sustainable growth and financial statement analysis
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Sustainable Growth and Financial Statement Analysis
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2007 Forecasts
2007 Pro Forma Income State.Sales 150Costs 135Net Income 15Dividends 6Ret. Earnings 9
2007 Pro Forma Balance SheetLiabilities 150
Assets 300Equity 109
whoops!
2006 Income StatementSales 100Costs 90Net Income 10Dividends 4Ret. Earnings 6
2006 Balance Sheet
Liabilities 100Assets 200
Equity 100
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External Funds Needed (EFN)
2007 Pro Forma Income State.
Sales 150
Costs 135
Net Income 15
Dividends 6
Ret. Earnings 9
2007 Pro Forma Balance Sheet
Liabilities 150
Assets 300
Equity 109
Total 300 Total 259
• There is a funding shortfall of 41 (A = 300, L&NW = 259)
• This must be made up by:1. Issuing new equity
2. Allowing the ratio of liabilities/sales to rise
3. Some combination of (1) and (2)
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EFN More Generally (Eq. 3.22, p. 70)
)6)(.150(10.)50(1)50(241
))((Pr
besojectedSalPMSalesSales
sLiabilitieSales
Sales
AssetsEFN
PM = Net Profit Margin
b = retention ratio (retained earnings/net income)
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Sustainable Growth Rate
• Growth rate in sales = g (i.e., S1 = (1+g)S0 and ΔS = S1 – S0 = gS0
• At what rate can we grow without issuing new equity or allowing liabilities/sales to increase (e.g., EFN = 0)?
ROEb
ROEbgPMbPMb
sales
equityg
PMbPMbsales
liab
sales
assetsg
bSgPMgSsales
liabgS
sales
assetsEFN
1)(
).
(
)1(.
0 000
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Dell’s Working Capital
• How did Dell fund 52% growth in sales for 1996?– Use 1995 data to forecast 1996 balance sheet and
compare with 1996 actual
• Can Dell sustain another year of 50% sales growth without issuing new equity or increasing its debt ratio?
• What role does Dell’s cash conversion cycle play in its funding needs?
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How Can We Assess and Explain Financial Performance?
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Financial Ratio Types
• Market Value
• Profitability
• Asset Management
• Leverage
• Liquidity
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Market Value Ratios
• Examples: Market-to-Book; Price-Earnings
• Questions: How do securities markets value the company’s assets? Earnings?
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Profitability Ratios
• Examples: Return on assets, equity, invested capital; gross, net profit margin
• Questions: How profitable is the company per dollar invested in the business; per dollar of sales?
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Asset Management Ratios
• Examples: asset turnover, days’ sales in receivables, inventory turnover, days’ sales in payables
• Questions: How efficiently does the company use its assets? How long does it take assets or liabilities to turn into cash?
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Financial Leverage Ratios
• Examples: Debt/assets; Debt/equity; Interest coverage
• Questions: How much of a burden does debt pose relative to assets, equity or cash flow? How risky is the company?
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Liquidity Ratios
• Examples: Current ratio, quick ratio, interval measure
• Questions: How easily can the company meet its immediate cash requirements? How risky is the company?
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Financial Ratios Relative to What?
• By themselves, financial ratios have no meaning. We need to compare to:
– Past data for the same company– Data for similar companies (e.g., same
industry)– Other ratios (i.e., DuPont ratios, Cash
Conversion Cycle)
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Does One Trend Coincide with Another?
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DuPont Ratios
Net Income x Sales x Assets = Net Income
Sales Assets Equity Equity
Net profit X Asset x Equity = ROE
margin turnover multiplier
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Like-A-Weed mini-case
• How is Like-A-Weed doing?
• Why is the net profit margin declining?
• Does the company have a financial or an operating problem?
• What should Like-A-Weed do?