accessing a firms future financial heath

HARvARD I "usrNEss l t.HooL

9-201-077REV: IL'-: l- l

Assessing a Firm's Future Financial Health

Assessing the long-term financial health of a company is an important task for management in itsformulation of goals and strategies and for outsiders as they consider the extension of credit, long-term supplier arrangements, or an investment in the company's equity. History abounds withexamples of firms that embarked upon overly ambitious programs and subsequently discovered thattheir portfolio of programs could not be financed on acceptable terms. The outcome frequer-rtly was

the abandonment of programs in midstream, at considerable financial, organizational and humancost.

It is the responsibility of management to arrticipate future imbalance in the corporate financialsystem before its severity is reflected in the financials, and to consider corrective action before bothtrme and money are exhausted. The avoidance of bankruptcy is an insufficient standard.

\{anagement must ensure the continuity of the flow of funds to all of its strategically importantprograms.

Figure I provides a conceptualization of the corporate financial system, with a suggested step-by-

step process to assess whether it will remain in balance over the ensuing 2-3 years. The remainder of;tris note discusses each of the steps in the process and then provides an exercise on the varioltsirnancial ratios that are useful as part of the analysis. The final section of the note demonstrates the

reiationship between a company's operating characteristics and its financial characteristics.

l-::: icte is a ren'ritten version of m earlier note (HBS No. 297-053) and has been prepared as the basis for clms discussion

l::;ighte2002PresidentandFellowsofHarvardCollege. Toordercopiesorrequestpermissiontoreproducematerials,call 1-r'-:{l--r:i*::e ilil.ard Business School Publishing, Boston, Me OZfgg, or €to to httP://ww.hbsp.harvardedu. No part of this public:::: ::- :=

=:::,juced, stored in a retrieval system, used in a spreadsheet, or trmsmitted in any form or by any means-lectronr. r-rff-:a:: :: xcpVing, recording, or otherwis*without the permission of Harvad Business School.

Step 1

Step 2

Sfep 3

Step 4

Future need forexternal finance

Sfep 5

Step 7

Sfep 8


Figure I

The Corporate Financial System

Outlook for sales

Future access to targetsources of external

financeSfep 6

Stress test for viabilityunder various scenarios

lnvestment'in assets tosupport prod uct-market

Future financial and

3 - 5 year financing plan

Operating, investing, andfinancing plan for next

Sfep 9


StE 1: Goals, Strategies, and Operating Characteristics

arrd

StE 2: Outlookfor Firm Sales

The starting point for assessing a firm's long-term financial health must be a thorc:t-investigation of (1) management's goals for the company and for each of the businesses (produ::markets) in which it chooses to compete; (2) the shategy plamed for each product market; (3; theoutlook for the market in terms of unit growth, product price, volatility and predictability; (a) themain operating/technological/competitive/regulatory characteristics and risks; and (5) the outlookfor the firm's sales.

Figure II

Goals, Strategies, and Operating Characteristics

The analyst is well-advised to devote substantial tirne exploring these areas as the corporatefinancial system is driven by the goals, strategies, market conditions, and the operating characteristicsand risks. The firm's strategy and sales growth in each of its product-markets will largely determ::.ethe investment in assets needed to support these strategies; and the effectiveness of the strate!::rscombined with the response of competitors, will strongly influence the firm's competitive and r:--:-:performance and its resultant access to funds to finance the investment in the various type as-::

Product-market choicesProduct-market

Outlook for market. unit sales. unit priceo volatilitv and

Competitive, technological,regulatory and operatingcharacteristics and risks

Outlook for firm. unit and dollar saleso volatilitv and

201-077 Assessing a Firm's Future |:--a-:.:-i -:ra-:

Step 3: Inaestments to Sttpport the Product-Market Strategy(ies)

The product-market strategies inevitably require investments in accounts receivable, inventories,plant & equipment and possibly, acquisitions. [Thev may also require heavy expenditures onresearch & development andlor high advertisrng and promotion expenditures to build marketposition. Because these expenditures are normallv erpensed, they will be discussed later as part ofthe sectiorr on performance.l Step 3 of the process is an attempt to estimate (1) the amounts that willbe tied up h each of these asset types, and (21 the -evel of total assets over the next 2-3 years. Ananalvst can make these estimates by studvint 'j.e :as: pattern of the collection period, the days ofinr.entolv, and plant & equipment as a percen: Lr: :.T: ..: goods sold; and then applying a "reasonablevalue" for each to the sales forecast or the fore;a-.: l: ..-:: of goods sold.

strong profitabilitr is a ne;e::-:. ---. =: --:.

- - : : :-j- : -': =e level of profitability strongly influences(i) the compall\''s ac.€:! :.- :.:: :-:,:j--: I :-" '. i-:a:.-a of the company's common stock; (3)mallagetnent'S rr':--:.::..S: :-- -iS-: --:::j:.--: !i--,J-r :-..1 : ii.€ i.rrTlpanr"S "SuStainable SaleS gfOWth".Once agar". a iea{:"::-. i:::::a;:-:: -i :-- -:-'.:c --:. :r.:::e::ern of profitability, starting with aCarenl.:i:;-.'. .-: --:.e ::=:..-:::::---:1-i:-:-:=: i:i ij.:-.l:.liitln-;:

i \\ta: has -e:.'-:.e e,.€::i€ -<'..- =-:.: i--: '..- .71 :...: F:oiitabilify?

2. is the ler-ei of profitabilih sr.Li:a-:.l.-::... r-'.i:-'-:.e..u:-cck for the market and forcompetitive and reguiaton' pressu:s? Figure III s::::-::',arizes market and industryfactors that can affect a firm's tuture profi: te::c::.::l:e. i\':l- profrtability benefit fromimproving ind ustry and competitir.e cond itcn-. I

Figure III

Sources of Downward Pressure on Profitability

$arkot and regulatory condlflons

Ilr Suppliers\

\ \

\\\

-| auyersl

*

Substitute products

New entrants

tlrarket end regulatory condltlone


Has management initiated major profit improvement programs?

Are there any "hidden" problems, such as suspiciously large levels o: r_---l:accounts receivable or inventories relative to sales, or a series of unusuai :=:-i::-*- ---

and / or accounting changes?

Is the company strong in terms of customer service, new prodllct development, pro:-::qr-rality, and management and employee retention and development? Is the current -e'. <-

of profitability at the expense of future growth and profitability?

Step 5: Future External Financing Needs

Whether a company has a future external financing need depends on (1) its future sales growth,(2) the length of its cash cycle, and (3) the future level of profitability and profit retention. Rapid sales

growth by a company with a long cash cycle (a long collection period + high inventories + high plant& equipment relative to sales) and low profitability/low profit retention is a recipe for an ever-increasing appetite for external finance, raised in the form of loans, debt issues, and/or sale of shares.Why? Because the rapid sales growth results in the rapid growth of an already large level of totalassets. The hcrease in total assets is offset partially by an increase in accounts payable and accruedexpenses, and by a small increase in owners' equity. However, the financing gap is substantial. Forexample, the company portrayed in Table I requires $126 million of additional external finance bythe end of year 2000 to support the increase in total assets required to support 25"/, per year sales

growth in a business that is fairly asset intensive.

Table I

Assuming a2Snhlncrease in Sales($ in millions)

3.

4.

5.

Assets 7999 2000

CashAccounts receivablelnventoriesPlant & equipmentTotal

$tz240200400

s 852

I zso/o

I zso/o

I zsuI 2so/"

$ 15

300250500

$1,065

Liabilities and Equity

Accrued expensesLong-term debtOwners'equityTotalExternal financing needTotal

80 I 25% 100

252 unchanged 252400 footnote 1

$ 8520

$ 8s2

442$ 939

126$1,065

If, however, the company reduced its sales growth to 5% (and total assets, accounts payable and

accrued expenses increased accordingly by 5%), the need for additional external finance would dropfrom $125 million to $0.

1 It is assumed that the firm earns $60 million (a 15% returrr on beginning of year equity) and pays out $1it milldividend.


High sales growth does not always result in a need for additional external finance. For example, a

food retailer that exterrds no credit to customers, has only eight days of inventory, and does not ownits warehouses and stores, can experience rapid sales growth and not have a need for additionalexternal finance p1gltdcd it is reasonably profitable. Because it has so few assets, the increase in totalassets is largeh' offset bv a corresponding, spontaneous increase in accounts payable and accruedexpenses.

Table II

Food Retailer - 20oo lncrease in Sales

Assets 7999 2000

CaShAccounts receivablelnventoriesPlant & equipmentTotal

s 12

c'7q^

s:l3

20o/o $ t+0

2096

$ 130

i 2oo/o^ 20%

Liabilities and E

Accounls pavableAccrued ex9e.s€sLolg-ter Jei:Owne's ecJr'r"TotalExtemal financing needTotal

s56

:

Q '^rC

s 109

200h| 2oo/o

$zg42

0I

$ 1300

$ 130

Step 5 requires the development of pro forma income statements and balance sheets for each ofthe next 2-3 yeats to estimate (1) the dollar amount and liming of future erternal financing needs, (2)

for how long the financing will be needed, (3) the confidence level in the forecasts, and (4) thedeferability of the underlying expenditures if the funds can not be raised on acceptable terms.

Step 6: Access to Target Sources of External Finance

Having estimated the future financing need, management must identify the target sources (e.9.,banks, insurance companies, public debt markets, public equity markets) and establish financialpolicies that will ensure access on acceptable terms:

1. How soundly is the company financed, given its level of profitability and cash flow, itslevel of business risk, and its future need for finance?

a. How current is the company in its payment of suppliers?

b. Is the company within its capacity to service the debt? What is the maturity structureof the existing debt?

c. is the company near to its borrowing limits according to restrictive covenants? Is itclose to its internal policies in terms of debt levels andlor debt ratings?

d. Are there any "hidden problems" such as unconsolidated subsidiaries with high debtlevels or large contingent or unfunded liabilities?

2. Does the company have assured access to the debt markets? What are the target sourcesand what are their criteria for lending?


3. Does the company have assured access on acceptable terms to the equitr' fi:.-a:-(E=- Is

there a market for the shares? How many shares could be sold and at what p:--:€- .t=management and/or the controlling shareholders(s) willing to issue additional sha:ts-

4. Does the company have assets that could be sold to raise funds? At what price and :---i",

quickly could the assets be sold under ideal conclitions? under adverse conditions?

Step 7: Viability of the 3-5 Year Plan

Are the company's goals, product-market strategies, investment requirements and financingneeds in balance with its financing capabilities over the 3-5 year planning period? \Atrhat approximatemix of debt and equity must be raised to remain in compliance with the firm's debt policy?

StE 8: Current Year Financing Plan

How should the firm meet the current year's financing need? How should it balance the benefitsof future financing flexibility (by selling equity now) and the hopes of realizing a higher share priceby waiting to sell the equity (and therefore issuing debt now)?

StE 9: Stress Test undu Scenarios of Adttersity

Most 3-5 year financing plans work well if the expected scenario on which they are based in factoccurs. The test of the soundness of a 3-5 year plan is whether the continuity of the flow of funds toall strategically important programs can be maintained (or at least maintained as well as that of yourcompetitors) even in times of adversity.

Figure IV is a somewhat more complete version of Figure I. Clearly, many of these questionsrequire information beyond that contained in a company's published financial statements. Manyrequire a thorough understanding of (1) the long-term goals and plans of management, (2) futureindustry structure and competitive behavior, (3) the competitive/technological/reg',iatory /operating characteristics of the industry and company, (4) the "availability" criteria of varioussources of finance, and (5) the soundness of management. Analysis of the published financialstatements and their footnotes is only one part of a complete analysis of a company's future financialhealth.

It is also clear that the evaluation of a firm's financial health can vary substantially, depending onthe perspective of the individual making the evaluation. A bank or supplier considering theextension of seasonal credit may consider a company a very safe bet, whereas a long-term lenderdependent on the health and profitability of that same company over a L5-year period may be verynervous.

Step lSt

Step #2

Step #3

Step #4

FINANCE NEXT 5 YEARS. amount. timing. for how long. deferability

Siep #8

Step #9

volatilitypredictability

. strategic

. operating'financial

+CURRENT YEAR PLAN

+STRESS TEST

FINANCIAL POLICIES. debt policy. distribution policy. financial reporting. 'availability rules'

step #>3-5 YEAR PLAN t/

Asaeesing a Firm's Future Financial Health

Figure IV

CORPORATE FINANCIAL SYSTEM

MISSION+

GOALS

SERVI CE/PRODUCT-MARKET SELECTIONSERVICE/PRODUCT-MARKET STRATEGY

Market, Competitive, Technological,Reg ulatory and Ope rating Ch aracferisfics

+FUTURE REVENUES

. growth rates

. volatility

. predictabilityCOST STRUCTURE

. fixed vs. variable

. avoidable

+RESOURCES REQUIRED TO SUPPORT

STMTEGIES/OPERATIONS. expenditures for market

and producVservicedevelopment

. working capital

. plant and equipment

FUTURE PERFORMANCE. service quality

-.-. balanced scorecard -.step #5

^/ . iiofitability \- step ti6

FUTURE NEED FOR level TARGET SOURCES FINANCE


The remainder of this note provides familiarity with the financial ratios that can N -r:_ _-answering some of the preceding questions. Exhibits 1 and 2 provide financial statemens :_-: _ tr- iand 7999 for a hypothetical company. The following section (Financial Ratios and Financial .{re-',

=_opresents four types of financial ratios and then asks a series of questions concerning the finr.: .statements in Exhibits 1 and 2. Use the equations to answer two overall questions:

1. Has the financial condition of the company changed during the four-year period?

2. \Atrhat are the most significant changes, as indicated by the financial ratios?

Financial Ratios and Financial Analysis

The two basic sources of financial data for a business entity are the income statement and thebalance sheet. The income statement summarizes revenues and expenses over a period of time, e.g.,for the year ending December 37,1999. The balance sheet is a liit of what the business owns (itsassets), what it owes (its liabilities) and what has been invested by the owners (owners' equity) at aspecific point in time, e.9., af December 37,1999.

From figures found on the income statement and the balance sheet, one can calculate thefollowing types of financial ratios:

1. Profitability ratios

2. Activity ratios

3. Leverage ratios

4. Liquidity ratios

Profitability Ratios: How Profitable is the Company?

Profitability is a necessity over the lor-rg run, for the level of profitability strongly influences (1) thecompany's access to debt finance, (2) the valuation of the company's common stock, (3) thecompany's willingness to issue common stock, and (4) the companyts sustainable growth rate. Onemeasure of the profitability of a business is profit as a percentage of sales, as determined by theprofitability ratio equation:

The information

Net profit after taxes

Net sales

necessary to determine a company's profit as a percentage of sales can be foundin the company's

1'. Magnetronics'profit as a percentage of sales for 1999 was $ _ divided by$ , or

-

uk.

2. This represented an increase/decrease from --% in1995.

3. The deterioration in profitability resulted from an increase/decrease in cost ofgoods sold as a percentage of sales, and from an increase/decrease in operatingexPenses as a percentage of sales. The only favorable factor was the decrease irrthe

201-077 Aseessing a Firm'e Future Financial Health

Management and inlestlr:s cften are more interested in the return earned on the funds investedthan in the level of proi:rs a-: a 3€:centage of sales. Companies operating in businesses requiring veryIittle investment in a-<-:. rten have lors profit margins but earn very attractive returns on investedfunds. Converselr'. :.€:e :r:e :.utrrerous examples of companies in very capital-intensive businessesthat earn mi-:::-\ -.-:r :Etiirn-< on invested funds, despite seemingly attractive profit margins.

Th"e:eic:e :: :-i '.rseru] io examine the refum eamed on the funds provided by the shareholders andb'\ r.e ::.i =:J:s h the company's interest-bearing debt. To increase the comparability across;c::.:a:::*. :: L. usefu.l to use EBIAT (eamings before interest but after taxes) as the measure of return.I::e ';-.e oi EBL{T as the measure of return also allows the analyst to compare the return on investedcapitai icalculated before the deduction of interest expense), with the company's estimated cost ofcapital to determine the long-term adequacy of the company's profitability.

4. Magnetronics had a total of $ of capital at year-end 1999 andduring 7999. Itsearned before interest but after taxes (EBIAT) $

return on invested capital is calculated as follows:

Earnings before interest but after taxes (EBIAT)

O-t*trbq"tty pt* trt"*rt - bet

In1999 this figures was

- %, which represented an increase/decrease from the

7o earned in 1995.

From the viewpoint of the shareholders, an equally important figure is the company's return onequity. Return on equity is calculated by dividing profit after tax by the owners' equity.

Profit after taxes= Return on equity

Owners' equity

Return on equity indicates how profitably the company is utilizing shareholders' funds.

5. Magnetronics had $

-

of owners'equity and earned $ _ after taxesin1999'Itsreturnonequitywas-oh,animprovemenUdeteriorationfrom the 7o earned in 1995.

Management can "improve" (or "hurt") its return on equity in several ways. Each method of"improvement" differs substantially in nature. The analyst must get behind the return on equityfigures and must understand the underlying causes of any changes. For example, did Return onSales improve? Did the company's management of assets change? Did the company increase the useof borrowed funds relative to owners'equity? These three possible explanations are combined in theDu Pont system of ratio analysis:

Net Income Sales Assetsl(OE = Sales Assets Equity

Actit'itu Rittios: How Well Does a Company Employ lts Assets?

The -cond basic lype of financial ratio is the activity ratio. Activity ratios indicate how well acompan)' emplovs its assets. Ineffective utilization of assets results in the need for more finance,unnecessan' interest costs, and a correspondingly lower return on capital employed. Furthermore,low activih' ratios or a deterioration in the activity ratios may indicate uncollectible accountsreceivables or obsolete inventory or equipment

10

Then, divide the accounts receivablesales that are still unpaid:

Assessing a Firm's Future Financial Health :o14::

Total asset turnover measures the company's effectiveness in utilizing its total assets a:.: --r

calculated by dividing total assets into sales:

Net sales

T"t"t "t*tt1. Total asset turnover for Magnentronics in1999 can be calculated by dividing

$-into$-.Thefurnoverimproved/deterioratedfromtimes in L995 to times in 1999.

It is useful to examine the turnover ratios for each type of asset, as the use of total assets may hideimportant problems in one of the specific asset categories. One important category is accountsreceivables. The average collection period measures the number of days that the comPany must waiton average between the time of sale and the tirne when it is paid. The average collection period iscalculated in two steps. First, divide annual credit sales by 365 days to determine average sales perday:

Net credit sales

365 days

by average sales per day to determine the number of days of

Accounts receivable

Credit sales per day

2. Magnetronics had $ invested in accounts receivables at year-end1999. Its average sales per day were $. during 1999 and its average

collection period was

-

days. This represented an improvemenUdeterioration from the average collection period of

-

days in 1995.

A third activity ratio is the inventory tumover ratio, which indicates the effectiveness with whichthe company is employing inventory. Since inventory is recorded on the balance sheet at cost (not at

its sales value), it is advisable to use cost of goods sold as the measure of aciivity. The inventoryturnover figure is calculated by dividing cost of good sold by inventory:

Cost of goods sold

Inventory

3. Magnetronics apparently needed $

-

of inventory at year-end 1999 tosupport its operations during 1999. Its activity during t999 as measured by thecostofgoodssoldwas$-.Itthereforehadaninventoryturnoverof

- ti*"' ifil;?

This represented an improvemenudeterioration from -

A fourth and final activity ratio is the fixed asset turnover ratio which measlrres the effectiveness

of the company in utilizing its plant and equipment:

Net sales

Net fixed assets

4. Magnetronics had net fixed assets of $ and sales of $

-

in1999. Ils fixed asset turnover ratio in 7999 was times, an improvemenUdeterioration from times in 1995.

t1

201477 Aeseeaing a Firm's Future Financial Health

5. So far, we have discussed three measure of profitability: They are (a)-(b)

and We have also discussedfour activity ratios which measure the effectiveness of the company in utilizingits assets: they are (d)

and (g)

6. The deterioration in Magnetronics' operating profits as a percentage of totalassets between 1995 and 1999 reulted primarily from

-Lrerage Rtf&li' Hr,t fuznrtv ts tlv Cnmpany Firunced?

The third bask npe ot financiai rabo L< the leverage ratio. The various leverage ratios measurethe relationship ot runds sugpind bv cral.itors and the funds supplied by the owners. The use ofborron'ed funds b1'profiable companies nill improve the return on equity. However, it increasesthe riskiness of the business and, il us€d in exces:<ile amounts, can result in financial embarrassment.

One leverage ratio, the debt ratio, measures the total tunds provided by creditors as a percentageof total assets:

Total liabilitiesTotal assets

Total liabilities include both current and long-term liabilities.

1. The total liabilities of Magnetronics as of December 37,1999, were $- or

-% of total assets. This represented an increase/decrease from

-%

as of December 3'1,,1995.

Lenders - especially long-term lenders - want reasonable assurance that the firm will be able torepay the loan in the future. They are concerned with the relationship between total debt and theeconomic value of the firm. This ratio is called the total debt ratio at market.

Total liabilitiesTotal liabilities + Market value of the equity

The market value of equity is calculated by multiplying the number of shares outstanding of commonstock times the market price per share.

2. The market value of Magnetronics' equity is $1.4,275,000 at December 31,, 1999.

( r-)(e)

12

Its total debt ratio at market was


A second ratio that relates the level of debt to economic value and performance i'=E --:=>

interest earned ratio. This ratio relates earnings before interest and taxes - a measure of prc-=: --:-,

and of long-term viability - to the interest expense - a measure of the level of debt.

Earnings before interest and taxes

Interest exPense

3. Magrretronics'earnjngs before interest and taxes were $ in 1999 and

its interest charges were $ Its times interest earned was

times. This represented an improvemenUdeterioration from the

times.

A fourth and final leverage ratio is the number of days of payables. This

average number of days that the company is taking to pay its suppliers of

comp6nents. It is calculaied by dividing annual purchases by 365 days topurchases per day:

Annual Purchases365 days

Accounts payable are then divided by average purchases per day:

Accounts payable

Average purchases Per daY

to determine the number of days purchases that are still unpaid'

It is often difficult to determine the purchases of a firm. Instead, the income statement shows cost

of goods sold, a figure that includes not only raw materials but also labor and overhead. Thus, it

oftEn is only possible to gain a rough idea as to whether or not a firm is becoming more or less

dependent onits supptierJfor finance. This can be done by relating accounts payable to cost of goods

sold,

Accounts payable

Cost of goods sold

and following this ratio over time.

4. Magnetronics owed its suppliers $ _- at year-end 1999. This represented

_% of cost of goods sold and was an increase/decrease from

-%

at year-

end 1995. The company appears to be more/less prompt in paying its suppliers

in 1999 than it was in 1,995'

5. The deterioration in Magnetronics' profitability, as measured by its return on

equity, fuom1.5.2"/, in 1995 to1.0.7"hin1999 resulted from the combined impact of

and

6. The financial riskiness of Magnetronics increased/decreased between 1995 and

1999.

1995 level of

ratio measures theraw materials anddetermine average

13

201477 Assessing a Firm's Future Financial Health

Liquiditv Ratios: How Liquid is the Company?

The fourth basic type of financial ratio is the liquidity ratio. These ratios measure a company'sability to meet financial obligations as they become current. The current ratio, defined as currentassets dirided by current liabilities,

Current assets

Current liabilities

assumes that current assets are much more readi.lv and certainly convertible into cash than otherassets. It relates these fairly liquid assets to the clarms that are due within one year - the currentliabilities.

1. Magnetronics held $- of curren: ass€ts at year-end 1999 and owed $- tocreditorsduetobepaidrr.ithinone\.ear.Itscurrentratiowas-,ElflimprovemenU deterioration rror. 'i.e ratio of

-

at year-end 1995.

The quick ratio or acid test, is sim-ar :o '-:re current ralio but excludes inventory from the currentaSSetS:

Cursri as-ts - Inventon'Current liabilities

lnventon' is excluded because it is often difficult to convert into cash (at least at book value) if thecompanv is struck by adversity.

2. The quick ratio for Magnetronics at year-end 1999 was

-/

an improvemenUdeterioration from the ratio of at vear-end 1995.

AWarning

The calculated ratios are no more valid than the financial statements from which they are derived.The quality of the financial statements should be assessed, and appropriate adjustments made, beforeany ratios are calculated. Particular attention should be placed on assessing the reasonableness of theaccounting choices and assumptions embedded in the financial statements.

The Case of the Unidentified lndustries

The preceding exercise suggests a series of questions that may be helpful in assessing a company'sfuture financial health. It also describes several ratios that are useful in answering some of thequestions, especially if the historical trend in these ratios is examine.

However, it is also important to compare the actual absolute value with some standard todetermine whether the company is performing well. Unfortunately, there is no single current ratio,inventory turnover, or debt ratio that is appropriate to all industries, and even within a specificindustry, ratios may vary significantly among companies. The operating and competitivecharacteristics of the company's industry greatly influence its investment in the various types ofassets, the riskiness of these investments, and the financial structure of its balance sheet.

Try to match the five following types of companies with their corresponding balance sheets andfinancial ratios as shown in Exhibit 3.

14

Assessing a Firm's Future Financial Health -T1-1-

1. Electric utility

2. fapanese trading company

3. Aerospacemanufacturer

4. Automobilemanufacturer

5. Supermarket chain

In doing the exercise, consider the operating and competitive characteristics of the industry and theirimplications for (1) the collection period, (2) inventory turnover, (3) the amount of plant andequipment and (4) the appropriate financial structure. Then identify which one of the five sets ofbalance sheets and financial ratios best matches your expectations.

15

201-077

Exhibitl Magnetronics,Inc.,Consolidatedand 1999 (thousands of dollars)

Asaeseing a Firm,s Future Financial Health

Income Statements for Years Ending December gt,lggs

199sNet salesCost of goods soldGross profitOperating epenseslnterest erpensesIncorne before taxesFederal income taxesNet income

$32,51319.183

$13,33010,758

361

$2,2111.040

$t-lzl

$48,76929.700

$19,06916,541

517$2,011

744$l-302

Exhibit 2 Magnetronics, lnc., Consolidated Balance Sheets at December 3I, I99S and 1999(thousands of dollars)

!995CashAccounts receivablelnventoriesCurrent assetsNet fixed assetsTotal assets

Notes payable, banksAccounts payableAccrued expenses and taxesCurrent liabilitiesLong-term debtStockholders' equityTotal liabilities and stockhotders equity

$ 1 ,6175,2274.032

$10,8764.073

$14-949

$ 8641 ,6152.028

$4,s072,7507.692

$14919

$2,0207,3808.220

$17,6205.160

$nfi$

$1 ,2132,8203,498

$7,5313,056

12.'193

$22J80

16

Aesessing a Firrr'e Future Financial Health

Exhibit 3 Unidentified Balance Sheet

,18

DBalance Sheet PercentagesCashReceivableslnventoriesOther current asselsProperty and equipment (neO

Other assetsTotalassets

Notes payableAccounts payableOther current liabilitiesLong-term debtother liabilitiesOwners'equityTotal liabilities and equity

Selected RatiosNet profits/net salesNet profits/total assetsNet profits/owners' eguityNei salesnotal assetsCollection period (days)lnventory turnoverTotal liabilities/total assetsLong-term debVowners equityCurrent assetycurrent liabilitiesQuick ratio

7.60/o

31.75.31.2

30.224.O

100-0%

38.4Yo

5.51.5

17.426.510.7

t_ooJ%

2.7o/o

4.72.03.0

66.621.0

100-0%

4.2%3.04.7

30.022.93s.2

100-0%

1.4o/o

2.923.0

1.849.921.0

l.00.o?o

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17

accessing a firms future financial heath

Documents

financial characteristics

marketfuture financial

firms sales

withexamples of firms

arrticipate future imbalance

corporate financialsystem

ambitious programs

itsformulation of goals