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CE Refresher

Comparative company financial data, readily


available, and your company's annual,
reports will enable you to predict the
future prospects of your industry. Here
are the necessary procedures to do so.

Part 19

How To Assess Your


Company's Progress
F. A. HOLLAND, F. A. WATSON and J. K. WILKINSON, University of Salford*

The past and present performance of your company This illustration, however, considerably oversimplifies,
can give you some indications about its future. It is wrong the life cycles of actual companies. Furthermore, the time
to assume that predicting a company's future is as scales can vary widely from one industry or company to
straightforward a matter as calculating for a single project another. Some companies, particularly in the chemical
the net present value or discounted-cash-flow rate of industry, appear to have been very successful in prolong-
return that are based on fairly accurate data. Since your ing phase II.
own prospects may depend on the future of your com- In the early phases of the life cycle of a company,
pany, it is worth making some predictions from the avail- assets are largely financed from stock and bond issues.
able data. As a company matures, retained earnings are increasingly
used to finance assets. Finally, the annual balance-sheet
Life. Cycle for a Company depreciation charges become the main source from which •
to finance assets.
The life cycle of a product was referred to in an earlier It is common practice to compare the performance of
article.1 In a similar manner, a company or an industry a company where possible with other companies in the
also tends to have a life cycle,2 which can be approxi- same area of industry, e.g., agricultural chemicals, phar-
mately represented by: maceuticals, etc. It is also preferable to compare your
own company with others in the same phase of their life
Phase IV cycle.
Phase IL I
Phase V Decisions as to the method of financing assets is the
province of the financial manager rather than the engi-
E neer. However, engineers should make themselves as
Phase II
aware as possible of the implications of such financial
Phase I decisions. This is not just to protect their job prospects
cc but is also in the interests of the company. Company
ifnance is far too important to be left entirely to financial
Time
specialists or accountants. At what point were the engi-
owned
The early life of a company is represented by phase I. neers in a blue-chip company like Rolls Royce, ren for
impending
The growth of the company tends to accelerate in phase H, its brilliant engineering, aware of its
significant group
and to decline in phase III. Phases IV and V represent bankruptcy? Could the existence of a of
erted it?
periods of relative maturity and decline, respectively. financially aware engineers have av
l responsibility
meet your authors, see Chem. Erq ., Oct. 1, 1973, p. 86. Although engineers have a professiona
it ytt
cHl.=!7,0lICAL ENG/NEERING/SZPT7MBER 16, 1974
CE REFRESHER ...

Company X Merges With Company Y on Basis of Earnings—Table I

X Company Y Company Merged Company 4111

Total assets $100,000 $100,000 $200,000

Total debtors and liabilities $ 30,000 $ 30.000 $ 60,000


Common-stock equity, par value $5 $ 50.000 $ 50,000 $112,500
Retained earnings and capital surplus $ 20,000 $ 20,000 $ 27,500
Total liabilities and stockholders' equity $100,000 $100,000 $200,000

Net worth = total assets — total debtors and liabilities $ 70,000 $ 70,000 $140,000

Net annual profit (after tax and interest) $ 20,000 $ 16,000 $ 36,000
Number of common stockholders' shares 10,000 10,000 22,500
Book value per share $7 $7 $6.22
Earnings per share $2 $1.60 $1.60
Market price per share $42 $16
Price/earnings ratio 21 10

to give the maximum possible assistance to the manage- intermediates to another in the group, the resulting verti-
ment of their company, they nevertheless should keep' cal integration can lead to a reduction in costs without
their eyes open for any obvious risks and weaknesses in the associated risk of withdrawal of essential supplies.
managerial decisions. Sales forces can also be made stronger and more effective.
• Is your company committed to a costly development A large company that obtains its income from a rela-
program on a new process or product that may bankrupt the tively wide product range is usually better able than a
company if it should fail? smaller company to take risks on launching new prod-
• Is your company likely to be taken over for its assets, and ucts, and to withstand the high percentage of failures to
are you and your colleagues likely to be faced with be expected. In the event of a failure, part of the loss
redundancy, early retirement or demotion? can be offset against income from other products, and
• Have you and your colleagues developed expertise the remainder absorbed as part of the administrative
in an area with potential for the future? If so, your overhead. A company may well decide on a merger with
company may be taken over for its technical knowhow, another that has proven products, rather than face the
and your own prospects may significantly improve. risk of failure on developing its own new products.
These and other questions are worth examining in the Clearly, a larger company can exercise greater control
light of available financial data. over a market than a smaller company, provided that
the former is not so big as to be regarded a monopoly
and so invite government action. Market research, adver-
Mergers and Consolidations
tising and distribution can all be done more effectively
Mergers and consolidations3 are frequently the result and economically by the larger organizations, and con-
of efforts by companies to initiate, prolong, or return to, trolled product wars can be staged to promote sales.
phase II of their life cycle. Companies of roughly equal Mergers are sometimes used to acquire additional
size may merge by pooling interests, including the two _ assets when it would be difficult to finance them from
managements. Alternatively, if the companies are not of internal sources. The exchange of equity can often be
equal size, the larger may purchase the smaller and take done more easily than the raising of cash. Furthermore,
over control. One way of avoiding the disappearance of new -assets can usually be obtained more quickly and
a company, as in mergers, is for the holding company cheaply by mergers than by building them from within,
to buy a controlling interest in the other company and especially in times of rapid inflation. Speed of acquisition
operate it as a subsidiary. This can be done without may be a critical factor in the penetration of a new
securing the approval of the stockholders. product or market. And with current delays in building
Mergers may be desirable for a variety of reasons. and engineering supplies, existing plant and machinery
These include: (a) taking advantage of economies of may be the motive for the merger.
scale, (b) reducing risks of various kinds, and (c) exercis- A small company may leave itself open to purchase
ing greater control over the market. if its net assets per share are high. It is then likely to
Economies of scale can be effected in the areas of prove attractive to a larger company seeking to improve
research, purchasing, production, advertising, sales, etc. its liquidity position. Fortunes have been made in recent
Larger companies can afford to spend more money than years by speculators who buy a company merely to strip
smaller ones on research and development of new prod- the easily available assets such as cash in hand or prop-
ucts and processes, essential for a company's continued erty. Such mergers usually lead to the winding up of the
existence. If one company can supply raw materials or company, and loss of jobs.
120 SEPTEMBER 16, 1974/CHEMICAL ENGINEERING
111•1111111•111•bei.

Company X Incorporates Company Z on Basis of Market Value—Table II

X Company Z Company Combined Company

$187,000 (includes
Total assets $100,000 $10,000 $77,000 goodwill)

Total debtors and liabilities $ 30,000 $ 3,000 $ 33,000


Common-stock equity $ 50,000 $ 7,000 . $ 60,000
Retained earnings and capital surplus $ 20,000 $ 94,000
Total liabilities and stockholders' equity $100,000 $10,000 $187,000

Net worth = total assets — total debtors and liabilities $ 70,000 $ 7,000 $154,000

Par value per share of common stock $5 $2 $5


Net annual profit (after tax and interest) $ 20,000. $ 3,500 $ 23,500
Number of common stockholders' shares 10,000 3,500 12,000
Book value per share $7 $2 $12.83
Earnings per share $2 $1 $1.96
Market price per share $42 $24
Price/earnings ratio 21 24

Financial Impact of Mergers smaller than company X, having only one-tenth the
amount of assets.
Financial terms are ultimately the deciding factors in The current market prices of companies X and Z are
mergers. Let us consider the simplified, vertical, balance $42 and $24 per share, respectively, which is a ratio of
sheets of companies X and Y, as shown in Table I. Ea'eh 7 to 4. Therefore, company X must give 2,000 shares of
company has the same breakdown of assets, stockholders' X for the 3,500 shares of Z at a market value of
equity and liabilities, but differs in its profits and market (2,000) ($42/share), or $84,000. The purchase consid-
prices. The balance sheet of a straight pooling-of-interests eration of $84,000 exceeds the net worth or book value
merger on the basis of earnings per share is shown in of company Z by ($84,000 — $7,000), or $77,000. This
the last column of Table I. difference is known as goodwill. It does not mean good-
Stockholders in company X receive five new shares will in its normal sense but represents the additional
earning $1.60 per share, for four old shares earning $2 money paid for a company that has the ability to earn
per share, which leaves their earnings unchanged. Stock- higher than normal profits. Goodwill is an intan gible
holders in company Y receive one new share earning asset and should be written off if its value is likely to
$1.60 per share, for one old share earning $1.60 per share, decrease as a consequence of the merger.
which also leaves their earnings unchanged. Note that Perhaps, company Z has a unique market for a partic-
in Table I the resultant increase in common-stock equity ular product that will give .company X an immediate
corresponds to an equal decrease in capital surplus since advantage over its other competitors. However, if com-
this has effectively financed the issue of free stock to pany X could be in the same business situation in five
holders of the original shares. It is not possible to predict years without the purchaSe of company Z, then the good-
what the market price of the new shares will be, and will should be written off over a five-year period. On the
this is indicated by a question mark in Table I. . other hand, if the goodwill represents customer loyalty
Notice that a major controlling interest of $40,000 in to company Z, which is immediately lost, the goodwill
stock of company X becomes a minority holding in the may have to be depreciated in the first year. Such a
merged group. Therefore, there is often a tendency to writeoff is not normally allowable for tax.purposes, and
sell some or all of the new stock after a merger. This will be treated as an expense.
will depress the logical market price of ($420,000 -1- The stockholders in company Z receive four new
$160,000)/22,500 = $25.78 per share, and decrease the shares earning $1.96 per share, as shown in Table II, i.e.
associated price/earnings ratio below the value of (4)($1.96) = $7.84, for seven old shares earning $1 per
$580,000/$36,000 = 16.11. share, i.e. $7, making them better off by 120 per old
If the merger had been based on the market price per share. In contrast, the original stockholders of company
share rather than the earnings per share, the stockholders X have had their earnings decreased from $2 to $1.96
of company X would have gained in earnings at the per share.
expense of the stockholders of company Y, who would However, the data in Table II present an overly sim-
have suffered a decrease in earnings. The merger may plified picture. If the management of company X has
result in a sufficiently high market price per share to more made a shrewd purchase, then the earnings should exceed
than compensate the stockholders of company Y. the combined earnings of the two companies, so that the
er
Let us now consider the straight purchase of company . stockholders of both companies X and Z will be bett
justed if
Z by company X on the basis of market price, as shown off. The new earnings will also have to be ad
nse—and
in Table II. In contrast to company Y, company Z is much the writeoff of goodwill is charged as an expe
121
CHEMICP.A.. ENGINEEP.:NG 'SEPTEIVISER 16, 1974
CE REFRESHER ..

Comparative Ratios for Selected U.S. Industry Groups for 1972-Table III

Plastic
Industry Agricultural Industrial Petroleum Materials and
Chemicals Drugs Chemicals Refining Synthetics

Number of companies 43 67 68 51 39
Row Ratio

Current assets 1.92 2.78 2.59 1.68 2.28


1 , ratio
Current debt (1.34, 3.37) (2.16, 3.49) (1.82, 3.25) (1.44, 2.08) (1.73, 3.05)

Net profit x 100 % 2.51 6.10 3.82 5.03 4.14


2
Net sales (1.66. 4.21) (2.48, 9.31) (1.91. 6.29) (2.63, 6.89) (2.54, 6.40)

Net profit x 100 6.77 12.76 9.71 9.86 11.30


3 %
Net worth (4.48, 11.09) {4.46, 20.54) (5.35, 14.39) (5.76, 12.68) (6.36, 18.17)

Net profit x 100 % 15.02 18.14 16.66 31.24 20.61


4
Net working capital (8.39, 26.87) (8.97, 28.97) (8.00, 26.29) (20.49. 54.90) (10.85, 32.81)

Net sales 2.90 2.01 2.24 1.91 2.84


5 tio
Net worth' ra (2.14, 4.75) (1.59, 3.06) (1.70, 3.37) (1.45, 3.66) (1.99, 4.22)

Net sales 4.50 3.19 4.34 8.16 5.21


ratio
Net working capital' (3.25, 7.17) (2.56, 4.33) (3.18, 6.37) (5.54, 11.12) (4.22, 7.96)

52 60 61 55 58
Collection period, days
(33, 97) (71, 45) (68, 48) (81, 44) (65, 47)

Net sales 9.5 5.3 6.5 11.5 8.7


ratio
(5.7, 17.3) (4.2, 7.3) (4.7, 8.7) (8.9, 15.0) (5.9. 12.3)
Inventory

Fixed assets x 100 41.8 47.8 73.8 103.9 63.6


,%
(74.3, 21.5) (63.8, 31.8) (102.3, 48.1) (124.4, 81.5) (89.9, 32.0)
Net worth

Current debt x 100 56.4 35.7 38.3 39.1 44.8


10 %
(124.7, 25.0) (61.3, 23.4) (66.1, 25.0) (55.1, 26.5) (67.5, 27.1)
Net worth

Total debt x 100 151.1 66.3 82.1 71.0


11 %
(260.8, 58.3) (127.0, 41.7) (136.7, 51-3) (128.7, 55.6)
Net worth
Inventory x 100 % 49.2 62.9 73.9 73.3
12
(121.5, 32.1) (79.9, 49.8) (95.7, 53.0) (100.1, 52.6)
Net working capital

Current debt x 100 139.4 95.8 101.0 224.7 132.9


13
(223.2, 109.2) (132.4, 66.4) (164.9, 77.8) (293.1, 156.6) (226.5, 84.3)
Inventory

Funded debt x 100 % 39.2 30.9 73.2 152.2 62.6


14
Net working capital (85.9, 11.1) (82.5, 9.8) (112.9, 47.4) (210.7, 88.3) (103.7, 24.4)

Source: Dun's Review, Nov. 1973. With permission of Dun & Bradstreet. Inc.
Single bold number is median value. Numbers in parentheses are lower and upper quartile values. respectively.
umailipMVIRO M MOmum.milmfilikanWIIHMhMERUMUWWWWW MU M MIWW4MMIIIIIMMUMOMMUMUMINOWIRMUMMIIIMUM M UNIMMIUMMUMMINIMOMMIIMIIMMIIMI M MOMMUMUMMUMMIIRM

they cannot be offset, for example, by the sale of redun- ratio is given-together with the lower and upper quartile
dant capital assets. values, respectively, in parentheses.
Again, it is not possible to predict what the market Row 1 in Table III is the:
price of the new shares will be, and this is indicated by
a question mark in Table H. Current Ratio = Current Assets (1)
Current Liabilities

Comparative Company Data which was discussed in Part 17 of this series. 4


Row 2 in Table III is the profit margin (PM):
Although it is not an easy matter to predict your com-
Net Annual Profit
pany's future with a high degree of accuracy, some-excel- (PM) = (2)
lent comparative data -are available to help you do so. Revenue From Annual Sales

Table III gives the comparative company data that which was discussed in Part 18.5 In this case, the net profit
have been compiled by Dun & Bradstreet for various referred to is the net annual profit after tax and de preci-
types of processing industries. The median value for each ation, ANNP. The net sales ,is the revenue from annual

122 SEPTEMBER 16, 1374/CHEMICAL ENGI NEERING


111111111111111111111111111111111111111111111111e141111111111111111111111.111111111111111111 1111111111111111111111111111IIIIIIIIIIIIIIIIIIIIIIMIIIIIIt11111M1111411111111111111 1111101111114111111111111111111111eilialeiNinit11111111 511111111111111111111111111 1111111111111111,111t111111111111111111111111111111111e11111111111111111111111111111111

Balance Sheet for U.S. Manufacturers of Industrial Ratios for Bloggs Industrial
Inorganic Chemicals-Table IV Chemical Co.-Table V
Assets % Liabilities: No. Ratio
= 2.60
Cash 4.3 Short-term due to banks 5.6 1. Current Assets
Marketable securities 2.2 Due to trade 14.5 Current Debt
Net receivables 26.2 Income taxes 3.1
( Net Profit)
Net inventory 24.6 Current maturities long-term 2. 100 = 4.00
Net Sales
All other current assets 0.9 debt 2.1
Total current assets 58.3 All other current liabilities 5.0 Net Profi
36.3 30.3 3. ( t100
)100 = 10.0
Fixed assets Total current debt Net Worth ,
All other noncurrent assets 5.4 Noncurrent debt unsub-
ordinated 18.3 Net Profit )
4. 100 = 18.18
Total unsubordinated debt 48.6 Net Working Capital
Subordinated debt 3.1
Net Sales
Tangible net worth 48.3 5 = 2.50
Net Worth
Total liabilities and
Total assets 100.0 stockholders' equity 100.0 Net Sales = 4.50
6.
Source: Abridged from "Annual Statement Studies, 1973 Edition," Copyright 1973 by Robert Morris Associ - Net Working Capital
ates, Philadelphia, Pa. The composite figures for each industry shown in the RMA studies may not be
representative of that entire industry, and they should not be automatically considered as representative norms.
7. Collection Period =
1111111{41111111111111111111111111111111111111111H11111111111111i111111111111111111111;111111111111111111111111111611111111111111111111111111{111111111111111111111111111111111111L1111411111111111t11111111111111111111111111111111111{11111111i Accounts Receivable =
61 days
Sales per Day

8. Net Sales - 7.14


1111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111111ililili111111111111111111111111‘1111111111111111111111111111111111l11111111t11111111i111111111111111111111111
Inventory

9.f Fixed Assets 1


100 = 74.00
Bloggs Industrial Chemical Co.-Table VI Net Worth I
(Balance Sheet on Dec. 31, 1973) 10. (Current Debt 1 =
100 35.00
Liabilities and Net Worth
Assets Stockholders' Equity
(Total Debt)
11
1Net Worth 113° 65-00
Current Asssets Liabilities
Cash 0.057 A, Current debt 0.140 An ( Inventory
Accounts receivable 0.167 A, 0.120 AS 12. 100 = 63.00
Long-term debt
Inventory 0.140 As Net Working Capital)
( Current Debt
13.
Total current assets 0.364 As Total debt 0.260 A, 100 = 100.00
Fixed assets 0.296 As \ Inventory I
Net worth 0,400 A,
Total liabilities and Funded Debt
14. ( Working Capital
Net )100 = 76.50
Total assets 0.660 As stockholders' equity
0.660 As
vaiiiiiiiiiiiimeisiiiitiiiiiille1111111111111111111111■1111111111i111111111111111111Meallite1111111111

sales, A3, after deductions for returns, allowances and The funded debt (referred to in row 14) consists of
discounts from gross sales. mortgages, bonds, debentures, serial notes, or other obli-
Row 3 in Table III is the return on equity (ROE): gations with maturity of more than one year from the -
statement data.
( NetAnnual Profit ) 00
(ROE) = 1 (3) Robert Morris Associates7 also compiles extensive
Stockholders' Equity
comparative company data for various industries. In
which was also discussed in Part 18.5 In this case, the addition to ratios similar to the Dun & Bradstreet ratios,
net worth is the tangible net worth representing the sum shown in Table III, Robert Morris Associates gives very
of the preferred and common stocks, surplus and un- useful breakdowns of assets and liabilities for various
divided profits or retained earnings, less any intangible industries. Table IV shows a breakdown of assets and
items such as goodwill, etc. liabilities for U.S. manufacturers of industrial inorganic
Row 7 in Table III is the: chemicals for 1972.
Average Collection Period =
(4) Application of Overall Company Ratios
Average Value of Accounts Receivable
One of the best ways for an engineer to develop an
Revenue From Sales per Day

Eq. (4) was discussed in Part 17.4 understanding of overall company ratios is to build up
123
CHEMICAL ENGINEERING/SEPTEMBER 16, 1974
CE REFRESHER...

a balance sheet for a hypothetical firm, Sloggs Industrial could be met by sale of the inventory, which takes
Chemical Co. The various ratios for this firm are listed in (0.140/13/As)(365), or 51 days.
Table V. Assuming that current debtors are due for payment
The balance sheet shown in Table VI has been built within 61 days, the same as the time allowed to creditors, no
up from the ratios in Table V in terms of the revenue bankruptcy petitions are likely.
from net annual sales, As,. The profit of 10% (indicated by ratio 3 in Table V)
We calculate the following values for the right-hand will be reduced by any dividend due to preferred stock-
side of the balance sheet: holders, because such payments are not part of fixed-debt
expenses; the residue is shared among the ordinary
From ratio 5: Net Worth = As/2.50 = 0.4,4s
stockholders. If all the long-term debts were in redeem-
From ratio 11: Total Debt = (0.4A5)(0.65) = 0.26As From
able 6% preferred shares, then (from ratio 3) the net
ratio 10: Current Debt = (0.4A5)(0.35) = 0.14A, annual profit (after tax) is: AN„ = 0.10(0.40As), or
Long-Term Debt =. Total Debt — Current Debt
0.04A5. Interest due on preferred shares is 0.06(0.12A5),
or 0.0072A5. Therefore, the earnings for the ordinary
Long-Term Debt = 0.26As — 0,14A5 = 0.12,4s
shares are:
We now calculate the following values for the left-hand 0.04A5 — 0.0072A5 =
side of the balance sheet: 0.1171
0.4,4, — 0.12As
From ratio 9: Fixed Assets = (0.4,45)(0.74) = 0.29621s From This value corresponds to 11.710/5 of common stock-
ratio 1: Cu:rrent Assets = (0.14A5)(2.60) = 0.36413 From holders' equity.
ratio 8: Inventory = A3/7.14 = 0.14A5
Assuming that available interest rates offered by banks,
governmen't., etc., for no-risk investment of capital are
From ratio 7: Accounts Receivable = (As/365)(61) = 0.167A5
10%, then the maximum economic market price of $100-
Cash and Short-Term Investments = Total Current Assets — stock units in Bloggs Industrial Chemical Co. is about
(Inventory + Accounts Receivable) $117. If all the debt is in bonds, etc., then the earnings on
Cash and Short-Term Investments = ordinary stock would be 100/$ of net worth, and the
0.364A5 = 0.307,43 = 0.057A5 maximum economic price of the stock would be about
$100 unless stock prices are expected to rise.
In addition to the data for the balance sheet, we can
Other ratios, such as the financial ratios discussed in
calculate the net annual profit (after tax), i.e. ratio 2, to be:
Part 18,5 can easily be deduced from those listed. For
ANN? = 0.04As.
example, the return on assets, (ROA), and the asset turn-
In practice, the ratios are obtained from the informa-
over ratio, (ATR), are:
tion published in the balance sheet. The advantage of
the above presentation for the engineer is that it relates NetT Anniua l Profit)mo = (0.04As)
( OA) = ( R100 = 6.06
everything to the revenue from net annual sales and, Assets ‘0.66/45
hence, underlines the importance of sales. Many engi- (Revenue From Annual Sales
neers tend to neglect this because they consider sales to (ATR) = \100
Total Assets
be the major unknown in process evaluation. By contrast,
(ATR) = (As/0.66A5)100 = 151.5
the marketing director will consider his sales-revenue
potential to be known with reasonable accuracy as a The lower quartile, median, and upper quartile listed
function of selling price. He will consider production cost in Table III are those at which the cumulative proba-
to be the significant unknown variable in the profit equa- bilities of achieving those values are 25%, 50% and 75%,
tion. This presentation simplifies the approach for the respectively. Since such curves become asymptotic to plus
engineer, but it is dangerous to extrapolate too far from or minus infinity at 0% and 100% probability, the proba-
the current sales revenue. bility curves for each ratio can be sketched in by the
Careful study of the ratios can produce many infer- methods of weighted assessments in a manner similar to
ences as to the health of the company. For example, the that outlined in Part 10.6
rra nr rl Al-tt ro tin. I TIAN fk,