1. INTRODUCTION TO CORPORATE FINANCE SECOND EDITION Lawrence Booth & W. Sean Cleary Prepared by Ken Hartviksen & Jared Laneus

2. Chapter 4 Financial Statement Analysis and Forecasting 4.1 Consistent Financial Analysis 4.2 A Framework for Financial Analysis 4.3 Leverage Ratios 4.4 Efficiency Ratios 4.5 Productivity Ratios 4.6 Liquidity Ratios 4.7 Valuation Ratios 4.8 Financial Forecasting 4.9 Formula Forecasting 4.10 Tim Hortons’ External Financing Requirements 2 Booth/Cleary Introduction to Corporate Finance, Second Edition

3. Learning Objectives 4.1 Identify the issues that need to be considered in applying consistent financial analysis. 4.2 Explain why return on equity is one of the key financial ratios used for assessing a firm’s performance, and how it can be used to provide information about three areas of a firm’s operations. 4.3 Describe, calculate and evaluate the key ratios relating to financial leverage. 4.4 Describe, calculate and evaluate the key ratios relating to efficiency. 4.5 Describe, calculate and evaluate the key ratios relating to productivity. 4.6 Describe, calculate and evaluate the key ratios relating to liquidity. 4.7 Describe, calculate and evaluate the key ratios relating to the valuation of a company. 4.8 Explain why financial forecasting is critical for both management and external parties, and explain how to prepare financial forecasts using the percentage of sales method. 4.9 Explain how external financing requirements are related to sales growth, profitability, dividend payouts, and sustainable growth rates. 4.10 Apply financial forecasting to a real company. 3 Booth/Cleary Introduction to Corporate Finance, Second Edition

4. Consistent Financial Analysis Consistent financial analysis across companies, industries and countries is important Analysts must understand the challenges to comparability and attempt to ascertain the financial health of the organizations they study, understanding the limitations inherent in financial accounting practice Intra-Company Comparisons GAAP provides considerable latitude for the company Once a firm chooses an acceptable accounting treatment for revenue recognition, capitalization of expenses, inventory valuation, etc., then the firm must use these same provisions year after year Any change in accounting principles must be noted in the notes to the financial statements and prior years restated to ensure there is a common basis of comparison to the present Therefore, internal comparisons, year-over-year, are possible and supported by GAAP 4 Booth/Cleary Introduction to Corporate Finance, Second Edition

5. Consistent Financial Analysis Inter-Company Comparisons Making comparisons between companies, even in the same industry, is much more difficult than comparing the same company to itself over time because: There is a potentially wide divergence in accounting treatment results under GAAP Historical, cost-based accounting can seriously affect efficiency, leverage and profitability ratios 5 Booth/Cleary Introduction to Corporate Finance, Second Edition

6. A Framework for Financial Analysis Financial statement analysis studies, absolute numbers, comparative statements and ratios to: Ascertain trends in the financial statements Identify areas of strength and concern The DuPont System gives a framework for the analysis of financial statements through the decomposition of the return on equity (ROE) ratio as shown in Figure 4-1: 6 Booth/Cleary Introduction to Corporate Finance, Second Edition

7. A Framework for Financial Analysis ROE is a function of: Leverage, or the use of debt Efficiency, the ability of a firm to control costs in relationship to sales Productivity, the degree to which a firm can generate sales in relationship to the assets employed ROE is not a pure ratio because it involves dividing an income statement item (a flow) by a balance sheet (or stock) item, as in Equations 4-1 and 4-7: Instead of using ending shareholders’ equity, many argue that average shareholders’ equity over the period should be used because shareholders’ equity changes over the year as income is earned and retained earnings grow 7 Booth/Cleary Introduction to Corporate Finance, Second Edition

8. A Framework for Financial Analysis Return on assets (ROA) shows the ratio of income to assets used to produce the income, and it can be further decomposed as the product of the net profit margin and sales to total assets ratio: Multiplying ROA by leverage (total assets divided by shareholders’ equity), we obtain ROE The DuPont system provides a good starting point for any financial analysis because: It shows that financial strength comes from many sources: profitability, asset utilization and leverage It reinforces the concept that good financial analysis requires looking at each ratio in the context of the others It shows that it is important to look at a sample of ratios from each major category to identify areas of strength and weakness 8 Booth/Cleary Introduction to Corporate Finance, Second Edition

9. A Framework for Financial Analysis Tables 4-1 and 4-2 show an ROE analysis for Tim Horton’s: 9 Booth/Cleary Introduction to Corporate Finance, Second Edition

10. A Framework for Financial Analysis Table 4-3 shows an ROE analysis for two of Tim Horton’s competitors: McDonald’s and Starbucks A ratio, by itself, is just a number; to judge if a ratio is “good” or “bad,” we must compare it for the same company over time (trend analysis), or to other companies in the same industry (industry analysis): 10 Booth/Cleary Introduction to Corporate Finance, Second Edition

11. Leverage Ratios Financial leverage occurs when a firm uses sources of financing that carry a fixed cost, such as long-term debt, and uses this to generate greater returns to shareholders Leverage means magnification of both profits and losses Leverage ratios include: Debt ratio Debt-equity ratio Times interest earned Cash flow to debt The debt ratio is a stock ratio that indicates the proportion of total assets financed by debt as at the balance sheet date; as in Equation 4-8: 11 Booth/Cleary Introduction to Corporate Finance, Second Edition

12. Leverage Ratios The debt-equity (D/E) ratio is a stock ratio that indicates the proportion that total debt represents in relationship to the shareholders’ equity (both common stock and retained earnings) at the balance sheet date; as in Equation 4-9: The times interest earned (TIE) ratio is an income statement (flow) ratio that indicates the number of times the firm’s pre-tax income (EBIT, earnings before interest and taxes) exceeds its fixed financial obligations to its lenders; as in Equation 4-1: 12 Booth/Cleary Introduction to Corporate Finance, Second Edition

13. Leverage Ratios The cash flow to debt ratio measures how long it would take to pay off a firm’s debt using cash flow from operations; as in Equation 4-11: 13 Booth/Cleary Introduction to Corporate Finance, Second Edition

14. Leverage Ratios Table 4-4 shows Tim Horton’s leverage ratios Tim Horton’s leverage ratios show that the amount of debt as a percentage of total financing decreased slightly in 2008, and their coverage ratio improved slightly Comparing Tim Horton’s to McDonald’s and Starbucks, Tim’s had a much lower percentage of debt financing and better coverage ratios 14 Booth/Cleary Introduction to Corporate Finance, Second Edition

15. Efficiency Ratios Efficiency ratios measure how efficiently a dollar of sales is turned into profits; these include: Degree of total leverage Break-even point Gross profit margin Operating margin Efficiency ratios give insight into a firm’s cost structure and can help analysts determine if problems exist with either variable or fixed costs, or both 15 Booth/Cleary Introduction to Corporate Finance, Second Edition

16. Efficiency Ratios Degree of total leverage (DTL) is an income statement ratio that measures the exposure of profits to changes in sales, as in Equation 4- 12: The greater the DTL, the greater the leverage effect The break-even point estimates the unit volume that must be produced and sold in order for the firm to cover all costs, both fixed and variable, as in Equation 4-13: The break-even point tends to increase as the use of fixed costs increases 16 Booth/Cleary Introduction to Corporate Finance, Second Edition

17. Efficiency Ratios Gross profit margin demonstrates the proportion of sales that are available to cover fixed (period) costs and financing expenses after variable costs have been paid, as in Equation 4-14: A declining gross profit margin raises concerns about the firm’s ability to control variable costs, such as direct materials and labour The operating margin measures the cumulative effect of both variable and period costs on the ability of the firm to turn sales into operating profits to cover interest, taxes, depreciation and amortization (EBITDA), as in Equation 4-15: 17 Booth/Cleary Introduction to Corporate Finance, Second Edition

18. Efficiency Ratios Table 4-6 shows Tim Horton’s efficiency ratios Tim Horton’s maintained steady profitability and higher gross profit margins than McDonald’s and Starbucks, except in 2008 when McDonald’s had a higher net profit margin Table 4-6 confirms that Tim Horton’s displayed consistently strong profitability in 2007 and 2008 18 Booth/Cleary Introduction to Corporate Finance, Second Edition

19. Productivity Ratios Productivity ratios measure the firm’s ability to generate sales from its assets; these include: Receivables turnover Average collection period (ACP) Inventory turnover Average days sales in inventory (ADSI) Fixed asset turnover Excessive investment in assets with little or no increase in sales reduces the rate of return on both assets (ROA) and equity (ROE) 19 Booth/Cleary Introduction to Corporate Finance, Second Edition

20. Productivity Ratios Receivables turnover measures the sales generated by every dollar of receivables, as in Equation 4-16: Average collection period (ACP) estimates the number of days it takes for a firm to collect on its accounts receivable, as in Equation 4-17: Example: If ACP is 40 days, and the firm’s credit policy is net 30, clearly customers are not paying according the to firm’s policies and there may be concerns about the quality of customer’s credit and what might happen if economic conditions deteriorate 20 Booth/Cleary Introduction to Corporate Finance, Second Edition

21. Productivity Ratios Inventory turnover measures the number of times ending inventory was “turned over” or sold during the year, as in Equations 4-18 and 4-19: When cost of goods sold is not publicly available, the inventory turnover ratio can be estimated using sales instead, as in Equation 4-19 Using sales instead of cost of good sold is not ideal, because while cost of goods sold is based on inventoried cost, sales includes a profit margin that may not be comparable to other firms This is a ratio that involves both stock and flow values and is strongly a function of ending inventory Managers often try to improve this ratio as they approach year end through inventory reduction strategies (e.g., cash and carry sales, inventory clearance, etc.) 21 Booth/Cleary Introduction to Corporate Finance, Second Edition

22. Productivity Ratios Average Days Sales in Inventory (ADSI) estimates the number of days of sales tied up in inventory, based on ending inventory values, as in Equation 4-20: Fixed asset turnover estimates the number of dollars of sales produced by each dollar of net fixed assets, as in Equation 4-21: 22 Booth/Cleary Introduction to Corporate Finance, Second Edition

23. Productivity Ratios Table 4-7 shows Tim Horton’s productivity ratios: 23 Booth/Cleary Introduction to Corporate Finance, Second Edition

24. Liquidity Ratios Liquidity ratios measure the ability of the firm to meet its financial obligations as they mature using liquid (i.e., cash and near cash) resources; these include: Working capital Current Quick (acid test) The working capital ratio measures the proportion of total assets invested in current assets, as in Equation 4-22 The working capital ratio demonstrates a firm’s capital intensity and corporate liquidity 24 Booth/Cleary Introduction to Corporate Finance, Second Edition

25. Liquidity Ratios The current ratio measures the number of dollars of current assets for each dollar of current liabilities, as in Equation 4-23: The current ratio estimates the capacity of the firm to meet its financial obligations as they mature The quick ratio or acid test ratio recognizes that inventories and other current assets may be less liquid and, in some cases, when liquidated quickly, can result in cash flows that are less than book value Therefore, the quick ratio gives a clearer indication of the firm’s ability to meet its maturing financial obligations out of very liquid current assets, as in Equation 4-24: 25 Booth/Cleary Introduction to Corporate Finance, Second Edition

26. Liquidity Ratios Table 4-8 shows Tim Horton’s liquidity ratios For 2008 Tim Horton’s quick ratio is less than 1, which indicates that the company could not pay off all of its current liabilities from its most liquid assts Tim Horton’s was more liquid than McDonald’s and Starbucks in 2007, but McDonald’s was more liquid than Tim Horton’s in 2008 26 Booth/Cleary Introduction to Corporate Finance, Second Edition

27. Liquidity Ratios Estimating Net Realizable Values When firms are financially strained and no longer a going concern, book (accounting) values become less valid Instead, net liquidation values can be estimated by discounting asset values based on their degree of liquidity Liquid assts are valued at close to or the same as book value Illiquid assets are discounted from book value based on their degree of liquidity Liabilities are stated in nominal terms, because it takes those dollars to satisfy debt obligations Preferred stock value is based on residual values, if any residual remains after liquidation Table 4-9 (see textbook) provides Scotia iTRADE’s risk ratings as an example 27 Booth/Cleary Introduction to Corporate Finance, Second Edition

28. Valuation Ratios Valuation ratios are used to assess how the market is valuing the firm (i.e., its share price) in relation to its assets, earnings, profits and dividends; these include: Equity book value per share (BVPS) Dividend yield Dividend payout Trailing Price-earnings (P/E) Forward P/E Market-to-book Earnings before interest, taxes, depreciation and amortization (EBITDA) multiple 28 Booth/Cleary Introduction to Corporate Finance, Second Edition

29. Valuation Ratios Book value per share (BVPS) expresses shareholders’ equity on a per share basis, as in Equation 4-25: Dividend yield expresses the dividend payout as a proportion of the current share price, as in Equation 4-26: The dividend yield can be compared to the yield on other investment instruments, such as bonds or the stocks of other dividend-paying companies 29 Booth/Cleary Introduction to Corporate Finance, Second Edition

30. Valuation Ratios The trailing P/E ratio is an earnings multiple based on the most recent earnings, as in Equation 4-28: The price-earnings (P/E) ratio is often used to estimate the value of a stock Example: A stock trading at a P/E multiple of 10 will take 10 years at current earnings to recover its price The forward P/E ratio is an earnings multiple based on forecast earnings per share and is often used to estimate the value of a stock for companies with rapid growth in EPS, as in Equation 4-29: Low P/E shares are regarded as value stocks High P/E shares are regarded as growth stocks 30 Booth/Cleary Introduction to Corporate Finance, Second Edition

31. Valuation Ratios The market-to-book ratio estimates the dollars of share price per dollar of book value per share, as in Equation 4-30: Given historical cost accounting as the basis for BVPS, the degree to which market value per share exceeds BVPS indicates the value that has been added to the company by management The EBITDA multiple expresses total enterprise value (TEV) for each dollar of operating income, or earnings before interest, taxes, depreciation and amortization (EBITDA), as in Equation 4-31: Total enterprise value is an estimate of the market value of the firm, i.e., the market value of both its equity and its debt 31 Booth/Cleary Introduction to Corporate Finance, Second Edition

32. Valuation Ratios Table 4-10 shows valuation ratios for Tim Horton’s Tim Horton’s stock price is over five times its book value per share, and has a high P/E ratio and EBITDA multiple High operating margins, good turnover and profitability support these valuation ratios 32 Booth/Cleary Introduction to Corporate Finance, Second Edition

33. Financial Forecasting Financial managers must produce forecasts of the results of business plans in order to: Determine if the plans will require additional external financing Determine if the plans will produce surplus cash resources that could be distributed to shareholders as dividends Assess financial forecasts to determine if plans are feasible; if poor results are forecast, management has the opportunity to amend plans in an attempt to produce better results before resources and committed The basis for all financial forecasts is the sales forecast and the most recent balance sheet values are the starting point Pro forma (forecast) balance sheets are projected, assuming some relationship with projected sales as a constant percentage of sales Current liabilities are usually assumed to rise and fall in a constant percentage with sales, and are called spontaneous liabilities because they change without negotiation with creditors 33 Booth/Cleary Introduction to Corporate Finance, Second Edition

34. The Percentage of Sales Method The percentage of sales method involves the following steps: 1.Determine the financial policy variables in which you are interested 2.Set all the non-financial policy variables as a percentage of sales 3.Extrapolate the balance sheet based on a percentage of sales 4.Estimate future retained earnings 5.Modify and re-iterate until the forecast makes sense This process most often results in a balance sheet that does not balance, so a “plug” (or balancing) amount is the external funds required, or the surplus funds forecast 34 Booth/Cleary Introduction to Corporate Finance, Second Edition

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36. The Percentage of Sales Method The prior pro forma balance sheet was developed using very naïve assumptions: Policy variables held constant Asset growth in all accounts held at the same percentage of sales Spontaneous liabilities increased at a constant percentage of sales One improvement is to realize that the firm’s equity will grow by the amount of retained earnings Note that in Table 4-13 retained earnings is net income (6) less dividends (3). Assuming the firm holds this percentage constant, we can project an increase in equity on the balance sheet as 50% of the 5% profit margin or 2.5% of sales. 36 Booth/Cleary Introduction to Corporate Finance, Second Edition

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38. The Percentage of Sales Method Further improvements to the pro forma balance sheet include: Recognizing that cash balances may not have to rise as a constant percentage of sales Cash balances are required for a variety of reasons: to support transactions, as a safety cushion against unforeseen cash needs, and as a speculative balance to take advantage of unforeseen opportunities Even at low levels of sales, cash balances are required As sales increase, additional cash on hand may be required, but at a decreasing percentage of sales 38 Booth/Cleary Introduction to Corporate Finance, Second Edition

39. The Percentage of Sales Method Figure 4-3 illustrates the difference between a simple percentage of sales forecast, and perhaps a more realistic forecast that includes a base amount (constant) and a decreasing percentage of sales 39 Booth/Cleary Introduction to Corporate Finance, Second Edition

40. The Percentage of Sales Method Further improvements to the pro forma balance sheet include re- examining asset growth assumptions: Refinement of the cash forecast Realization that EFR can be offset by marketable securities that can be easily liquidated to finance growth needs Re-examination of assumptions of accounts receivable growth and whether we want to change credit policies in the context of the forecast macroeconomic and competitive environment Re-examination of inventory management policies taking into account the macroeconomic and competitive environment Realization that increases in net fixed assets is “lumpy” and not continuously incremental; if the firm has excess capacity, it may not need to invest any further in fixed assets until it is forecast to exceed that capacity Additional improvements also include re-examining assumptions about growth in spontaneous liabilities 40 Booth/Cleary Introduction to Corporate Finance, Second Edition

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42. The Percentage of Sales Method Given assumptions about capacity, and there being no need for further expansion in plant and equipment to support anticipated sales growth, we can re-examine our assumptions about the cost structure of the firm Figure 4-16 (next slide) shows the effects of these changes on the pro forma income statement Variable costs (direct materials and direct labour) will likely grow in proportion to sales Fixed costs, however, should remain fixed; by modifying the income statement for this change in assumptions, we see the net result of this is an increase in forecast net income Most firms do not follow a constant dividend payout ratio, but hold dividends constant over multiple years; we will assume $3 dividends will be paid for the next three years 42 Booth/Cleary Introduction to Corporate Finance, Second Edition

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44. The Percentage of Sales Method Given our modified income statement and assumptions regarding net profit and cash dividends, we can prepare a final revised balance sheet The balance sheet now shows we forecast significant surplus cash resources and must make some decisions about their management: should they be invested in marketable securities or paid as dividends? 44 Booth/Cleary Introduction to Corporate Finance, Second Edition

45. Formula Forecasting We can express the foregoing percentage of sales method of forecasting using equations rather than spreadsheets Equation 4-32 shows the external financing requirements (EFR): EFR = a × S × g – b × PM × (1 + g) × S where: a = the treasurer’s financial policy variable, the total invested capital or net assets of the firm as a percentage of its sales g = sales growth rate S = current period sales S × g = next period sales a × S × g = incremental capital required PM = profit margin on sales b= payout ratio 1 – b = retention or plowback ratio 45 Booth/Cleary Introduction to Corporate Finance, Second Edition

46. Formula Forecasting External financing requirements can also be expressed as a linear function of the sales growth rate (g) by dividing both sides of Equation 4-32 by the current sales level to obtain Equation 4-33: Equation 4-33 is plotted in Figure 4-4; the sustainable growth rate (g*) occurs where the blue line intersects the horizontal axis 46 Booth/Cleary Introduction to Corporate Finance, Second Edition

47. Formula Forecasting The sustainable growth rate (g*) is the sales growth rate at which the firm neither generates nor needs external financing; it can sustain its own rate of growth through the reinvestment of its own profits. Equation 4-34 gives the sustainable growth rate: When g > g*, EFR > 0 (external financing will be required) When g = g*, EFR = 0 (the firm can finance its own growth with retained earnings) When g < g*, EFR < 0 (the firm will have surplus funds available after financing its planned growth) 47 Booth/Cleary Introduction to Corporate Finance, Second Edition

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