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FINANCIAL ANALYSIS AND DECISION MAKING:

HANDBOOK & TEMPLATES

Neil G. Cohen, DBA, CFA School of Business

The George Washington University Washington, DC USA

ngcohen@gwu.edu

2013 Neil G. Cohen. All rights reserved. 2 July 2013

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TABLE OF CONTENTS

CHAPTER 1 - USING FINANCIAL STATEMENTS INTELLIGENTLY !The Close Relationship between Finance and Accounting: The IS/BS Model "Structure and Terminology Issues #$Reliability of Financial Statements Bogus or Accurate? #%

CHAPTER 2 - FINANCIAL STATEMENT ANALYSIS WITH RATIOSPurpose of Financial Ratios Diagnostic Metrics Taxonomy of Financial Ratios The DuPont Formula &'Ratio Interpretation Template &(Operating Leverage and Breakeven Levels &%

CHAPTER 3 - FORECASTING FINANCIAL STATEMENTS &DETERMINING EXTERNAL FINANCING NEEDEDPercentage-of-Sales Forecasting of Financial Statements & Determining External Financing Needed ))The Short-Form Forecasting Model ))Interpreting External Financing Needed ''

CHAPTER 4 - FINANCIAL ARITHMETIC THE TIME VALUE OF MONEYBasics of Time Value of Money '%Tables for Compounding & Discounting ")Automating the Calculations Using HandyCalc "*

CHAPTER 5 - CAPITAL BUDGETING & COST OF CAPITALOverview of Capital Budgeting $#Calculate the Discount Rate Weighted Average Cost of Capital (kwacc) (+Calculate Decision Criteria: Net Present Value, Profitability Index, Internal Rate of Return, Payback Period (%

CHAPTER 6 - EQUITY VALUATIONThe Basics *(Dividend Discount Model (DDM) %*Free Cash Flow Equity Valuation (FCF) Model %%Market Multiples Equity Valuation Model #+&Nine Elements in the Equity Valuation Process A Summary #+$

CHAPTER 7 - DEBT VS. EQUITY FINANCING& LEASE VS. BORROW-TO-BUY ANALYSISThe Debt vs. Equity Decision #+(The Lease vs. Borrow-to-Buy Decision #

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The image on the book cover depicts five key concepts in financial decision-making:

Return and Risk, always considered together, refer to the duality at the root of finance theory, where return is a rate of return on investment and risk is the variability over time in that rate of return.

Growth is the objective of (most) businesses, to grow revenues, profits, and the value of the business.

Sustainability refers to the hope that growth in revenues, profits, and stock price will continue into the future.

Cash Is King! (the kings crown) refers to the maxim that if its not cash money (the stack of money), its not real. The accountants measurement of net income and retained earnings do not represent money that can be spent (the cigar box, where the money is kept in a small business); only cash can be spent.

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CHAPTER 1

USING FINANCIAL STATEMENTS INTELLIGENTLY The Close Relationship between Finance and Accounting: The IS/BS Model Introduction Learning Objectives

1. Understand the layout and terminology of an income statement 2. Understand the layout and terminology of a balance sheet 3. Understand the layout and terminology of a cash flow statement 4. Understand the link between the income statement and balance sheet 5. Understand why Cash is King!

Accounting is a Foreign Language This is a discussion about linguistics you are learning a foreign language with all the challenges that involves: irregularities, too many synonyms and code switching, which to a linguist, is changing from one language to another in the same sentence or paragraph. Accountants and financial analysts dont make it easy for users of financial statements, with so many different terms and formats for presenting financial statements. This makes it frustrating for learners. Relax about it; as in language learning, practice and repetition is the key. You will get better at it as you go along. Its a skill, and building a skill takes time. Cash Basis versus Accrual Accounting Accrual accounting records all transactions, whether or not cash has changed hands. For example, if you pay employees every two weeks, the salary due them accrues day-by-day on your books as a current liability you owe to them. Similarly, if you obtained inventory on credit, then sell it to your own customer before you pay your supplier for it, the cost of the goods sold includes the cost of those items. Cash basis means that transactions are recorded only when cash changes hands: merchandise is sold for cash or an employee's salary is paid in cash. This means that when merchandise is sold on credit, or when raw materials are bought from suppliers on credit, no record of the transaction goes into the company's books if the cash basis is used. Accordingly, an income statement drawn at any given time, under the cash basis, will not reflect all of the business's transactions, and may provide a misleading picture of business performance. Under accrual accounting, such transactions must be included, as they should be, because they are costs of doing business. Under the cash basis, they would be excluded, understating the cost of doing business and overstating income tax and profit. Some businesses, especially those dealing in services rather than products and where cash is paid, can operate on the cash basis without great danger of having distorted financial statements. It is required under the accounting law, however, that most businesses use accrual accounting. This accounting method matches sales revenue against those

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expenses incurred which generated the revenue for the accounting period, whether or not cash has changed hands. The IS/BS Model

Financial statements describe the operations of a business - the scorecard for the business. Shown above is a summary diagram of the Income Statement/Balance Sheet accounting model of the business - organizing financial data so the performance of the business can be measured and controlled. The accounting model consists of the income statement, the balance sheet, and the cash flow statement, each of which is discussed in the material that follows. The information in financial statements is summarized with financial ratios, the subject of Chapter 2. Dont worry about that now. Gain a solid understanding of the financial statement terminology and structure first things first! View the balance sheet as a snapshot of a business, freezing action at a moment in time. It lists the dollar amount in each asset, liability, and equity account. In contrast, view the income statement as a moving picture summarizing the flow of revenues and expenses during the period of time. Where the balance sheet is written as of an ending date (the moment in time), the income statement is written to cover a period of time (month, quarter, year). The balance sheet and the income statement are linked when the profit retained in the business, shown on the final line of the income statement, is added to the equity section of the balance sheet, increasing the owners investment in the business, or decreasing it if there is a loss.

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Balance Sheet is a SNAPSHOT of account balances FROZEN at a POINT in time

Income Statement is a MOVING PICTURE of transactions FLOWING over a PERIOD of time

ASSETS = LIABILITIES + EQUITY

COMMON EQUITY = COMMON STOCK + RETAINED EARNINGS

The universal accounting equation is shown in the box above: Assets equal liabilities plus equity. Look at the income statement/balance sheet model and relate what you see in the box, the accounting equation, to the structure of the financial statements depicted in the model. Since the last line on the income statement summarizes the results of running the business during a period of time.sales revenue minus expenses minus taxes minus dividends equals profit reinvested in the business.that profit reinvested is transferred into the equity account on the balance sheet. The balance sheet then portrays the position of the business at a moment in time at the end of the accounting period. An accountant is obligated to prepare financial statements that truly and fairly portray the results of business operations, following accounting principals and the law. No matter what country is involved, these are the fundamental principles:

the business is assumed to be a going concern completeness truth clarity of presentation consistency with prior year agreement with closing balance sheet of previous year accrual accounting with matching of revenue and expenses prudence disclosures individual valuation of assets and liabilities inter period allocation of income and expense

You will soon realize that formats and terminology for financial statements vary widely. To keep the focus clear and unambiguous, the formats used throughout this book are a

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composite of illustrative financial statements from United States Generally Accepted Accounting Principles (USGAAP), International Accounting Standards (IAS), and International Financial Reporting Standards (IFRS)1. This approach minimizes confusion for those who are learning about financial statements for the first time. As your skills develop and your understanding deepens, you will be able to work with any format and terminology that comes your way, because USGAAP, IAS, and IFRS are variations on the same theme. Layout and Terminology of the Income Statement

Revenue is also called sales, net sales, or turnover in some countries. Cost of sales, sometimes called cost of goods sold (CGS), is the cost to the

business of either buying and/or producing the goods/services it sells. It includes wages, cost of operating a factory, depreciation, and other direct and indirect production costs. Cost of sales is a combination of fixed and variable costs.

Sales minus cost of sales equals gross profit, also called gross margin. It represents the amount remaining to cover general overhead expenses after deducting the cost of making or buying the goods that are sold.

1A concise, clearly written article on IFRS is Illustrative Financial Statements Presentation and Disclosure Checklist: International Financial Reporting Standard for Small and Medium-Sized Entities. Find it on this website: http://www.ifrs.org/IFRS+for+SMEs/IFRS+for+SMEs+and+related+material.htm

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Distribution costs, sometimes called selling costs, are those connected with sales and marketing activity.

Administrative costs are the general overhead of the business. Research and development expense can be included here or given a separate account title of its own. Although distinctions between fixed cost and variable cost are rarely found in published financial statements, you can think of distribution costs as more variable than administrative costs although both categories include both fixed and variable components.

Depreciation and amortization expense recognizes the usage of fixed assets such as buildings (but not land, which is not depreciated), machines, and equipment. Many income statements do not show depreciation expense as a separate item. Instead, it is included as part of cost of sales, distribution costs, administrative costs, etc. Remember that depreciation is a non-cash charge. An expense such as paying salary to workers means that cash is paid out a cash charge. Depreciation is a non-cash charge because no cash is paid out. It is an expense that recognizes the use of previously purchased fixed assets. Depreciation and amortization expense is linked to the balance sheet when the annual expense is added to the account for accumulated depreciation and amortization on the balance sheet. For example, an asset is purchased for $1,000 to be depreciated over 10 years. Each year there is $100 depreciation expense on the income statement. After the first year, the fixed asset is booked at $900, the $1,000 purchase price minus $100 depreciation for the first year. After ten years, the fixed asset will be valued at $0 because $100 of depreciation for each of 10 years accumulates to $1,000.

Other operating costs is a catch-all account for other items Restructuring costs will be zero unless these non-recurring costs occur. Profit from operations is gross profit less all operating expenses. This account

is also called earnings before interest and taxes (EBIT). It is also called operating profit, and is sometimes it is called trading profit.

Interest, financing expense is interest paid on borrowed money. Income from investments is non-operating income Disposal of operations will be zero unless these non-recurring costs occur. Profit before tax is the sum of operating profit or loss, financial profit or loss,

and extraordinary items. Income tax is income tax. Profit after tax is profit before tax minus income tax. This is the so-called

bottom line of an income statement, the figure showing how well the business has performed during the accounting period.

Minority interest, other provides a place to enter these special categories, if relevant.

Dividends means cash dividends paid to owners Other is a catch-all category Reinvested in the business also called increase in retained earnings, which

is transferred to the balance sheet to show the increase (or decrease if a loss occurs) in the stockholders equity from the current periods activity.

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Layout and Terminology of the Balance Sheet

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Assets are listed in order of liquidity (that is, the ease with which the asset can be converted into cash). Liabilities are listed according to the priority claims of creditors. Equity is the difference between assets and liabilities; it represents the book value of the owner's equity in the business. It is called book value because it is the amount on the books. It has little or nothing to do with the market value of the business, as you will see later in the course. Equity is considered a residual because it is the amount remaining after what is owed (liabilities) is subtracted from what is owned (assets). Current assets:

Cash & equivalents includes the cash in the till, cash in the bank, and highly liquid, high quality securities with short maturities

Investments are liquid investments, usually securities Trade receivable, also called accounts receivable, is the total amount of money

owed to your company by the customers who have purchased goods or services on credit. The credit terms may be very short, such as 15 days, or very long, up to one year. If you know from past experience that a certain percentage of these accounts, say 2%, will never be collected, the accounts receivable entry should be net of the estimate of uncollectible accounts. Deduct an estimate of bad debts to get net accounts receivable.

Inventory means goods available for sale to customers, and includes all costs involved in producing or obtaining them. In manufacturing, it is divided into three categories: raw materials, work-in-progress, and finished goods. Include only goods available for sale; office supplies, spare parts for production equipment, and gasoline for delivery trucks may not be classified as inventory items.

Other current assets is a catchall category. Non-current assets, also called fixed assets:

Property, plant and equipment-gross are assets with useful lives in excess of one year. Note that land is not depreciated it does not wear out or get used up.

Accumulated depreciation and amortization is the aggregate, cumulative depreciation and amortization expense from all income statements, year-by-year.

Property, plant, and equipment-net is property, plant and equipment less accumulated depreciation and amortization.

Investment property is ambiguous and depends on the situation, likely to be an ownership interest in another business

Goodwill is the excess of market value paid over book value in an acquisition. It may also include intangibles such as intellectual property or trademarks.

Other is a catchall category.

Current liabilities: Trade and other payables, also called accounts payable, is the amount of

money owed to suppliers for goods or services bought on credit. The credit terms can be very short, say 10 days, or up to one year, and still be considered a current liability. This account is vendor financing.

Retirement benefit obligation is pension payments due to retired employees within one year.

Tax liabilities, also called income tax payable or accrued taxes, is the income tax due to governments within one year.

Leases due in 1 year is short-term lease payments due Loan, debt due in 1 year is the principal amount of borrowings due in one year.

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Other is a catchall category. Non-current liabilities, sometimes called long-term debt:

Retirement benefit obligation is aggregate pension payments due to retired employees.

Deferred tax liabilities are the reconciling entry between the income tax calculated on GAAP taxable income and the income tax calculated on the income tax return. An alternative definition is the difference between taxes due and taxes paid under different accounting regimes, such as accelerated depreciation used on the tax return and straight-line depreciation used on GAAP financial statements.

Finance leases due after 1 year is the present value of future lease payments. Loans, debts due after 1 year is the principal amounts of borrowings. Other is a catchall category.

Shareholders equity (Net worth):

Preferred stock is the par value of preferred shares outstanding. Common stock is the par value of shares issued to shareholders. Additional paid-in capital is the difference between the amount the investor

paid for shares issued and the par value of the shares when the shares were issued. In modern accounting, common stock and paid-in-capital can be summed, to represent the money paid by owners when the shares were issued to them.

Other is a catchall category. Retained earnings is accumulated profit (loss) since the business started. It is

increased (decreased) each year when profits reinvested in the business (from the income statement) are added to the previous balance of accumulated profits on the balance sheet. (Treasury stock is a deduction for common stock repurchased by the corporation. It is a misnomer because stock repurchase reduces shares outstanding repurchased shares no longer exist after they are repurchased they are cancelled - therefore, treasury stock does not exist and does not appear as an entry on this balance sheet.

Total equity (also called net worth) is the sum of preferred stock, common stock, additional paid-in-capital, other, and retained earnings

Minority interest is a catchall category. The Link between Income Statement and Balance Sheet The above sections discussed the income statement and the balance sheet independently. From now on, the two financial statements will be discussed as a set, because one cannot be interpreted without the other. From our discussion of income statements, you should remember that the bottom line is profit after tax minus dividends: profit reinvested in the business. This is the result of the moving picture of business operations for the year (or quarter or month). How do the results of the moving picture get into the snapshot shown by the balance sheet? The answer is simple: profit (loss) reinvested in the business, shown at the bottom of the income statement, is added to the accumulated profit (loss) on the balance sheet.

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Keep in mind that :

income statement reinvested profit is for only one period of time the period for that particular income statement only.

reinvested profit on the balance sheet is the accumulation of all reinvested profits from all the income statements since the business began.

Similarly, keep in mind that:

depreciation and amortization expense on the income statement is for that period only.

accumulated depreciation and amortization on the balance sheet is the cumulative depreciation expense from all the income statements.

Learn not to confuse depreciation expense (income statement) with accumulated depreciation (balance sheet). Eventually, accumulated depreciation reduces the book value of an asset to zero; signifying that is has been fully depreciated. Profit versus Cash Profit after tax is not the same as cash (unless cash basis accounting is used). Profit is a measurement of revenue minus expenses minus tax transactions, as defined by GAAP rules for accrual accounting, whether or not cash changes hands. As actual cash is collected, some goes to pay expenses, some goes to increase assets, some goes to pay liabilities, and some goes to pay dividends. A growing business almost always spends more cash than it receives, using external funds to close the gap. Therefore, please, never confuse cash with profit - they are not the same. A business with large and growing profit often has a cash deficit until it raises money from debt or equity financing. Material presented in subsequent weeks will emphasize why CASH IS KING. Cash is money. A firm can have positive net profit yet still go out of business because of a lack of cash .A business can invest money in working capital and fixed assets, or use the money to repay debt and give dividends to shareholders. Profit and retained earnings are creatures of accounting methods, not money. Lots of effort will be made during the weeks that follow to clarify this notion further. It is one of your key learning objectives - you cant afford to misunderstand it. Layout and Terminology of the Cash Flow Statement Cash flow statements are also called:

Statement of sources and uses of funds Statement of sources and application of funds Statement of funds flows Statement of changes in financial position Funds statement

Although there are variations in the layouts of cash flow statements, all of them are used as a bridge between the income statement and the balance sheet, for the purpose of tracing how funds were used and where those funds came from. A cash flow statement shown on the following page is derived from the income statement and balance sheet it is not a unique statement. It rearranges the income statement and balance sheet data.

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Classification of Sources and Uses of Funds The table below shows a simple summary for understanding the difference between a source and a use of funds.

The cash flow statement summarizes the where got-where gone situation sources and uses of funds. It is divided into three categories, operating activities, investing activities, and financing activities. The sum of cash inflows and outflows is the annual increase or decrease in cash. That figure, adjusted for the effect of foreign exchange rate changes and the cash balance at the beginning of the year, gives the cash balance at the end of the year.

Operating activities are income statement flows. GAAP requires interest paid to be entered in this category, even though it seems more like an investment activity. Net cash provided by operating activities is sometimes abbreviated CFFO, Cash Flow From Operations.

Investing activities represent increases or decreases in balance sheet asset accounts.

Financing activities are increases or decreases in balance sheet liability or equity accounts adjusted by Dividends from the income statement.

Know the three parts of the Cash Flow Statement, as it is shown above, know that it is derived from the income statement and balance sheet and is not a unique statement, and know the source/use definitions in the table above. Your primary effort should be placed on the income statement and balance sheet. Summary You must know, intimately, the format and terminology of income statements and balance sheets, however boring it may seem at this early point in the course. These statements are the way we portray the companies we are talking about. Above all, you must appreciate that net income on the income statement does not represent cash. It sounds silly to say it, but, only cash (on the balance sheet) is cash. It is the only money you can spend. You cant spend profit and you cant spend retained earnings. They may be accounting accruals, creations of accounting rules, but they are not cash. Thats why we say Cash is King! There will be a lot more said about this as the course rolls on.

ASSET LIABILITY + EQUITY

increases in these accounts increases in these accountsare USES of funds are SOURCES of funds

decreases in these accounts decreases in these accountsare SOURCES of funds are USES of funds

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Structure and Terminology Issues

Learning Objectives

1. Realize that financial statements are presented in many variations with no standard format

2. Realize that terminology of financial statements in full of synonyms and ambiguity

3. Learn to look for the context of the financial statements and interpret the details accordingly

Be Aware of Multiple Layouts for Financial Statements You might expect published financial statements to follow a rigid layout where all income statements and balance sheets have the same format, with the same titles presented in the same order. Although accounting standards specify a detailed order of presentation and set of account titles, considerable variations from this layout are found in practice. You should not be bothered by variations from the system of accounts presented in the accounting standard. What you need to know is the logic of how the financial statements are organized and how they fit together, and to be flexible enough to interpret the context of what is presented. Its frustrating for the learner, I know, but it will become clear once you reach a critical mass of knowledge. Be Aware of Different Words Used to Name the Same Account Titles Account names in financial statements can have more than one name, causing confusion when you look at statements from different companies in different countries. You must be aware of the synonyms because they occur so often. For example, profit after tax can also be called either after tax profit, net profit, earnings after tax, or net incomeall synonyms. You must be aware of the synonyms because they occur so often. For example, profit after tax can also be called either after tax profit, net profit, earnings after tax, or net incomeall synonyms. You must be aware of the synonyms because they occur so often. We dont know if authors use terminology shifts on purpose to test your ability to be flexible, or if they are merely being careless. There is no nationwide or worldwide organization that decrees standard terminology. Normally, you can determine the meaning of an unfamiliar term from the context. Alternatively, use the list of synonyms. Listed below are groups of synonyms for terms that are used interchangeably, categorized as:

income statement balance sheet other

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Income statement (profit and loss statement): Revenue Sales Turnover Gross profit (money terms) Gross margin (percentage) Contribution margin Operating profit Earnings before interest and taxes (EBIT) Trading profit Pre-tax profit Profit before tax Earnings before tax Income before tax After-tax profit Profit after tax Earnings after tax Net income Net profit Balance sheet (position statement): Return on equity (ROE) Return on shareholders investment Return to owners Share capital Common shares Common stock Invested capital Paid-in capital Stated value Additional paid-in value Excess over par Accumulated surplus Retained earnings Reinvested profit Earned surplus Balance sheet profit

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Other: Leverage Financial Leverage Gearing Capital budgeting Investment decision Cost-benefit analysis Project analysis Summary This discussion made you aware of the too-numerous synonyms involved in financial statement terminology. We might wish for more consistency, but know that we wont get it, and must be ready to deal with financial statements as we find them. As you gain experience as a user of financial statements, familiarity with the context will permit you to interpret them properly in spite of terminology and format shifts.

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Reliability of Financial Statements Bogus or Accurate?

Learning Objectives

1. Understand purpose of financial statements 2. Understand why many financial statements are bogus

Is the Measuring Device Rigid or Elastic? Now that you have begun to master the terminology and structure of financial statements, do a reality check about the usefulness of this information.

First off, think about this metal ruler. One inch is always one-inch long. The aluminum does not stretch or shrink. It always stays the same. The user of the ruler relies that the measuring device is consistent. Second off, think of the elastic band in these sweat pants. The tag inside says the size is 34, but you can stretch them to a 38 at least, or you can shrink them to maybe a 32 or 30.

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Are the accounting principles that lie behind financial statements more like the aluminum ruler or the sweat pants waistband? We might like it better if the answer was ruler but that is the wrong answer. At their best, financial statements are put together using rules with lots of flexibility. If this shocks you, give it some thought. You dont want to be an overly trusting and nave user of financial statements. Accounting fraud is vigorously prosecuted all over the world. Huge fines are paid. Huge out-of-court settlements are paid by offending accounting firms when users financial statements successfully claim that they relied on those statements and were materially misled. Jail terms for perpetrators of accounting fraud are not unusual. Although the link below is about the law in the United States, it is included for your reference: http://www.sarbanes-oxley-forum.com/ Summary Published financial statements are not what they seem. Dont be reticent about taking them with a grain of salt. Even in the absence of covert fraud, there is a lot of bogus information in financial statements. Its healthy to view them as instruments used by corporations to put their best foot forward.

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CHAPTER 2

FINANCIAL STATEMENT ANALYSIS WITH RATIOS Financial ratio analysis summarizes the data from the income statement and balance sheet so you can measure the performance of a business. Also, ratios are the basis for making forecasts of future operations. Learning Objectives

1. Interpret a financial statement using financial ratios 2. Understand the difference between comparisons of historical trends within a

company and comparisons of ratios between companies 3. Understand the power of the DuPont formula 4. Understand the limitations of financial ratio analysis 5. Perform financial ratio analysis in an Excel spreadsheet

Purpose of Financial Ratios - Diagnostic Metrics Think of financial ratios as measures of the relative health or sickness of a business. Just as a physician takes readings of a patient's temperature, blood pressure, heart rate, and blood count, a manager takes readings of a firm's liquidity, leverage, efficiency, profitability, and growth. Where the physician compares the readings to generally accepted guidelines such as a temperature of 98.6 degrees as normal, the manager uses

trends over time within the company comparisons to peer companies and industry benchmarks.

By itself, a financial ratio means little. Its meaning comes from making the proper comparisons.

As you look at the discussion below, keep track of where the input figures for the ratios come from. Some ratios are made up of income statement figures, some are made up of balance sheet figures, and others use figures from both income statement and balance sheet. The RATIO INTERPRETATION template lists each ratio by name, and also shows its numerator and denominator, a useful display to help you remember the ratios and see their sources. In interpreting a ratio, remember that it results from many inputs. You may not be able to say that the ratio is bad, for example, solely because the numerator is too high. Instead, the problem may be that the denominator is the cause of the problem rather than the numerator. Be careful about jumping to conclusions before you examine all of the inputs making up the ratio.

Taxonomy of Financial Ratios The ratios are listed in these categories:

Liquidity Leverage Efficiency/Asset-Use

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Profitability DuPont Formula a summary model including three of the above ratios, leverage,

efficiency, and profitability (but not liquidity) multiplied together resulting in return on equity

Growth rates Liquidity Ratios Liquidity ratios measure the ability of the company to pay its bills. A liquid asset is one that can be converted to cash quickly without suffering a loss of value. Remember that assets are listed in the balance sheet in increasing order of relative liquidity. Keep in mind that current assets are uses of funds increasing them means increased investment in the business, and vice versa. Similarly, current liabilities are sources of funds, such as supplier creditincreases provide more available funds to invest in the business.

The current ratio compares current assets to current liabilities to show by how much current assets (cash plus accounts receivable plus inventories) exceeds current liabilities (bills that must be paid relatively soon). A lower current ratio means that you are in a riskier position, because fewer liquid assets will be there to cover current debts. A high ratio means greater liquidity. But a high ratio may also mean that you have too much invested in current assets. Remember, finance involves trade-offs. You may sleep better at night knowing that the current ratio is high and you are in not danger of becoming insolvent (running out of liquid assets so bills cannot be paid). The other side of the issue is that excessive investment in current assets reduces your rate of return, because more assets mean greater investment, the denominator in the rate of return calculation.

The quick ratio, sometimes called the acid-test ratio, is similar to the current ratio. The difference is that inventory, the least liquid current asset, is deducted from the numerator of the fraction, because inventory can be liquidated less quickly than cash or accounts receivable.

Days sales in receivables, also called collection period, measured in number of days, shows how long it takes to collect from customers who get credit. The smaller the number of days, the more efficient the collections, and the less money must be invested in offering credit to customers. If customers demand relaxed credit terms, keeping receivables too low may reduce sales. The numerator of the fraction is net receivables (after deducting uncollectible accounts). The denominator is sales divided by 365, which gives sales per day.

Days cost of goods sold in inventory shows how many days of production (or purchases from vendors) is invested in inventory. The smaller the number of days, the better, because it means less money invested in inventory. The risk of stock-outs must be considered; if inventory is too low, sales might fall when orders cant be filled. Another way to measure the same thing is inventory turnover. It shows how many times inventory is sold (turns over) each year, a measure of inventory efficiency. The higher the ratio the better, because it implies a smaller inventory for the level of sales, and a smaller inventory means that less money is invested in the business, raising rate of return. A ratio that is too low might imply the risk of running out of inventory and losing sales. A ratio measured in days, like days cost of goods sold in inventory, is easy to interpret because 45 days vs. 90 days is easily interpreted.

Days cost of sales in payables, also called payment period, measured in number of days, shows how long it takes to pay suppliers who offer credit. The smaller the number of days, the quicker the suppliers are getting paid. The

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numerator of the fraction is net payables. The denominator is cost of sales divided by 365, which gives cost of sales per day.

Leverage Ratios Leverage ratios measure the use of borrowed money. They are measures of financial risk, which means the likelihood of insolvency or bankruptcy if you are unable to pay debts such as interest payments and repayment of loan principal. High leverage ratios are not automatically considered bad but should be interpreted as indications that the manager decided to use debt aggressively. The hope is to grow faster or increase profits by putting borrowed money to work. This is a reasonable goal. Understand that such a strategy involves risk. You must consider the risk-return trade-off in deciding how much debt is acceptable.

Long-term debt to total capital compares the sum of long-term liabilities in the numerator to the sum of long-term liabilities plus equity in the denominator. The higher the ratio, the greater the use of borrowing, and the greater the financial risk. IAS requires that financial leases be included in long-term liabilities.

Long-term debt to equity is the ratio of permanent debt financing to the funds supplied by owners. Remember that the funds supplied by owners, equity, includes money paid for shares when it was issued combined with all accumulated profits reinvested in the business during its entire history.

Times interest earned (coverage ratio) indicates how easy or how hard it is to cover fixed interest payments on borrowed money. The numerator of the fraction is the funds available to pay interest, what remains after all operating expenses are deducted from revenue, i.e., EBIT. The denominator of the fraction is interest that must be paid. Think of it as the number of times the funds available for interest payments cover the interest that must be paid. The higher the coverage ratio, the safer, the greater the cushion available if EBIT falls.

Full burden coverage restates the times interest earned ratio to include lease payments. Times interest earned considers only the interest expense part of borrowing. Full burden treats leases as fixed expenses just like debt, providing a more comprehensive indicator about whether operating profit is sufficient to service both leases and debt.

Efficiency/Asset-Use Ratios The purpose of your business is to generate revenue and profits. Therefore, you invest in assets to create the business and produce the product or service you sell. So you want to measure how good you are at using assets to generate revenue, hence the efficiency ratios.

Fixed asset turnover measures the efficiency of fixed assets in generating revenue. This is a turnover ratio, so a higher result is a good result.

Total asset turnover measures the overall asset efficiency. Profitability Ratios Profitability ratios measure profit in relation to the income statement and balance sheet.

Gross margin measures how much of each euro of revenue is left after cost of goods sold is deducted. It is a measure of how much is left to pay other expenses after the cost of making or buying the goods is deducted, before consideration of other operating expenses.

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Operating profit margin measures what is left after all operating expenses are deducted from the revenue figure.

Return on sales (ROS) compares profit after tax to sales. It shows how much of each euro of sales is left after all expenses, including income taxes, are paid. It does not consider repayment of debt principal, which is not an expense

Return on assets (ROA) compares profit after tax to total assets. Return on equity (ROE) compares profit after tax to the funds supplied by owners,

equity. This may be the most important number from the viewpoint of the owner, because it measures the rate of return on the money invested in the business.

Return on invested capital (ROIC) compares EBIT after tax to the assets used to generate sales. Where ROS and ROA are dependent on and biased by the extent of debt financing used, because the numerator is profit after tax, ROIC is a performance metric independent of financing, because its numerator is after tax EBIT no interest expense is considered in the calculation as it is in ROS and ROA.

In the table below, Company A has earnings after tax (net income) of $18 with a ROE of 18%, while Company B has 4 times the earnings after tax but a ROE of 7.2%, less than one-half that of Company A. The bottom three lines of the example show three rate of return metrics. Company Bs are all the same because it has no debt (financial leverage). The ROIC measure removes the impact of the financial policy differences an important lesson.

The DuPont Formula The DuPont formula is a powerful diagnostic tool because it decomposes Return on Equity (ROE) into three components. It is a concise and focused look at how profitability, leverage, and efficiency combine to determine the return on equity (ROE) of a business. The three terms are multiplicative, their product being ROE. The terms are:

1. Profitability = Net Income Sales 2. Efficiency = Sales Total Assets 3. Leverage = Total Assets Shareholders equity, generating #4: 4. Return on Equity (ROE) = Net Income Equity

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The DuPont formula explained above describes a three-component approach. The following describes a five-component approach that decomposes the profitability ratio into interest burden and tax burden so these two additional components can be examined separately.

1. Operating Profit Margin = EBIT Sales 2. Interest Burden = Before Tax Profit Net Income 3. Tax Burden = Net Income Before Tax Profit 4. Leverage = Total Assets Equity 5. Efficiency = Sales Total Assets, generating #6: 6. Return on Equity = Net Income Equity

Growth Rates Growth rates provide percentage figures to measure growth over time in sales, expenses, profits, assets, or any other entry on the financial statements. Each is the percentage change from one year to the next. It is useful to compare growth rates of one account over different periods, and to compare growth rates for several accounts for the same time period, to uncover the relative changes. Warnings in Using Financial Ratios Warning signs are always posted when financial ratio analysis is underway. Several of the warnings follow. Please keep them in mind, because the quality of the conclusions you draw from a ratio analysis is important. They may be the basis of significant business decisions.

Comparisons are relative. Understand the reasons behind changes in the trend of a ratio. Economic causes or industry causes may be the driving force rather than causes within your company. Do not get caught in the trap of thinking that differences in absolute dollar amounts are always significant ones. Be aware of the difference between relative comparisons and absolute comparisons, hence the year-to-year percentage changes shown the table above.

Seasonal trends must be identified to avoid misinterpretation of the ratios. Some ratios will rise and fall during the year, as a result of seasonal influences that repeat year after year. Therefore, a change in a ratio from one quarter of the year to the next may be normal.

Compare ratios using common time periods. Avoid comparing ratios using annual data to those using quarterly or semiannual data, unless adjustments are made.

When significant changes in the underlying economic, industry, or company relationships have taken place during the periods of comparison, be extremely wary about drawing conclusions that will be used to plan for the future.

When earnings per share figures are calculated and compared, you must remember to make adjustments for changes in the number of shares issued and outstanding from year to year (the number of shares changes when new shares are issued or repurchased, or when a split occurs). The denominator of the earnings-per-share calculation for all periods must contain the number of shares outstanding for the most recent time period. Unless the calculation is made using this number, the earnings-per-share data will be useless.

The list of ratios for liquidity, leverage, efficiency, and profitability includes 16 ratios. What happens if many of them show adverse changes from year to year? Be aware

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that only one weak factor could be the driving force behind every weak ratio, so be careful about considering driving factors and resulting factors. For example, a business with too much borrowing will have too much interest, so all debt ratios will be weak all caused by the same thing. In the DuPont formula, if both efficiency and profitability are constant, and debt is rising, ROE will rise, which should not be interpreted as a strength, but a weakness.

If the increase in debt is caused by strongly growing revenue, is it a bad thing or a good thing? It may be either a matter of context provided by other information. These relationships are circular. It is dangerous to consider ratios as independent factors.

Ratios often pose questions for further investigation rather than giving you the answer to questions. It is often necessary to look back at the numbers in the income statement and the balance sheet to properly interpret the result.

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Ratio Interpretation Template (best viewed at 175% magnification or see Template Set.xls)

First, look only at the DuPont Formula ratios Table in rows 121-125. You see the decomposition of ROE, which more-than-tripled from 6.8% to 21.3%. Profitability went up, about three times. Efficiency went up 21%, and leverage went down 19% (reducing leverage is good from a default risk standpoint, but bad from a ROE standpoint because lower profitability means lower ROE). The ROE check is performed in the spreadsheet by computing ROE directly as NP/E, rather than multiplying the three components together, to verify the calculation in row 121. The trend column is the rate of change from 2009 to 2010, showing the relative change for each component. The 216% change in profitability is the key driver of the 212% change in ROE. Conclusions from the financial ratio analysis of Universal Industries are:

The large 212% increase in ROE, as discussed above, caused by very large 212% increase in profitability, helped by a smaller but still impressive 21% change in efficiency, hurt a little by a 19% decline in leverage is impressive but not likely to be sustainable.

Profitability increase is powered by operating cost decreases shown in rows 114-15 and reduction of interest expense because of lower debt, confirmed. Unless sustainable, which is unlikely, profit growth may normalize in the future. Growth in revenue in row 128 is lower than growth in profits in rows 129-130, confirming the suspicion that profitability gains are driven by cost reduction rather than either unit volume or unit price increases.

Big improvements in times interest earned and full burden coverage ratios may lead to a higher credit-quality rating and a reduction in interest expense.

The liquidity situation is mixed; both days in receivables and inventory have improved (fewer days), but days in payables are higher. Collection of receivables may be more efficient and inventory control may be better, but, finance managers may view these metrics differently than production, marketing, and sales managers. More days in payables may mean that Universal is taking better advantage of vendor financing, but, it may be missing discounts for quick payment.

9596979899

100101102103104105106107108109110111112113114115116117118119120121122123124125126127128129130131

A B C D E F G HYEAR 2010 2011 TREND PRELIMINARY INTERPRETATION NUMERATOR DEMONINATOR

Liquidity RatiosCurrent ratio 1.6 1.3 -21% negative, less liquidity current assets current liabilitiesQuick ratio 1.1 0.8 -21% negative, less liquidity curr assets-inventory current liabilitiesDays sales in receivables 75.4 56.3 -25% positive, quicker collections receivables revenue/365 daysDays cost of sales in inventory 59.9 54.0 -10% positive, faster turnover inventory cost of sales/365 daysDays cost of sales in payables 47.6 65.0 37% negative, paying more slowly payables cost of sales/365 days

Leverage Ratios Long-term debt to total capital 57.9% 45.5% -21% positive, less financial risk l-t leases+loans+debt l-t leases+loans+debt+equityLong-term debt to equity 137.4% 83.5% -39% positive, less financial risk l-t leases+loans+debt equityTimes interest earned 1.8 3.8 109% positive, better coverage operating profit (EBIT) finance costsFull burden coverage 1.5 3.1 107% positive, better coverage oper profit + lease exp finance costs + (lease exp/[1-tax rate])

Efficiency (Asset-Use) Ratios Fixed asset turnover 1.2 1.4 19% positive, faster turnover revenue total non-current assetsTotal asset turnover 0.8 1.0 21% positive, faster turnover revenue total assets

Profitability Ratios Gross margin 23.9% 34.9% 46% positive, big improvement gross profit revenueOperating profit margin 6.8% 11.3% 65% positive, bigger improvement operating profit (EBIT) revenueReturn on sales 2.7% 8.6% 216% positive, still bigger improvement net profit revenueReturn on total assets (ROA) 2.2% 8.5% 283% positive, still bigger improvement net profit total assetsReturn on equity (ROE) 6.8% 21.2% 212% positive, big improvement net profit equityReturn on invested capital (ROIC) 4.7% 9.4% 100% positive, big improvement EBIT*I1-tax rate) total assets

DuPont Formula - ROE 6.8% 21.3% 212% profitability x efficiency x leverage Profitability 2.7% 8.6% 216% positive, big improvement net profit revenue Efficiency 0.8 1.0 21% positive, better turnover revenue total assets Leverage 3.1 2.5 -19% positive, less financial risk total assets equityROE Check 6.8% 21.2% 212% calculation check to verify row 121 net profit equity

Compound Annual Growth RatesRevenues 40.8% 2010 - 2009 2009Gross profit 105.7% 2010 - 2009 2009Operating profit (EBIT) 131.9% 2010 - 2009 2009Total assets 16.0% 2010 - 2009 2009

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Summary You probably expect these financial ratios to give you answers about financial performance of businesses, but they may pose more questions than answers. It takes lots of practice and seasoning to work comfortably with them. A quick ratio analysis can be performed by with the DuPont Formula, then adding in the Coverage ratio.

The question always comes up, do I need to memorize these ratios? Can I use a cheat sheet? Sure you can use a cheat sheet. But the more you rely on a cheat sheet, the less you know, the more you're going to struggle. You'll see that these ratios come up over and over again. So knowledge of what the terms mean, where the ratio comes from (income statement or balance sheet), if the ratio is made up of numerator or denominator only from the income statement or only from the balance sheet, or one from income statement and one from balance sheet, you should be getting used to all of that. Your color-coded IS/BS Model always guides you in seeing the source of each numerator and each denominator.

Notice the three categories for decision-making listed in the IS/BS Model, upper-right corner:

WORKING CAPITAL changes spontaneously with revenue ?what levels of ca, cl, s-t loans? CAPITAL BUDGETING ?which projects to accept? FINANCING ?how much debt capacity?

Your study of financial ratios should have given you insights into the following questions:

What about WORKING CAPITAL POLICY? Is each account trending up or down over time? Is each account tracking with the industry benchmark, or is it higher or lower?

What about Fixed Assets (the result of CAPITAL BUDGETING POLICY)? Is turnover rising or falling over time? Is turnover tracking with the industry benchmark, or is it higher or lower? Is there an indication about full or partial use of plant capacity, i.e., efficiency? Can a measure of high or low operating leverage (risk) be discerned?

What about FINANCING POLICY? Is interest coverage rising or falling over time? Is interest coverage tracking with the industry benchmark, or it is higher or lower? Is debt capacity being used lightly or heavily? Can a measure of high or low financial leverage be discerned?

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Operating Leverage and Breakeven Levels

Breakeven Analysis and Operating Leverage

Published financial statements do not help us very much if we want to distinguish between fixed and variable costs. Nevertheless, such knowledge, if we had it, would be important. You do have fixed and variable cost breakdowns for your own business, so this lesson tells you how important it is and what you need to know about it. Learning Objectives

1. Understand behavior of variable costs and fixed costs 2. Understand the double-edged sword of operating leverage 3. Understand difference between operating leverage and financial leverage

Breakeven Analysis

You may want to know, for each year of a business plan, what minimum level of revenue is needed to cover the costs of doing business. In other words, the break-even level of revenue is where you have zero before tax profit, but where all operating and financial expenses are covered. A complete discussion of break-even levels requires understanding of the behavior of fixed costs and variable costs. Some of the expense items listed on the income statement are fixed, that is, they stay at the same level no matter what the revenue is. An example of a fixed cost is rent. When the doors are open for business, rent does not rise or fall as revenue rises or falls. In contrast, other expense items on the income statement are variable costs, that is, they vary up and down as revenue volume varies up and down. An example of that is electricity used to power production machines. Be aware that even fixed costs are variable over the long run, such as an increase in rent when you move to a larger building. Breakeven Chart Below is the classic breakeven chart, plotting revenue against fixed cost, variable cost, and total cost. Where the revenue line intersects with the total cost line, profit is zero, defining the breakeven level of revenue.

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Notice that

the fixed cost line steps up, indicating that growth in the business leads to increased overhead

the variable cost line starts at zero the total costs line sums variable and fixed cost, and starts at the minimum level

of fixed cost the revenue line starts at zero and is steeper than the cost lines breakeven is defined as zero profit, where revenue equals total cost

Breakeven PointRevenue

Cost ProfitTotal Cost

LossVariable Cost

Fixed Cost

Volume (Units)

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Fixed vs. variable costs Look at the income statement. Think about the nature of each of these categories. Ask yourself: To what extent are these costs fixed? In the long run, all costs are variable because even salaried employees can be fired, leases can be broken, buildings can be sold, and factories can be expanded. Legacy companies such as airlines use bankruptcy law to reduce fixed cost by rescheduling debt service payments, revising contractual terms of leases, rewriting collective bargaining agreements covering wages, health care, and pensions. For cost of goods sold, part of it is fixed and part variable. Only knowledge of the specifics behind a particular business will provide an estimate of the breakdown. Foremen's salaries, a portion of assembly-line laborers' salaries, a portion of plant maintenance cost, and a portion of the heat and light bill can all be considered fixed costs. No matter what fluctuations occur in revenue, the business will continue to operate, and expenses will be incurred. The portion of cost of goods sold that is not fixed is variable. That means the materials used in the production process, the electricity used by the machines, and the workers' salaries that are directly related to the volume of production are variable. General overhead is partly fixed and partly variable. Any personnel subject to layoff constitute variable costs, but there are limits to laying off experienced personnel who may not be available for rehiring when business picks up. It may be short-sighted to attempt to convert fixed costs into variable costs during temporary periods of slow business, because gearing back to full production may cost more than was saved, or may be hampered by not being able to rehire qualified personnel. For example, firing people will cost you in terms of reputation (people will be less willing to work for you and may demand greater compensation to do so), retraining costs and overall morale. Fixed cost, variable cost, and risk It can be said that high fixed-cost businesses are more risky than low fixed cost businesses. With high fixed costs, it is easier for a decline in revenue to result in a loss, because fixed costs must be paid even when revenue drops. A business with low fixed costs, however, can suffer a much larger drop in revenue before a loss occurs, because as its revenue fall, most of the costs of operating fall along with them. Therefore, keep in mind the magnification effect behind the relationship of fixed costs to total costs.

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The box below demonstrates operating leverage. Company A has $200 of fixed costs. As its revenue doubles from one year to the next, its operating profit triples. Company B has no fixed costs, only variable costs. As its revenue doubles from one year to the next, its operating profit doubles the same proportion as the revenue increase. In contrast, Company A had a magnified increase in its operating profit, tripling when revenue doubled. This is how operating leverage works. The presence of fixed costs causes a magnified change in operating profit when revenues change. Dont forget that it works both ways the change in operating profit is magnified on the downside as well as the upside. That is why it involves risk.

Summary Operating leverage is an under-appreciated aspect of financial management. Much more attention is paid to financial leverage, which is a big oversight. The significance of operating leverage is, the greater the proportion of fixed operating costs to operating total costs, the greater will be the change in EBIT when sales change. With General Motors having very heavy fixed costs because of its labor contracts, a given percentage of falling sales creates a magnified fall in EBIT. If 100% of costs were variable, they would rise and fall in proportion to rises and falls in sales. Leverage is a double-edged sword. When it cuts with you, its good because a given percentage change in sales generates a magnified percentage change in profit. When it cuts against you, the fall in sales, percentage-wise, generates a magnified drop in profit. Most companies have more control over their financial leverage than over their operating leverage. The fixed cost-variable cost relationship is determined to a great extent by the nature of the industry. Modern auto manufacturers have sophisticated plants, which imply high fixed cost. If they assembled the vehicles under a canvas shed behind a barn, using itinerant labor and hand tools, hardly any of their costs would be fixed.

Operating Leverage Company A Company B

YEAR 1 YEAR 2 YEAR 1 YEAR 2Revenue 1000 2000 1000 2000Fixed cost 200 200 0 0Variable cost 600 1200 800 1600Operating profit 200 600 200 400

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CHAPTER 3 FORECASTING FINANCIAL STATEMENTS &

DETERMINING EXTERNAL FINANCING NEEDED Learning Objectives

1. Use financial ratios as the basis of financial statement forecasts 2. Know that the forecast is driven by the anticipated growth rate in sales 3. Understand why and how the forecast reveals how much external financing is

needed to sustain the business plan portrayed in the forecast 4. Know difference between accounts that change spontaneously with sales and

those that change only when policy changes 5. Learn how to perform and interpret financial statement forecast in an Excel

spreadsheet

Percentage-of-Sales Forecasting of Financial Statements & Determining External Financing Needed

This presentation draws on the previously discussed concept of sources and uses of funds:

The number at the bottom of the income statement, profit reinvested in the business, is a source of funds (as long it is a positive number not a loss).

It is added into the equity side of the balance sheetthe sources of funds side, along with increases in current liabilities, another source of funds.

Increases in the asset accounts, current assets and long-term assets, are uses of funds, those needed to grow the business.

Then the two sides are totaled, with the plug figure making up the difference, where uses exceed sources, showing external financing required

In the event that sources exceed uses, which may occur when a business is not growing (a cash cow), the excess goes into cash. Thats why businesses that are not growing, and are not increasing their assets, but remain profitable, are called cash cows.

This chapter presents two ways to perform percentage of sales forecasting.

1. First, a short-form forecasting approach is designed to explain the concept and methodology. It is directed a forecasting beginners who need to start with the basics; it is more for pedagogy than it is for applications, because it is pared down and simplified.

2. Then, a long-form forecasting approach is presented which has the depth and complexity of a full-blown forecasting model.

The Short-Form Forecasting Model The template below shows a short-form forecasting model for Leahy Bread Company, a chain of bakeries with 1,027 locations. Notice 11 rows of income statement data followed by 13 rows of income statement data, ending with a single row labeled External Financing Needed. In the three left-hand columns, you see two years of history, 2010 and 2011. In the three right-hand columns, you see a single forecast year, 2012. Everything is on a single page of 32 rows and 7 columns, so you can see it all at once, without flipping pages back-and-forth or scrolling through Excel. (By comparison, the Long-Form Forecasting Model has 131 rows and 18 columns.)

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Leahy Bread Company (LBC) is growing and building new bakeries. Revenues in 2011 were $828,971,000, with Net Income of $42,011,000, a return on sales of 6%, down from 8% in 2010. It has a term loan of $241,940,000, a big increase from the previous year; much of it used to build new stores as Property, Plant and Equipment grew to $495,000,000 in 2011, an increase of $226,191,000 from 2010, a 84% increase.

The Financial Director wants to know how much external financing will be needed, either debt or equity, as of the end of 2012, so he uses the Short-Form Forecasting Model to get a quick forecast. In Columns D and E, he enters the assumptions required for the forecast based on 2011 historical results. He could use averages of both 2010 and 2011 instead, or he could adjust any of the inputs based on his own judgment and knowledge of the business and economic conditions. This is how he did it:

1. The forecast is driven by a planned 20% increase in revenues, entered in cell E5. That percentage increase is high because of revenue from recently built stores.

2. The ratio of cost of goods sold to revenue was 75.8% in 2011, but he lowers it to 70% based on expected cost decreases for raw materials.

3. Depreciation is not driven by revenue as was cost of goods sold. Instead, it is driven by the amount of depreciable assets, plant, property, and equipment. The assumption is that depreciation will be 12.5% of PPE, entered as a number in E7.

4. E8 gets the ratio of g&a expense to revenue, C8 divided by C5, 7.7%, but this is increased to 10% to allow for more advertising.

5. Interest expense in row 11 is 7% of the expected term loan outstanding during 2012. New financing is unknown until the finance director knows if more borrowing

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A B C D E F G(000) omitted 2010 2011 2012

history history forecast assumptions inputs formula forecastNumber of Bakeries 877 1,027INCOME STATEMENTS:Revenue 640,275 828,971 target growth rate 20.0% =C5*(1+E5) 994,765Cost of Goods Sold 474,796 628,534 ratio: cgs/revenue 70.0% =E6*G5 696,336Depreciation 33,011 44,166 $: 12.5% of ppe 61,875 =0.125*C23 61,875General and Administrative 50,240 63,502 ratio: g&a/revenue 10.0% =E8*G5 99,477Total Expenses 558,047 736,202 =G6+G7+G8 857,687Operating Profit (EBIT) 82,228 92,769 =G5-G9 137,078Interest Expense 3,246 16,931 7% of 2012 term loan =0.07*G8 16,936Pretax Profit 78,982 75,838 =G10-G11 120,142Tax 29,995 33,827 ratio: tax/pretax profit 44.6% E12*G12 53,589Net Income 48,987 42,011 G12-G13 66,554

BALANCE SHEETS: 2010 2011Cash and Short Term Investments 60,651 72,122 $: same as 2010 =C18 72,122Accounts Receivable 25,158 30,919 ratio: rec/rev per day 30.0 =E19*(G5/365) 81,762Inventory 7,358 8,714 ratio: inv/cgs per day 5.1 =E20*(G6/365) 9,654Prepaid Expenses 9,607 15,863 $: 12,400 given given, no formula 12,400Current Assets 102,774 127,618 =sum(G18.G21) 175,938Net Property, Plant and Equipment 268,809 495,000 $: 640,000 given given, no formula 640,000Total Assets 371,583 622,618 =sum(G22.G23) 815,938

Accounts Payable 8,222 10,842 ratio: pay/cgs per day 6.30 =E26*(G6/365) 12,012Current Liabilities 8,222 10,842 =g26 12,012Term Loan 46,383 241,940 term loan in place given, no formula 241,940Total Liabilities 54,605 252,782 =G27+G28 253,952Stockholder's Equity 316,978 369,836 previous+net income =C30+G14 436,390Total Liabilities & Equity 371,583 622,618 =G29+G30 690,341EXTERNAL FINANCING NEEDED EFN result =G24-G31 125,596

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will occur. He does not know if more borrowing will occur until this forecast of EFN is completed.

6. The income tax rate in E13 is calculated by dividing C13 by C12. 7. Cash and short term investments in row 18 does not change. 8. E19 gets a much higher ratio of receivables to revenue per day instead of 13.6 days

in 2011. Increased catering and more commercial accounts will cause a longer collection period, 30 days.

9. Inventory is perishable and turns rapidly, so E20 gets the ratio of inventory to cost of goods sold per day of 5.1 days.

10. Prepaid expenses is a given, 12,400 in G21, because it is expected to fall to this level at the end of 2012.

11. Property, plant, and equipment will increase from 495,000 at the end of 2011 to 640,000 at the end of 2012, so 640,000 is entered in G23.

12. Payables are based on the 2011 level of 6.3 days. 13. The term loan remains at 241,940, so that amount goes into G28. 14. Stockholders equity is the sum of the previous years amount plus the net

income for the current year, so F30 gets the sum of C30 plus G14. If dividends are paid in cash, F14 must be reduced by the amount of the dividends.

15. The final step is deducting the total of USES of FUNDS (G24) from SOURCES OF FUNDS (G31) to get EXTERNAL FINANCING NEEDED. Total Assets are the total of funds used in the business the amount that must be invested to generate the revenue on the income statement. Total Liabilities and Equity is the sources of funds, where the money comes from. In this forecast, USES are $125,596 higher than SOURCES, meaning that that much money must be raised from either debt or equity financing by the end of 2012.

You just witnessed the process of making a forecast, from beginning to end. Data from the past was used in combination with judgment about the future based on knowing the business. Realize that the bullet points in the step-by-step process listed above can be categorized in two ways:

1. Those that are based on ratios, such as rows 5 (revenue), 6 (cost of goods sold), 8 (general and administrative expense), 13 (tax), 19 (receivables), 20 (inventory), and 26, (payables). For each of these entries, the input in Column E either has a ratio based on historical experience or it is overridden by expert judgment; then a formula in Column F does the calculations, using the input in Column E. Financial analysts refer to these entries as spontaneously changing as revenues change; they are revenue driven.

2. Rows 7, 11, 18, 21, 23 and 28 do not have inputs in Column E because they are not driven by historical ratios (or revised based on expert judgment) used in the formulas in Column F, but entered directly in Column F as amounts of money. These entries do not change spontaneously with revenues, but must be determined by managers.

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The Long-Form Forecasting Model (LFFM) The forecasting process results in projected income statements for the next five years, 2012-2016. Forecast for shorter or longer periods by deleting or adding columns or leaving them blank. Starting with the first row of the income statement, revenue, and go down row-by-row, entering your educated guess in each of the assumption cells, based on historical ratios and intentions about the future. Then, you do he same thing for the balance sheet, working row-by-row. The forecasts are in nominal terms, with inflation already imbedded in the forecasted growth rate. You can control the assumption for each of the rows and each of the time periods rather than using the same one across all periods as some forecasting models do. Also, notice that the number of accounts in the financial statements is extensive - rows labeled other lets you customize to some extent, as long as the formulas do what you intend them to do. Always be aware of what the formulas in the forecast cells, Columns M.Q, are doing with the assumptions you enter in Columns H.L. (some columns not shown, best viewed at 150% or 175% magnification, go to Template Set.xls for all-column view)

Step-by-Step Forecast of Income Statement

1. Enter data from historical income statements in Columns B-F. The labels in Column A in the Long-Form Forecasting Model may not exactly match the labels in the statements you are working from, so it will be necessary to fit the source data to the model; use catch-all Other category as necessary. Be careful not to disturb

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A E F G H I J K L M N OINCOME STATEMENT .forecast assumptions.. .forecast..

PERIOD -1 0 1 2 3 4 5 1 2 3JANUARY 1-DECEMBER 31 2010 2011 2012 2013 2014 2015 2016 2012 2013 2014

0.5Revenue 869.5 1224.0 revenue growth rate 10.0% 12.0% 12.0% 12.0% 8.0% 1346.4 1508.0 1688.9Cost of sales (661.9) (797.0) cost of sales/revenue 66.0% 67.0% 64.0% 63.0% 63.0% (888.6) (1010.3) (1080.9)Gross profit 207.6 427.0 457.8 497.6 608.0Other operating income 6.7 10.1 estimated amount 10.1 10.1 10.1 10.1 10.1 10.1 10.1 10.1Distribution costs (52.7) (108.3) cost/revenue 8.8% 8.0% 7.2% 6.5% 6.0% (119.1) (120.6) (121.6)Administrative costs (84.4) (149.1) cost/revenue 12.2% 12.2% 12.2% 12.2% 12.2% (164.0) (184.0) (206.0)Depreciation & amortization expense 0.0 0.0 % of ppe 7.5% 7.5% 7.5% 7.5% 7.5% (65.4) (65.4) (65.4)Other operating costs (17.7) (23.4) cost/revenue 1.9% 1.9% 1.9% 1.9% 1.9% (25.7) (28.7) (32.1)Restructuring costs 0.0 (18.3) estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total operating costs (810.0) (1086.0) (1252.8) (1398.9) (1496.0)Profit from operations (EBIT) 59.5 138.0 93.6 109.0 192.9Interest, financing expense (33.0) (36.7) 0.0 0.0 0.0Income from investments 1.7 15.7 estimated amount 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0Disposal of operations 0.0 8.5 estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Profit before tax 28.2 125.5 98.6 114.0 197.9Income tax (4.4) (19.6) average tax rate 15.6% 15.6% 15.6% 15.6% 15.6% (15.4) (17.8) (30.9)Profit after tax 23.8 105.9 83.2 96.2 167.0Minority interest (0.1) (0.6) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Net profit 23.7 105.3 83.2 96.2 167.0Dividends (8.0) (5.0) payout ratio 10.0% 15.0% 20.0% 25.0% 25.0% (8.3) (14.4) (33.4)Other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Reinvested in the business 15.7 100.3 74.8 81.8 133.6

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formulas, entering data only in blank data-entry cells. Remember that income statement entries represent flows during the time period.

2. Estimate revenue growth H8.L8 as a percentage for each year of the five-year planning periods beyond the base year in Column F. The growth rates set here combine unit and price level increases into a single growth rate.

3. Enter percentages for each of the operating expense items for each time period: cost of sales in H9.L9, distribution costs in H12.L12, and administrative costs in I13.L13. Base them on historical ratios and judgment on their likely behavior in the future. The formulas in the template multiply your assumed ratio by the revenue for that period, the essence of the percentage-of-sales method of forecasting. A complication lies in the assumption that all operating costs are variable with respect to revenue, which simplifies reality. The income statement uses the format of published financial statements, which do not break out fixed and variable costs separately.

4. Other operating income (if any) H11.L11 is entered as a number, not a ratio; no formula is involved. The number entered in the assumption cell is entered in the forecast cell.

5. Depreciation and amortization expense in H14.L14 is forecasted as a percentage of prior year depreciable fixed assets and can be derived from information in the footnotes to published financial statements. Often, depreciation expense is included in cost of goods sold and other expense accounts, and is not shown as a separate item; in that case leave H14.L14 blank.

6. Other operating costs in H15.L15 are left blank unless this category is needed for other items that are forecasted as a percentage of revenue.

7. Restructuring costs, if any, are entered in H16.L16 as a number. 8. Entering interest, financing expense in H19.L19 is challenging. Until the forecast is

complete, the amount of external financing needed is not known. Since the amount of financing is not known, interest expense cannot be known either. For existing loans and debt that will not be repaid during the forecast period, enter interest expense for that debt; for existing loans and debt that will be repaid during the forecast period, enter zero. Enter them as nominal numbers.

9. Income from investments in H20.L20, disposal of operations in H21.L21, H25.L25 minority interest, and H26.L26 other are entered as numbers if these categories are relevant. No formulas are involved; the amount entered in the forecast cell is transferred to the forecast cell.

10. The income tax rate in H23.L23 is based on historical income tax rates and is entered as a percentage.

11. The dividend payout ratio in H28.L28 is based on historical dividend payout ratios. If the dividend is given as a number, convert it into a ratio.

To understand how Excel calculates the forecast, put your cursor on the forecasted cells, Columns M.Q for each row. You will see how the assumption is used in a formula to calculate the forecasted item. Please take special care to recall, just as in the Short-Form Forecasting Model, that some line items forecast with an assumed ratio, others forecast with a number. Where the assumption cell contains a ratio, a formula in the forecast produces the result. Where the assumption cell contains a number, that number is transferred to the forecast cell. For Cells B33.F39, enter data if they are available.

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Step-by-Step Forecast of Balance Sheet Forecast

(some columns not shown, best viewed at 150% or 175% magnification, go to Template Set.xls for all-column view)

The forecasted balance sheets are prepared by entering a reasonable estimate of the projected assumption in each row, just as you did with the income statement forecast. Remember that balance sheet entries represent end-of-period balances. Some balance sheet accounts change spontaneously with changes in revenue; others change only as a result of policies decided by the managers of the business. It is important to distinguish between those accounts that change spontaneously, such as

accounts receivable inventory accounts payable

41424344454647484950515253545556575859606162636465666768697071727374757677787980818283848586878889909192

A E F G H I J K L M N OBALANCE SHEET

.forecast assumptions.. .forecast..PERIOD -1 0 1 2 3 4 5 1 2 3

AS OF DECEMBER 31 2010 2011 2012 2013 2014 2015 2016 2012 2013 2014ASSETS Current assets:Cash & equivalents 1.2 5.6 % of revenue 0.5% 0.5% 0.5% 0.5% 0.5% 6.2 6.9 7.7Investments 29.7 37.2 estimated amount 37.2 37.2 37.2 27.2 27.2 37.2 37.2 37.2Trade receivables 179.5 188.9 days revenues 50.0 52.0 54.0 56.0 58.0 184.4 214.8 249.9Inventory 108.6 117.9 days cost of sales 50 55 55 60 60 121.7 152.2 162.9Other 0.0 0.0 0 0 0 0 0 0.0 0.0 0.0 Total current assets 319.0 349.6 349.5 411.2 457.7Non-current assets: Property, plant & equipment-gross 600.4 722.5 estimated capex 150.0 0.0 0.0 150.0 0.0 872.5 872.5 872.5Accumulated deprec. & amort. (33.6) (62.9) by formula (128.3) (193.8) (259.2)Property, plant & equipment-net 566.8 659.6 744.2 678.7 613.3Investment property 11.4 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0Goodwill 0.1 0.6 0.6 0.6 0.5 0.5 0.4 0.6 0.6 0.5Other 1 167.1 213.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Other 2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total non-current assets 745.4 885.2 756.8 691.3 625.8 Total assets 1064.4 1234.8 1106.3 1102.5 1083.5

LIABILITIES AND EQUITY Current liabilities:Trade & other payables 86.3 141.9 days cost of sales 50 55 60 60 60 121.7 152.2 177.7Retirement benefit obligation 4.5 3.8 estimated amount 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0Tax liabilities 2.0 8.2 %age of curr inc tax 40.0% 40.0% 40.0% 40.0% 40.0% 6.2 7.1 12.4Leases due in 1 year 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5Loans, debt due in 1 year 102.5 111.9 112.0 112.0 112.0 112.0 112.0 112.0 112.0 112.0Other 2.0 8.6 8.6 8.6 8.6 8.6 8.6 8.6 8.6 8.6 Total current liabilities 198.8 275.9 254.0 285.5 316.1Non-current liabilities:Retirement benefit obligation 34.0 30.2 estimated amount 30.2 30.2 30.2 30.2 30.2 30.2 30.2 30.2Deferred tax liabilities 6.4 15.4 estimated amount 15.4 15.4 15.4 15.4 15.4 15.4 15.4 15.4Finance leases due after 1 year 1.2 0.9 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0Loans, debts due after 1 year 474.9 413.1 413.0 413.0 413.0 413.0 413.0 413.0 413.0 413.0Other 0.0 0.0 estimated amount 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total non-current liabilities 516.5 459.6 459.6 459.6 459.6 Total liabilities 715.3 735.5 713.6 745.1 775.7Stockholder's equity: Preferred stock 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Common stock 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0Paid-in surplus 32.1 32.9 estimated amount 32.9 32.9 32.9 32.9 32.9 32.9 32.9 32.9Other 35.1 83.5 estimated amount 83.5 83.5 83.5 83.5 83.5 83.5 83.5 83.5Retained earnings 159.3 259.7 prev r/e + curr reinv prof 334.5 416.3 550.0 Total equity 346.5 496.1 570.9 652.7 786.4Minority interest 2.6 3.2 Total liabilities & equity 1064.4 1234.8 1284.5 1397.8 1562.1

EXTERNAL FINANCING NEEDED: (178.2) (295.3) (478.6)

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and those that change only when management decides to change them, by a change in policy, by an actual decision, such as:

fixed assets (Some analysts increase fixed assets in proportion to increases in revenues. This may be an unwise short cut. It fails to take excess capacity into account. It also fails to consider that fixed assets are not necessarily scalable to revenue increases.)

short-term borrowing long-term borrowing dividend payout equity repurchase equity issue

Remember that the net working capital accounts of receivables, inventory, and payables are determined by two inputs:

receivables is calculated by revenue per day x number of days of revenues in receivables (collection period) revenue is a spontaneous change, but the days revenues in receivables is a policy issue determined by managers if they want to tighten credit terms, they reduce the number of days, and vice versa.

inventory is calculated by cost of goods sold per day x number of days of cost of goods sold in inventory cost of goods sold changes when revenue changes, but the number of days of cost of goods sold is a policy decision that is adjusted by managers.

payables is calculated by cost of goods sold per day x number of days of payables in cost of goods sold the number of days of payables is a policy decision that is adjusted by managers if they pay their suppliers quickly the number of days is lower.

1. For H47.L47, estimate the minimum cash balance based on the historical trend. For

most businesses, cash is not driven by sales, so this forecast is a rough guestimate. Some analysts prefer to enter a number amount in H47.L47, and change the formulas in M47.Q47 to accept those numbers. Investments in H48.L48 is entered as an amount.

2. Set trade receivables in H49.L49 as the number of days revenue in receivables. As just stated above, the number of days is a policy matter - it can be smaller or larger depending on how generous managers want to be in extending credit to customers. But, once the number of days is set, accounts receivable changes spontaneously with revenues. For example, a 60-day collection period, favored by the marketing department, means that the firm must invest twice as much in receivables compared to a 30-day collection period. No provision for uncollectible receivables is made in this forecast.

3. Set inventory in H50.L50 as the number of days costs of sales in inventory. It can rise or fall throughout the period, depending on judgments about competitive conditions, breadth of product lines, the production cycle, and other relevant factors. But once the number of days is set, inventory behaves spontaneously in response to changes in revenue levels.

4. Use other in H51.L51 if necessary, entering a number which is transferred to the forecast cell.

5. All non-current asset assumptions, except accumulated depreciation in H55.L55, are entered as numbers and are transferred directly to the forecast cells. They do not change spontaneously when revenue changes; they are determined by engineering estimates comparing existing capacity with forecasted capacity. Many

40

businesses have excess plant capacity and are able to increase production without buying new plant, property and equipment. Care should be taken so that production levels implied by revenue do not exceed plant capacity. Increases in fixed assets should be made only for revenue increases requiring production that exceeds existing capacity. When revenue increases solely because of price increases, no additional plant capacity is needed.

6. Accumulated depreciation is calculated automatically; no entry is required. Formulas take depreciation expense from row 14 on the income statement to adjust accumulation depreciation on row 55 of the balance sheet. When the source financial statements do not specify depreciation expense, but include it with cost of goods sold and other expense items, the forecast of depreciation expense (IS) and accumulated depreciation (BS) will not be accurate.

7. H57.H60 contain numerical assumptions for investment property, goodwill, and other. Leave them blank if not relevant.

8. Trade payables in H66.L66 is entered as the number of days cost of sales; it changes spontaneously with sales. For example, a 10-day payment period may mean that the firm can take advantage of discounts offered by suppliers if they receive payment quickly. But, since accounts payable is a source of funds (supplier financing), as the payment period falls, the firm must find other sources of financing if it reduces its payment period. Financing not provided by trade credit must be provided elsewhere.

9. Retirement benefit obligation, if known, is entered as a number in H67.L67. 10. Tax liabilities in H68.L68 is entered as a percentage of income tax on the income

statement. It represents income tax due to the government. 11. Leases dues in one year in H69.L69 and loans due in one year in H70.L70 are

entered as numbers indicating the outstanding amount at the end of the time period. These numbers can be entered as zeroes, consistent with their status as current liabilities, due in one year. After external financing needed is calculated, financial managers will decide how much of that external financing need can be provided by short term leases and borrowing.

12. Retirement benefit obligation in H74.L74 and deferred tax liabilities in H75.L75 are entered as numbers, if known and relevant.

13. Leases and loans in H76.L76 and H77.L77 include only items that are outstanding in the base year and will not be repaid in the forecast years. Reduce the lease amount by annual payments scheduled. Reduce the loan amount by annual principal payments scheduled.

14. Other in H78.L78, if any, is entered as a number. 15. Entries in H82.L85 for preferred stock, common stock, paid-in-surplus, and other

are entered as numbers from the base year. New financing should not be entered because it depends on the external financing needed, the result of the forecast, and decisions by the managers and their advisers.

16. Add Reinvested in the business balance from the income statement forecasts to equity on the balance sheet, linking the income statements with the balance sheets.

17. Retained earnings in H86.L86 needs no entry. It is calculated automatically by summing the previous period retained earnings (row 86) from the balance sheet and current period reinvested in the business (row 30) from the income statement.

18. Enter minority interest in H88.L88 if known and relevant. 19. Examine the total assets (row 62) and the total liability plus equity (row 89) of the

balance sheet. Notice that the two sides do not balance. Usually, in a growing business, the asset side (uses of funds) will show a higher amount than the liability plus equity side (sources of funds), which means that external financing (EFN) is

41

needed. Row 91 subtracts row 62 from row 89, calculating EFN. A positive number for EFN indicates a shortage of uses over sources, telling you that external financing is needed and must be arranged. A negative number of EFN indicates a surplus of sources over uses, telling you that no external financing is needed and that the business will generate cash. IMPORTANT: Since balance sheets cumulate end-of-period balances, the EFN numbers in cells M91.Q91 must be interpreted as cumulative, not additive. This vital is discussed below.

To understand how Excel calculates the forecast, put your cursor on the forecasted cells, Columns M.Q for each row. You will see how the assumption is used in a formula to calculate the forecasted item. Please take special care to recall, just as in the Short-Form Forecasting Model, that some line items forecast with an assumed ratio, others forecast with a number. Where the assumption cell contains a ratio, a formula in the forecast produces the result. Where the assumption cell contains a number, that number is transferred to the forecast cell. Circularity Between Interest Expense (IS) & External Financing Needed (BS) The financial statements forecasted above must be considered as preliminary; they are incomplete. Financing cost, as shown on the projected income statement, measures only the interest on the existing debt. If external financing need is raised from debt sources, financing cos