Chapter 13. Financial Planning.

Financial planning involves analyzing the financial flows of a company; forecasting the consequences of various investment, financing, and dividend decisions; and weighing the effects of various alternatives.

The idea is to determine where the firm has been, where it is now, and where it is going -not only the most likely course of events, but deviations from the most likely outcome.

METHODS OF ANALYSIS.
One of the valuable aids we find is a funds-flow statement, with which a financial manager or creditor may evaluate how a firm uses funds and may determine how this uses are financed.

In the analysis of future funds flows, we have the cash budget statement (determines the short-term cash needs of the firm) and the pro forma statement (enables the financial manager to analyze the effect of various policy decisions on the future financial condition and performance of the firm).

The final method of analysis involves sustainable growth modeling. Here we determine whether the sales growth objectives of the company are consistent with its operating efficiency and with its financial ratios.


SOURCE AND USE OF FUNDS.
The flow of funds in a firm may be visualized as a continuous process. For every use of funds, there must be an offsetting source, so that the reservoir of cash fluctuates over time with the production schedule, sales, collection of receivables, capital expenditure and financing.

The funds statement is a method by which we study the net funds flow between two points in time.

Funds Statement on a Cash Basis.
Source and use statements tell us the major uses of funds and how those uses have been financed over time.

Basically, one prepares a funds statement on a cash basis by:
(1) Classifying net balance sheet changes that occur between two points in time.

(2) Classifying, from the income statement and the shareholders' equity statement, the factors that increase cash and the factors that decrease cash.

(3) Consolidating this information in a source and use of funds statement form.

Sources of funds that increase cash are:
1. A net decrease in any asset other than cash or fixed assets.
2. A gross decrease in fixed assets.
3. A net increase in any liability.
4. Proceeds from the sale of preferred or common stock.
5. Funds provided by operations.

Uses of funds include:
1. A net increase in any asset other than cash or fixed assets.
2. A gross increase in fixed assets.
3. A net decrease in any liability.
4. A retirement or purchase of stock.
5. Cash dividends.

Categorizing the Changes. Once all sources and uses are computed, they may be arranged in statement form. When we substract the total uses of funds from the total sources, the difference should equal the actual change in cash between the two statement dates. Frequently, discrepancies will be due to equity adjustments, and the analyst should be alert to this possibility.

Accounting Statement of Cash Flows.
This statement employs positive and negative number for the increases and decreases in cash, respectively. Also, changes are categorized into operating activities, investing activities, and financing activities. A third difference is that it records gross investment in not only property, plant, and equipment (fixed assets) but also dispositions. Finally, repurchase of stock is considered a separate item.

Implications.
The analysis of funds statements gives us a rich insight into the financial operations of a firm -an insight that will be specially valuable when analyzing past and future expansion plans of the firm and the impact of these plans on liquidity. You can detect imbalances in the uses of funds and undertake appropriate actions.


CASH BUDGETING.
A cash budget is arrived at through a projection of future cash receipts and cash disbursements of the firm over various intervals of time. It reveals the timing and amount of expected cash inflows and outflows over the period studied. Cash budgets are indispensible as a planning tool when you manage a seasonal business for cash.

Preparation of the Cash Budget: Receipts.
The key to the accuracy of most cash budgets is the forecast of sales. This forecast can be based on an internal analysis (asking sales representatives to project sales), an external one (looking at trends in the economy and industry), or both (which would be more accurate).

Sales to Cash Receipts. The next job is to determine the cash receipts from these sales. For cash sales, cash is received at the time of sale; for credit sales, receipts do not come until later.

The firm should be ready to change its assumptions with respect to collections when there is an underlying shift in the payment habits of its customers.

Other receipts. In addition to the collection of sales from a product or service, cash receipts may arise from the sale of assets, from sale of stock, from a debt issue, from a tax refund, and from free income. For the most part, things of this sort are planned in advance and are predictable for purposes of cash budgeting.

Receivable Collection Period.
Different lags in the collections of sales result when the average collections period assumption is changed.

Forecasting Disbursements.
Given the sales forecast, management may choose to gear production closely to seasonal sales, to produce at a relatively constant rate over time, or to have a mixed production strategy. Once a production schedule has been stablished, estimates can be made of the needs in materials, labor, and additional fixed assets. As with receivables, there is a lag between the time a purchase is made and the time of actual cash payment.

Net Cash Flow and Cash Balance.
Once we are satisfied that we have taken into account all foreseeable cash inflows and outflows, we combine the cash receipts and cash disbursements schedules to obtain the net cash inflow or outflow for each month. The net cash flow may then be added to beginning cash in January and the projected cash position computed month by month for the period under review.

Deviations from Expected Cash Flows.
We stress again that a cash budget represents merely an estimate of future cash flows. Depending on the care devoted to preparing the budget and the volatility of cash flows resulting from the nature of the business, actual cash flows will deviate more or less widely from those that were expected.

In the face of uncertainty, we must provide information about the range of possible outcomes, and therefore working on additional cash budgets that consider different sets of assumptions (one for a maximum probable decline of business and another for a maximum probable increase in business).


PRO FORMA STATEMENTS.
Pro forma statements project forward the balance sheet and income statement.

Pro Forma Income Statement.
The pro forma income statement is a projection of income for a period of time in the future. As before, the key to accuracy is the sales forecast.

The pro forma income statement need not be based on a cash budget. Instead, one can make direct estimates of all the items. By first estimating a sales level, one can multiply.hystorical ratios of cost of goods sold and various expense items by the level in order to derive the statement.

Pro Forma Balance Sheet.
Pro formas can be based on the cash budget or on turnover ratios and percents of sales.

Estimates Based on Turnover. If a cash budget is not available, the receivable balance may be estimated on the basis of a turnover ratio. This ratio should be based on past experience. To obtain the estimated level of receivables, projected sales are simply divided by the turnover ratio.

Fixed Asset Estimate. Future net fixed assets are estimated by adding planned expenditures to existing net fixed assets and subtracting from this sum depreciation for the period, plus any sale of fixed assets at book value. Because capital expenditures are planned in advance, fixed assets generally are fairly easy to forecast.

Liability Estimates. We estimate accounts payable by adding total projected purchases for January through June, less total projected cash payments for purchases for the period, to the December 31 balance.

Equity, Cash, and Borrowing Estimates. Shareholder's equity at June 30 would be that at December 31 plus profits after taxes for the period, less the amount of cash dividends to be paid. In general, cash and notes payable serve as balancing factors in the preparation of the pro forma balance sheets, whereby assets and liabilities plus shareholders' equity are brought into balance.

Putting It Together. Once we have estimated all the components, they are combined into a balance sheet format.

Use of Ratios and Implications.
Financial ratios may be computed for analysis of the statements; these ratios and the raw figures may be compared with those for present and past balance sheets. Continual revision of these forecast keeps the firm alert to changing conditions in its environment and in its internal operations.


SUSTAINABLE GROWTH MODELING.
The management of growth requires careful balancing of the sales objectives of the firm with its operating efficiency and financial resources.

In the way of definition, the sustainable growth rate (SGR) is the maximum percent increase in sales that is possible, given a set of target financial and operating ratios.

If actual growth exceeds the SGR, something must give, and frequently it is the debt ratio. By modeling the process of growth, we are able to make intelligent trade-offs.

Steady-State Model.
To illustrate the calculation of a sustainable growth rate, we begin with a steady-state model where the future is exactly like the past with respect to balance sheet and performance ratios. Assumed also is that the firm engages in no external equity financing; the equity account builds only through earnings retention.

Variables employed.
A/S = total assets-to-sales ratio
NP/S = net profit margin (net profits divided by sales)
b = retention rate of earnings (1-b is the dividend payout ratio)
D/Eq. = debt-to-equity ratio
S₀ = most recent annual sales (beginning sales)
∆S = absolute change in sales from the most recent annual sales.

Sustainable Growth Rate. The idea is that an increase in assets (a use of funds) must equal the increase in liabillities and shareholders' equity (a source of funds). See formula in page 404.

Illustration. See the example in page 405.

Modeling under Changing Assumptions.
Most situations do not conform to steady-state modeling, so year-by-year modeling is in order.

In effect, the sales of the previous year and equity at the previous year serve as foundations on which to build year-by-year modeling. Also, we express dividends in terms of the absolute amount that a company wishes to pay, as opposed to a payout ratio. Finally, we allow for the sale of common stock in a given year, though this can be specified as zero. See formula in page 406.

Our Earlier Illustration. See example in page 406.

Varying Our Assumptions. See example in page 406.

Solving for Asset Turnover.
With any five of six variables, together with beginning equity and beginning sales, it is possible to solve for the sixth:
 Solving for the Asset Turnover. Assets-to-sales is a sensitive driver of the sustainable growth rate for capital-intensive businesses. See formula in page 407.
 Solving for the Debt Ratio. See formula in page 408.
 Solving for the Net Profit Margin. See formula in page 408.
 Solving for the Dividend. See formula in page 408.
 Solving for New Equity. See formula in page 409.

Implications.
By simulation, then, one is able to gain insight into the sensitivity of certain variables in the overall growth pictures.

To grow in a stable, balanced way, the equity base must grow proportionally with sales. When this is not the case, one or more financial ratios must change in order for the divergence in the two growth rates to be accommodated.

By putting things into a sustainable growth model, we are able to check the consistency of various growth plans.

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EJERCICIOS - Serie 1 - Capítulo 13

Chapter 12. Financial Ratio Analysis.

The firm's purpose is not only internal control but also better understanding of what capital suppliers seek in financial condition and performance from it.

INTRODUCTION TO FINANCIAL ANALYSIS.
The type of analysis varies according to the specific interests of the party involved:
 Trade creditors are interested primarily in the liquidity of a firm.
 Bondholders are more interested in the cash-flow ability of the company to service debt over the long run.
 Investors in a company's stock are concerned principally with present and expected future earnings and the stability of these earnings about a trend, as well as their covariance with the earnings of other companies.
 Management also employs financial analysis for purposes of internal control. In particular, it is concerned with profitability on investment in the various assets of the company and in the efficiency of asset management.

Use of financial ratios.
Financial ratios help us size up a company as to trends and relative to others.

The analysis of financial ratios involves two types of comparison:
Trend Analysis. Compare a present ratio with past and expected future ratios for the same company.
Comparison with Others. Compare the ratios of one firm with other similar firms or the industry average.

Some Caveats
The analyst should avoid using rules of thumb indiscriminately for all industries. The analysis must be in relation to the type of business in which the firm is engaged and to the firm itself.

Similarly, analysis of the deviation from the norm should be based on some knowledge of the distribution of ratios for the companies involved.

Comparisons with the industry must be approached with caution. The industry ratios should not be treated as target asset and performance norms. Rather, they provide general guidelines.

The analyst should realize that the various companies within an industry grouping may not be homogeneous.

Because reported financial data and their ratios are numerical, there is a tendency to regard them as precise portrayals of a firm's true financial status. The analyst should use caution in interpreting the comparisons between the data of different firms, even with standardized figures.

Types of Ratios.
Financial ratios can be grouped into five types: liquidity, debt, profitability, coverage, and market value ratios.


LIQUIDITY RATIOS.
Liquidity ratios allow assessment of whether a company is likely to be able to pay its bills.

Current Ratio = Current assets / Current liabilities

Quick Ratio = Current assets less inventories / Current liabilities
or Acid-Test

Liquidity of Receivables.
A longer average collection period results in more funds being tied up in receivables, which are liquid only insofar as the can be collected in a reasonable amount of time:

Average collection period = (Receivables x 365) / Annual credit sales
Receivable turnover ratio = Annual credit sales / Receivables

Year-End versus Average Receivables. When sales are seasonal or have grown considerable over the year, using the year-end receivable balance may not be appropriate: an average of the monthly closing balance should be used.

Interpreting the information. Either ratio must be analysed in relation to the billing terms given on the sales.

Aging of Accounts. With this method, we categorize the receivables at a moment in time according to the proportions billed in previous months. This gives us considerably more information than the calculation of the average collection period because it pinpoints the trouble spots more specifically.

Duration of payables.

Average payable period = (Accounts payable x 365) / Purchases

Liquidity of Inventories.
Inventory turns tell us the funds being tied up in inventories as well as give us a hint as to possible obsolescence.

Inventory turnover ratio = Cost of goods sold / Average inventory

DEBT RATIOS.
Debt ratios reflect the relative proportion of debt funds employed.

Debt-to-equity ratio = Total debt / Shareholders' equity
Long-term capitalization = Long-term debt / Total capitalization

Cash Flow to Debt and Capitalization.
The cash flow is defined as earnings before interest, taxes, depreciation, and amortization (EBITDA).

Cash-flow-to-total-liabilities ratio = Cash flow (EBITDA) / Total liabilities

This ratio is useful in assessing the creditworthiness of a company seeking debt funds.
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Cash-flow-to-long-term-debt-ratio = Cash flow (EBITDA) / Long-term debt

This ratio is used to evaluate the bonds of a company.
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Enterprise value-to-EBITDA ratio = (Total borrowings + Equity / Cash flow (EBITDA)

The higher this ratio, the greater the value that is being placed on the securities. When the ratio exceeds 8 the possibility of default is significant.


COVERAGE RATIOS.
Coverage ratios are designed to relate the financial charges of a firm to its ability to service them. Coverage ratios give insight into the ability of a company to service its debt.

Interest Coverage Ratio.

Interest coverage ratio = Earnings before interest and taxes / Interest charges

There are different methods to calculate the interest charges:
 Overall coverage method. A company must meet all fixed interest, regardless of the seniority of the claim.
 Prior deductions method. We deduct interest on the senior bonds from average earnings and then divide the residual by the interest on the junior bonds. This method is the most objectionable, as it gives the illusion that junior bonds are more secure than senior obligations.
 Cumulative deduction method. It is the most widely used method. Carrying charges of all debt ranking ahead or pari passu with the issue in question is divided into available earnings. For example, coverage for senior bonds are calculated only using their interest charges (and not considering junior bonds). On the other hand, coverage for the junior bonds is determined by adding the interest charges on both bonds and relating the total to average earnings.

Cash-Flow Coverage Ratios.

Cash-flow coverage of interest =
EBITDA / Annual interest payments

This ratio is very useful in determining whether a borrower is going to be able to service interest payments on a loan. Lenders want a coverage ratio comfortably above 2.0. To be investment grade it usually must be 4.0.
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Cash-flow coverage of interest and principal ratio = EBITDA / Interest + Principal payments [1/(1-t)]
where t is the income tax rate and principal payments are annual.

PROFITABILITY RATIOS.
These ratios indicate the firm's efficiency of operation.

Profitability in Relation to Sales.

Gross profit margin = Sales less cost of goods sold / Sales

This ratio indicates the efficiency of operations as well as how products are priced.
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Net profit margin = Net profits after taxes / Sales

If the gross profit margin is essentially unchanged over a period of several years, but the net profit margin has declined, we know that the cause is either higher selling, general, and administrative expenses (SG&A) relative to sales or a higher tax rate.

On the other hand, if the gross profit margin falls, we know that the cost of producing the goods relative to sales has increased, This ocurrence, in turn, may be due to problems in pricing or costs.
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SG&A to sales = Selling, general & administrative expenses / Sales

When the SG&A-to-sales increases over time and/or is large relative to peer companies it gives us cause for concern.

Net profit margin is a combination of the gross profit margin and SG&A to sales.

Profitability in Relation to Investment.

Rate of return on equity = (Net profits after taxes - Preferred stock dividend) / Shareholders' equity

This ratio tells us the earning power on shareholders' book investment.
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Return on assets (ROA) = Net profits after taxes / Total assets

Net operating profit rate of return =
Earnings before interest and taxes / Total assets

Turnover and Earning Power.
Higher asset turnover means less investment in assets is necessary to produce sales.

Asset turnover ratio = Sales / Total assets

This ratio tells us the relative efficiency with which the firm utilizes its resources in order to generate output. It varies according to the type of company being studied.
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Earning power = Net profits after taxes / Total assets

Another way to look at the return on equity is to gross it up by the equity multiplier associated with the use of debt.

Return on equity (ROE) = Earning power x (1 + Debt/Equity)

MARKET VALUE RATIOS.
There are several widely used ratios that relate the market value of a company's stock to profitability, to dividends, and to book equity.

Price/earnings, dividend yield, and market/book give indication of the relative valuation of a stock.

Price/Earnings Ratio.
The higher this ratio, the more value of the stock that is being ascribed to future earnings as opposed to present earnings. That is to say, likely future growth is what is being valued.

P/E ratio = Share price / Earnings per share

Dividend Yield.
Typically companies with good growth potential retain a high proportion of earnings and have a low dividend yield, whereas companies in more mature industries pay out a high portion of their earnings and have relatively high dividend yield.

Dividend yield = Dividends per share / Share price

Market-to-Book Ratio.
The market-to-book value ratio is a relative measure of how the growth option for a company is being valued vis-à-vis its physical assets. The greater the expected growth and value placed on such, the higher this ratio.

M/B ratio = Share price / Book value per share

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Another ratio used is the Tobin's Q ratio, in which the market value of a company is the sum of the market values of all debt instruments plus the total market value of the stock.

Q ratio = Market value of company / Replacement costs of assets

Similar to the ratio above, companies with Q ratios of less than 1.0 often are harvest situation that are worth more dead than alive (a company earns less than what financial markets require). The higher the Q ratio, the greater the industry attractiveness and/or competitive advantage.


PREDICTIVE POWER OF FINANCIAL RATIOS.
A number of empirical studies have tested the predictive power of financial ratios. The best ratios for predictive purposes are debt-to-equity, cash-flow-to-debt, net operating profit margin, debt coverage and its stability, return on investment, size, and earnings stability.

Predicting Financial Distress.
Ratios have predictive power when it comes to financial distress. It appears that a handful of ratios can be used to predict the long-term credit standing of a firm.

Altman found that five financial ratios were able to discriminate rather effectively between bankrupt (Z<1.81) and nonbankrupt companies(Z>2.99), beginning up to 5 years prior to the bankruptcy event.

The Z-score model itself was the following:
Z = 1.2 X₁ + 1.4 X₂ + 3.3 X₃ + 0.6 X₄ + 1.0 X₅
where:
X₁ = Working capital to total assets
X₂ = Cumulative retained earnings to total assets
X₃ = Earnings before interest and taxes to total assets
X₄ = Market value of equity to book value of total liabilities
X₅ = Sales to total assets

This model was expanded into what is known as the Zeta model, which includes Z scores for thousands of companies.


COMMON SIZE AND INDEX ANALYSES.
It is often useful to express balance sheet and income statement items as percentages. The percentages can be related to totals (common size analysis), or to some base year (index analysis).

The evaluation of trends in financial statemente percentages over time affords the analyst insight into the underlying improvement or deterioration in financial condition and performance.

Statement Items as Percentages of Totals.
Common size expresses assets and liabilities as a percent of total assets, and expenses and profits as a percent of sales.

Statement Items as Indexes Relative to a Base Year.
Index analysis expresses balance sheet and income statement items in index form relative to a base year.

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EJERCICIOS - Serie 1 - Capítulo 12

Chapter 1. Goals and Functions of Finance

The financial manager's domain includes:
 Investment in assets and new products.
 Determining the best mix of financing and dividends in relation to a company’s overall valuation.

CREATION OF VALUE.
A company's financial goal is to maximize shareholder wealth. Value creation occurs when you do something for your shareholders that they cannot do for themselves.

Profit Maximization versus Value Creation.
An objective of maximizing earnings per share is not the same as maximizing market price per share, since the former does not consider:
1) The timing or duration of expected returns.
2) The risk or uncertainty of the prospective earnings stream.
3) The dividend the company might pay.

Agency Problems.
The agency theory of the firm says that the principals (stockholders) can assure themselves that the agent (management) will make optimal decisions only if appropriate incentives are given and only if the agent is monitored.

Agency costs involve conflicts between stakeholders -equity holders, lenders, employees, suppliers, etc.-, which usually arise because they have different objectives, thereby causing each party to want to monitor the others.

A Normative Goal.
The purpose of capital markets is to allocate savings efficiently in an economy, from ultimate savers to ultimate users of funds who invest in real assets. This allocation occurs on the basis of expected return and risk, which are embodied in the share price.

Social Responsibility. This is not to say that management should ignore social responsibility. Social goals and economic efficiency can work together to benefit multiple stakeholders, and not only the stockholders.

Functions of Finance. The functions of finance involve three major decisions a company must make: the investment decision, the financing decision, and the dividend/share repurchase decision. Each must be considered in relation to our objective; an optimal combination of the three will create value.


INVESTMENT DECISION.
Capital investment is the allocation of capital to investment proposals whose benefits are to be realized in the future. Because the future benefits are not known with certainty, investment proposals necessarily involve risk. Therefore, investments in capital projects should provide expected returns in excess of what financial markets require.

In addition to selecting new investments, a company must manage existing assets efficiently.


FINANCING DECISION.
Capital structure involves determining the best mix of debt, equity, and hybrid securities to employ. If a company can change its total valuation by varying its capital structure, an optimal financing mix would exist, in which market price per share could be maximized.


DIVIDEND/SHARE REPURCHASE DECISION.
Excess cash can be distributed to stockholders directly through dividends or indirectly via share repurchase (which allows to avoid tax consequences).

The value, if any, of these actions to investors must be balanced against the opportunity cost of the retained earnings lost as a means of equity financing, which could bring share prices down.


BRINGING IT ALL TOGETHER.
Financial management endeavors to make optimal investment, financing and dividend/share repurchase decisions.