Question and Problem Sets

I attached the reading material and questions along with 2 excel templates 

a total of 8 questions

I will have to email you because some of the images did not copy to the attachment.

need this in 24 hours…..if you can do please let me know asap

Purpose of Assignment

Provide students with a basic understanding of financial management, goal of the firm, and the basic financial statements. Students should be able to calculate and analyze solvency, liquidity, profitability and market value ratios, and create proforma financial statements.

Assignment Steps 

Resources: Tutorial help on Excel® and Word functions can be found on the Microsoft®Office website. There are also additional tutorials via the web that offer support for office products. 

Complete the following Questions and Problems (Concepts and Critical Thinking Questions for Ch. 1 Only) from each chapter as indicated. 

Show all work and analysis. 

Prepare in Microsoft® Excel® or Word. 

• Ch. 1: Questions 3 & 11 (Concepts Review and Critical Thinking Questions section)
• Ch. 2: Questions 4 & 9 (Questions and Problems section): Microsoft® Excel® template provided for Problem 4.
• Ch. 3: Questions 4 & 7 (Question and Problems section)
• Ch. 4: Questions 1 & 6 (Questions and Problems section): Microsoft® Excel® template provided for Problem 6.

Format your assignment consistent with APA guidelines if submitting in Microsoft® Word. 

Click the Assignment Files tab to submit your assignment.

Materials

• Question and Problem Sets Grading Guide
• Ch. 2 Problem 4 Microsoft® Excel® Template
• Ch. 4 Problem 6 Microsoft® Excel® Template
• Fundamentals of Corporate Finance, Ch. 1: Introduction to Corporate Finance
• Fundamentals of Corporate Finance, Ch. 2: Financial Statements, Taxes, and Cash Flow
• Fundamentals of Corporate Finance, Ch. 3: Working with Financial Statements
• Fundamentals of Corporate Finance, Ch. 4: Long-Term Financial Planning and Growth

· Ch. 1: Questions 3 & 11 (Concepts Review and Critical Thinking Questions section)

· I will high light in

 

BOLD the questions in the ” Concepts Review and Critical Thinking ” section below in Ch 1...

This can be answered in a word document. no specific word count is needed….as long as the question is answered…..it will be fine

if any questions please ask

PART 1 Overview of Corporate Finance

Introduction to Corporate Finance

1

GEORGE ZIMMER, FOUNDER of The Men’s Wearhouse, for years appeared in television ads promising “You’re going to like the way you look. I guarantee it.” But, in mid-2013, Zimmer evidently didn’t look so good to the company’s board of directors, which abruptly fired him. It was reported that Zimmer had a series of disagreements with the board, including a desire to take the company private. Evidently, Zimmer’s ideas did not “suit” the board.

Understanding Zimmer’s journey from the founder of a clothing store that used a cigar box as a cash register, to corporate executive, and finally to ex-employee takes us into issues involving the corporate form of organization, corporate goals, and corporate control, all of which we discuss in this chapter. You’re going to learn a lot if you read it. We guarantee it.

For updates on the latest happenings in finance, visit 

www.fundamentalsofcorporatefinance.blogspot.com

.

Learning Objectives

After studying this chapter, you should understand:

LO1	The basic types of financial management decisions and the role of the financial manager.
LO2	The goal of financial management.
LO3	The financial implications of the different forms of business organization.
LO4	The conflicts of interest that can arise between managers and owners.

To begin our study of modern corporate finance and financial management, we need to address two central issues. First, what is corporate finance and what is the role of the financial manager in the corporation? Second, what is the goal of financial management? To describe the financial management environment, we consider the corporate form of organization and discuss some conflicts that can arise within the corporation. We also take a brief look at financial markets in the United States.

Page 21.1 Corporate Finance and the Financial Manager

In this section, we discuss where the financial manager fits in the corporation. We start by defining corporate finance and the financial manager’s job.

WHAT IS CORPORATE FINANCE?

Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:

1.  What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?

2.  Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?

3.  How will you manage your everyday financial activities such as collecting from customers and paying suppliers?

These are not the only questions by any means, but they are among the most important. Corporate finance, broadly speaking, is the study of ways to answer these three questions. Accordingly, we’ll be looking at each of them in the chapters ahead.

THE FINANCIAL MANAGER

A striking feature of large corporations is that the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. In a large corporation, the financial manager would be in charge of answering the three questions we raised in the preceding section.

The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). 

Figure 1.1

 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems. The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. These treasury activities are all related to the three general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s office.

For current issues facing CFOs, see 
ww2.cfo.com
.

FINANCIAL MANAGEMENT DECISIONS

As the preceding discussion suggests, the financial manager must be concerned with three basic types of questions. We consider these in greater detail next.

Capital Budgeting The first question concerns the firm’s long-term investments. The process of planning and managing a firm’s long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset.

capital budgeting
The process of planning and managing a firm’s long-term investments.

The types of investment opportunities that would typically be considered depend in part on the nature of the firm’s business. For example, for a large retailer such as Walmart, deciding whether to open another store would be an important capital budgeting decision. Similarly, for a software company such as Oracle or Microsoft, the decision to develop and market a new spreadsheet program would be a major capital budgeting decision. Some decisions, such as what type of computer system to purchase, might not depend so much on a particular line of business.

Page 3FIGURE 1.1
A Sample Simplified Organizational Chart

Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, as we will see in the chapters ahead, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be by far the most important things we will consider.

Capital Structure The second question for the financial manager concerns ways in which the firm obtains and manages the long-term financing it needs to support its long-term investments. A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what are the least expensive sources of funds for the firm?

capital structure
The mixture of debt and equity maintained by a firm.

Page 4If we picture the firm as a pie, then the firm’s capital structure determines how that pie is sliced—in other words, what percentage of the firm’s cash flow goes to creditors and what percentage goes to shareholders. Firms have a great deal of flexibility in choosing a financial structure. The question of whether one structure is better than any other for a particular firm is the heart of the capital structure issue.

In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. Also, corporations borrow money from a variety of lenders in a number of different, and sometimes exotic, ways. Choosing among lenders and among loan types is another job handled by the financial manager.

Working Capital Management The third question concerns working capital management. The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm’s receipt and disbursement of cash.

working capital
A firm’s short-term assets and liabilities.

Some questions about working capital that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them? (3) How will we obtain any needed short-term financing? Will we purchase on credit, or will we borrow in the short term and pay cash? If we borrow in the short term, how and where should we do it? These are just a small sample of the issues that arise in managing a firm’s working capital.

Conclusion The three areas of corporate financial management we have described—capital budgeting, capital structure, and working capital management—are very broad categories. Each includes a rich variety of topics, and we have indicated only a few questions that arise in the different areas. The chapters ahead contain greater detail.

Concept Questions

1.1a   What is the capital budgeting decision?

1.1b   What do you call the specific mixture of long-term debt and equity that a firm chooses to use?

1.1c   Into what category of financial management does cash management fall?

1.2 Forms of Business Organization

Large firms in the United States, such as Ford and Microsoft, are almost all organized as corporations. We examine the three different legal forms of business organization—sole proprietorship, partnership, and corporation—to see why this is so. Each form has distinct advantages and disadvantages for the life of the business, the ability of the business to raise cash, and taxes. A key observation is that as a firm grows, the advantages of the corporate form may come to outweigh the disadvantages.

SOLE PROPRIETORSHIP

A sole proprietorship is a business owned by one person. This is the simplest type of business to start and is the least regulated form of organization. Depending on where you live, you might be able to start a proprietorship by doing little more than getting a business license and opening your doors. For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships.

sole proprietorship
A business owned by a single individual.

Page 5The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is that the owner has unlimited liability for business debts. This means that creditors can look beyond business assets to the proprietor’s personal assets for payment. Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income.

The life of a sole proprietorship is limited to the owner’s life span, and the amount of equity that can be raised is limited to the amount of the proprietor’s personal wealth. This limitation often means that the business is unable to exploit new opportunities because of insufficient capital. Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner.

PARTNERSHIP

A partnership is similar to a proprietorship except that there are two or more owners (partners). In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement, such as “let’s start a lawn mowing business,” or a lengthy, formal written document.

partnership
A business formed by two or more individuals or entities.

In a limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner’s liability for business debts is limited to the amount that partner contributes to the partnership. This form of organization is common in real estate ventures, for example.

The advantages and disadvantages of a partnership are basically the same as those of a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wishes to sell out or dies. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners’ combined wealth. Ownership of a general partnership is not easily transferred because a transfer requires that a new partnership be formed. A limited partner’s interest can be sold without dissolving the partnership, but finding a buyer may be difficult.

Because a partner in a general partnership can be held responsible for all partnership debts, having a written agreement is very important. Failure to spell out the rights and duties of the partners frequently leads to misunderstandings later on. Also, if you are a limited partner, you must not become deeply involved in business decisions unless you are willing to assume the obligations of a general partner. The reason is that if things go badly, you may be deemed to be a general partner even though you say you are a limited partner.

Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages add up to a single, central problem: the ability of such businesses to grow can be seriously limited by an inability to raise cash for investment.

CORPORATION

The corporation is the most important form (in terms of size) of business organization in the United States. A corporation is a legal “person,” separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation.

corporation
A business created as a distinct legal entity composed of one or more individuals or entities.

Page 6Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organization. Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a number of things, including the corporation’s name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued. This information must normally be supplied to the state in which the firm will be incorporated. For most legal purposes, the corporation is a “resident” of that state.

The bylaws are rules describing how the corporation regulates its existence. For example, the bylaws describe how directors are elected. These bylaws may be a simple statement of a few rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be amended or extended from time to time by the stockholders.

In a large corporation, the stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Managers are charged with running the corporation’s affairs in the stockholders’ interests. In principle, stockholders control the corporation because they elect the directors.

As a result of the separation of ownership and management, the corporate form has several advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is therefore not limited. The corporation borrows money in its own name. As a result, the stockholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested.

The relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are why the corporate form is superior for raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and attract new investors. Apple is an example. The company was a pioneer in the personal computer business. As demand for its products exploded, it had to convert to the corporate form of organization to raise the capital needed to fund growth and new product development. The number of owners can be huge; larger corporations have many thousands or even millions of stockholders. For example, in 2014, General Electric Company (better known as GE) had about 4 million stockholders and about 10.1 billion shares outstanding. In such cases, ownership can change continuously without affecting the continuity of the business.

The corporate form has a significant disadvantage. Because a corporation is a legal person, it must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed again as income to those stockholders. This is double taxation, meaning that corporate profits are taxed twice: at the corporate level when they are earned and again at the personal level when they are paid out.
1

Today, all 50 states have enacted laws allowing for the creation of a relatively new form of business organization, the limited liability company (LLC). The goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners, so an LLC is essentially a hybrid of partnership and corporation. Although states have differing definitions for LLCs, the more important scorekeeper is the Internal Revenue Service (IRS). The IRS will consider an LLC a corporation, thereby subjecting it to double taxation, unless it meets certain specific criteria. In essence, an LLC cannot be too corporation-like, or it will be treated as one by the IRS. LLCs have become common. For example, Goldman, Sachs and Co., one of Wall Street’s last remaining partnerships, decided to convert from a private partnership to an LLC (it later “went public,” becoming a publicly held corporation). Large accounting firms and law firms by the score have converted to LLCs.

Page 7TABLE 1.1 Intemational Corporations

As the discussion in this section illustrates, the need of large businesses for outside investors and creditors is such that the corporate form will generally be the best for such firms. We focus on corporations in the chapters ahead because of the importance of the corporate form in the U.S. and world economies. Also, a few important financial management issues, such as dividend policy, are unique to corporations. However, businesses of all types and sizes need financial management, so the majority of the subjects we discuss bear on any form of business.

A CORPORATION BY ANOTHER NAME …

The corporate form of organization has many variations around the world. The exact laws and regulations differ from country to country, of course, but the essential features of public ownership and limited liability remain. These firms are often called joint stock companies, public limited companies, or limited liability companies, depending on the specific nature of the firm and the country of origin.

Table 1.1

 gives the names of a few well-known international corporations, their countries of origin, and a translation of the abbreviation that follows the company name.

Concept Questions

1.2a   What are the three forms of business organization?

1.2b   What are the primary advantages and disadvantages of sole proprietorships and partnerships?

1.2c   What is the difference between a general and a limited partnership?

1.2d   Why is the corporate form superior when it comes to raising cash?

1.3 The Goal of Financial Management

Assuming that we restrict ourselves to for-profit businesses, the goal of financial management is to make money or add value for the owners. This goal is a little vague, of course, so we examine some different ways of formulating it to come up with a more precise definition. Such a definition is important because it leads to an objective basis for making and evaluating financial decisions.

Page 8POSSIBLE GOALS

If we were to consider possible financial goals, we might come up with some ideas like the following:

Survive.

Avoid financial distress and bankruptcy.

Beat the competition.

Maximize sales or market share.

Minimize costs.

Maximize profits.

Maintain steady earnings growth.

These are only a few of the goals we could list. Furthermore, each of these possibilities presents problems as a goal for the financial manager.

For example, it’s easy to increase market share or unit sales: All we have to do is lower our prices or relax our credit terms. Similarly, we can always cut costs simply by doing away with things such as research and development. We can avoid bankruptcy by never borrowing any money or never taking any risks, and so on. It’s not clear that any of these actions are in the stockholders’ best interests.

Profit maximization would probably be the most commonly cited goal, but even this is not a precise objective. Do we mean profits this year? If so, we should note that actions such as deferring maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to increase profits now, but these activities aren’t necessarily desirable.

The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s still unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see in more detail in the next chapter, these accounting numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us what the appropriate trade-off is between current and future profits.

The goals we’ve listed here are all different, but they tend to fall into two classes. The first of these relates to profitability. The goals involving sales, market share, and cost control all relate, at least potentially, to different ways of earning or increasing profits. The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory. The pursuit of profit normally involves some element of risk, so it isn’t really possible to maximize both safety and profit. What we need, therefore, is a goal that encompasses both factors.

THE GOAL OF FINANCIAL MANAGEMENT

The financial manager in a corporation makes decisions for the stockholders of the firm. Given this, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders’ point of view, what is a good financial management decision?

If we assume that stockholders buy stock because they seek to gain financially, then the answer is obvious: Good decisions increase the value of the stock, and poor decisions decrease the value of the stock.

Given our observations, it follows that the financial manager acts in the shareholders’ best interests by making decisions that increase the value of the stock. The appropriate goal for the financial manager can thus be stated quite easily:

Page 9

The goal of financial management is to maximize the current value per share of the existing stock.

The goal of maximizing the value of the stock avoids the problems associated with the different goals we listed earlier. There is no ambiguity in the criterion, and there is no short-run versus long-run issue. We explicitly mean that our goal is to maximize the current stock value.

If this goal seems a little strong or one-dimensional to you, keep in mind that the stockholders in a firm are residual owners. By this we mean that they are entitled to only what is left after employees, suppliers, and creditors (and anyone else with a legitimate claim) are paid their due. If any of these groups go unpaid, the stockholders get nothing. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

Because the goal of financial management is to maximize the value of the stock, we need to learn how to identify investments and financing arrangements that favorably impact the value of the stock. This is precisely what we will be studying. In fact, we could have defined corporate finance as the study of the relationship between business decisions and the value of the stock in the business.

A MORE GENERAL GOAL

Given our goal as stated in the preceding section (maximize the value of the stock), an obvious question comes up: What is the appropriate goal when the firm has no traded stock? Corporations are certainly not the only type of business; and the stock in many corporations rarely changes hands, so it’s difficult to say what the value per share is at any given time.

As long as we are dealing with for-profit businesses, only a slight modification is needed. The total value of the stock in a corporation is simply equal to the value of the owners’ equity. Therefore, a more general way of stating our goal is as follows: Maximize the market value of the existing owners’ equity.

With this in mind, it doesn’t matter whether the business is a proprietorship, a partnership, or a corporation. For each of these, good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it. In fact, although we focus on corporations in the chapters ahead, the principles we develop apply to all forms of business. Many of them even apply to the not-for-profit sector.

Finally, our goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. What we mean is that the financial manager best serves the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free marketplace.

SARBANES-OXLEY

In response to corporate scandals at companies such as Enron, WorldCom, Tyco, and Adelphia, Congress enacted the Sarbanes-Oxley Act in 2002. The act, better known as “Sarbox,” is intended to protect investors from corporate abuses. For example, one section of Sarbox prohibits personal loans from a company to its officers, such as the ones that were received by WorldCom CEO Bernie Ebbers.

One of the key sections of Sarbox took effect on November 15, 2004. Section 404 requires, among other things, that each company’s annual report must have an assessment of the company’s internal control structure and financial reporting. An independent auditor must then evaluate and attest to management’s assessment of these issues.

Page 10Sarbox contains other key requirements. For example, the officers of the corporation must review and sign the annual reports. They must explicitly declare that the annual report does not contain any false statements or material omissions; that the financial statements fairly represent the financial results; and that they are responsible for all internal controls. Finally, the annual report must list any deficiencies in internal controls. In essence, Sarbox makes company management responsible for the accuracy of the company’s financial statements.

Because of its extensive reporting requirements, compliance with Sarbox can be very costly, which has led to some unintended results. Since its implementation, hundreds of public firms have chosen to “go dark,” meaning that their shares are no longer traded on the major stock exchanges, in which case Sarbox does not apply. Most of these companies stated that their reason was to avoid the cost of compliance. Ironically, in such cases, the law had the effect of eliminating public disclosure instead of improving it.

For more about Sarbanes-Oxley, visit 

www.soxlaw.com

.

Concept Questions

1.3a   What is the goal of financial management?

1.3b   What are some shortcomings of the goal of profit maximization?

1.3c   Can you give a definition of corporate finance?

1.4 The Agency Problem and Control of the Corporation

We’ve seen that the financial manager acts in the best interests of the stockholders by taking actions that increase the value of the stock. However, we’ve also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders’ expense? In the following pages, we briefly consider some of the arguments relating to this question.

AGENCY RELATIONSHIPS

The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests. For example, you might hire someone (an agent) to sell a car you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problem.

agency problem
The possibility of conflict of interest between the stockholders and management of a firm.

Suppose you hire someone to sell your car and agree to pay that person a flat fee when he or she sells the car. The agent’s incentive in this case is to make the sale, not necessarily to get you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way in which an agent is compensated is one factor that affects agency problems.

MANAGEMENT GOALS

To see how management and stockholder interests might differ, imagine that the firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to Page 11take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

More generally, the term agency costs refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity, such as the one we have just described.

Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control or, more generally, corporate power or wealth. This goal could lead to an overemphasis on corporate size or growth. For example, cases in which management is accused of overpaying to buy up another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefit the stockholders of the purchasing company.

Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals.

DO MANAGERS ACT IN THE STOCKHOLDERS’ INTERESTS?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates, at least in part, to the way managers are compensated. Second, can managers be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that even in the largest firms, management has a significant incentive to act in the interests of stockholders.

Managerial Compensation Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and often to share value in particular. For example, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth, the more valuable is this option. In fact, options are often used to motivate employees of all types, not just top managers. For example, in late 2014, Google’s more than 46,000 employees owned enough options to buy 6.1 million shares in the company. Many other corporations, large and small, have adopted similar policies.

The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, according to The Wall Street Journal, the best-paid executive in 2013 was Lawrence Ellison, the CEO of Oracle. According to The Journal, he made about $76.9 million. By way of comparison, Ellison made only slightly more than LeBron James ($72.3 million) and Robert Downey Jr. ($75 million). Information about executive compensation, along with lots of other information, can be easily found on the Web for almost any public company. Our nearby Work the Web box shows you how to get started.

Business ethics are considered at 

www.business-ethics.com

.

Page 12Control of the Firm Control of the firm ultimately rests with stockholders. They elect the board of directors, who in turn hire and fire managers. The fact that stockholders control the corporation was made abundantly clear by Steve Jobs’s experience at Apple. Even though he was a founder of the corporation and was largely responsible for its most successful products, there came a time when shareholders, through their elected directors, decided that Apple would be better off without him, so out he went. Of course, he was later rehired and helped turn Apple around with great new products such as the iPod, iPhone, and iPad.

An important mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else’s stock. A proxy fight develops when a group solicits proxies in order to replace the existing board and thereby replace existing managers. For example, in 2013, hedge fund Elliott Management launched a proxy battle with oil company Hess Corporation. Elliott argued that Hess should divest its smaller divisions and focus solely on exploration and production and that CEO/chairman John Hess should be stripped of the position of chairman. In the end, Hess stepped down as chairman, three directors backed by Elliott were placed on the board of directors, and Hess announced plans to sell its retail gasoline, marketing, and trading businesses.

Another way that managers can be replaced is by takeover. Firms that are poorly managed are more attractive as acquisitions because a greater profit potential exists. Thus, avoiding a takeover gives management another incentive to act in the stockholders’ interests. For example, in the chapter opener, we discussed George Zimmer’s firing by the board of The Men’s Wearhouse. A few months later, rival Jos. A. Bank made a bid to buy the company, despite the fact that Bank was a significantly smaller firm. The offer was rejected. But, in an interesting turn of events, The Men’s Wearhouse offered to buy Jos. A. Bank! After months of back and forth, the two companies announced in March 2014 that a deal had been finalized, with The Men’s Wearhouse buying Jos. A. Bank for $65 per share. That price was about 38 percent higher than Bank’s stock price when talks began, so The Men’s Wearhouse made an excellent “suit-or.”

Conclusion The available theory and evidence are consistent with the view that stockholders control the firm and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will undoubtedly be times when management goals are pursued at the expense of the stockholders, at least temporarily.

STAKEHOLDERS

Our discussion thus far implies that management and stockholders are the only parties with an interest in the firm’s decisions. This is an oversimplification, of course. Employees, customers, suppliers, and even the government all have a financial interest in the firm.

Taken together, these various groups are called stakeholders in the firm. In general, a stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners.

stakeholder
Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.

Concept Questions

1.4a   What is an agency relationship?

1.4b   What are agency problems and how do they come about? What are agency costs?

1.4c   What incentives do managers in large corporations have to maximize share value?

Page 13

WORK THE WEB

The Web is a great place to learn more about individual companies, and there are a slew of sites available to help you. Try pointing your Web browser to 

finance.yahoo.com

. Once you get there, you should see something like this on the page:

To look up a company, you must know its “ticker symbol” (or just ticker for short), which is a unique one- to four-letter identifier. You can click on the “Symbol Lookup” link and type in the company’s name to find the ticker. For example, we typed in “PZZA”, which is the ticker for pizza maker Papa John’s. Here is a portion of what we got:

There’s a lot of information here and many links for you to explore, so have at it. By the end of the term, we hope it all makes sense to you!

Questions

1.  Go to finance.yahoo.com and find the current stock prices for Southwest Airlines (LUV), Harley-Davidson (HOG), and Starwood Hotels & Resorts (HOT).

2.  Get a quote for American Express (AXP) and follow the “Key Statistics” link. What information is available on this link? What domrq, ttm, yoy, and lfy mean?

1.5 Financial Markets and the Corporation

We’ve seen that the primary advantages of the corporate form of organization are that ownership can be transferred more quickly and easily than with other forms and that money can be raised more readily. Both of these advantages are significantly enhanced by the existence of financial markets, and financial markets play an extremely important role in corporate finance.

Page 14CASH FLOWS TO AND FROM THE FIRM

The interplay between the corporation and the financial markets is illustrated in 

Figure 1.2

. The arrows in 
Figure 1.2
trace the passage of cash from the financial markets to the firm and from the firm back to the financial markets.

Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash flows to the firm from the financial markets (A). The firm invests the cash in current and fixed assets (B). These assets generate cash (C), some of which goes to pay corporate taxes (D). After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the financial markets as cash paid to creditors and shareholders (F).

A financial market, like any market, is just a way of bringing buyers and sellers together. In financial markets, it is debt and equity securities that are bought and sold. Financial markets differ in detail, however. The most important differences concern the types of securities that are traded, how trading is conducted, and who the buyers and sellers are. Some of these differences are discussed next.

PRIMARY VERSUS SECONDARY MARKETS

Financial markets function as both primary and secondary markets for debt and equity securities. The term primary market refers to the original sale of securities by governments and corporations. The secondary markets are those in which these securities are bought and sold after the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued by both governments and corporations. In the discussion that follows, we focus on corporate securities only.

Primary Markets In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, whereas a private placement is a negotiated sale involving a specific buyer.

FIGURE 1.2
Cash Flows between the Firm and the Financial Markets

Page 15By law, public offerings of debt and equity must be registered with the Securities and Exchange Commission (SEC). Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable.

To learn more about the SEC, visit 

www.sec.gov

.

Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the SEC and do not require the involvement of underwriters (investment banks that specialize in selling securities to the public).

Secondary Markets A secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. Although a corporation is directly involved only in a primary market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations. The reason is that investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired.

Dealer versus Auction Markets There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses.

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically.

Auction markets differ from dealer markets in two ways. First, an auction market or exchange has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

Trading in Corporate Securities The equity shares of most of the large firms in the United States trade in organized auction markets. The largest such market is the New York Stock Exchange (NYSE). There is also a large OTC market for stocks. In 1971, the National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ (which originally stood for NASD Automated Quotation system and is pronounced “naz-dak”). NASDAQ-listed companies tend to be smaller and trade less actively. There are exceptions, of course. Both Microsoft and Intel trade OTC, for example. Nonetheless, the total value of NASDAQ stocks is much less than the total value of NYSE stocks.

To learn more about the exchanges, visit 

www.nyse.com

 and 

www.nasdaq.com

.

There are many large and important financial markets outside the United States, of course, and U.S. corporations are increasingly looking to these markets to raise cash. The Tokyo Stock Exchange and the London Stock Exchange (TSE and LSE, respectively) are two well-known examples. The fact that OTC markets have no physical location means that Page 16national borders do not present a great barrier, and there is now a huge international OTC debt market. Because of globalization, financial markets have reached the point where trading in many investments never stops; it just travels around the world.

Listing Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ from one exchange to another.

The NYSE has the most stringent requirements of the exchanges in the United States. For example, to be listed on the NYSE, a company is expected to have a market value for its publicly held shares of at least $100 million. There are additional minimums on earnings, assets, and number of shares outstanding.

Concept Questions

1.5a   What is a dealer market? How do dealer and auction markets differ?

1.5b   What does OTC stand for? What is the large OTC market for stocks called?

1.5c   What is the largest auction market in the United States?

 

1.6   Summary and Conclusions

This chapter introduced you to some of the basic ideas in corporate finance:

1.  Corporate finance has three main areas of concern:

a.  Capital budgeting: What long-term investments should the firm take?

b.  Capital structure: Where will the firm get the long-term financing to pay for its investments? In other words, what mixture of debt and equity should the firm use to fund operations?

c.  Working capital management: How should the firm manage its everyday financial activities?

2.  The goal of financial management in a for-profit business is to make decisions that increase the value of the stock or, more generally, increase the market value of the equity.

3.  The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation.

4.  There is the possibility of conflicts between stockholders and management in a large corporation. We called these conflicts agency problems and discussed how they might be controlled and reduced.

5.  The advantages of the corporate form are enhanced by the existence of financial markets. Financial markets function as both primary and secondary markets for corporate securities and can be organized as either dealer or auction markets.

Of the topics we’ve discussed thus far, the most important is the goal of financial management: maximizing the value of the stock. Throughout the text, we will be analyzing many different financial decisions, but we will always ask the same question: How does the decision under consideration affect the value of the stock?

Page 17

CONNECT TO FINANCE

Connect Finance offers you plenty of opportunities to practice mastering these concepts. Log on to connect.mheducation.com to learn more. If you like what you see, ask your professor about using Connect Finance!

Can you answer the following Connect Quiz questions?

Section 1.1	Deciding which fixed assets should be purchased is an example of what type of decision?
Section 1.2	What form of ownership is easiest to transfer?
Section 1.3	What best describes the goal of financial management?
Section 1.4	In a corporation, the primary agency conflict arises between which two parties?

CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS

1.   The Financial Management Decision Process [LO1] What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.

2.   Sole Proprietorships and Partnerships [LO3] What are the four primary disadvantages of the sole proprietorship and partnership forms of business organization? What benefits are there to these types of business organization as opposed to the corporate form?

3.   Corporations [LO3] What is the primary disadvantage of the corporate form of organization? Name at least two advantages of corporate organization.

4.   Sarbanes-Oxley [LO4] In response to the Sarbanes-Oxley Act, many small firms in the United States have opted to “go dark” and delist their stock. Why might a company choose this route? What are the costs of “going dark”?

5.   Corporate Finance Organization [LO1] In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance?

6.   Goal of Financial Management [LO2] What goal should always motivate the actions of a firm’s financial manager?

7.   Agency Problems [LO4] Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise?

8.   Primary versus Secondary Markets [LO3] You’ve probably noticed coverage in the financial press of an initial public offering (IPO) of a company’s securities. Is an IPO a primary market transaction or a secondary market transaction?

9.   Auction versus Dealer Markets [LO3] What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets? What kind of market is NASDAQ?

10.   Not-for-Profit Firm Goals [LO2] Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate?

Page 1811.   Goal of the Firm [LO2] Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

12.   Ethics and Firm Goals [LO2] Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer.

13.   International Firm Goal [LO2] Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not?

14.   Agency Problems [LO4] Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company’s management immediately begins fighting off this hostile bid. Is management acting in the shareholders’ best interests? Why or why not?

15.   Agency Problems and Corporate Ownership [LO4] Corporate ownership varies around the world. Historically individuals have owned the majority of shares in public corporations in the United States. In Germany and Japan, however, banks, other large financial institutions, and other companies own most of the stock in public corporations. Do you think agency problems are likely to be more or less severe in Germany and Japan than in the United States? Why? Over the last few decades, large financial institutions such as mutual funds and pension funds have been becoming the dominant owners of stock in the United States, and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control?

16.   Executive Compensation [LO4] Critics have charged that compensation to top managers in the United States is simply too high and should be cut back. For example, focusing on large corporations, Robert Kotick, CEO of Activision Blizzard, earned about $64.9 million in 2013. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as LeBron James, top entertainers such as Tom Hanks and Oprah Winfrey, and many others at the top of their respective fields earn at least as much, if not a great deal more.

MINICASE

The McGee Cake Company

In early 2008, Doc and Lyn McGee formed the McGee Cake Company. The company produced a full line of cakes, and its specialties included chess cake*, lemon pound cake, and double-iced, double-chocolate cake. The couple formed the company as an outside interest, and both continued to work at their current jobs. Doc did all the baking, and Lyn handled the marketing and distribution. With good product quality and a sound marketing plan, the company grew rapidly. In early 2013, the company was featured in a widely distributed entrepreneurial magazine. Later that year, the company was featured in Gourmet Desserts, a leading specialty food magazine. After the article appeared in Gourmet Desserts, sales exploded, and the company began receiving orders from all over the world.

Because of the increased sales, Doc left his other job, followed shortly by Lyn. The company hired additional workers to meet demand. Unfortunately, the fast growth experienced by the company led to cash flow and capacity problems. The company is currently producing as many cakes as possible with Page 19the assets it owns, but demand for its cakes is still growing. Further, the company has been approached by a national supermarket chain with a proposal to put four of its cakes in all of the chain’s stores, and a national restaurant chain has contacted the company about selling McGee cakes in its restaurants. The restaurant would sell the cakes without a brand name.

Doc and Lyn have operated the company as a sole proprietorship. They have approached you to help manage and direct the company’s growth. Specifically, they have asked you to answer the following questions.

QUESTIONS

1.  What are the advantages and disadvantages of changing the company organization from a sole proprietorship to an LLC?

2.  What are the advantages and disadvantages of changing the company organization from a sole proprietorship to a corporation?

3.  Ultimately, what action would you recommend the company undertake? Why?

__________

* Chess cake is quite delicious and distinct from cheesecake. The origin of the name is obscure.

·

Ch. 3: Questions 4 & 7 (Question and Problems section)

·

· I HIGH LIGHTED IT BELOW IN BOLD

PART 2

 

Financial Statements and Long-Term Financial Planning

Working with Financial Statements

3

THE PRICE OF A SHARE OF COMMON STOCK in cereal maker General Mills closed at about $49 on January 8, 2014. At that price, General Mills had a price–earnings (PE) ratio of 18. That is, investors were willing to pay $18 for every dollar in income earned by General Mills. At the same time, investors were willing to pay $105, $31, and $11 for each dollar earned by Adobe Systems, Google, and Ford, respectively. At the other extreme were Blackberry and Twitter. Both had negative earnings for the previous year, yet Blackberry was priced at about $9 per share and Twitter at about $59 per share. Because they had negative earnings, their PE ratios would have been negative, so they were not reported. At the time, the typical stock in the S&P 500 index of large company stocks was trading at a PE of about 16, or about 16 times earnings, as they say on Wall Street.

Price-to-earnings comparisons are examples of the use of financial ratios. As we will see in this chapter, there are a wide variety of financial ratios, all designed to summarize specific aspects of a firm’s financial position. In addition to discussing how to analyze financial statements and compute financial ratios, we will have quite a bit to say about who uses this information and why.

For updates on the latest happenings in finance, visit 

www.fundamentalsofcorporatefinance.blogspot.com

.

Learning Objectives

After studying this chapter, you should understand:

LO1	How to standardize financial statements for comparison purposes.
LO2	How to compute and, more importantly, interpret some common ratios.
LO3	The determinants of a firm’s profitability.
LO4	Some of the problems and pitfalls in financial statement analysis.

In 

Chapter 2

, we discussed some of the essential concepts of financial statements and cash flow. 

Part 2

, this chapter and the next, continues where our earlier discussion left off. Our goal here is to expand your understanding of the uses (and abuses) of financial statement information.

Financial statement information will crop up in various places in the remainder of our book. 
Part 2
 is not essential for understanding this material, but it will help give you an overall perspective on the role of financial statement information in corporate finance.

A good working knowledge of financial statements is desirable simply because such statements, and numbers derived from those statements, are the primary means of communicating financial information both within the firm and outside the firm. In short, much of the language of corporate finance is rooted in the ideas we discuss in this chapter.

Page 50Furthermore, as we will see, there are many different ways of using financial statement information and many different types of users. This diversity reflects the fact that financial statement information plays an important part in many types of decisions.

In the best of all worlds, the financial manager has full market value information about all of the firm’s assets. This will rarely (if ever) happen. So, the reason we rely on accounting figures for much of our financial information is that we are almost always unable to obtain all (or even part) of the market information we want. The only meaningful yardstick for evaluating business decisions is whether they create economic value (see 

Chapter 1

). However, in many important situations, it will not be possible to make this judgment directly because we can’t see the market value effects of decisions.

We recognize that accounting numbers are often just pale reflections of economic reality, but they are frequently the best available information. For privately held corporations, notfor-profit businesses, and smaller firms, for example, very little direct market value information exists at all. The accountant’s reporting function is crucial in these circumstances.

Clearly, one important goal of the accountant is to report financial information to the user in a form useful for decision making. Ironically, the information frequently does not come to the user in such a form. In other words, financial statements don’t come with a user’s guide. This chapter and the next are first steps in filling this gap.

3.1 Cash Flow and Financial Statements: A Closer Look

At the most fundamental level, firms do two different things: They generate cash and they spend it. Cash is generated by selling a product, an asset, or a security. Selling a security involves either borrowing or selling an equity interest (shares of stock) in the firm. Cash is spent in paying for materials and labor to produce a product and in purchasing assets. Payments to creditors and owners also require the spending of cash.

In 
Chapter 2
, we saw that the cash activities of a firm could be summarized by a simple identity:

Cash flow from assets = Cash flow to creditors + Cash flow to owners

This cash flow identity summarizes the total cash result of all transactions a firm engages in during the year. In this section, we return to the subject of cash flow by taking a closer look at the cash events during the year that lead to these total figures.

SOURCES AND USES OF CASH

Activities that bring in cash are called sources of cash. Activities that involve spending cash are called uses (or applications) of cash. What we need to do is to trace the changes in the firm’s balance sheet to see how the firm obtained and spent its cash during some period.

To get started, consider the balance sheets for the Prufrock Corporation in 
Table 3.1
. Notice that we have calculated the change in each of the items on the balance sheets.

Looking over the balance sheets for Prufrock, we see that quite a few things changed during the year. For example, Prufrock increased its net fixed assets by $149 and its inventory by $29. (Note that, throughout, all figures are in millions of dollars.) Where did the money come from? To answer this and related questions, we need to first identify those changes that used up cash (uses) and those that brought cash in (sources).

A little common sense is useful here. A firm uses cash by either buying assets or making payments. So, loosely speaking, an increase in an asset account means the firm, on a net basis, bought some assets—a use of cash. If an asset account went down, then on a net basis, the firm sold some assets. This would be a net source. Similarly, if a liability account goes down, then the firm has made a net payment—a use of cash.

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sources of cash
A firm’s activities that generate cash.

uses of cash
A firm’s activities in which cash is spent. Also called applications of cash.

TABLE 3.1

Page 51

Given this reasoning, there is a simple, albeit mechanical, definition you may find useful. An increase in a left-side (asset) account or a decrease in a right-side (liability or equity) account is a use of cash. Likewise, a decrease in an asset account or an increase in a liability (or equity) account is a source of cash.

Looking again at Prufrock, we see that inventory rose by $29. This is a net use because Prufrock effectively paid out $29 to increase inventories. Accounts payable rose by $32. This is a source of cash because Prufrock effectively has borrowed an additional $32 payable by the end of the year. Notes payable, on the other hand, went down by $35, so Pru-frock effectively paid off $35 worth of short-term debt—a use of cash.

Based on our discussion, we can summarize the sources and uses of cash from the balance sheet as follows:

Company financial information can be found in many places on the Web, including 
finance.yahoo.com
, 
finance.google.com
, and 
money.msn.com

.

TABLE 3.2

Page 52

The net addition to cash is just the difference between sources and uses, and our $14 result here agrees with the $14 change shown on the balance sheet.

This simple statement tells us much of what happened during the year, but it doesn’t tell the whole story. For example, the increase in retained earnings is net income (a source of funds) less dividends (a use of funds). It would be more enlightening to have these reported separately so we could see the breakdown. Also, we have considered only net fixed asset acquisitions. Total or gross spending would be more interesting to know.

To further trace the flow of cash through the firm during the year, we need an income statement. For Prufrock, the results for the year are shown in 

Table 3.2

.

Notice here that the $242 addition to retained earnings we calculated from the balance sheet is just the difference between the net income of $363 and the dividends of $121.

THE STATEMENT OF CASH FLOWS

There is some flexibility in summarizing the sources and uses of cash in the form of a financial statement. However it is presented, the result is called the statement of cash flows.

We present a particular format for this statement in 
Table 3.3
. The basic idea is to group all the changes into three categories: operating activities, financing activities, and investment activities. The exact form differs in detail from one preparer to the next.

Don’t be surprised if you come across different arrangements. The types of information presented will be similar; the exact order can differ. The key thing to remember in this case is that we started out with $84 in cash and ended up with $98, for a net increase of $14. We’re just trying to see what events led to this change.

Going back to 
Chapter 2
, we note that there is a slight conceptual problem here. Interest paid should really go under financing activities, but unfortunately that’s not the way the accounting is handled. The reason, you may recall, is that interest is deducted as an expense when net income is computed. Also, notice that the net purchase of fixed assets was $149. Because Prufrock wrote off $276 worth of assets (the depreciation), it must have actually spent a total of $149 + 276 = $425 on fixed assets.

Once we have this statement, it might seem appropriate to express the change in cash on a per-share basis, much as we did for net income. Ironically, despite the interest we might have in some measure of cash flow per share, standard accounting practice expressly prohibits reporting this information. The reason is that accountants feel that cash flow (or some component of cash flow) is not an alternative to accounting income, so only earnings per share are to be reported.

As shown in 
Table 3.4
, it is sometimes useful to present the same information a bit differently. We will call this the “sources and uses of cash” statement. There is no such statement in financial accounting, but this arrangement resembles one used many years ago. As we will discuss, this form can come in handy, but we emphasize again that it is not the way this information is normally presented.

statement of cash flows
A firm’s financial statement that summarizes its sources and uses of cash over a specified period.

Page 53TABLE 3.3

TABLE 3.4

Page 54Now that we have the various cash pieces in place, we can get a good idea of what happened during the year. Prufrock’s major cash outlays were fixed asset acquisitions and cash dividends. It paid for these activities primarily with cash generated from operations.

Prufrock also retired some long-term debt and increased current assets. Finally, current liabilities were not greatly changed, and a relatively small amount of new equity was sold. Altogether, this short sketch captures Prufrock’s major sources and uses of cash for the year.

Concept Questions

3.1a   What is a source of cash? Give three examples.

3.1b   What is a use, or application, of cash? Give three examples.

3.2 Standardized Financial Statements

The next thing we might want to do with Prufrock’s financial statements is compare them to those of other similar companies. We would immediately have a problem, however. It’s almost impossible to directly compare the financial statements for two companies because of differences in size.

For example, Ford and GM are serious rivals in the auto market, but GM is bigger (in terms of market share), so it is difficult to compare them directly. For that matter, it’s difficult even to compare financial statements from different points in time for the same company if the company’s size has changed. The size problem is compounded if we try to compare GM and, say, Toyota. If Toyota’s financial statements are denominated in yen, then we have size and currency differences.

To start making comparisons, one obvious thing we might try to do is to somehow standardize the financial statements. One common and useful way of doing this is to work with percentages instead of total dollars. In this section, we describe two different ways of standardizing financial statements along these lines.

COMMON-SIZE STATEMENTS

To get started, a useful way of standardizing financial statements is to express each item on the balance sheet as a percentage of assets and to express each item on the income statement as a percentage of sales. The resulting financial statements are called common-size statements. We consider these next.

Common-Size Balance Sheets   One way, though not the only way, to construct a common-size balance sheet is to express each item as a percentage of total assets. Pru-frock’s 2014 and 2015 common-size balance sheets are shown in 

Table 3.5

.

Notice that some of the totals don’t check exactly because of rounding. Also notice that the total change has to be zero because the beginning and ending numbers must add up to 100 percent.

In this form, financial statements are relatively easy to read and compare. For example, just looking at the two balance sheets for Prufrock, we see that current assets were 19.7 percent of total assets in 2015, up from 19.1 percent in 2014. Current liabilities declined from 16.0 percent to 15.1 percent of total liabilities and equity over that same time. Similarly, total equity rose from 68.1 percent of total liabilities and equity to 72.2 percent.

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common-size statement
A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

Page 55TABLE 3.5

Overall, Prufrock’s liquidity, as measured by current assets compared to current liabilities, increased over the year. Simultaneously, Prufrock’s indebtedness diminished as a percentage of total assets. We might be tempted to conclude that the balance sheet has grown “stronger.” We will say more about this later.

Common-Size Income Statements   A useful way of standardizing the income statement is to express each item as a percentage of total sales, as illustrated for Prufrock in 
Table 3.6
.

This income statement tells us what happens to each dollar in sales. For Prufrock, interest expense eats up $.061 out of every sales dollar and taxes take another $.081. When all is said and done, $.157 of each dollar flows through to the bottom line (net income), and that amount is split into $.105 retained in the business and $.052 paid out in dividends.

These percentages are useful in comparisons. For example, a relevant figure is the cost percentage. For Prufrock, $.582 of each $1 in sales goes to pay for goods sold. It would be interesting to compute the same percentage for Prufrock’s main competitors to see how Prufrock stacks up in terms of cost control.

Page 56TABLE 3.6

Common-Size Statements of Cash Flows Although we have not presented it here, it is also possible and useful to prepare a common-size statement of cash flows. Unfortunately, with the current statement of cash flows, there is no obvious denominator such as total assets or total sales. However, if the information is arranged in a way similar to that in 

Table 3.4

, then each item can be expressed as a percentage of total sources (or total uses). The results can then be interpreted as the percentage of total sources of cash supplied or as the percentage of total uses of cash for a particular item.

COMMON-BASE YEAR FINANCIAL STATEMENTS: TREND ANALYSIS

Imagine we were given balance sheets for the last 10 years for some company and we were trying to investigate trends in the firm’s pattern of operations. Does the firm use more or less debt? Has the firm grown more or less liquid? A useful way of standardizing financial statements in this case is to choose a base year and then express each item relative to the base amount. We will call the resulting statements common-base year statements.

For example, from 2014 to 2015, Prufrock’s inventory rose from $393 to $422. If we pick 2014 as our base year, then we would set inventory equal to 1.00 for that year. For the next year, we would calculate inventory relative to the base year as $422/393 = 1.07. In this case, we could say inventory grew by about 7 percent during the year. If we had multiple years, we would just divide the inventory figure for each one by $393. The resulting series is easy to plot, and it is then easy to compare companies. 

Table 3.7

 summarizes these calculations for the asset side of the balance sheet.

COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS

The trend analysis we have been discussing can be combined with the common-size analysis discussed earlier. The reason for doing this is that as total assets grow, most of the other accounts must grow as well. By first forming the common-size statements, we eliminate the effect of this overall growth.

For example, looking at 
Table 3.7
, we see that Prufrock’s accounts receivable were $165, or 4.9 percent of total assets, in 2014. In 2015, they had risen to $188, which was 5.2 percent of total assets. If we do our analysis in terms of dollars, then the 2015 figure would be $188/165 = 1.14, representing a 14 percent increase in receivables. However, if we work with the common-size statements, then the 2015 figure would be 5.2%/4.9% = 1.06. This tells us accounts receivable, as a percentage of total assets, grew by 6 percent. Roughly speaking, what we see is that of the 14 percent total increase, about 8 percent (= 14% – 6%) is attributable simply to growth in total assets.

common-base year statement
A standardized financial statement presenting all items relative to a certain base year amount.

Page 57TABLE 3.7

NOTE: The common-size numbers are calculated by dividing each item by total assets for that year. For example, the 2014 common-size cash amount is $84/3,373 = 2.5%. The common-base year numbers are calculated by dividing each 2015 item by the base year (2014) dollar amount. The common-base cash is thus $98/84 = 1.17, representing a 17 percent increase. The combined common-size and base year figures are calculated by dividing each common-size amount by the base year (2014) common-size amount. The cash figure is therefore 2.7%/2.5% = 1.08, representing an 8 percent increase in cash holdings as a percentage of total assets. Columns may not total precisely due to rounding.

Concept Questions

3.2a   Why is it often necessary to standardize financial statements?

3.2b   Name two types of standardized statements and describe how each is formed.

3.3 Ratio Analysis

Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. Using ratios eliminates the size problem because the size effectively divides out. We’re then left with percentages, multiples, or time periods.

There is a problem in discussing financial ratios. Because a ratio is simply one number divided by another, and because there are so many accounting numbers out there, we could examine a huge number of possible ratios. Everybody has a favorite. We will restrict ourselves to a representative sampling.

In this section, we only want to introduce you to some commonly used financial ratios. These are not necessarily the ones we think are the best. In fact, some of them may strike you as illogical or not as useful as some alternatives. If they do, don’t be concerned. As a financial analyst, you can always decide how to compute your own ratios.

What you do need to worry about is the fact that different people and different sources seldom compute these ratios in exactly the same way, and this leads to much confusion. The specific definitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are ever using ratios as a tool for analysis, you should be careful to document how you calculate each one. And if you are comparing your numbers to numbers from another source, be sure you know how those numbers are computed.

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financial ratios
Relationships determined from a firm’s financial information and used for comparison purposes.

Page 58We will defer much of our discussion of how ratios are used and some problems that come up with using them until later in the chapter. For now, for each of the ratios we discuss, we consider several questions:

1. How is it computed?

2. What is it intended to measure, and why might we be interested?

3. What is the unit of measurement?

4. What might a high or low value tell us? How might such values be misleading?

5. How could this measure be improved?

Financial ratios are traditionally grouped into the following categories:

1. Short-term solvency, or liquidity, ratios.

2. Long-term solvency, or financial leverage, ratios.

3. Asset management, or turnover, ratios.

4. Profitability ratios.

5. Market value ratios.

We will consider each of these in turn. In calculating these numbers for Prufrock, we will use the ending balance sheet (2015) figures unless we say otherwise. Also notice that the various ratios are color keyed to indicate which numbers come from the income statement and which come from the balance sheet.

SHORT-TERM SOLVENCY, OR LIQUIDITY, MEASURES

As the name suggests, short-term solvency ratios as a group are intended to provide information about a firm’s liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm’s ability to pay its bills over the short run without undue stress. Consequently, these ratios focus on current assets and current liabilities.

For obvious reasons, liquidity ratios are particularly interesting to short-term creditors. Because financial managers work constantly with banks and other short-term lenders, an understanding of these ratios is essential.

One advantage of looking at current assets and liabilities is that their book values and market values are likely to be similar. Often (though not always), these assets and liabilities just don’t live long enough for the two to get seriously out of step. On the other hand, like any type of near-cash, current assets and liabilities can and do change fairly rapidly, so today’s amounts may not be a reliable guide to the future.

Current Ratio   One of the best known and most widely used ratios is the current ratio. As you might guess, the current ratio is defined as follows:

Here is Prufrock’s 2015 current ratio:

Because current assets and liabilities are, in principle, converted to cash over the following 12 months, the current ratio is a measure of short-term liquidity. The unit of measurement is either dollars or times. So, we could say Prufrock has $1.31 in current assets for every $1 in current liabilities, or we could say Prufrock has its current liabilities covered 1.31 times over.

To a creditor—particularly a short-term creditor such as a supplier—the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. Absent some extraordinary circumstances, we would expect to see a current ratio of at least 1 because a current ratio of less than 1 would mean that net working capital (current assets less current liabilities) is negative. This would be unusual in a healthy firm, at least for most types of businesses.

Go to 

www.reuters.com

 to examine comparative ratios for a huge number of companies.

Page 59The current ratio, like any ratio, is affected by various types of transactions. For example, suppose the firm borrows over the long term to raise money. The short-run effect would be an increase in cash from the issue proceeds and an increase in long-term debt. Current liabilities would not be affected, so the current ratio would rise.

Finally, note that an apparently low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power.

EXAMPLE 3.1 Current Events

Suppose a firm pays off some of its suppliers and short-term creditors. What happens to the current ratio? Suppose a firm buys some inventory. What happens in this case? What happens if a firm sells some merchandise?

The first case is a trick question. What happens is that the current ratio moves away from 1. If it is greater than 1 (the usual case), it will get bigger. But if it is less than 1, it will get smaller. To see this, suppose the firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. If we use $1 in cash to reduce current liabilities, then the new current ratio is ($4 – 1)/($2 – 1) = 3. If we reverse the original situation to $2 in current assets and $4 in current liabilities, then the change will cause the current ratio to fall to 1/3 from 1/2.

The second case is not quite as tricky. Nothing happens to the current ratio because cash goes down while inventory goes up—total current assets are unaffected.

In the third case, the current ratio will usually rise because inventory is normally shown at cost and the sale will normally be at something greater than cost (the difference is the markup). The increase in either cash or receivables is therefore greater than the decrease in inventory. This increases current assets, and the current ratio rises.

The Quick (or Acid-Test) Ratio   Inventory is often the least liquid current asset. It’s also the one for which the book values are least reliable as measures of market value because the quality of the inventory isn’t considered. Some of the inventory may later turn out to be damaged, obsolete, or lost.

More to the point, relatively large inventories are often a sign of short-term trouble. The firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory.

To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the current ratio, except inventory is omitted:

Notice that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. Again, the idea is that inventory is relatively illiquid compared to cash.

For Prufrock, this ratio for 2015 was:

The quick ratio here tells a somewhat different story than the current ratio because inventory accounts for more than half of Prufrock’s current assets. To exaggerate the point, if this inventory consisted of, say, unsold nuclear power plants, then this would be a cause for concern.

Page 60To give an example of current versus quick ratios, based on recent financial statements, Walmart and Manpower Inc. had current ratios of .83 and .14, respectively. However, Manpower carries no inventory to speak of, whereas Walmart’s current assets are virtually all inventory. As a result, Walmart’s quick ratio was only .22, whereas Manpower’s was .14, the same as its current ratio.

Other Liquidity Ratios   We briefly mention three other measures of liquidity. A very short-term creditor might be interested in the cash ratio:

You can verify that for 2015 this works out to be .18 times for Prufrock.

Because net working capital, or NWC, is frequently viewed as the amount of short-term liquidity a firm has, we can consider the ratio of NWC to total assets:

A relatively low value might indicate relatively low levels of liquidity. Here, this ratio works out to be ($708 − 540)/$3,588 = 4.7%.

Finally, imagine that Prufrock was facing a strike and cash inflows began to dry up. How long could the business keep running? One answer is given by the interval measure:

Total costs for the year, excluding depreciation and interest, were $1,344. The average daily cost was $1,344/365 = $3.68 per day.

1

 The interval measure is thus $708/$3.68 = 192 days. Based on this, Prufrock could hang on for six months or so.

2

The interval measure (or something similar) is also useful for newly founded or start-up companies that often have little in the way of revenues. For such companies, the interval measure indicates how long the company can operate until it needs another round of financing. The average daily operating cost for start-up companies is often called the burn rate, meaning the rate at which cash is burned in the race to become profitable.

LONG-TERM SOLVENCY MEASURES

Long-term solvency ratios are intended to address the firm’s long-term ability to meet its obligations, or, more generally, its financial leverage. These are sometimes called financial leverage ratios or just leverage ratios. We consider three commonly used measures and some variations.

Total Debt Ratio The total debt ratio takes into account all debts of all maturities to all creditors. It can be defined in several ways, the easiest of which is this:

Page 61In this case, an analyst might say that Prufrock uses 28 percent debt.
3
 Whether this is high or low or whether it even makes any difference depends on whether capital structure matters, a subject we discuss in 

Part 6

.

Prufrock has $.28 in debt for every $1 in assets. Therefore, there is $.72 in equity (=$1 − .28) for every $.28 in debt. With this in mind, we can define two useful variations on the total debt ratio—the debt–equity ratio and the equity multiplier:

The fact that the equity multiplier is 1 plus the debt–equity ratio is not a coincidence:

The thing to notice here is that given any one of these three ratios, you can immediately calculate the other two; so, they all say exactly the same thing.

A Brief Digression: Total Capitalization versus Total Assets Frequently, financial analysts are more concerned with a firm’s long-term debt than its short-term debt because the short-term debt will constantly be changing. Also, a firm’s accounts payable may reflect trade practice more than debt management policy. For these reasons, the long-term debt ratio is often calculated as follows:

The $3,048 in total long-term debt and equity is sometimes called the firm’s total capitalization, and the financial manager will frequently focus on this quantity rather than on total assets.

To complicate matters, different people (and different books) mean different things by the term debt ratio. Some mean a ratio of total debt, some mean a ratio of long-term debt only, and, unfortunately, a substantial number are simply vague about which one they mean.

This is a source of confusion, so we choose to give two separate names to the two measures. The same problem comes up in discussing the debt–equity ratio. Financial analysts frequently calculate this ratio using only long-term debt.

Times Interest Earned   Another common measure of long-term solvency is the times interest earned (TIE) ratio. Once again, there are several possible (and common) definitions, but we’ll stick with the most traditional:

Ratios used to analyze technology firms can be found at 

www.chalfin.com

 under the “Publications” link.

Page 62As the name suggests, this ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio. For Prufrock, the interest bill is covered 4.9 times over.

Cash Coverage A problem with the TIE ratio is that it is based on EBIT, which is not really a measure of cash available to pay interest. The reason is that depreciation, a noncash expense, has been deducted out. Because interest is definitely a cash outflow (to creditors), one way to define the cash coverage ratio is this:

The numerator here, EBIT plus depreciation, is often abbreviated EBITD (earnings before interest, taxes, and depreciation—say “ebbit-dee”). It is a basic measure of the firm’s ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations.

A common variation on EBITD is earnings before interest, taxes, depreciation, and amortization (EBITDA—say “ebbit-dah”). Here amortization refers to a noncash deduction similar conceptually to depreciation, except it applies to an intangible asset (such as a patent) rather than a tangible asset (such as a machine). Note that the word amortization here does not refer to the repayment of debt, a subject we discuss in a later chapter.

ASSET MANAGEMENT, OR TURNOVER, MEASURES

We next turn our attention to the efficiency with which Prufrock uses its assets. The measures in this section are sometimes called asset utilization ratios. The specific ratios we discuss can all be interpreted as measures of turnover. What they are intended to describe is how efficiently or intensively a firm uses its assets to generate sales. We first look at two important current assets: inventory and receivables.

Inventory Turnover and Days’ Sales in Inventory   During the year, Prufrock had a cost of goods sold of $1,344. Inventory at the end of the year was $422. With these numbers, inventory turnover can be calculated as follows:

In a sense, Prufrock sold off or turned over the entire inventory 3.2 times.

4

 As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we are managing inventory.

If we know we turned our inventory over 3.2 times during the year, we can immediately figure out how long it took us to turn it over on average. The result is the average days’ sales in inventory:

Page 63This tells us that, roughly speaking, inventory sits 115 days on average before it is sold. Alternatively, assuming we have used the most recent inventory and cost figures, it will take about 115 days to work off our current inventory.

To give an example, in December 2013, the U.S. automobile industry as a whole had a 54-day supply of cars, less than the 60-day supply considered normal. This figure means that at the then-current rate of sales, it would have taken 54 days to deplete the available supply. Of course, there is significant variation across models, with newer, hotter-selling models in shorter supply (and vice versa). So, also in December 2013, the Nissan LEAF had only 13 days of sales compared to 232 days for the Cadillac ATS.

It might make more sense to use the average inventory in calculating turnover. Inventory turnover would then be $1,344/[($393 + 422)/2] = 3.3 times.

5

 It depends on the purpose of the calculation. If we are interested in how long it will take us to sell our current inventory, then using the ending figure (as we did initially) is probably better.

In many of the ratios we discuss in this chapter, average figures could just as well be used. Again, it depends on whether we are worried about the past, in which case averages are appropriate, or the future, in which case ending figures might be better. Also, using ending figures is common in reporting industry averages; so, for comparison purposes, ending figures should be used in such cases. In any event, using ending figures is definitely less work, so we’ll continue to use them.

Receivables Turnover and Days’ Sales in Receivables  Our inventory measures give some indication of how fast we can sell product. We now look at how fast we collect on those sales. The receivables turnover is defined much like inventory turnover:

Loosely speaking, Prufrock collected its outstanding credit accounts and reloaned the money 12.3 times during the year.

6

This ratio makes more sense if we convert it to days, so here is the days’ sales in receivables:

Therefore, on average, Prufrock collects on its credit sales in 30 days. For obvious reasons, this ratio is frequently called the average collection period (ACP).

Note that if we are using the most recent figures, we could also say that we have 30 days’ worth of sales currently uncollected. We will learn more about this subject when we study credit policy in a later chapter.

EXAMPLE 3.2 Payables Turnover

Here is a variation on the receivables collection period. How long, on average, does it take for Prufrock Corporation to pay its bills? To answer, we need to calculate the accounts payable turnover rate using cost of goods sold. We will assume that Prufrock purchases everything on credit.

Page 64The cost of goods sold is $1,344, and accounts payable are $344. The turnover is therefore $1,344/$344 = 3.9 times. So, payables turned over about every 365/3.9 = 94 days. On average, then, Prufrock takes 94 days to pay. As a potential creditor, we might take note of this fact.

Asset Turnover Ratios  Moving away from specific accounts like inventory or receivables, we can consider several “big picture” ratios. For example, NWC turnover is:

This ratio measures how much “work” we get out of our working capital. Once again, assuming we aren’t missing out on sales, a high value is preferred. (Why?)

Similarly, fixed asset turnover is:

With this ratio, it probably makes more sense to say that for every dollar in fixed assets, Prufrock generated $.80 in sales.

Our final asset management ratio, the total asset turnover, comes up quite a bit. We will see it later in this chapter and in the next chapter. As the name suggests, the total asset turnover is:

In other words, for every dollar in assets, Prufrock generated $.64 in sales.

To give an example of fixed and total asset turnover, based on recent financial statements, Southwest Airlines had a total asset turnover of .88, compared to 1.50 for IBM. However, the much higher investment in fixed assets in an airline is reflected in Southwest’s fixed asset turnover of 1.17, compared to IBM’s 4.41.

EXAMPLE 3.3 More Turnover

Suppose you find that a particular company generates $.40 in sales for every dollar in total assets. How often does this company turn over its total assets?

The total asset turnover here is .40 times per year. It takes 1/.40 = 2.5 years to turn total assets over completely.

PROFITABILITY MEASURES

The three measures we discuss in this section are probably the best known and most widely used of all financial ratios. In one form or another, they are intended to measure how efficiently a firm uses its assets and manages its operations. The focus in this group is on the bottom line, net income.

Page 65Profit Margin  Companies pay a great deal of attention to their profit margins:

This tells us that Prufrock, in an accounting sense, generates a little less than 16 cents in profit for every dollar in sales.

All other things being equal, a relatively high profit margin is obviously desirable. This situation corresponds to low expense ratios relative to sales. However, we hasten to add that other things are often not equal.

For example, lowering our sales price will usually increase unit volume but will normally cause profit margins to shrink. Total profit (or, more important, operating cash flow) may go up or down; so the fact that margins are smaller isn’t necessarily bad. After all, isn’t it possible that, as the saying goes, “Our prices are so low that we lose money on everything we sell, but we make it up in volume”?

7

Return on Assets Return on assets (ROA) is a measure of profit per dollar of assets. It can be defined several ways, but the most common is this:

Return on Equity  Return on equity (ROE) is a measure of how the stockholders fared during the year. Because benefiting shareholders is our goal, ROE is, in an accounting sense, the true bottom-line measure of performance. ROE is usually measured as follows:

For every dollar in equity, therefore, Prufrock generated 14 cents in profit; but again this is correct only in accounting terms.

Because ROA and ROE are such commonly cited numbers, we stress that it is important to remember they are accounting rates of return. For this reason, these measures should properly be called return on book assets and return on book equity. In fact, ROE is sometimes called return on net worth. Whatever it’s called, it would be inappropriate to compare the result to, for example, an interest rate observed in the financial markets. We will have more to say about accounting rates of return in later chapters.

The fact that ROE exceeds ROA reflects Prufrock’s use of financial leverage. We will examine the relationship between these two measures in more detail shortly.

EXAMPLE 3.4 ROE and ROA

Because ROE and ROA are usually intended to measure performance over a prior period, it makes a certain amount of sense to base them on average equity and average assets, respectively. For Prufrock, how would you calculate these?

Page 66We first need to calculate average assets and average equity:

With these averages, we can recalculate ROA and ROE as follows:

These are slightly higher than our previous calculations because assets and equity grew during the year, so the average values are below the ending values.

MARKET VALUE MEASURES

Our final group of measures is based, in part, on information not necessarily contained in financial statements—the market price per share of stock. Obviously, these measures can be calculated directly only for publicly traded companies.

We assume that Prufrock has 33 million shares outstanding and the stock sold for $88 per share at the end of the year. If we recall that Prufrock’s net income was $363 million, we can calculate its earnings per share:

Price–Earnings Ratio  The first of our market value measures, the price–earnings (PE) ratio (or multiple), is defined here:

In the vernacular, we would say that Prufrock shares sell for eight times earnings, or we might say that Prufrock shares have or “carry” a PE multiple of 8.

PE ratios vary substantially across companies, but, in 2014, a typical large company in the United States had a PE in the 15–20 range. This is on the high side by historical standards, but not dramatically so. A low point for PEs was about 5 in 1974. PEs also vary across countries. For example, Japanese PEs have historically been much higher than those of their U.S. counterparts.

Because the PE ratio measures how much investors are willing to pay per dollar of current earnings, higher PEs are often taken to mean the firm has significant prospects for future growth. Of course, if a firm had no or almost no earnings, its PE would probably be quite large; so, as always, care is needed in interpreting this ratio.

Sometimes analysts divide PE ratios by expected future earnings growth rates (after multiplying the growth rate by 100). The result is the PEG ratio. Suppose Prufrock’s anticipated growth rate in EPS was 6 percent. Its PEG ratio would then be 8/6 5 1.33. The idea behind the PEG ratio is that whether a PE ratio is high or low depends on expected future growth. High PEG ratios suggest that the PE is too high relative to growth, and vice versa.

Price–Sales Ratio  In some cases, companies will have negative earnings for extended periods, so their PE ratios are not very meaningful. A good example is a recent start-up. Such companies usually do have some revenues, so analysts will often look at the price–sales ratio:

Price–sales ratio = Price per share/Sales per share

Page 67In Prufrock’s case, sales were $2,311, so here is the price–sales ratio:

Price–sales ratio = $88/($2,311/33) = $88/$70 = 1.26

As with PE ratios, whether a particular price–sales ratio is high or low depends on the industry involved.

Market-to-Book Ratio  A third commonly quoted market value measure is the market-to-book ratio:

Notice that book value per share is total equity (not just common stock) divided by the number of shares outstanding.

Because book value per share is an accounting number, it reflects historical costs. In a loose sense, the market-to-book ratio therefore compares the market value of the firm’s investments to their cost. A value less than 1 could mean that the firm has not been successful overall in creating value for its stockholders.

Market-to-book ratios in recent years appear high relative to past values. For example, for the 30 blue-chip companies that make up the widely followed Dow Jones Industrial Average, the historical norm is about 1.7; however, the market-to-book ratio for this group has recently been twice this size.

Another ratio, called Tobin’s Q ratio, is much like the market-to-book ratio. Tobin’s Q is the market value of the firm’s assets divided by their replacement cost:

Notice that we used two equivalent numerators here: the market value of the firm’s assets and the market value of its debt and equity.

Conceptually, the Q ratio is superior to the market-to-book ratio because it focuses on what the firm is worth today relative to what it would cost to replace it today. Firms with high Q ratios tend to be those with attractive investment opportunities or significant competitive advantages (or both). In contrast, the market-to-book ratio focuses on historical costs, which are less relevant.

As a practical matter, however, Q ratios are difficult to calculate with accuracy because estimating the replacement cost of a firm’s assets is not an easy task. Also, market values for a firm’s debt are often unobservable. Book values can be used instead in such cases, but accuracy may suffer.

Enterprise Value–EBITDA Ratio  A company’s enterprise value is an estimate of the mar ket value of the company’s operating assets. By operating assets, we mean all the assets of the firm except cash. Of course, it’s not practical to work with the individual assets of a firm because market values would usually not be available. Instead, we can use the right-hand side of the balance sheet and calculate the enterprise value as:

We use the book value for liabilities because we typically can’t get the market values, at least not for all of them. However, book value is usually a reasonable approximation for market value when it comes to liabilities, particularly short-term debts. Notice that the sum of the value of the market values of the stock and all liabilities equals the value of the firm’s assets from the balance sheet identity. Once we have this number, we subtract the cash to get the enterprise value.

Page 68TABLE 3.8 Common Financial Ratios

Enterprise value is frequently used to calculate the EBITDA ratio (or multiple):

This ratio is similar in spirit to the PE ratio, but it relates the value of all the operating assets (the enterprise value) to a measure of the operating cash flow generated by those assets (EBITDA).

CONCLUSION

This completes our definitions of some common ratios. We could tell you about more of them, but these are enough for now. We’ll go on to discuss some ways of using these ratios instead of just how to calculate them. 

Table 3.8

 summarizes the ratios we’ve discussed.

Page 69

Concept Questions

3.3a   What are the five groups of ratios? Give two or three examples of each kind.

3.3b   Given the total debt ratio, what other two ratios can be computed? Explain how.

3.3c   Turnover ratios all have one of two figures as the numerator. What are these two figures? What do these ratios measure? How do you interpret the results?

3.3d   Profitability ratios all have the same figure in the numerator. What is it? What do these ratios measure? How do you interpret the results?

3.4 The DuPont Identity

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As we mentioned in discussing ROA and ROE, the difference between these two profitability measures is a reflection of the use of debt financing, or financial leverage. We illustrate the relationship between these measures in this section by investigating a famous way of decomposing ROE into its component parts.

A CLOSER LOOK AT ROE

To begin, let’s recall the definition of ROE:

If we were so inclined, we could multiply this ratio by Assets/Assets without changing anything:

Notice that we have expressed the ROE as the product of two other ratios—ROA and the equity multiplier:

ROE = ROA × Equity multiplier = ROA × (1 + Debt–equity ratio)

Looking back at Prufrock, for example, we see that the debt–equity ratio was .39 and ROA was 10.12 percent. Our work here implies that Prufrock’s ROE, as we previously calculated, is this:

ROE = 10.12% × 1.38 = 14.01%

The difference between ROE and ROA can be substantial, particularly for certain businesses. For example, in 2013, American Express had an ROA of 3.12 percent, which is fairly typical for financial institutions. However, financial institutions tend to borrow a lot of money and, as a result, have relatively large equity multipliers. For American Express, ROE was about 24.40 percent, implying an equity multiplier of 7.81 times.

We can further decompose ROE by multiplying the top and bottom by total sales:

If we rearrange things a bit, ROE looks like this:

Page 70What we have now done is to partition ROA into its two component parts, profit margin and total asset turnover. The last expression of the preceding equation is called the DuPont identity, after the DuPont Corporation, which popularized its use.

We can check this relationship for Prufrock by noting that the profit margin was 15.71 percent and the total asset turnover was .64:

This 14.01 percent ROE is exactly what we had before.

The DuPont identity tells us that ROE is affected by three things:

1. Operating efficiency (as measured by profit margin).

2. Asset use efficiency (as measured by total asset turnover).

3. Financial leverage (as measured by the equity multiplier).

Weakness in either operating or asset use efficiency (or both) will show up in a diminished return on assets, which will translate into a lower ROE.

Considering the DuPont identity, it appears that the ROE could be leveraged up by increasing the amount of debt in the firm. However, notice that increasing debt also increases interest expense, which reduces profit margins, which acts to reduce ROE. So, ROE could go up or down, depending. More important, the use of debt financing has a number of other effects, and as we discuss at some length in 
Part 6
, the amount of leverage a firm uses is governed by its capital structure policy.

The decomposition of ROE we’ve discussed in this section is a convenient way of systematically approaching financial statement analysis. If ROE is unsatisfactory by some measure, then the DuPont identity tells you where to start looking for the reasons.

General Motors provides a good example of how DuPont analysis can be very useful and also illustrates why care must be taken in interpreting ROE values. In 1989, GM had an ROE of 12.1 percent. By 1993, its ROE had improved to 44.1 percent, a dramatic improvement. On closer inspection, however, we find that over the same period GM’s profit margin had declined from 3.4 to 1.8 percent, and ROA had declined from 2.4 to 1.3 percent. The decline in ROA was moderated only slightly by an increase in total asset turnover from .71 to .73 over the period.

Given this information, how is it possible for GM’s ROE to have climbed so sharply? From our understanding of the DuPont identity, it must be the case that GM’s equity multiplier increased substantially. In fact, what happened was that GM’s book equity value was almost wiped out overnight in 1992 by changes in the accounting treatment of pension liabilities. If a company’s equity value declines sharply, its equity multiplier rises. In GM’s case, the multiplier went from 4.95 in 1989 to 33.62 in 1993. In sum, the dramatic “improvement” in GM’s ROE was almost entirely due to an accounting change that affected the equity multiplier and didn’t really represent an improvement in financial performance at all.

DuPont analysis (and ratio analysis in general) can be used to compare two companies as well. Yahoo! and Google are among the most important Internet companies in the world. We will use them to illustrate how DuPont analysis can be useful in helping to ask the right questions about a firm’s financial performance. The DuPont breakdowns for Yahoo! and Google are summarized in 

Table 3.9

.

As shown, in 2013, Yahoo! had an ROE of 10.4 percent, up from its ROE in 2012 of 8.0 percent. In contrast, in 2013, Google had an ROE of 14.8 percent, about the same as its ROE in 2012 of 15.0 percent. Given this information, how is it possible that Google’s ROE could be so much higher during this period of time, and what accounts for the increase in Yahoo!’s ROE?

DuPont identity
Popular expression breaking ROE into three parts: operating efficiency, asset use efficiency, and financial leverage.

Page 71TABLE 3.9

On closer inspection of the DuPont breakdown, we see that Yahoo!’s profit margin in 2013 was 29.2 percent. Meanwhile, Google’s profit margin was 21.6 percent. Further, Yahoo! and Google have similar financial leverage. What can account for Google’s advantage over Yahoo! in ROE? We see that in this case, it is clear that the difference between the two firms comes down to asset utilization.

AN EXPANDED DUPONT ANALYSIS

So far, we’ve seen how the DuPont equation lets us break down ROE into its basic three components: profit margin, total asset turnover, and financial leverage. We now extend this analysis to take a closer look at how key parts of a firm’s operations feed into ROE. To get going, we went to finance.yahoo.com and found financial statements for science and technology giant DuPont. What we found is summarized in 

Table 3.10

.

Using the information in 
Table 3.10
, 

Figure 3.1

 shows how we can construct an expanded DuPont analysis for DuPont and present that analysis in chart form. The advantage of the extended DuPont chart is that it lets us examine several ratios at once, thereby getting a better overall picture of a company’s performance and also allowing us to determine possible items to improve.

TABLE 3.10

Page 72FIGURE 3.1
Extended DuPont Chart for DuPont

Looking at the left side of our DuPont chart in 
Figure 3.1
, we see items related to profitability. As always, profit margin is calculated as net income divided by sales. But as our chart emphasizes, net income depends on sales and a variety of costs, such as cost of goods sold (CoGS) and selling, general, and administrative expenses (SG&A expense). DuPont can increase its ROE by increasing sales and also by reducing one or more of these costs. In other words, if we want to improve profitability, our chart clearly shows us the areas on which we should focus.

Turning to the right side of 
Figure 3.1
, we have an analysis of the key factors underlying total asset turnover. Thus, for example, we see that reducing inventory holdings through more efficient management reduces current assets, which reduces total assets, which then improves total asset turnover.

Page 73

Concept Questions

3.4a   Return on assets, or ROA, can be expressed as the product of two ratios. Which two?

3.4b   Return on equity, or ROE, can be expressed as the product of three ratios. Which three?

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3.5 Using Financial Statement Information

Our last task in this chapter is to discuss in more detail some practical aspects of financial statement analysis. In particular, we will look at reasons for analyzing financial statements, how to get benchmark information, and some problems that come up in the process.

WHY EVALUATE FINANCIAL STATEMENTS?

As we have discussed, the primary reason for looking at accounting information is that we don’t have, and can’t reasonably expect to get, market value information. We stress that whenever we have market information, we will use it instead of accounting data. Also, if there is a conflict between accounting and market data, market data should be given precedence.

Financial statement analysis is essentially an application of “management by exception.” In many cases, such analysis will boil down to comparing ratios for one business with average or representative ratios. Those ratios that seem to differ the most from the averages are tagged for further study.

Internal Uses  Financial statement information has a variety of uses within a firm. Among the most important of these is performance evaluation. For example, managers are frequently evaluated and compensated on the basis of accounting measures of performance such as profit margin and return on equity. Also, firms with multiple divisions frequently compare the performance of those divisions using financial statement information.

Another important internal use we will explore in the next chapter is planning for the future. As we will see, historical financial statement information is useful for generating projections about the future and for checking the realism of assumptions made in those projections.

External Uses  Financial statements are useful to parties outside the firm, including short-term and long-term creditors and potential investors. For example, we would find such information quite useful in deciding whether to grant credit to a new customer.

We would also use this information to evaluate suppliers, and suppliers would review our statements before deciding to extend credit to us. Large customers use this information to decide if we are likely to be around in the future. Credit-rating agencies rely on financial statements in assessing a firm’s overall creditworthiness. The common theme here is that financial statements are a prime source of information about a firm’s financial health.

We would also find such information useful in evaluating our main competitors. We might be thinking of launching a new product. A prime concern would be whether the competition would jump in shortly thereafter. In this case, we would be interested in learning about our competitors’ financial strength to see if they could afford the necessary development.

Finally, we might be thinking of acquiring another firm. Financial statement information would be essential in identifying potential targets and deciding what to offer.

Page 74CHOOSING A BENCHMARK

Given that we want to evaluate a division or a firm based on its financial statements, a basic problem immediately comes up. How do we choose a benchmark, or a standard of comparison? We describe some ways of getting started in this section.

Time Trend Analysis  One standard we could use is history. Suppose we found that the current ratio for a particular firm is 2.4 based on the most recent financial statement information. Looking back over the last 10 years, we might find that this ratio had declined fairly steadily over that period.

Based on this, we might wonder if the liquidity position of the firm has deteriorated. It could be, of course, that the firm has made changes that allow it to more efficiently use its current assets, the nature of the firm’s business has changed, or business practices have changed. If we investigate, we might find any of these possible explanations behind the decline. This is an example of what we mean by management by exception—a deteriorating time trend may not be bad, but it does merit investigation.

Peer Group Analysis  The second means of establishing a benchmark is to identify firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways. In other words, we need to identify a peer group. There are obvious problems with doing this because no two companies are identical. Ultimately the choice of which companies to use as a basis for comparison is subjective.

One common way of identifying potential peers is based on Standard Industrial Classification (SIC) codes. These are four-digit codes established by the U.S. government for statistical reporting. Firms with the same SIC code are frequently assumed to be similar.

The first digit in an SIC code establishes the general type of business. For example, firms engaged in finance, insurance, and real estate have SIC codes beginning with 6. Each additional digit narrows down the industry. So, companies with SIC codes beginning with 60 are mostly banks and banklike businesses; those with codes beginning with 602 are mostly commercial banks; and SIC code 6025 is assigned to national banks that are members of the Federal Reserve system. 

Table 3.11

 lists selected two-digit codes (the first two digits of the four-digit SIC codes) and the industries they represent.

Standard Industrial Classification (SIC) code
A U.S. government code used to classify a firm by its type of business operations.

TABLE 3.11 Selected Two-Digit SIC Codes

Page 75SIC codes are far from perfect. For example, suppose you were examining financial statements for Walmart, the largest retailer in the United States. The relevant two-digit SIC code is 53, General Merchandise Stores. In a quick scan of the nearest financial database, you would find about 20 large, publicly owned corporations with a similar SIC code, but you might not be comfortable with some of them. Target would seem to be a reasonable peer, but Neiman Marcus also carries the same industry code. Are Walmart and Neiman Marcus really comparable?

As this example illustrates, it is probably not appropriate to blindly use SIC code–based averages. Instead, analysts often identify a set of primary competitors and then compute a set of averages based on just this group. Also, we may be more concerned with a group of the top firms in an industry, not the average firm. Such a group is called an aspirant group because we aspire to be like its members. In this case, a financial statement analysis reveals how far we have to go.

Beginning in 1997, a new industry classification system was initiated. Specifically, the North American Industry Classification System (NAICS, pronounced “nakes”) is intended to replace the older SIC codes, and it will eventually. Currently, however, SIC codes are still widely used.

With these caveats about industry codes in mind, we can now take a look at a specific industry. Suppose we are in the retail hardware business. 

Table 3.12

 contains some condensed common-size financial statements for this industry from the Risk Management Association (RMA, formerly known as Robert Morris Associates), one of many sources of such information. 

Table 3.13

 contains selected ratios from the same source.

There is a large amount of information here, most of which is self-explanatory. On the right in 
Table 3.12
, we have current information reported for different groups based on sales. Within each sales group, common-size information is reported. For example, firms with sales in the $10 million to $25 million range have cash and equivalents equal to 6.7 percent of total assets. There are 33 companies in this group, out of 337 in all.

On the left, we have three years’ worth of summary historical information for the entire group. For example, operating profit fell from 2.3 percent of sales to 1.7 percent over that time.

Table 3.13
 contains some selected ratios, again reported by sales groups on the right and time period on the left. To see how we might use this information, suppose our firm has a current ratio of 2. Based on these ratios, is this value unusual?

Looking at the current ratio for the overall group for the most recent year (third column from the left in 
Table 3.13
), we see that three numbers are reported. The one in the middle, 2.8, is the median, meaning that half of the 337 firms had current ratios that were lower and half had bigger current ratios. The other two numbers are the upper and lower quartiles. So, 25 percent of the firms had a current ratio larger than 4.9 and 25 percent had a current ratio smaller than 1.6. Our value of 2 falls comfortably within these bounds, so it doesn’t appear too unusual. This comparison illustrates how knowledge of the range of ratios is important in addition to knowledge of the average. Notice how stable the current ratio has been for the last three years.

EXAMPLE 3.5 More Ratios

Take a look at the most recent numbers reported for Sales/Receivables and EBIT/Interest in 
Table 3.13
. What are the overall median values? What are these ratios?

If you look back at our discussion, you will see that these are the receivables turnover and the times interest earned, or TIE, ratios. The median value for receivables turnover for the entire group is 36.7 times. So, the days in receivables would be 365/36.7 = 10, which is the boldfaced number reported. The median for the TIE is 2.6 times. The number in parentheses indicates that the calculation is meaningful for, and therefore based on, only 295 of the 337 companies. In this case, the reason is that only 295 companies paid any significant amount of interest.

Page 76TABLE 3.12 Selected Financial Statement Information

Page 77TABLE 3.13 Selected Ratios

Page 78

M = $ thousand; MM = $ million.

© 2011 by RMA All rights reserved. No part of this table may be reproduced or utilized in any form or by any means, eletronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without permission in writing from RMA.

There are many sources of ratio information in addition to the one we examine here. Our nearby Work the Web box shows how to get this information for just about any company, along with some useful benchmarking information. Be sure to look it over and then benchmark your favorite company.

PROBLEMS WITH FINANCIAL STATEMENT ANALYSIS

We close our chapter on financial statements by discussing some additional problems that can arise in using financial statements. In one way or another, the basic problem with financial statement analysis is that there is no underlying theory to help us identify which quantities to look at and to guide us in establishing benchmarks.

As we discuss in other chapters, there are many cases in which financial theory and economic logic provide guidance in making judgments about value and risk. Little such help exists with financial statements. This is why we can’t say which ratios matter the most and what a high or low value might be.

One particularly severe problem is that many firms are conglomerates, owning more or less unrelated lines of business. The consolidated financial statements for such firms don’t fit any neat industry category. Well-known companies like General Electric (GE) and 3M fall into this category. More generally, the kind of peer group analysis we have been describing works best when the firms are strictly in the same line of business, the industry is competitive, and there is only one way of operating.

Another problem that is becoming increasingly common is that major competitors and natural peer group members in an industry may be scattered around the globe. The automobile industry is an obvious example. The problem here is that financial statements from outside the United States do not necessarily conform at all to GAAP. The existence of different standards and procedures makes it difficult to compare financial statements across national borders.

Even companies that are clearly in the same line of business may not be comparable. For example, electric utilities engaged primarily in power generation are all classified in the same group (SIC 4911). This group is often thought to be relatively homogeneous. However, most utilities operate as regulated monopolies, so they don’t compete much with each other, at least not historically. Many have stockholders, and many are organized as cooperatives with no stockholders. There are several different ways of generating power, ranging from hydroelectric to nuclear, so the operating activities of these utilities can differ quite a bit. Finally, profitability is strongly affected by regulatory environment, so utilities in different locations can be similar but show different profits.

Page 79

WORK THE WEB

As we discussed in this chapter, ratios are an important tool for examining a company’s performance. Gathering the necessary financial statements to calculate ratios can be tedious and time-consuming. Fortunately many sites on the Web provide this information for free. One of the best is 
www.reuters.com
. We went there, entered the ticker symbol “HD” (for Home Depot), and then went to the ratio page. Here is an abbreviated look at the results:

The website reports the company, industry, and sector ratios. As you can see, Home Depot has higher quick and current ratios than the industry.

Questions

1. Go to 

www.reuters.com

 and find the major ratio categories listed on this website. How do the categories differ from the categories listed in this textbook?

2. Go to 

www.reuters.com

 and find all the ratios for Home Depot. How does the company compare to the industry for the ratios presented on this website?

Several other general problems frequently crop up. First, different firms use different accounting procedures—for inventory, for example. This makes it difficult to compare statements. Second, different firms end their fiscal years at different times. For firms in seasonal businesses (such as a retailer with a large Christmas season), this can lead to difficulties in comparing balance sheets because of fluctuations in accounts during the year. Finally, for any particular firm, unusual or transient events, such as a one-time profit from an asset sale, may affect financial performance. In comparing firms, such events can give misleading signals.

Page 80

Concept Questions

3.5a   What are some uses for financial statement analysis?

3.5b   Why do we say that financial statement analysis is management by exception?

3.5c   What are SIC codes and how might they be useful?

3.5d   What are some problems that can come up with financial statement analysis?

 

3.6 Summary and Conclusions

This chapter has discussed aspects of financial statement analysis:

1. Sources and uses of cash: We discussed how to identify the ways in which businesses obtain and use cash, and we described how to trace the flow of cash through a business over the course of the year. We briefly looked at the statement of cash flows.

2. Standardized financial statements: We explained that differences in size make it diffi-cult to compare financial statements, and we discussed how to form common-size and common-base period statements to make comparisons easier.

3. Ratio analysis: Evaluating ratios of accounting numbers is another way of comparing financial statement information. We therefore defined and discussed a number of the most commonly reported and used financial ratios. We also discussed the famous DuPont identity as a way of analyzing financial performance.

4. Using financial statements: We described how to establish benchmarks for comparison and discussed some types of information that are available. We then examined potential problems that can arise.

After you have studied this chapter, we hope that you have some perspective on the uses and abuses of financial statements. You should also find that your vocabulary of business and financial terms has grown substantially.

CONNECT TO FINANCE

For more practice, you should be in Connect Finance. Log on to connect.mheducation.com to get started!

Can you answer the following Connect Quiz questions?

Section 3.1	What is an example of a source of cash?
Section 3.2	Pioneer Aviation has total liabilities of $23,800 and total equity of $46,200. Current assets are $8,600. What is the common-size percentage for the current assets?
Section 3.3	What ratio measures the number of days that a firm can operate based on its current assets?
Section 3.4	What is the correct formula for computing the return on equity?
Section 3.5	If you want to identify other firms that have similar assets and operations as your firm, what should you refer to?

Page 81

CHAPTER REVIEW AND SELF-TEST PROBLEMS

3.1   Sources and Uses of Cash Consider the following balance sheets for the Philippe Corporation. Calculate the changes in the various accounts and, where applicable, identify the change as a source or use of cash. What were the major sources and uses of cash? Did the company become more or less liquid during the year? What happened to cash during the year?

3.2   Common-Size Statements Here is the most recent income statement for Philippe. Prepare a common-size income statement based on this information. How do you interpret the standardized net income? What percentage of sales goes to cost of goods sold?

Page 823.3   Financial Ratios Based on the balance sheets and income statement in the previous two problems, calculate the following ratios for 2015:

3.4   ROE and the DuPont Identity Calculate the 2015 ROE for the Philippe Corporation and then break down your answer into its component parts using the DuPont identity.

ANSWERS TO CHAPTER REVIEW AND SELF-TEST PROBLEMS

3.1   We’ve filled in the answers in the following table. Remember, increases in assets and decreases in liabilities indicate that we spent some cash. Decreases in assets and increases in liabilities are ways of getting cash.
   Philippe used its cash primarily to purchase fixed assets and to pay off short-term debt. The major sources of cash to do this were additional long-term borrowing, reductions in current assets, and additions to retained earnings.

Page 83The current ratio went from $1,072/1,922 = .56 to $853/1,725 = .49, so the firm’s liquidity appears to have declined somewhat. Overall, however, the amount of cash on hand increased by $5.

3.2   We’ve calculated the common-size income statement here. Remember that we simply divide each item by total sales.

Net income is 3.6 percent of sales. Because this is the percentage of each sales dollar that makes its way to the bottom line, the standardized net income is the firm’s profit margin. Cost of goods sold is 68.6 percent of sales.

3.3   We’ve calculated the following ratios based on the ending figures. If you don’t remember a definition, refer back to 
Table 3.8
.

3.4   The return on equity is the ratio of net income to total equity. For Philippe, this is $146/$3,347 = 4.4%, which is not outstanding.
   Given the DuPont identity, ROE can be written as follows:

Notice that return on assets, ROA, is 3.6% × .549 = 1.98%.

Page 84

CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS

1.   Current Ratio [LO2] What effect would the following actions have on a firm’s current ratio? Assume that net working capital is positive.

a. Inventory is purchased.

b. A supplier is paid.

c. A short-term bank loan is repaid.

d. A long-term debt is paid off early.

e. A customer pays off a credit account.

f. Inventory is sold at cost.

g. Inventory is sold for a profit.

2.   Current Ratio and Quick Ratio [LO2] In recent years, Dixie Co. has greatly increased its current ratio. At the same time, the quick ratio has fallen. What has happened? Has the liquidity of the company improved?

3.   Current Ratio [LO2] Explain what it means for a firm to have a current ratio equal to .50. Would the firm be better off if the current ratio were 1.50? What if it were 15.0? Explain your answers.

4.   Financial Ratios [LO2] Fully explain the kind of information the following financial ratios provide about a firm:

a. Quick ratio.

b. Cash ratio.

c. Total asset turnover.

d. Equity multiplier.

e. Long-term debt ratio.

f. Times interest earned ratio.

g. Profit margin.

h. Return on assets.

i. Return on equity.

j. Price–earnings ratio.

5.   Standardized Financial Statements [LO1] What types of information do common-size financial statements reveal about the firm? What is the best use for these common-size statements? What purpose do common-base year statements have? When would you use them?

6.   Peer Group Analysis [LO2] Explain what peer group analysis is. As a financial manager, how could you use the results of peer group analysis to evaluate the performance of your firm? How is a peer group different from an aspirant group?

7.   DuPont Identity [LO3] Why is the DuPont identity a valuable tool for analyzing the performance of a firm? Discuss the types of information it reveals compared to ROE considered by itself.

8.   Industry-Specific Ratios [LO2] Specialized ratios are sometimes used in specific industries. For example, the so-called book-to-bill ratio is closely watched for semiconductor manufacturers. A ratio of .93 indicates that for every $100 worth of chips shipped over some period, only $93 worth of new orders were received. In November 2013, the semiconductor equipment industry’s book-to-bill ratio was 1.11, compared to 1.05 during the month of October 2013. The book-to-bill ratio reached a recent low of .75 during October 2012 and a recent high of 1.23 during July 2010. The three-month average of worldwide bookings in November 2013 was $1.24 billion, an increase of 10.1 percent from October 2013, while the three-month average of billings was $1.11 billion, a 4.0 percent decrease from October 2013. What is this ratio intended to measure? Why do you think it is so closely followed?

9.   Industry-Specific Ratios [LO2] So-called same-store sales are a very important measure for companies as diverse as McDonald’s and Sears. As the name suggests, examining same-store sales means comparing revenues from the same stores or restaurants at two different points in time. Why might companies focus on same-store sales rather than total sales?

Page 8510.   Industry-Specific Ratios [LO2] There are many ways of using standardized financial information beyond those discussed in this chapter. The usual goal is to put firms on an equal footing for comparison purposes. For example, for auto manufacturers, it is common to express sales, costs, and profits on a per-car basis. For each of the following industries, give an example of an actual company and discuss one or more potentially useful means of standardizing financial information:

a. Public utilities.

b. Large retailers.

c. Airlines.

d. Online services.

e. Hospitals.

f. College textbook publishers.

11.   Statement of Cash Flows [LO4] In recent years, several manufacturing companies have reported the cash flow from the sale of Treasury securities in the cash from operations section of the statement of cash flows. What is the problem with this practice? Is there any situation in which this practice would be acceptable?

12.   Statement of Cash Flows [LO4] Suppose a company lengthens the time it takes to pay suppliers. How would this affect the statement of cash flows? How sustainable is the change in cash flows from this practice?

1.   Calculating Liquidity Ratios [LO2] SDJ, Inc., has net working capital of $1,920, current liabilities of $4,380, and inventory of $3,750. What is the current ratio? What is the quick ratio?

2.

   Calculating Profitability Ratios [LO2] Shelton, Inc., has sales of $17.5 million, total assets of $13.1 million, and total debt of $5.7 million. If the profit margin is 6 percent, what is net income? What is ROA? What is ROE?

3.   Calculating the Average Collection Period [LO2] Aguilera Corp. has a current accounts receivable balance of $438,720. Credit sales for the year just ended were $5,173,820. What is the receivables turnover? The days’ sales in receivables? How long did it take on average for credit customers to pay off their accounts during the past year?

4.   Calculating Inventory Turnover [LO2] The Green Corporation has ending inventory of $417,381, and cost of goods sold for the year just ended was $4,682,715. What is the inventory turnover? The days’ sales in inventory? How long on average did a unit of inventory sit on the shelf before it was sold?

5.   Calculating Leverage Ratios [LO2] Levine, Inc., has a total debt ratio of .53. What is its debt–equity ratio? What is its equity multiplier?

6.

   Calculating Market Value Ratios [LO2] Makers Corp. had additions to retained earnings for the year just ended of $395,000. The firm paid out $195,000 in cash dividends, and it has ending total equity of $5.3 million. If the company currently has 170,000 shares of common stock outstanding, what are earnings per share? Dividends per share? Book value per share? If the stock currently sells for $64 per share, what is the market-to-book ratio? The price–earnings ratio? If the company had sales of $5.15 million, what is the price–sales ratio?

7.   DuPont Identity [LO4] If Roten Rooters, Inc., has an equity multiplier of 1.15, total asset turnover of 2.10, and a profit margin of 6.1 percent, what is its ROE?

8.   DuPont Identity [LO4] Zombie Corp. has a profit margin of 5.1 percent, total asset turnover of 1.95, and ROE of 16.15 percent. What is this firm’s debt–equity ratio?

BASIC

(Questions 1–17)

Page 869.   Sources and Uses of Cash [LO4] Based only on the following information for Dawn Corp., did cash go up or down? By how much? Classify each event as a source or use of cash.

10.

   Calculating Average Payables Period [LO2] Hare, Inc., had a cost of goods sold of $57,382. At the end of the year, the accounts payable balance was $10,432. How long on average did it take the company to pay off its suppliers during the year? What might a large value for this ratio imply?

11.   Enterprise Value–EBITDA Multiple [LO2] The market value of the equity of Thompson, Inc., is $610,000. The balance sheet shows $39,000 in cash and $204,000 in debt, while the income statement has EBIT of $96,000 and a total of $143,000 in depreciation and amortization. What is the enterprise value–EBITDA multiple for this company?

12.   Equity Multiplier and Return on Equity [LO3] SME Company has a debt– equity ratio of .65. Return on assets is 8.2 percent, and total equity is $515,000. What is the equity multiplier? Return on equity? Net income?
   Just Dew It Corporation reports the following balance sheet information for 2014 and 2015. Use this information to work Problems 13 through 17.

13.   Preparing Standardized Financial Statements [LO1] Prepare the 2014 and 2015 common-size balance sheets for Just Dew It.

14.   Preparing Standardized Financial Statements [LO1] Prepare the 2015 common-base year balance sheet for Just Dew It.

15.   Preparing Standardized Financial Statements [LO1] Prepare the 2015 combined common-size, common-base year balance sheet for Just Dew It.

16.   Sources and Uses of Cash [LO4] For each account on this company’s balance sheet, show the change in the account during 2015 and note whether this change was a source or use of cash. Do your numbers add up and make sense? Explain your answer for total assets as compared to your answer for total liabilities and owners’ equity.

Page 8717.   Calculating Financial Ratios [LO2] Based on the balance sheets given for Just Dew It, calculate the following financial ratios for each year:

a. Current ratio.

b. Quick ratio.

c. Cash ratio.

d. NWC to total assets ratio.

e. Debt–equity ratio and equity multiplier.

f. Total debt ratio and long-term debt ratio.

18.

   Using the DuPont Identity [LO3] Y3K, Inc., has sales of $5,783, total assets of $2,604, and a debt–equity ratio of .75. If its return on equity is 11 percent, what is its net income?

19.   Days’ Sales in Receivables [LO2] A company has net income of $186,000, a profit margin of 7.9 percent, and an accounts receivable balance of $123,840. Assuming 70 percent of sales are on credit, what is the company’s days’ sales in receivables?

20.   Ratios and Fixed Assets [LO2] The Caughlin Company has a long-term debt ratio of .45 and a current ratio of 1.25. Current liabilities are $987, sales are $6,860, profit margin is 8.6 percent, and ROE is 17.5 percent. What is the amount of the firm’s net fixed assets?

21.   Profit Margin [LO4] In response to complaints about high prices, a grocery chain runs the following advertising campaign: “If you pay your child $1.50 to go buy $50 worth of groceries, then your child makes twice as much on the trip as we do.” You’ve collected the following information from the grocery chain’s financial statements:

Evaluate the grocery chain’s claim. What is the basis for the statement? Is this claim misleading? Why or why not?

22.

   Return on Equity [LO2] Firm A and Firm B have debt–total asset ratios of 55% and 40% and returns on total assets of 8% and 11%, respectively. Which firm has a greater return on equity?

23.   Calculating the Cash Coverage Ratio [LO2] Ugh Inc.’s net income for the most recent year was $17,382. The tax rate was 34 percent. The firm paid $3,953 in total interest expense and deducted $4,283 in depreciation expense. What was the cash coverage ratio for the year?

24.   Cost of Goods Sold [LO2] W & B Corp. has current liabilities of $387,000, a quick ratio of .85, inventory turnover of 8.4, and a current ratio of 1.35. What is the cost of goods sold for the company?

25.   Ratios and Foreign Companies [LO2] Prince Albert Canning PLC had a net loss of £27,835 on sales of £204,350. What was the company’s profit margin? Does the fact that these figures are quoted in a foreign currency make any difference? Why? In dollars, sales were $327,810. What was the net loss in dollars?
   Some recent financial statements for Smolira Golf Corp. follow. Use this information to work Problems 26 through 30.

INTERMEDIATE

(Questions 18–30)

Page 88

26.

   Calculating Financial Ratios [LO2] Find the following financial ratios for Smolira Golf Corp. (use year-end figures rather than average values where appropriate):

Page 89

27.   DuPont Identity [LO3] Construct the DuPont identity for Smolira Golf Corp.

28.   Statement of Cash Flows [LO4] Prepare the 2015 statement of cash flows for Smolira Golf Corp.

29.   Market Value Ratios [LO2] Smolira Golf Corp. has 25,000 shares of common stock outstanding, and the market price for a share of stock at the end of 2015 was $58. What is the price–earnings ratio? What are the dividends per share? What is the market-to-book ratio at the end of 2015? If the company’s growth rate is 9 percent, what is the PEG ratio?

30.   Tobin’s Q [LO2] What is Tobin’s Q for Smolira Golf? What assumptions are you making about the book value of debt and the market value of debt? What about the book value of assets and the market value of assets? Are these assumptions realistic? Why or why not?

EXCEL MASTER IT! PROBLEM

The eXtensible Business Reporting Language (XBRL) is likely the future of financial reporting. XBRL is a computer language that “tags” each item and specifies what that item is. XBRL reporting has already been adopted for use in Australia, Japan, and the United Kingdom. As of early 2011, a Securities and Exchange Commission advisory committee has recommended that U.S. companies be required to submit financial reports to the SEC in XBRL format. It has been suggested that requiring XBRL be gradually implemented, so it could be several years before we see all companies file XBRL financial reports. All listed U.S. companies file electronic reports with the SEC, but the reports are only available in html or text format. XBRL reporting will allow investors to quickly download financial statements for analysis.

Currently, several companies voluntarily submit financial statements in XBRL format. For this assignment, go to the SEC website at 

www.sec.gov

. Once there, look up the financials for a company. Next to the 10-Q (quarterly) and 10-K (annual) reports, you should notice a link that says “Interactive.” Click on this link, follow the “Financial Statements” link, and select “View Excel Document.” This link will allow you to download all of the financial statements in one Excel document. Download the Excel document and copy into the next worksheet. Use these statements to calculate the ratios on that worksheet. Do you notice any changes in these ratios that might indicate further investigation?

MINICASE

Ratio Analysis at S&S Air, Inc.

Chris Guthrie was recently hired by S&S Air, Inc., to assist the company with its financial planning and to evaluate the company’s performance. Chris graduated from college five years ago with a finance degree. He has been employed in the finance department of a Fortune 500 company since then.

S&S Air was founded 10 years ago by friends Mark Sexton and Todd Story. The company has manufactured and sold light airplanes over this period, and the company’s products have received high reviews for safety and reliability. The company has a niche market in that it sells primarily to individuals who own and fly their own airplanes. The company has two models; the Birdie, which sells for $53,000, and the Eagle, which sells for $78,000.

Page 90Although the company manufactures aircraft, its operations are different from commercial aircraft companies. S&S Air builds aircraft to order. By using prefabricated parts, the company can complete the manufacture of an airplane in only five weeks. The company also receives a deposit on each order, as well as another partial payment before the order is complete. In contrast, a commercial airplane may take one and one-half to two years to manufacture once the order is placed.

Mark and Todd have provided the following financial statements. Chris has gathered the industry ratios for the light airplane manufacturing industry.

Chapter 2

Chapter 2

In” be installed in Excel.

Problems 2, 3, 4, 6, 7, 14, 15, 19

Input boxes in tan

Output boxes in yellow

Given data in blue

Calculations in red

Answers in green

NOTE: Some functions used in these spreadsheets may require that

the “Analysis ToolPak” or “Solver Add

–

To install these, click on the Office button

then “Excel Options,” “Add-Ins” and select

“Go.” Check “Analyis ToolPak” and

“Solver Add-In,” then click “OK.”

#4

Chapter 2

Sales

Costs –
Depreciation expense

Interest expense –

(0%)

–

$ – 0

$ – 0

per share

ERROR:#DIV/0!

Question 4

Input area:

Sales

Costs

Depreciation expense

Interest expense

Tax rate

Cash dividends

Shares outstanding

Output area:

Income Statement

$

–

0

– 0

EBIT

$ –

EBT

$ – 0

Taxes

Net income

Addition to retained earnings

Earnings per share

ERROR:#DIV/0!

Dividends

#6

Chapter 2

Input area:

Taxable income

34%

35%

Output area:

15%

25%

34% 0
39% 0

34% 0

35% 0
38% 0

35% 0

15%

Question 6
	Taxable income
0 – 50,000			15%
50,001 – 75,000		25%
75,001 – 100,000				34%
100,001 – 335,000		39%
335,001 – 10,000,000
10,000,001 – 15,000,000				35%
15,000,001 – 18,333,333		38%
18,333,334 +
Taxes:
$ 50,000
(50,000)
The marginal tax rate is

#7

Chapter 2

Input area:

Sales
Costs

Tax rate

Output area:

Income Statement
Sales $ – 0
Costs –
Depreciation expense – 0
EBIT $ –
Interest expense –
EBT $ – 0

–
Net income $ – 0

$ – 0

Question 7
Depreciation Expense
Interest Expense
Taxes (0%)
		Operating cash flow

#14

Chapter 2

Input area:

Sales
Costs

Depreciation expense
Interest expense

Taxes
Dividends

Output area:

Income Statement
Sales $ – 0
Costs –

Other expenses – 0

Depreciation expense – 0
EBIT $ –
Interest expense –
EBT $ – 0

Taxes –

Net income $ – 0

Dividends $ – 0
Addition to retained earnings $ – 0

Operating cash flow $ – 0

$ – 0

$ – 0

$ – 0

$ –

$ – 0

Question 14
	Other expenses
2015 New equity
Net new long-term debt
Change in fixed assets
	a.
	b.	Cash flow to creditors
	c.	Cash flow to stockholders
d.	Cash flow from assets
Net capital spending
Change in NWC

#15

Chapter 2

Input area:

Sales
Costs

Addition to retained earnings

Interest expense
Tax rate

Output area:

Income Statement
Sales $ – 0
Costs –

Depreciation expense $ – 0

EBIT $ –
Interest expense –
EBT $ – 0

Taxes – 0

Net income $ – 0
Dividends $ – 0
Addition to retained earnings $ – 0

Question 15

Dividends paid

#19

Chapter 2

Input area:

Sales
Costs

Depreciation expense
Interest expense

Tax rate

Output area:

Income Statement
Sales $ – 0
Costs –

Administrative and selling expenses –

Depreciation expense – 0
EBIT $ –
Interest expense –
EBT $ – 0

Taxes (0%) 0
a. Net income $ – 0
b. Operating cash flow $ – 0
c.

Question 19
	Administrative and selling expenses
Net income was negative because of the tax deductibility and
interest expense. However, the actual cash flow from operations
was positive because depreciation is a non-cash expense and
interest is a financing expense, not an operating.

HIGH Lighted in BOLD

·

Ch. 2: Questions 4 & 9 (Questions and Problems section): Microsoft® Excel® template provided for Problem 4.         attached is the excel template that is to be used for problem number 4     I will highlight the questions below.  question 9 can be done either in a word doc or excel

Financial Statements, Taxes, and Cash Flow

2

· A WRITE-OFF by a company frequently means that the value of the company’s assets has declined. For example, in mid-2013, Microsoft announced that it would write off nearly $900 million due to its unsold Surface RT tablet computer inventory. Then, in December 2013, oil and gas giant BP announced that it was writing off $1.08 billion due to a failed Brazilian oil well.
· These write-offs were big, but not record-setting. Possibly the largest write-offs in history were done by the media company Time Warner, which took a charge of $45.5 billion in the fourth quarter of 2002. This enormous write-off followed an earlier, even larger, charge of $54 billion.
· So did stockholders in Microsoft lose $900 million because of the write-offs? The answer is probably not. Understanding why ultimately leads us to the main subject of this chapter: that all-important substance known as cash flow.
·

· For updates on the latest happenings in finance, visit 

www.fundamentalsofcorporatefinance.blogspot.com

.

· Learning Objectives

· After studying this chapter, you should understand:

LO1

The difference between accounting value (or “book” value) and market value.

LO2

The difference between accounting income and cash flow.

LO3

The difference between average and marginal tax rates.

LO4

How to determine a firm’s cash flow from its financial statements.

· In this chapter, we examine financial statements, taxes, and cash flow. Our emphasis is not on preparing financial statements. Instead, we recognize that financial statements are frequently a key source of information for financial decisions, so our goal is to briefly examine such statements and point out some of their more relevant features. We pay special attention to some of the practical details of cash flow.

· As you read, pay particular attention to two important differences: (1) the difference between accounting value and market value and (2) the difference between accounting income and cash flow. These distinctions will be important throughout the book.

· Page 212.1 The Balance Sheet

· Excel Master It!

·

· Excel Master coverage online

· The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm’s equity) at a given point in time. 

Figure 2.1

illustrates how the balance sheet is constructed. As shown, the left side lists the assets of the firm, and the right side lists the liabilities and equity.

· balance sheet
Financial statement showing a firm’s accounting value on a particular date.

· ASSETS: THE LEFT SIDE

· Assets are classified as either current or fixed. A fixed asset is one that has a relatively long life. Fixed assets can be either tangible, such as a truck or a computer, or intangible, such as a trademark or patent. A current asset has a life of less than one year. This means that the asset will convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year and is thus classified as a current asset. Obviously, cash itself is a current asset. Accounts receivable (money owed to the firm by its customers) are also current assets.

·

· Three excellent sites for company financial information are 
finance.yahoo.com
, 
finance.google.com
, and 
money.cnn.com
.

· LIABILITIES AND OWNERS’ EQUITY: THE RIGHT SIDE

· The firm’s liabilities are the first thing listed on the right side of the balance sheet. These are classified as either current or long-term. Current liabilities, like current assets, have a life of less than one year (meaning they must be paid within the year) and are listed before long-term liabilities. Accounts payable (money the firm owes to its suppliers) are one example of a current liability.

· A debt that is not due in the coming year is classified as a long-term liability. A loan that the firm will pay off in five years is one such long-term debt. Firms borrow in the long term from a variety of sources. We will tend to use the terms bond and bondholders generically to refer to long-term debt and long-term creditors, respectively.

· Finally, by definition, the difference between the total value of the assets (current and fixed) and the total value of the liabilities (current and long-term) is the shareholders’ equity, also called common equity or owners’ equity. This feature of the balance sheet is intended to reflect the fact that, if the firm were to sell all its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders. So, the balance sheet “balances” because the value of the left side always equals the value of the right side. That is, the value of the firm’s assets is equal to the sum of its liabilities and shareholders’ equity:

1

· FIGURE 2.1
The Balance Sheet. Left Side: Total Value of Assets.
Right Side: Total Value of Liabilities and Shareholders’ Equity.

·

· Page 22

· This is the balance sheet identity, or equation, and it always holds because shareholders’ equity is defined as the difference between assets and liabilities.

· NET WORKING CAPITAL

· As shown in 
Figure 2.1
, the difference between a firm’s current assets and its current liabilities is called net working capital. Net working capital is positive when current assets exceed current liabilities. Based on the definitions of current assets and current liabilities, this means the cash that will become available over the next 12 months exceeds the cash that must be paid over the same period. For this reason, net working capital is usually positive in a healthy firm.

· net working capital
Current assets less current liabilities.

· EXAMPLE 2.1 Building the Balance Sheet

· A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt of $200. What does the balance sheet look like? What is shareholders’ equity? What is net working capital?

· In this case, total assets are $100 + 500 = $600 and total liabilities are $70 + 200 = $270, so shareholders’ equity is the difference: $600 − 270 = $330. The balance sheet would look like this:

·

· Net working capital is the difference between current assets and current liabilities, or $100 − 70 = $30.

·

Table 2.1

 shows simplified balance sheets for the fictitious U.S. Corporation. The assets on the balance sheet are listed in order of the length of time it takes for them to convert to cash in the normal course of business. Similarly, the liabilities are listed in the order in which they would normally be paid.

· The structure of the assets for a particular firm reflects the line of business the firm is in and also managerial decisions about how much cash and inventory to have and about credit policy, fixed asset acquisition, and so on.

·

· Disney has a good investor relations site at 
thewaltdisneycompany.com/investors
.

· The liabilities side of the balance sheet primarily reflects managerial decisions about capital structure and the use of short-term debt. For example, in 2015, total long-term debt for U.S. was $454 and total equity was $640 + 1,629 = $2,269, so total long-term financing was $454 + 2,269 = $2,723. (Note that, throughout, all figures are in millions of dollars.) Of this amount, $454/2,723 = 16.67% was long-term debt. This percentage reflects capital structure decisions made in the past by the management of U.S.

· TABLE 2.1 Balance Sheets

· Page 23

· There are three particularly important things to keep in mind when examining a balance sheet: liquidity, debt versus equity, and market value versus book value.

· LIQUIDITY

· Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively liquid asset; a custom manufacturing facility is not. Liquidity actually has two dimensions: ease of conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one that can be quickly sold without significant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a substantial price reduction.

·

· Annual and quarterly financial statements (and lots more) for most public U.S. corporations can be found in the EDGAR database at 
www.sec.gov
.

· Assets are normally listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid assets are listed first. Current assets are relatively liquid and include cash and assets we expect to convert to cash over the next 12 months. Accounts receivable, for example, represent amounts not yet collected from customers on sales already made. Naturally, we hope these will convert to cash in the near future. Inventory is probably the least liquid of the current assets, at least for many businesses.

· Fixed assets are, for the most part, relatively illiquid. These consist of tangible things such as buildings and equipment that don’t convert to cash at all in normal business activity (they are, of course, used in the business to generate cash). Intangible assets, such as a trademark, have no physical existence but can be very valuable. Like tangible fixed assets, they won’t ordinarily convert to cash and are generally considered illiquid.

· Liquidity is valuable. The more liquid a business is, the less likely it is to experience financial distress (that is, difficulty in paying debts or buying needed assets). Unfortunately, liquid assets are generally less profitable to hold. For example, cash holdings are the most liquid of all investments, but they sometimes earn no return at all—they just sit there. There is therefore a trade-off between the advantages of liquidity and forgone potential profits.

· Page 24DEBT VERSUS EQUITY

· To the extent that a firm borrows money, it usually gives first claim to the firm’s cash flow to creditors. Equity holders are entitled to only the residual value, the portion left after creditors are paid. The value of this residual portion is the shareholders’ equity in the firm, which is just the value of the firm’s assets less the value of the firm’s liabilities:

· Shareholders’ equity = Assets − Liabilities

· This is true in an accounting sense because shareholders’ equity is defined as this residual portion. More important, it is true in an economic sense: If the firm sells its assets and pays its debts, whatever cash is left belongs to the shareholders.

· The use of debt in a firm’s capital structure is called financial leverage. The more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage. As we discuss in later chapters, debt acts like a lever in the sense that using it can greatly magnify both gains and losses. So, financial leverage increases the potential reward to shareholders, but it also increases the potential for financial distress and business failure.

· MARKET VALUE VERSUS BOOK VALUE

· The values shown on the balance sheet for the firm’s assets are book values and generally are not what the assets are actually worth. Under Generally Accepted Accounting Principles (GAAP), audited financial statements in the United States mostly show assets at historical cost. In other words, assets are “carried on the books” at what the firm paid for them, no matter how long ago they were purchased or how much they are worth today.

· Generally Accepted Accounting Principles (GAAP)
The common set of standards and procedures by which audited financial statements are prepared.

· For current assets, market value and book value might be somewhat similar because current assets are bought and converted into cash over a relatively short span of time. In other circumstances, the two values might differ quite a bit. Moreover, for fixed assets, it would be purely a coincidence if the actual market value of an asset (what the asset could be sold for) were equal to its book value. For example, a railroad might own enormous tracts of land purchased a century or more ago. What the railroad paid for that land could be hundreds or thousands of times less than what the land is worth today. The balance sheet would nonetheless show the historical cost.

·

· The home page for the Financial Accounting Standards Board (FASB) is 
www.fasb.org
.

· The difference between market value and book value is important for understanding the impact of reported gains and losses. For example, from time to time, accounting rule changes take place that lead to reductions in the book value of certain types of assets. However, a change in accounting rules all by itself has no effect on what the assets in question are really worth. Instead, the market value of an asset depends on things like its riskiness and cash flows, neither of which have anything to do with accounting.

· The balance sheet is potentially useful to many different parties. A supplier might look at the size of accounts payable to see how promptly the firm pays its bills. A potential creditor would examine the liquidity and degree of financial leverage. Managers within the firm can track things like the amount of cash and the amount of inventory the firm keeps on hand. Uses such as these are discussed in more detail in 

Chapter 3

.

· Managers and investors will frequently be interested in knowing the value of the firm. This information is not on the balance sheet. The fact that balance sheet assets are listed at cost means that there is no necessary connection between the total assets shown and the value of the firm. Indeed, many of the most valuable assets a firm might have—good management, a good reputation, talented employees—don’t appear on the balance sheet at all.

· Similarly, the shareholders’ equity figure on the balance sheet and the true value of the stock need not be related. For example, in early 2014, the book value of IBM’s equity was about $20 billion, while the market value was $204 billion. At the same time, Google’s book value was $72 billion, while the market value was $381 billion.

· Page 25For financial managers, then, the accounting value of the stock is not an especially important concern; it is the market value that matters. Henceforth, whenever we speak of the value of an asset or the value of the firm, we will normally mean its market value. So, for example, when we say the goal of the financial manager is to increase the value of the stock, we mean the market value of the stock.

· EXAMPLE 2.2 Market Value versus Book Value

· The Klingon Corporation has net fixed assets with a book value of $700 and an appraised market value of about $1,000. Net working capital is $400 on the books, but approximately $600 would be realized if all the current accounts were liquidated. Klingon has $500 in long-term debt, both book value and market value. What is the book value of the equity? What is the market value?

· We can construct two simplified balance sheets, one in accounting (book value) terms and one in economic (market value) terms:

·

· In this example, shareholders’ equity is actually worth almost twice as much as what is shown on the books. The distinction between book and market values is important precisely because book values can be so different from true economic value.

· Concept Questions

· 2.1a   What is the balance sheet identity?

· 2.1b   What is liquidity? Why is it important?

· 2.1c   What do we mean by financial leverage?

· 2.1d   Explain the difference between accounting value and market value. Which is more important to the financial manager? Why?

· 2.2 The Income Statement

· Excel Master It!
·
· Excel Master coverage online

· The income statement measures performance over some period of time, usually a quarter or a year. The income statement equation is:

·

· income statement
Financial statement summarizing a firm’s performance over a period of time.

· If you think of the balance sheet as a snapshot, then you can think of the income statement as a video recording covering the period between before and after pictures. 

Table 2.2

 gives a simplified income statement for U.S. Corporation.

· Page 26TABLE 2.2 Income Statement

·

· The first thing reported on an income statement would usually be revenue and expenses from the firm’s principal operations. Subsequent parts include, among other things, financing expenses such as interest paid. Taxes paid are reported separately. The last item is net income (the so-called bottom line). Net income is often expressed on a per-share basis and called earnings per share (EPS).

· As indicated, U.S. paid cash dividends of $103. The difference between net income and cash dividends, $309, is the addition to retained earnings for the year. This amount is added to the cumulative retained earnings account on the balance sheet. If you look back at the two balance sheets for U.S. Corporation, you’ll see that retained earnings did go up by this amount: $1,320 + 309 = $1,629.

· EXAMPLE 2.3 Calculating Earnings and Dividends per Share

· Suppose U.S. had 200 million shares outstanding at the end of 2015. Based on the income statement in 
Table 2.2
, what was EPS? What were dividends per share?

· From the income statement, we see that U.S. had a net income of $412 million for the year. Total dividends were $103 million. Because 200 million shares were outstanding, we can calculate earnings per share, or EPS, and dividends per share as follows:

·

· When looking at an income statement, the financial manager needs to keep three things in mind: GAAP, cash versus noncash items, and time and costs.

· GAAP AND THE INCOME STATEMENT

· An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. The general rule (the recognition or realization principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.

· Page 27Expenses shown on the income statement are based on the matching principle. The basic idea here is to first determine revenues as described previously and then match those revenues with the costs associated with producing them. So, if we manufacture a product and then sell it on credit, the revenue is realized at the time of sale. The production and other costs associated with the sale of that product will likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some different time.

· As a result of the way revenues and expenses are realized, the figures shown on the income statement may not be at all representative of the actual cash inflows and outflows that occurred during a particular period.

· NONCASH ITEMS

· A primary reason that accounting income differs from cash flow is that an income statement contains noncash items. The most important of these is depreciation. Suppose a firm purchases an asset for $5,000 and pays in cash. Obviously, the firm has a $5,000 cash outflow at the time of purchase. However, instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a five-year period.

· noncash items
Expenses charged against revenues that do not directly affect cash flow, such as depreciation.

· If the depreciation is straight-line and the asset is written down to zero over that period, then $5,000/5 = $1,000 will be deducted each year as an expense.
2
 The important thing to recognize is that this $1,000 deduction isn’t cash—it’s an accounting number. The actual cash outflow occurred when the asset was purchased.

· The depreciation deduction is simply another application of the matching principle in accounting. The revenues associated with an asset would generally occur over some length of time. So, the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.

· As we will see, for the financial manager, the actual timing of cash inflows and outflows is critical in coming up with a reasonable estimate of market value, so we need to learn how to separate the cash flows from the noncash accounting entries. In reality, the difference between cash flow and accounting income can be pretty dramatic. For example, consider the case of Malaysia Airlines: Malaysia Airlines reported a net loss of MYR830 million ($252.8 million) for the first nine months of 2013. Sounds bad, but Malaysia Airlines also reported a positive cash flow of MYR555 million ($169.1 million), a difference of about $421.9 million!

· TIME AND COSTS

· It is often useful to think of the future as having two distinct parts: the short run and the long run. These are not precise time periods. The distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on.

· If our time horizon is relatively short, however, some costs are effectively fixed—they must be paid no matter what (property taxes, for example). Other costs such as wages to laborers and payments to suppliers are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas.

· The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs.

· Page 28

· WORK THE WEB

· The U.S. Securities and Exchange Commission (SEC) requires that most public companies file regular reports, including annual and quarterly financial statements. The SEC has a public site named EDGAR that makes these free reports available at 

www.sec.gov

. We went to “Search for Company Filings” and looked up Google:

·

· Here is a partial view of what we got:

·

· The two reports we look at the most are the 10-K, which is the annual report filed with the SEC, and the 10-Q. The 10-K includes the list of officers and their salaries, financial statements for the previous fiscal year, and an explanation by the company of the financial results. The 10-Q is a smaller report that includes the financial statements for the quarter.

· Questions

· 1.  As you can imagine, electronic filing of documents with the SEC has not been around for very long. Go to 

www.sec.gov

 and find the filings for General Electric. What is the date of the oldest 10-K available on the website for General Electric? Look up the 10-K forms for IBM and Apple to see if the year of the first electronic filing is the same for these companies.

· 2.  Go to 

www.sec.gov

 and find out when the following forms are used: Form DEF 14A, Form 8-K, and Form 6-K.

· Product costs include such things as raw materials, direct labor expense, and manufacturing overhead. These are reported on the income statement as costs of goods sold, but they include both fixed and variable costs. Similarly, period costs are incurred during a particular time period and might be reported as selling, general, and administrative expenses. Once again, some of these period costs may be fixed and others may be variable. Page 29The company president’s salary, for example, is a period cost and is probably fixed, at least in the short run.

· The balance sheets and income statement we have been using thus far are hypothetical. Our nearby Work the Web box shows how to find actual balance sheets and income statements online for almost any company. Also, with the increasing globalization of business, there is a clear need for accounting standards to become more comparable across countries. Accordingly, in recent years, U.S. accounting standards have become more closely tied to International Financial Reporting Standards (IFRS). In particular, the Financial Accounting Standards Board (FASB), which is in charge of U.S. GAAP policies, and the International Accounting Standards Board, which is in charge of IFRS polices, have been working toward a convergence of policies since 2002, but a final resolution has yet to be reached.

·

· For more information about IFRS, check out the website 

www.ifrs.org

.

· Concept Questions

· 2.2a   What is the income statement equation?

· 2.2b   What are the three things to keep in mind when looking at an income statement?

· 2.2c   Why is accounting income not the same as cash flow? Give two reasons.

· 2.3 Taxes

· Excel Master It!
·
· Excel Master coverage online

· Taxes can be one of the largest cash outflows a firm experiences. For example, for the fiscal year 2013, ExxonMobil’s earnings before taxes were about $57.71 billion. Its tax bill, including all taxes paid worldwide, was a whopping $24.26 billion, or about 42 percent of its pretax earnings. Also for fiscal year 2013, Walmart had a taxable income of $24.66 billion, and the company paid $8.11 billion in taxes, an average tax rate of 33 percent.

· The size of a company’s tax bill is determined by the tax code, an often amended set of rules. In this section, we examine corporate tax rates and how taxes are calculated. If the various rules of taxation seem a little bizarre or convoluted to you, keep in mind that the tax code is the result of political, not economic, forces. As a result, there is no reason why it has to make economic sense.

· CORPORATE TAX RATES

· Corporate tax rates in effect for 2015 are shown in 

Table 2.3

. A peculiar feature of taxation instituted by the Tax Reform Act of 1986 and expanded in the 1993 Omnibus Budget Reconciliation Act is that corporate tax rates are not strictly increasing. As shown, corporate tax rates rise from 15 percent to 39 percent, but they drop back to 34 percent on income over $335,000. They then rise to 38 percent and subsequently fall to 35 percent.

· According to the originators of the current tax rules, there are only four corporate rates: 15 percent, 25 percent, 34 percent, and 35 percent. The 38 and 39 percent brackets arise because of “surcharges” applied on top of the 34 and 35 percent rates. A tax is a tax is a tax, however, so there are really six corporate tax brackets, as we have shown.

· Page 30TABLE 2.3 Corporate Tax Rates

·

· AVERAGE VERSUS MARGINAL TAX RATES

· In making financial decisions, it is frequently important to distinguish between average and marginal tax rates. Your average tax rate is your tax bill divided by your taxable income—in other words, the percentage of your income that goes to pay taxes. Your marginal tax rate is the rate of the extra tax you would pay if you earned one more dollar. The percentage tax rates shown in 
Table 2.3
 are all marginal rates. Put another way, the tax rates in 
Table 2.3
 apply to the part of income in the indicated range only, not all income.

· average tax rate
Total taxes paid divided by total taxable income.

· marginal tax rate
Amount of tax payable on the next dollar earned.

· The difference between average and marginal tax rates can best be illustrated with a simple example. Suppose our corporation has a taxable income of $200,000. What is the tax bill? Using 
Table 2.3
, we can figure our tax bill:

·

· Our total tax is thus $61,250.

·

· The IRS has a great website! (

www.irs.gov

).

· In our example, what is the average tax rate? We had a taxable income of $200,000 and a tax bill of $61,250, so the average tax rate is $61,250/200,000 = 30.625%. What is the marginal tax rate? If we made one more dollar, the tax on that dollar would be 39 cents, so our marginal rate is 39 percent.

· EXAMPLE 2.4 Deep in the Heart of Taxes

· Algernon, Inc., has a taxable income of $85,000. What is its tax bill? What is its average tax rate? Its marginal tax rate?

· From 
Table 2.3
, we see that the tax rate applied to the first $50,000 is 15 percent; the rate applied to the next $25,000 is 25 percent; and the rate applied after that up to $100,000 is 34 percent. So Algernon must pay .15 × $50,000 + .25 × 25,000 + .34 × (85,000 − 75,000) = $17,150. The average tax rate is thus $17,150/85,000 = 20.18%. The marginal rate is 34 percent because Algernon’s taxes would rise by 34 cents if it had another dollar in taxable income.

·

Table 2.4

 summarizes some different taxable incomes, marginal tax rates, and average tax rates for corporations. Notice how the average and marginal tax rates come together at 35 percent.

· Page 31TABLE 2.4 Corporate Taxes and Tax Rates

·

· With a flat-rate tax, there is only one tax rate, so the rate is the same for all income levels. With such a tax, the marginal tax rate is always the same as the average tax rate. As it stands now, corporate taxation in the United States is based on a modified flat-rate tax, which becomes a true flat rate for the highest incomes.

· In looking at 
Table 2.4
, notice that the more a corporation makes, the greater is the percentage of taxable income paid in taxes. Put another way, under current tax law, the average tax rate never goes down, even though the marginal tax rate does. As illustrated, for corpo rations, average tax rates begin at 15 percent and rise to a maximum of 35 percent.

· Normally the marginal tax rate is relevant for financial decision making. The reason is that any new cash flows will be taxed at that marginal rate. Because financial decisions usually involve new cash flows or changes in existing ones, this rate will tell us the marginal effect of a decision on our tax bill.

· There is one last thing to notice about the tax code as it affects corporations. It’s easy to verify that the corporate tax bill is just a flat 35 percent of taxable income if our taxable income is more than $18.33 million. Also, for the many midsize corporations with taxable incomes in the range of $335,000 to $10,000,000, the tax rate is a flat 34 percent. Because we will normally be talking about large corporations, you can assume that the average and marginal tax rates are 35 percent unless we explicitly say otherwise.

· We should note that we have simplified the U.S. tax code in our discussions. In reality, the tax code is much more complex and is riddled with various tax deductions and loopholes allowed for certain industries. As a result, the average corporate tax rate can be far from 35 percent for many companies. 
Table 2.5
 displays average tax rates for various industries.

· TABLE 2.5 Average Tax Rates

·

· Page 32As you can see, the average tax rate ranges from 33.8 percent for electric utilities to 4.5 percent for biotechnology firms.

· Before moving on, we should note that the tax rates we have discussed in this section relate to federal taxes only. Overall tax rates can be higher if state, local, and any other taxes are considered.

· Concept Questions

· 2.3a   What is the difference between a marginal and an average tax rate?

· 2.3b   Do the wealthiest corporations receive a tax break in terms of a lower tax rate? Explain.

· 2.4 Cash Flow

· Excel Master It!
·
· Excel Master coverage online

· At this point, we are ready to discuss perhaps one of the most important pieces of financial information that can be gleaned from financial statements: cash flow. By cash flow, we simply mean the difference between the number of dollars that came in and the number that went out. For example, if you were the owner of a business, you might be very interested in how much cash you actually took out of your business in a given year. How to determine this amount is one of the things we discuss next.

· No standard financial statement presents this information in the way that we wish. We will therefore discuss how to calculate cash flow for U.S. Corporation and point out how the result differs from that of standard financial statement calculations. There is a standard financial accounting statement called the statement of cash flows, but it is concerned with a somewhat different issue that should not be confused with what is discussed in this section. The accounting statement of cash flows is discussed in 
Chapter 3
.

· From the balance sheet identity, we know that the value of a firm’s assets is equal to the value of its liabilities plus the value of its equity. Similarly, the cash flow from the firm’s assets must equal the sum of the cash flow to creditors and the cash flow to stockholders (or owners):

·

· This is the cash flow identity. It says that the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm. What it reflects is the fact that a firm generates cash through its various activities, and that cash is either used to pay creditors or paid out to the owners of the firm. We discuss the various things that make up these cash flows next.

· CASH FLOW FROM ASSETS

· Cash flow from assets involves three components: operating cash flow, capital spending, and change in net working capital. Operating cash flow refers to the cash flow that results from the firm’s day-to-day activities of producing and selling. Expenses associated with the firm’s financing of its assets are not included because they are not operating expenses.

· cash flow from assets
The total of cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and change in net working capital.

· operating cash flow
Cash generated from a firm’s normal business activities.

· As we discussed in 

Chapter 1

, some portion of the firm’s cash flow is reinvested in the firm. Capital spending refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets). Finally, change in net working capital is measured as the net change in current assets relative to current liabilities for the period being examined and Page 33represents the amount spent on net working capital. The three components of cash flow are examined in more detail next.

· Operating Cash Flow To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don’t want to include depreciation because it’s not a cash outflow, and we don’t want to include interest because it’s a financing expense. We do want to include taxes because taxes are (unfortunately) paid in cash.

· If we look at U.S. Corporation’s income statement (
Table 2.2
), we see that earnings before interest and taxes (EBIT) are $694. This is almost what we want because it doesn’t include interest paid. We need to make two adjustments. First, recall that depreciation is a noncash expense. To get cash flow, we first add back the $65 in depreciation because it wasn’t a cash deduction. The other adjustment is to subtract the $212 in taxes because these were paid in cash. The result is operating cash flow:

·

· U.S. Corporation thus had a 2015 operating cash flow of $547.

· Operating cash flow is an important number because it tells us, on a very basic level, whether a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows. For this reason, a negative operating cash flow is often a sign of trouble.

· There is an unpleasant possibility of confusion when we speak of operating cash flow. In accounting practice, operating cash flow is often defined as net income plus depreciation. For U.S. Corporation, this would amount to $412 + 65 = $477.

· The accounting definition of operating cash flow differs from ours in one important way: Interest is deducted when net income is computed. Notice that the difference between the $547 operating cash flow we calculated and this $477 is $70, the amount of interest paid for the year. This definition of cash flow thus considers interest paid to be an operating expense. Our definition treats it properly as a financing expense. If there were no interest expense, the two definitions would be the same.

· To finish our calculation of cash flow from assets for U.S. Corporation, we need to consider how much of the $547 operating cash flow was reinvested in the firm. We consider spending on fixed assets first.

· Capital Spending Net capital spending is just money spent on fixed assets less money received from the sale of fixed assets. At the end of 2014, net fixed assets for U.S. Corporation (
Table 2.1
) were $1,644. During the year, U.S. wrote off (depreciated) $65 worth of fixed assets on the income statement. So, if the firm didn’t purchase any new fixed assets, net fixed assets would have been $1,644 − 65 = $1,579 at year’s end. The 2015 balance sheet shows $1,709 in net fixed assets, so U.S. must have spent a total of $1,709 − 1,579 = $130 on fixed assets during the year:

·

· Page 34This $130 is the net capital spending for 2015.

· Could net capital spending be negative? The answer is yes. This would happen if the firm sold off more assets than it purchased. The net here refers to purchases of fixed assets net of any sales of fixed assets. You will often see capital spending called CAPEX, which is an acronym for capital expenditures. It usually means the same thing.

· Change in Net Working Capital In addition to investing in fixed assets, a firm will also invest in current assets. For example, going back to the balance sheets in 
Table 2.1
, we see that, at the end of 2015, U.S. had current assets of $1,403. At the end of 2014, current assets were $1,112; so, during the year, U.S. invested $1,403 − 1,112 = $291 in current assets.

· As the firm changes its investment in current assets, its current liabilities will usually change as well. To determine the change in net working capital, the easiest approach is just to take the difference between the beginning and ending net working capital (NWC) figures. Net working capital at the end of 2015 was $1,403 − 389 = $1,014. Similarly, at the end of 2014, net working capital was $1,112 − 428 = $684. Given these figures, we have the following:

·

· Net working capital thus increased by $330. Put another way, U.S. Corporation had a net investment of $330 in NWC for the year. This change in NWC is often referred to as the “addition to” NWC.

· Conclusion Given the figures we’ve come up with, we’re ready to calculate cash flow from assets. The total cash flow from assets is given by operating cash flow less the amounts invested in fixed assets and net working capital. So, for U.S., we have:

·

· From the cash flow identity given earlier, we know that this $87 cash flow from assets equals the sum of the firm’s cash flow to creditors and its cash flow to stockholders. We consider these next.

· It wouldn’t be at all unusual for a growing corporation to have a negative cash flow. As we see next, a negative cash flow means that the firm raised more money by borrowing and selling stock than it paid out to creditors and stockholders during the year.

· A Note about “Free” Cash Flow Cash flow from assets sometimes goes by a different name, free cash flow. Of course, there is no such thing as “free” cash (we wish!). Instead the name refers to cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments. We will stick with “cash flow from assets” as our label for this important concept because, in practice, there is some variation in exactly how free cash flow is computed; different users calculate it in different ways. Nonetheless, whenever you hear the phrase “free cash flow,” you should understand that what is being discussed is cash flow from assets or something quite similar.

· free cash flow
Another name for cash flow from assets.

· Page 35CASH FLOW TO CREDITORS AND STOCKHOLDERS

· The cash flows to creditors and stockholders represent the net payments to creditors and owners during the year. Their calculation is similar to that of cash flow from assets. Cash flow to creditors is interest paid less net new borrowing; cash flow to stockholders is dividends paid less net new equity raised.

· cash flow to creditors
A firm’s interest payments to creditors less net new borrowing.

· cash flow to stockholders
Dividends paid out by a firm less net new equity raised.

· Cash Flow to Creditors Looking at the income statement in 
Table 2.2
, we see that U.S. paid $70 in interest to creditors. From the balance sheets in 
Table 2.1
, we see that long-term debt rose by $454 − 408 = $46. So U.S. Corporation paid out $70 in interest, but it borrowed an additional $46. Thus, net cash flow to creditors is:

·

· Cash flow to creditors is sometimes called cash flow to bondholders; we will use these terms interchangeably.

· Cash Flow to Stockholders From the income statement, we see that dividends paid to stockholders amounted to $103. To get net new equity raised, we need to look at the common stock and paid-in surplus account. This account tells us how much stock the company has sold. During the year, this account rose by $40, so $40 in net new equity was raised. Given this, we have the following:

·

· The cash flow to stockholders for 2015 was thus $63.

· The last thing we need to do is to verify that the cash flow identity holds to be sure we didn’t make any mistakes. From the previous section, we know that cash flow from assets is $87. Cash flow to creditors and stockholders is $24 + 63 = $87, so everything checks out. 

Table 2.6

 contains a summary of the various cash flow calculations for future reference.

· As our discussion indicates, it is essential that a firm keep an eye on its cash flow. The following serves as an excellent reminder of why doing so is a good idea, unless the firm’s owners wish to end up in the “Po’ ” house:

· QUOTH THE BANKER, “WATCH CASH FLOW”

· Once upon a midnight dreary as I pondered weak and weary
Over many a quaint and curious volume of accounting lore,
Seeking gimmicks (without scruple) to squeeze through
   some new tax loophole,
Suddenly I heard a knock upon my door, Only this, and nothing more.

· Then I felt a queasy tingling and I heard the cash a-jingling
As a fearsome banker entered whom I’d often seen before.
His face was money-green and in his eyes there could be seen
Dollar-signs that seemed to glitter as he reckoned up the score.
   “Cash flow,” the banker said, and nothing more.

· Page 36TABLE 2.6 Cash Flow Summary

·

· I had always thought it fine to show a jet black bottom line.
But the banker sounded a resounding, “No.
Your receivables are high, mounting upward toward the sky;
Write-offs loom. What matters is cash flow.”
   He repeated, “Watch cash flow.”

· Then I tried to tell the story of our lovely inventory
Which, though large, is full of most delightful stuff.
But the banker saw its growth, and with a mighty oath
He waved his arms and shouted, “Stop! Enough!
   Pay the interest, and don’t give me any guff!”

· Next I looked for noncash items which could add ad infinitum
To replace the ever-outward flow of cash,
But to keep my statement black I’d held depreciation back,
And my banker said that I’d done something rash.
   He quivered, and his teeth began to gnash.

· When I asked him for a loan, he responded, with a groan,
That the interest rate would be just prime plus eight,
And to guarantee my purity he’d insist on some security—
All my assets plus the scalp upon my pate.
   Only this, a standard rate.

· Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable:
The result is certain—unremitting woe!
And I hear the banker utter an ominous low mutter,
   “Watch cash flow.”

· Herbert S. Bailey Jr.

· Source: “Quoth the Banker, ‘Watch Cash Flow,’ ” from Publishers Weekly, January 13, 1975. Copyright © 1975 by Publishers Weekly. All rights reserved. Used with permission.

· To which we can only add, “Amen.”

· Page 37AN EXAMPLE: CASH FLOWS FOR DOLE COLA

· This extended example covers the various cash flow calculations discussed in the chapter. It also illustrates a few variations that may arise.

· Operating Cash Flow During the year, Dole Cola, Inc., had sales and cost of goods sold of $600 and $300, respectively. Depreciation was $150 and interest paid was $30. Taxes were calculated at a straight 34 percent. Dividends were $30. (All figures are in millions of dollars.) What was operating cash flow for Dole? Why is this different from net income?

· The easiest thing to do here is to create an income statement. We can then pick up the numbers we need. Dole Cola’s income statement is given here:

·

· Net income for Dole was thus $79. We now have all the numbers we need. Referring back to the U.S. Corporation example and 
Table 2.6
, we have this:

·

· As this example illustrates, operating cash flow is not the same as net income because depreciation and interest are subtracted out when net income is calculated. If you recall our earlier discussion, we don’t subtract these out in computing operating cash flow because depreciation is not a cash expense and interest paid is a financing expense, not an operating expense.

· Net Capital Spending Suppose beginning net fixed assets were $500 and ending net fixed assets were $750. What was the net capital spending for the year?

· From the income statement for Dole, we know that depreciation for the year was $150. Net fixed assets rose by $250. Dole thus spent $250 along with an additional $150, for a total of $400.

· Page 38Change in NWC and Cash Flow from Assets Suppose Dole Cola started the year with $2,130 in current assets and $1,620 in current liabilities, and the corresponding ending figures were $2,260 and $1,710. What was the change in NWC during the year? What was cash flow from assets? How does this compare to net income?

· Net working capital started out as $2,130 − 1,620 = $510 and ended up at $2,260 − 1,710 = $550. The addition to NWC was thus $550 − 510 = $40. Putting together all the information for Dole, we have the following:

·

· Dole had a cash flow from assets of −$181. Net income was positive at $79. Is the fact that cash flow from assets was negative a cause for alarm? Not necessarily. The cash flow here is negative primarily because of a large investment in fixed assets. If these are good investments, the resulting negative cash flow is not a worry.

· Cash Flow to Stockholders and Creditors We saw that Dole Cola had cash flow from assets of −$181. The fact that this is negative means that Dole raised more money in the form of new debt and equity than it paid out for the year. For example, suppose we know that Dole didn’t sell any new equity for the year. What was cash flow to stockholders? To creditors?

· Because it didn’t raise any new equity, Dole’s cash flow to stockholders is just equal to the cash dividend paid:

·

· Now, from the cash flow identity, we know that the total cash paid to creditors and stockholders was −$181. Cash flow to stockholders is $30, so cash flow to creditors must be equal to −$181 − 30 = −$211:

·

· Because we know that cash flow to creditors is −$211 and interest paid is $30 (from the income statement), we can now determine net new borrowing. Dole must have borrowed $241 during the year to help finance the fixed asset expansion:

· Page 39

· Concept Questions

· 2.4a   What is the cash flow identity? Explain what it says.

· 2.4b   What are the components of operating cash flow?

· 2.4c   Why is interest paid not a component of operating cash flow?

·  

· 2.5   Summary and Conclusions

· This chapter has introduced some of the basics of financial statements, taxes, and cash flow:

· 1.  The book values on an accounting balance sheet can be very different from market values. The goal of financial management is to maximize the market value of the stock, not its book value.

· 2.  Net income as it is computed on the income statement is not cash flow. A primary reason is that depreciation, a noncash expense, is deducted when net income is computed.

· 3.  Marginal and average tax rates can be different, and it is the marginal tax rate that is relevant for most financial decisions.

· 4.  The marginal tax rate paid by the corporations with the largest incomes is 35 percent.

· 5.  There is a cash flow identity much like the balance sheet identity. It says that cash flow from assets equals cash flow to creditors and stockholders.

· The calculation of cash flow from financial statements isn’t difficult. Care must be taken in handling noncash expenses, such as depreciation, and not to confuse operating costs with financing costs. Most of all, it is important not to confuse book values with market values, or accounting income with cash flow.

· CONNECT TO FINANCE

·

· Do you use Connect Finance to practice what you learned? If you don’t, you should—we can help you master the topics presented in this material. Log on to 

connect.mheducation.com

 to learn more!

· Can you answer the following Connect Quiz questions?

Section 2.1	What types of accounts are the most liquid?
Section 2.2	What is an example of a noncash expense?
Section 2.3	The marginal tax rate is the tax rate which _________.
Section 2.4	Interest expense is treated as what type of cash flow?

· Page 40

· CHAPTER REVIEW AND SELF-TEST PROBLEM

· 2.1   Cash Flow for Mara Corporation This problem will give you some practice working with financial statements and figuring cash flow. Based on the following information for Mara Corporation, prepare an income statement for 2015 and balance sheets for 2014 and 2015. Next, following our U.S. Corporation examples in the chapter, calculate cash flow from assets, cash flow to creditors, and cash flow to stockholders for Mara for 2015. Use a 35 percent tax rate throughout. You can check your answers against ours, found in the following section.

·

· ANSWER TO CHAPTER REVIEW AND SELF-TEST PROBLEM

· 2.1   In preparing the balance sheets, remember that shareholders’ equity is the residual. With this in mind, Mara’s balance sheets are as follows:

·

· The income statement is straightforward:

·

· Page 41Notice that we’ve used an average 35 percent tax rate. Also notice that the addition to retained earnings is just net income less cash dividends.

· We can now pick up the figures we need to get operating cash flow:

·

· Next, we get the net capital spending for the year by looking at the change in fixed assets, remembering to account for depreciation:

·

· After calculating beginning and ending NWC, we take the difference to get the change in NWC:

·

· We now combine operating cash flow, net capital spending, and the change in net working capital to get the total cash flow from assets:

·

· To get cash flow to creditors, notice that long-term borrowing decreased by $1,021 during the year and that interest paid was $196:

·

· Finally, dividends paid were $250. To get net new equity raised, we have to do some extra calculating. Total equity was up by $6,739 − 5,440 = $1,299. Of this Page 42increase, $222 was from additions to retained earnings, so $1,077 in new equity was raised during the year. Cash flow to stockholders was thus:

·

· As a check, notice that cash flow from assets ($390) equals cash flow to creditors plus cash flow to stockholders ($1,217 − 827 = $390).

· CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS

· 1.   Liquidity [LO1] What does liquidity measure? Explain the trade-off a firm faces between high liquidity and low liquidity levels.

· 2.   Accounting and Cash Flows [LO2] Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period?

· 3.   Book Values versus Market Values [LO1] In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?

· 4.   Operating Cash Flow [LO2] In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow. Explain what each is and why it is excluded in operating cash flow.

· 5.   Book Values versus Market Values [LO1] Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can this happen with market values? Why or why not?

· 6.   Cash Flow from Assets [LO4] Suppose a company’s cash flow from assets is negative for a particular period. Is this necessarily a good sign or a bad sign?

· 7.   Operating Cash Flow [LO4] Suppose a company’s operating cash flow has been negative for several years running. Is this necessarily a good sign or a bad sign?

· 8.   Net Working Capital and Capital Spending [LO4] Could a company’s change in NWC be negative in a given year? (Hint: Yes.) Explain how this might come about. What about net capital spending?

· 9.   Cash Flow to Stockholders and Creditors [LO4] Could a company’s cash flow to stockholders be negative in a given year? (Hint: Yes.) Explain how this might come about. What about cash flow to creditors?

· 10.   Firm Values [LO1] Referring back to the Microsoft example used at the beginning of the chapter, note that we suggested that Microsoft’s stockholders probably didn’t suffer as a result of the reported loss. What do you think was the basis for our conclusion?

· 11.   Enterprise Value [LO1] A firm’s enterprise value is equal to the market value of its debt and equity, less the firm’s holdings of cash and cash equivalents. This figure is particularly relevant to potential purchasers of the firm. Why?

· Page 4312.   Earnings Management [LO2] Companies often try to keep accounting earnings growing at a relatively steady pace, thereby avoiding large swings in earnings from period to period. They also try to meet earnings targets. To do so, they use a variety of tactics. The simplest way is to control the timing of accounting revenues and costs, which all firms can do to at least some extent. For example, if earnings are looking too low this quarter, then some accounting costs can be deferred until next quarter. This practice is called earnings management. It is common, and it raises a lot of questions. Why do firms do it? Why are firms even allowed to do it under GAAP? Is it ethical? What are the implications for cash flow and shareholder wealth?

·

· BASIC

· (Questions 1–12)

· 1.   Building a Balance Sheet [LO1] KCCO, Inc., has current assets of $5,300, net fixed assets of $24,900, current liabilities of $4,600, and long-term debt of $10,300. What is the value of the shareholders’ equity account for this firm? How much is net working capital?

·

2

.   Building an Income Statement [LO1] Billy’s Exterminators, Inc., has sales of $817,000, costs of $343,000, depreciation expense of $51,000, interest expense of $38,000, and a tax rate of 35 percent. What is the net income for this firm?

· 3.   Dividends and Retained Earnings [LO1] Suppose the firm in Problem 2 paid out $95,000 in cash dividends. What is the addition to retained earnings?

· 4.   Per-Share Earnings and Dividends [LO1] Suppose the firm in Problem 3 had 90,000 shares of common stock outstanding. What is the earnings per share, or EPS, figure? What is the dividends per share figure?

· 5.   Calculating Taxes [LO3] The Dyrdek Co. had $267,000 in 2014 taxable income. Using the rates from 
Table 2.3
 in the chapter, calculate the company’s 2014 income taxes.

·

6

.   Tax Rates [LO3] In Problem 5, what is the average tax rate? What is the marginal tax rate?

· 7.   Calculating OCF [LO4] Ridiculousness, Inc., has sales of $43,800, costs of $22,700, depreciation expense of $2,100, and interest expense of $1,600. If the tax rate is 35 percent, what is the operating cash flow, or OCF?

· 8.   Calculating Net Capital Spending [LO4] Bowyer Driving School’s 2014 balance sheet showed net fixed assets of $2.7 million, and the 2015 balance sheet showed net fixed assets of $3.5 million. The company’s 2015 income statement showed a depreciation expense of $328,000. What was net capital spending for 2015?

· 9.   Calculating Additions to NWC [LO4] The 2014 balance sheet of Steelo, Inc., showed current assets of $4,630 and current liabilities of $2,190. The 2015 balance sheet showed current assets of $5,180 and current liabilities of $2,830. What was the company’s 2015 change in net working capital, or NWC?

·

10

.   Cash Flow to Creditors [LO4] The 2014 balance sheet of Sugarpova’s Tennis Shop, Inc., showed long-term debt of $1.95 million, and the 2015 balance sheet showed long-term debt of $2.28 million. The 2015 income statement showed an interest expense of $235,000. What was the firm’s cash flow to creditors during 2015?

· 11.   Cash Flow to Stockholders [LO4] The 2014 balance sheet of Sugarpova’s Tennis Shop, Inc., showed $670,000 in the common stock account and $4.1 million in the additional paid-in surplus account. The 2015 balance sheet showed $825,000 and $4.4 million in the same two accounts, respectively. If the company paid out $565,000 in cash dividends during 2015, what was the cash flow to stockholders for the year?

· Page 4412.   Calculating Total Cash Flows [LO4] Given the information for Sugarpova’s Tennis Shop, Inc., in Problems 10 and 11, suppose you also know that the firm’s net capital spending for 2015 was $1,250,000 and that the firm reduced its net working capital investment by $45,000. What was the firm’s 2015 operating cash flow, or OCF?

· INTERMEDIATE

· (Questions 13–22)

· 13.   Market Values and Book Values [LO1] Klingon Widgets, Inc., purchased new cloaking machinery three years ago for $6 million. The machinery can be sold to the Romulans today for $4.8 million. Klingon’s current balance sheet shows net fixed assets of $3.3 million, current liabilities of $850,000, and net working capital of $220,000. If all the current assets were liquidated today, the company would receive $1.05 million cash. What is the book value of Klingon’s total assets today? What is the sum of NWC and the market value of fixed assets?

·  

14

.   Calculating Total Cash Flows [LO4] Volbeat Corp. shows the following information on its 2015 income statement: sales = $267,000; costs = $148,000; other expenses = $8,200; depreciation expense = $17,600; interest expense = $12,400; taxes = $32,620; dividends = $15,500. In addition, you’re told that the firm issued $6,400 in new equity during 2015 and redeemed $4,900 in outstanding long-term debt.

· a. What is the 2015 operating cash flow?

· b. What is the 2015 cash flow to creditors?

· c. What is the 2015 cash flow to stockholders?

· d. If net fixed assets increased by $25,000 during the year, what was the addition to NWC?

·  15.   Using Income Statements [LO1] Given the following information for Gandolfino Pizza Co., calculate the depreciation expense: sales = $61,000; costs = $29,600; addition to retained earnings = $5,600; dividends paid = $1,950; interest expense = $4,300; tax rate = 35 percent.

· 16.   Preparing a Balance Sheet [LO1] Prepare a 2015 balance sheet for Cornell Corp. based on the following information: cash = $134,000; patents and copyrights = $670,000; accounts payable = $210,000; accounts receivable = $105,000; tangible net fixed assets = $1,730,000; inventory = $293,000; notes payable = $160,000; accumulated retained earnings = $1,453,000; long-term debt = $845,000.

· 17.   Residual Claims [LO1] Red Hawk Inc., is obligated to pay its creditors $6,800 during the year.

· a. What is the market value of the shareholders’ equity if assets have a market value of $8,700?

· b. What if assets equal $5,900?

·

18

.   Marginal versus Average Tax Rates [LO3] (Refer to 
Table 2.3
.) Corporation Growth has $89,500 in taxable income, and Corporation Income has $8,950,000 in taxable income.

· a. What is the tax bill for each firm?

· b. Suppose both firms have identified a new project that will increase taxable income by $10,000. How much in additional taxes will each firm pay? Why is this amount the same?

·  19.   Net Income and OCF [LO2] During 2014, Raines Umbrella Corp. had sales of $675,000. Cost of goods sold, administrative and selling expenses, and depreciation expenses were $435,000, $85,000, and $125,000, respectively. In addition, the company had an interest expense of $70,000 and a tax rate of 35 percent. (Ignore any tax loss carryback or carryforward provisions.)

· a. What is Raines’s net income for 2014?

· b. What is its operating cash flow?

· c. Explain your results in (a) and (b).

· Page 4520.   Accounting Values versus Cash Flows [LO2] In Problem 19, suppose Raines Umbrella Corp. paid out $102,000 in cash dividends. Is this possible? If net capital spending and net working capital were both zero, and if no new stock was issued during the year, what do you know about the firm’s long-term debt account?

· 21.   Calculating Cash Flows [LO2] Quarles Industries had the following operating results for 2015: sales = $30,096; cost of goods sold = $21,476; depreciation expense = $5,341; interest expense = $2,409; dividends paid = $1,716. At the beginning of the year, net fixed assets were $18,018, current assets were $6,336, and current liabilities were $3,564. At the end of the year, net fixed assets were $22,176, current assets were $7,829, and current liabilities were $4,159. The tax rate for 2015 was 35 percent.

· a. What is net income for 2015?

· b. What is the operating cash flow for 2015?

· c. What is the cash flow from assets for 2015? Is this possible? Explain.

· d. If no new debt was issued during the year, what is the cash flow to creditors? What is the cash flow to stockholders? Explain and interpret the positive and negative signs of your answers in (a) through (d).

·

22

.   Calculating Cash Flows [LO4] Consider the following abbreviated financial statements for Parrothead Enterprises:

·

· a. What is owners’ equity for 2014 and 2015?

· b. What is the change in net working capital for 2015?

· c. In 2015, Parrothead Enterprises purchased $2,080 in new fixed assets. How much in fixed assets did Parrothead Enterprises sell? What is the cash flow from assets for the year? (The tax rate is 35 percent.)

· d. During 2015, Parrothead Enterprises raised $420 in new long-term debt. How much long-term debt must Parrothead Enterprises have paid off during the year? What is the cash flow to creditors?

· CHALLENGE

· (Questions 23–26)

· 23.   Net Fixed Assets and Depreciation [LO4] On the balance sheet, the net fixed assets (NFA) account is equal to the gross fixed assets (FA) account (which records the acquisition cost of fixed assets) minus the accumulated depreciation (AD) account (which records the total depreciation taken by the firm against its fixed assets). Using the fact that NFA = FA − AD, show that the expression given in the chapter for net capital spending, NFAend − NFAbeg + D (where D is the depreciation expense during the year), is equivalent to FAend − FAbeg.

· 24.   Tax Rates [LO3] Refer to the corporate marginal tax rate information in 
Table 2.3
.

· a. Why do you think the marginal tax rate jumps up from 34 percent to 39 percent at a taxable income of $100,001, and then falls back to a 34 percent marginal rate at a taxable income of $335,001?

· b. Compute the average tax rate for a corporation with exactly $335,001 in taxable income. Does this confirm your explanation in part (a)? What is the average tax rate for a corporation with exactly $18,333,334 in taxable income? Is the same thing happening here?

· Page 46c. The 39 percent and 38 percent tax rates both represent what is called a tax “bubble.” Suppose the government wanted to lower the upper threshold of the 39 percent marginal tax bracket from $335,000 to $200,000. What would the new 39 percent bubble rate have to be?

· Use the following information for Taco Swell, Inc., for Problems 25 and 26 (assume the tax rate is 34 percent):

·

Chapter 4

Chapter 4

In” be installed in Excel.

Problems 5, 6, 20, 22

Input boxes in tan

Output boxes in yellow

Given data in blue

Calculations in red

Answers in green

NOTE: Some functions used in these spreadsheets may require that

the “Analysis ToolPak” or “Solver Add

–

To install these, click on the Office button

then “Excel Options,” “Add-Ins” and select

“Go.” Check “Analyis ToolPak” and

“Solver Add-In,” then click “OK.”

#5

Chapter 4

– 0

–

assets

Total $ –

Sales $ – 0 Current assets $ – 0 Current liabilities $ – 0
Costs – 0 Fixed assets – 0 Long-term debt – 0

Taxable income $ – 0 Equity – 0

– 0 Total $ – 0 Total $ – 0

Net income $ – 0

$ – 0

$ – 0

$ – 0

Question 5

Input area:

Sales

Current assets

Current liabilities

Costs

Fixed assets

Long-term debt

Taxable income

$

– 0

Equity

Taxes

Total

$ –

Net income

$ – 0

Payout ratio

Sales increase

Tax rate

Output area:

Pro forma income statement

Pro forma balance sheet

Taxes (0%)

Dividends

Add. To RE

External financing

#6

Chapter 4

Input area:

Sales Current assets

Costs Fixed assets Equity – 0
Taxable income $ – 0 Total $ – Total $ –
Taxes –

Net income $ – 0

Payout ratio
Tax rate

Output area:

00%

ERROR:#DIV/0!

Question 6
Debt
Return on assets											ERROR:#DIV/0!
Retention ratio		1
Internal growth rate

#20

Chapter 4

Input area:

Payout ratio

Output area:

ERROR:#DIV/0!

1

ERROR:#DIV/0!

ERROR:#DIV/0!

Question 20
Profit margin
Total asset turnover
Total debt ratio
Debt/equity
	Plowback ratio
Return on equity
Sustainable growth rate

#22

Chapter 4

Input area:

Net income
Dividends

Output area:

$ –

$ –

Plowback ratio ERROR:#DIV/0!

ERROR:#DIV/0!

ERROR:#DIV/0!

ERROR:#DIV/0!

ERROR:#DIV/0!

ERROR:#DIV/0!

Equity for ROE)

Question 22
Beginning equity
Ending TA
Addition to RE
Ending equity
ROE (beg. equity)
ROE (ending equity)
Exact SGR
ROE x b (using beg.
	Equity for ROE)
ROE x b (using end


Ch. 4: Questions 1 & 6 (Questions and Problems section): Microsoft®

 

Excel® template provided for Problem 6.

 I attached the excel template where the answer to problem 6 is done. I will highlight below

Long-Term Financial Planning and Growth

4

GROWTH RATES ARE IMPORTANT TOOLS for evaluating a company and, as we will see later, for valuing a company’s stock. When thinking about (and calculating) growth rates, a little common sense goes a long way. For example, in 2013, retailing giant Walmart had about 838 million square feet of stores, distribution centers, and so forth. The company expected to increase its square footage by about 4.2 percent over the next year. This doesn’t sound too outrageous, but can Walmart grow its square footage at 4.2 percent indefinitely?

We’ll get into the calculation in our next chapter, but if you assume that Walmart grows at 4.2 percent per year over the next 285 years, the company will have about 100 trillion square feet of property, which is about the total land mass of the entire United States! In other words, if Walmart keeps growing at 4.2 percent, the entire country will eventually be one big Walmart. Scary.

Sirius XM Satellite Radio is another example. The company had total revenues of about $805,000 in 2002 and $3.8 billion in 2013. This represents an annual increase of about 116 percent! How likely do you think it is that the company can continue this growth rate? If this growth continued, the company would have revenues of about $17.93 trillion in just 11 years, which is about twice the gross domestic product (GDP) of the United States. Obviously, Sirius XM Radio’s growth rate will slow substantially in the next several years. So, long-term growth rate estimates must be chosen very carefully. As a rule of thumb, for really long-term growth estimates, you should probably assume that a company will not grow much faster than the economy as a whole, which is about 1 to 3 percent (inflation-adjusted).

Proper management of growth is vital. Thus, this chapter emphasizes the importance of planning for the future and discusses some tools firms use to think about, and manage, growth.

For updates on the latest happenings in finance, visit 

www.fundamentalsofcorporatefinance.blogspot.com

.

Learning Objectives

After studying this chapter, you should understand:

LO1	How to apply the percentage of sales method.
LO2	How to compute the external financing needed to fund a firm’s growth.
LO3	The determinants of a firm’s growth.
LO4	Some of the problems in planning for growth.

Page 92A lack of effective long-range planning is a commonly cited reason for financial distress and failure. As we discuss in this chapter, long-range planning is a means of systematically thinking about the future and anticipating possible problems before they arrive. There are no magic mirrors, of course, so the best we can hope for is a logical and organized procedure for exploring the unknown. As one member of GM’s board was heard to say, “Planning is a process that at best helps the firm avoid stumbling into the future backward.”

Financial planning establishes guidelines for change and growth in a firm. It normally focuses on the big picture. This means it is concerned with the major elements of a firm’s financial and investment policies without examining the individual components of those policies in detail.

Our primary goals in this chapter are to discuss financial planning and to illustrate the interrelatedness of the various investment and financing decisions a firm makes. In the chapters ahead, we will examine in much more detail how these decisions are made.

We first describe what is usually meant by financial planning. For the most part, we talk about long-term planning. Short-term financial planning is discussed in a later chapter. We examine what the firm can accomplish by developing a long-term financial plan. To do this, we develop a simple but useful long-range planning technique: the percentage of sales approach. We describe how to apply this approach in some simple cases, and we discuss some extensions.

To develop an explicit financial plan, managers must establish certain basic elements of the firm’s financial policy:

1. The firm’s needed investment in new assets: This will arise from the investment opportunities the firm chooses to undertake, and it is the result of the firm’s capital budgeting decisions.

2. The degree of financial leverage the firm chooses to employ: This will determine the amount of borrowing the firm will use to finance its investments in real assets. This is the firm’s capital structure policy.

3. The amount of cash the firm thinks is necessary and appropriate to pay shareholders: This is the firm’s dividend policy.

4. The amount of liquidity and working capital the firm needs on an ongoing basis: This is the firm’s net working capital decision.

As we will see, the decisions a firm makes in these four areas will directly affect its future profitability, need for external financing, and opportunities for growth.

A key lesson to be learned from this chapter is that a firm’s investment and financing policies interact and thus cannot truly be considered in isolation from one another. The types and amounts of assets a firm plans on purchasing must be considered along with the firm’s ability to raise the capital necessary to fund those investments. Many business students are aware of the classic three Ps (or even four Ps) of marketing. Not to be out-done, financial planners have no fewer than six Ps: Proper Prior Planning Prevents Poor Performance.

Financial planning forces the corporation to think about goals. A goal frequently espoused by corporations is growth, and almost all firms use an explicit, companywide growth rate as a major component of their long-term financial planning. For example, in September 2007, Toyota Motor announced that it planned to sell about 9.8 million vehicles in 2008 and 10.4 million vehicles in 2009, becoming the first auto manufacturer to sell more than 10 million vehicles in a year. Of course, Toyota’s plans didn’t come to fruition. In 2009, the company only sold 7.2 million cars, and it sold 8.6 million in 2010. In 2013, the company sold 9.98 million cars and projected sales of 10.43 million cars in 2014, again hoping to cross over 10 million cars sold in a year.

Page 93There are direct connections between the growth a company can achieve and its financial policy. In the following sections, we show how financial planning models can be used to better understand how growth is achieved. We also show how such models can be used to establish the limits on possible growth.

4.1 What Is Financial Planning?

Financial planning formulates the way in which financial goals are to be achieved. A financial plan is thus a statement of what is to be done in the future. Many decisions have long lead times, which means they take a long time to implement. In an uncertain world, this requires that decisions be made far in advance of their implementation. If a firm wants to build a factory in 2018, for example, it might have to begin lining up contractors and financing in 2016 or even earlier.

GROWTH AS A FINANCIAL MANAGEMENT GOAL

Because the subject of growth will be discussed in various places in this chapter, we need to start out with an important warning: Growth, by itself, is not an appropriate goal for the financial manager. Clothing retailer J. Peterman Co., whose quirky catalogs were made famous on the TV show Seinfeld, learned this lesson the hard way. Despite its strong brand name and years of explosive revenue growth, the company was ultimately forced to file for bankruptcy—the victim of an overly ambitious, growth-oriented expansion plan.

Amazon.com

, the big online retailer, is another example. At one time, Amazon’s motto seemed to be “growth at any cost.” Unfortunately, what really grew rapidly for the company were losses. Amazon refocused its business, explicitly sacrificing growth in the hope of achieving profitability. The plan seems to be working as 
Amazon.com
 has become a profitable retailing giant.

As we discussed in 

Chapter 1

, the appropriate goal for a firm is increasing the market value of the owners’ equity. Of course, if a firm is successful in doing this, then growth will usually result. Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself. We discuss growth simply because growth rates are so commonly used in the planning process. As we will see, growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies. Also, if we think of growth as growth in the market value of the equity in the firm, then goals of growth and increasing the market value of the equity in the firm are not all that different.

DIMENSIONS OF FINANCIAL PLANNING

It is often useful for planning purposes to think of the future as having a short run and a long run. The short run, in practice, is usually the coming 12 months. We focus our attention on financial planning over the long run, which is usually taken to be the coming two to five years. This time period is called the planning horizon, and it is the first dimension of the planning process that must be established.

planning horizon
The long-range time period on which the financial planning process focuses (usually the next two to five years).

In drawing up a financial plan, all of the individual projects and investments the firm will undertake are combined to determine the total needed investment. In effect, the smaller investment proposals of each operational unit are added up, and the sum is treated as one big project. This process is called aggregation. The level of aggregation is the second dimension of the planning process that needs to be determined.

aggregation
The process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big project.

Once the planning horizon and level of aggregation are established, a financial plan requires inputs in the form of alternative sets of assumptions about important variables. For example, suppose a company has two separate divisions: one for consumer products and Page 94one for gas turbine engines. The financial planning process might require each division to prepare three alternative business plans for the next three years:

You can find growth rates at 

www.reuters.com

 and 
finance.yahoo.com
.

1. A worst case: This plan would require making relatively pessimistic assumptions about the company’s products and the state of the economy. This kind of disaster planning would emphasize a division’s ability to withstand significant economic adversity, and it would require details concerning cost cutting and even divestiture and liquidation. For example, in August 2013, Microsoft announced that previously announced “limited time” $100 price reductions on the company’s Surface tablet would become permanent. Excess inventories were blamed for the dramatic price cuts. As we mentioned in a previous chapter, Microsoft also wrote off about $900 million in excess inventory of the Surface tablet.

2. A normal case: This plan would require making the most likely assumptions about the company and the economy.

3. A best case: Each division would be required to work out a case based on optimistic assumptions. It could involve new products and expansion and would then detail the financing needed to fund the expansion. For example, Sony announced that it was holding back inventory to ensure that anyone who wanted a PS4 would get one. Unfortunately, this plan did not work, at least in Europe where retailers ran out of stock. And while we have discussed Microsoft’s inventory problems with its Surface tablet, the company ran out of inventory for its Surface 2 and Surface Pro 2 in late 2013. In fact, because of the shortage, Surface 2 tablets were selling at $100 over retail price on Amazon.

In this discussion, business activities are aggregated along divisional lines, and the planning horizon is three years. This type of planning, which considers all possible events, is particularly important for cyclical businesses (businesses with sales that are strongly affected by the overall state of the economy or business cycles).

WHAT CAN PLANNING ACCOMPLISH?

Because a company is likely to spend a lot of time examining the different scenarios that will become the basis for its financial plan, it seems reasonable to ask what the planning process will accomplish.

Examining Interactions As we discuss in greater detail in the following pages, the financial plan must make explicit the linkages between investment proposals for the different operating activities of the firm and its available financing choices. In other words, if the firm is planning on expanding and undertaking new investments and projects, where will the financing be obtained to pay for this activity?

Exploring Options The financial plan allows the firm to develop, analyze, and compare many different scenarios in a consistent way. Various investment and financing options can be explored, and their impact on the firm’s shareholders can be evaluated. Questions concerning the firm’s future lines of business and optimal financing arrangements are addressed. Options such as marketing new products or closing plants might be evaluated.

Avoiding Surprises Financial planning should identify what may happen to the firm if different events take place. In particular, it should address what actions the firm will take if things go seriously wrong or, more generally, if assumptions made today about the future are seriously in error. As physicist Niels Bohr once observed, “Prediction is very difficult, particularly when it concerns the future.” Thus, one purpose of financial planning is to avoid surprises and develop contingency plans.

Page 95For example, when Tesla Motors announced its new Model X in February 2012, the company promised that production would begin in 2013. In 2013, when production had yet to start, Tesla pushed backed production until late 2014. A company spokesperson stated that production was being delayed “to allow ourselves to focus on production and enhancements in Model S.” Of course, even though production of the Model S had begun on time several years earlier, production of that model was below expectations for at least a year. Thus, a lack of proper planning can be a problem for even the most hi-tech companies.

Ensuring Feasibility and Internal Consistency Beyond a general goal of creating value, a firm will normally have many specific goals. Such goals might be couched in terms of market share, return on equity, financial leverage, and so on. At times, the linkages between different goals and different aspects of a firm’s business are difficult to see. Not only does a financial plan make explicit these linkages, but it also imposes a unified structure for reconciling goals and objectives. In other words, financial planning is a way of verifying that the goals and plans made for specific areas of a firm’s operations are feasible and internally consistent. Conflicting goals will often exist. To generate a coherent plan, goals and objectives will therefore have to be modified, and priorities will have to be established.

For example, one goal a firm might have is 12 percent growth in unit sales per year. Another goal might be to reduce the firm’s total debt ratio from 40 to 20 percent. Are these two goals compatible? Can they be accomplished simultaneously? Maybe yes, maybe no. As we will discuss, financial planning is a way of finding out just what is possible—and, by implication, what is not possible.

Conclusion Probably the most important result of the planning process is that it forces managers to think about goals and establish priorities. In fact, conventional business wisdom holds that financial plans don’t work, but financial planning does. The future is inherently unknown. What we can do is establish the direction in which we want to travel and make some educated guesses about what we will find along the way. If we do a good job, we won’t be caught off guard when the future rolls around.

Concept Questions

4.1a   What are the two dimensions of the financial planning process?

4.1b   Why should firms draw up financial plans?

4.2 Financial Planning Models: A First Look

Just as companies differ in size and products, the financial planning process will differ from firm to firm. In this section, we discuss some common elements in financial plans and develop a basic model to illustrate these elements. What follows is just a quick overview; later sections will take up the various topics in more detail.

A FINANCIAL PLANNING MODEL: THE INGREDIENTS

Most financial planning models require the user to specify some assumptions about the future. Based on those assumptions, the model generates predicted values for many other variables. Models can vary quite a bit in complexity, but almost all have the elements we discuss next.

Excel Master It!

Excel Master coverage online

Page 96Sales Forecast Almost all financial plans require an externally supplied sales forecast. In our models that follow, for example, the sales forecast will be the “driver,” meaning that the user of the planning model will supply this value, and most other values will be calculated based on it. This arrangement is common for many types of business; planning will focus on projected future sales and the assets and financing needed to support those sales.

Frequently, the sales forecast will be given as the growth rate in sales rather than as an explicit sales figure. These two approaches are essentially the same because we can calculate projected sales once we know the growth rate. Perfect sales forecasts are not possible, of course, because sales depend on the uncertain future state of the economy. To help a firm come up with its projections, some businesses specialize in macroeconomic and industry projections.

As we discussed previously, we frequently will be interested in evaluating alternative scenarios, so it isn’t necessarily crucial that the sales forecast be accurate. In such cases, our goal is to examine the interplay between investment and financing needs at different possible sales levels, not to pinpoint what we expect to happen.

Pro Forma Statements A financial plan will have a forecast balance sheet, income statement, and statement of cash flows. These are called pro forma statements, or pro formas for short. The phrase pro forma literally means “as a matter of form.” In our case, this means the financial statements are the form we use to summarize the different events projected for the future. At a minimum, a financial planning model will generate these statements based on projections of key items such as sales.

In the planning models we will describe, the pro formas are the output from the financial planning model. The user will supply a sales figure, and the model will generate the resulting income statement and balance sheet.

Asset Requirements The plan will describe projected capital spending. At a minimum, the projected balance sheet will contain changes in total fixed assets and net working capital. These changes are effectively the firm’s total capital budget. Proposed capital spending in different areas must thus be reconciled with the overall increases contained in the long-range plan.

Financial Requirements The plan will include a section about the necessary financing arrangements. This part of the plan should discuss dividend policy and debt policy. Sometimes firms will expect to raise cash by selling new shares of stock or by borrowing. In this case, the plan will have to consider what kinds of securities have to be sold and what methods of issuance are most appropriate. These are subjects we consider in 

Part 6

 of our book, where we discuss long-term financing, capital structure, and dividend policy.

The Plug After the firm has a sales forecast and an estimate of the required spending on assets, some amount of new financing will often be necessary because projected total assets will exceed projected total liabilities and equity. In other words, the balance sheet will no longer balance.

Because new financing may be necessary to cover all of the projected capital spending, a financial “plug” variable must be selected. The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance.

For example, a firm with a great number of investment opportunities and limited cash flow may have to raise new equity. Other firms with few growth opportunities and ample cash flow will have a surplus and thus might pay an extra dividend. In the first case, external equity is the plug variable. In the second, the dividend is used.

Page 97Economic Assumptions The plan will have to state explicitly the economic environment in which the firm expects to reside over the life of the plan. Among the more important economic assumptions that will have to be made are the level of interest rates and the firm’s tax rate.

A SIMPLE FINANCIAL PLANNING MODEL

We can begin our discussion of long-term planning models with a relatively simple example. The Computerfield Corporation’s financial statements from the most recent year are as follows:

Unless otherwise stated, the financial planners at Computerfield assume that all variables are tied directly to sales and current relationships are optimal. This means that all items will grow at exactly the same rate as sales. This is obviously oversimplified; we use this assumption only to make a point.

Suppose sales increase by 20 percent, rising from $1,000 to $1,200. Planners would then also forecast a 20 percent increase in costs, from $800 to $800 × 1.2 = $960. The pro forma income statement would thus be:

The assumption that all variables will grow by 20 percent lets us easily construct the pro forma balance sheet as well:

Notice that we have simply increased every item by 20 percent. The numbers in parentheses are the dollar changes for the different items.

Now we have to reconcile these two pro formas. How, for example, can net income be equal to $240 and equity increase by only $50? The answer is that Computerfield must have paid out the difference of $240 − 50 = $190, possibly as a cash dividend. In this case, dividends are the plug variable.

Suppose Computerfield does not pay out the $190. In this case, the addition to retained earnings is the full $240. Computerfield’s equity will thus grow to $250 (the starting amount) plus $240 (net income), or $490, and debt must be retired to keep total assets equal to $600.

Planware provides insight into cash flow forecasting (

www.planware.org

).

Page 98With $600 in total assets and $490 in equity, debt will have to be $600 − 490 = $110. Because we started with $250 in debt, Computerfield will have to retire $250 − 110 = $140 in debt. The resulting pro forma balance sheet would look like this:

In this case, debt is the plug variable used to balance projected total assets and liabilities.

This example shows the interaction between sales growth and financial policy. As sales increase, so do total assets. This occurs because the firm must invest in net working capital and fixed assets to support higher sales levels. Because assets are growing, total liabilities and equity (the right side of the balance sheet) will grow as well.

The thing to notice from our simple example is that the way the liabilities and owners’ equity change depends on the firm’s financing policy and its dividend policy. The growth in assets requires that the firm decide on how to finance that growth. This is strictly a managerial decision. Note that in our example, the firm needed no outside funds. This won’t usually be the case, so we explore a more detailed situation in the next section.

Concept Questions

4.2a   What are the basic components of a financial plan?

4.2b   Why is it necessary to designate a plug in a financial planning model?

4.3 The Percentage of Sales Approach

In the previous section, we described a simple planning model in which every item increased at the same rate as sales. This may be a reasonable assumption for some elements. For others, such as long-term borrowing, it probably is not: The amount of long-term borrowing is something set by management, and it does not necessarily relate directly to the level of sales.

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In this section, we describe an extended version of our simple model. The basic idea is to separate the income statement and balance sheet accounts into two groups—those that vary directly with sales and those that do not. Given a sales forecast, we will then be able to calculate how much financing the firm will need to support the predicted sales level.

The financial planning model we describe next is based on the percentage of sales approach. Our goal here is to develop a quick and practical way of generating pro forma statements. We defer discussion of some “bells and whistles” to a later section.

percentage of sales approach
A financial planning method in which accounts are varied depending on a firm’s predicted sales level.

THE INCOME STATEMENT

We start out with the most recent income statement for the Rosengarten Corporation, as shown in 

Table 4.1

. Notice we have still simplified things by including costs, depreciation, and interest in a single cost figure.

Rosengarten has projected a 25 percent increase in sales for the coming year, so we are anticipating sales of $1,000 × 1.25 = $1,250. To generate a pro forma income statement, we assume that total costs will continue to run at $800/1,000 = 80% of sales. With this assumption, Rosengarten’s pro forma income statement is shown in 

Table 4.2

. The effect here of assuming that costs are a constant percentage of sales is to assume that the profit margin is constant. To check this, notice that the profit margin was $132/1,000 = 13.2%. In our pro forma, the profit margin is $165/1,250 = 13.2%, so it is unchanged.

Page 99TABLE 4.1
Rosengarten Corporation Income Statement

TABLE 4.2
Rosengarten Corporation Pro Forma Income Statement

Next, we need to project the dividend payment. This amount is up to Rosengarten’s management. We will assume Rosengarten has a policy of paying out a constant fraction of net income in the form of a cash dividend. For the most recent year, the dividend payout ratio was this:

dividend payout ratio
The amount of cash paid out to shareholders divided by net income.

We can also calculate the ratio of the addition to retained earnings to net income:

Addition to retained earnings/Net income = $88/132 = 66 2/3%

This ratio is called the retention ratio or plowback ratio, and it is equal to 1 minus the dividend payout ratio because everything not paid out is retained. Assuming that the payout ratio is constant, here are the projected dividends and addition to retained earnings:

retention ratio
The addition to retained earnings divided by net income. Also called the plowback ratio.

THE BALANCE SHEET

To generate a pro forma balance sheet, we start with the most recent statement, as shown in 

Table 4.3

.

On our balance sheet, we assume that some items vary directly with sales and others do not. For items that vary with sales, we express each as a percentage of sales for the year just completed. When an item does not vary directly with sales, we write “n/a” for “not applicable.”

Page 100TABLE 4.3 Rosengarten Corporation Balance Sheet

For example, on the asset side, inventory is equal to 60 percent of sales (= $600/1,000) for the year just ended. We assume this percentage applies to the coming year, so for each $1 increase in sales, inventory will rise by $.60. More generally, the ratio of total assets to sales for the year just ended is $3,000/1,000 = 3, or 300%.

This ratio of total assets to sales is sometimes called the capital intensity ratio. It tells us the amount of assets needed to generate $1 in sales; so the higher the ratio is, the more capital-intensive is the firm. Notice also that this ratio is just the reciprocal of the total asset turnover ratio we defined in the last chapter.

capital intensity ratio
A firm’s total assets divided by its sales, or the amount of assets needed to generate $1 in sales.

For Rosengarten, assuming that this ratio is constant, it takes $3 in total assets to generate $1 in sales (apparently Rosengarten is in a relatively capital-intensive business). Therefore, if sales are to increase by $100, Rosengarten will have to increase total assets by three times this amount, or $300.

On the liability side of the balance sheet, we show accounts payable varying with sales. The reason is that we expect to place more orders with our suppliers as sales volume increases, so payables will change “spontaneously” with sales. Notes payable, on the other hand, represent short-term debt such as bank borrowing. This item will not vary unless we take specific actions to change the amount, so we mark it as “n/a.”

Similarly, we use “n/a” for long-term debt because it won’t automatically change with sales. The same is true for common stock and paid-in surplus. The last item on the right side, retained earnings, will vary with sales, but it won’t be a simple percentage of sales. Instead, we will explicitly calculate the change in retained earnings based on our projected net income and dividends.

We can now construct a partial pro forma balance sheet for Rosengarten. We do this by using the percentages we have just calculated wherever possible to calculate the projected amounts. For example, net fixed assets are 180 percent of sales; so, with a new sales level of $1,250, the net fixed asset amount will be 1.80 × $1,250 = $2,250, representing an increase of $2,250 − 1,800 = $450 in plant and equipment. It is important to note that for items that don’t vary directly with sales, we initially assume no change and simply write in the original amounts. The result is shown in 

Table 4.4

. Notice that the change in retained earnings is equal to the $110 addition to retained earnings we calculated earlier.

Page 101TABLE 4.4

Inspecting our pro forma balance sheet, we notice that assets are projected to increase by $750. However, without additional financing, liabilities and equity will increase by only $185, leaving a shortfall of $750 − 185 = $565. We label this amount external financing needed (EFN).

A PARTICULAR SCENARIO

Our financial planning model now reminds us of one of those good news–bad news jokes. The good news is we’re projecting a 25 percent increase in sales. The bad news is that this isn’t going to happen unless Rosengarten can somehow raise $565 in new financing.

This is a good example of how the planning process can point out problems and potential conflicts. If, for example, Rosengarten has a goal of not borrowing any additional funds and not selling any new equity, then a 25 percent increase in sales is probably not feasible.

If we take the need for $565 in new financing as given, we know that Rosengarten has three possible sources: short-term borrowing, long-term borrowing, and new equity. The choice of some combination among these three is up to management; we will illustrate only one of the many possibilities.

Suppose Rosengarten decides to borrow the needed funds. In this case, the firm might choose to borrow some over the short term and some over the long term. For example, current assets increased by $300, whereas current liabilities rose by only $75. Rosengarten could borrow $300 − 75 = $225 in short-term notes payable and leave total net working capital unchanged. With $565 needed, the remaining $565 − 225 = $340 would have to come from long-term debt. 

Table 4.5

 shows the completed pro forma balance sheet for Rosengarten.

Page 102TABLE 4.5

We have used a combination of short- and long-term debt as the plug here, but we emphasize that this is just one possible strategy; it is not necessarily the best one by any means. There are many other scenarios we could (and should) investigate. The various ratios we discussed in 

Chapter 3

 come in handy here. For example, with the scenario we have just examined, we would surely want to examine the current ratio and the total debt ratio to see if we were comfortable with the new projected debt levels.

Now that we have finished our balance sheet, we have all of the projected sources and uses of cash. We could finish off our pro formas by drawing up the projected statement of cash flows along the lines discussed in 
Chapter 3
. We will leave this as an exercise and instead investigate an important alternative scenario.

AN ALTERNATIVE SCENARIO

The assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases. In particular, note that we effectively assumed that Rosengarten was using its fixed assets at 100 percent of capacity because any increase in sales led to an increase in fixed assets. For most businesses, there would be some slack or excess capacity, and production could be increased by perhaps running an extra shift. According to the Federal Reserve, the overall capacity utilization for U.S. manufacturing companies in November 2013 was 76.8 percent, up from a low of 64.4 percent in June 2009.

For example, in January 2012, Volkswagen announced that it would spend $7 billion in North America over the next five years with the goal of selling one million vehicles in the U.S. by 2018. At about the same time, General Motors (GM) announced plans to close two Australian plants and reached a deal to close the company’s Opel plant in Germany. About six months before, Ford announced that it was closing its two largest Australian plants as well. Evidently GM and Ford had excess capacity, whereas Volkswagen did not.

In another example, in November 2013, ketchup maker Heinz announced that it was closing three factories in North America. The company stated that it would increase production at other plants to compensate for the closings. Apparently, Heinz had significant excess capacity at its production facilities.

Page 103If we assume that Rosengarten is operating at only 70 percent of capacity, then the need for external funds will be quite different. When we say “70 percent of capacity,” we mean that the current sales level is 70 percent of the full-capacity sales level:

This tells us that sales could increase by almost 43 percent—from $1,000 to $1,429—before any new fixed assets would be needed.

In our previous scenario, we assumed it would be necessary to add $450 in net fixed assets. In the current scenario, no spending on net fixed assets is needed because sales are projected to rise only to $1,250, which is substantially less than the $1,429 full-capacity level.

As a result, our original estimate of $565 in external funds needed is too high. We estimated that $450 in new net fixed assets would be needed. Instead, no spending on new net fixed assets is necessary. Thus, if we are currently operating at 70 percent capacity, we need only $565 − 450 = $115 in external funds. The excess capacity thus makes a considerable difference in our projections.

EXAMPLE 4.1 EFN and Capacity Usage

Suppose Rosengarten is operating at 90 percent capacity. What would sales be at full capacity? What is the capital intensity ratio at full capacity? What is EFN in this case?

Full-capacity sales would be $1,000/.90 = $1,111. From 
Table 4.3
, we know that fixed assets are $1,800. At full capacity, the ratio of fixed assets to sales is this:

So, Rosengarten needs $1.62 in fixed assets for every $1 in sales once it reaches full capacity. At the projected sales level of $1,250, then, it needs $1,250 × 1.62 = $2,025 in fixed assets. Compared to the $2,250 we originally projected, this is $225 less, so EFN is $565 − 225 = $340.

Current assets would still be $1,500, so total assets would be $1,500 + 2,025 = $3,525. The capital intensity ratio would thus be $3,525/1,250 = 2.82, which is less than our original value of 3 because of the excess capacity.

These alternative scenarios illustrate that it is inappropriate to blindly manipulate financial statement information in the planning process. The results depend critically on the assumptions made about the relationships between sales and asset needs. We return to this point a little later.

One thing should be clear by now. Projected growth rates play an important role in the planning process. They are also important to outside analysts and potential investors. Our nearby Work the Web box shows you how to obtain growth rate estimates for real companies.

Concept Questions

4.3a What is the basic idea behind the percentage of sales approach?

4.3b Unless it is modified, what does the percentage of sales approach assume about fixed asset capacity usage?

WORK THE WEB

Page 104Calculating company growth rates can involve detailed research, and a major part of a stock analyst’s job is to estimate them. One place to find earnings and sales growth rates on the Web is Yahoo! Finance at 

finance.yahoo.com

. We pulled up a quote for 3M Company and followed the “Analyst Estimates” link. Here is an abbreviated look at the results:

As shown, analysts expect, on average, revenue (sales) of $31.02 billion in 2013, growing to $32.61 billion in 2014, an increase of 5.1 percent. We also have the following table comparing 3M to some benchmarks:

As you can see, the estimated earnings growth rate for 3M is lower than the industry growth rate over the next five years. What does this mean for 3M stock? We’ll get to that in a later chapter.

Questions

1. One of the things shown here is the projected sales growth for 3M during 2014 at the time this was captured from 

finance.yahoo.com

. How does the current sales projection or the actual sales number differ from this projection? Can you think of any reasons for the difference?

2. On the same Web page, you can find the earnings history for 3M. How close have analysts been to estimating 3M earnings? In other words, what has the “surprise” been in 3M earnings?

4.4 External Financing and Growth

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Page 105External financing needed and growth are obviously related. All other things staying the same, the higher the rate of growth in sales or assets, the greater will be the need for external financing. In the previous section, we took a growth rate as given, and then we determined the amount of external financing needed to support that growth. In this section, we turn things around a bit. We will take the firm’s financial policy as given and then examine the relationship between that financial policy and the firm’s ability to finance new investments and thereby grow.

Once again, we emphasize that we are focusing on growth not because growth is an appropriate goal; instead, for our purposes, growth is simply a convenient means of examining the interactions between investment and financing decisions. In effect, we assume that the use of growth as a basis for planning is just a reflection of the very high level of aggregation used in the planning process.

EFN AND GROWTH

The first thing we need to do is establish the relationship between EFN and growth. To do this, we introduce the simplified income statement and balance sheet for the Hoffman Company in 
Table 4.6
. Notice that we have simplified the balance sheet by combining short-term and long-term debt into a single total debt figure. Effectively, we are assuming that none of the current liabilities varies spontaneously with sales. This assumption isn’t as restrictive as it sounds. If any current liabilities (such as accounts payable) vary with sales, we can assume that any such accounts have been netted out in current assets. Also, we continue to combine depreciation, interest, and costs on the income statement.

Suppose the Hoffman Company is forecasting next year’s sales level at $600, a $100 increase. Notice that the percentage increase in sales is $100/500 = 20%. Using the percentage of sales approach and the figures in 

Table 4.6

, we can prepare a pro forma income statement and balance sheet as in 

Table 4.7

. As 
Table 4.7
 illustrates, at a 20 percent growth rate, Hoffman needs $100 in new assets (assuming full capacity). The projected addition to retained earnings is $52.8, so the external financing needed (EFN) is $100 − 52.8 = $47.2.

Page 106TABLE 4.6

TABLE 4.7

Notice that the debt–equity ratio for Hoffman was originally (from 
Table 4.6
) equal to $250/250 = 1.0. We will assume that the Hoffman Company does not wish to sell new equity. In this case, the $47.2 in EFN will have to be borrowed. What will the new debt– equity ratio be? From 
Table 4.7
, we know that total owners’ equity is projected at $302.8. The new total debt will be the original $250 plus $47.2 in new borrowing, or $297.2 total. The debt–equity ratio thus falls slightly from 1.0 to $297.2/302.8 = .98.

Table 4.8

 shows EFN for several different growth rates. The projected addition to retained earnings and the projected debt–equity ratio for each scenario are also given (you should probably calculate a few of these for practice). In determining the debt–equity ratios, we assumed that any needed funds were borrowed, and we also assumed any surplus funds were used to pay off debt. Thus, for the zero growth case, debt falls by $44, from $250 to $206. In 
Table 4.8
, notice that the increase in assets required is simply equal to the original assets of $500 multiplied by the growth rate. Similarly, the addition to retained earnings is equal to the original $44 plus $44 times the growth rate.

TABLE 4.8 Growth and Projected EFN for the Hoffman Company

Page 107FIGURE 4.1
Growth and Related Financing Needed for the Hoffman Company

Table 4.8
 shows that for relatively low growth rates, Hoffman will run a surplus, and its debt–equity ratio will decline. Once the growth rate increases to about 10 percent, however, the surplus becomes a deficit. Furthermore, as the growth rate exceeds approximately 20 percent, the debt–equity ratio passes its original value of 1.0.

Figure 4.1

 illustrates the connection between growth in sales and external financing needed in more detail by plotting asset needs and additions to retained earnings from 
Table 4.8
 against the growth rates. As shown, the need for new assets grows at a much faster rate than the addition to retained earnings, so the internal financing provided by the addition to retained earnings rapidly disappears.

As this discussion shows, whether a firm runs a cash surplus or deficit depends on growth. Microsoft is a good example. Its revenue growth in the 1990s was amazing, averaging well over 30 percent per year for the decade. Growth slowed down noticeably over the 2000–2010 period; nonetheless, Microsoft’s combination of growth and substantial profit margins led to enormous cash surpluses. In part because Microsoft pays a relatively small dividend, the cash really piled up; in 2014, Microsoft’s cash horde exceeded $77 billion.

FINANCIAL POLICY AND GROWTH

Based on our preceding discussion, we see that there is a direct link between growth and external financing. In this section, we discuss two growth rates that are particularly useful in long-range planning.

The Internal Growth Rate The first growth rate of interest is the maximum growth rate that can be achieved with no external financing of any kind. We will call this the internal growth rate because this is the rate the firm can maintain with internal financing only. In 
Figure 4.1
, this internal growth rate is represented by the point where the two lines cross. At this point, the required increase in assets is exactly equal to the addition to retained Page 108earnings, and EFN is therefore zero. We have seen that this happens when the growth rate is slightly less than 10 percent. With a little algebra (see Problem 31 at the end of the chapter), we can define this growth rate more precisely:

internal growth rate
The maximum growth rate a firm can achieve without external financing of any kind.

Here, ROA is the return on assets we discussed in 
Chapter 3
, and b is the plowback, or retention, ratio defined earlier in this chapter.

For the Hoffman Company, net income was $66 and total assets were $500. ROA is thus $66/500 = 13.2%. Of the $66 net income, $44 was retained, so the plowback ratio, b, is $44/66 = 2/3. With these numbers, we can calculate the internal growth rate:

Thus, the Hoffman Company can expand at a maximum rate of 9.65 percent per year without external financing.

The Sustainable Growth Rate We have seen that if the Hoffman Company wishes to grow more rapidly than at a rate of 9.65 percent per year, external financing must be arranged. The second growth rate of interest is the maximum growth rate a firm can achieve with no external equity financing while it maintains a constant debt–equity ratio. This rate is commonly called the sustainable growth rate because it is the maximum rate of growth a firm can maintain without increasing its financial leverage.

sustainable growth rate
The maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt–equity ratio.

There are various reasons why a firm might wish to avoid equity sales. For example, as we discuss in 

Chapter 15

, new equity sales can be expensive. Alternatively, the current owners may not wish to bring in new owners or contribute additional equity. Why a firm might view a particular debt–equity ratio as optimal is discussed in 

Chapters 14

 and 

16

; for now, we will take it as given.

Based on 
Table 4.8
, the sustainable growth rate for Hoffman is approximately 20 percent because the debt–equity ratio is near 1.0 at that growth rate. The precise value can be calculated (see Problem 31 at the end of the chapter):

This is identical to the internal growth rate except that ROE, return on equity, is used instead of ROA.

For the Hoffman Company, net income was $66 and total equity was $250; ROE is thus $66/250 = 26.4 percent. The plowback ratio, b, is still 2/3, so we can calculate the sustainable growth rate as follows:

Thus, the Hoffman Company can expand at a maximum rate of 21.36 percent per year without external equity financing.

Page 109

EXAMPLE 4.2 Sustainable Growth

Suppose Hoffman grows at exactly the sustainable growth rate of 21.36 percent. What will the pro forma statements look like?

At a 21.36 percent growth rate, sales will rise from $500 to $606.8. The pro forma income statement will look like this:

We construct the balance sheet just as we did before. Notice, in this case, that owners’ equity will rise from $250 to $303.4 because the addition to retained earnings is $53.4.

As illustrated, EFN is $53.4. If Hoffman borrows this amount, then total debt will rise to $303.4, and the debt–equity ratio will be exactly 1.0, which verifies our earlier calculation. At any other growth rate, something would have to change.

Determinants of Growth In the last chapter, we saw that the return on equity, ROE, could be decomposed into its various components using the DuPont identity. Because ROE appears so prominently in the determination of the sustainable growth rate, it is obvious that the factors important in determining ROE are also important determinants of growth.

From 
Chapter 3
, we know that ROE can be written as the product of three factors:

ROE = Profit margin × Total asset turnover × Equity multiplier

If we examine our expression for the sustainable growth rate, we see that anything that increases ROE will increase the sustainable growth rate by making the top bigger and the bottom smaller. Increasing the plowback ratio will have the same effect.

Putting it all together, what we have is that a firm’s ability to sustain growth depends explicitly on the following four factors:

1. Profit margin: An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth.

Page 1102. Dividend policy: A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases sustainable growth.

3. Financial policy: An increase in the debt–equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate.

4. Total asset turnover: An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity.

The sustainable growth rate is a very useful planning number. What it illustrates is the explicit relationship between the firm’s four major areas of concern: its operating efficiency as measured by profit margin, its asset use efficiency as measured by total asset turnover, its dividend policy as measured by the retention ratio, and its financial policy as measured by the debt–equity ratio.

Given values for all four of these, there is only one growth rate that can be achieved. This is an important point, so it bears restating:

If a firm does not wish to sell new equity and 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.

As we described early in this chapter, one of the primary benefits of financial planning is that it ensures internal consistency among the firm’s various goals. The concept of the sustainable growth rate captures this element nicely. Also, we now see how a financial planning model can be used to test the feasibility of a planned growth rate. If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention, or sell new shares.

The two growth rates, internal and sustainable, are summarized in 

Table 4.9

.

TABLE 4.9 Summary of Internal and Sustainable Growth Rates

Page 111

IN THEIR OWN WORDS …

Robert C. Higgins on Sustainable Growth

Most financial officers know intuitively that it takes money to make money. Rapid sales growth requires increased assets in the form of accounts receivable, inventory, and fixed plant, which, in turn, require money to pay for assets. They also know that if their company does not have the money when needed, it can literally “grow broke.” The sustainable growth equation states these intuitive truths explicitly.

Sustainable growth is often used by bankers and other external analysts to assess a company’s credit-worthiness. They are aided in this exercise by several sophisticated computer software packages that provide detailed analyses of the company’s past financial performance, including its annual sustainable growth rate.

Bankers use this information in several ways. Quick comparison of a company’s actual growth rate to its sustainable rate tells the banker what issues will be at the top of management’s financial agenda. If actual growth consistently exceeds sustainable growth, management’s problem will be where to get the cash to finance growth. The banker thus can anticipate interest in loan products. Conversely, if sustainable growth consistently exceeds actual, the banker had best be prepared to talk about investment products, because management’s problem will be what to do with all the cash that keeps piling up in the till.

Bankers also find the sustainable growth equation useful for explaining to financially inexperienced small business owners and overly optimistic entrepreneurs that, for the long-run viability of their business, it is necessary to keep growth and profitability in proper balance.

Finally, comparison of actual to sustainable growth rates helps a banker understand why a loan applicant needs money and for how long the need might continue. In one instance, a loan applicant requested $100,000 to pay off several insistent suppliers and promised to repay in a few months when he collected some accounts receivable that were coming due. A sustainable growth analysis revealed that the firm had been growing at four to six times its sustainable growth rate and that this pattern was likely to continue in the foreseeable future. This alerted the banker to the fact that impatient suppliers were only a symptom of the much more fundamental disease of overly rapid growth, and that a $100,000 loan would likely prove to be only the down payment on a much larger, multiyear commitment.

Robert C. Higgins is the Marguerite Reimers Professor of Finance, Emeritus, at the Foster School of Business at the University of Washington. He pioneered the use of sustainable growth as a tool for financial analysis.

A NOTE ABOUT SUSTAINABLE GROWTH RATE CALCULATIONS

Very commonly, the sustainable growth rate is calculated using just the numerator in our expression, ROE × b. This causes some confusion, which we can clear up here. The issue has to do with how ROE is computed. Recall that ROE is calculated as net income divided by total equity. If total equity is taken from an ending balance sheet (as we have done consistently, and is commonly done in practice), then our formula is the right one. However, if total equity is from the beginning of the period, then the simpler formula is the correct one.

In principle, you’ll get exactly the same sustainable growth rate regardless of which way you calculate it (as long as you match up the ROE calculation with the right formula). In reality, you may see some differences because of accounting-related complications. By the way, if you use the average of beginning and ending equity (as some advocate), yet another formula is needed. Also, all of our comments here apply to the internal growth rate as well.

A simple example is useful to illustrate these points. Suppose a firm has a net income of $20 and a retention ratio of .60. Beginning assets are $100. The debt–equity ratio is .25, so beginning equity is $80.

If we use beginning numbers, we get the following:

ROE = $20/80 = .25 = 25%

Sustainable growth = .60 × .25 = .15 = 15%

For the same firm, ending equity is $80 + .60 × $20 = $92. So, we can calculate this:

ROE = $20/92 = .2174 = 21.74%

Sustainable growth = .60 × .2174/(1 − .60 × .2174) = .15 = 15%

These growth rates are exactly the same (after accounting for a small rounding error in the second calculation). See if you don’t agree that the internal growth rate is 12%.

EXAMPLE 4.3 Profit Margins and Sustainable Growth

Page 112The Sandar Co. has a debt–equity ratio of .5, a profit margin of 3 percent, a dividend payout ratio of 40 percent, and a capital intensity ratio of 1. What is its sustainable growth rate? If Sandar desired a 10 percent sustainable growth rate and planned to achieve this goal by improving profit margins, what would you think?

ROE is .03 × 1 × 1.5 = 4.5 percent. The retention ratio is 1 − .40 = .60. Sustainable growth is thus .045(.60)/[1 − .045(.60)] = 2.77 percent.

For the company to achieve a 10 percent growth rate, the profit margin will have to rise. To see this, assume that sustainable growth is equal to 10 percent and then solve for profit margin, PM:

For the plan to succeed, the necessary increase in profit margin is substantial, from 3 percent to about 10 percent. This may not be feasible.

Concept Questions

4.4a How is a firm’s sustainable growth related to its accounting return on equity (ROE)?

4.4b What are the determinants of growth?

4.5 Some Caveats Regarding Financial Planning Models

Financial planning models do not always ask the right questions. A primary reason is that they tend to rely on accounting relationships and not financial relationships. In particular, the three basic elements of firm value tend to get left out—namely cash flow size, risk, and timing.

Because of this, financial planning models sometimes do not produce meaningful clues about what strategies will lead to increases in value. Instead, they divert the user’s attention to questions concerning the association of, say, the debt–equity ratio and firm growth.

The financial model we used for the Hoffman Company was simple—in fact, too simple. Our model, like many in use today, is really an accounting statement generator at heart. Such models are useful for pointing out inconsistencies and reminding us of financial needs, but they offer little guidance concerning what to do about these problems.

In closing our discussion, we should add that financial planning is an iterative process. Plans are created, examined, and modified over and over. Page 113The final plan will be a result negotiated between all the different parties to the process. In fact, long-term financial planning in most corporations relies on what might be called the Procrustes approach.

1

Upper-level managers have a goal in mind, and it is up to the planning staff to rework and ultimately deliver a feasible plan that meets that goal.

The final plan will therefore implicitly contain different goals in different areas and also satisfy many constraints. For this reason, such a plan need not be a dispassionate assessment of what we think the future will bring; it may instead be a means of reconciling the planned activities of different groups and a way of setting common goals for the future.

Concept Questions

4.5a What are some important elements that are often missing in financial planning models?

4.5b Why do we say planning is an iterative process?

 

4.6 Summary and Conclusions

Financial planning forces the firm to think about the future. We have examined a number of features of the planning process. We described what financial planning can accomplish and the components of a financial model. We went on to develop the relationship between growth and financing needs, and we discussed how a financial planning model is useful in exploring that relationship.

Corporate financial planning should not become a purely mechanical activity. If it does, it will probably focus on the wrong things. In particular, plans all too often are formulated in terms of a growth target with no explicit linkage to value creation, and they frequently are overly concerned with accounting statements. Nevertheless, the alternative to financial planning is stumbling into the future. Perhaps the immortal Yogi Berra (the baseball catcher, not the cartoon character) put it best when he said, “Ya gotta watch out if you don’t know where you’re goin’. You just might not get there.”

2

CONNECT TO FINANCE

If you are using Connect Finance in your course, get online to take a Practice Test, check out study tools, and find out where you need additional practice.

Can you answer the following Connect Quiz questions?

Section 4.1	Murphy’s, Inc., is in the process of preparing a financial plan for the firm for the next five years. This five-year period is referred to as the___________.
Section 4.2	What is generally the first step in the financial planning process?
Section 4.3	A firm has current sales of $272,600 with total assets of $311,000. What is the full-capacity capital intensity ratio if the firm is currently operating at 68 percent capacity?
Section 4.4	What growth rate assumes that the debt–equity ratio is held constant?
Section 4.5	What is generally considered when compiling a financial plan?

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CHAPTER REVIEW AND SELF-TEST PROBLEM

4.1   Calculating EFN Based on the following information for the Skandia Mining Company, what is EFN if sales are predicted to grow by 10 percent? Use the percentage of sales approach and assume the company is operating at full capacity. The payout ratio is constant.

4.2   EFN and Capacity Use Based on the information in Problem 4.1, what is EFN, assuming 60 percent capacity usage for net fixed assets? Assuming 95 percent capacity?

4.3   Sustainable Growth Based on the information in Problem 4.1, what growth rate can Skandia maintain if no external financing is used? What is the sustainable growth rate?

ANSWERS TO CHAPTER REVIEW AND SELF-TEST PROBLEMS

4.1   We can calculate EFN by preparing the pro forma statements using the percentage of sales approach. Note that sales are forecast to be $4,250 × 1.10 = $4,675.

Page 1154.2   Full-capacity sales are equal to current sales divided by the capacity utilization. At 60 percent of capacity:

With a sales level of $4,675, no net new fixed assets will be needed, so our earlier estimate is too high. We estimated an increase in fixed assets of $2,420 − 2,200 = $220. The new EFN will thus be $78.7 − 220 = −$141.3, a surplus. No external financing is needed in this case.

At 95 percent capacity, full-capacity sales are $4,474. The ratio of fixed assets to full-capacity sales is thus $2,200/4,474 = 49.17%. At a sales level of $4,675, we will thus need $4,675 × .4917 = $2,298.7 in net fixed assets, an increase of $98.7. This is $220 − 98.7 = $121.3 less than we originally predicted, so the EFN is now $78.7 − 121.3 = −$42.6, a surplus. No additional financing is needed.

4.3   Skandia retains b = 1 − .3337 = 66.63% of net income. Return on assets is $247.5/3,100 = 7.98%. The internal growth rate is thus:

Return on equity for Skandia is $247.5/800 = 30.94%, so we can calculate the sustainable growth rate as follows:

CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS

1.   Sales Forecast [LO1] Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales the key input?

2.   Sustainable Growth [LO3] In the chapter, we used Rosengarten Corporation to demonstrate how to calculate EFN. The ROE for Rosengarten is about 7.3 percent, and the plowback ratio is about 67 percent. If you calculate the sustainable growth rate for Rosengarten, you will find it is only 5.14 percent. In our calculation for EFN, we used a growth rate of 25 percent. Is this possible? (Hint: Yes. How?)

3.   External Financing Needed [LO2] Testaburger, Inc., uses no external financing and maintains a positive retention ratio. When sales grow by 15 percent, the firm has a negative projected EFN. What does this tell you about the firm’s internal growth rate? How about the sustainable growth rate? At this same level of sales growth, what will happen to the projected EFN if the retention ratio is increased? What if the retention ratio is decreased? What happens to the projected EFN if the firm pays out all of its earnings in the form of dividends?

4.   EFN and Growth Rates [LO2, 3] Broslofski Co. maintains a positive retention ratio and keeps its debt–equity ratio constant every year. When sales grow by 20 percent, the firm has a negative projected EFN. What does this tell you about the firm’s sustainable growth rate? Do you know, with certainty, if the internal growth rate is greater than or less than 20 percent? Why? What happens to the projected EFN if the retention ratio is increased? What if the retention ratio is decreased? What if the retention ratio is zero?

Page 116Use the following information to answer the next six questions: A small business called The Grandmother Calendar Company began selling personalized photo calendar kits. The kits were a hit, and sales soon sharply exceeded forecasts. The rush of orders created a huge backlog, so the company leased more space and expanded capacity; but it still could not keep up with demand. Equipment failed from overuse and quality suffered. Working capital was drained to expand production, and, at the same time, payments from customers were often delayed until the product was shipped. Unable to deliver on orders, the company became so strapped for cash that employee paychecks began to bounce. Finally, out of cash, the company ceased operations entirely three years later.

5.   Product Sales [LO4] Do you think the company would have suffered the same fate if its product had been less popular? Why or why not?

6.   Cash Flow [LO4] The Grandmother Calendar Company clearly had a cash flow problem. In the context of the cash flow analysis we developed in 

Chapter 2

, what was the impact of customers not paying until orders were shipped?

7.   Product Pricing [LO4] The firm actually priced its product to be about 20 percent less than that of competitors, even though the Grandmother calendar was more detailed. In retrospect, was this a wise choice?

8.   Corporate Borrowing [LO4] If the firm was so successful at selling, why wouldn’t a bank or some other lender step in and provide it with the cash it needed to continue?

9.   Cash Flow [LO4] Which was the biggest culprit here: too many orders, too little cash, or too little production capacity?

10.   Cash Flow [LO4] What are some of the actions that a small company like The Grandmother Calendar Company can take if it finds itself in a situation in which growth in sales outstrips production capacity and available financial resources? What other options (besides expansion of capacity) are available to a company when orders exceed capacity?

BASIC

(Questions 1–15)

1.   Pro Forma Statements [LO1] Consider the following simplified financial statements for the Yoo Corporation (assuming no income taxes):

The company has predicted a sales increase of 15 percent. It has predicted that every item on the balance sheet will increase by 15 percent as well. Create the pro forma statements and reconcile them. What is the plug variable here?

2.

   Pro Forma Statements and EFN [LO1, 2] In the previous question, assume the company pays out half of net income in the form of a cash dividend. Costs and assets vary with sales, but debt and equity do not. Prepare the pro forma statements and determine the external financing needed.
Page 1173.   Calculating EFN [LO2] The most recent financial statements for Hornick, Inc., are shown here (assuming no income taxes):
Assets and costs are proportional to sales. Debt and equity are not. No dividends are paid. Next year’s sales are projected to be $8,968. What is the external financing needed?
4.   EFN [LO2] The most recent financial statements for Reply, Inc., are shown here:
Assets and costs are proportional to sales. Debt and equity are not. A dividend of $2,400 was paid, and the company wishes to maintain a constant payout ratio. Next year’s sales are projected to be $32,085. What is the external financing needed?

5.

   EFN [LO2] The most recent financial statements for Cornwall, Inc., are shown here:

Assets, costs, and current liabilities are proportional to sales. Long-term debt and equity are not. The company maintains a constant 40 percent dividend payout ratio. As with every other firm in its industry, next year’s sales are projected to increase by exactly 15 percent. What is the external financing needed?
6.   Calculating Internal Growth [LO3] The most recent financial statements for Schenkel Co. are shown here:

Assets and costs are proportional to sales. Debt and equity are not. The company maintains a constant 30 percent dividend payout ratio. What is the internal growth rate?

7.   Calculating Sustainable Growth [LO3] For the company in the previous problem, what is the sustainable growth rate?
Page 1188.   Sales and Growth [LO2] The most recent financial statements for Alexander Co. are shown here:
Assets and costs are proportional to sales. The company maintains a constant 30 percent dividend payout ratio and a constant debt–equity ratio. What is the maximum increase in sales that can be sustained assuming no new equity is issued?
9.   Calculating Retained Earnings from Pro Forma Income [LO1] Consider the following income statement for the Heir Jordan Corporation:
A 20 percent growth rate in sales is projected. Prepare a pro forma income statement assuming costs vary with sales and the dividend payout ratio is constant. What is the projected addition to retained earnings?
10.   Applying Percentage of Sales [LO1] The balance sheet for the Heir Jordan Corporation follows. Based on this information and the income statement in the previous problem, supply the missing information using the percentage of sales approach. Assume that accounts payable vary with sales, whereas notes payable do not. Put “n/a” where needed.
Page 11911.   EFN and Sales [LO2] From the previous two questions, prepare a pro forma balance sheet showing EFN, assuming a 15 percent increase in sales, no new external debt or equity financing, and a constant payout ratio.

12.

   Internal Growth [LO3] If Stone Sour Co. has an ROA of 8 percent and a payout ratio of 30 percent, what is its internal growth rate?
13.   Sustainable Growth [LO3] If Gold Corp. has an ROE of 15 percent and a payout ratio of 25 percent, what is its sustainable growth rate?
14.   Sustainable Growth [LO3] Based on the following information, calculate the sustainable growth rate for Kaleb’s Welding Supply:

15.   Sustainable Growth [LO3] Assuming the following ratios are constant, what is the sustainable growth rate?

16.

   Full-Capacity Sales [LO1] Southern Mfg., Inc., is currently operating at only 92 percent of fixed asset capacity. Current sales are $690,000. How fast can sales grow before any new fixed assets are needed?
INTERMEDIATE
(Questions 16–26)
17.   Fixed Assets and Capacity Usage [LO1] For the company in the previous problem, suppose fixed assets are $520,000 and sales are projected to grow to $790,000. How much in new fixed assets are required to support this growth in sales? Assume the company maintains its current operating capacity.
18.   Growth and Profit Margin [LO3] Dante Co. wishes to maintain a growth rate of 12 percent per year, a debt–equity ratio of .85, and a dividend payout ratio of 30 percent. The ratio of total assets to sales is constant at .95. What profit margin must the firm achieve?

19.

   Growth and Assets [LO3] A firm wishes to maintain an internal growth rate of 6.5 percent and a dividend payout ratio of 25 percent. The current profit margin is 7 percent, and the firm uses no external financing sources. What must total asset turnover be?
20.   Sustainable Growth [LO3] Based on the following information, calculate the sustainable growth rate for Hendrix Guitars, Inc.:

21.

   Sustainable Growth and Outside Financing [LO3] You’ve collected the following information about Draiman, Inc.:
Page 120What is the sustainable growth rate for the company? If it does grow at this rate, how much new borrowing will take place in the coming year, assuming a constant debt–equity ratio? What growth rate could be supported with no outside financing at all?
 22.   Sustainable Growth Rate [LO3] Gilmore, Inc., had equity of $161,000 at the beginning of the year. At the end of the year, the company had total assets of $305,000. During the year, the company sold no new equity. Net income for the year was $29,000 and dividends were $6,200. What is the sustainable growth rate for the company? What is the sustainable growth rate if you use the formula ROE × b and beginning of period equity? What is the sustainable growth rate if you use end of period equity in this formula? Is this number too high or too low? Why?
23.   Internal Growth Rates [LO3] Calculate the internal growth rate for the company in the previous problem. Now calculate the internal growth rate using ROA × b for both beginning of period and end of period total assets. What do you observe?
24.   Calculating EFN [LO2] The most recent financial statements for Fleury, Inc., follow. Sales for 2015 are projected to grow by 20 percent. Interest expense will remain constant; the tax rate and the dividend payout rate will also remain constant. Costs, other expenses, current assets, fixed assets, and accounts payable increase spontaneously with sales. If the firm is operating at full capacity and no new debt or equity is issued, what external financing is needed to support the 20 percent growth rate in sales?

Page 12125.   Capacity Usage and Growth [LO2] In the previous problem, suppose the firm was operating at only 80 percent capacity in 2014. What is EFN now?

26.   Calculating EFN [LO2] In Problem 24, suppose the firm wishes to keep its debt– equity ratio constant. What is EFN now?
27.   EFN and Internal Growth [LO2, 3] Redo Problem 24 using sales growth rates of 15 and 25 percent in addition to 20 percent. Illustrate graphically the relationship between EFN and the growth rate, and use this graph to determine the relationship between them. At what growth rate is the EFN equal to zero? Why is this internal growth rate different from that found by using the equation in the text?
CHALLENGE
(Questions 27–32)
28.   EFN and Sustainable Growth [LO2, 3] Redo Problem 26 using sales growth rates of 30 and 35 percent in addition to 20 percent. Illustrate graphically the relationship between EFN and the growth rate, and use this graph to determine the relationship between them. At what growth rate is the EFN equal to zero? Why is this sustainable growth rate different from that found by using the equation in the text?
29.   Constraints on Growth [LO3] Volbeat, Inc., wishes to maintain a growth rate of 12 percent per year and a debt–equity ratio of .35. Profit margin is 6.1 percent, and the ratio of total assets to sales is constant at 1.80. Is this growth rate possible? To answer, determine what the dividend payout ratio must be. How do you interpret the result?
30.   EFN [LO2] Define the following:
Assuming all debt is constant, show that EFN can be written as follows:

Hint: Asset needs will equal A × g. The addition to retained earnings will equal PM(S)b × (1 + g).
31.   Growth Rates [LO3] Based on the result in Problem 30, show that the internal and sustainable growth rates are as given in the chapter. Hint: For the internal growth rate, set EFN equal to zero and solve for g.
32.   Sustainable Growth Rate [LO3] In the chapter, we discussed the two versions of the sustainable growth rate formula. Derive the formula ROE × b from the formula given in the chapter, where ROE is based on beginning of period equity. Also, derive the formula ROA × b from the internal growth rate formula.
EXCEL MASTER IT! PROBLEM

Financial planning can be more complex than the percentage of sales approach indicates. Often, the assumptions behind the percentage of sales approach may be too simple. A more sophisticated model allows important items to vary without being a strict percentage of sales.
Consider a new model in which depreciation is calculated as a percentage of beginning fixed assets, and interest expense depends directly on the amount of debt. Debt is still the Page 122plug variable. Note that since depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer constant. Also, for the same reason, taxes and dividends will no longer be a fixed percentage of sales. The parameter estimates used in the new model are:
The model parameters can be determined by whatever methods the company deems appropriate. For example, they might be based on average values for the last several years, industry standards, subjective estimates, or even company targets. Alternatively, sophisticated statistical techniques can be used to estimate them.
The Moore Company is preparing its pro forma financial statements for the next year using this model. The abbreviated financial statements are presented below.

a.   Calculate each of the parameters necessary to construct the pro forma balance sheet.
b.   Construct the pro forma balance sheet. What is the total debt necessary to balance the pro forma balance sheet?
c.   In this financial planning model, show that it is possible to solve algebraically for the amount of new borrowing.
Page 123
MINICASE

Planning for Growth at S&S Air
After Chris completed the ratio analysis for S&S Air (see 
Chapter 3
), Mark and Todd approached him about planning for next year’s sales. The company had historically used little planning for investment needs. As a result, the company experienced some challenging times because of cash flow problems. The lack of planning resulted in missed sales, as well as periods when Mark and Todd were unable to draw salaries. To this end, they would like Chris to prepare a financial plan for the next year so the company can begin to address any outside investment requirements. The income statement and balance sheet are shown here:

Questions