1. Financial Analysis and Long-Term Planning
Chapter 14
Financial Analysis and Long-Term Planning
© 2011 John Wiley and Sons

2. Chapter Outcomes Describe what is meant by financial
statement analysis
Describe the five basic types of financial
ratios
Indicate what is meant by Du Pont analysis and
indicate its major components
Explain the importance of the quality of financial
statements

3. Chapter Outcomes (Continued)
Describe the link between asset investment requirements and sales growth
Describe how internally generated financing occurs
Describe how additional external financing requirements are determined
Describe cost-volume-profit analysis

4. Financial Statement Analysis
Why?
Reflects effect of economic and competitive environment
Internal uses by management
External uses
Investors
Suppliers
Lenders

5. Ratio Analysis Absolute numbers versus ratios Types of ratio analysis
trend or time series
cross-sectional
industry average

6. Ratio Analysis Difficulties GAAP
Multiproduct firms and other differences
Within same industry, ratio characteristics may differ between large/small, domestic/global firms
Ratios may be defined differently by various sources

7. Ratio Analysis Focus on different ratios depends on user:
Bank loan officer
Long-term lender/bondholder
Equity investor

8. Types of Financial Ratios
Liquidity
Asset Management
Financial Leverage
Profitability
Market Value

9. Liquidity Ratios Current ratio = Current Assets Current Liabilities
Quick or acid-test ratio =
(Cash + Accts. Receivable)
Average payment period =
Accts Payable / (COGS/365)

10. Asset Management
Total Asset Turnover (TATO) = Net Sales / Total Assets
Fixed Asset Turnover = Net Sales / Fixed Assets

11. More Asset Management
Average collection period = Accts Receivable / (Net Sales/365)
Inventory Turnover =
Cost of goods sold
Inventory

12. Financial Leverage
Total Debt to Total Assets = Total Liabilities / Total Assets
Total Debt to Equity = Total Liabilities / Stockholder’s Equity (SE)
Equity Multiplier = Total Assets / SE

13. Financial Leverage (Continued)
Interest Coverage = EBIT / Interest expense
Fixed Charge Coverage = Earnings before Fixed Charges
Before-tax Fixed Charges
Fixed Charges: interest, rent, lease, sinking fund payments, etc.

14. Profitability Operating Profit Margin = EBIT / Net Sales
Net Profit Margin (PM)
= Net Income / Net Sales
Operating Return on Assets
= EBIT / Total Assets
Return on Assets (ROA)
= Net Income / Total Assets
Return on Equity (ROE)
= Net Income / Stockholder’s Equity

15. Market Value
Price / earnings (P/E) ratio
Price / book ratio

16. A Note on Quality Financial Statements
Quality financial statements reflect the firm’s true economic condition
Quality Income Statement
Repeatable revenues
Lack of one-time charges or gains
Quality Balance Sheet
Marketable inventory
Not at debt capacity
Market value of firm’s assets exceed their book values

17. Ratios and Puzzles
Examine ratios to determine a firm’s strengths and weaknesses
Dig deeper to discover cause of disappointing or deteriorating ratios

18. DuPont Method ROA = profit margin x TA turnover = NI/Sales x Sales/TA
Indicates there are two ways to earn a given level of ROA:
Low PM x High TATO
(grocery store)
High PM x Low TATO
(jewelry store)

19. More DuPont analysis... ROE = ROA x equity multiplier
= (NI / TA) x (TA / equity)
Breaking down ROA into its parts:
Net income x Sales x Assets
Sales Assets Equity

20. Analyzing ROE
ROE can change over time or differ across firms because of differing:
profit margins
total asset turnover
financial leverage
some combination of these three reasons

21. Long-Term Financial Planning
Failing to plan is planning to fail
Future growth/asset needs
Future financing arrangements

22. Percent of Sales Technique
ASSETS DOLLAR PERCENT
AMOUNT OF SALES ($700,000)
Cash & marketable sec. $ 25, %
Accounts receivable ,
Inventories ,
Total current assets ,
Net plant & equipment ,
Land ,
Total fixed assets ,
Total assets $500,

23. Percent of Sales LIABILITES AND DOLLAR PERCENT
EQUITY AMOUNT OF SALES ($700,000)
Accounts payable $ 78, %
Notes payable ,
Accrued liabilities ,
Total current liabilities ,
Long-term debt ,
Total liabilities ,
Total stockhldrs’ equity ,
Total liabilities & equity $500,

24. Using this information to forecast financing needs
Sales forecast: from $700,000 to $770,000
Forecast asset needs
TA = Sales x (TA percent of sales)
= $70,000 x = $49,980
Financing needs
TA = (TL + SE) = $49,980

25. Getting the funds... Needed financing can be raised from
internal sources
external sources

26. Internally generated funds
Assume profit margin is 8% and the firm pays 50% of its profits as dividends
Forecasted net income = sales forecast x profit margin
= $770,000 x 0.08 = $61,600
Addition to retained earnings = net income forecast – dividends
=$61,600 – 0.50 ($61,600) = $30,800

27. Externally generated financing
Spontaneous financing
Accounts payable 11.1% of Δ sales
Accruals 4.3% of Δ sales
= ( ) x ($70,000)
= (0.154) x ($70,000)
= $10,780

28. External financing needs
= TA - RE - spontaneous financing
=$49,980 - $30,800 - $10,780
= $8,400
We estimate the firm will need to raise $8,400 over the coming year

29. Cost-Volume-Profit Analysis
EBIT (or operating income) =
Sales
less: variable costs (VC)
less: fixed costs (FC)
= (Price x Qty) - (VC x Qty) - FC

30. Operating Profit Estimates
Given a unit sales or quantity estimate, we can estimate operating profit,
EBIT = (Price x Qty) - (VC x Qty) - FC
A special case: Breakeven
EBIT = 0 = (Price x Qty) - (VC x Qty) - FC
QtyBE = Fixed Costs
(Price - VC)

31. Fixed Costs and Operating Leverage
Fixed operating costs result in a larger percentage change in EBIT for a given percentage change in sales
Net sales $700,000
Less: variable costs (60% of sales) 420,000
Less: fixed costs ,000
Earnings before interest
and taxes $ 80,000

32. –10% %
Net sales $630, $770,000
Less: variable costs
(60% of sales) , ,000
Less: fixed costs 200, ,000
EBIT $ 52, $108,000
Percent change
in EBIT: –35% +35%

33. What happened?
A 10% change in sales is magnified or levered into a 35% change in EBIT
Degree of operating leverage (DOL) =
(% change in EBIT / % change in sales)
= 35% / 10% = 3.5
Another way: DOL =
sales - variable costs
sales - variable costs - fixed costs

34. As fixed costs rise, the leverage effect rises: use FC = $250,000
PERCENT CHANGE IN SALES
–10% base case %
Net sales $630,000 $700, $770,000
Less: VC (60%
of sales) , , ,000
Less: FC , , ,000
EBIT $ 2, $ 30, $ 58,000
EBIT % change
from base case –93.3% %

35. Degree of operating leverage (DOL) =
(% change in EBIT / % change in sales)
= 93.3% / 10% = 9.33

36. Using DOL
Given DOL, we can estimate the change in operating income for a given change in sales
DOL = (% change EBIT / % change sales)
% change in EBIT =
% change in sales x DOL

37. Example Going back to our base case: Net sales $700,000
Less: variable costs (60% of sales) 420,000
Less: fixed costs ,000
Earnings before interest
and taxes $ 80,000
Problem: Forecast EBIT if sales are expected to rise 10 percent

38. Forecasting EBIT Sales are expected to rise 10 percent
Current EBIT = $80,000
DOL = 3.5
%change in EBIT =
% change in sales x DOL
% change in EBIT = 10% x 3.5 = 35%
EBIT estimate = $80, ($80,000)
EBIT estimate = $108,000

39. Web Links www.berkshirehathaway.com www.finance.yahoo.com