HBS: Finance: Introductory Section

Test

1. pro-forma balance sheet = a projection of a company’s assets, liabilities, and equity

2. collection period = AR / (Net sales yearly / 365)

3. CAGR = (final value / original value)^(1/years)

4. increase inventory uses funds

5. Research and development expense = real activity generating value for customers

7. Free Cash Flow (FCF) = amount of cash generated by an enterprise after expenditures required to
maintain or expand its asset base as indicated in the business strategy.
= EBIT(1-tax) +non cash expenses (depreciation etc) - chnge NWC - chnge CAPEX

9. receivables turnover = Sales / value of average receivables

11. cost of capital = return you can receive on an investment with similar risk

12. In a world with no taxes, shareholders are indifferent between dividend payouts and share
repurchases.

14. companies prefer shorter payback periods to longer payback periods : False

15. decrease in accounts receivable = source of cash. Increase in accounts payable = source of cash.

16. Efficient frontier = The set of efficient portfolios that may be formed from a group of risky assets
or securities. A portfolio is said to be efficient if no other feasible portfolio offers a higher expected
return for the same risk, or lower risk for the same expected return.

16. The portfolio that offers the highest level of return for a given level of risk is called the

X Efficient frontier – not correct ???

Minimum variance portfolio

Optimal portfolio

Maximum variance portfolio

18. perpetuity growth : value = initial investment / rate of return

19. “Conservation of Business Risk” implies that a change in the capital structure of a company also
changes the amount of business risk per dollar of equity, but not the total amount of risk.

20. interval measure = average daily operating expenses divided by (current assets minus inventory).
The result is the number of days the company can continue to use its assets to meet its expenses.

=> increases with Cash increase or Receivables increase

27. All else equal, a firm with higher days in inventory will have a shorter cash cycle.

28. Competitor closing leads to Increase in sales; increase in cost of goods sold for you
Financial statements
Ratio analysis
Six basic categories:
• Growth
• Profitability
• Liquidity
• Leverage
• Efficiency
• Risk
Most financial ratios = simple comparison between items from a balance sheet and/or income
statement

Growth
A business’ growth possibilities = able to produce more cash, to become more valuable.

Has it been growing lately? How fast? How consistently?

 Annual growth rate of sales, EBIT and income

 CAGR of these

Profitability
Insufficient to simply assess if gross profit, operating profit, and net income, are positive or negative.
Need to compare profits to something:

 how much sales were required to generate a given profit?

o operating profit over sales = the operating margin.
 How large an asset base was required?
o operating profit over assets is one way to measure pre-tax return on assets

Efficiency or Activity Ratios

Asset turnover = sales / Asset (! Decide at which date you want the assets: beginning or end or
average of period)

In the example, asset turnover decreased because the previous manager invested in additional
equipment to grow the company but they never worked. Why ? will need to be investigated.

Inventory turnover = COGS/Inventory

Inventory days = 365/ Inventory turnover = Inventory/(COGS/365)

All else equal, we prefer a lower number of days in inventory, which corresponds to a higher
inventory turnover, because it needs less capital to achieve the same result, but industries vary and
inventories can achieve another goal.

Seasonality and cyclicality

Among efficiency ratios, all those involving the working capital accounts — current assets and
current liabilities — will be affected by seasonality
Cyclicality comes from business cycles — expansion and recession, for example, rather than seasons
of the year.

Liquidity
liquidity denotes "closeness to cash," and is associated with the company's ability to meet known
near-term cash obligations and/or to cope with unexpected needs for cash.

Current ratio = current assets (cash, marketable securities, and working capital items that will turn
into cash within one year.) / current liabilities (amounts owed to suppliers, employees, lenders, and
the government within a year)

Most common used liquidity ratio. A low current ratio may be an early warning of future liquidity
problems

Quick ratio = (cash + marketable securities + receivables) / current liabilities

The same but inventories are excluded from current assets, because inventory is generally
considered less liquid than receivables

Quick ratio is more affected by seasonality than current ratio.

Financial leverage or gearing

created when a company borrows money to fund its operations. Debt creates fixed financial charges
(interest and principal payments), that make a company's net earnings and cash flow more volatile.

Leverage ratios try to identify if the company utilized its capacity for borrowing and to spot possible
problems associated with over-borrowing.

Debt ratio = debt /capital = (current portion LTD + ST debt + LT debt)/ (same debt + equity)

! Different definitions of "debt" are possible: sometimes debt is defined to equal total liabilities
(everything other than shareholders' equity), or only long-term debts such as mortgages, bonds and
debentures, including their current portions, or total liabilities excluding trade-related accounts such
as accounts payable and accrued expenses. It is necessary to know whet we are talking about.

Times interest earned ratio (= "interest coverage ratio")= extent to which earnings cover interest
payments= EBIT / interest

Risk
difficult to measure using data solely from financial statements

fixed to variable costs ratio = fixed costs / var costs = (SG&A+Depreciation)/COGS

This definition assumes that all SG&A is fixed and that all COGS is variable by convention

Sales to fixed cost

Contribution margin = (revenues – var costs)/sales

Common-size Financial Statements
= sized by one parameter such as sales or in percentage rather than currency.

Common-size balance sheets typically express all items as a percent of total assets.

Common-size income statements generally express all items as a percent of net sales.

Interpretation
The computation of financial ratios is fairly mechanical but interpreting them is seldom so
straightforward.

 Which ratio to look at depends on what information you are trying to learn about a company.
It also depends on personal preferences, available data, and available benchmarks.
 Most have little or no intrinsic meaning and must be compared to other data to make sense

Time trend
Golden State's difficulties during 2005-2006
are apparent when comparing ratios over
time. Growth slowed. Profitability fell.
Efficiency dropped. Liquidity deteriorated.
Leverage increased. It is not surprising that
Mr. Cota reclaimed control of the company.
Further, the results of his efforts show in
the clear improvement of the same ratios in
2007.

Industry comparison: benchmarks against

other companies in the same business

Budgets and target: comparison of a company's actual performance to the targets set beforehand.

Rules of Thumb: for instance current ratio > 1.0

At best rules of thumb reflect a capable analyst's years of experience. At their worst, they are
subjective notions that should be challenged or at least supplemented with other data.

Qualifications
limitations: ratios based solely on financial statements overlook other crucial determinants of
performance and financial conditions. For example, market share is an important measure of
performance that cannot be computed solely from financial statements;

It may be difficult to identify truly similar companies for external comparisons;

Accounting methods may differ across otherwise similar companies, e.g., in different countries;
A given company may change accounting methods over time;

Ratios may be distorted by non-operating activities and transactions, by extraordinary events, and
discontinued operations.

Ratios may be distorted by seasonality and cyclicality;

Most ratios are computed using book values rather than market values, which may be substantially
different. For example, a debt-to-assets measure of leverage that seems high when computed in
terms of book values might be quite reasonable if a company's fixed assets are worth substantially
more than their book values.

Cash cycle and growth

Even a profitable company will experience financial problems if it runs out of cash. This is especially
true for companies that are growing quickly: Rapid growth creates a need for financing that, if not
prudently met, can precipitate a crisis or, at a minimum, retard growth.

Cash cycle
operating or net working capital (NWC) cycle.

the characteristics of the cash cycle are determined by fundamental properties of a given business,
such as Golden State's seasonal canning business. But managerial choices affect the cash cycle as
well — for example, how much credit the company chooses to extend to its customers will lengthen
or shorten the cycle.

Cash versus Profit

For example, if Golden State sells a can of peaches for more than its cost to produce, it has generated
a profit, even if the customer has not yet paid for the peaches. That is, even if Golden State hasn't
received its profit in cash, the profit has been earned, and the income statement will reflect it
accordingly. For purposes of cash management, however, it matters a great deal when Golden State
gets paid. In the same way, it matters when Golden State pays the farmer for produce, the container
company for cans, etc.
Cash cycle: Inflows and Outflows

in the long run we would expect a profitable business to have greater inflows than outflows, and
hence still less to worry about. But for most businesses, the outflows happen before the inflows.
Golden State has to buy the peaches and cans before it can sell them to a customer. This
fundamental fact creates a financing need = need for working capital. Growth will require even
more capital.

Financing need = amount of money, not a number of days. How large a loan is implied by a cash
conversion cycle of, say 15 days? It depends on the scale of operations.

Extended Cash cycle:

considering not only NWC but also financing needs

When the company is profitable, some cash will go to lenders (interest and principal payments.)
Some may go to shareholders as dividends.

Some will stay in the company and be reinvested in fixed assets, such as machinery.

issuance of new securities may bring new cash into the firm from investors rather than customers.

This new cash may be for further investment in working capital or fixed assets, or to finance losses.

We could further complicate the picture by adding taxes

Cash conversion cycle

CCC = days inventory (=Inventories/(COGS/365)) + receiveable period (=AR/(sales/365)) – payable
period (=AP/(COGS/365))

Seasonality in operations causes predictable fluctuations in working capital accounts, including cash.
To fund the seasonal peaks in working capital, many businesses, such as Golden State, rely on
revolving credit. A revolving credit facility works a lot like consumer credit cards — the company
may borrow up to some agreed-upon limit as necessary, and then repays the loan as its seasonal
needs recede. Most revolving credit agreements impose further conditions, such as limits based on
available collateral (usually receivables and inventory) and a requirement that the loan be completely
paid off for some period during each year.

Sources and use

Sources and Uses of funds statement can be prepared to monitor funding needs and patterns.

Simply take balance sheets from two different dates and subtract one from the other.

The amount by which each line in the balance sheet has changed from one date to the other is then
categorized as either a source or a use of funds.

Because balance sheets balance, sources will always be equal to uses.

Growth
• amplifies the natural need for financing implied by a cash cycle in which outflows precede
inflows.
• will need additional funds to expand capacity.
• Future growth rate depends on the market but also on its ability to obtain adequate
financing

Internal growth rate = rate at which it can grow without any new external funding

= retention rate * net income / beginning assets = retention rate * ROBA

Retention rate = 1 – dividends= fraction of earnings retained by company

Sustainable growth rate = retention rate * ROBE (return on before equity)

rate at which a company can grow if (1) it does not issue any new external equity, and (2) it keeps its
operating and financing ratios constant.

When no dividends are paid, sustainable growth must equal the return on equity.

DuPont formula
Decomposes Return on Beginning Equity in terms of profit margin, asset turnover and financial
leverage.

A change in ratios (e.g. profitability, efficiency, or leverage) translates into a change in ROBE and
hence, sustainable growth. Even more fundamentally, a company wishing to grow fast could simply
issue new external equity - i.e., sell more stock to investors.

But raising leverage or selling shares, for example, permits higher growth. But repeated increases in
leverage could also lead to bankruptcy. And repeated issuances of new shares may dilute ownership.
What particular growth rate is optimal ?

Financial forecasting
Projected financial statements are often called pro forma statements.
Goal = answer questions such as : what will our financing requirements be if we grow sales at 10%
next year? If we grow at 10% for each of the next five years, what will happen to earnings per share if
we increase leverage? Will a recession cause us to violate a covenant on our bank loan?

Basic ingredients:
Business forecast: sales growth, product price, market size, competitor reactor, market share etc

Managerial policies and decisions: how to manage working capital accounts, how much to spend on
marketing and promotions, on R&D, etc.

External eco conditions: inflation rates, interest rates, and exchange rates

Accounting identities: equivalence of assets and liabilities plus equity, and link between profit and
retained earnings.

Process: formulate forecast then test it.

Tests for reasonableness take many forms, such as comparisons to past performance, to
competitors, to macroeconomic indicators or other external benchmarks.

Error vs bias

Pro Formas
If goal = estimate external funding required by proposed business plans.

This can be expressed in a simple equation: External funding needed = projected total assets –
projected liability and equity

Percent of sales forecasting

One of the simplest approaches to preparing pro formas: it projects many income statement and
balance sheet accounts as a percent of sales. If sales are expected to grow 10%, then so does
everything else.

Account classification: which should vary with sales ?

Accounts that vary with a company's sales include most current assets and liabilities, i.e. accounts
payable, accounts receivable, accrued expenses, cost of goods sold excluding depreciation, etc. These
are elements of the operating cycle and generally tied to the level of operations.

 Cash
  AR
 Inventories
 AP
 Other accrued expenses
 Sales
 COGS
 SG&A (SG&A are mostly fixed costs, that is, they do not vary with sales, but they are unlikely
to remain fixed in the face of high growth.)

Other accounts are determined by deliberate managerial actions or contracts (such as debt
agreements), and hence may not vary directly with sales. A good example is net property, plant and
equipment, which increases with capital expenditures and decreases with depreciation.

 Depreciation
 Net fixed assets
 Current portion of LT debt
 LT debt
 Net worth

Income statement items varying with sales:

 COGS
 SG&A
 taxes

Express them as a % of sales. Some assumptions are to me made.

Projecting accounts
Balance sheet items varying with sales:

Using efficiency ratios rather than percent of sales values as assumptions makes it straightforward to
state the forecasts in terms of management's target efficiency ratios.

Cash Days sales in cash = (cash + securities) /(sales /

365)
AR Collection period
Inventories Days in inventory
AP Payables period
Other accrued expenses % of sales

If external fundings needed calculated is negative, it means no new funding is required. Makes sense
if the forecasted growth is less than internal growth rate.

Interest expense procedure

 Start with the same revolving credit and interest payment as previous year
 Calculate pro forma and need for external funding or not ?
 In our case required new funding is negative (we will repay debt), so assuming 8% interest
rate, and a new, lower revolving credit forecast,
 New revolving credit = old revolving credit – debt to repay or + new credit need
  new estimated interest expense = (Revolving credit + long-term debt + current
portion long-term debt)* interest rate

 recompute Proforma income statement.

 As interest expense falls, net income will rise => increases company net worth
2008 Net worth = 2007 Net worth + Net Income – Dividends
 Recalculate proforma balance sheet. If we still have a negative need for funding, iterate until
it equilibrates.

=>

Seasonality
Bear in mind that the pro forma balance sheet we just prepared is as of a certain date, specifically,
the end of the calendar year. The negative external funding requirement corresponds to December
31, 2008. But we know that Golden State's peak financing period is earlier, at harvest time or just
after, when inventory is higher and receivables have not yet been collected.
Pro-forma to evaluate company expansion scenarios
Evaluate an aggressive growth strategy over the next five to six years

- two possible expansions, supported by the use of the cold storage facility and the jarring line.
- possibility of developing new food lines with higher prices

Goals:

- understand the financial implications of an aggressive strategy

- use these forecasts to figure out how much funding would be required, and when
- figure out how to meet the financing need, perhaps with a combination of debt and equity
- estimate how much profit will be earned, and hence, how much you might consider paying
Mr. Cota for the company

Step 1: Selected business forecasts and managerial policies

Compute pro-forma income statement : % of sales, SG&A rising due to increased marketing then
lower

and selected balance sheet items (cash, inv, AR, AP, accrued exp) etc (assumption for days and %)

Step 2: Partially completed pro formas

put the operating forecasts into the appropriate lines in pro forma income statements and balance
sheets, based on Step 1

Step 3: interest expense iteration

 interest rate initial guess = interest rate (say 8%) times the sum of the revolving credit
balance and the current and non-current portion of long-term debt.
 Revolving credit based on cap $55,000.
 income statement recalculation
 net income impact company net worth
 recompute the required external funding as a plug figure.
 Assume this new financing need is supported with debt (costing 8%)
Uncertainty

Step 3: interest expense iterations

1- initial guess of interest expenses / revolving credit

2- proforma update
3- new ext funding computation
(Remember revolving is roughly like a credit card, and has a cap)
4- balanced final proforma

New net worth = prior net worth + net income (-dividends)

a: Partially completed pro formas, based on Step 2

Step 3b: Completed pro formas

See Excel sheet

Uncertainty
Sensitivity analysis changes in one assumption at a time for instance for sales growth 3% or 6%.

Scenario analysis combines several assumptions into scenarios, either particularly likely or salient,
for instance opening or a competitor nearby. This could halve sales growth and raise COGS as a
percent of sales to 75%

Simulations = sophisticated statistical analyses such as Monte Carlo Simulation. we assign a

probability distribution to one or more forecast variables and compute the resulting pro forma
statements. This leads to a probability distribution for the variable we are interested in, say, net
income and/or the external funding need.

Complex simulations involve many variables and probability distributions, along with estimates of
covariability. Properly constructed and interpreted, simulation analysis is a powerful technique for
understanding how uncertainty in one or more inputs affects the probability distribution of the
output.

Review – we learnt:
 pro forma statements are projections of a company's future financial statements—they will
depend on the forecast date and time-frame;
 financial forecasts combine several basic ingredients: a business forecast, managerial
choices, external variables, and accounting identities;
  the simplest pro formas employ percent-of-sales forecasts, a technique whereby most
accounts vary directly with sales; note, though, that simplicity is not always a paramount
consideration, and many businesses employ much more sophisticated forecasting
techniques;
 how external funding needs may be estimated using pro forma financial statements using an
iterative algorithm; and
 how to test assumptions and outputs for reasonableness

Time Value of Money and Project Valuation

discounted cash flow (DCF) analysis

Future value = present value * (1+ r), where r = market interest rate on a risk-free investment

For instance r = rate of return for risk-free security, US treasure bonds etc

Compounding = converting PV to FV for a number of years t : FV = PV * (1+r)^t

Discounting is simply the reverse of compounding : PV = FV / (1+r)^(t)

PV of a Cash Flow Stream: example Valuing Golden State's Jarring Line Project

- a cold storage shed and an additional small jarring line was installed
- selling it would bring $10,000
- keeping it could be used to increase production. It could be used for only five seasons, after
which its value is no greater than the cost to have it removed and taken away.
o Incremental sales
o But also incremental costs: COGS, SG&A and inventory.

Decision between money today (sell it) or over next 5 years:

Calculate incremental cash flow

 Incremental revenue
 Incremental gross profit
 But additional commissions to sales team => incr gross profit less commissions
 Incremental taxable income
 Incremental taxes
 Incremental op cash flow

Calculate NWC

 Only inventory will increase in this case – as a one-off

Decision criteria:

 Net present value. should be>0. Beware that some important effects can be left ouf of NPV
 Payback period and discounted payback period
o Payback period = time it takes to recoup the original investment in a project
o Based on incremental cash flow : ignores time-value of money
o Or on cumulative discounted cash flow: considers the time value of money,
o Both leave out any gains after the payback period !
 Internal rate of return.
o discount rate at which the NPV of an investment equals zero.
o To use IRR as an investment criterion, one compares it to the cost of capital.
o Accept projects where IRR > cost of capital
o IRR function in Excel
o IRR=Discount at which NPV = 0

relationship between the NPV and discount rate may be plotted on a graph, the NPV and IRR
methods lead to the same conclusion. If an investment has a positive NPV, its IRR is typically greater
than the cost of capital and vice versa.

Perpetuities
stream of cash flows that occur at regular intervals and last forever.

example of a true perpetuity is the consol bond issued by the British government.
PV = CF/(1+r) + CF2/(1+r)^2+ CF3/(1+r)^3+… CFn/(1+r)^n where CFi = cash generated in year i

With a constant cash flow CF : PV = CF / r

With a cash flow growing by a factor g per year: PV = CF / ( r – g ) with CF the initial cashflow