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Financial Analysis and Planning

INTRODUCTION

This chapter shows us how to use a firm's financial data to analyze past performance and assess
its current financial condition. Financial analysis involves using the accounting statements to
measure and interpret past performance. Past performance, while no guarantee of future
performance, can help us understand the future. The chapter demonstrates the use of financial
ratios and discusses the limitations of financial analysis. Ratios are convenient summary
measures and always have to be viewed with healthy skepticism. The ratios commonly used for
financial analysis, however, help you to ask the right questions about a firm's financial
performance.

The chapter also provides an introduction to financial planning. Growth and financial planning
go hand in hand. Financial planning helps identify the financing requirements needed to fund
growth and the need for external financing.

KEY CONCEPTS IN THE CHAPTER

Five classes of financial ratios are typically used in financial analysis. These are leverage ratios,
liquidity ratios, efficiency ratios, profitability ratios, and market value ratios. Each of these
classes is described briefly below.

Leverage Ratios: These ratios tell us about a firm's financial leverage. Book values are often
used in place of market values. Several debt ratios are used. No generally satisfactory measure
of earnings variability exists, although all financial analysts try to get a handle on it. Some
commonly used leverage ratios are given below.

Debt ratio = (long-term debt + value of leases)/(long-term debt + value of leases

+ equity)

Debt-equity ratio = (long-term debt + value of leases)/equity

Times interest earned = (EBIT + depreciation)/interest

Liquidity Ratios: These ratios attempt to measure the short-run ability of the firm to meet its
current liabilities. Reserve borrowing power may mean more than any of these ratios.
Common liquidity ratios:

Net working capital to total assets = net working capital/total assets

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 Current = current assets/current liabilities

Quick Ratio = (cash + marketable securities + receivables)/current liabilities

Cash ratio = (cash + marketable securities)/current liabilities

Efficiency Ratios: These ratios measure how efficiently the firm uses its assets.

Sales to Assets (Asset Turnover) = sales/average total assets

Days in Inventory = (Average inventory/cost of goods sold) X 365

Average collection period = average receivables/average daily sales

Profitability: More ambiguity exists in these ratios than in any others. One ratio alone is likely
to be misleading; the entire set, and trends, are likely to provide more insights.

Net profit margin = (EBIT - tax)/sales

Return on total assets = (EBIT - taxes)/average total assets

Return on equity = earnings available for common/average equity

Payout ratio = dividends per share/earnings per share

Market Value Ratios: These are often used to measure a firm's performance. Some analysts
prefer them to other performance measures precisely because they use market data and because
capital markets send information to a firm's management. Four market-based ratios are:

Price-earnings ratio = stock price/earnings per share

Dividend yield = dividend per share/stock price

Market-to-book = stock price/book value per share

Tobin's q = market value of assets/estimated replacement cost

Benchmarks: Ratios without benchmarks are not of much use. Among the options are: year by
year for the same firm, one firm to a set of comparable firms, one firm to firms classified in the
same industry, and industry-to-industry and one firm. Be cautious. Also be careful about which
ratios you select; all ratios may be created equal, but some ratios are likely to be more equal than
others.
Accounting Rules and Definitions: An important point to be kept in mind while conducting
financial analysis is that the ratios are based on accounting information produced by the
company’s accountants. Accountants enjoy considerable discretion and flexibility as to the
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treatment of intangible assets as well as many other elements, which go into an accounting
statement. When you calculate financial ratios and make comparisons, you need to look below
the surface to see how particular items have been treated. Some of the items, which could make
significant differences on ratios, depending on how they are treated include:

- Depreciation
- Deferred tax
- Intangible assets
- Goodwill
- Off-balance-sheet debt
- Pensions
- Derivatives
- Foreign accounting practices.

Applications of Financial Analysis: Financial analysis is used to evaluate the creditworthiness

of borrowers. Evidence suggests that failed firms tend to have identifiable financial
characteristics peculiar to themselves several years before they actually fail. Credit analysis of
bonds indicates that financial analysis predicts a large percentage of bond ratings. Financial
ratios have been used successfully to estimate a firm's market-related risk.

DuPont System: This shows the linkages among some profitability and efficiency ratios. The
DuPont equations are expressed in terms of the return on assets (ROA) or the return on equity
(ROE).

Firms would like to earn high ROA. ROA is the product of the sales to assets ratio and profit
margin. Generally, the ratios are determined by the type of industry the firm is in, the level of
competition, and the firm’s own competitive strength. ROE includes the effect of leverage also.
Again, this is a function of the industry and firm’s own choice of leverage.

Financial Planning: Financial plans project the funds requirement for the firm’s projected
growth plan. Normally, firms prepare alternate plans reflecting different scenarios. The primary
objective of the financial plan is ensuring that the firm will have the needed funds to meet the
expansion plans. The basic uses and sources relationship can be used to project the external
funding requirement:

External funds needed = operating cash flow - investment in fixed assets

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 - investment in net working capital - dividends.

These projections can be best carried out using spreadsheet programs. Sophisticated models are
often used, though the models may not emphasize the tools of financial analysis such as present
value, market risk, etc. The simple percentage of sales model can work very well in most cases.

Growth and External Financing: Two measures of growth are often used to indicate the level
of growth that can be financed without having to resort to external financing. The first, internal
growth rate, gives the growth rate that can be sustained without any external financing. This can
be calculated as follows:

Internal growth rate = retained earnings/assets

This can be expressed in an alternate form, which gives greater insight into the measure:

Internal growth rate = (retained earnings/net income) X (net income/equity) X

(equity/assets)
= plowback ratio X return on equity X (equity/assets)

The internal growth rate implies that the firm will not use any external funding. A more
practical measure is the sustainable growth rate, which measures the growth that can be
sustained without any external equity financing.

Sustainable growth rate = plowback ratio X return on equity

WORKED EXAMPLES

1. For 1998, make a thorough financial ratio analysis of Great Tires, Inc. Use the data in the
table below.

Great Tires, Inc. 1998 1997

Balance Sheet
Cash & short-term securities 175 100
Receivables 500 350
Inventories 750 755
Other current assets 100 75
Total current assets 1,525 1,280

Plant and equipment 1,105 1,170

Other long-term assets 150 100

Total assets 2,780 2,550

Debt due 25 35
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Payables 510 405
Other current liabilities 15 10
Total current liabilities 550 450

Long-term debt and capital leases 375 425

Other long-term liabilities 225 175
Preferred stock 250 250
Shareholders' equity 1,380 1,250

Total liabilities & equity 2,780 2,550

Income Statement
Net sales 3,465 3,210
Cost of goods sold 2,252 2,119
Other expenses 346 314
Depreciation 77 62
Earnings before interest and tax (EBIT) 790 715
Net interest 40 46
Tax 285 254
Net income 465 415
Preferred stock dividend 25 25
Earnings applicable to common stock 440 390
Common dividends 260 260
Earnings retained 180 130

Other Financial Information

Market value of equity 6,675
Average number of shares 100
Earnings per share 4.40
Dividends per share 2.60
Share price 66.75

SOLUTION

Leverage ratios:
a. Debt ratio = ($375 + $225)/($375 + $225 + $1,380) = 30.3%
b. Debt-equity ratio = ($375 + $225)/$1,380 = 43.5%
c. Times interest earned = ($790 + $77)/$40 = 21.7 times

Liquidity ratios:
a. Net working capital to total assets = ($1,525 - $550)/$2,780 = 35.1%
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 b. Current = $1,525/$550 = 2.77
c. Quick = ($175 + $500)/$550 = 1.23
d. Cash = $175/$550 = 0.32
e. Interval measure = ($175 + $500)/[($2,252 + $346)/365] = 94.8 days

Profitability or efficiency ratios:

a. Sales to total assets = $3,465/[($2,780 + $2,550)/2] = 1.30
b. Sales to net working capital = $3,465/{[($1,525 - $550) + ($1,280 - $450)]/2} = 3.84
c. Net profit margin = ($790 - $285)/$3,465 = 14.6%
d. Inventory turnover = $2,252/[($750 + $755)/2] = 3.0
e. Average collection period = [($500 + $350)/2]/($3,465/365) = 44.8 days
f. Return on total assets = ($790 - $285)/[($2,780 + $2,550)/2] = 18.9%
g. Return on equity = $440/[($1,380 + $1,250)/2] = 33.5%
h. Payout = $2.60/$4.40 = 59.1%
(1) Plowback = 100% - 59.1% = 40.9%
(2) Growth in equity from plowback = [($4.40- $2.60)/$4.40] X ($4.40/$13.80) = 13.0%

Market value ratios:

a. Price-earnings ratio = $66.75/$4.40 = 15.2 times
b. Dividend yield = $2.60/$66.75 = 3.90%
c. Market-to-book = $66.75/($1,380/100) = 4.8 times

2. The table below contains financial data for Green Grass Mulchers, Inc., manufacturer of the
world-famous Green Thumbers. Calculate a complete set of financial ratios for the company
and make a statement about the financial soundness of the firm.

Green Grass Mulchers, Inc. 1998 1997

Balance Sheet
Cash & short-term securities 125 75
Receivables 438 300
Inventories 750 650
Other current assets 125 75
Total current assets 1,438 1,100

Plant and equipment 1,867 1,450

Other long-term assets 188 100

Total assets 3,493 2,650

Debt due 75 60
Payables 615 375
Other current liabilities 25 15
Total current liabilities 715 450

Long-term debt and capital leases 1,191 425

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Other long-term liabilities 305 175
Preferred stock 150 150
Shareholders' equity 1,132 1,000

Total liabilities & equity 3,493 2,650

Income Statement
Net sales 3,985 3,586
Cost of goods sold 2,815 2,590
Other expenses 484 436
Depreciation 93 73
Earnings before interest and tax (EBIT) 593 487
Net interest 127 49
Tax 177 166
Net income 289 272
Preferred stock dividend 14 14
Earnings applicable to common stock 275 258
Common dividends 140 126
Earnings retained 135 132

Other Financial Information

Market value of equity 2,485 1,952
Average number of shares 70 70
Earnings per share 3.93 3.69
Dividends per share 2.00 1.80
Share price 35.50 27.88

SOLUTION

The ratios are shown in the table below. Also shown are data for the firm's past 5 years of
operations and for the industry. The last two columns show deviations from the 5-year average
and from the industry. Although hardly conclusive, these comparisons suggest that the company
is doing okay, not much better on average and not much worse.

Green Grass Mulchers, Inc.

Prior Deviations from.
5-year Industry Firm Industry
1998 Average Average Average Average
Leverage ratios:
Debt ratio 56.9% 37.6% 30.7% -19.3% -26.2%
Debt-equity ratio 132.2% 57.0% 60.0% -75.2% -72.2%
Times interest earned 5.4 4.1 7.1 - 0.6 2.4

Liquidity ratios:
Net working capital 20.7% 22.0% 30.0% 1.30% 9.30%
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 to total assets
Current 2.01 2.25 2.35 0.24 0.34
Quick 0.79 0.83 1.01 0.04 0.22
Cash 0.17 0.17 0.24 0.00 0.07
Interval measure 62.3 54.8 110.1 -7.5 47.8

Profitability or efficiency ratios:

Sales to total assets 1.30 1.63 1.34 0.33 0.04
Sales to net working capital 5.80 5.52 4.23 -0.28 -1.57
Net profit margin 10.4% 11.5% 10.3% 1.1% -0.1%
Inventory turnover 4.0 3.8 3.4 -0.2 -0.6
Average collection period 33.8 35.1 31.6 1.3 -2.2
Return on total assets 13.5% 19.9% 17.9% 6.4% 4.4%
Return on equity 25.8% 21.3% 19.2% -4.5%. -6.6%
Payout 50.9% 54.7% 52.4% 3.8% 1.5%
Plowback 49.1% 45.3% 47.6% -3.8% -1.5%
Growth in equity 11.9% 10.9% 11.3% -1.0% -0.6%
from plowback

Market value ratios:

Price-earnings 9.0 14.4 10.5 5.4 1.5
Dividend yield 5.63% 3.01% 4.32% -2.62% -1.31%
Market-to-book 3.1 4.7 3.5 1.6 0.4

3. Brinkley Corp. had sales of $500 million last year and total assets of $400 million. The
company earned a net income of $50 million and paid dividends of $25 million. The net
equity for the firm was $200 million. Calculate the internal growth rate and the sustainable
growth rate for the firm.

Net income = $50 million - $25 million = $25 million

Internal growth rate = Net income/Assets = $25 million/$400 million = 6.25 percent
Plowback ratio = $25 million/$50 million = 0.50
ROE = $50 million/$200 million = 25 percent
Sustainable growth rate = plowback ratio X ROE = 0.5 X 25 = 12.5 per cent.

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SUMMARY

The chapter describes the five classes of financial ratios commonly used in financial analysis.
Of course, financial analysis is a lot more than the ratios. The ratios should be used to analyze
past performance, for assessing current financial standing, and to understand the future
prospects. Remember that the ratios provide answers. Often, they provide the basis for asking
questions. One has to be careful and selective in the use of financial ratios.

The chapter also provides a brief look into financial planning. Financial planning helps a firm
prepare for meeting the financial needs for future growth. Simple percentage of sales model can
work well. More sophisticated models are available, but they suffer from the limitation that they
are not based on finance theory. Two useful growth measures, the internal growth rate and the
sustainable growth, can tell you the extent of the growth that can be pursued with no external
funding or no external equity financing.

LIST OF TERMS

Average collection period Net profit margin

Current assets Net working capital
Current liabilities Payout ratio
Current ratio Price-earnings ratio
Debt ratio Quick ratio
Debt-equity ratio Return on equity (ROE)
Dividend yield Return on total assets (ROA)
Inflation premium Sales-to-assets ratio
Internal growth rate Sustainable growth rate
Leverage ratio Tobin’s q

EXERCISES

Fill-in Questions

1. The difference between current assets and current liabilities is called

____________________.

2. _________________ measure the firm's financial leverage.

3. Long-term debt and the value of leases are included in the (numerator, denominator)
________________ of both the __________________ ratio and the _______________ ratio.

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4. Times interest earned is a (liquidity, profitability, leverage) _______________________
ratio.

5. Assets that are in cash or will be turned into cash in the near future are called _____________.

6. Liabilities that are to be paid in the near future are called ______________________.

7. The _____________________ ratio is the same as the _______________________ ratio

except inventories and "other current assets" are dropped from the numerator.

8. The extent to which a firm's assets are being turned over is captured by the
_______________ ratio.

9. ___________________ measures the percentage of sales, which finds its way into profits.

10. The speed with which customers pay their bills is measured by the ____________________.

11. One overall measure of financial performance is captured by the _________________ ratio.

12. The _________________ ratio is computed by relating earnings available to common to

(average, ending, beginning) _________________ equity.

13. Nuts, Inc.'s cash dividend per share was $2.40 and its earnings per share were $6.20, so its
____________ ratio was 38.7 percent. Nuts, Inc.'s market price per share is $75.25, so its
__________________ ratio is 12.14 times and its _________________ is 3.19 percent.

14. If Nuts, Inc.'s equities and liabilities have a market value of $175 million and a replacement
cost of $160 million, its _________________ is 1.09.

15. As with share prices, earnings seem to follow a(n) __________________; there is almost no
relationship between a company's earnings growth in one period and the rest.

16. If finished goods that would have produced a profit of $1,000 are sold at prices to reflect a
10 percent inflation rate, the incremental gain is called ______________________ and is
$________________.

17. The growth that can be financed without resorting to any external equity financing is called
the ________________.

18. The growth rate that can be achieved without resorting to any external financing is the
______________.

Problems

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1. For 1998, make a thorough financial ratio analysis of Beauty, Inc. Use the data in the table
below.

Beauty Inc. 1998 1997

Balance Sheet
Cash & short-term securities 150 135
Receivables 480 435
Inventories 860 775
Other current assets 110 100
Total current assets 1,600 1,445

Plant and equipment 1,611 1,420

Other long-term assets 150 100

Total assets 3,361 2,965

Debt due 55 45
Payables 615 565
Other current liabilities 45 30
Total current liabilities 715 640

Long-term debt and capital leases 375 425

Other long-term liabilities 225 175
Preferred stock 100 100
Shareholders' equity 1,946 1,000

Total liabilities & equity 3,361 2,965

Income Statement
Net Sales 5,750 5,180
Cost of goods sold 4,125 3,710
Other expenses 750 515
Depreciation 64 57
Earnings before interest and tax (EBIT) 811 898
Net interest 43 47
Tax 292 323
Net income 476 528
Preferred stock dividend 9 9
Earnings applicable to common stock 467 519
Common dividends 198 198
Earnings retained 269 321

Other Financial Information

Market value of equity 6,188
Average number of shares 110
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Earnings per share 4.25
Dividends per share 1.80
Share price 56.25

2. The table below contains financial data for Garden Reach Shop, Inc., manufacturer of the
Slow Release Plant Food. Calculate a complete set of financial ratios for the company, and
make a statement about the financial soundness of the firm.

Garden Reach Shop, Inc. 1998 1997

Balance Sheet
Cash & short-term securities 180 160
Receivables 520 475
Inventories 995 890
Other current assets 100 95
Total current assets 1,795 1,620

Plant and equipment 2,500 2,650

Other long-term assets 750 675

Total assets 5,045 4,945

Debt due 75 60
Payables 615 375
Other current liabilities 25 15
Total current liabilities 715 450

Long-term debt and capital leases 3,090 3,070

Other long-term liabilities 305 175
Preferred stock 250 250
Shareholders' equity 685 1,000
Total liabilities & equity 5,045 4,945
Income Statement
Net sales 6,750 5,925
Cost of goods sold 5,800 5,355
Other expenses 450 575
Depreciation 150 30
Earnings before interest and tax (EBIT)) 350 -35
Net interest 416 397
Tax -25 -164
Net income -41 -268
Preferred stock dividend 33 33
Earnings applicable to common stock -74 -301
Common dividends 0 14
Earnings retained -74 -315

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Other Financial Information
Market value of equity 167 840
Average number of shares 70 70
Earnings per share -l.06 -4.30
Dividends per share 0.00 0.20
Share price 2.38 12.00

3. Green Grocers Corp. had sales of $220 million last year. The company’ sales to assets ratio
was 1.25. The net income for the year was $11 million. The company paid a dividend of $3
million. The ROE was 12.5 percent. Calculate the internal growth rate and the sustainable
growth rate.

Essay Questions

1. Explain the use of the DuPont system.

2. Describe how a bank lending officer might use ratio analysis. Select five ratios that would
be most useful for the purpose.

3. Discuss the statement – “Financial planning models have no finance in them.”

4. What connection is there among the payout ratio, plowback, return on equity, and growth in
equity? Explain fully.

5. What is the practical significance of internal growth rate and sustainable growth rate?
Which, if any, should be the goal for growth for a company?

6. You are a newly hired financial analyst at an investment firm specializing in web commerce.
Your first task is to review all the studies the firm produced and to recommend a system by
which to compare individual companies. You are somewhat perplexed because the
"industry" is not well defined and most of the companies are new and small and do not have
any earnings. What do you do? Do the ratios contained in the text help? Explain fully.

ANSWERS TO EXERCISES

Fill-in Questions

1. Net working capital 10. Average collection period

2. Leverage ratios 11. Return on total assets
3. Numerator; debt; debt-equity 12. Return on equity; average
4. Leverage 13. Payout; price-earnings; dividend yield
5. Current assets 14. Tobin’s q
6. Current liabilities 15. Random walk
7. Quick; current 16. Inventory profit; $100
8. Sales to assets 17. Sustainable growth rate
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9. Net profit margin 18. Internal growth rate

Problems

1. Beauty, Inc.
Leverage ratios:
a. Debt ratio = ($375 + $225)/($375 + $225 + $1,946) = 23.6%
b. Debt-equity ratio = ($375 + $225)/$1,946 = 30.8%
c. Times interest earned ($811 + $64)/$43 = 20.3 times

Liquidity ratios:
a. Net working capital to total assets = ($1,600- $715)/$3,361 = 26.3%
b. Current = $1,600/$715 = 2.24
c. Quick = ($150 + $480)/$715 = 0.88
d. Cash = $150/$715 = 0.21
e. Interval measure = ($150 + $480)/[($4,125 + $750)/365] = 47.2 days

Profitability or efficiency ratios:

a. Sales to total assets = $5,750/[($3,361 + $2,965)/2] = 1.82
b. Sales to net working capital = $5,750/{[($1,600 - $715) + ($1,445 - $640)]/2} = 6.80
c. Net profit margin = ($811 - $292)/$5,750 = 9.0%
d. Inventory turnover = $4,125/[($860 + $775)/2] = 5.0
e. Average collection period = [($480 + $435)/ 2]/($5,750/365) = 29.0 days
f. Return on total assets = ($811 - $292)/[($3,361 + $2,965)/2] = 16.4%
g. Return on equity = $467/[($1,946 + $1,625)/2] = 26.1%
h. Payout = $1.80/$4.25 = 42.4%
(1) Plowback = 100% - 42.4% = 57.6%
(2) Growth in equity from plowback = [($4.25 - $1.80)/$4.25] X ($4.25/$17.69) = 13.8%

Market value ratios:

a. Price-earnings = $56.25/$4.25 = 13.2 times
b. Dividend yield = $1.80/$56.25 = 3.20%
c. Market-to-book = $56.25/($1,946/110) = 3.2 times

2. Garden Reach Shop, Inc.

Prior Deviations from:
5-year Industry Firm Industry
1998 Average Average Average Average
Leverage ratios:
Debt ratio 83.2% 37.6% 30.7% -45.6% -52.5%
Debt-equity ratio 495.6% 57.0% 60.0% -438.6% -435.6%
Times interest earned 1.2 4.1 7.1 3.3 6.3

Liquidity ratios:
Net working capital 21.41% 22.0% 30.0% 0.59% 8.59%
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 to total assets
Current 2.51 2.25 2.35 -0.26 -0.16
Quick 0.98 0~83 1.01 -0.15 0.03
Cash 0.25 0.17 0.24 -0.08 -0.01
Interval measure 40.9 54.80 110.10 13.9 69.2

Profitability or efficiency ratios:

Sales to total assets 1.35 1.63 1.34 0.28 -0.01
Sales to net working capital 6.00 5.52 4.23 -0.48 -1.77
Net profit margin 5.6% 11.5% 10.3% 5.9% 4.7%
Inventory turnover 6.2 3.8 3.4 -2.4 -2.8
Average collection period 26.9 35.1 31.6 8.2 4.7
Return on total assets 7.5% 19.9% 17.9% 12.4% 10.4%
Return on equity -8.8% 21.3% 19.2% 30.1% 28.0%
Payout 0.0% 54.7% 52.4% 54.7% 52.4%
Plowback 100.0% 45.3% 47.6% -54.7% -52.4%
Growth in equity from -10.8% 10.9% 11.3% 21.7% 22.1%
plowback
Market value ratios
Price-earnings -2.2 14.4 10.5 16.6 12.7
Dividend yield 0.00% 3.01% 4.32% 3.01% 4.32%
Market-to-book 0.3 4.7 3.5 44 3.2

3. Net income = $11 million

Retained earnings = $11 million- $3 million = $8 million
Assets = sales/(sales/asset ratio) = $220 million/1.25 = $176 million
Internal growth rate = retained earnings/assets = $8 million/$176 million = 4.55 percent
Plowback ratio = $8 million/$11 million = 0.73
Sustainable growth rate = plowback X ROE = 0.73 X 12.5 = 9.13 percent

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