Professional Documents
Culture Documents
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2.1 FINANCIAL ANALYSIS
Financial analysis is an evaluation of both a
firm’s past financial performance and its
prospects for the future.
Typically, it involves an analysis of the firm’s
financial statements and its flow of funds.
Financial statement analysis involves the
calculation of various ratios. It is used by such
interested parties such as :
Creditors,
Investors, and
managers to determine the firm’s financial position
relative to that of others.
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Objectives of Analysis for Creditors
A creditor is ultimately concerned with the ability of an
existing or prospective borrower to make interest and
principal payments on borrowed funds.
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Objectives of Analysis for Investors
An investor attempts to arrive at an estimation of a
company’s future earnings stream in order to attach a
value to the securities being considered for purchase
or liquidation.
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Objectives for Analysis for Management
Management relates to all questions raised
by creditors and investors.
Management must also consider its
employees, the general public, regulators,
and the financial press.
Looks to financial statement data to
determine
How well has the firm performed and why?
What operating areas have contributed to
success and which have not?
What are strengths and weaknesses of the
company’s financial position?
What changes should be implemented to
improve future performance?
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FINANCIAL STATMENT ANALYSIS
The financial statements of an enterprise
present the summarized data of its assets,
liabilities, and equities in the balance sheet and
its revenue and expenses in the income
statement.
The financial statements are sources of data for
financial statement analysis
Balance Sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flows
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Financial Analysis …
Various measuring instruments may be used to
evaluate the financial health of a business, including
Horizontal, Vertical, and Ratio analyses.
financial analyst uses the ratios to make two types of
comparisons:
(a) Industry Comparison:- The ratios of a firm are
compared with those of similar firms or with industry
averages or norms to determine how the company is
faring relative to its competitors.
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(b) Trend Analysis:-A firm’s present ratio is
compared with its past and expected future
ratios to determine whether the company’s
financial condition is improving or deteriorating
over time.
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2.1.1. RATIO ANALYSIS
It is essential to compare figures from different
categories.
Ratios are tools, and their value is limited when
used alone. The more tools used, the better the
analysis.
So to, we need to be skilled with the financial tools
we use.
There are many ratios that an analyst can use,
depending upon what the user considers to be
important relationships.
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RATIO TYPES
Financial ratios can be classified into five
groups:
A. Liquidity ratios
B. Activity ratios
C. Leverage ratios
D. Profitability ratios
E. Market value ratios
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A. Liquidity Ratios
Liquidity ratios measure a firm’s ability to meet
cash needs as they arise-ability of a firm to meet
near-term demands for cash
Should include analysis of selected financial ratios and
a comparison with industry averages
Analyzing corporate liquidity is especially important to
creditors.
Liquidity ratios include:
Current ratio
Quick or acid-test ratio
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Current Ratio
Current Assets
Current liabilities
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Example- Consider Financial statements of Micro Drive
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Example
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CR=Current asset/current liabilities
=$1000/310=3.2, industry average is 4.2
Is the current ratio of Micro Drive good or bad? Sometimes the answer
depends on who is asking the question.
For example, suppose a supplier is trying to decide whether to extend
credit to Micro Drive.
In general, creditors like to see a high current ratio.
If a company is getting into financial difficulty, it will begin paying its
bills (accounts payable) more slowly, borrowing from its bank, and so
on, so its current liabilities will be increasing.
If current liabilities are rising faster than current assets then the current
ratio will fall, and this could spell trouble.
Because the current ratio provides the best single indicator of the extent
to which the claims of short-term creditors are covered by assets that
are expected to be converted to cash fairly quickly, it is the most
commonly used measure of short-term solvency.
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Now consider the current ratio from the perspective of a
shareholder.
A high current ratio could mean that the company has a lot of
money tied up in non productive assets, such as excess cash or
marketable securities.
Or perhaps the high current ratio is due to large inventory
holdings, which might well become obsolete before they can be
sold.
Thus, shareholders might not want a high current ratio.
An industry average is not a magic number that all firms should
strive to maintain-in fact, some very well-managed firms will be
above the average, while other good firms will be below it.
However, if a firm’s ratios are far remote from the averages for its
industry, this is a red flag, and analysts should be concerned
about why the variance occurs.
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Current assets - Inventory
Quick or Acid-Test Ratio Current liabilities
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B. Activity (Asset management) Ratios
Asset management ratios measure how effectively a firm is
managing its assets.
If a company has excessive investments in assets, then its
operating capital will be unduly high, which will reduce its free
cash flow and ultimately its stock price.
On the other hand, if a company does not have enough assets
then it will lose sales, which will hurt profitability, free cash flow, and
the stock price.
Therefore, it is important to have the right amount invested in
assets.
Activity ratios include
i. Inventory Turnover
ii. Average Collection Period
iii. Fixed Asset turnover
iv. Total Asset turnover
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i. Inventory Turnover
Measures firm’s efficiency in managing its inventory.
It measures how fast the inventory is turned over to produce the
years sales.
Inventory turnover ratio = Sales/Inventories
=$3,000/$615 = 4.9, Industry average = 9.0
As a rough approximation, each item of Micro Drive’s inventory
is sold out and restocked, or “turned over,” 4.9 times per year,
much lower than the industry average.
This suggests that Micro Drive is holding too much inventory.
High levels of inventory add to net operating working capital
(NOWC), which reduces FCF, which leads to lower stock prices.
In addition, Micro Drive’s low inventory turnover ratio makes us
wonder whether the firm is actually holding obsolete goods not
worth their stated value.
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Inventory turnover
Note that sales occur over the entire year, whereas
the inventory figure is measured at a single point in
time.
For this reason, it is better to use an average inventory
measure.
If the firm’s business is highly seasonal, or if there has
been a strong upward or downward sales trend
during the year, then it is especially useful to make
some such adjustment.
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ii. Average Collection Period
Also called Accounts Receivable Turnover or Days Sales Outstanding.
Shows the average length of time that a firm must wait after making a sale, but
before receiving cash.
Measures efficiency of firm’s collection and credit policies.
DSO = Receivables / (Annual sales /365)
=375 /(3000/365)
= 45.6 days = 46 days
Micro Drive has 46 DSO, well above the 36-day industry average
Micro Drive’s sales terms call for payment within 30 days.
The fact that 46 days of sales are outstanding indicates that customers, on
average, are not paying their bills on time.
As with inventory, high levels of accounts receivable cause high levels of
NOWC, which hurts FCF and stock price.
A customer who is paying late may well be in financial trouble, in which
case Micro Drive may have a hard time ever collecting the receivable.
Therefore, if the trend in DSO has been rising but the credit policy has not
been changed, steps should be taken to review credit standards and to
expedite the collection of accounts receivable.
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Net sales
iii. Fixed Asset Turnover Net property, plant, equipment
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Net sales
iv. Total Asset Turnover
Total assets
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C. DEBT MANAGEMENT/ Financial Leverage Ratios
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Total liabilities
i. Debt Ratio
Total assets
The ratio of total liabilities to total assets is called the debt ratio,
or sometimes the total debt ratio.
Considers the proportion of all assets that are financed with
debt.
It measures the percentage of funds provided by current
liabilities and long-term debt:
Debt ratio = Total liabilities/Total assets
=$310 + $754
$2,000
= 53.2%; Industry average = 40.0%
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Creditors prefer low debt ratios because the lower the
ratio, the greater the cushion against creditors’ losses
in the event of liquidation.
Stockholders, on the other hand, may want more
leverage because it magnifies their return.
Micro Drive’s debt ratio is 53.2% but its debt ratio in the
previous year was 47.6%, which means that creditors
are now supplying more than half the total financing.
In addition to an upward trend, the level of the debt
ratio is well above the industry average.
Creditors may be reluctant to lend the firm more
money because a high debt ratio is associated with a
greater risk of bankruptcy.
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Some sources report the debt-to-equity ratio,
defined as:
Debt-to-equity ratio =Total liabilities/(Total assets − Total liabilities)
= $310 +$754 / ($2,000 − ($310 + $754)
= 1.14; Industry average = 0.67
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ii. Times Interest Earned (TIE)
Earning Before Interest and Tax (EBIT)
Interest expense
Indicates how well operating earnings cover fixed
interest expenses, also called the interest coverage
ratio.
Times-interest-earned (TIE) ratio for Micro Drive
=$283.8/$88 =3.2 times, Industry average = 6.0
The TIE ratio measures the extent to which operating
income can decline before the firm is unable to meet
its annual interest costs.
Failure to meet this obligation can bring legal action
by the firm’s creditors, possibly resulting in bankruptcy.
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Times Interest Earned ratio
Note that Earnings Before Interest and Taxes (EBIT),
rather than Net Income, is used in the numerator.
Because interest is paid with pre-tax dollars, the firm’s
ability to pay current interest is not affected by taxes.
Micro Drive’s interest is covered 3.2 times.
The industry average is 6, so Micro Drive is covering its
interest charges by a relatively low margin of safety.
Thus, the TIE ratio reinforces the conclusion from our
analysis of the debt ratio that Micro Drive would face
difficulties if it attempted to borrow additional funds.
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iii. Fixed Charge or EBITDA Coverage ratio
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EBITDA coverage ratio for Micro Drive = $383.8 + $28
$88 + $20 + $28
= $411.8
$136
= 3.0 times, Industry average = 4.3
Micro Drive had $383.8 million of earnings before interest, taxes,
depreciation, and amortization (EBITDA).
Also, lease payments of $28 million were deducted while calculating
EBITDA.
That $28 million was available to meet financial charges; hence
it must be added back, bringing the total available to cover fixed
financial charges to $411.8 million.
Fixed financial charges consisted of $88 million of interest, $20 million of
sinking fund payments, and $28 million for lease payments, for a total of
$136 million.
Therefore, Micro Drive covered its Fixed Financial Charges by 3.0 times.
However, if EBITDA declines then the coverage will fall.
Moreover, Micro Drive’s ratio is well below the industry average, so again
the company seems to have a relatively high level of debt.
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The EBITDA coverage ratio is most useful for relatively
short-term lenders such as banks, which rarely make
loans (except real estate-backed loans) for longer
than about 5 years.
Over a relatively short period, depreciation-
generated funds can be used to service debt.
Over a longer time, those funds must be reinvested to
maintain the plant and equipment or else the
company cannot remain in business.
Therefore, banks and other relatively short-term
lenders focus on the EBITDA coverage ratio, whereas
long-term bondholders focus on the TIE ratio.
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D. PROFITABILITY RATIOS
Profitability ratios measure the overall performance of
a firm and its efficiency in managing assets, liabilities,
and equity.
Profitability is the net result of a number of policies and
decisions.
The ratios examined thus far provide useful clues as to
the effectiveness of a firm’s operations, but the
Profitability ratios go on to show the combined effects
of liquidity, asset management, and debt on operating
results.
Profitability ratios include
Net Profit Margin (PM)
Basic Earnings Power (BEP)
Return on total Assets (ROA) or Return on Investment (ROI)
Return on Equity (ROE)
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i. Net Profit Margin: %age of income from a birr amount of sale.
The net profit margin, which is also called the profit margin on sales.
Net profit margin =Net income available to common stockholders/Sales
=$113.5/$3,000 = 3.8%; Industry average = 5.0%
Micro Drive’s net profit margin is below the industry average of 5%, but why
is this so?
Is it due to inefficient operations, high interest expenses, or both?
Instead of just comparing net income to sales, many analysts also break
the income statement into smaller parts to identify the sources of a low net
profit margin.
For example, the operating profit margin is defined as
Operating Profit Margin = EBIT/sales
The operating profit margin identifies how a company is performing with
respect to its operations before the impact of interest expenses is
considered.
Some analysts drill even deeper by breaking operating costs into their
components.
For example, the gross profit margin is defined as
Gross profit margin = (Sales − Cost of goods sold)/ Sales
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ii. Basic Earnings Power (BEP)
Basic earning power (BEP) ratio = EBIT/ Total assets
=$283.8/$2,000 =14.2%; Industry average= 17.2%
This ratio shows the raw earning power of the firm’s
assets before the influence of taxes and leverage, and it
is useful for comparing firms with different tax situations
and different degrees of financial leverage.
Because of its low turnover ratios and low profit margin
on sales, Micro Drive is not getting as high a return on its
assets as is the average company in its industry.
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iii. Return on Total Assets (ROA)
The ratio of net income to total assets measures the
return on total assets (ROA) after interest and taxes.
This ratio is also called the return on asset.
Return on total assets (ROA) = Net income available to
common stockholders/Total assets
=$113.5/ $2,000 = 5.7%; Industry Average = 9.0%
Micro Drive’s 5.7% return is well below the 9% average
for the industry.
This low return is due to
1. the company’s low Basic Earning Power and
2. high interest costs resulting from its above-average use of debt;
both of these factors cause Micro Drive’s net income to be
relatively low.
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iv. Return on Equity (ROE)
Measures rate of return on stockholders’ investment
The ratio of net income to common equity
ROE = Net income available to common stockholders/Common equity
=$113.5/$896 = 12.7%; Industry average =15.0%
Stockholders invest to earn a return on their money,
and this ratio tells how well they are doing in an
accounting sense.
Micro Drive’s 12.7% return is below the 15% industry
average, but not as far below as its return on total
assets.
This somewhat better result is due to the company’s
greater use of debt.
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E. MARKET VALUE RATIOS
Market value ratios are a way to measure the value
of a company’s stock relative to that of another
company.
Market value ratios relate a firm’s stock price to its
Earnings,
Cash Flow, and
Book Value per share.
Includes
Price/Earnings (P/E) Ratio:
Price/Cash Flow Ratio
Market/Book Ratio
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i. Price Per Earnings(P/E) Ratio
Shows how much investors are willing to pay per birr of
reported profit (Current earnings).
Relates earnings per common share to the market price at
which the stock trades, expressing the “multiple” that the
stock market places on a firm’s earnings
Micro Drive’s stock sells for $23, with an earnings per share (EPS) of
$2.27.
P/E ratio = Price per share/ Earnings per share
= $23.00/ $2.27 = 10.1; Industry average = 12.5
P/E ratios are higher for firms with strong growth prospects, other
things held constant, but they are lower for riskier firms.
Because Micro Drive’s P/E ratio is below the average, this suggests
that the company is regarded as being somewhat riskier than most,
as having poorer growth prospects, or both.
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ii. Price/Cash Flow Ratio
Stock prices depend on a company’s ability to
generate cash flows.
Consequently, investors often look at the price/cash
flow ratio, where cash flow is defined as net income
plus depreciation and amortization:
Price/cash flow ratio = Price per share/ Cash flow per share
=$23.00/$4.27 = 5.4; Industry average = 6.8
Micro Drive’s price/cash flow ratio is also below the
industry average, once again suggesting that its
growth prospects are below average, its risk is above
average, or both.
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iii. Market Per Book value(M/B) Ratio
Shows how much investors are willing to pay for Book
value of a firm.
The ratio of a stock’s market price to its book value
gives another indication of how investors regard the
company.
Companies with relatively high rates of return on
equity generally sell at higher multiples of book value
than those with low returns.
Book value per share = Common Equity/Shares Outstanding
=$896/50 = $17.92
Divide the market price by the book value to get a
market/book (M/B) ratio of 1.3 times:
Market/book ratio (M/B) = Market price per share/Book value per share
= $23.00/ $17.92 = 1.3; Industry average = 1.7
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Investors are willing to pay relatively little for a dollar of Micro
Drive’s book value.
The average company in the S&P 500 had a market/book ratio of
about 2.50 in early 2009.
Since M/B ratios typically exceed 1.0, this means that investors
are willing to pay more for stocks than their accounting book
values.
The book value is a record of the past, showing the cumulative
amount that stockholders have invested, either directly by
purchasing newly issued shares or indirectly through retaining
earnings.
In contrast, the market price is forward-looking, incorporating
investors’ expectations of future cash flows.
For example, in early 2009 Alaska Air had a market/book ratio of
only 0.81, reflecting the airline industry’s problems, whereas
Apple’s market/book ratio was 3.45, indicating that investors
expected Apple’s past successes to continue.
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Relating the Ratios-The Du Pont System
Is helpful to complete the evaluation of a firm by
considering the interrelationship among the individual
ratios
(4)
(3) Financial (5)
Return on investment leverage Return on equity
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Return on Equity =
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USES AND LIMITATION OF RATIOS
A. Strengths:
(a) Easier to understand than absolute measures.
(b) Easier to look at changes over time.
(c) Puts performance into context.
(d) Can be used as targets.
(e) Summarise results.
B. USES
Used for decision making by
Managers
Creditors
Stockholders
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c. Limitations
1. it is difficult to develop meaningful industry average
for multi-industry firms.
2.Most firms want to be better than averages.
3.Inflation may distort firm’s balance sheets.
4.Seasonal factors can distort ratio analysis.
5.Firms can employ “window dressing” technique.
6.Different accounting practices can distort comparison.
7.it is difficult to generalize whether a particular ratio is
good or bad.
8.A firm may have some good ratios and another bad
ratios making difficult to tell whether a company is
good or bad in balance.
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LOOKING BEYOND THE NUMBERS
Sound Financial Analysis involves more than just calculating and
comparing ratios-Qualitative Factors analysts must consider.
To what extent are the company’s revenues tied to one key
customer or to one key product? To what extent does the
company rely on a single supplier? Reliance on single customers,
products, or suppliers increases risk.
What percentage of the company’s business is generated
overseas? Companies with a large percentage of overseas
business are exposed to risk of currency exchange volatility and
political instability.
What are the probable actions of current competitors and the
likelihood of additional new competitors?
Do the company’s future prospects depend critically on the
success of products currently in the pipeline or on existing
products?
How does the legal and regulatory environment affect the
company?
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2.1.2. Common size, Index and Trend Analyses
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B. Index (percentage change) Analysis
items in the financial statement are expressed as an
index relative to the base year.
All items of the base year are assigned a 100%
index.
All items in the subsequent to the base year valued
relative to the base year items.
◦ Eg. Indexed financial statements.
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2.2. FINANCIAL PLANNING
Financial Planning :
1.Is a process of deciding on a firm’s future financial
position by predicting results under various alternative
ways of achieving goals and deciding the desired
goals.
2.Helps for guiding and coordinating a firm’s action to
achieve its objectives.
3.Results in pro-forma (forecasted/budgeted) financial
statements and additional fund need (AFN).
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FORCASTING FINANCIAL REQUIREMENTS
Additional Finance Requirement or Need (AFN) is the
fund needed from external sources to meet targeted
performance.
Financial requirement planning allows financial
managers to make an intelligent guess about the
future financial condition of their firms.
It involves:
a) Determining how much money a firm will need during a
given period,
b) Determining how much money a firm will generate during
the same period, and
c) Determining Financial Requirements (a-b).
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FINANCIAL REQUIREMENTS PLAN METHODS
Two methods:
Projected or pro-forma financial statements method
Formula Method
A.Pro-forma financial statements method
Uses constant sales growth rate to forecast accounts.
is a simple technique of forecasting financial
statements.
It forecasts assets , liabilities and equity needed and
subtracts projected liabilities and equity from
projected assets to determine Additional Fund Needed
(AFN).
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Steps to Determine AFN
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1. Forecast Income Statement
The Purpose is to determine how much income the
company will earn and retain for reinvestment during
the forecast year.
Begin with sales forecast, based on a sales growth (g)
forecast.
assumes that all costs will increase at the same rate as
sales. In more complicated situations, however,
specific costs will be forecasted separately.
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• Steps –B.I/S
Forecast sales for next period (S1) = So x(1+g).
Forecast costs for next period (C1) = Co x(1+g).
Carry over interest expense and preferred
dividend.
I1 = Io , df = df
Forecast common dividends for next period based
on dividend growth rate:
(Dividend Per Share1) = Dividend Per Share o x(1+d).
total Dividend 1 = Dividend Per Share1 x(no of shares).
Determine additions to retained earnings (R/E).
• Additions to R/E = NI- Dividends
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2. Forecast balance sheet
Growth in sales projections will necessarily lead to:
demand for more cash
Higher receivables
Stocking of additional inventory
Acquisition of new plant and equipment
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• Steps- B. B/S
Forecast assets for next period (A1) = Ao x(1+g).
Forecast spontaneous generated funds for next
period (CL1) = CLo x(1+g).
Set an initial values of equities that requires mgt
decision.
• N/P1 = N/Po , LTD1 = LTD1, CK1= CK0
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3. Raise Additional Fund Needed
AFN will be financed by borrowing or selling stocks
or a combination of these.
Decide the finance mix.
Add additional fund needed to initially forecasted
amounts.
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4. Financing Feedback
Forecast additional interest expense due to
financing action.
Interest exp= interest rate x borrowing
Forecast additional dividends due to financing
action.
• No. new shares = money raised/stock price
• Additional = No. new shares x forecasted dividend per share
Add additional interest expense and dividend
payments.
• This reduces the original Additions to R/E determined in step 1 and
results shortfalls.
Decide the financing mix to cover this short fall.
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This requires additional interest and dividend
payments which in turn results shortfalls.
After about five iteration, the shortfall will be small
and the forecast is considered complete.
Finally, prepare forecasted financial statements.
Example: Assume the following financial statement for 2009 and forecast
financial statement for 2010.
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Alex Corporation Balance Sheets (in million Birr)
December, 31 2009
Net sales 3000.0
Costs excluding depreciation 2616.2
Depreciation costs 100.0
Total Operating costs 2716.2
Earnings before interest and taxes (EBIT) 283.8
Les interest expense 88.0
Earnings before tax 195.8
Income tax (40%) 78.3
Net income before referred dividend 117.5
Preferred dividend 4.0
Net income available to common stockholders 113.5
Common dividends 57.5
Addition to retained earnings 6-69
56.0
Additional Data
Per-share data
Common stock price 23.00
Earnings per-share (EPS) 2.27
Dividends per-share (DPS) 1.15
Book value per-share (BVPS) 17.92
There are 50 million common stock shares in 2009.
There are 400,000 preferred stock shares in 2009.
Estimated Sales growth for 2010 = 10%.
Estimated dividend growth for 2010 = 8%.
Additional financing mix:
Notes payable 25% @ 8%
Bonds payable 25% @ 10%
Common stock issuance 50%
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Summary of the Pro-forma Method.
Amount in million Birr
Increase in sales 300.00
Increase in asset 200.00
From: external
N/P 29.53
B/P 29.53
Common Stock 59.06
Total AFN 118.12
R/e 62.00
spont liab 20.00
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◦
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Solution
AFN = 0.667 (ΔS)-O.067 (ΔS)-0.038(3300)* (1-0.509)
=0.667 (300)-0.067 (300)-0.038(3300)(0.491)
=200 million-20million-62 million = 118 million.
• The total increase (Fund) required financing the increase in
assets is 200 million, and is financed as follows:
1.From spontaneous liabilities 20 million
2.From Retained earnings 62 million
3.from External financing:
– Notes payable 25% at 8 % 29.5 million
– Long-term debt 25% at 10% 29.5 million
– Common stock issue 50% 59.0 million
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END of Chapter Two
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