understanding corporate finance

8/9/2019 Understanding Corporate Finance

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Understanding Corporate Finance

Robert N. Holt,Ph.D.,C.P.A.

Fifth Edition

© Copyright 2011

Ivy Software


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Table of Contents

Title Page

Introduction..................................................................................................................................1

Chapter One- Analyzing Financial Statements............................................................................2

Chapter Two- Projecting Earnings and Cash Flow....................................................................20

Chapter Three- Creating Value for Stockholders.......................................................................28

Chapter Four- Capital Budgeting................................................................................................38

Chapter Five- Calculating the Cost of Raising Capital...............................................................46

Chapter Six- Assessing Merger and Acquisition Targets...........................................................57

Chapter Seven- Financing Investments.......................................................................................63

Illustrations..................................................................................................................................72


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Introduction

Students of finance quickly learn that it is a complex discipline. Many balk at the prospect of continuingtheir study when they realize that it is a field that no one will ever wholly master. Others are dismayed when theyrealize that the best financial managers are those which keep themselves continually apprised of the latesttheoretical and practical developments: the commitment necessary to sustain excellence in this profession is a profound one.

Because finance is such an encompassing field, specialization is prevalent. There are experts ininvestment analysis, security analysis, lending, security underwriting, leasing, personal finance, and corporatefinance, to name a very few of the specializations. Pick up an annual report of any financial services company andyou will gain an understanding of the diversity.

Despite the diversity of the subject, there are a few basic principles which apply to the entire field. Thenotion of value creation and the importance of judgment in financial decisions are two principles that will never besuperseded by new analytical techniques.

In effort to focus the purpose of this text, a perspective has been chosen. The reader should understandthat this entire book has been written from the point of view of a general manager in a public corporation. Thespecial problems and opportunities in private businesses are not addressed. However, all of the analyticaltechniques that are discussed are applicable to both kinds or organizations.

Understanding Corporate Finance is a practitioner-oriented, introductory text designed for managers andanalysts. In this book new theoretical trails are not blazed; rather, it is the intent of the author to provide the readerwith the basic analytical skills which are necessary for one to function effectively as a general manager. If therehas been little theoretical pioneering, current theory has been provided when such knowledge is necessary to theunderstanding of an analytical method.

This text is a cumulative one. It is necessary to understand Chapter 1 before preceding to Chapter 2, andso on. Important terms, and those that the user will likely see again, are presented in bold type. UnderstandingCorporate Finance is intended as a companion piece to the personal computer-based course of the same name. Iis in the interactive problem sessions that the user will test his or her understanding, and be presented with anopportunity to learn about corporate finance by participating in the resolution of real problems.

What will the student gain by completing this course? It is intended that a user will master the basicfinancial skills that every general manager should understand. Furthermore, it is hoped that the reader will gain a perspective that will foster ability to understand the financial behavior of corporations and capital markets.

The author is indebted to the teaching methods and subject material of the Colgate Darden GraduateSchool of Business Administration First Year program. Without the benefit of an individual's experience in that program, this work would not have been possible. I am especially indebted to Dana Dame, who wrote the firsdraft of this book.

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Chapter 1 Analyzing Financial Statements

INTRODUCTION

Financial statements can be the source of information for several dissimilar groups. Banks may wish toexamine a firm's reports to make lending decisions, or union locals may want to know how their company is

performing in order to structure an upcoming round of contract negotiationsthe users of a company's externalfinancial reports can be found both inside and outside the firm and can be friendly or hostile.

The basic quantitative tools that analysts use to interpret a firm's reports are not difficult to grasp. As longas the statements that are being used are comparable, performance measures can be easily calculated. Today

government agencies and certain professional organizations oversee the form and content of external financialstatements so that they can be successfully compared. This ability for an analyst to easily compare financialreports has not always been possible.

In 1934, because of the disparities that existed in financial reports and other reasons, Congress created theSecurities and Exchange Commission (SEC). The SEC was charged with regulating all companies that have publicly traded securities. Since the creation of the SEC, only such "public" companies have been required to publish external financial statements. Private companies, although not required to do so, prepare financiastatements for external users, if not the public as a whole. A bank, for instance, often requires private companiesto provide it with financial reports before it considers issuing loans.

One of the primary objectives of the SEC is to ensure that a firm's external statements contain accuratefinancial information that fairly represents underlying economic reality. In order to execute this basic philosophythe SEC periodically publishes Accounting Series Releases (ASRs), which dictate the standards to be followed bythe accounting profession. Although the SEC has the Congressional authority to set accounting standards, it hasthrough the years allowed the accounting profession to regulate itself, subject, naturally, to the SEC's approval.

Since 1934, various committees of accounting professionals have provided this service. Today, the principal organization to which the SEC has implicitly granted authority to monitor accounting standards is theFinancial Accounting Standards Board (FASB). The FASB has outlined a set of major goals for financialaccounting:

The objectives [of external financial reporting] stem primarily from the informational needs ofexternal users who lack the authority to prescribe the financial information they want from anenterprise and therefore, must use the information that management communicates to them.

Financial reporting should provide information that is useful to present and potential

investors, creditors and other users in making rational investment, credit and similar decisions.

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The role of financial reporting in the economy is to provide information that is useful in

making business and economic decisions, not to determine what those decisions should be. Therole of financial reporting requires it to provide evenhanded, neutral or unbiased information .1

The FASB further indicates that financial statements should report not only a firm's economic resources, butclaims on those resources by creditors and investors as well.

It is important to realize that the SEC and FASB do not precisely delineate all accounting standards, bu

rather they choose to provide flexible guidelines in many cases. Flexibility in accounting standards is desirable because there are vast differences among firms. A body of customs, not unlike English common law, has evolvedand comprise what is known as Generally Accepted Accounting Principles (GAAP). One of the fundamentagoals of GAAP is to provide a framework for financial reporting so that the statements of very different firms can be compared. Other goals of GAAP include rules governing:

Accounting Periods financial reports should be prepared periodically, and cover periods of equallength. Companies may choose the time of year that they desire their accounting periods to end (the SECrequires a report at least annually).

Matching in their statements, firms should include all expenses incurred to realize the revenues that

they report.

Conservatism firms, given a situation where measurement uncertainties produce equally likely profitfigures, should report the lowest figure. Firms should strive to anticipate all expenses, and not reportrevenues until they can be properly recognized. Deliberate understatement is forbidden.

Understandability the information contained in reports should be written at a level that a reader with areasonable comprehension of business principles can understand.

Relevance reports should contain information that is relevant to the decisions at hand, and be user-oriented.

Reliability information that is provided must be complete and verifiable.

Consistency firms should strive to use consistent accounting methods so that their statements can becompared over time.

The preceding list of concepts does by no means include all of the GAAP, but rather those that areespecially relevant to external reporting. In addition to these principles, the FASB has identified specificrequirements that apply to the external reports of all firms. These requirements include that all firms must report

The Financial Position at Period's End

1

FASB, Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises" (Stanford, Conn.: 1978), pars.28, 33, 34.

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The Cash Flows for the Period

The Earnings for the Period

The Comprehensive Income for the Period

The Investments by and Distributions to Owners for the Period

In the next section, the financial statements which fulfill these requirements will be introduced.

THE FINANCIAL STATEMENTS

Before the statements can be presented, a few general concepts about financial statements should beunderstood. Since accounting principles allow a certain degree of leeway in external reporting, an analyst should become acquainted with the particular methods that the company under study has chosen to use in its reports. Forexample, a firm recently may have switched from the First-In-First-Out (FIFO) method of valuing inventory to theLast-In-First-Out (LIFO) method. In inflationary times this switch would result in the firm assigning a higher costo the goods sold than it would have under the previous method. This in turn would cause the reported income toappear lower under the new method, given an equal sales level in the two years, and the analyst might err in his

conclusion about the cause of the lower earnings unless it is realized that the switch has occurred. In addition tounderstanding the accounting principles that are being used, the analyst must look beyond the mere statementsthemselves to the footnotes of the reports. Frequently, the footnotes contain the clues that are necessary tounderstand which accounting principles apply. A third consideration for an analyst is whether the statements have been independently audited. Quarterly statements frequently are not examined. Where reports have beenindependently audited, the auditor's report should be read carefully. A qualified opinion attached to an annualreport, where the auditor qualifies the company's application of accounting principles, may be cause for seriousconcern. It may, however, merely indicate one of several conditions, such as industry practice, that cannot beverified by the auditors using Generally Accepted Auditing Standards.

With the idea that the statements of real companies should be approached somewhat cautiously, we are

ready to proceed to the financial statements of a fictional toy manufacturer.

The Balance Sheet

The balance sheet, or statement of financial position, fulfills the FASB requirement that a firm report itsfinancial position at period's end. It records a firm's assets, liabilities, and owners' equity at a point in time, thelast day of the reporting period, in accordance with the universal accounting convention:

Assets = Liabilities + Owners' Equity

As mentioned earlier, reporting periods are chosen at management's discretion, but must be consistentfrom year to year. Firms ordinarily choose to end their fiscal years in a month where their statements will recordtheir most favorable financial position, or the season which most accurately reflects their typical financialsituation. As shown in Figure 1.1, the Clever Toy Company has chosen to end its reporting period on December31st. At this time of year, as a company with seasonal sales, Clever Toy has much lower inventory levels than itwould during the peak production months of the summer, when inventory is allowed to build for the heavy fallsales season. By December, large inventories have been converted to sales. A balance sheet prepared in Junewould record a very different picture.

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Examine Figure 1.1 for a moment. Notice that the heading indicates that this report represents thefinancial position on a particular day. The accounts have been arranged into "current" (having due dates less thanone year or reporting period) and "noncurrent" (having due dates greater than one year or reporting period) portions. Accounts are conventionally listed in order of decreasing liquidity. Liquidity is a measure of how

easily an item may be converted to cash the greater an item's liquidity, the easier it can be converted to cash.

Since the financial position is displayed for more than one year, the report shown is called a comparative

balance sheet

Figure 1.1The Clever Toy Company

Balance Sheet

As of December 31

ASSETS 2011 2010

Current AssetsCashMarketable Securities

Accounts ReceivableInventoriesPrepaid Expenses and Other Assets

$ 160,000146,000

390,000372,00097,000

$ 88,00042,000

376,000404,000128,000

Total Current Assets $1,165,000 $1,038,000

Long-Term AssetsInvestmentsLandBuildingsEquipment

367,00064,000

309,000708,000

337,00064,000

301,000720,000

Total Assets $2,613,000 $2,460,000

LIABILITIES AND OWNERS' EQUITY

Current LiabilitiesBank Notes PayableCurrent Portion - Long Term DebtAccounts Payable and Accrued ExpensesAccrued Taxes

$ 42,00011,000

532,000109,000

$ 35,00025,000

473,000129,000

Total Current Liabilities

Long-Term LiabilitiesLong Term DebtDeferred Income Taxes

$ 694,000

370,00088,000

$ 662,000

326,00087,000

Total Liabilities $1,152,000 $1,075,000

Owners' EquityCommon Stock (100,000 shares)Paid-in CapitalRetained Earnings

235,00050,000

1,176,000

235,00050,000

1,100,000

Total Liabilities and Owners' Equity $2,613,000 $2,460,000

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The Income Statement

The income statement, also referred to as a statement of earnings or profit and loss (P&L) statementfulfills the requirement that a firm disclose its earnings for a period and show a comprehensive report of thefactors that influenced those earnings during that period. Therefore, the intent of the income statement is to matcha company's expenses with its revenues for an entire reporting period , whether that is a week, month, quarter orfiscal year.

The difference between the firm's revenues and all expenses, including taxes, is the firm's net income forthe period. Net income is also referred to as net profit, net earnings, or profit after tax in various circles. It isvery important to realize that the company's net income and its cash flow for the same period are rarely the samefigure. When they are equivalent, it is purely coincidental. There are certain noncash expenses, such asdepreciation and amortization, which reduce net income but do not reduce a firm's cash position, because noncashexpenses do not involve a transfer of cash. All expenses are deducted from a firm's revenues to arrive at a neincome figure, but all expenses do not use cash. Neither are all cash outlays recorded as expenses: purchases ofinventory or property, plant, and equipment are not expenses.

The Clever Toy Company's income statement is shown in Figure 1.2. Examine that statement for amoment. Notice that the heading clearly indicates that the report covers a period of time, in this case a full year

An income statement by convention begins with a figure representing the company's revenues (or sales) for the period. From this figure, the cost of producing the company's goods or services, which is the cost of goods soldor cost of sales, is then deducted. The remaining subtotal is referred to as the gross margin or gross profitFrom the gross margin, the remaining expenses which the company chooses not to directly allocate to the cost ofsales, are subtracted. These expenses include operating expenses, interest on loans, and taxes. Notice the presence of the noncash expense, depreciation.

Financial analysts use certain subtotals from income statements in their calculations. Unfortunately, oftenthere are variations in the statements which force analysts to perform detective work to ascertain what thesesubtotals are. Some of the more popular subtotals from income statements that have not been previouslydiscussed include:

Operating Income The firm's income after operating expenses from its main line of business, beforeinclusion of income from investments, and before interest or taxes have been deducted.

Earnings Before Interest and Taxes (EBIT) The firm's total income from all sources before interestor taxes have been deducted.

Earnings Before Tax (EBT) The firm's EBIT, less interest charges.

When examining income statements, analysts must be as familiar with the company's preparation methodsas they are when they examine the firm's balance sheets.

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Income Statement

For the Year Ended December 31

2011 2010

Net RevenuesLess Cost of Goods Sold

$3,414,0001,886,000

$3,010,0001,580,000

Gross Profit

Less Operating Expenses

SalariesSales and AdministrationOther ExpensesDepreciation

1,528,000

300,000680,000

80,000175,000

1,430,000

280,000640,00079,000

175,000

Operating Income

Plus Income from Investments

Less Interest Expense

293,00026,000

35,000

256,00018,000

27,000

Operating Income Before Taxes

Less Income Taxes284,000120,000

247,000104,000

Net Income $ 164,000 $ 143,000

Statement of Owners' Equity

The statement of owners' equity, or statement of stockholders' equity, fulfills the requirement that acompany publicize all investments in the firm, and all distributions to owners, during the course of the reporting

period. Stated in other words, the purpose of this statement is to describe all changes which have occurred in theowners' equity accounts. Sources of new equity, or investments in the firm, include the firm's earnings and proceeds from the sale of stock during the reporting period, if any. Reductions in equity include the distribution ofdividends, and the purchase and retirement of outstanding stock (outstanding shares which have been purchased but not yet retired are referred to as treasury stock ).

As in all financial statements, formats vary in statements of owners' equity. The format illustrated inFigure 1.3 is typical. Notice the entries in Figure 1.3. As in the income statement, this report clearly indicates thathe statement covers an entire period. The three columns of figures listed make up all of the components oowners' equity, as listed on the balance sheet. Beneath the beginning balances, figures are entered only wherethey are appropriate. The dashed lines mean "not applicable". Notice which entries define sources, and which

ones are uses of owners' equity, as discussed earlier in this section. Refer back to Figure 1.1, and compare theowners' equity entries on the balance sheet to this statement.

A subset of this statement, which only includes the changes in the firm's retained earnings account for the period, is often included in a company's financial statements. It is referred to as a statement of retainedearnings, and may be incorporated in the income statement.

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Statement of Owner's Equity

For the Year Ended December 31, 2011

Common Stock Paid-in Capital Retained Earnings

Balance December 31, 2010

Add: Net IncomeProceeds from Sale of Stock

Subtract:DividendsIncrease in Treasury Stock

Balance December 31, 2011

$235,000

-0

-0

$235,000

$50,000

-0

-0

$50,000

$1,100,000

164,000-

88,000-

$1,176,000

Perhaps you have realized that the reason "retained earnings" are so named is that they are earnings that

the firm has "retained" and not distributed in the form of dividends. Retained earnings are not cash. Compare thecash balance with the retained earnings entry on Clever Toy's balance sheet. The retained earnings entryrepresents the cumulative total of net income that the company has earned, and not distributed, since it came into being.

The Statement of Cash Flows

In December 1987, the Financial Accounting Standards Board (FASB) published Statement of Financia Accounting Standards No. 95, Statement of Cash Flows. This pronouncement requires for the first time thacompanies present a statement of cash flows in published financial statements. Prior to this announcementcompanies presented a statement of changes in financial position (often referred to as a "funds statement"). The

statement of changes in financial position could be presented on either a working capital flow basis or a cash flow basis. The working capital approach explained the changes in working capital, whereas the cash basis explainedthe changes in cash during a period. The current format of the statement of cash flows is shown in Figure 1.4.

There are three major headings in Figure 1.4: (1) Cash Flow from Operating Activities, (2) Cash Flowfrom Investing Activities and (3) Cash Flow from Financing Activities. Cash Flow from Operating Activities begins with net income and proceeds to add noncash expenses and in addition shows certain other adjustmentsDepreciation is added to net income since depreciation is a noncash expense. In other words, depreciationrequires no cash outlay, yet it is an expense and does reduce net income. Adding it back to net income is justifiedsince we are trying to translate net income to cash. Changes in current assets and liabilities is the next majorsection of the statement. As sales increase, one would expect to see increases in accounts receivable andinventories to support these sales. Unfortunately as receivables and/or inventories increase, cash is "used up." Inthis case receivables increased by $14,000 - See figure 1-1. An increase in inventories from one year to the nextindicates that cash has been invested in the inventory increase. On the other hand, if inventories decrease, cash is"freed up." The inventory decrease from one year to the next indicates a disinvestment in this asset. In this caseinventories decreased by $32,000. For current liabilities such as accounts payable, the opposite entails. If anaccounts payable increases, cash is "freed up" since the payment is delayed. If an accounts payable balancedecreases from one year to the next, cash is "used up," since the company repaid more debt than it incurred duringthe year. In this case, the total current liabilities increase (other than taxes) was $52,000.

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The second section of the statement of cash flows is cash flow from investing activities and presents cashflows related to the purchase and sale of property, plant and equipment and other noncurrent assets such as long-term investments. To some extent these purchases and sales are discretionary, since management may postponethe purchase of assets or even sell assets when the economic or business outlook is poor and cash is scarce.According to Clever Toy Company's balance sheet, building and equipment acquisitions net of dispositions was$171,000. This is calculated by taking the 2011 ending balance of buildings and equipment ($1,017,000) andadding to it the depreciation for 2011 ($175,000). The result is all buildings and equipment subject to depreciation

during the year. The total is $1,192,000. Subtracting the beginning balance of the buildings and equipment for2011 ($1,021,000) gives the acquisitions net of dispositions (171,000). In addition, the long-term investmentsincreased by $30,000.

Cash flows from financing activities shows the effects of financing transactions such as issuance andrepayment of debt, issuance and repurchase of stock and payment of dividends. Clever Toy Company's long-termdebt increased by $44,000 during 2011. This is reflected as a source of cash in the statement of cash flows. Hadthe long-term debt decreased during the year, this would have indicated that the company repaid more debt than it borrowed, and thus would have been a use of cash. The deferred income tax account (another long-term liabilityincreased by $1,000. The common stock paid-in capital accounts were unchanged indicating no new issuance ostock. The change in retained earnings of $76,000 has been partially explained by net income that was reported in

the operating activities section. The remainder of the change in retained earnings is attributable to cash dividends paid of $88,000 as reported in the Statement of Owners' Equity. The dividends are a use of cash. The net cashused by financing activities was $43,000. The net increase in cash was $72,000.

To summarize the cash flow statement, The Clever Toy Company earned $164,000 in 20 11, but becauseof noncash expenses and changes in current assets and liabilities, it generated operating cash of $316,000. Itobtained long-term financing of $44,000 and used the total cash generated of $360,000 to acquire buildings,equipment and long-term investments (net of dispositions) of $201,000. In addition, cash dividends of $88,000were paid and cash increased by $72,000.

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Statement of Cash Flows (Indirect Method)

For the year ended December 31, 2011

(dollars in thousands)

Cash Flow From Operating Activities

Net Income $ 164Adjustment to Reconcile Net Income to

Cash Provided by Operating Activities:

Depreciation 175

Change in Current Assets and Liabilities

Accounts Receivable (increase) decrease (14)

Inventory (increase) decrease 32

Other current Assets (increase) decrease (73)

Accounts Payable and Accrued

Expenses increase (decrease) 52

Taxes Payable increase (decrease) (20)

Cash Provided by Operating Activities $ 316

Cash Flow From Investing Activities

Acquisition of Property, Plant and Equipment $ 201

Cash Provided by Investing Activities (201)

Cash Flow from Financing Activities

Issuance of Long-Term Debt $ 44

Cash Dividends Paid

(88)

Cash Provided (Used) by Financing Activities

(43)

Net Increase (Decrease) in Cas

h

72

Cash Balance at Beginning of Year

88

Cash Balance at End of Year

$ 160

RATIO CALCULATION

The balance sheet, income statement, owners' equity report, and cash flow statement often constitute the totaamount of information that an analyst can obtain when researching a company. Through the years, certain ratiosthat can be derived from these statements have been developed. These ratios are easy to calculate, but can be

deceptively difficult to interpret, especially when inferences must be made about the economic realities that lie beneath the numbers.

The ratios that are used most often vary with the analysts' perspectives. An issuer of short-term credit wilconcentrate on numbers which indicate a firm's short-term health, for example. Ratios can be organized into threecategories. Operating Performance ratios measure a firm's profitability and asset usage skill. Liquidity ratiosmeasure a firm's ability to meet its short-term financial obligations, and its skill in managing working capitalRatios of Financial Strength indicate the risk which can be associated with the way a company has packaged thedebt and equity that it uses to finance its assets

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The following ratios will be calculated from Clever Toy's financial statements.

I. Operating Performance Ratios

Profit Margin indicates a firm's ability to convert sales into earnings; also called return on sales.

Clever Toy's profit margin for 2011 is $164,000 or 4.8%.$3,414,000

When considered alone, a profit margin of 4.8% might be deemed a small return on sales. However, the percentage must be considered within the context of the toy manufacturing industry. A 4.8% margin may becommendable for producers of toys. A retail grocer might be content with a profit margin of 1%. A softwarefirm, on the other hand, may earn a 40% ROS.

Gross Margin indicates the average percentage by which the sales price of a company's goods or servicesexceeds the cost of those goods or services.

Clever Toy's gross margin for 2011 is $1,528,000 or 44.8%.$3,414,000

A manufacturing company's gross margin typically falls between 25 and 50%.

Asset Turnover measures a firm's ability to generate sales through its assets; it is especially important toconsider this ratio along with qualitative issues. For example, a high asset turnover may be the result of acompany having neglected essential investments in new equipment rather than having highly productive assets.

Our toy manufacturer's asset turnover equals $3,414,000 (net sales) divided by the average total assets for the

year. The average total assets is the amount at the beginning of 2011, $2,460,000, plus the amount at the end ofthe year, $2,613,000, divided by 2. $3,414,000 divided by $2,535,500 is 1.35.

Thus, Clever Toy "turns over" its assets 1.35 times per year. A capital-intensive firm such as an electricutility may have an asset turnover below one, while a service-oriented firm could turn its assets ten times in a year.

Return on Assets (ROA) is considered by many to be the best indicator of a firm's asset usage skill, and iscomposed of two elements. ROA is also referred to as return on investment (ROI).

Return on Assets = Profit Margin x Asset Turnover

or:

You can easily derive ROA by dividing net income by average total assets, but by examining the two componentsyou can determine where changes in the firm's ROA may have come from.

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Clever Toy's ROA for 2011 is 4.8% x 1.35 or 6.48%. In industrial settings, ROA figures between 5 and10% are common. By contrast, a well-managed bank may have an ROA as low as 1.0%.

Return on Equity (ROE) measures the return on investment for the firm's shareholders a bit morediscretely than the ROA ratio. ROA includes the return for both owners and creditors (since assets are typicallyfunded by a combination of debt equity).

In this formula, net income (after interest and taxes) may be used unless there are holders of preferred stock. "Netincome available to shareholders" is net income minus any dividends paid to preferred stockholders. Since CleverToy has never issued preferred stock, its ROE for 2011 is $164,000 divided by the average owners' equity,$1,423,000, or 11.5%. This figure is in the range of a typical industrial company.

Earnings per Share (EPS) is simply the company's net income available to shareholders divided by theaverage number of shares of common stock outstanding during the year; analysts use changes in this figure from period to period to measure a company's performance. Recent criticisms have been leveled at those who focus tooclosely on this measure, because of its short-term perspective. Nevertheless, it remains an extremely sensitive and

influential measure. Clever Toy's EPS for 2011 is

Since firms may have different numbers of common shares outstanding, it is not generally useful to compare EPSfigures among companies.

Price-Earnings Ratio (P/E) is the market price of the company's stock divided by EPS; it is the multipleof a firm's earnings per share that investors are willing to pay for one of the company's shares. The P/E indicatesthe stock market's opinion of a company's prospects for growth and earnings, as well as the market's perception of

the firm's risk. If the market perceives that a company's earnings or growth potential has improved, then the P/Ewill generally rise. If a firm's prospects deteriorate, or its perceived risk in the eyes of the market increases, thenthe P/E will generally fall. Since our toy company's stock is currently trading at $30.00 per share, its P/E is

A P/E is high or low with respect to an industry or stock exchange average. If the exchange on which CleverToy's stock is traded has an average P/E of 12 for all companies, then 18.3 would be considered fairly highthough not extraordinarily so.

Payout Ratio refers to the percentage of earnings per share that a company distributes in the form ofdividends, or similarly, the percentage of net income that a company pays out in dividends. This percentage isinfluenced by the composition of the firm's shareholders, the type of industry that the firm is in, and the firm'sgrowth prospects. Generally, young, high-growth companies pay few, if any, dividends, while more maturecompanies in mature industries tend to pay higher dividends. Clever Toy's payout ratio in 2011 is

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A payout ratio of 55% is reasonably high and reflects the mature industry in which Clever Toy competes.

Times Interest Earned is a ratio that indicates how many times a firm's earnings exceed its interestobligations, and is used by creditors as a rough estimate of the firm's ability to meet its payments. However because earnings are not equivalent to cash flows, it is only an approximation.

The numerator in this ratio, EBIT, is used instead of Net Income, because it is the intent of the ratio toreveal how many times interest charges could be covered by the annual income. Including interest expense or itsaffect on taxes in the numerator would double-count the coverage. The times interest earned ratio for Clever Toyis $293,000 + $26,000 divided by $35,000, or 9.11 in 2011. The firm's earnings have exceeded its interestobligations 9.11 times. There are variations on this ratio in which other obligations such as dividends, sinkingfunds, and various combinations may be substituted in the denominator. These kinds of calculations arecollectively referred to as coverage ratios.

II. Liquidity Ratios

Current Ratio measures a company's ability to meet short-term obligations and unforeseen needs, and isstated in terms of working capital.

Acceptable current ratios are varied because industries differ in their working capital requirements. Generallycreditors accept lower current ratios in stable industries than they do in others. Clever Toy's current ratio for 2011is:

Quick Ratio is a variation of the current ratio which uses only assets which can readily be converted intocash in the numerator; this ratio is sometimes referred to as the acid test ratio. Some analysts prefer this ratio because they question a firm's ability to convert assets other than cash equivalents (such as inventory) completelyinto cash, as the current ratio assumes. A quick ratio which is excessively high suggests that the firm may not be productively employing its cash.

The quick ratio for Clever Toy in 2011 is

As with the current ratio, industry specific figures are the only relevant guide for comparison of quick ratios.

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Receivables Turnover indicates how quickly a company ordinarily converts accounts receivable intocash.

This ratio can perhaps be one of the most misleading. One must remember that the balance sheet is a snapshot othe company's finances, which are likely to vary significantly during a year. Inventories build toward peak selling

seasons and then are sold and converted to accounts receivable or cash. However, if one remembers this caveatthe ratio can be a useful tool. The ratio for this toy company in 2011 is $3,414,000 divided by the averageaccounts receivable figure for 2011, $383,000, or 8.91 times. Essentially, this ratio indicates that if the December31 balance of accounts receivable is representative of the average balance throughout the year, then thereceivables "turn over" about 9 times during the year.

Days Sales Outstanding (DSO) merely converts the receivables turnover figure into the equivalennumber of days.

The receivables turnover figure for Clever Toy calculated above is an annual one. Therefore, the DSO is 365 days

divided by 8.91 times, or 40.96. The average age of an uncollected account is therefore about 41 days. The mosuseful comparisons of DSO figures are ordinarily conducted within a firm. If, for instance, a firm's statedcollection policy is terms of 30 days, and the average "age" of the company's receivables exceeds that by severalweeks, then actions should be taken to bring the receivables into line.

Inventory Turnover is another indicator of how well a company is managing its working capitalaccounts, in this case its investment in inventory; in managing inventory, a company must solve the dilemma ofover-investment in inventory versus the risk of stockouts. Generally, companies strive to maximize this ratioCost of goods sold is used in the numerator rather than sales because cost of goods sold represents the totalamount of inventory that was sold during the period. Sales figures include markups over the cost of goods sold.

As with the receivables turnover, the calculation of inventory turnover can be misleading when annual figures areused. Clever Toy's turnover ratio is:

You should look for trends within a company when you consider this ratio. As with DSO, an inventoryturnover figure that is slipping (increasing disproportionately to an increase in sales, for instance) should beregarded with concern.

Days Inventory converts the above ratio into days in the same manner as DSO. Therefore, our toycompany's average days inventory is

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Operating Cycle calculations allow an analyst to estimate how long it takes a business to complete the cycle of(1) purchase of inventory, (2) conversion of inventory to finished goods, (3) sale of finished goods, and (4)collection of the ensuing receivable. It should be a corollary to the calculation of a current ratio.

Operating Cycle = DSO + Days Inventory

The operating cycle for our company in 2011 is 75 + 41 = 116 days. A firm which is reducing the length of this

cycle would be improving its performance.

Accounts Payable Turnover indicates how far a company is "stretching" its trade payable obligations.

Since companies are not required to divulge their purchases during a reporting period, the cost of goods sold pluschanges in inventory levels between periods is used as a proxy by many analysts. For Clever Toy this proxyfigure is the COGS, $1,886,000, minus the decrease in the inventory level from 2010 to 2011, $32,000, which nets$1,854,000. The average accounts payable for the year is $502,500. The turnover ratio is thus 3.68 times for

2011. A company's discretion in controlling this ratio depends on its creditors, and to what extent its payableshave been previously extended.

Days Payable converts the above ratio into the appropriate number of days in exactly the same way asDSO is calculated. Our example is

The operating cycle described earlier can be modified to include the number of days that payables are extended.This figure, DSO + Days inventory - DPO, is referred to as the working capital cycle. For Clever Toy the working

capital cycle is 75 days + 41 days - 99 days or 17 days net.

III. Financial Strength Ratios

Debt to Total Assets calculations indicate the percentage of the company's assets which is being provided by creditors.

The debt to assets ratio for Clever Toy is

Aggressively managed firms will attempt to maximize this ratio, confident that the earnings of the company willmore than cover the fixed cost of the debt. Acceptable maximums range from as low as .3 to over 1.0. As withmost of these ratios, industry-specific norms are better guides than a general industry average.

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Stockholders' Equity to Assets is the percentage which complements the ratio above by describing the percentage of assets paid through contributions of the firm's shareholders.

The equity to assets ratio for Clever Toy is

An investor in the equity of a company feels "safer" as this ratio approaches the theoretical limit of 1.0, because atthat level a firm would have no liabilities. For years, the management of E. I. duPont deNemours held fast to the principle that debt was to be avoided; duPont's equity to assets ratio was consistently near 1.0. However, todaythe equity markets (and even duPont) believe that a firm should use a certain level of debt in its capital structure inorder to financially lever the firm's earnings. Financial leverage will be discussed more fully in the next chapterThe result of these two opposing forces is that this ratio falls somewhere between the extremes, and an acceptablefigure is industry-specific.

Debt to Capitalization is a popular ratio calculated in many ways; as with all of these financial strength ratios, itis more useful when compared to other companies with similar characteristics in the same industry. Thenumerator of this ratio differs from that of debt to total assets in that the former includes only long term debt, i.e.,that which will not mature within one year.

Many debts can be classified as "long term", and therein lies the source of differences in the calculation. Theimportant rule is for the analyst to be consistent. A popular method among financial analysts is to includedeferred income taxes with long term debt in this ratio. Clever Toy's ratio thus calculated is

Debt to Equity indicates the proportion of borrowing to equity in the capital structure. The ratio iscalculated accordingly:

Clever Toy's ratio is

There are several other ratios of financial strength, and variations of the ones presented here, that may have thesame names. When a particular ratio is quoted, therefore, a prudent analyst always determines how the ratio wascalculated.

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The duPont Formula

The ratios described here under the categories of operating performance, liquidity, and financial strengthdo by no means exhaust the total number that are available. Analysts are always free to create ratios that best suitheir purposes. Neither are ratios examined singly all the time. There are various combinations and series whichare useful. One such series allows an analyst to investigate the components of a firm's return on equity. Firstdeveloped at E.I. duPont deNemours, this famous series has come to be referred to as the " duPont Formula" . To

an informed analyst, the duPont formula presents a snapshot of almost every key ingredient of a firm's financial performance. The formula is calculated as follows:

By examining changes in the components over a series of accounting periods, an analyst can determine whichfigures have most influenced the firm's profitability, or determine what may have caused changes. For example, ifin the analysis of two years' financial statements you see that ROE has increased dramatically, you should knowthat: 1) the firm reaped more profit out of each dollar of sales, 2) assets were used more efficiently, therebygenerating increased revenues, or 3) the financial leverage of the firm increased. The duPont methodology allows

you to isolate which of these factors is responsible for the boost in ROE.

Sustainable Growth

Another widely used series of ratios is used to calculate a firm's sustainable rate of growth. Oftenmanagers wish to know to what extent their company can grow without having to obtain outside financing. Acompany's sales cannot expand without commensurate growth in the level of inventory that the company mustcarry, or without the size of the company's investment in accounts receivable having to expand to accommodateadditional customers. Not only does the asset base which generates sales have to expand, but as the logic of thefundamental accounting concept that:


suggests, the size of the debt or equity financing the assets must increase by the same degree. This internally funded sustainable growth rate (G) can be determined by making a few assumptions and then examining thefollowing series of ratios, some of which have been introduced:

If one assumes that in the coming year, the company will attempt to keep these ratios consistent with the current

year, then the product of these ratios yields the internally funded sustainable rate of growth. For Clever Toy, thesustainable rate of growth is calculated as follows (numbers represent thousands of dollars).

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In this example, Clever Toy would be able to expand its asset base by only 5% in the coming year withoutobtaining outside funds (either debt or equity).

Take a few minutes and consider the relationships in the sustainable growth formula. As one can do in theduPont formula, it is quite easy to cancel terms and simplify this equation, to "ROE times the retention ratio (oneminus the payout ratio)". Often this abbreviated form of the equation suits an analyst's needs adequatelyHowever, an understanding of the components which make up the expanded version enables a manager to see the

relationships among the firm's assets, liabilities, equity, and dividend policy. Moreover, the complete formula canreveal how certain decisions can influence the growth of a firm. This relationship will be explored further in alater chapter.

FINANCIAL ANALYSIS

Ratios from financial statements provide concise measures for business performance. However, ratios canhave meaning only when they can be compared to something. Percentage changes in various components offinancial statements are also sources of information for analysts, and they, too, require comparisons.

Horizontal percentage changes measure differences from year to year in discrete components of

financial statements. For example, a horizontal analysis of Clever Toy's income statement reveals the followingchanges from 2000 to 2001:

Percentage increase

Net Revenues 13.4%Cost of Goods Sold 19.4Gross Profit 6.8Total Operating Expenses 5.2Operating Income 15.0 Net Income 14.7

Vertical Percentage analyses reveal percentage changes in another way. In this type of analysis, one component(usually sales) is chosen as a benchmark and used to express other components. A vertical analysis of CleverToy's income statement for the years 2010 and 2011 reveals the following:

Components as a Percent of Sales

2011 2010

Cost of Goods Sold 55.2% 52.5%Gross Profit 44.7 47.5

Total Operating Expenses 36.2 39.0Operating Income 8.6 8.5 Net Income 4.8 4.7

The percentage changes in both kinds of analyses raise questions to which answers must be found. For examplethe company reduced its operating expenses by nearly 3% of sales. Why did its net income increase by only onetenth of a percent of sales?

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As mentioned previously, one of the fundamental goals of financial accounting is to ensure that financialstatements are comparable. That comparability is possible not only within a firm, but between firms andindustries, and over the course of years.

Trend Analysis

Many analysts are interested in how a company has performed over time. Such historical comparisons are

used to judge how management has met its obligations in the past, and also as a basis to project how managementmay perform in the future. While year to year changes can be very important, trends are preeminent.

Comparing various ratios in successive years is one way that trends may be discovered. Performing percentage analyses as illustrated above is another.

Comparative Analysis

An investor may have chosen a particular industry in which he plans to purchase stock, but still mustchoose a company, or a manager may wish to know how his company is performing compared to his company's

chief competitor. Such situations provide opportunities for intercompany analyses. The same kinds of techniquesthat are used in intracompany analyses are appropriate. However, the most useful comparisons are made betweencompanies of similar size. Also, you must be wary of the different accounting methods which may have beenused. Finally, you should be aware of the different strategies that the companies are pursuing before drawingconclusions. For example, one company may have decided to produce its product as inexpensively as possibleand to rely on advertising expenditures for sales. Its competitor may be producing a very expensive productwhich it believes will intrinsically attract customers. These two companies might be of equal size, have equasales and incomes, yet have very different expense figures on their income statements.

Comparison to Industry

Extremely useful comparisons can be drawn between a company and the industry in which it competes.Industry figures are widely available from such publishers as Robert Morris Associates and Standard and PoorOne must realize, however, that several accounting practices are represented in industry composites. Nevertheless, a firm's performance relative to its industry has consequences as far reaching at its bond rating andthe price its stock can command on Wall Street.

A Final Word on Financial Analysis

No financial analysis is complete that is comprised of mere numbers. A quantitative analysis must be balanced with serious consideration of the galaxy of qualitative issues in which companies exist. It is essentiathat an analyst understand how changes in the general and sectoral portions of the economy will affect an industry

in general and a firm in particular. Changes in price levels, raw material availability, and interest rates can allhave significant impact. An investigation of how a firm fared in the past when faced with such changes can beextremely rewarding to an observer. No less important than economic considerations is an understanding of the bases of competition within an industry, and an assessment as to whether the subject company has identified those"keys to success". A company may understand the keys to success yet still have a poor record of execution. Aqualitative analysis should precede the quantitative portion, because it may highlight the numbers which should beof greatest interest.

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Chapter 2Projecting Earnings and Cash Flow

INTRODUCTION

Forecasting is perhaps the world's second oldest profession. From the court astrologers of the ancientBabylonian kings, to the President's Council of Economic Advisors, soothsayers have long been consulted for the purpose of financial planning. Forecasting of any kind is an artistic endeavor, for it requires that you take certainobservations from the surrounding world and translate them into a medium. Those who make financia projections attempt to be of the Realist School, and their medium is the pro forma financial statement.

There are many groups, internal and external, that seek to project a company's future financial

performance. Within a firm, the Chief Financial Officer may wish to review pro forma statements in order toestimate the amount of external funding that the firm will need to fund expected growth in the coming year. Onthe other hand, the potential sources of those external funds will certainly want to assess the company's needs andits ability to repay them. These assessments also rely on the creation of pro forma statements.

As was mentioned in the last chapter, financial analysis can have two general objectives. The first is toallow the analyst to judge a firm's past performance. The second objective is to collect information to use as thefoundation for projections. For instance, a horizontal percentage analysis might reveal that a firm has experiencedannual sales growth of ten percent for the last five years. Is it not reasonable to believe that this kind of growthwill continue next year? A vertical percentage analysis could indicate that the same firm has also had consistentadvertising expenditures for the same time period. Wouldn't a reasonable person expect the company to continue

this trend? The answer to both of those questions is another equation: are those really reasonable assumptions?The truth is that pro forma statements are only as accurate as the assumptions that underlie them.

In every industry, there are certain factors that influence its well being. An industry may have developed practices to mitigate the uncertainties which surround some of those factors, but rarely all of them. Furthermorecertain components of financial statements can influence the "bottom line" more than others. The level of sales ina given year, of course, always significantly impacts a firm's profitability. However, other components can beimportant, too. A company with typically thin gross margins, whose cost of goods sold quickly reflectsfluctuations in its raw material prices, can experience erratic earnings despite stable revenues. Another firm's profitability may be susceptible to interest rate increases. In short, cost structures vary widely among industriesand companies. The qualitative issues that analysts should address can underscore not only those kinds of risks

but also the opportunities as well. If financial forecasting must be based on assumptions which are tenuous at best, then what can be done about it? The only solution is to try many assumptions. Only after having done socan one be prudently confident in a forecast.

For the remainder of this chapter, we will work through the pro forma development process. This processwill introduce you to the fundamental skills which you must understand in order to develop your own methods forfinancial forecasting. The process illustrated is a rather complete one; your experienced judgment may in time

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indicate where an analysis can be streamlined. Because there are so many uses for financial projections, there arenaturally many techniques. Every famous artist has a unique style.

DEVELOPING PRO FORMA STATEMENTS

The process of developing pro forma statements involves three distinct steps. The first step, the qualitativeanalysis, enables you to identify the key assumptions that will frame the next step, the quantitative analysis.During this quantitative step, an analyst uses many of the comparative techniques that were discussed in Chapter 1

to examine a firm's historical performance. Then, using a variety of tools, the forecaster combines historicatrends with judicious assumptions and projects the statements. The final task in developing a forecast is to test thecritical assumptions that you used in step two.

Qualitative Analysis

This first step in financial forecasting is the same one used in any financial analysis: to acquaint yourselfwith the qualitative issues facing both the company and the industry in which it competes. Since your forecastwill be based largely on assumptions, it is useful to know the factors which influence a company's performance.The best place to start is to assess the factors which may influence the industry as a whole. It is ordinarily safe toassume that consequences which can affect an industry will affect a company within that industry. The following

is an outline of qualitative factors which should be analyzed in detail, as each directly impacts the profitability of afirm and its competitive posture:

Qualitative Factors - Industry

I. Industry DefinitionA. Product or Service - Number and DiversityB. Product Users - Number and DiversityC. Industry Maturity and Profit TrendsD. Fragmentation or Concentration - Number and Size of PlayersE. Competition Basis - Operations

F. Capital Investment RequiredG. Barriers to Entry into the Industry by CompetitorsH. Important Changes in the Competitive Environment Over Time

II. Sales InfluencesA. General Economic ConditionsB. Marketing StrategiesC. Specific Areas of the Economy Impacted

III. Cost StructureA. Components of Costs of Producing (Variable Costs)B. Unavoidable Costs (Fixed Costs)

C. Required Resource AvailabilityD. Percentage of Fixed and Variable in Total CostsE. Price Level Effects on Costs

Admittedly, this is a rather extensive list of qualitative considerations. Some of these questions can only beanswered with educated guesses, while others are widely documented. The important thing to remember is thatthere is a sound reason for asking these questions: it is critical for a forecaster to establish which assumptions willmost influence his projection.

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Having examined the industry, the next step is to ask some company-specific questions. They can be similarlycategorized in the following outline:

Qualitative Factors - Company

I. Company Definition

A. Products or Services1. Innovative or Mainstream2. Number Offered

B. Product Users - Relative Strength of CustomersC. Current Management

1. Composition2. Tenure

D. Large or Small Player in IndustryE. Competitive ReputationF. Age of FacilitiesG. Relative Strength of Suppliers

II. Sales InfluencesA. Marketing Strategy

III. Cost StructureA. Components of Costs of Producing (Variable Costs)B. Unavoidable Costs (Fixed Costs)C. Required Resource AvailabilityD. Percentage of Fixed and Variable in Total CostsE. Price Level Effects on Costs

By addressing these questions, you accomplish several things. You can now form an opinion on the predictabilityof the company in question. It may have characteristics that are fully consistent with its industry, or it may be amaverick. By considering the company's management, intended strategies, facilities, size, product line, and coststructure, you can define the critical variables that will significantly influence the firm's future performance.These critical variables will be the critical assumptions upon which your pro forma statements will be built.

Quantitative Analysis

In this portion of the analysis, time horizons are very important. The salient issues identified in the last stepcan help define a framework for research and can establish a point in the future where projections might lose theircredibility. At one extreme, there are mature, stable industries where decades of information is both available and

useful; at the other, there are those which have existed only for months, and for whom virtually no informationcan be found. There is similar difficulty associated with establishing a projection's horizon. A typical companyfalls somewhere between the extremes. In every case, accuracy diminishes with the length of time.

In this mathematical part of the problem, we have two objectives. The first is to determine how a companyhas performed in the past, and the second is to use that foundation and your assumptions to project the future.

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Historical Evaluation

Using reliable information, such as industry surveys published by Robert Morris Associates, Standard &Poor's, Value Line, and others, you should locate the key ratios for the industry. Important ratios may be all of theones introduced in the last chapters, or the few critical variables that you have identified. Additional informationneeds may be suggested by your reasons for developing the pro formas. At minimum, you should obtain theinformation required to quantify the industry's historical sales growth, asset usage skill, profitability, return onequity, dividend policy, liquidity, and capital structure.

This information serves two purposes. You can test the assumptions that you have made during the first partof the analysis. You have also quantified the industry's record, and this may prove useful later.

The next step is to perform a similar analysis of the company. Since individual company figures are no published as frequently as industry figures on certain trends such as sales growth rates, it may be necessary to use percentage analysis to ascertain some of the numbers. Both horizontal and vertical methods are appropriate. Aswith the industry, in addition to figures that you may otherwise need, you should determine the firm's rate of salesgrowth, skill in asset usage, profitability, return on equity, dividend policy, liquidity, and capital structure. Thefirm's cost structure must also be thoroughly analyzed.

Having determined these two sets of figures, one should compare them. Do the company's numbers compare

favorably with the industry's, or are there significant differences? In performing this comparison, it is useful toremember qualitative issues such as the firm's age, and the composition of its management. Such issues may provide insights into the differences that you may notice. From this comparison, a forecaster can ordinarily formthe judgments needed to project the company's future statements.

Projecting the Statements

At this point, an analyst has a fairly good understanding of the company and industry. Knowing the pasthowever, is not the same as knowing the future. This is the portion of the analysis where the qualitative ideas thatwere formed are married to the numbers. Estimates must be made about the factors which influence the company

For instance, if a company's sales are inextricably entwined with the general economy, then the analyst must guesshow the economy will perform. Other equally large guesses may also be required. You should not be concernedabout achieving great accuracy at this stage of the forecast. Remember that you will be testing these assumptionslater in the analysis.

There is a trap that analysts frequently fall into when making the basic assumptions about a company's futureFaced with uncertainty, they compensate by making the most conservative estimates possible. The greachallenge is to resist this temptation, and instead, using the qualitative and quantitative information at hand, make projections that are consistent with what you have observed.

Having made the necessary assumptions, the forecaster next applies those assumptions to the numbers. The

most prevalent method is to directly project the statements with percentages. Ordinarily, sales growth rates aredecided upon first. . From these sales figures, income statements are constructed using the desired vertical percentages. For example, an analyst may have decided that it is likely that a company will experience ten percensales growth during the chosen time horizon. Using the last known sales figure, and the percentages projected forthe cost structure, an income statement might be forecast as follows:

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ABC Company

Income Statement

Assumed % Actual Pro Forma............................of Sales 2006 2007 2008 2009 2010

Sales (10% growth) 100 1000 1100 1210 133 1464Cost of Goods Sold 65 630 715 787 865 952

Gross Margin 370 385 423 466 512Operating Expenses 20 190 220 242 266 293Interest Expense 2 20 22 24 27 29

Earnings Before Taxes 160 143 157 173 190 ________________________________________________________________

Taxes (40% assumed) 64 57 63 69 76

________________________________________________________________

Net Earnings 96 86 94 104 114

Notice that the projected cost structure (operating expenses, in this example) for the pro formas portion is differenfrom that actually experienced in 2006. You may be wondering how particular percentages of growth and cost arechosen. In addition to making educated guesses based upon historical trends and healthy assumptions, statisticamethods may be employed.

If the historical observations are indistinguishable, that is, there were no unique influences associated with a particular year, then averages, variances, standard deviations, and other statistical devices may be directlyemployed to derive percentages. If, as is the usual case, there were unique events associated with particular

observations, then statistical methods may still be useful, if the appropriate allowances are made. There is dangerthat an analyst will be lead into a false sense of security when extreme accuracy is sought through statisticalmethods, or in minutely detailed projections. Always remember that the most significant portions of your projection are, no matter how carefully contrived, still little more than educated guesses.

Balance sheets are ordinarily projected after income statements, because the firm's growth in retainedearnings, an outcome of projected income, is a required input for the balance sheet. Balance sheets are projectedwith the same percentage methods as income statements. The forecaster assumes a certain relationship betweenassets and liabilities, and combines this with the changes in owners' equity that result from his projection of netincome, dividends, and capital injections. The analyst, in doing this, makes judgments about the firm's workingcapital policies, cash reserves, capital expenditures, and debt structure. The sustainable growth formula can often

provide insight into the relationships which must be maintained in order for the firm to meet the requirements of acertain growth rate.

One useful technique in balance sheet projections is to use a "plug". A plug is used to force the basicaccounting equation:


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It is disheartening to many students when they realize that projected balance sheets will never, of their ownaccord, balance. Because asset growth, liabilities and equity are forecast independently, the likelihood that projected assets will equal projected liabilities and equities is, indeed, remote. For this reason, the "plug method"has been developed. Where assets have been projected to grow at a rate faster than liabilities and equity, the plugwould indicate outside financing (either debt or equity) must be obtained. Conversely, where projected assets areless than the projected liabilities and equity, the firm will possess an overabundance of capital, which would bedisplayed as an "excess cash" (or other current asset) plug figure. In sophisticated projections, assumptions may

be made as to the character of the plug. For instance, it may be assumed that a negative plug (i.e., a capitashortfall) will be financed through the issuance of long-term debt. Since debt is generally not lent without chargeinterest must be added to the amount of debt. This, naturally, increases the size of the plug, effectively borrowingenough to pay both the interest and the other projected expenditures. An increase in interest charges wilaccordingly reduce pretax income and income taxes. This, of course, changes net income which, in truth, causesretained earnings to change. Alas, now that we have adjusted the income statement to accommodate interestcharges, we find that the resultant change in retained earnings has caused the balance sheet not to balance.

Fortunately, computers can solve the fabulously complex interrelationships which can arise when makingfinancial projections. For purposes of illustration, however, let's simplify our assumptions, as shown below, incontinuing the forecast of the ABC Company.

Assumptions:

1. ABC Company will maintain its current working capital policy.

2. No dividends will be paid.

3. The company will increase its investment in property, plant and equipment in 2007 and 2008, andthereafter will invest only enough to offset depreciation charges.

4. Owner's equity will only grow by the amounts previously forecast in the income statement, about 2.8%

annually. No new stock will be sold.

5. There will be no interest expense or interest income incurred as a result of the plug figure.

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ABC Company

Balance Sheets

Actual Pro Forma...................................2006 2007 2008 2009 2010

Current Assets 1100 1130 1160 1190 1225 Noncurrent Assets 3000 3100 3200 3200 3200

Total Assets 4100 4230 4360 4390 4425

Current Liabilities 600 600 600 600 600 Noncurrent Liabilities 300 300 300 300 300Owners' Equity 3200 3286 3380 3484 3598Total Liabilities &Owners' Equity 4100 4186 4280 4384 4498

Plug:Excess Cash - - - - 73 Notes Payable 44 __ 80 6 -Total Liabilities,

Owners' Equity &Plug 4100 4230 4360 4390 4425

Notice that only the current assets and owners' equity accounts are increased. One fundamental assumption beingmade is that the $3200 asset base of property, plant and equipment will support the projected sales growthAnother is that the company's credit and inventory policies will adjust to meet the new sales levels (as is indicated by the increase in current assets). Liabilities, on the other hand, are explicitly kept constant. The plug figurenotes payable or excess cash, thus reflects the total amount of funding that will be required or be in the excess ofthe explicit need. Once these figures have been determined it is management's responsibility to decide where thatfunding may come from.

Balance sheets and income statements are the two statements that are typically forecasted. The remainingstatements, if required, can be derived from them. In addition to financial statements, analysts frequently forecastcash flows. Forecasting a cash budget combines methods used in forecasting income statements and balancesheets. In such projections, detailed information is required about the firm's working capital policy, its planned purchases, operating cycle, and typical seasonal sales patterns. Cash budgets are ordinarily projected by monthrather than by year. Since external analysts rarely have access to such detailed information, they often projeccash flow from operations. These projections are annual, and as defined in Chapter 1, require only that theanalyst have net income figures and an idea of the firm's noncash charges. Projected noncash charges are simplyadded to net income to arrive at the cash flow from operations for a given year. Most of the analytical techniquesthat will be discussed in the rest of this text will use "cash flow from operations".

Sensitivity Analysis

The final and perhaps most crucial portion of financial forecasting is to test the assumptions that were used toderive the projection. This assumption testing is referred to as sensitivity analysis. In this step you are, inessence, testing the validity of your calculations by subjecting them to change. If you recall that forecasts areoften based upon how an analyst believes the general economy is going to perform in the future, you will realizethe significance of this step. To perform a sensitivity analysis of a forecast, you must recall the criticalassumptions made to develop the projection. An assumption is critical if it has significant bearing on the

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company's statements. After identifying these crucial elements again, substitute them in your pro formas, varyingthem one by one, and examine their impact. To gain initial information and avoid confusion, it is important tovary only one at a time, holding other variables constant. Once you have done this, the results may suggesappropriate pairings to change. To determine the degree that the variables must be changed requires judgment onthe analyst's part. A useful place to begin is in the historical figures. Calculating a variance for past sales levelsand other components of the statements may provide a useful range for your sensitivity analysis. Often, "best"and "worst" case scenarios are envisioned and calculated. As you may have imagined, sensitivity analysis can bea very involved process. The gravity of the situation requiring the projections is the only guide to how "sensitive"

your conclusions may be, and how much analysis is required. The advent of electronic spreadsheets has renderedthis task a more easily manageable one. Variables can be changed at will, and the results are almostinstantaneous.

The results of a sensitivity analysis are finally reviewed in light of the decision at hand. The figures ordinarilyreveal a certain sales level or cost figure at which a "go" decision may become a "no go" one, as well as aminimum earnings or cash flow to support the decision. These points on which decisions depend must beseparately reflected upon. If necessary, they can be assigned probabilities or considered in terms of the decision-maker's risk profile.

The creation of pro forma statements thus requires that the decision maker consider the problem from two

perspectives. In doing so, the exact composition of the firm's future may not be correctly foretold, but a range ofreasonable possibilities will. Such a framework for decision making is far superior to pure guess work or wishfulthinking.

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Chapter 3Creating Value for Stockholders

In the preceding chapters, certain analytical tools have been introduced. While every general manager should be familiar with these basic methods, it is more important for a manager to be able to apply the results of ananalysis to the larger issues confronting the firm. Informed decisions are more likely to result in a strongercompany.

Every manager has varied, and occasionally conflicting, allegiances within the firm. Financial managers have

one additional charge to conduct the affairs of the firm in the stockholders' best interests. In this respectfinancial managers share points of view with the firm's top managers, and with its board of directors.

Why should a company be concerned with the stockholders' interests? A cynical manager may surmise thastockholders who are unhappy with a managerial decision have the right to sell their holdings in the firm. This isundeniably true; however, when stock is offered for sale in quantities which exceed market demand, the price(value) associated with those shares will, in response to the law of supply and demand, be driven down. If asufficient number of stockholders sell their shares, a company will find that its stock price has significantlydeclined. It is naturally in a company's best interest to maintain its stocks' value at the highest level the marke

will allow this enables the company to acquire more funds from fewer shares in a stock issue, for example. Forthis reason alone, companies endeavor to avoid shareholder dissatisfaction.

There are other important reasons. Stockholders are the owners of the firm; managers have traditionallyanswered to owners. If contemporary managers can be found guilty of disregarding this traditional relationship, i

may be because they are more removed from the owners in a corporation, with its board of directors and severallayers of management, than they may have been in the simpler business structures of the past. Nonethelessmanagers, and indeed all employees, bear a fiduciary responsibility to the owners of the firm, whether there be oneor one hundred thousand, to preserve and build the owners' investment in the firm. This philosophy represents theunder-pinning of capitalism.

From a legal perspective, another important reason for managers to act in behalf of equity holders is related tothe terms which usually accompany debt that the firm chooses to absorb. The claims of a company's debt holdersare nearly always senior to the company's stockholders. Debt service and contractual obligations of any kindordinarily take precedence over dividends.

In the event of bankruptcy, creditors are satisfied before the owners may claim the firm's residual assets, if anyremain. Therefore, managers are by default the shareholders' fiduciary representatives in the firm. Only they canconduct the affairs of the company in such a way that it can provide an acceptable return to the owners, in excessof the company's contractual obligations.

To maintain the firm's stock price and other traditional reasons, then, the prudent financial manager carefullyconsiders a major company decision from two vantage points. The first is to project how the determination wildirectly affect the firm. The second is to predict the resulting shareholder reaction. Often, the two results are not

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compatible and a compromise must be sought. In solving these dilemmas, there should be a dominant goal in themind of the manager: the creation of value. As long as a company can continue to enhance the value of theowners' holdings in the firm, then it is worthwhile for managers to resolve the disagreements that may arise.

The Creation of Value

The concept of the creation of value is one of the most comprehensive and significant issues that you willencounter in the study of finance. Theoretically, managerial intentions should be enacted only when they can add

value to the firm. Value is added to a firm when earnings are enhanced, operational or financial risks arereduced, or when efficiencies result as the consequence of a decision, among other reasons. Decisions which

added value to the firm, in turn add value to the owners of the firm whether in the form of increased dividendswhich can be paid to them, or in the value of their stockholdings, which appreciate as a result of the decision. Oneother significant tenet of the "creation of value" theory is that management should continue to reinvest capital inthe business only for as long as the returns being generated by the business exceed those which the shareholderscould realize by investing their capital elsewhere, assuming comparable risks. Management obtains capital for

investment in the firm from a variety of sources debt, retained earnings (which, essentially, are withhelddividends), and new equity issues. The various forms of capital are employed in the purchase of assets, whichostensibly provide a certain return. Management's return on investment in assets is measured in terms of earningsor cash flows. A firm's investors (debt holders and shareholders) receive their returns on investment in the form o

interest payments, dividends, or rising stock values.

All investors require returns which are commensurate with the risk of their investments. Investors requirehigher returns on risky investments, and conversely, will accept lower returns for less risky pursuits. As long as afirm's owners are able to acquire a rate of return which exceeds the cost of the capital they have invested, value is being added to their portfolios. It is management's obligation to appraise the business opportunities that areavailable to the firm, and to act in the shareholders' interests. Such considerations should dictate the firm'sdividend policy. If management is able to invest capital in such a way that a high return can be realized, then arelatively low dividend payout can be justified. In such a case, shareholders should not object to their potentiadividends being reinvested in the firm. On the other hand, if managers cannot foresee attractive investments, it istheir duty to return the shareholders' capital so that they can invest their funds elsewhere. Between these

extremes, where a firm in a stable business has expectations of steady if not rapidly growing earnings, relativelyhigh payout ratios can be seen. It is for these reasons that a "growth" company may pay no dividends, a maturestable one may pay high dividends, and a dying company may liquidate itself.

Thus far, we have explored management's relationship to a company's owners. A financial manager's premierresponsibility is to add value to the firm, so that this increase can filter through to the firm's investors. How domanagers create this additional value? To explore this question, we return to the most basic accounting identityand express it as follows:

Assets = Debt + Equity

This equation indicates that a firm's assets must be balanced by an equal package of debt and equity. Debt

may be in the form of payables and accruals, loans, or any form of liability that you can imagine. Equity can beretained earnings, the net value of its stock issues, or paid-in capital. There are certain exotic forms of debt andequity, such as convertibles and preferred stock, which have characteristics of both debt and equity, and will not be discussed at present. This combination of debt and equity which balances a firm's assets is referred to as thefirm's capital structure, or capitalization. Managers have two methods by which they can add value to a firmthrough components on either side of this accounting equality.

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Perhaps the most intuitively apparent means by which value can be added to firms is through investment innew income-producing assets. Additional assets can come in any forms. A firm may invest in more efficienmachinery which will save the company operating costs. Or, growing sales may warrant an investment in planexpansion, working capital accounts, or additional marketing expenditures. In short, new assets can be tangible(PP&E) or intangible (marketing expenditures, accounts receivable, etc.). The important consequence of an assetacquisition should be that it creates new income, cash flow, or efficiency that outweighs its cost . If such a resuloccurs, then value has been added to the firm.

To create value on the right side of the balance sheet is a more complex undertaking. In the most fundamentasense, value can be created in a firm's capital structure if its managers select proportions of debt and equity, whichare used to finance the firm's assets, in the most efficient possible way. Consider the following diagram, which isan expanded version of the basic accounting identity:

Assets = Debt + Equity

Common Stock + Retained Earnings

Net Income - Dividends

In this relational diagram, you can see the financing choices a manager has when a new asset is to beacquired. Again, for the moment, exotic securities will be ignored. Conventionally, financial managers try to

match financing with the life of an asset a long-term asset is financed with long-term financing and a short-term asset is financed with short-term sources. Typical long-term sources of debt are loans and bond issuesShort-term debt has many forms, and can be supplier credit, loans, commercial paper, or bank lines of credit.Equity is considered a source of long-term funds. Notice the sources of equity: equity can be obtained fromwithin the firm, by withholding dividends from stockholders, or from without the firm, through the issuance ofnew securities.

When a manager selects a source of financing, he creates value by selecting the most appropriate form forthe situation at hand. To arrive at a choice, a manager first considers the impact of the decision on factors within

the firm.

One internal consideration is the amount of funding needed, relative to the size of the firm's capitalstructure. A relatively small requirement might preclude the option of a bond or stock issue, for example, becausesuch sources are usually reserved for large funding needs. Another consideration is the cost of the various

sources. Lenders obviously require payments of interest on debt borrowers are legally bound to make timely payments of interest and principal as dictated in the loan agreement or they may be forced into bankruptcyCommon stock also bears a cost, dividends, though it is not as legally compelling as the payment of interest, formanagement can choose to withhold dividend payments without the retribution of bankruptcy proceedings. Thecost of interest, as any homeowner knows, is deductible for tax purposes. In effect, the government subsidizes asmuch as 46% of the cost of borrowing by allowing interest payments to shield corporate income from taxation

Dividends, on the other hand, receive no such preferential treatment. In fact, dividends are taxed both at thecorporate level, because they are not considered a deductible outlay, and at the personal level of the stockholderManagement is thrust with the responsibility of balancing the cheaper after-tax cost of borrowing with thecontractual burden to pay interest. This dilemma will be investigated further in Chapter 7.

Another internal issue to be considered is the composition of the firm's existing capitalization. Is there adisproportionate amount of either debt or equity already present? A firm which is already heavily laden with debtmay find it difficult to pay more interest. If the company has a large proportion of its capital structure comprised

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of common stock, managers may avoid issuing additional shares for fear of alienating the existing shareholders orlosing control of the c

understanding corporate finance

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