshortfallthatshouldhavebeenforecast Construct a Cash BudgetConstruct a Cash Budget77Copyright2009PearsonEducation,Inc.PublishingasPrenticeHall