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Finance:IntroductorySection
WelcometoFinance
YouareabouttobeginHarvardBusinessSchool'sinteractiveFinancecourse,whichwillintroduceyoutotheprinciplesof
finance.Successfulcompletionofthisintroductorysectionwillprepareyouforfurtherstudyoffinancialmanagement,
financialmarkets,andfinancialinstrumentsandtheapplicationofthesedisciplinesinorganizationsthroughouttheworld.
UsingtheTutorial
ThestructureoftheHarvardBusinessSchoolFinancetutorialanditsnavigationaltoolsareeasytomaster.Ifyouare
readingthistext,youmusthaveclickedonthenavigationitemlabeledUsingtheTutorialontheleft.
PleaseclickontheHelpiconintheupperrightcornerofthetutorialtoviewaclickableanimationonhowtousethis
tutorial.Youwillbeabletoreferbacktotheseinstructionsthroughoutthetutorial.
WhatisFinance?
Allcorporations,whetherlargeorsmall,neworold,confrontfundamentaldecisionsabouthowtodeploycapitalthatis,
whattoinvestinandhowtoraisefundsneededforinvestment.Thesechoicesarecentraltothedisciplineofcorporate
financialmanagement.Fundamentally,thestudyofcorporatefinancecoverstheprinciples,analyticaltools,and
institutionalknowledgeamanagerneedstomakegoodinvestmentandfinancingdecisions.Inaddition,however,awell
runcorporationneedsafinancialinfrastructuresystemsformonitoringcashandcashflow,forcreatingoperatingand
financialbudgets,formeasuringandreportingitsfinancialandoperatingperformance,formanagingitscurrentand
expectedtaxliabilities,andsoforth.Definedbroadly,thefieldoffinancecoversallthesetopics,andmanyrelatedonesas
well,suchasthemarketsinwhichfinancialcontractsarepricedandtraded,andtheinstitutionsthatuse,support,and
regulatethem.Thistutorialcannotcoverallthematerialaqualifiedmanagerneedstoknowrather,itsgoalistogetyou
startedandprepareyouforfurtherstudy.
TutorialOverview
Eachmoduleinthistutorialwillintroducenewfinancialconceptsandtools.Thesewilloftenbeillustratedinthecontext
ofasimple,stylizedcompany,calledtheGoldenStateCanningCompany.Tocementyourunderstandingofthematerial,
youwillbeaskedtocompletevariousexercisesasyouproceedthrougheachmodule.Alongtheway,youwillalsogettosee
andusesomerealworldcorporatedata.Forexample,you'llusefinancialinformationfromtheJ.M.SmuckerCompanyto
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helpyouevaluateaprojectproposedforGoldenStateCanning.Eachmoduleendswithacapsulesummaryofthematerial
justcovered.
Ifyouarealreadyfamiliarwithbasicfinanceconceptsandtools,youmaywishtotakethepretestbeforebeginningthe
tutorial.Ifyouarenotveryfamiliarwithfinance,simplyskipthepretesttosavetime.Ifyoutakethepretestandanswer
75%ofthequestionscorrectly,youarealreadyreasonablywellpreparedforfurtherstudyandneednotcontinuewiththe
tutorial.However,youshouldfeelfreetoexplorethetutorialanyway,focusingonareasinwhichyouwanttorefreshyour
knowledge.Ifyouanswerlessthan75%correctly,startatthebeginningofthetutorialandgothroughthematerialinthe
orderinwhichitispresented.Whenyouarefinished,youshouldtakeFinalExam1totestyourself.Ifyouanswer75%of
thesequestionscorrectly,youarefinished!Otherwise,youshouldgobackandreviewpartsofthetutorialthatgaveyou
difficultyandthentakeFinalExam2.
Thetutorialconsistsoffourmodulesfocusedonanalyzingacompany'spast,current,andfutureperformance,mostlyusing
itsfinancialstatements.ThesemodulesincludeanIntroduction,RatioAnalysis,theCashCycleandGrowth,andFinancial
Forecasting.ThenextmodulecoversTimeValueofMoneyasitrelatestoGoldenStateCanning.
PretestIntroduction
WelcometothepreassessmenttestfortheHBSFinancetutorial.Thistestwillallowyoutoassessyourknowledgeofsome
basicfinancialprinciples.
Allquestionsmustbeansweredforyourexamtobescored.
Navigation:
Toadvancefromonequestiontothenext,selectoneoftheanswerchoicesor,ifapplicable,completewithyourownchoice
andclicktheSubmitbutton.Aftersubmittingyouranswer,youwillnotbeabletochangeit,somakesureyouaresatisfied
withyourselectionbeforeyousubmiteachanswer.Youmayalsoskipaquestionbypressingtheforwardadvancearrow.
PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthe
navigationalarrowsatanytime.Althoughyoucanskipaquestion,youmustnavigatebacktoitandansweritallquestions
mustbeansweredfortheexamtobescored.
Yourresultswillbedisplayedimmediatelyuponcompletionoftheexam.
Aftercompletion,youcanreviewyouranswersatanytimebyreturningtotheexam.
GoodLuck!
Introduction
Inthissectionyouwillusecommonanalyticaltoolstoassessacompany'sfinancialconditionandperformance.Inother
words,howisthecompanydoing?Whatsortofshapeisitin?Youwillbeintroducedtofinancialratioanalysis,commonsize
financialstatements,thecashcycle,sourcesandusesanalysis,sustainablegrowth,andthepreparationofforecastsandpro
formafinancialstatements.
FinancialStatements
Learningtoanalyzebusinessesrequireslearningtoworkwithfinancialstatementsmuchasaportraitartistmustlearnto
draw,oraphysicianmustlearnanatomy.Financialstatementsdonotgiveacompleteoranidealrenderingofabusiness,
buttheyareubiquitousandconvenient.
Theyshareacommonformacrossmanydifferenttypesofbusinesses.
Theyexpresseverythingincommonunits.
Theyprovideasystematicwayoflinkingthepast,present,and(expected)futureperformance.
Perhapsmostimportant,theyarefundamentallyquantitative,acharacteristicsometimesbemoanedforthelimitationsit
implies,butonethatconveystheboonofmathematicalmanipulability.Imaginehowdifficultitwouldbetoevaluatea
businessifwecouldrepresentitonlypictorially,orinwords,butnotwithnumbers.
Thistutorialpresumesyouarefamiliarwithbasicfinancialaccounting.Inparticular,itmakesextensiveuseofcorporate
incomestatementsandbalancesheets.Ifyouhavenotalreadydoneso,pleasecompletetheHBSFinancialAccounting
Tutorialforacomprehensiveintroductiontofinancialaccountingandbasicfinancialstatements.
GoldenStateCanning
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Thischapterillustratesfinancialstatementanalysiswithasimplebusiness.Togetstarted,pleaseadopttheperspectiveof
aprospectiveownerandmanagerofthebusiness,asfollows.
DownloadFinancialStatementshere.
RatioAnalysis
ThefirststepinanalyzingGoldenState'spotentialistoexamineitsrecentperformanceandcurrentfinancialcondition.
Financeprofessionalsuseamyriadofdifferentfinancialratiostoassessfinancialhealthsomany,infact,thatithelpsto
groupthemintocategories.Herearesixbasiccategories:
Growth
Profitability
Liquidity
Leverage
Efficiency
Risk
Beawarethatnoteveryoneusesthesamecategories,anddifferentanalystsmaydefineagivenratiodifferently.
Definition
Mostfinancialratiosconsistofasimplecomparisonbetweenitemsofinterestfromabalancesheetand/orincome
statementthatyieldinsightintoconditionorperformance.
Forexample,lookingatGoldenState'sbalancesheetwecancompareitsequitytoitsassetsandcomputetheequityto
assetratioin2007.
Growth
Youarelookingforabusinesswithgrowthpossibilities.Moregenerally,investorsandmanagerswanttheirbusinessesto
producemorecash,tobecomemorevaluable.Inshort,theyarelookingforgrowth.Weusuallymeasuregrowthasarateof
changeovertimeinaspecificitemofinterest,suchassales,assets,profits,orcashflow.
OneoftheattractionsofGoldenStateisthepossibilityofgrowingthebusiness.Hasitbeengrowinglately?Howfast?
Howconsistently?Historicgrowthratesmaybeanindicatoroffuturegrowthpotential.
CompoundAverageGrowthRate
Inadditiontocomputingacompany'syeartoyeargrowthrates,wemaybeinterestedinaveragegrowthratesovera
longerperiod.Onewaytomeasurethisistocomputeacompoundaveragegrowthrate(CAGR).TheCAGRisthesingle
constantgrowthratethat,whencompoundedoverafinitenumberofyears,producestheobservedendpointfromthe
observedstartingvalue.
Sales
ComputeGoldenState'syeartoyeargrowthratesforsales,aswellastheCAGRforGoldenState'ssalesfrom2004to
2007.
OperatingProfit
YoudecidetoinvestigateGoldenState'sgrowthfurtherbycomputingthegrowthinitsoperatingprofit.Operating
profitisoftenreferredtoasearningsbeforeinterestandtaxes(EBIT).
Profitability
Inadditiontoknowingwhetheracompanyisgrowing,wewanttoknowifitisprofitable.Wecouldsimplylookatgross
profit,operatingprofit,andnetincome,toseeifeachispositiveornegative.Butthat'snotenough.Ithelpstocompare
profitstosomething.Forexample,howmuchsaleswererequiredtogenerateagivenprofit?Howlargeanassetbasewas
required?Ifwecompareoperatingprofittosales,wegettheoperatingmargin.Comparingoperatingprofittoassetsis
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onewaytomeasurepretaxreturnonassets.
ProfitMargins
Weobservedpositive,ifunimpressivesalesgrowthforGoldenState.Operatingprofitgrewfasterbutwasunevenover
time.TogetaclearerpictureofGoldenState'sprofitability,let'slookatitsprofitmargins.Wecanthinkofprofit
marginsinahierarchyinwhicheachsuccessivemargintakesanadditionalfactorintoaccount.
ReturnonEquity
Since,ifyoudecidetobuyGoldenState,youwillbeinvestingmostofyoursavings,youareinterestedinhowmuch
profitthecompanywillproduce,comparedtoyourinvestment.Thereturnonbeginningequity(ROBE)compares
netincomeduringagivenyeartoowner'sequityatthebeginningoftheyear.ROBEisapopularmeasureoffinancial
performanceamonginvestorsandmanagersandwillbediscussedingreaterdetailinfuturechapters.Anothercommon
variantofthisratioisROE,whichcomparesnetincomeduringtheyeartoendofyearowner'sequity.
Efficiency
Manyfinancialratiosareintendedtohelpassesstheefficiencyofacompany'soperations.Someanalystscallthis
category"ActivityRatios".Forexamplewemaywanttomeasurehowwellabusinessemploysitsplantandequipment,its
inventory,itscreditfromsuppliers,andsoforth.Orwemaywanttoknowhowquicklyitsreceivablesarecollectedorhow
longsomeproductsstayininventorybeforeasale.
AssetTurnover
Now,computeaverageassetturnoverfortheremainingthreeyears,toseeifthereisatrend.
Inventory
Foramanufacturingcompanyoraretailer,wewouldliketoknowhowlongittakesthecompanytoproduceandsellits
goods.Thelongerittakes,themorefinancingwillberequired.Acommonratiocomparesthecostofgoodssoldto
inventory.Notethatonceagain,thiscombinesanitemfromtheincomestatement(COGS)toonefromthebalance
sheet(inventory)sowehavetostipulatebeginning,ending,oraverageinventory.DividingCOGSbyendinginventory
gives(ending)inventoryturnover.Let'scomputethisforGoldenStatefor2007.
Anothercommonformulationofaninventoryratioisdaysininventory.Itusesthesamebasicinformation,but
expressestheamountofinventoryheldintermsofthenumberofdaysofCOGSitrepresents.Tocomputedaysin
inventory,weexpressinventoryasafractionofCOGS(thisissimplythereciprocalofinventoryturnover)andthen
applythatfractionto365daysperyear.
Allelseequal,wepreferalowernumberofdaysininventory,whichcorrespondstoahigherinventoryturnover.Higher
turnoverindicatesaneedforlessinventoryandcorrespondinglylowercapitalrequirementstofinancetheinventory.
Butindustriesvarywidely,andsometimesacompanymaybewillingtocarrymoreinventoryifitfurtherssomeother
goal.Forexample,itmaybepossibletochargehigherpricesorreachmoreorbettercustomersbycarryingmore
inventory.
Let'sexamineGoldenState'sDaysinInventoryforthewholeperiod20042007.GoldenState'sdaysininventoryrose
steadilyfrom2004to2006andfellslightlyin2007.However,theseasonalnatureofGoldenState'sbusinessshould
makeuscarefulaboutinterpretingthisresult.
SeasonalityandCyclicality
Likemanybusinesses,GoldenState'scanningoperationsareseasonal:thecompanyiscanningmoreproduceatcertain
timesoftheyearthanothers.Seasonalpatternsaregenerallypredictabletheyfollowthecalendar.GoldenState's
seasonalpeakisdrivenbythegrowingseason.Forothercompanies,suchasretailers,theseasonalpeakmaybedriven
byconsumers'buyinghabitsforexample,purchasinggiftsforholidaysorsuntanlotioninthesummer.
Liquidity
Foranasset,liquiditydenotes"closenesstocash,"ortheeasewithwhichtheassetcanbeconvertedtocashwithoutaloss
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ofvalue.Foranentirecompany,liquidityisassociatedwiththecompany'sabilitytomeetknownneartermcash
obligationsand/ortocopewithunexpectedneedsforcash.
Liquidityratiosprovideanindicationofacompany'sabilitytopayor"liquidate"shorttermobligations,generally,those
fallingduewithinoneyear.Illiquiditymayhaveseriousconsequencesifitresultsindefaultondebtobligationsorifit
impairsfutureaccesstocredit.Ontheotherhand,excessiveliquiditymayreflectpoorassetutilization.
CurrentRatio
Themostcommonmeasureofliquidityisthecurrentratio.Thecurrentratiosimplycomparescurrentassetstocurrent
liabilities.Currentassetsincludecash,marketablesecurities,andworkingcapitalitemsthatwillturnintocashwithin
oneyear.Currentliabilitiesincludeamountsowedtosuppliers,employees,lenders,andthegovernmentwithinayear.
Alowcurrentratiomaybeanearlywarningoffutureliquidityproblemsasneartermobligationscomedueingreater
amountsthanarecoveredbycontemporaneousliquidassets.
Let'sexamineGoldenState'sliquiditybycalculatingitscurrentratioduring20032007.
QuickRatio
Anothermeasureofliquidityissimplytheamountofcashonhand.WecaneasilyseethatGoldenState'scashdropped
steadilyfrom2004to2006.
Howtightwerethingsin2007?Togetanidea,let'scomputethecompany'squickratiofor2007.Thequickratioislike
thecurrentratio,exceptthatinventoriesareexcludedfromcurrentassets.Why?Becauseinventoryisgenerally
consideredlessliquidthanreceivables(anditiscertainlylessliquidthancash).
Leverage
Financialleverage(sometimescalled"gearing")iscreatedwhenacompanyborrowsmoneytofunditsoperations.Debt
createsfixedfinancialcharges,namelyinterestandprincipalpayments,thatmakeacompany'snetearningsandcashflow
morevolatile.
DebtRatio
Oneofthemostcommonleverageratioscomparesdebttocapital,alsocommonlycalledthedebtratio.Thisisan
indication,forGoldenState,oftheextenttowhichMr.Cotahasutilizeddebttofinancethecompany'soperations.In
otherwords,whatfractionofGoldenState'scapitalisdebtasopposedtoequity?Beawarethat"debtratio"isaname
appliedtoavarietyofdifferentlydefinedratiositisimportanttochecktheparticulardefinitionbeingusedbya
givenanalyst.Forthemoment,wewillcomputeGoldenState'sdebtratioasinterestbearingdebtdividedbyinterest
bearingdebtplusequity.
TimesInterestEarned
Thetimesinterestearnedratio(alsoknownasthe"interestcoverageratio")isanothermeasureofleverage.It
examinestheextenttowhichacompany'searningscoveritsinterestpayments.Sometimesthisratioiscomputedusing
cashflowinsteadofoperatingprofitinthenumerator.
Risk
Thefutureperformanceofabusinessisuncertainitcouldbebetterorworse,dependingonwhathappensintheworld.
Wecanthinkofthisuncertaintyasrisk,andnotethatitvariesacrossbusinessesandindustries,sowewouldliketo
measureit.
Riskisdifficulttomeasureusingdatasolelyfromfinancialstatements,anditwillbestudiedingreaterdetailinafuture
chapter.Fornow,notethatnoneoftheratiosmentionedsofarmeasuresriskdirectly(thoughleverageisassociatedwith
financialrisk).Sohowcanweassessit?Onepossibilityistoscanhistoricaloperatingresultstogetanideaofthevolatility
ofsalesorprofit,forexample.ButwehavealreadyseenintheGoldenStateexamplethatsuchvariabilitycouldarisein
manyways,notallofwhichhavetodowithrisk.
FixedtoVariableCosts
Oneindicatorofoperatingriskistheratiooffixedcoststovariablecostsinacompany'soperations.Variablecostsvary
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directlywithsales,whilefixedcostsremainconstantregardlessofhigherorlowersales.Publishedfinancialstatements
seldomprovideunambiguousseparationsorallocationsofvariableandfixedcosts,thoughmanycompaniesperform
suchallocationsinternally,preciselyasameansofunderstandingrisk.Allelseequal,ahigherproportionoffixedcosts
denoteshigheroperatingrisk.Atthesametime,itdenotesthepotentialforeconomiesofscalethepossibilityof
growingsaleswithoutincreasingfixedcosts,whichtranslatesintohigheroperatingmargins(thisisknownas"operating
leverage").
Let'scompareGoldenState'sratiooffixedtovariablecosts.
Whatisthe2007ratio?
CommonsizeFinancialStatements
Youhavealreadycoveredthemaincategoriesoffinancialratios.Commonsizefinancialstatementsprovideaquickand
comprehensivelookatsomeofthem,andaconsistentmeansofcomparisonforsome.
Acommonsizefinancialstatementissimplyonethathasbeenscaledbyasingleparameter,suchassalesorassets,sothat
eachitemisexpressedinrelativeorpercentageterms,ratherthaninunitsofcurrency.Suchstatementsmakeiteasyto
spottrendsovertimethatarenotduetogrowth.Andtheyfacilitatecomparisonsofdifferentcompaniesinrelativeterms,
regardlessofdifferencesinsize.
Whilemanyoftheratiosintroducedabovecomenaturallyoutofacommonsizeincomestatementorbalancesheet(e.g.,
thegrossmargin,operatingmargin,debtratios,etc.),othersdonot,becausetheyconsistofitemsfromboththebalance
sheetandincomestatement(forexample,assetturnover).
BalanceSheet
Commonsizebalancesheetstypicallyexpressallitemsasapercentoftotalassets.
CompletethemissingitemsinGoldenState's2007commonsizebalancesheet.
IncomeStatement
Commonsizeincomestatementsgenerallyexpressallitemsasapercentofnetsales,enablingustostudyGoldenState's
costandprofitstructures.
CompletethemissingitemsinGoldenState's2007commonsizeincomestatement.
Trends
BylookingatGoldenState'scommonsizefinancialstatementsovertheyearswecanspotpotentiallyimportanttrends:
Interpretation
Theprecedingsectioncoveredonlyasmallfractionofthemanydifferentratiosthatyoumayencounterintherealworldof
financialanalysis.Differentanalystsandmanagerscomputedifferentratios.Moreconfusingly,eachmaydefineagiven
ratiodifferentlyfromsomeoneelse.Howshouldyoudecidewhichvariationofaparticularratiotolookat?Itdepends,of
course,onwhatyouaretryingtolearnaboutacompany.Italsodependsonpersonalpreferences,availabledata,and
availablebenchmarks.
Thecomputationoffinancialratiosisfairlymechanical,asyouhaveseen.Interpretingthem,however,isseldomso
straightforward.Mosthavelittleornointrinsicmeaning.Thatis,eventhoughtheyaddressimportanttopics,suchas
growthandprofitability,andtheyareinherentlycomparisonsofsay,operatingprofittosalestheymustbesubjected
tostillfurthercomparisonstobemeaningful.Soifwefind,forexample,thatGoldenState'soperatingmarginis8%,how
doweknowwhethertobeimpressedordisappointed?
Thissectionprovidessomeguidance.Financialratiosareusuallyinterpretedaccordingtooneoranotheroffourbasic
comparisons:changesovertime,peercompanies,prespecifiedbudgetsortargets,andrulesofthumb.
TimeTrend
Oneofthemostinformativewaystointerpretacompany'sratiosistocomparethemtothesamecompany'spast
performance.YouhavealreadyperformedthissortofcomparisonformanyofGoldenState'sratios.
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IndustryComparison
ThoughwecanseeGoldenState'sprofitmarginsriseandfallovertime,wehavenoexternalbenchmarktohelpus
decidewhethertheyareimpressiveordisappointing.Onesetofusefulbenchmarksisothercompaniesinthesame
business,perhapsevendirectcompetitors,whosefinancialstatementsmaybeavailableforcomparison.Sometimes
suchcomparisonsaredonecompanybycompany.
Budgets
RulesofThumb
Finally,someanalystsdeveloprulesofthumbtohelptheminterpretratios.Forexample,onemightsaythatthecurrent
ratioshouldbegreaterthan1.0asaruleofthumb.Attheirbest,rulesofthumbreflectacapableanalyst'syearsof
experience.Attheirworst,theyaresubjectivenotionsthatshouldbechallengedoratleastsupplementedwithother
data.
GoldenStateCanning
ThefollowingvideoreviewssomeofwhatwehavelearnedaboutGoldenStatethroughourstudyofitsfinancialratios
andhighlightssometopicsforfurtherstudyandinvestigation.
ListofCommonRatios
Thissectionpresentsacompendiumofcommonratios.Youshouldnotexpecttomemorizealltheratiosandtheir
formulas,atleastnotnow.Instead,aPDFfilecontainingtheformulasoftheratiospresentedinthischaptercanbe
downloadedbyclickinghere.
Growth
Growthratioscouldbecomputedforalmostanyitemonthebalancesheetorincomestatement.However,analysts
usuallyfocusongrowthinsales,operatingprofit,netincome,theworkingcapitalaccounts,fixedassets,andtotalassets.
Wecanlookatyeartoyeargrowthratesorataveragerates.Anaveragemaybecompounded(aswecomputedthe
CAGR)above,ornot.Acompoundedaverageissometimesreferredtoasa"geometricmean"whileanoncompounded
averageofyeartoyearratesisan"arithmeticmean."
Profitability
Thisisalistofcommonmeasuresofprofitability.
Efficiency
Thereisanabundanceofefficiencyratios.Asampleofcommononesfollows.
Liquidity
Thissectionprovidesformulasanddefinitionsforsomeliquidityratios.
Leverage
Youcancomputethefollowingmeasuresofleverage.
Risk
Youcancomputethreemeasuresofrisk.
Qualifications
Someofthelimitationsofratioanalysisandcommonsizefinancialstatementsare:
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Ratiosbasedsolelyonfinancialstatementsoverlookothercrucialdeterminantsofperformanceandfinancial
conditions.Forexample,marketshareisanimportantmeasureofperformancethatcannotbecomputedsolely
fromfinancialstatements
Itmaybedifficulttoidentifytrulysimilarcompaniesforexternalcomparisons
Accountingmethodsmaydifferacrossotherwisesimilarcompanies,e.g.,forcompaniesindifferentcountries
Agivencompanymaychangeaccountingmethodsovertime
Ratiosmaybedistortedbynonoperatingactivitiesandtransactions,byextraordinaryevents,anddiscontinued
operations.
Ratiosmaybedistortedbyseasonalityandcyclicality
Mostratiosarecomputedusingbookvaluesratherthanmarketvalues,whichmaybesubstantiallydifferent.For
example,adebttoassetsmeasureofleveragethatseemshighwhencomputedintermsofbookvaluesmightbe
quitereasonableifacompany'sfixedassetsareworthsubstantiallymorethantheirbookvalues.
Review
Youshouldnowhaveageneralunderstandingofratioanalysisanditspurposetomanagersandinvestors.Inparticular,
youlearned:
Howtocomputeratiosinthesixcategoriesofgrowth,profitability,efficiency,liquidity,leverage,andrisk
Howtocreatecommonsizefinancialstatements
Howcommonratiosarechosenandinterpreted
Someofthelimitationsofratioanalysis.
CashCycleandGrowth
Evenaprofitablecompanywillexperiencefinancialproblemsifitrunsoutofcash.Thisisespeciallytrueforcompanies
thataregrowingquickly.Rapidgrowthcreatesaneedforfinancingthat,ifnotprudentlymet,canprecipitateacrisisor,ata
minimum,retardgrowth.Oneofthekeystomanaginggrowthfromafinancialperspectiveisthecashcycle.
Thischapterintroducesthecashcycleandsomeanalyticaltoolsthathelpmanagersunderstandandmanageit.Theseinclude
sourceandusesanalysis,andinternalandsustainablegrowthrates.
CashCycle
Thecashcycleissometimescalledtheoperatingornetworkingcapital(NWC)cycle.Itisarepresentationofthe
movementofcashthroughacycleofoperations.Forexample,theoperatingcycleofawholesalerbeginswiththepurchase
ofgoodsfromasupplier,whichisheldasinventoryuntilacustomerpurchasesthegoods,andeventuallypaysthe
wholesaler,whointurnpaysthesupplier.Theorderinwhichtheseeventsoccur,andthelengthoftimebetweenthem,
drivethenaturalflowofcashinandoutofthebusiness.Thisoperatingcycleinvolvesdifferentsteps,dependingonthe
businessbeingexamined.Thatis,theoperatingcycleforamanufacturerwillbedifferentfromthatofawholesaleror
retailer,oraservicecompany.Accordingly,thecashcyclesforeachwilldifferaswell.
Tosomeextentthecharacteristicsofthecashcyclearedeterminedbyfundamentalpropertiesofagivenbusiness,suchas
GoldenState'sseasonalcanningbusiness.Butmanagerialchoicesaffectthecashcycleaswellforexample,howmuch
creditthecompanychoosestoextendtoitscustomerswilllengthenorshortenthecycle.
CashversusProfit
Notethatthecashcyclefocusesoncashflowratherthanprofit.Whatisthedifference?Profitisdefinedbyaccounting
principlesandrulesthatarenotdesignedtotrackcashflowandconsequentlydonotcorrespondtoit.
Whydoesitmatterthatwetrackandmanagecashflowinadditiontoprofit?Withoutcashflow,evenaprofitable
companywillgooutofbusiness.Withit,evenanunprofitableonemayoperateforalongtime.
InflowsandOutflows
Thinkofthecashcycleasreflectingarecurringsetofactivities.Acompanybuysgoods,sellsthem,collectscash,anduses
thecashtobuymoregoods,sellsthem,andsoforth.Everycompanyhasacashcycle.
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Illustration
Youmightsupposethatforahealthybusiness,theinflowsandoutflowsthatcomprisethecashcyclewillbalanceeach
otherout,sothereisnothingtoworryabout.Indeed,inthelongrunwewouldexpectaprofitablebusinesstohave
greaterinflowsthanoutflows,andhencestilllesstoworryabout.Butformostbusinesses,theoutflowshappenbefore
theinflows.GoldenStatehastobuythepeachesandcansbeforeitcansellthemtoacustomer.Thisfundamentalfact
createsafinancingneed.Let'sexamineGoldenState'scashcycle.
KnowingthatGoldenState'scashconversioncycleissomecertainnumberofdaysishelpful,butit'snotenough.When
Mr.Cotagoestohisbankforaloantocoverhisfinancingneed,hehastoborrowanamountofmoney,notanumberof
days.Howlargealoanisimpliedbyacashconversioncycleof,say15days?Itdependsonthescaleofoperations.Fora
largecanningoperation,15daysisalargerloanthanforasmalleroperation.
Growth
Thesimplefactthatoutflowsprecedeinflowscreatesaneedforfinancingofthebasicworkingcapitalaccounts.
Sometimesthisneedforfinancingissimplyreferredtoasaneedforworkingcapital.GoldenStatewillhavetofind
lendersorshareholderswillingtocontributecapitaltomeetthisneed(retainedearningsarefundscontributedby
shareholders).Howmuchcapitaldependsonhowlargeoperationsare:wesawthatlargeroperationsrequiremore
capital.RecallthatGoldenStatewantstogrowitwantstobecomelargerandlarger.Growthwillrequireevenmore
capital.Thehigherthegrowth,themorecapitalisrequired.Ineffect,agrowingfirmisusingcashcollectedfrom
yesterday'ssalestofundtomorrow'spurchases.Thiscausesashortfallbecauseagrowingfirmisbiggertomorrowthanit
wasyesterday.
Extensions
Sofar,wehaveonlyconsideredtheworkingcapitalaccounts.Amorecompletelookatthecashcyclewouldincludeother
sourcesandusesofcashaswell.
CashConversionCycle
Wementionedthecashconversioncycle(CCC)aboveinthecontextoftheworkingcapitalcycle.Let'scomputeitnow
forGoldenStateusingsomeofthekeyratiosweexaminedinanearlierchapter.TheCCCcombinesthreeratios:daysin
inventory,collectionperiodandpayablesperiod.Forsimplicity,assumethatcreditpurchasesareequaltoCOGSinyour
calculationofdayspayable.
Seasonality
Wesawinthepreviousmodulethatseasonalpatternsinabusinessaffectitsfinancialappearance.Suchseasonal
patternsobviouslyaffecttheoperatingcycleand,inturn,thecashcycle.
SourcesandUses
Anotherwayofmonitoringacompany'sfundingneedsandpatternsistoprepareastatementofSourcesandUsesof
funds.Accountantshavespecializedformatsforsuchstatements,whichyouhavealreadystudiedelsewhere.Auseful
shortcutforpreparingasourcesandusesanalysisissimplytotakebalancesheetsfromtwodifferentdatesandsubtract
onefromtheother.Theamountbywhicheachlineinthebalancesheethaschangedfromonedatetotheotheristhen
categorizedaseitherasourceorauseoffunds.Becausebalancesheetsbalance,itwillalwaysbethecase(withinrounding
error)thatsourcesequaluses.
Let'sconstructGoldenState'ssourcesandusesstatementusingthebalancesheetsprovidedbyMr.Cota.Inparticular,we
areinterestedinwhathappenedtothecompanywhileitwasrunbythehiredmanager.Solet'scompareyearend2004to
2006.Thiswillshowuswhathappenedduringthemanager'stwoyearstint.Thediagrambelow,forexample,showsthat
AccountsReceivabledeclinedfrom2006to2007by$4.2thousand.Thischangerepresentsasourceoffunds.
Construction
Twostepsarenecessarytocreateastatementofsourcesanduses:
1.Computethechangesbetweentwobalancesheets.Oftenthesewillbefromoneyearendtothenext,
butwecouldchooseanyperiodofinterest.ForGoldenStatewearelookingnowatatwoyearperiod.
2.Thentheobservedchangesneedtobeclassifiedaseithersourcesoruses.
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NowweneedtocategorizeeachchangeinGoldenState'sbalancesheetaseitherasourceorause.
Examples
Sourcesoffundscomefromreducinganassetorincreasingaliability.
Usesoffundscomefromincreasinganassetordecreasingaliability.
GoldenState
Testyourknowledgebyconstructingasourcesandusesstatementfor20062007,andthencompareittothe2004
2006statement.Thiswillhighlightsomedifferencesbetweenthecompany'sperformanceunderthemanagerversus
Mr.Cota.
Growth
Aswehaveseen,growthamplifiesthenaturalneedforfinancingimpliedbyacashcycleinwhichoutflowsprecede
inflows.ThiswillbetrueforGoldenStateaswell,shouldyoudecidetoacquireitandsucceedingrowingit.Increasingthe
company'ssaleswillrequirepurchasingmoreproduceandcans,andthismustbedonebeforetheoutputcanbesold.
Aftertheoutputissold,creditmustbeextendedtocustomers.Moreover,inthelongrun,withsustainedgrowth,Golden
Statewillneedadditionalfundstoexpandcapacity.Infact,thecompany'sgrowthrateinthefuturemightbeconstrained
byitsabilitytoobtainadequatefinancing.HowfastcanGoldenStategrow?Thisdependsinpart,ofcourse,onthemarket
forcannedproduceandcompetitiveconditions.Butwewillfocushereonthefinancingproblem.
InternalGrowthRate
Acompany'sinternalgrowthrateistherateatwhichitcangrowwithoutanynewexternalfunding(frombanksor
shareholdersforexample),andassumingitsoperatingratiosremainunchanged.Withoutexternalfunding,the
company'sonlysourceoffundsforgrowthisitsretainedearnings.Soitsinternalgrowthrateissimplytheratioofnew
retainedearningstobeginningofperiodassets.Newretainedearningswillequalnetincomeminusdividends,
sometimescomputedasnetincometimestheretentionrate.Theretentionrateissimplythefractionofnetincomenot
paidoutasdividends
SustainableGrowthRate
Anothermeasureofacompany'scapacityforfinancinggrowthisitssustainablegrowthrate.Thisistherateat
whichacompanycangrowif(1)itdoesnotissueanynewexternalequityand(2)itkeepsitsoperatingandfinancing
ratiosconstant.Thesustainablegrowthrateisgenerallyhigherthantheinternalgrowthrateforafirmwithleverage.
Theinternalgrowthrateiscomputedassumingnonewexternalfinancingofanykind.Bycontrast,thesustainable
growthrateiscomputedassumingnonewexternalequityinotherwords,thesustainablegrowthrateassumesnew
externalborrowinginamountsnecessarytokeepthedebtratioconstant.Thisnewborrowingsupportsmoregrowth,
whichiswhythesustainablegrowthrateishigherthantheinternalgrowthrate.
Howisthesustainablegrowthratecalculated?Itequalstheretentionratetimesthereturnonbeginningequity.
Whyisthesustainablegrowthratetiedtothereturnonequity?Toseewhy,assumenodividends,sotheretentionrate
is100%.Now,sinceoperatingandfinancingratiosarepresumedconstant,theonlywaytogrowthebalancesheetis
withnewfinancing.Newfinancingistiedtonewearnings,whichinturndeterminehowmuchnewborrowingmustbe
donetokeepleverageconstant.Salesmayonlygrowasfastasassets,givenconstantoperatingratios.Inthisway,growth
isconstrainedbytherateatwhichequitycanbeaugmentedbyearnings.Inotherwords,sustainablegrowthmustequal
thereturnonequity.
DuPontFormula
Theinternalandsustainablegrowthrates(theretentionratetimesROBAandROBE,respectively)areuseful
benchmarks.Theybothindicatethatthemoreprofitableacompanyisthefasteritcangrow,allelseequal.Theso
called"DuPontformula"isarestatementofROBEintermsofotherratios.
Qualifications
Theinternalandsustainablegrowthratesareusefulbenchmarks,butnothardconstraints.Canacompanygrowfaster
thanitssustainablegrowthrate?Certainly.How?WehavealreadyseenviatheDuPontformulathatachangeinratios
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(e.g.profitability,efficiency,orleverage)translatesintoachangeinROBEandhence,sustainablegrowth.Evenmore
fundamentally,acompanywishingtogrowfastcouldsimplyissuenewexternalequityi.e.,sellmorestocktoinvestors.
Manyhighgrowthcompaniesdoexactlythat.
Nothingsofarhasshownusthataparticulargrowthrateisoptimal.Itistruethatraisingleverageorsellingshares,for
example,permitshighergrowth.Butrepeatedincreasesinleveragecouldalsoleadtobankruptcy.Andrepeated
issuancesofnewsharesmaydiluteownership.Howfasttogrowacompanyandhowtofinancethegrowtharecomplex
managerialproblems.
Review
Thedominantthemeinthischapteristheimportanceofmanagingcash,whichmustbeunderstoodinthecontextofa
company'soperatingcycle.
Youdiscoveredtheimportanceofthecashcycleanditsrelationshiptotheoperatingcycle,particularlytheworkingcapital
accounts.Andyousawtheinterrelationshipoftheworkingcapitalaccountsinthecashcycle.
Youlearnedhowtocreateastatementofsourceandusestoanalyzethefundingofacompanyoveragivenperiod.
Youlearnedhowtocomputeinternalandsustainablegrowthratesforacompany,andtherelationshipbetweeneachof
theseandbasicfinancialratioscoveredinthepreviouschapter.
FinancialForecasting
Inprevioussectionswestudiedacompany'sperformanceandfinancialconditionbyanalyzingitspastandpresentfinancial
statements.Inthissectionwewilllookforwardratherthanbackwardandconstructprojectedfinancialstatementstogain
insightintoacompany'slikelyfutureperformanceandfinancialcondition.
Projectedfinancialstatementsareoftencalledproformastatements.Theycanhelpaddressmanyquestionsamanager
mightbeinterestedin,suchas:whatwillourfinancingrequirementsbeifwegrowsalesat10%nextyear?Ifwegrowat
10%foreachofthenextfiveyears?Whatwillhappentoearningspershareifweincreaseleverage?Willarecessioncauseus
toviolateacovenantonourbankloan?Andsoforth.
BasicIngredients
Financialforecastsandproformafinancialstatementsarebasedonafewkeyinputsthatwillcertainlyvaryfromcaseto
case,butarealwayspresent.
Abusinessforecastmaybesimpleorelaborate.Forexample,thegistofaforecastmightbesimplya10%growthinsales.
Oritmightinvolveprojectingmarketsize,penetration,acertainproductprice,competitors'reactions,andhence,market
share.Theforecastshouldbeconsistentwiththebusinessstrategyarticulatedbytopmanagement.
Givenastrategyandkeyelementsofabusinessforecast,therearepoliciestobesetinsupportofit,suchashowtomanage
workingcapitalaccounts,howmuchtospendonmarketingandpromotions,onR&D,etc.Managerssetthesepoliciesand
theproformafinancialstatementsshouldincorporatethem.
Economicfactorssuchasinflationrates,interestrates,andexchangerateswillaffectthecompany'sforecasts.
Proformasrelyonaccountingrelationshipssuchastheequivalenceofofassetsandliabilitiesplusequity,andthelink
betweenprofitandretainedearnings.
TheProcess
Onceformulated,forecastsshouldbescrutinizedandtested.Thisprocessmaybeformalandrigorousorsomewhatless
formal,dependingonhowtheforecastistobeused.Testsforreasonablenesstakemanyforms,suchascomparisonsto
pastperformance,tocompetitors,tomacroeconomicindicatorsorotherexternalbenchmarks.Ultimately,ithelpstobe
skepticalanddemandclearsupport.Forexample:
Bias,ErrorandUncertainty
Evengoodforecastsarefallibleinthesensethattheymaynotcometrue.Injudgingaforecast,itisimportantto
distinguishbetweenerrorandbias.Errorsaresimplymistakes,butoveralongperiodandmanyforecasts,wewould
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expectthatthemistakeswilltendtoevenoutsometimesthingsgobetterthanexpectedandsometimesworse.In
contrast,biasesaresystematictendenciestounderoroverestimate,andassuchtheydon'tcanceloutevenoveralong
period.Somebiasesariseunintentionally,perhapsthroughsimpleoptimismorpessimism.Othersmaybedeliberately
builtintoaforecast,forexample,toreflecta"bestcase"or"worstcase"scenario,ortoensureconservatism.Mostanalysts
willtrytogetridofunintentionalbiasesthoroughtestingandvettingofforecasts.Deliberatebiasesshouldbeexplained
andsupported.
ProFormas
Proformabalancesheetsareprojectionsofacompany'sassets,liabilities,andequity.Proformaincomestatements
containprojectionsofrevenues,costs,andprofit.Inalmostallrespects,proformafinancialstatementsarejustlikeany
regularstatements,exceptthattheyhaven'thappenedyetandmightneverhappen.Althoughhypothetical,theystillfollow
alltheusualaccountingrules:balancesheetsmustbalanceretainedearningsmustequalthepriorbalanceplusnet
incomeminusdividendsnetfixedassetsmustequalthebeginningbalancepluscapitalexpendituresminusdepreciation
andsoforth.
Tobeinformative,proformafinancialstatementsshouldbepreparedwithaclearmission.WhatamItryingtofigure
out?Forexample,acommongoalistoestimatetheamountofexternalfundingrequiredbyproposedbusinessplans.This
canbeexpressedinasimpleequation.
Theproformajustdescribedwillnottellushowtoraisetherequiredadditionalfunding.Shouldweuselongtermdebtor
shorttermdebt?Shouldweraiseequitybysellingadditionalstock?Toanswersuchquestions,wemightdevisestillmore
proformas.Tohelpusdecide,wecouldprepareproformasreflectingthedifferentpossibilitiesandthenanalyzeand
comparekeyratios,suchasleverageandcoverage,forexample.
PercentofSalesForecasting
Oneofthesimplestapproachestopreparingproformasis"percentofsales"forecasting,socalledbecauseitprojects
manyincomestatementandbalancesheetaccountsasapercentofsales.Initspurestform,itsimplyscalesall
projectionsupordownwithprojectedsales.Ifsalesareexpectedtogrow10%,thensodoeseverythingelse.
Let'sprepareandinterpretproformastatementsforGoldenStatein2008.We'lluseamodifiedversionofpercentof
salesforecasting,inwhichmany,butnotall,itemsaretiedtosalesgrowth.
First,weconsultMr.CotaandfindoutthatheexpectsGoldenState'srevenuetoincreaseby6%from2007to2008.
Nowwewillconstructproformafinancialstatementstoestimatehowmuchadditionalexternalfinancingwillbe
requiredtosupportthislevelofgrowth.
AccountsClassification
AkeystepincomputingGoldenState's2008proformastatementsistodeterminewhichaccountswethinkshould
varydirectlywithsales.Thepercentofsalesmethodclassifiesaccountsintotwocategories:
Exercise
FixedAccounts
First,let'sseehowaccountsthatdonotvarywithsalesareforecasted.Fornowwewillassumeinterestexpensesand
therevolvingcredittobefixedatlastyear'slevel.(Thereasonforthischoicewillbecomeapparentlater.Notethatfor
allaccountsthatvarywithsales,subtotalsandtotalsareinitiallyleftblankandwillbeaddedinsubsequentslides.)
HistoricalVariations
Foreachoftheaccountsthatvarywithsales,aforecastispreparedbasedoneachaccount'sexpectedrelationshipwith
sales.Thisrelationshipisofteninferredfromhistoricalfinancialstatements.Soourfirststepistoestimatethese
historicalrelationships.
ProjectingAccounts
Thefollowingtwoexamplesillustrateprojectinganaccountfortheincomestatementandbalancesheet,respectively,
usingpercentofsalesforecasting.
Let'sprojectGoldenState'scostsofgoodssold(COGS),thenextitemontheincomestatementbelowrevenue.
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Let'sexamineabalancesheetaccountnow.Wecanestimateaccountspayable,whichweexpecttovarywithsales.
Exercise
InterestExpense
Nowwecometoastandardprobleminproformapreparation.Wehaven'tmadeacarefulforecastforGoldenState's
2008interestexpenseyet,sincethisdependsonhowmuchitborrows,notonsales.Butwedon'tknowhowmuchthe
companywillborrowuntilweknowwhatitsexternalfundingneedis!Itisasthoughweneedtoalreadyknowthe
answerinordertocomputetheanswer.Fortunately,thereisasimpleprocedurewecanfollow.Inessence,wetakea
guessatinterestexpense,andthenseewhattheguessimpliesaboutfundingneeds.Thenwesupposethefunding
needismetwithdebt,andcalculateareasonableamountofinterestonallthedebt.Wecomparethat"reasonable
amount"toourinitialguess.Iftheyaren'tsame,wechangeourguessandgothroughtheprocessagain,repeating
untilthe"reasonableamount"ofinterestequalstheguessedatinterest.Let'swalkthroughtheprocessforGolden
State.
Exercise
ThemanagerMr.Cotahiredfor2005preparedsomeforecastsfor2005,usingtheactual2004financialstatements
asastartingpoint.Asanexercise,finishhisproformastatementsfor2005bycalculatinginterestexpensesand
revolvingcreditfor2005,andmakingsurethebalancesheetbalances.Assumean8percentinterestrateon
revolvingcreditandlongtermdebtaccounts.Remembertoiterateuntilyourinterestexpenseisconsistentwiththe
outstandingamountofdebtandtheexternalfundingneediszero.Reportbackwithyourfindings.
Seasonality
WenotedinprevioussectionsthatGoldenState'soperationsarehighlyseasonal.Bearinmindthattheproforma
balancesheetwejustpreparedisasofacertaindate,specifically,theendofthecalendaryear.Thenegativeexternal
fundingrequirementcorrespondstoDecember31,2008.ButweknowthatGoldenState'speakfinancingperiodis
earlier,atharvesttimeorjustafter,wheninventoryishigherandreceivableshavenotyetbeencollected.Weshould
expectthatexternalfundingrequirementsatthattimemightbequitedifferent,andmaybeevenpositive!Toaddress
thisreality,highlyseasonalbusinessesgenerallycomputequarterly,orevenmonthly,proformaforecaststomakesure
theyhaveadequatefundingattheirseasonalpeakwithoutviolatingloancovenants.
GoldenState'sExpansion
The2008proformastatementsassumed6%salesgrowth,basedonconversationswithMr.Cotaand,mostlikely,his
currentintentionsformanagingGoldenState.
However,youareinterestedinGoldenStateforitsgrowthpotential,andyouexpecttoformulatemoreambitious
growthplansifyouacquireit.
Let'swalkthroughtheprocessofcreatingsuchproformas.Thesearemorecomplexthantheonewejustlookedat,so
we'lldividetheprocessintothreesteps.
Step1
Thefirsttaskistopreparebusinessforecastsandoperatingpolicies.Keyfeaturesofanillustrativeplanforexpanding
GoldenStateare:
Normaloperationsduring2008,accordingtoMr.Cota'soperatingplan,whilepreparationsaremadetobegin
expandingin2009.
Useofthecoldstoragecapacitytoextendcanningoperationswellbeyondthecurrentseasonalpeak.
Developmentofnewproductsbasedondifferenttypesofproduceandgourmetand/orallnaturalrecipes,to
beintroducedasbrandedgoodsinlocalandregionaldistributionchannels.
Extensionofexistinglinesintoregionaldistributiontoboostsalesgrowth.
Useofthejarringlinebothtoincreaseannualoutputandtoproducenewlines.
Newactivitieswillrequireexpendituresforproductdevelopmentandmarketing,newoverhead,addedcapital
spending,additionalinventoryduebothtothenewlinesandtheextendedseason.
Theaccompanyingchartabovesummarizeskeyoperatingassumptionsassociatedwiththisexpansionstrategy.
Download
SixYearGolden
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StateProFormas
Step2
Thenextstepistoputtheoperatingforecastsintotheappropriatelinesinproformaincomestatementsandbalance
sheetsfortheperiod20092013.(For2008,wewillusetheproformaswealreadyprepared.)
Wehaveenoughinformationtocompletetheincomestatementsallthewaythrough"operatingprofit."
Onthebalancesheets,wehaveeverythingweneedfortheassetside.Wehaveallthecurrentliabilitiesexceptforthe
revolvingcredit,alongwithlongtermdebt.Inotherwords,wehaveonlyalittlemoretodotofinishthestatements.
Download
SixYearGolden
StateProFormas
Step3
DownloadSixYearGoldenStateProFormas
DownloadSixYearGoldenStateProFormas
DownloadSixYearGoldenStateProFormas
Werepeattheabovestepsfor2010andsoforth.
Uses
Let'shaveacloserlookatthesixyearforecastsforGoldenStatetoseewhattheycantellus.
Uncertainty
Allbusinessforecastsarecharacterizedbyuncertainty.Agoodanalystwillusehisorherknowledgeofthebusinessto
identifykeyuncertaintiesandtestkeyassumptions.Whatifsalesgrowby3%or10%ratherthan6%?Whatifthislevel
ofgrowthrequiresadditionalspendingonmarketing?
Threeapproachesarecommonlyusedtotestthereasonablenessofforecasts:sensitivityanalysis,scenarioanalysis,and
simulation.
SensitivityAnalysis
Sensitivityanalysisfocusesononevariableandcomputestheeffectontheplugfigure(orsomeotheritemof
interest)ofachangeinthatsinglevariable,assumingeverythingelsestaysconstant.
Let'sseewhathappensifGoldenState'ssalesweretogrowat3%,holdingallotherassumptionsconstant.
ScenarioAnalysis
Whilesensitivityanalysisstudieschangesinoneassumptionatatime,scenarioanalysiscombinesconcurrent
changesinmanyassumptions.Thecombinationsofassumptionsareintendedtocorrespondtoparticularscenarios,
choseneitherbecausetheyareparticularlylikelyorparticularlysalientinsomeotherway.
Forexample,supposeacompetingcanningcompanyopensanewfactoryinthevicinityofGoldenState'soperations.
ThisnewcompetitionalmostcertainlywouldaffectGoldenStateinmorethanoneway.Thescenariomightinclude
lowersalesvolume,theneedtolowersalesprices,competitionforlocalcrops,risingrawmaterialprices,etc.
Simulation
Finally,simulationsaresophisticatedstatisticalanalysesperformedbycomputerprogramsusingboththe
mathematicsofprobabilityandstatisticsandrawcomputingpower.Acommonversionofthissortofanalysisiscalled
MonteCarloSimulation.
Review
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Youshouldnowunderstandthebasicprinciplesunderlyingfinancialforecastsandbefamiliarwithsomesimple
techniques.Inparticular,youlearned:
Thatproformastatementsareprojectionsofacompany'sfuturefinancialstatements.Theywilldependonthe
forecastdateandtimeframe.
Financialforecastscombineseveralbasicingredients:abusinessforecast,managerialchoices,externalvariables,
andaccountingidentities.
Thesimplestproformasemploypercentofsalesforecasts,atechniquewherebymostaccountsvarydirectlywith
sales.Note,though,thatsimplicityisnotalwaysaparamountconsideration,andmanybusinessesemploymuch
moresophisticatedforecastingtechniques.
Howexternalfundingneedsmaybeestimatedusingproformafinancialstatementsusinganiterativealgorithm.
Howtotestassumptionsandoutputsforreasonableness.
TimeValueofMoneyandProjectValuation
Manycorporatedecisionsinvolveconsiderationsofvalue:howmuchisabusiness,abrand,aproject,orafacilityworth?
Evenmoretothepoint,howmuchisitworthcomparedtowhatitcosts?Acommonwaytoestimatevalueistomodelthe
businessorprojectasastreamofcashflowsexpectedtooccurovertime,andtocomputethepresentvalueofthestream.
Thisgeneralmethodiscalleddiscountedcashflow(DCF)analysisanditmaybeappliedtomanybusinesssituations.
ThischapterpresentstheprinciplesbehindDCFvaluationandthemathematicsofdiscounting.Futurechapterstreatthe
problemofhowtodevelopadiscountrateforuseinaDCFanalysisandhowtoapplythemethodologytovalueanentire
company.
Thischapteralsoexaminescommoninvestmentcriteria:netpresentvalue(NPV),internalrateofreturn(IRR),andpayback
period.Youwillseehoweachiscalculated,whateachisusedfor,andthestrengthsandweaknessesofeachasaninvestment
criterion.
Introduction
Thetimevalueofmoneyembodiesthepremisethatadollartodayisworthmorethanadollartomorrow.Adollarnot
consumedtodaymaybesavedandinvested.Consequently,adollarinvestedtodaywillbeworthadollarplusinterest
tomorrow.Thetimevalueofmoneyisexpressedbythefollowingequation:
CompoundingandDiscounting
Ifweknowpresentvaluewecanalwaysconvertittofuturevaluebyaprocesscalled"compounding".Compoundingisthe
mathematicalcomputationofhowmuchinterestwillbeearnedinthefirstyear,theninthesecondyear,including
interestoninterest,andsoforthforaslongastheinvestmentisoutstanding.Youhaveprobablyusedtheconceptof
compoundingtocalculatehowmuchyoursavingsaccountwillbeworthatsomefuturedatewhenyouwanttospendthe
accumulatedfunds.
Discountingissimplythereverseofcompounding.Whencompoundingyoubeginwithapresentvalueandturnitintoa
futurevaluebymultiplyingby(1+r)forasmanyyearsasnecessary.Whendiscounting,youbeginwithaknownfuture
valueandyoucomputeanequivalentpresentvalue,nowdividingby(1+r).Forexample,supposeyouaresavingmoney
topurchaseacar.Youwouldliketoknowhowmuchmoneyyouneedtoinvesttodayinanaccountpaying10percent
annualinterestifyouwanttobesuretohave$20thousanddollarsataspecificfuturedate.Let'sdothediscounting.
Exercise
Youdeposit$100at5%interestforthefirstyear,withtheinterestincreasingeachyearbyonepercentagepoint.What
isthevalueafterfiveyears?
Supposethatinsteadoftheannuallyescalatinginterestratesyouinvestedyour$100inanaccountthatpaidaconstant
7%annualinterestrate(theaverageoftheescalatingrates).Wouldyouhavemore,less,orthesameamountofmoney
attheendoffiveyears,comparedtothe$140.2fromthepreviousexercise?
Youwerehopingtohave$200afterinvestingforfiveyears,ratherthanthe$140.2showninthepreviousexercise.
Supposingyoucanfindaninvestmentthatpays8%annualinterestinsteadof7%,howmuchdoyouneedtoinvest
todaytoachieveyourgoal?
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PVofaCashFlowStream
Sofarwehavediscountedonlyonefuturecashflowfromfuturevaluetopresentvalue,butmanyinvestmentsinvolve
multiplecashflowsoccurringatdifferentpointsintime.Forexample,supposeyouownagovernmentbondthatwillpay
you$100todayandeachyearforthenextfouryears,atotaloffivepayments.Whatisthevalueofsuchabondtoday?It
cannotbe$500,thesumofthepayments,becauseyouwon'treceivethemalltoday.Instead,wecancomputethevalue
asthesumofthepresentvalueofeachofthefivepayments.Iftdenotesthepointintimeatwhicheachpaymentoccurs
andrdenotesthemarketinterestrateonfiveyeargovernmentbonds(let'sassumer=5%),thentheformalexpression
ofthisis:
Next,wewillapplythediscountingconceptandmathematicstovalueabusinessprojectthatGoldenStatemightwantto
undertake.
ValuingGoldenState'sJarringLineProject
MakingtheDecision
IncrementalCashFlows
Mr.Cotagivesussomecalculationsmadebythepreviousmanagershowingthenumberofjars(5,000perseason)that
thelinecanhandle,andtheexpectedwholesalepriceofajaroffruit,assumingnopriceincreases.Thesamesetof
calculationsshowstheCOGSforjarredfruit,andrevealsthatthegrossprofitmarginisthesame23%forjarred
fruitasitisforGoldenState'scanningoperations.Withthisinformation,wecancalculatetheannualincrementalgross
profitforthejarringline.
Wewillhavetopayadditionalcommissionstothesalesteamtopromoteandsellthejarredproduct.Incremental
commissionsof3%implyacostof$525peryear($17,500x0.03=$525),whichwewillsubtractfromincrementalgross
profit.
Theresultingannualincrementalcashflowis:
Theincrementaloperatingcashflowwejustcomputedcanbederivedinotherways,too.Anothercommonapproachis
toapplyataxrate(actually1minusthetaxrate)directlytothe$3,500wecomputedasincrementalgrossprofitless
commissions,andthenaddthetaxshieldassociatedwithincrementaldepreciation.
Thisisthesameresultwecalculatedabove.
Thedepreciationtaxshield,whichequalsthedepreciationchargetimesthetaxrate,issimplytheamountoftaxessaved
byvirtueofbeingabletodeductdepreciationfromourtaxableincome.
Yetanothercommonderivationoftheincrementaloperatingcashflowbeginswithtaxableincomeascomputed
previously:
Wesubtracttaxesfromthisamountasbefore(taxat36%=$540),whichgivesusincrementalnetincome.
Butnetincomedoesnotequalcashflow,becausesomeoftheexpensewechargedagainsttheprojectwasnoncash,
namelydepreciationof$2,000.Soweaddbackthenoncashdepreciationtothenetincome:
Notethatweobtainthesameannualincrementaloperatingcashflowestimateof$2,960fromallthreemethods.
NetWorkingCapital
Manybusinessprojects,suchasGoldenState'sjarringline,requireincrementalinvestmentsinworkingcapital.Thatis,
thecashcycleweexaminedinapreviouschapterisaffectedbychangesinaccountspayable,accountsreceivable,
inventory,andsoforththatcomeaboutasaresultofoperatingthejarringline.Ingeneral,wewillneedtoestimate
theseeffectsinordertocapturealloftheincrementalcashflowsassociatedwithaprojectlikethejarringline.
PuttingItAllTogether
WenowhavenearlyenoughinformationtocomputethepresentvalueofGoldenState'sjarringline,assumingwekeep
itandoperateit.
Therewillbean$800investmentininventory,followedbyincrementaloperatingcashflowsof$2,960everyyearfor
fiveyears.We'llassumethatthesecashflowsdon'tstartuntil2009,oneyearfromnow.
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InvestmentDecisionCriteria
We'vedonesomeanalysisoftheincrementalcashflowsassociatedwithGoldenState'sjarringline.Butwehavenotyet
usedthemtomakeabusinessdecisionabouttheline.Shouldwekeepitorsellit?Inthissectionwe'llexaminesome
commoncriteriausedtomakesuchdecisions,andmoregenerallytoevaluateproposedinvestments.Theyare:
Netpresentvalue
Paybackperiodanddiscountedpaybackperiod
Internalrateofreturn.
NetPresentValue
Nowweknowthepresentvalueofoperatingthejarringlineis$11,078.Towhatshouldthisfigurebecompared?It
shouldbecomparedtothevalueofthejarringlineifwedonotoperateit.Ifwedon'toperateit,itjustsitsthere,
producingnothing,soavalueof$0isonepossiblepointofcomparison.ButrecallthatMr.Cotasuggestedsellingthe
lineandtoldusitwouldfetch$10,000ifwesolditrightawayin2008.Thisisamoresensiblecomparisonthan$0.
Moregenerally,NPVisthedifferencebetweenhowmuchaprojectisworth(thePV)andhowmuchitcosts(the
investment).WhenNPVisgreaterthan0,theprojectisworthmorethanitcostsandconverselywhenNPVislessthan
0,theprojectcostsmorethanit'sworth.Accordingly,aproject'sNPVistheamountbywhichwealthorfirmvalue
increasesordecreasesifyouundertaketheproject.
Thislastobservationleadsnaturallytoapowerfulruleformakinginvestmentdecisions.Theruleis:
InvestinallprojectsforwhichNPVisgreaterthan0.
Thesearetheprojectsthatincreasewealth,becausetheyareworthmorethantheycost.Thisistheruleapersonwould
followtomaximizewealth,orthatafirmwouldfollowtomaximizeitsvalue.
ThegeneralformulaforNPVis:
TheNPVruleleadstosimpledecisioncriteria.Examineallprojectsand:
Inrealbusinesssituations,thecalculationsonwhichNPVrestsmaybeverycomplex,andinputsareestimatedwith
varyingdegreesofconfidence.Sometimespertinentconsiderationsareleftoutofthepresentvaluecalculations,simply
becausetheyaretoodifficulttoquantify.Consequently,somefirmsuseNPVasinimportant,butnotdecisiveor
exclusive,considerationintheirdecisionsaboutinvestmentopportunities.Andmanyfirmssupplementitwithother
calculationsandcriteria.Wewillpresenttwoofthem,paybackperiodandinternalrateofreturn.
PaybackPeriod
Thepaybackperiodisdefinedasthetimeittakestorecouptheoriginalinvestmentinaproject.Allelsebeingequal,
companiesprefershorterpaybackperiodsduetothetimevalueofmoneyand,perhaps,becauseofriskconsiderations.
Computingthepaybackperiodisusuallystraightforwardafterincrementalcashflowshavebeenestimated.Onesimply
computestheaccumulatedcashflowforeachyear,beginninginyearzeroandcomparestheaccumulatedcashflowto
theinitialinvestment.Thepaybackperiodisthepointintimeatwhichaccumulatedcashflowequalstheinitialoutlay.
Let'sfigureoutthepaybackperiodforGoldenState'sjarringlineproject.
ThepaybackperiodforGoldenState'sjarringprojectisapproximately3yearsand8months.
Themainadvantageofthepaybackperiodcalculationisitssimplicity.Unfortunately,itincludesnoformaltreatmentof
thetimevalueofmoney.Perhapsevenmoreseriously,itignoresallcashflowsbeyondthepaybackperiod.Soaproject
withaverylarge,butsomewhatdistant,payoffisnottreatedkindlybythiscalculation.
DiscountedPaybackPeriod
AvariationonpaybackperiodisDiscountedPaybackPeriod.Thedifferenceisthatinsteadofusingcumulativecash
flowtocalculatethepayback,oneusescumulativediscountedcashflow.Thisvariationconsidersthetimevalueof
money,butstillignorescashflowbeyondthepaybackhorizon.
Thediscountedpaybackperiodforthejarringprojectisapproximately4.5years.Asyouwouldexpect,itislonger
thanusingthenondiscountedcashflows.
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InternalRateofReturn
AnotherinvestmentcriterionisInternalRateofReturn(IRR).TheIRRisdefinedasthediscountrateatwhichthe
NPVofaninvestmentequalszero.TouseIRRasaninvestmentcriterion,onecomparesittothecostofcapital.Typically,
projectsforwhichIRRexceedsthecostofcapitalareprojectsforwhichNPV>0.
InGoldenState'sjarringproject,weusedadiscountrateof8%.Inreality,determiningtheappropriatediscountrate
reliesonanumberoffactors,suchasprevailinginterestratesandtheinherentriskinessoftheproject.Wewillconsider
howtoestimatecostsofcapitalinthenextchapter.
GoldenState'sJarringProject
UsingthediscountedincrementalcashflowsforGoldenState,wecandeterminetheIRRforthejarringproject.The
processofdetermininganIRRisiterative:applydifferentdiscountratestotheNPVcalculationuntil
NPV=0.
ExcelhasanIRRfunctiontoacceleratethisprocess.InsertthecostoftheprojectintoYear2008andapplytheIRR
functionacrosstherelevantincrementalcashflows.
WhenusingExcelorothermeansofcalculation,itiscriticaltoplacecashflowsinthecorrectperiods.
IRRandNPV
TherelationshipbetweentheNPVanddiscountratemaybeplottedonagraph.Inthecaseofthejarringlineproject,
thegraphlookslikethis:
Asthediscountrateincreases,theNPVfallsandthepointwhereitcrossesthediscountrateaxis(NPV=0)istheIRR.
Inmanycircumstances,theNPVandIRRmethodsleadtothesameconclusion.IfaninvestmenthasapositiveNPV,
itsIRRistypicallygreaterthanthecostofcapitalandviceversa.
Incaseswherethecashflowsdonotfollowatypicalpatternofoutflowfollowedbyseveralyearsofinflow,theIRR
approachcanyieldincorrectorambiguousresults.Morespecifically,incaseswherethesigns(plusorminus)ofthe
streamofcashflowschangemorethanonce,therewillbemorethanoneIRR.Byitsnature,theIRRalsoimplicitly
assumesthatinterimcashflowsthatiscashyoureceivebetweenthebeginningandtheendoftheprojectare
reinvestedforthelifeoftheprojectandyieldareturnequaltotheIRR.Thismaynotbetrueinpractice,andisnot
similarlyassumedbytheNPVcalculation.
Perpetuities
Aperpetuityisastreamofcashflowsthatoccuratregularintervalsandlastforever.Anexampleofatrueperpetuityis
theconsolbondissuedbytheBritishgovernment.Whatisthepresentvalueofaperpetuity?Tocalculateit,addupthe
presentvaluesofallthecashflowsatadiscountrateofr:
Thislookscumbersome,butfortunately,themathematicsofinfiniteseriesprovidesuswithasimpleformulaforthe
presentvalueofaperpetuitythatpaysus$1oneyearfromnow(att=1),andanotherdollareveryyearthereafterforever.
Theformulais:
Thisisaveryusefulformulaforsomebusinessesandinvestments,becauseagoingconcern,forexample,maygenerate
cashflowforaverylongtime,approximately"forever".Tousetheformulainsuchasetting,wemodifyitasfollows:
where"CF"istheamountofcashgeneratedeachyear,beginninginyearone,andristhediscountrate.
GrowingPerpetuities
Theformulaeaboveassumethecashflowremainsconstant.Thereisasimilarlysimpleformulaforthepresentvalueof
aperpetuitywherethecashflowsgrowataconstantrate,g,everyyear.Theformulais:
whereCFistheinitialcashflow,risthediscountrateandgistheconstantgrowthrateofthecashflows.Notethatwhen
g=0,thisformulareducestothesameonepresentedabove.
WewillrevisitperpetuitieswhenweperformthevaluationofGoldenStateasanentity.Fornow,itisimportanttonote
thatthegrowthrate,g,mustbelessthanthediscountrate,r.Fortunately,thisisnotanunreasonableconditionto
imposenocompany,indeednoeconomy,canproduceacashflowthatgrowsfasterthanthediscountrateforever.
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Review
Inthischapterwecoveredthetimevalueofmoneyandhowtoperformasimpleprojectvaluation.Youshouldhavean
understandingof:
Theconceptofthetimevalueofmoney.
Howtoperformdiscountingandcompoundingonasinglecashflowandcalculatethepresentvalueofastreamof
cashflows.
Theconceptofincrementalcashflows
Differentmethodsforcomputingincrementalcashflows.
NPVasaprimaryinvestmentdecisionmakingcriterion.
PaybackperiodandIRRasadditionalfinancialcharacteristicsofinvestmentproposals,andthelimitationsofeach
approach.
Howtocalculatethepresentvalueofperpetuities.
Conclusion
Congratulations!Youhavecompletedthiscourseonbasicfinancialanalysis.We'vecoveredmanytopics:financialratio
analysis,thecashcycle,sustainablegrowth,proformaforecasting,compoundinganddiscounting,andsimpleinvestment
decisioncriteria,amongothers.
Thereismoretolearnaboutthesetopics,andstillmoretopicswehavenotyetevenbegun.Nevertheless,youshouldbe
preparednowforfurtherstudyoffinanceand,inparticular,tobeginmorespecializedtopicssuchascapitalstructuretheory,
portfoliotheory,andbusinessvaluation.
Totestyourknowledgeofthematerialcoveredsofar,takethefinalexambyclickingonthetabtotheleft.Beforebeginning
theexam,however,youmaywishtotakesometimetogobackandreviewtopicsofyourchoosinganywhereinthecourse.
Takeasmuchtimeasyoulikethenwhenyou'reready,returntotheexam.
FinalExam1Introduction
WelcometothepostassessmenttestfortheHBSFinancetutorial.Thistestwillallowyoutoassessyourknowledgeofsome
basicfinancialprinciples.
Navigation:
Toadvancefromonequestiontothenext,selectoneoftheanswerchoicesor,ifapplicable,completewithyourownchoice
andclicktheSubmitbutton.Aftersubmittingyouranswer,youwillnotbeabletochangeit,somakesureyouaresatisfied
withyourselectionbeforeyousubmiteachanswer.Youmayalsoskipaquestionbypressingtheforwardadvancearrow.
PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthe
navigationalarrowsatanytime.Althoughyoucanskipaquestion,youmustnavigatebacktoitandansweritallquestions
mustbeansweredfortheexamtobescored.
Yourexamresultswillbedisplayedimmediatelyuponcompletionoftheexam.
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4/11/2016 Finance:IntroductorySection
Aftercompletion,youcanreviewyouranswersatanytimebyreturningtotheexam.
Goodluck!
FinalExam2Introduction
WelcometothesecondpostassessmenttestfortheHBSFinancetutorial.Thistestwillallowyoutoassessyourknowledge
ofsomebasicfinancialprinciples.
Navigation:
Toadvancefromonequestiontothenext,selectoneoftheanswerchoicesor,ifapplicable,completewithyourownchoice
andclicktheSubmitbutton.Aftersubmittingyouranswer,youwillnotbeabletochangeit,somakesureyouaresatisfied
withyourselectionbeforeyousubmiteachanswer.Youmayalsoskipaquestionbypressingtheforwardadvancearrow.
PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthe
navigationalarrowsatanytime.Althoughyoucanskipaquestion,youmustnavigatebacktoitandansweritallquestions
mustbeansweredfortheexamtobescored.
IMPORTANT:Takethisexamonlyaftertakingthepreviousfinalassessmentexam.Thereareonlytwofinal
assessmentexams.Thus,ifyoudidnotreceiveapassingscoreonthefirst,itiscriticalthatyoureviewthe
coursematerialscarefullybeforetakingthisexam.
Yourresultswillbedisplayedimmediatelyuponcompletionoftheexam.
Aftercompletion,youcanreviewyouranswersatanytimebyreturningtotheexam.
Goodluck!
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