Chapter 7 Accounting for Financial Management

1. Chapter 7 Accounting for Financial Management • Balance sheet • Income statement • Statement of cash flows • Accounting income versus cash flow • MVA and EVA

2. Balance Sheet

3. Income statement

4. Statement of Cash Flows

5. Free Cash Flow What is free cash flow (FCF)? Why is it important? • FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. • A company’s value depends upon the amount of FCF it can generate.

6. Operating Capital • Traditional return measures are influenced by the capital structure, tax brackets, and non-operating assets of the firm. • Using operating assets/capital focuses on the efficiency of operations within the firm, rather than these other factors.

7. What are operating current assets? • Operating current assets are the current assets needed to support operations. • Op CA include: cash, inventory, receivables. • Op CA exclude: short-term investments, because these are not a part of operations.

8. What are operating current liabilities? • Operating current liabilities are the current liabilities resulting as a normal part of operations. • Op CL include: accounts payable and accruals. • Op CL exclude: notes payable, because this is a source of financing, not a part of operations.

9. Definitions • Net Operating Working Capital Use the balance sheet data given in Table 7-1 (2012): NOWC = Operating current assets − Operating current liabilities = (Cash + Accounts receivable + Inventories) − (Accounts payable + Accruals) = ($10 + $375 + $615) − ($60 + $140) = $800 million

10. Definitions • Total Net Operating Capital Total net operating capital = $800 + $1,000 = $1,800 million • We use the terms “total net operating capital”, “operating capital” or “net operating capital” to mean the same thing

11. Comparing performance • Net income is influenced by the amount of debt a firm carries in addition to the performance of managers. • Net Operating Profit After Taxes shows the amount of net income the firm would have if it had no debt or financial assets.

12. Net Operating Profit After Taxes NOPAT = $283(1 − 0.4) = $283(0.6) = $169.8 million Free Cash Flow FCF = $169.8 – ($1,800 – $1,455) = $169.8 – $345 = −$175.2 million Operating Cash Flow Operating cash flow = NOPAT + Depreciation = $169.8 + $100 = $269.8 million Definitions

13. Return on Invested Capital (ROIC) Return on Invested Capital =$169.8/$1,800 = 0.0943 So MicroDrive had an ROIC in 2012 of 9.43%. But is this enough to cover its cost of capital?

14. Market Value Added (MVA) • Shareholder wealth is maximized by maximizing the difference between the market value of the firm's stock and the amount of equity capital that was supplied by shareholders. This difference is called the Market Value Added (MVA) : • MVA = Market Value of the Firm - Book Value of the Firm • Market Value = (# shares of stock)(price per share) + Value of debt • Book Value = Total common equity + Value of debt • If the market value of debt is close to the book value of debt, then MVA is: • MVA = Market value of equity – book value of equity

15. Economic Value Added (EVA) • So we can also calculate EVA in terms of ROIC

16. Adding Value to the firm • Sometimes during high growth periods FCF can be negative. • However, if ROIC>WACC then the firm is still increasing in value. Investors are getting a higher return from operations than the cost of capital to fund the operations. • For example, Home Depot had high growth, negative FCF, but a high ROIC.

17. Chapter 8 Analysis of Financial Statements Ratio analysis Du Pont system Limitations of ratio analysis

18. Five Major Categories of Ratios • Liquidity: Can we make required payments as they fall due? • Asset management: Do we have the right amount of assets for the level of sales? • Debt management: Do we have the right mix of debt and equity? • Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? • Market value: Do investors like what they see as reflected in P/E and M/B ratios? (Table 8-2)

19. Financial Ratio

20. Two More Aspects Effects of Debt on ROA and ROE: • ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. • However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase. Interpreting Market Based Ratios: • P/E: How much investors will pay for $1 of earnings. Higher is better. • M/B: How much paid for $1 of book value. Higher is better. • P/E and M/B are high if ROE is high, risk is low.

21. Du Pont System • The Du Pont system focuses on: • Expense control (PM) • Asset utilization (TATO) • Debt utilization (EM) • It shows how these factors combine to determine the ROE.

22. Du Pont System ROA = (113/3000)*(3000/2000) = 3.77% × 1.5 = 5.65% ROE = (113/2000)*(2000/896) = 5.65% × $2.23 = 12.6% ROE = (113/3000)*(3000/2000)*(2000/896) = (3.77%)(1.5)(2.23)= 12.6%

23. Potential Problems and Limitations of Ratio Analysis? • Comparison with industry averages is difficult if the firm operates many different divisions. • “Average” performance is not necessarily good. • Seasonal factors can distort ratios. • Different accounting and operating practices can distort comparisons. • Sometimes it is difficult to tell if a ratio value is “good” or “bad.” • Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition. • As an excellent analyst, you need to look beyond the numbers!

24. Chapter 9 Financial Planning and Forecasts • Three important uses: • Forecast the amount of external financing that will be required • Evaluate the impact that changes in the operating plan have on the value of the firm • Set appropriate targets for compensation plans

25. Steps in Financial Forecasting • Forecast sales • Project the assets needed to support sales • Project internally generated funds • Project outside funds needed • Decide how to raise funds • See effects of plan on ratios and stock price

26. Forecast Sales • The sales forecast generally starts with a review of sales during the past 5 to 10 years. However, many factors should be taken into account: the national and global economies, the firm's and its competitors' new products, planned advertising programs, and so on.

27. Next Questions: • How much new capital will be needed to fund the increased sales? Can this capital be raised internally, or will new external funds be needed? • In view of current economic conditions, will it be feasible to raise the needed capital? We answer these questions in the following sections using two approaches: • the additional funds needed (AFN) equation method. • the forecasted financial statements method.

28. Method 1: AFN (Additional Funds Needed) Key Assumptions: • Operating at full capacity. • Each type of asset grows proportionally with sales. • Payables and accruals grow proportionally with sales. • Profit margin and payout ratios are maintained • Know the % increase/decrease in sales.

29. Definitions of Variables in AFN • A*/S0: assets required to support sales; called capital intensity ratio. • ∆S: increase in sales. • L*/S0: spontaneous liabilities ratio • M: profit margin (Net income/sales) • RR: retention ratio; percent of net income not paid as dividend.

30. Assets Assets = 0.5 sales 1,250  Assets = (A*/S0)Sales = 0.5($500) = $250. 1,000 Sales 0 2,000 2,500 A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500. Assets vs. Sales

31. How would increases in these items affect the AFN? • Higher sales: • Increases asset requirements, increases AFN. • Higher dividend payout ratio: • Reduces funds available internally, increases AFN. • Higher profit margin: • Increases funds available internally, decreases AFN. • Higher capital intensity ratio, A*/S0: • Increases asset requirements, increases AFN. • Pay suppliers sooner: • Decreases spontaneous liabilities, increases AFN.

32. AFN • Sales_2012=$3000 million • increase 10% means $300 millions increase in sales next year  it requires assets increase to: A*/S0 * ∆S = 2000/3000*300 = 200 million.  it requires liabilities increase to: L*/S0 * ∆S= (60+140)/3000* 300=20 million  Internal funds available: S1 *M *(1- payout ratio) =3000*(1+10%) * (113.5/3000)* (1- 57.5/113.5)=61.58 million  So you need to find way to raise the remaining (AFN) 200-20-61.58=118.42 millions

33. Implications of AFN • If AFN is positive, then you must secure additional financing. • If AFN is negative, then you have more financing than is needed. • Pay off debt. • Buy back stock. • Buy short-term investments.

34. 1,100 1,000  Declining A/S Ratio Assets Base Stock Sales 0 2,000 2,500 $1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. Declining ratio shows economies of scale. Going from S = $0 to S = $2,000 requires $1,000 of assets. Next $500 of sales requires only $100 of assets. Economies of Scale When economies of scale occur, the ratios are likely to change over time as the size of the firm increases.

35. Excess Capacity • If a firm has excess capacity, then sales can grow before the firm must add fixed assets. • Calculate the target fixed assets/sales ratio, and use this ratio to calculate what increase in fixed assets is required.

36. 1,500 1,000 Assets 500 500 1,000 2,000 Sales A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A. Lumpy Assets In many industries, technological considerations dictate that if a firm is to be competitive, it must add fixed assets in large, discrete units; such assets are often referred to as lumpy assets

37. Example • consider MicroDrive and use the data from its financial statements in Figure 9-2, but now assume that excess capacity exists in fixed assets. Specifically, assume that fixed assets in 2012 were being utilized to only 96% of capacity. If fixed assets had been used to full capacity, • 1) Then 2012 sales could have been as high as $3,125 million versus the $3,000 million in actual sales:

38. Example • 2) MicroDrive's target fixed assets/sales ratio should be 32% rather than 33.3%: • 3) Therefore, if MicroDrive's sales increase to $3,300 million, its fixed assets would have to increase to $1,056 million:

39. Example Summary: How different factors affect the AFN forecast. • Economies of scale: leads to less-than-proportional asset increases. • Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity.