2. Financial Statements and Long-Term Financial Planning

3. Working with Financial Statements

• Cash flow from assets = Cash flow to creditors + Cash flow to stockholders(owners) 
• Sources and uses of cash
  • how to trace the flow of cash through the business over the year
  • - sources: a firm's activities that generate cash
    - uses: application of cash 
• Standardized financial statements
  • differences in size make it difficult to compare financial statement
  • how to form common-size and common–base period statements to make comparisons easier
• Ratio analysis
  • Evaluating ratios of accounting numbers to compare financial statement information
    • Du Pont identity 
  • BalanceSheet
    • Liquidity(유동성)
      • Does inventory have Liquidity?
        • Liquidity is how easily change it to cash
        • Actually inventory turns back very low cash than receivables and short-term investments
        • Thus, inventory may not be liquid and needs to know the quick ratio and current ratio
      • Good Liquidity Ratio
        • Current Ratios should be above 1
        • Quick Ratios should also be above 1 or at least close to 1
        • Cash Ratio depends on how liquid the receivables are, and other considerations
      • To reduce liquidity, invest long-term rather than short-term and spend some cash on expenditure
    • Solvency ~ Debt Ratio
      • Solvency (Leverage) Ratios
      • No negative equity
        • = bankrupt
        • = not have sufficient assets to pay for its liabilities
        • = The company has disappeared
      • The problem is Book equity (not reflect future cash flows)
        • market equity = stock price X shares outstanding
      • To measure leverage, use market value as equity on debt ratio
        • market value of equity = Market Capitalization 
        • market value of assets = Market Capitalization + Total Liabilities
      • Good Leverage Ratio
        • below 1! No greater than 1
        • if over 1, go bankrupt
    • Income Statement
      • Profitability Ratios
        
        • OPAT = Operating income - tax
          • OPAT != net income
            • Net income = approximately (OPAT - Interest Payment)
          • ROA = OPAT / Assets 
          • Do not use EPS to compare profitability across firms
            • EPS = net income / shares outstanding changed by stock splits, share repurchases
        • EBITDA
          • Operating Income (EBIT) = EBITDA - Depreciation and Amortization
          • Depreciation captures implicit cost of using the company's assets to generate profits
          • Thus use EBITDA-Taxes instead of OPAT
            • Net profit margin = (EBITDA-Taxes) / Revenues
            • ROA = (EBITDA-Taxes) / Assets
          • Be careful, profitability seems larger when looking at EBITDA

 

• Cash Flow Statement 
  • compare companies on 3 main point
    • Cash from operating activities 
    • Cash from investing activities 
    • Cash from financing activities

• convention on expenditure
  • - when expenditure: cash out
  • + when earning: cash in

 

• Using financial statements
  • establish benchmarks for comparison purposes
  • types of information that are available
•  Financial Statement Analysis
  • Time-trend analysis: find the possible explanations on the decline in financial statement
  • Peer Group Analysis
    • Peer group: ex -  SIC codes
    • Aspirant group: identify a set of primary competitors, not the average firm 
  • problem: Difficult to compare
    • Do not fit any neat industry category
    •  Major competitors and natural peer group member in an industry may be scattered around the globe
    • - Existence of difference standards, procedures, and times

+) Value over Profits

- Market value of assets / OPAT

 

4. Long-Term Financial Planning and Growth

• Financial planning
  • it forces the firm to think about the future
  • Dimension
    • planning horizon: long period means the next 2~5 years
    • Aggregation: process that smaller investment proposals of each firm are added up and treated as one big project
    •  Scenarios Division
      • 1. The worst case: pessimistic assumptions
        2. Normal case: the most likely assumptions
        3. The best case: optimistic assumptions

 

• what financial planning can accomplish and the components of a financial model
  • Accomplishment 
    • Examining interactions
      • explicit the ***linkages*** between investment proposals for the different operating activities of the firm and the financing choices available to the firm
    • Exploring Options
      • opportunity for the firm to develop, analyze, and compare many different scenarios 
    • Avoiding Surprises
      • identify what may happen to the firm if different events take place 
    • Ensuring Feasibility & Internal Consistency
      •  Verifying that the firm's goal and plans made concerning specific areas of a firm's operations are feasible and internally consistent
  • Ingredients of model
    • Sales Forecast
    • Pro Forma Statements
    • Asset Requirements
    • Financial Requirements:  financing arrangements such as dividend policy and debt policy
    • The Plug
      • Plug variable is equity:  a great number of investment opportunities & limited cash flow
      • Plug variable is dividend: few growth opportunities & ample cash flow will have a surplus 
    • Economic Assumptions
      • - level of interest rated 
        - firm's tax rate
• decided by relationship between growth and financing needs
  • ROE = Profit margin X total asset turnover X equity multiplier
  • Therefore if a firm does not wish to sell new equity & its profit margin, dividend policy, financial policy, and total asset turnover(or capital intensity) are all fixed, then there is only one possible growth rate
  • At Internal growth rate point, EFN is zero (required increase in asset = addition to retained earnings)
    • EFN (external financing needed) = Total Assets - Total liabilities and equity
    • the amount of financing the business requires form outside sources to remain profitable
  • Sustainable growth rate: maintain growth without increasing its financial leverage
    • how to increase it?
      • Increase Profit Margin ->  increase the firm's ability to generate funds internally 
      • Decrease Dividend -> increase the retention ratio & increases internally generated equity
        •  Rentention ratio (plowback ratio)  = Addition to retained earnings / Net income
      • Financial Policy:  Increase in the debt-equity ratio -> increase the firm's financial leverage
      • Increase Total Asset Turnover -> sales generated for each dollar in assets & decrease the firm's need for new assets as sales grow