Financial Planning and Forecasting

Transcription

1 Financial Planning and Forecasting 1. Preamble Why planning? It is important to understand why planning and forecasting are central to managing the finances of any organization. Planning is a human activity par excellence, associated with intelligent economic behavior. When we plan, we wish to represent in our minds possible future events that have not yet unraveled. A plan is nothing more than a mental simulation of some slice of reality, aimed at devising a course of action for achieving a specific goal. Let it be clear: planning, although making use of forecasting techniques does not foretell the future. Crystal balls are for psychics, not planners. A good planner is not the one who can predict the future; but rather the one who can explain with a reasonable degree of confidence what needs to be done if things unfold in a certain way. A well made plan is merely allowing us to glimpse ahead at what to expect if such and such things happen. And when such and such events do happen, we can somewhat prepare to deal with them. This is why planning is a great tool for dealing with uncertainty: not because we know what will happen, but because by pretending -we learn to deal with what might happen. As such, planning requires a self-consistent model of reality. Since economic reality itself would be too difficult (more like impossible, and that if you're an optimist) to represent in a self-consistent manner, we should settle for a simplified model. To be more specific, let us settle for a simplified model of the corporation. How simplified? The simpler the model the greater the chance of maintaining self-consistency. A self-consistent model is one that we can understand logically; one that has no internal contradictions; one that looks much like a puzzle in which all pieces fall into place, that is, there is no piece of the puzzle that does not fit (otherwise we would be left scratching our heads). To make the planning process more palatable, let us begin with the simplest model possible: a corporation represented by an income statement in which earnings are equal to sales minus costs; and a balance sheet in which debt and equity represent claims on total assets. From these variables we can also estimate several basic measures of operating performance: debt-toequity ratio, total debt ratio, profit margin, ROA, ROE, dividend per share, book value of equity per share, and cash flow to claimholders. In real life the number of variables generating uncertainty is huge. Almost every aspect of our economic and social environment seems subject to uncertainty. In our model however, if too many variables were to change at random, we could not make any sense of our plan - in fact the whole exercise would become futile. We require that a majority of variables move deterministically so that we can make meaningful predictions. The balance sheet and income statement represent precisely such a model: almost all variables in the model change in a predictable manner, having specified mathematical relationships among them. That leaves one important variable to roam freely: the volume of sales. Why sales, and not costs? Because sales follow demand, a variable over which we have little control. In fact the volume of sales drives our entire plan. Once we forecast sales all other variables become predictable given the specification of our model. 1

2 2. The Simplest Planning Example Known to Man SimpleToy Inc. is a toy company with the following financial standing. The firm has 100 share outstanding and the board recommends a long-term target capital structure of about 63% (as measured by the proportion of assets financed with debt). Table 2.1 Financial statements and ratios of SimpleToy Inc. Today Sales $5, Costs $3, NI $1, Addition to RE $ Dividend $ Assets $3, Liabilities $2, Equity $1, Total L&E $3, Financing Deficit $0.00 Debt-to-equity % Debt-to-assets 62.86% Assets turnover % Profit margin 30.00% ROA 42.86% ROE % Dividend per share $5.25 Book value per share $13.00 Cash flow to creditors 0 Cash flow to shareholders $ Total CF $ Simulating the future can be fun but it can also become boring. There are gazillions of possible scenarios lurking in the shadows. A great many of them are dull and not very insightful. We would not be learning a great deal from them. Nor do we have enough imagination and time to consider all possible occurrences. We have to direct our simulation towards those instances that carry the most interesting (or even dramatic) consequences for our corporation. This represents one of the most important tenet of the planning philosophy: simulate the most consequential situations, the ones that really matter. Next is an open-ended list of potentially interesting questions to consider: If sales remain flat (no change in sales and costs), what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? This question is relevant because the no-change scenario is arguably the best naïve forecast. We are naturally inclined to believe that the future is likely to be like the past, because we are hardwired to search for recursive patterns all around us. The inordinate number of stock traders who indulge in technical analysis represents the epitome of our propensity for inductive thinking. If sales increase by 40% what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? One has to understand what happens when things are looking up and demand is growing. The percentage has been chosen arbitrarily and for the time being is as good as any other figure. How fast can sales increase before you need to raise external debt or equity? This is an extremely interesting question. The moment we need to access the bond or stock market we are introducing additional uncertainty in our plan. We just made the case that sales are dependent on the demand for the firm's product, which represents a wild card. In the same manner, the demand for the firm's bonds or common stock represents another wild cart. How much can increase in sales can you tolerate before you need to raise external debt or equity, without altering your 2

3 capital structure and dividend policy? As we identify another critical threshold in our simulation, the deterministic predictability of operating performance (not to mention market valuation, which was never deterministically predictable to start with) is taking another hit. A stable and consistent capital structure and dividend policy fall in line with any investor's desire for predictability. The moment we abandon it, we are introducing yet another element of uncertainty. Before we proceed we need to provide additional information. Its role is to maintain our plan simple and free of internal contradictions: Assets and costs vary proportional to sales. This assumption is reasonable because as sales go up it is expected that inputs required to produce the output must be going up as well. This assumption is particularly true for most manufacturing and service firms, but does not hold for producers of knowledge and culture (in their case the marginal cost of producing one additional unit of output is negligible). Moreover, let us assume that the retention ratio is 65%. a. If sales remain flat (no change in sales and costs), what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? Table 2.2 Pro-forma financial statements of SimpleToy (zero growth in sales) Today Next year Change Sales $5, $5, % Costs $3, $3, % NI $1, $1, % Addition to RE $ $ % Dividend $ $ % Assets $3, $3, % Liabilities $2, $2, % Equity $1, $2, % Total L&E $3, $4, % Financing Deficit/Surplus $0.00 Surplus = $ Things to note: There is no change in sales, costs, or net income, yet equity increased by 75% due to the internal accumulation of profits. There is negative financing deficit of $975, i.e., a financing surplus. This means we have enough internal capital to finance additional assets. Financial policy decision: Invest in additional assets Pay an extra dividend Redeem a portion of the outstanding debt 3

4 a.1. Invest $975 in additional assets Table 2.3 Financial statements and ratios of SimpleToy Inc. (zero growth in sales and 28% increase in assets) Today Next year Sales $5, $5, Costs $3, $3, NI $1, $1, Addition to RE $ $ Dividend $ $ Assets $3, $4, Liabilities $2, $2, Equity $1, $2, Total L&E $3, $4, Financing Deficit $0.00 $0.00 Debt-to-equity % 96.70% Debt-to-assets 62.86% 49.16% Assets turnover % % Profit margin 30.00% 30.00% ROA 42.86% 33.52% ROE % 65.93% Dividend per share $5.25 $5.25 Book value per share $13.00 $22.75 Cash flow to creditors 0 0 Cash flow to shareholders $ $ Total CF $ $ Consequences: Assets are increasing (this is trivial) Financial leverage is down, due to the accumulation of internal profits (that is, internally generated equity) Asset utilization ratio is down because the volume of assets is up, yet sales remain flat. Profit margin remains constant ROA is down because the volume of assets is up, yet net income remains the same ROE is down because a)roa is lower, and b)financial leverage is lower - Remember: ROE = ROA(1+D/E) Book value per share is higher Cash flow is made solely of dividends accruing to shareholders 4

5 a.2. Pay an extra dividend Table 2.4 Financial statements and ratios of SimpleToy Inc. (zero growth in sales and extraordinary dividend) Today Next year Change Sales $5, $5, % Costs $3, $3, % NI $1, $1, % Addition to RE $ $ % Dividend $ $ % Assets $3, $3, % Liabilities $2, $2, % Equity $1, $1, % Total L&E $3, $3, % Financing Deficit/Surplus $0.00 $0.00 Debt-to-equity % % Debt-to-assets 62.86% 62.86% Assets turnover % % Profit margin 30.00% 30.00% ROA 42.86% 42.86% ROE % % Dividend per share $5.25 $5.25 Book value per share $13.00 $13.00 Cash flow to creditors 0 0 Cash flow to shareholders $ $1, Total CF $ $1, Consequences: There is no change in assets, liabilities, profitability ratios, etc. Cash flow to shareholders is up dramatically due to the extraordinary dividend. 5

6 a.3. Redeem a portion of the outstanding debt Table 2.5 Financial statements and ratios of SimpleToy Inc. (zero growth in sales and 44.3% decrease in liabilities) Today Next year Change Sales $5, $5, % Costs $3, $3, % NI $1, $1, % Addition to RE $ $ % Dividend $ $ % Assets $3, $3, % Liabilities $2, $1, % Equity $1, $2, % Total L&E $3, $3, % Financing Deficit/Surplus $0.00 $0.00 Debt-to-equity % 53.85% Debt-to-assets 62.86% 35.00% Assets turnover % % Profit margin 30.00% 30.00% ROA 42.86% 42.86% ROE % 65.93% Dividend per share $5.25 $5.25 Book value per share $13.00 $22.75 Cash flow to creditors Cash flow to shareholders $ $ Total CF $ $1, Things to note: There is no change in assets Financial leverage is down: equity is up following the accumulation of internally generated equity, while debt is down, following an early repayment. In other words, retained profits are used to pay down the debt. The firm is undergoing a recapitalization, replacing debt with internal equity. No change in profitability ratios, except ROE: the decrease in financial leverage has an adverse impact on ROE Cash to claimholders is up dramatically following the early debt repayment. 6

7 b. If sales increase by 40% what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? Table 2.6 Pro-forma financial statements of SimpleToy (40% growth in sales) Today Next year Change Sales $5, $7, % Costs $3, $4, % NI $1, $2, % Addition to RE $ $1, % Dividend $ $ % Assets $3, $4, % Liabilities $2, $2, % Equity $1, $2, % Total L&E $3, $4, % Financing Deficit/Surplus $0.00 Deficit = $35.00 Things to note: Assets are up by 40%, yet Total L&E are up by only 39% - following the accumulation of internal equity. Assets grow faster than sources, hence there is a financing deficit of $35. Alternatives: Borrow $35 Raise $35 in external equity 7

8 c. How much can sales increase before you need to raise external debt or equity? Interesting question. We can answer it in two ways: Try to find a formula; or, use trial and error Find a formula: Financing deficit = Increase in Assets - Addition to Retained earnings (2.a) that is: Financing deficit = (Assets)(g) Net Income(Retention)(1+g) (2.b) where: g = rate of growth in sales We want to find g such that the financing deficit is zero, hence we can rewrite (2.b) in the following way: 0 = g + (Net Income/Assets)(Retention)(1+g) (2.c) From here we find g = ROA (Retention)/[1-ROA(Retention)] (2.d) In our example the largest growth rate in sales possible without external financing is: (0.4286*0.65)/( *0.65)= 38.61% Indeed, at a 38% growth rate there is small financing surplus of $15.5, yet at a 40% growth rate in sales there is already a small financing deficit of $35. The critical (maximum) growth rate with no external financing is obviously between 38% and 40%. d. How much can increase in sales can you tolerate before you need to raise external debt or equity, without altering your capital structure and dividend policy? Again, there are two possible ways of answering this question: Find a formula Use trial and error Find a suitable formula: Financing deficit = Increase in assets - Addition to Retained earnings New borrowing (such that D/E remains as before, i. e., 1.7) 2.e Set the Financing deficit = 0 Critical growth rate (also known a s SGR) = ROE (Retention)/[1-ROE(Retention)] In this example g = 298%, meaning that SimpleToys Inc. can grow its sales almost four times before it needs to raise external equity. At g = 298% there is a financing deficit of $ If this amount were to be borrowed, the D/E ratio will still be around 169%. 8

9 3. A more complex example Toy Inc. is a toy company with the following financial standing: Table 2.6 Income statement of Toy Inc. Today Sales $5, (Costs) $3, (Depreciation) $1, EBIT $ (Interest) $80.75 EBT $ (Tax) $ Net income $ Addition to RE $ Dividend $96.85 Table 2.7 Balance sheet of Toy Inc. Today Today A/P $ Cash $ N/P $ Inventory $ Current liabilities $ A/R $ Current assets $1, Long-term debt $1, Other long-term $0.00 Gross fixed assets $3, Depreciation $1, Outstanding shares $1, Net fixed assets $2, Retained earnings $ Other assets $ Owner's equity $1, Total assets $3, Total L&E $3,

10 Due to the ongoing recession the company has faced sluggish demand during the last holiday season and is currently operating at 75% percent capacity. Its assets are depreciated in a straight line (the amount of depreciation equals gross assets divided by their expected economic life) and the company faces a 34% tax rate. The cost of long-term borrowing is 4.25%, and the company has a earnings retention ratio of 65%. There are 100 shares outstanding and the price per share is $25. Next year's sales remain a big question. The management is trying to plan ahead, taking into consideration various possibilities. If the economy recovers, sales could surge, if the recession deepens, sales could plumet. Questions to ponder: What is the current operating performance of the company? How well are its resources utilized? What is the current cash flow generated by the company? If sales remain flat (no change in sales and costs), what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? If sales plummet by 30%, what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? If sales increase by 20% what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? How much can sales increase before you need to raise external debt or equity? How much can increase in sales can you tolerate before you need to raise external debt or equity, without altering your capital structure and dividend policy? What happens if sales increase by 50%? In answering the above questions, we should consider the following additional information: There are now two toy plants of equal capacity in use. If one must increase production capacity, one will need to add one super-plant at a cost of $2,500. The super-plant will double output capacity because it would use the latest technology. At growth rates higher than 60%, the company will need to invest an additional $2,000 in Other assets. The board maintains a long-term capital structure of 63%, as measured by the proportion of total assets financed with debt. Current assets (except cash) and accounts payable vary proportional to sales. The costs of goods sold increase/decrease half as fast as sales. This current year the company has repurchased shares worth $1,

11 a. What is the current operating performance of the company? How well are its resources utilized? Table 2.8 Financial ratio analysis of Toy Inc. Today NWC $ NWC change from last period $0.00 Current ratio 1.43 Quick ratio 0.71 Cash ratio 0.14 TAT 1.43 FAT 2.50 NWC turnover Inventory Turnover 7.00 Day's Sales in Inventory Receivable Turnover Day's Sales in Receivables D/E 1.69 Total debt ratio 0.63 LT debt ratio 0.43 TIE 6.19 Cash coverage Profit margin 5.53% ROA 7.91% ROE 21.29% Dividend per share $0.97 EPS $2.77 Book value per share $13.00 Dividend yield 3.87% b. What is the current cash flow generated by the company? Table 2.9 Cash flow to claimholders, Toy Inc. CF to creditors $80.75 CF to shareholders $1, CF from assets $1,

12 c. If sales remain flat (no change in sales and costs), what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? Table 2.10 Pro-forma income statement of Toy Inc. (zero growth in sales) Today Next year Sales $5, $5, % (Costs) $3, $3, % (Depreciation) $1, $1, % EBIT $ $ % (Interest) $80.75 $ % EBT $ $ % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.11 Pro-forma (unbalanced) balance sheet of Toy Inc. (zero growth in sales) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $2, Surplus Total L&E $3, $3, $1, Why do we have a financing surplus of $1,179.86? Because we have recuperated $1,000 in depreciation, and generated $ in new profit, of which $96.85 has been paid out as dividend, leaving us with $179. While we have added $179 in retained earnings on the right-hand side of the balance sheet, we have not decided yet how to invest the surplus. At this point, this represents a financial policy decision. Possible alternatives: Keep some of the surplus in cash - for precautionary reasons; Redeem some of the notes payable Invest in additional inventory Invest in other assets 12

13 c.1. Keep $1,000 of the surplus in precautionary cash, and redeem some of the notes payable: Table 2.11 Pro-forma balance sheet of Toy Inc. (zero growth in sales, and decrease in notes payable) Today Next year Today Next year Cash $ $1, A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $2, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $3, Total L&E $3, $3, Table 2.12 Financial ratios of Toy Inc. (zero growth in sales, and decrease in notes payable) Today Next year NWC $ $1, NWC change from last period $0.00 $1, Curent ratio Quick ratio Cash ratio TAT FAT NWC turnover Inventory Turnover Day's Sales in Inventory Receivables Turnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin 5.53% 5.53% ROA 7.91% 7.91% ROE 21.29% 18.70% Dividend per share $0.97 $0.97 EPS $2.77 $2.77 Book value per share $13.00 $14.80 Dividend yield 3.87% 3.87% 13

14 This financial policy decision has several notable implications: It leaves the value of assets unchanged It increases short-term solvency It reduces financial leverage It increases book value per share ROE has dropped from 21.29% to 18.70% while other profitability ratios have remained constant It increases the cash flow to creditors Why so dramatic an improvement in short-term solvency? Because we have kept $1,000 in cash for precautionary reasons. We didn't want to decrease the volume of total assets (it doesn't look too good with investors to show declining assets, it appears as though you are winding down), we have kept at hand an amount no less than the amount of annual depreciation (if we can get away with it). What happens when fixed assets are depreciated is this: on the balance sheet, fixed assets are transformed into current assets, that is, less liquid assets are transformed into more liquid assets. If you think about it, this is how any business proceeds. Initial capital is first raised in the form of cash (the most liquid asset). Cash is then invested in less liquid assets (plant, equipment, etc). Then, in the process of running the business, the entrepreneur aims at restoring the initial liquidity of his capital. Of course, the entrepreneur is willing to take the tremendous risk of purchasing less liquid assets with his initial cash (this is called making a firm-specific investment) because he/she hopes to eventually realize a profit. The bottom line is that depreciation is one of the mechanisms through which the entrepreneur restores the initial liquidity of his capital; depreciation simply changes the structure of total assets: it reduces the weight of illiquid assets and increases that of liquid assets, other things constant. In this particular example the magnitude of amounts are a little exaggerated for the sake of illustrating a principle. In a real-life situation, the manager might keep less cash at hand, unless going through very tough times. Instead of $1,000, we might as well keep only $300 in cash and invest the rest in other assets. The case illustrated above is just one possibility among many. Also, remember that (on the income statement) depreciation is not a cash item, but has significant cash flow implications because it generates a tax shield. The amount of depreciation is deducted from taxable income creating a savings for shareholders equal to the amount of depreciations times the corporate tax rate. Another cause for the improvement in short-term solvency in this example is obviously due to a decrease in notes payable. Overall, current assets (cash in particular) have gone up, while current liabilities have gone down. Why has FAT improved so dramatically? This has little to do with the managerial skills or the business savvy of the CEO (CFO), although you can rest assured he/she would brag about it if given a chance. The jump in FAT is a mere consequence of deducting depreciation. Net fixed assets have decreased by $1,000, while sales and net income have remained constant. Why has ROE decreased while ROA has remained constant? This happened because financial leverage has been reduced. Remember that ROE is a direct function of ROA and financial leverage. (ROE = ROA(1+D/E)) Table 2.13 Cash flow to claimholders, Toy Inc. (zero growth in sales, and 26% decrease in notes payable) CF to creditors $ CF to shareholders $96.85 CF from assets $ By repaying $ in notes payables in addition to interest, the cash flow to creditors now stands at $ ($ $179.89), driving total cash flow to claimholders to $

15 c.2. Keep $1,000 in cash and invest in additional inventory: Table 2.14 Pro-forma income statement of Toy Inc. (zero growth in sales, increase in inventory) Today Next year Sales $5, $5, % (Costs) $3, $3, % (Depreciation) $1, $1, % EBIT $ $ % (Interest) $80.75 $ % EBT $ $ % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.15 Balance sheet of Toy Inc. (zero growth in sales, increase in inventory) Today Next year Today Next year Cash $ $1, A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $2, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $3, Total L&E $3, $3, The implications of investing the surplus in additional inventory: Total assets increase Short-term solvency ratios increase (although the quick ratio increases to a lesser extent than the others) While FAT is up, TAT is down Inventory turnover decreases Financial leverage is down Both ROA and ROE are down Book value per share is up 15

16 Table 2.16 Financial ratio analysis of Toy Inc. (zero growth in sales, increase in inventory) Today Next year NWC $ $1, NWC change from last period $0.00 $1, Curent ratio Quick ratio Cash ratio TAT FAT NWC turnover InventTurnover Day's Sales in Inventory ReceivTurnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin 5.53% 5.53% ROA 7.91% 7.52% ROE 21.29% 18.70% Dividend per share $0.97 $0.97 EPS $2.77 $2.77 Book value per share $13.00 $14.80 Dividend yield 3.87% 3.87% Table 2.17 Cash flow to claimholders, Toy Inc. (zero growth in sales, 36% increase in inventory) CF to creditors $80.75 CF to shareholders $96.85 CF from assets $

17 c.3. invest in other assets Table 2.18 Pro-forma income statement of Toy Inc. (zero growth in sales, increase in other assets) Today Next year Change Sales $5, $5, % (Costs) $3, $3, % (Depreciation) $1, $1, % EBIT $ $ % (Interest) $80.75 $ % EBT $ $ % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.19 Pro-forma balance sheet of Toy Inc. (zero growth in sales, increase in other assets) Today Next year Today Next year Cash $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $1, Owner's equity $1, $1, Total assets $3, $3, Total L&E $3, $3, The implications of investing the surplus in other assets: Total assets have increased While FAT has increased, TAT has decreased Financial leverage has decreased Both ROA and ROE have decreased Book value per share has increased 17

18 Table 2.20 Financial ratio analysis of Toy Inc. (zero growth in sales, increase in other assets) Today Next year NWC $ $ NWC change from last period $0.00 $0.00 Curent ratio Quick ratio Cash ratio TAT FAT NWC turnover InventTurnover Day's Sales in Inventory ReceivTurnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin 5.53% 5.53% ROA 7.91% 7.52% ROE 21.29% 18.70% Dividend per share $0.97 $0.97 EPS $2.77 $2.77 Book value per share $13.00 $14.80 Dividend yield 3.87% 3.87% Table 2.21 Cash flow to claimholders, Toy Inc. (zero growth in sales, 36% increase in Other assets) CF to creditors $80.75 CF to shareholders $96.85 CF from assets $

19 d. If sales plummet by 30%, what type of financial policy decisions would you face, and how would they affect operating performance and cash flows? (Remember that costs increase/decrease only half as fasts as sales). Let us assume that sales do plummet by 30%. Furthermore, this near-catastrophe 1 is due to the fact that some of the inventory has become unsellable, and many of the usual clients of the firm have gone out of business, leaving Toy Inc. holding the bag. Table 2.22 Pro-forma income statement of Toy Inc. (30% decline in sales) Today Next year %change Sales $5, $3, % (Costs) $3, $2, % (Depreciation) $1, $1, % EBIT $ $ % (Interest) $80.75 $ % EBT $ $ % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.23 Pro-forma balance sheet of Toy Inc. (30% decline in sales) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ ($375.89) Other assets $ $ Owner's equity $1, $ Total assets $3, $2, Surplus Total L&E $3, $2, $ It looks as though there is financing surplus, but this is so because we have not decided yet how to book the recovered depreciation. Other things to note: EBIT and net earnings are negative. The firm will post a loss! Despite negative earnings, the firms still has to make good on its interest payments, but not on the tax. There is no money for the dividend, unless the board wishes to dip into the firm's cash reserves, or borrow money to pay it. If consistently following the policy of paying a fraction of net earnings, however, there is no more dividend this year. On the balance sheet, owner's equity has dropped dramatically because this year's loss has been subtracted from retained earnings. Possible financial policy alternatives: Keep as much cash at hand, just in case things are getting worse Bite the bullet and recognize that some of the inventory is crap that nobody wants, and that some of firm's corporate clients will never pay the invoice. 1A drop in sales of 30% amounts to nothing short of a catastrophe. In the Fall of 2008 CM and Chrysler experienced dramatic sales declines on various models ranging from 15% to 45%. As a result, their respective CEOs flew their private jets to Washington to ask Congress for bailout money, that is to beg for corporate welfare 19

20 d.1. Precautionary cash Table 2.24 Pro-forma balance sheet of Toy Inc. (30% decline in sales, precautionary cash) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ ($375.89) Other assets $ $ Owner's equity $1, $ Total assets $3, $2, Total L&E $3, $2, Table 2.25 Ratio analysis of Toy Inc. (30% decline in sales, inventory and accounts receivables write-off) Today Next year NWC $ $ NWC change from last period $0.00 $ Current ratio Quick ratio Cash ratio TAT FAT NWC turnover Inventory Turnover Day's Sales in Inventory Receivables Turnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin 5.53% % ROA 7.91% % ROE 21.29% % Dividend per share $0.97 $0.00 EPS $2.77 -$5.56 Book value per share $13.00 $7.44 Dividend yield 3.87% 0.00% 20

21 Table 2.26 Cash flow to claimholders, Toy Inc. (30% decline in sales, inventory and accounts receivables write-off) CF to creditors $80.75 CF to shareholders $0.00 CF from assets $80.75 Consequences: Total assets are down Short-term liquidity ratios are temporarily up, but this is due to accumulated depreciation NWC turnover is decreasing Financial leverage is increasing TIE and cash coverage of interest payments ratios are worsening All profitability ratios are now negative Book value of equity is taking a hit Cash flow to claimholders merely consists of interest payments made to creditors 21

22 e. If sales increase by 20% what type of financial policy decisions would you face, and how would it affect operating performance and cash flows? Table 2.30 Pro-forma income statement of Toy Inc. (20% growth in sales) Today Next year Change Sales $5, $6, % (Costs) $3, $3, % (Depreciation) $1, $1, % EBIT $ $1, % (Interest) $80.75 $ % EBT $ $1, % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.30 Pro-forma (unbalanced) balance sheet of Toy Inc. (20% growth in sales) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $2, Surplus Total L&E $3, $3, $1, Things to note: While sales are up by only 20%, net income is increasing by 155%, due in part to the fact that costs went up by only 10%. Owner's equity is up because 65% of earnings are added to retained earnings on the balance sheet. The company is approaching full capacity. The utilization ratio increases from 75% to 90%(0.75x1.2). At this point, there is a negative financing deficit (EFN), that is, a financing surplus. But it is not over yet. Financial policy decisions: Since sales are up, and could stay there for some time, one must ensure an adequate level of inventory and accounts receivables. At the same time, the firm can also raise the level of its accounts payable to reflect higher sales. The CEO could use some of the firm's idle cash in oder to purchase new inventory and invest in accounts receivables. Let us say that a 10% increase would be reasonable. The same figure would apply to accounts payable as well. For simplicity, let us keep $1,010 in cash for precautionary reasons, if we can get away with it. But that still leaves a handsome financing surplus. What to do with it? The CEO could invest it in a taller and bigger headquarters building cooler looking and more alluring. Or he/she could buy a few business jets. Or, he could throw a big birthday party for his (much) younger wife. Or, he/she could buy a vast waterfront property in Florida to use it as a retreat for board meetings. 22

23 e.1. Invest in perks and other assets Table 2.31 Pro-forma balance sheet of Toy Inc. (20% growth in sales, growth in assets) Today Next year Today Next year Cash $ $1, A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $2, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $3, Total L&E $3, $3, Table 2.32 Ratio analysis of Toy Inc. (20% growth in sales, growth in assets) Today Next year NWC $ $1, NWC change from last period $0.00 $ Current ratio Quick ratio Cash ratio TAT FAT NWC turnover Inventory Turnover Day's Sales in Inventory Receivables Turnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin 5.53% 11.76% ROA 7.91% 17.69% ROE 21.29% 40.13% Dividend per share $0.97 $2.47 EPS $2.77 $7.06 Book value per share $13.00 $17.59 Dividend yield 3.87% 9.88% 23

24 Table 2.33 Cash flow to claimholders, Toy Inc. (20% growth in sales, growth in assets) CF to creditors $80.75 CF to shareholders $ CF from assets $ Notable consequences: Total assets have increased because the financing surplus is being invested in other assets. Short-term solvency ratios are on the upswing, notwithstanding a modest increase in accounts payable. FAT is up significantly, owing to the reduction in net fixed assets (due to depreciation) and the increase in sales. TAT, however, is up marginally because the increase in sales has been accompanied by increases in current and other assets, which almost offset the drop in net fixed assets. Other asset utilization ratios remained unchanged. Financial leverage is down, because equity is accumulating internally. Profitability ratios are all up. Book value of equity is up as well, and if the market sees this sales boost as a good omen, the market price of shares could rise too. Cash flow to shareholders is up because the dividend per share is increasing due to higher earnings. 24

25 e.2. But enough of this science-fiction...our CEO being a good sport, might chose to repurchase some outstanding shares (instead of investing in other assets ) to reward the shareholders and emphasize for all to see the financial health of Toy Inc. More precisely the firm would repurchase 10 shares at $48.87 each, that is, at a significant premium over their current market value. As a result, after the share repurchase, the price of remaining shares would stabilize around $30. Table 2.34 Pro-forma balance sheet of Toy Inc. (20% growth in sales, 10 common shares repurchased) Today Next year Today Next year Cash $ $1, A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $2, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $3, Total L&E $3, $3, Table 2.35 Ratio analysis of Toy Inc. (20% growth in sales, 10 common shares repurchased) Today Next year NWC $ $1, NWC change from last period $0.00 $ Curent ratio Quick ratio Cash ratio TAT FAT NWC turnover InventTurnover Day's Sales in Inventory ReceivTurnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin 5.53% 11.76% ROA 7.91% 20.16% ROE 21.29% 55.57% Dividend per share $0.97 $2.74 EPS $2.77 $7.84 Book value per share $13.00 $14.11 Dividend yield 3.87% 9.15% 25

26 Table 2.36 Cash flow to claimholders, Toy Inc. (20% growth in sales, 10 common shares repurchased) CF to creditors $80.75 CF to shareholders $ CF from assets $ Notable consequences: Total assets remain at the same level In spite of higher earnings, owners equity is down marginally because the share repurchase has been paid for from retained earnings. TAT and FAT are up due to higher sales and higher sales combined with lower Net Fixed Assets respectively Financial leverage has increased marginally due to the slight reduction in equity. All profitability ratios are bound to increase. Book value of equity (per share) is up in spite of lower equity because the number of outstanding shares is lower. Cash flow to shareholders is up dramatically due to the share repurchase. 26

27 f. What happens if demand for toys is bound to increase by 50%? Obviously, the current production capacity of the company cannot accommodate such a dramatic increase in output. At most, given the current 75% capacity utilization, output (and sales) can increase no more than 33% (0.75 x 1.33 = 1) before one needs to add another plant. Let us go ahead thus and take this important step in the hope that the spike in demand is more or less permanent, otherwise our decision would turn into a blunder. Table 2.37 Pro-forma income statement of Toy Inc. (50% growth in sales, production capacity increase) Today Next year Change Sales $5, $7, % (Costs) $3, $4, % (Depreciation) $1, $1, % EBIT $ $1, % (Interest) $80.75 $ % EBT $ $1, % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.38 Pro-forma (unbalanced) balance sheet of Toy Inc. (50% growth in sales, production capacity increase) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $5, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $2, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $4, Deficit Total L&E $3, $4, $ We note a dramatic jump in earnings We use internal equity (some of which is invested in the cash accumulating until now in the company's coffers), as well accounts payable to increase the inventory and AR needed to sustain this higher level of sales. The remaining cash is used to purchase another plant, but unfortunately, this is not enough. We still have a financing deficit that we cannot cover internally. We need to borrow $

28 Table 2.39 Pro-forma balance sheet of Toy Inc. (50% growth in sales, production capacity increase, debt financing) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $5, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $2, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $4, Total L&E $3, $4, Table 2.40 Ratio analysis of Toy Inc. (50% growth in sales, production capacity increase, debt financing) Today Next year NWC $ $ NWC change from last period $0.00 $ Curent ratio Quick ratio Cash ratio TAT FAT NWC turnover InventTurnover Day's Sales in Inventory ReceivTurnover Day's Sales in Receivables D/E Total debt ratio LT debt ratio TIE Cash coverage Profit margin 5.53% 10.66% ROA 7.91% 18.20% ROE 21.29% 43.92% Dividend per share $0.97 $2.80 EPS $2.77 $7.99 Book value per share $13.00 $18.19 Dividend yield 3.87% 11.19% 28

29 Table 2.41 Cash flow to claimholders, Toy Inc. (50% growth in sales, production capacity increase, debt financing) CF to creditors -$ CF to shareholders $ CF from assets $63.29 Things to note: The new capacity utilization ratio is now (0.75 x 1.5)/(2)= 56% Short-term solvency is marginally up (the cash ratio is down because the firm used up almost all the cash available). TAT and FAT are slightly higher because sales increase faster than total assets and fixed assets. Financial leverage is slightly down because internal equity is accumulating faster than debt. All profitability ratios are moving up 29

30 g. It is interesting to ask what is the highest growth rate in sales that can be achieved without having to borrow any additional money. This rate is sometimes called the Internal Growth Rate (IGR). It is more or less obvious that as long as the firm operates at or under full capacity there is no need to borrow. Here is what happens at 33% percent growth in sales: Table 2.42 Pro-forma income statement of Toy Inc. (33% growth in sales) Today Next year Change Sales $5, $6, % (Costs) $3, $4, % (Depreciation) $1, $1, % EBIT $ $1, % (Interest) $80.75 $ % EBT $ $1, % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.43 Pro-forma (unbalanced) balance sheet of Toy Inc. (33% growth in sales) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $3, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $1, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $2, Surplus Total L&E $3, $4, $1, The firm operates at 100% capacity, but it doesn't need any new capital investment (for the time being). There is a seizable financing surplus of $1, There is plenty of room to buy new business jets (that is, toys) for the CEO and CFO, to acquire smaller competitors, pay down part of the outstanding debt, or pay extra dividends to the shareholders. 30

31 And this is what happens at 34% growth in sales: Table 2.44 Pro-forma income statemwnt of Toy Inc. (34% growth in sales) Today Next year Change Sales $5, $6, % (Costs) $3, $4, % (Depreciation) $1, $1, % EBIT $ $ % (Interest) $80.75 $ % EBT $ $ % (Tax) $ $ % Net income $ $ % Addition to RE $ $ % Dividend $96.85 $ % Table 2.45 Pro-forma (unbalanced) balance sheet of Toy Inc. (34% growth in sales) Today Next year Today Next year Cash $ $ A/P $ $ Inventory $ $ N/P $ $ A/R $ $ Current liabilities $ $ Current assets $1, $1, Long-term debt $1, $1, Gross fixed assets $3, $5, Other long-term $0.00 $0.00 Depreciation $1, $2, Outstanding shares $1, $1, Net fixed assets $2, $2, Retained earnings $ $ Other assets $ $ Owner's equity $1, $1, Total assets $3, $4, Deficit Total L&E $3, $3, $ At a growth rate slightly higher than the Internal Growth Rate (34% > 33%), the financing deficit is $472.26, higher than it would be at a growth rate of 50%. Why is this so? Because the firm needs to invest an additional $2,500 in fixed assets regardless of whether sales are up by 34% or 50%. However, internal equity is accumulating faster when sales grow by 50% than when they grow by only 34%. From this example it is clear that the Internal Growth Rate is 33%. 31