Financial Analysis, Forecasting and Leverage
a. Ratio Analysis
Ratios are used in much of our daily life. We buy cars based on miles per gallon;
we evaluate baseball players by earned run andbatting averages, basketball players by
field goal and foul-shooting percentages, and so on. These are all ratios constructed to
judge comparative performance. Financial ratios serve a similar purpose, but you must
know what is being measured to construct a ratio and to understand the significance of
the resultant number.
Financial ratios are used to weigh and evaluate the operating performance of the
firm. While an absolute value such as earnings of $50,000 or accounts receivable of
$100,000 may appear satisfactory, its acceptability can be measured only in relation to
other values. For this reason, financial managers emphasize ratio analysis. For example,
are earnings of $50,000 actually good? If we earned $50,000 on $500,000 of sales (10
percent “profit margin” ratio), that might be quite satisfactory—whereas earnings of
$50,000 on $5,000,000 could be disappointing (a meager 1 percent return). After we have
computed the appropriate ratio, we must compare our results to those achieved by similar
firms in our industry, as well as to our own performance record. Even then, this “number-
crunching” process is not fully adequate, and we are forced to supplement our financial
findings with an evaluation of company management, physical facilities, corporate
governance, sustainability, and numerous other factors.
Many libraries and universities subscribe to financial services such as Bloomberg,
Standard & Poor’s Industry Surveys and Corporate Reports, the Value Line Investment
Survey FactSet, and Moody’s Corporation. Standard & Poor’s also leases a computer
database called S&P IQ to banks, corporations, investment organizations, and
universities. Compustat contains financial statement data on over 99,000 global securities
for a 20-year period. Ratios can also be found on such websites as finance.yahoo.com.
These data can be used for countless ratios to measure corporate performance. The ratios
used in this text are a sample of the major ratio categories used in business, but other
classification systems can also be constructed.
The first grouping, the profitability ratios, allows us to measure the ability of the
firm to earn an adequate return on sales, total assets, and invested capital. Many of the
problems related to profitability can be explained, in whole or in part, by the firm’s
ability to effectively employ its resources. Thus the next category is asset utilization
ratios. Under this heading, we measure the speed at which the firm is turning over
accounts receivable, inventory, and longer-term assets. In other words, asset utilization
ratios measure how many times per year a company sells its inventory or collects all of its
accounts receivable. For long-term assets, the utilization ratio tells us how productive the
fixed assets are in terms of generating sales.
In category C, the liquidity ratios, the primary emphasis moves to the firm’s
ability to pay off short-term obligations as they come due. In category D, debt utilization
ratios, the overall debt position of the firm is evaluated in light of its asset base and
earning power.
The users of financial statements will attach different degrees of importance to the
four categories of ratios. To the potential investor or security analyst, the critical
consideration is profitability, with secondary consideration given to such matters as
liquidity and debt utilization. For the banker or trade creditor, the emphasis shifts to the
firm’s current ability to meet debt obligations. The bondholder, in turn, may be primarily
influenced by debt to total assets—while also eyeing the profitability of the firm in terms
of its ability to cover debt obligations. Of course, the experienced analyst looks at all the
ratios, but with different degrees of attention.
Ratios are also important to people in the various functional areas of a business.
The marketing manager, the head of production, the human resource manager, and many
of their colleagues must all be familiar with ratio analysis. For example, the marketing
manager must keep a close eye on inventory turnover; the production manager must
evaluate the return on assets; and the human resource manager must look at the effect of
“fringe benefits” expenditures on the return on sales.
Definitions alone carry little meaning in analyzing or dissecting the financial
performance of a company. For this reason, we shallapply our four categories of ratios to
a hypothetical firm, the Saxton Company. The use of ratio analysis is rather like solving a
mystery in which each clue leads to a new area of inquiry.
In analyzing the profitability ratios, we see the Saxton Company shows a lower
return on the sales dollar (5 percent) than the industry average of 6.7 percent. However,
its return on assets (investment) of 12.5 percent exceeds the industry norm of 10 percent.
There is only one possible explanation for this occurrence—a more rapid turnover of
assets than that generally found within the industry. This is verified in Ratio 2b, in which
sales to total assets is 2.5 for the Saxton Company and only 1.5 for the industry. Thus
Saxton earns less on each sales dollar, but it compensates by turning over its assets more
rapidly (generating more sales per dollar of assets).
The Du Pont company was a forerunner in stressing that satisfactory return on
assets may be achieved through high profit margins or rapid turnover of assets, or a
combination of both. We shall also soon observe that under the Du Pont system of
analysis, the use of debt may be important. The Du Pont system causes the analyst to
examine the sources of a company’s profitability. Since the profit margin is an income
statement ratio, a high profit margin indicates good cost control, whereas a high asset
turnover ratio demonstrates efficient use of the assets on the balance sheet. Different
industries have different operating and financial structures. For example, in the heavy
capital goods industry the emphasis is on a high profit margin with a low asset turnover
—whereas in food processing, the profit margin is low and the key to satisfactory returns
on total assets is a rapid turnover of assets.
Equally important to a firm is its return on equity or ownership capital. For the
Saxton Company, return on equity is 20 percent, versus an industry norm of 15 percent.
Thus the owners of Saxton Company are more amply rewarded than are other
shareholders in the industry. This may be the result of one or two factors: a high return on
total assets or a generous utilization of debt or a combination thereof. This can be seen
through Ratio 3b, which represents a modified or second version of the Du Pont formula.
Actually, the return on assets of 12.5 percent in the numerator is higher than the
industry average of 10 percent, and the ratio of debt to assets in the denominator of 37.5
percent is higher than the industry norm of 33 percent. Please see the denominators in
Ratio 3b to confirm these facts. Both the numerator and denominator contribute to a
higher return on equity than the industryaverage (20 percent versus 15 percent). Note that
if the firm had a 50 percent debt-to-assets ratio, return on equity would go up to 25
percent.
This does not necessarily mean debt is a positive influence, only that it can be
used to boost return on equity. The ultimate goal for the firm is to achieve maximum
valuation for its securities in the marketplace, and this goal may or may not be advanced
by using debt to increase return on equity. Because debt represents increased risk, a lower
valuation of higher earnings is possible.2 Every situation must be evaluated individually.
As an example of the Du Pont analysis compares two well-known retail store
chains, Walmart and Target. In 2017, Target was more profitable in terms of profit
margins (3.9 percent versus 2.8 percent). However, Walmart turned over its assets 2.4
times a year versus a slower 1.9 times for Target. Walmart’s long-held philosophy was
set by its late founder, Sam Walton: Give the customer a bargain in terms of low prices
(and low profit margins) but move the merchandise quickly (higher turnover).
Multiplying each company’s profit margin by the asset turnover, we see that
Walmart and Target have similar returns on assets. However, notice that Walmart is more
conservatively financed than Target. Walmart’s capital structure is 60.9 percent debt.
Target uses 70.7 percent debt. As a result, Target’s return on equity was significantly
higher. Keep in mind that a higher debt ratio also creates a more volatile ROE. While
Target’s ROE was higher than Walmart’s, economic growth was high in 2017. If the
economy falters, Target’s ROE will probably fall more than Walmart’s. Finally, as a
general statement in computing all the profitability ratios, the analyst must be sensitive to
the age of the assets. Plant and equipment purchased 15 years ago may be carried on the
books far below its replacement value in an inflationary economy. A 20 percent return on
assets purchased in the early 1990s may be inferior to a 15 percent return on newly
purchased assets.
The second category of ratios relates to asset utilization, and the ratios in this
category may explain why one firm can turn over its assets more rapidly than another.
Notice that all of these ratios relate the balance sheet (assets) to the income statement
(sales). The Saxton Company’s rapid turnover of assets is primarily explained in Ratios
4, 5, and 6.
Saxton collects its receivables faster than does the industry. This is shown by the
receivables turnover of 11.4 times versus 10 times for the industry, and in daily terms by
the average collection period of 32 days, which is 4 days faster than the industry norm.
The average collection period suggests how long, on average, customers’ accounts stay
on the books. The Saxton Company has $350,000 in accounts receivable and $4,000,000
in credit sales, which when divided by 360 days yields average daily credit sales of
$11,111. We divide accounts receivable of $350,000 by average daily credit sales of
$11,111 to determine how many days credit sales are on the books (32 days).
In addition, the firm turns over its inventory 10.8 times per year, as contrasted
with an industry average of 7 times.3 This tells us that Saxton generates more sales per
dollar of inventory than the average company in the industry, and we can assume the firm
uses very efficient inventory-ordering and cost-control methods. The firm maintains a
slightly lower ratio of sales to fixed assets (plant and equipment) than does the industry
(5 versus 5.4), as shown above. This is a relatively minor consideration in view of the
rapid movement of inventory and accounts receivable. Finally, the rapid turnover of total
assets is again indicated.
After considering profitability and asset utilization, the analyst needs to examine
the liquidity of the firm. The Saxton Company’s liquidity ratios fare well in comparison
with the industry. Notice that Saxton’s current ratio is higher than the industry average
because it has more current assets, relative to its current liabilities. This suggests that
Saxton should be in a relatively good position to pay its current debts as they come due.
Likewise, Saxton’s quick ratio is higher than its average competitor’s. Further analysis
might involve building a cash budget to determine if the firm can meet each maturing
obligation as it comes due.
Ratios for times interest earned and fixed charge coverage show that the Saxton
Company debt is being well managed compared to the debt management of other firms in
the industry. Times interest earned indicates the number of times that income before
interest and taxes covers the interest obligation (11 times). The higher the ratio, the
stronger is the interest-paying ability of the firm. The figure for income before interest
and taxes ($550,000) in the ratio is the equivalent of the operating profit figure presented
in the upper part. Fixed charge coverage measures the firm’s ability to meet all fixed
obligations rather than interest payments alone, on the assumption that failure to meet any
financial obligation will endanger the position of the firm. In the present case, the Saxton
Company has lease obligations of $50,000 as well as the $50,000 in interest expenses.
Thus the total fixed charge financial obligation is $100,000. We also need to know the
income before all fixed charge obligations. In this case, we take income before interest
and taxes (operating profit) and add back the $50,000 in lease payments.
b. Trend Analysis
Over the course of the business cycle, sales and profitability may expand and
contract, and ratio analysis for any one year may not present an accurate picture of the
firm. Therefore, we look at the trend analysis of performance over a number of years.
However, without industry comparisons even trend analysis may not present a complete
picture.
For example, see that the profit margin for the Saxton Company has improved,
while asset turnover has declined. This by itself may look good for the profit margin and
bad for asset turnover. However, when compared to industry trends, we see the firm’s
profit margin is still below the industry average. With asset turnover, Saxton has
improved in relation to the industry, even though it is in a downward trend. Similar data
could be generated for the other ratios.
By comparing companies in the same industry, the analyst can examine and
compare trends over time. In looking at the computer industry data in, it is apparent that
profit margins and returns on equity have changed over time for IBM and Apple. This is
primarily due to intensified competition within the industry. IBM began to feel the
squeeze on profits first, beginning in 1991, and actually lost money in 1993. By 1994,
Lou Gerstner had taken over as chairman and chief executive officer at IBM and had
begun turning the company around; by 1997, IBM was back to its old levels of
profitability and hitting all-time highs for return on stockholders’ equity. This continued
until the recession of 2001–2002. During the next decade, IBM engaged in financial
engineering. It kept repurchasing shares of stock in the market, reducing its share count
from 29.7 billion shares in 2004 to 17.2 billion shares in 2014. During the same years, its
revenues decreased from $96.3 billion to $94.5 billion.
In 2003, Apple Computer began its amazing 10-year run, creating the iPod,
annual versions of the iPhone, the iPad, the iPad mini, and new versions of its MacBook
and iMac computers. Note that even though Apple’s profit margin far exceeds that of
IBM, IBM still has a higher return on equity. This takes us back to the Du Pont model.
IBM has a debt-to-assets ratio of 84.5 percent in its capital structure, while Apple has a
64.3 percent debt-to-assets ratio.
Apple was almost debt free until 2013 when, under pressure from institutional
stockholders, the company agreed to sell a total of $35.3 billion of debt and use the
proceeds to buy back stock and raise its dividends. From 2015 to 2017, Apple spent
almost $100 billion buying back stock and substantially increasing its debt-to-assets ratio.
In contrasting the two companies, we should point out that while IBM’s revenues were
stagnant from 2004 to 2017, Apple grew its revenues from $8.2 billion in 2004 to
$229.234 billion, almost tripling IBM’s 2017 revenues of $78.4 billion.
What will be the trends for these two companies for the rest of the decade?
Technology is changing so quickly that no one can say. Both are likely to remain lean in
operating expenses but highly innovative in new product development.
c. Impact of Inflation on Financial Analysis
Before, coincident with, or following the computation of financial ratios, we
should explore the impact of inflation and other sources of distortion on the financial
reporting of the firm. As illustrated in this section, inflation causes phantom sources of
profit that may mislead even the most alert analyst. Disinflation also causes certain
problems, and we shall consider these as well.
The major problem during inflationary times is that revenue is almost always
stated in current dollars, whereas plant and equipment or inventory may have been
purchased at lower price levels. Thus profit may be more a function of increasing prices
than of satisfactory performance. Although inflation has been moderate since the early
1990s, it tends to reappear, so you should be aware of its consequences.
The Stein Corporation shows the income statement for 2018. At year-end the firm
also has 100 units still in inventory at $1 per unit. Assume that in the year 2019 the
number of units sold remains constant at 100. However, inflation causes a 10 percent
increase in price, from $2 to $2.20. Total sales will go up to $220, but with no actual
increase in physical volume. Further, assume the firm uses FIFO inventory pricing, so
that inventory first purchased will be written off against current sales. In this case, 2018
inventory will be written off against year 2019 sales revenue.
As mentioned, inflation-related information was formerly required by the FASB
for large companies, but this is no longer the case. It is now purely voluntary. What are
the implications of this type of inflation-adjusted data? From a study of 10 chemical firms
and 8 drug companies, using current cost (replacement cost) data found in the financial
10K statements these companies filed with the Securities and Exchange Commission, it
was found that the changes shown in occurred in their assets, income, and selected ratios.
The comparison of replacement cost and historical cost accounting methods in the
table shows that replacement cost reduces income but at the same time increases assets.
This increase in assets lowers the debt-to-assets ratio, since debt is a monetary asset that
is not revalued because it is paid back in current dollars. The decreased debt-to-assets
ratio would indicate the financial leverage of the firm is decreased, but a look at the
interest coverage ratio tells a different story. Because the interest coverage ratio measures
the operating income available to cover interest expense, the declining income penalizes
this ratio, and the firm has decreased its ability to cover its interest cost.
As long as prices continue to rise in an inflationary environment, profits appear to
feed on themselves. The main problem is that when price increases moderate
( disinflation), there will be a rude awakening for management and unsuspecting
stockholders as expensive inventory is charged against softening retail prices. A 15 or 20
percent growth rate in earnings may be little more than an “inflationary illusion.”
Industries most sensitive to inflation-induced profits are those with cyclical products,
such as lumber, copper, rubber, and food products, as well as those in which inventory is
a significant percentage of sales and profits.
A leveling off of prices is not necessarily bad. Even though inflation-induced
corporate profits may be going down, investorsmay be more willing to place their funds
in financial assets such as stocks and bonds. The reason for the shift may be a belief that
declining inflationary pressures will no longer seriously impair the purchasing power of
the dollar. Lessening inflation means the required return that investors demand on
financial assets will be going down, and with this lower demanded return, future earnings
or interest should receive a higher current valuation.
None of this happens with a high degree of certainty. To the extent that investors
question the permanence of disinflation (leveling off of price increases), they may not act
according to the script. That is, lower rates of inflation will not necessarily produce high
stock and bond prices unless reduced inflation is sustainable over a reasonable period.
Whereas financial assets such as stocks and bonds have the potential (whether
realized or not) to do well during disinflation, such is not the case for tangible (real)
assets. Precious metals, such as gold and silver, gems, and collectibles, which boomed in
the highly inflationary environment of the late 1970s, fell off sharply a decade later, as
softening prices reduced the perceived need to hold real assets as a hedge against
inflation. The shifting back and forth by investors between financial and real assets may
occur many times over a business cycle.
There is also the danger of deflation, actual declining prices in which everyone
gets hurt from bankruptcies and declining profits. Deflation was a major contributor to
the length and severity of the worldwide Great Depression of the 1930s. Deflation
occurred again in Russia, Japan, and other foreign countries in 1998, and it became a
concern in the United States during the “Great Recession” from 2007 to 2012. The
Federal Reserve and other national banks would rather have a low- inflation economy (1
or 2 percent per year) than a deflationary economy.
d. Other Elements of Distortion in Reported Income
The effect of changing prices is but one of a number of problems the analyst must
cope with in evaluating a company. Other issues, such as the reporting of revenue, the
treatment of nonrecurring items, and the tax write-off policy, cause dilemmas for the
financial manager or analyst. We can illustrate this point by considering the income
statements for two hypothetical companies in the same industry. Both firms had identical
operating performances for 2018—but Company A is very conservative in reporting its
results, while Company B has attempted to maximize its reported income.
If both companies had reported income of $280,000 in the prior year of 2017,
Company B would be thought to be showing substantial growth in 2018 with net income
of $700,000, while Company A would be reporting a “flat,” or no-growth, year in 2018.
However, we have already established that the companies have equal operating
performances.
Company B reported $200,000 more in sales, although actual volume was the
same. This may be the result of different concepts of revenue recognition. For example,
certain assets may be sold on an installment basis over a long period. A conservative firm
may defer recognition of the sales or revenue until each payment is received, while other
firms may attempt to recognize a fully effected sale at the earliest possible date.
Similarly, firms that lease assets may attempt to consider a long-term lease as the
equivalent of a sale, while more conservative firms recognize as revenue each lease
payment only when it comes due. Although the accounting profession attempts to
establish appropriate methods of financial reporting through generally accepted
accounting principles, reporting varies among firms and industries.
The conservative firm (Company A) may well be using LIFO accounting in an
inflationary environment, thus charging the last-purchased, more expensive items against
sales, while Company B uses FIFO accounting—charging off less expensive inventory
against sales. The $300,000 difference in cost of goods sold may also be explained by
varying treatment of research and development costs and other items.
Firm A has reported net income of $350,000, while Firm B claims $700,000. The
$350,000 difference is attributed to different methods of financial reporting, and it should
be recognized as such by the analyst. No superior performance has actually taken place.
The analyst must remain ever alert in examining each item in the financial statements,
rather than accepting bottom-line figures.
Ratio analysis allows the analyst to compare a company’s performance to that of
others in its industry. Ratios that initially appear good or bad may not retain that
characteristic when measured against industry peers. There are four main groupings of
ratios. Profitability ratios measure the firm’s ability to earn an adequate return on sales,
assets, and stockholders’ equity. The asset utilization ratios tell the analyst how quickly
the firm is turning over its accounts receivable, inventory, and longer-term assets.
Liquidity ratios measure the firm’s ability to pay off short-term obligations as they come
due, and debt utilization ratios indicate the overall debt position of the firm in light of its
asset base and earning power.
The Du Pont system of analysis first breaks down return on assets between the
profit margin and asset turnover. The second step shows how this return on assets is
translated into return on equity through the amount of debt the firm has. Throughout the
analysis, the analyst can better understand how return on assets and return on equity are
derived.
Over the course of the business cycle, sales and profitability may expand and
contract, and ratio analysis for any one year may not present an accurate picture of the
firm. Therefore, we look at the trend analysis of performance over a period of years. A
number of factors may distort the numbers accountants actually report. These include the
effect of inflation or disinflation, the timing of the recognition of sales as revenue, the
treatment of inventory write-offs, and so on. The well-trained financial analyst must be
alert to all of these factors.
e. Pro Forma Income Statement
For analysis, we shall assume the Goldman Corporation has two primary
products: wheels and casters. Our sales projection callsfor the sale of 1,000 wheels and
2,000 casters at prices of $30 and $35, respectively. As indicated in, we anticipate total
sales of $100,000.
For the tables in this, we will use color-coded conventions that have become
standard in Excel. Blue values are initial inputs (or assumptions). Black values are
calculations in the table. Green values are pulled from a prior table.
Based on anticipated sales, we determine the necessary production plan for the
six-month period. The number of units produced will depend on the beginning inventory
of wheels and casters, our sales projection, and the desired level of ending inventory.
Assume that on January 1, 2019, the Goldman Corporation has in stock the items. We
will add the projected quantity of unit sales for the next six months to our desired ending
inventory and subtract our stock of beginning inventory (in units) to determine our
production requirements. This process is illustrated below. We must now determine the
cost to produce these units. We see that the cost of units in stock was $16 for wheels and
$20 for casters. However, we shall assume the price of materials, labor, and overhead
going into the new products is now $18 for wheels and $22 for casters, as indicated.
The main consideration in constructing a pro forma income statement is the costs
specifically associated with units sold during the time period (the cost of goods sold).
Note that in the case of wheels we anticipate sales of 1,000 units, as indicated in, but we
are producing 1,015, to increase our inventory level by 15 units.
For profit measurement purposes, we will not charge these extra 15 units against
current sales.1 Furthermore, in determining the cost of the 1,000 units sold during the
current time period, we will not assume that all of the items sold represent inventory
manufactured in this period. We shall assume the Goldman Corporation uses FIFO (first-
in, first-out) accounting and it will first allocate the cost of current sales to beginning
inventory and then to goods manufactured during the period.
For example, 1,000 units of wheels are to be sold at a total revenue of $30,000. Of
the 1,000 units, 85 units are from beginning inventory at a $16 cost, and the balance of
915 units is from current production at an $18 cost. The total cost of goods sold for
wheels is $17,830, yielding a gross profit of $12,170. The pattern is the same for casters,
with sales of $70,000, cost of goods sold of $43,640, and gross profit of $26,360. The
combined sales for the two products are $100,000, with cost of goods sold of $61,470 and
gross profit of $38,530.
Having computed total revenue, cost of goods sold, and gross profits, we must
now subtract other expense items to arrive at a net profit figure. We deduct general and
administrative expenses as well as interest expenses from gross profit to arrive at
earnings before taxes, then subtract taxes to determine aftertax income, and finally deduct
dividends to ascertain the contribution to retained earnings. For the Goldman
Corporation, we shall assume general and administrative expenses are $12,000, interest
expense is $1,500, and dividends are $1,500.
Combining the gross profit with our assumptions on other expense items, we
arrive at the pro forma income statement. As shown toward the bottom of the table, we
anticipate earnings after taxes of $20,024, dividends of $1,500, and an increase in
retained earnings of $18,524.
f. Cash Budget
As previously indicated, the generation of sales and profits does not necessarily
ensure there will be adequate cash on hand to meet financial obligations as they come
due. This was especially true in the credit crisis period of 2007–2009 as many firms had
to go into temporary bankruptcy. Macy’s and Chrysler are two examples. A profitable
sale may generate accounts receivable in the short run but no immediate cash to meet
maturing obligations. For this reason, we must translate the pro forma income statement
into cash flows. In this process, we divide the longer-term pro forma income statement
into smaller and more precise time frames to anticipate the seasonal and monthly patterns
of cash inflows and outflows. Some months may represent particularly high or low sales
volume or may require dividends, taxes, or capital expenditures.
In the case of the Goldman Corporation, we break down the pro forma income
statement for the first half of the year 2019 into a series of monthly cash budgets. We
showed anticipated sales of $100,000 over this time period; we shall now assume these
sales can be divided into monthly projections.
A careful analysis of past sales and collection records indicates 20 percent of sales
is collected in the month of sales and 80 percent in the following month. The cash receipt
pattern related to monthly. It is assumed that sales for December 2018 were $12,000.
The primary considerations for cash payments are monthly costs associated with
inventory manufactured during the period (material, labor, and overhead) and
disbursements for general and administrative expenses, interest payments, taxes, and
dividends. We must also consider cash payments for any new plant and equipment, an
item that does not show up on our pro forma income statement. Costs associated with
units manufactured during the period may be taken from the data.
We see that the total costs for components in the two products are materials,
$34,390; labor, $17,195; and overhead, $11,125. We shall assume all these costs are
incurred on an equal monthly basis over the six-month period. Even though the sales
volume varies from month to month, we assume we are employing level monthly
production to ensure maximum efficiency in the use of various productive resources.
Average monthly costs for materials, labor, and overhead.
The primary purpose of the cash budget is to allow the firm to anticipate the need
for outside funding at the end of each month. In the present case, we shall assume the
Goldman Corporation wishes to have a minimum cash balance of $5,000 at all times. If it
goes below this amount, the firm will borrow funds from the bank. If it goes above
$5,000 and the firm has a loan outstanding, it will use the excess funds to reduce the loan.
This pattern of financing is demonstrated illustrates a fully developed cash budget with
borrowing and repayment provisions.
The fourth entry is the additional monthly loan or loan repayment, if any, required
to maintain a minimum cash balance of $5,000. To keep track of our loan balance, the
fifth entry represents cumulative loans outstanding for all months. Finally, we show the
cash balance at the end of the month, which becomes the beginning cash balance for the
next month.
At the end of January the firm has $6,380 in cash, but by the end of February the
cumulative cash position of the firm is negative, necessitating a loan of $5,072 to
maintain a $5,000 cash balance. The firm has a loan on the books until May, at which
time there is an ending cash balance of $11,069. During April and May the cumulative
cash balance is greater than the required minimum cash balance of $5,000, so loan
repayments of $4,548 and $4,479 are made to retire the loans completely in May. In June
the firm is once again required to borrow $5,886 to maintain a $5,000 cash balance.
g. Pro Forma Balance Set
The integration of financial statements is a critical aspect of financial analysis and
planning for any corporation. In this segment, we embark on a journey to amalgamate the
pro forma income statement, cash budget, and prior period's balance sheet into a cohesive
pro forma balance sheet, reflecting the cumulative changes in the corporation over time.
By examining the prior period's balance sheet and translating these items to represent
June 30, 2019, we gain valuable insights into the financial health and trajectory of the
company.
Understanding the Pro Forma Balance Sheet Integration Process: Before delving
into the specifics of the pro forma balance sheet as of June 30, 2019, it's essential to
understand the methodology behind this integration process. The pro forma balance sheet
serves as a snapshot of the company's financial position at a specific point in time,
incorporating both historical data and forward-looking projections. By combining the pro
forma income statement and cash budget with the prior period's balance sheet, we can
accurately reflect the cumulative effects of operational and financial activities on the
company's financial position.
Analysis of Prior Period's Balance Sheet (December 31, 2018) presents the last
balance sheet dated December 31, 2018, serving as the foundation for our pro forma
balance sheet as of June 30, 2019. This balance sheet provides a starting point,
showcasing the company's assets, liabilities, and shareholders' equity as of the end of the
prior period.
Pro Forma Balance Sheet as of June 30, 2019 depicts the new pro forma balance
sheet as of June 30, 2019, integrating the pro forma income statement and cash budget
with the prior period's balance sheet. Each item in the pro forma balance sheet is
meticulously calculated and explained based on prior calculations, assumptions, and
projected financial performance.
Explanation of Items in the Pro Forma Balance Sheet: detailed explanations
accompany each item in the pro forma balance sheet, elucidating the rationale behind the
calculations and assumptions made. These explanations provide transparency and clarity,
allowing stakeholders to understand the underlying factors influencing the company's
financial position.
Comprehensive Financial Analysis and Implications: The integration of the pro
forma income statement, cash budget, and prior period's balance sheet into the pro forma
balance sheet offers a comprehensive view of the company's financial standing as of June
30, 2019. This analysis enables stakeholders to assess the company's liquidity, solvency,
and overall financial health, facilitating informed decision-making and strategic planning.
Conclusion: In conclusion, the integration of financial statements is integral to
understanding and analyzing a company's financial performance and position. By
synthesizing the pro forma income statement, cash budget, and prior period's balance
sheet into a pro forma balance sheet, stakeholders can gain valuable insights into the
company's financial trajectory and make informed decisions to drive future growth and
success.
In the journey of corporate growth and expansion, financing plays a pivotal role in
sustaining operations, supporting asset acquisition, and driving profitability. In this
segment, we delve into the intricate mechanisms of financing growth, focusing on the
utilization of accounts payable, notes payable, and retained earnings to fuel expansion.
By analyzing the interplay between these financial instruments, we gain deeper insights
into the strategies employed by companies to sustainably finance their growth initiatives.
Utilization of Accounts Payable, Notes Payable, and Retained Earnings: As
companies embark on a path of growth, they often leverage a combination of internal and
external financing sources to support their expansion plans. Accounts payable,
representing amounts owed to suppliers for goods and services purchased on credit, serve
as a short-term financing mechanism allowing companies to manage cash flow
effectively. Similarly, notes payable entail formal agreements to repay borrowed funds,
typically used for longer-term financing needs. Additionally, retained earnings,
accumulated profits not distributed to shareholders, are a crucial internal source of
financing growth.
Financial Dynamics of Growth Financing: In the scenario presented, the company
has experienced significant growth financed by accounts payable, notes payable, and
retained earnings. The increase in assets, reflected in the pro forma balance sheet,
necessitates additional financing to support the expansion. Despite the high degree of
profitability anticipated, external financing, in the form of bank loans amounting to
$5,886, is required to bridge the gap between asset buildup and liabilities increase.
Detailed Analysis of Financing Components:
1. Accounts Payable: The increase in accounts payable indicates the company's ability to
leverage trade credit to finance its operations and growth initiatives. By extending
payment terms with suppliers, the company can allocate funds towards asset acquisition
and expansion activities while managing short-term liquidity requirements effectively.
2. Notes Payable: The utilization of notes payable signifies the company's access to external
financing sources to support long-term investment projects. These formal borrowing
agreements provide the necessary capital to finance asset acquisitions and expansion
initiatives, enabling the company to pursue growth opportunities beyond its immediate
financial capacity.
3. Retained Earnings: The accumulation of retained earnings reflects the company's
profitability and reinvestment of earnings into the business. Retained earnings serve as a
valuable internal source of financing, allowing the company to fund growth initiatives
without relying solely on external debt or equity financing.
Strategic Considerations and Future Outlook: While the company anticipates a
high degree of profitability, prudent financial management dictates the need for a
balanced approach to financing growth. By strategically utilizing accounts payable, notes
payable, and retained earnings, the company can sustain its expansion while maintaining
financial flexibility and stability. Moreover, proactive engagement with financial
institutions for additional funding ensures adequate resources to support future growth
endeavors and capitalize on emerging opportunities.
Conclusion: In conclusion, the financing of growth involves a judicious blend of
internal and external funding sources, including accounts payable, notes payable, and
retained earnings. By understanding the dynamics of these financing components and
their implications on the company's financial position, stakeholders can make informed
decisions to support sustainable growth and value creation in the long term.
h. Percent-of-Sales Method
An alternative to tracing cash and accounting flows to determine financial needs
is to assume that accounts on the balance sheet will maintain a given percentage
relationship to sales. We then indicate a change in the sales level and ascertain our related
financing needs. This is known as the percent-of-sales method. For example, for the
Howard Corporation, introduced we show the following balance sheet accounts in dollars
and their percentage of sales, based on a sales volume of $200,000.
Cash of $5,000 represents 2.5 percent of sales of $200,000; receivables of
$40,000 are 20 percent of sales; and so on. No percentages are computed for notes
payable, common stock, and retained earnings because they are not assumed to maintain
a direct relationship with sales volume.
Once we know how much money we need to finance our growth, we will then
decide whether to finance the sales growth with an increase in notes payable or the sale of
common stock or long-term debt. There are two possible scenarios for our calculations.
First, if the company is operating at full capacity, it will need to buy new plant and
equipment to produce more goods to sell. Second, if the company is operating at less than
full capacity, it can increase sales with its current plant and equipment, so it will only
need to add more current assets to increase its sales.
In the case of full capacity, any dollar increase in sales will necessitate a 35
percent increase in current assets, as well as a 25 percent increase in plant and equipment.
These percentages are found in the bottom half. Of this 60 percent, 25 percent will be
spontaneously or automatically financed through accounts payable and accrued expenses,
leaving 35 percent to be financed by profit or additional outside sources of financing. We
will assume the Howard Corporation has an aftertax return of 6 percent on the sales
dollar, and 50 percent of profits are paid out as dividends.
If sales increase from $200,000 to $300,000, the $100,000 increase in sales will
necessitate $35,000 (35 percent) in additional financing. Since we will earn 6 percent on
total sales of $300,000, we will show a profit of $18,000. With a 50 percent dividend
payout, $9,000 will remain for internal financing. This means $26,000 out of the $35,000
must be financed from outside sources. Our formula to determine the need for new funds
follows.
Presumably, the $26,000 can be financed at the bank or through some other
appropriate source. What if the company is operating at less than full capacity and
doesn’t need to buy new plant and equipment? This often happens when the economy is
coming out of a recession. In this case, we will need to increase our assets by the 35
percent of spontaneous current assets.
Notice that when we don’t need to buy new equipment, the required new funds
amount drops significantly. In this case, we need an extra $1,000 of financing. Using the
percent-of-sales method is much easier than tracing through the various cash flows to
arrive at the pro forma statements. Nevertheless, the output is much less meaningful, and
we do not get a month-to-month breakdown of the data. The percent-of-sales method is a
broad-brush approach, while the development of pro forma statements is more exacting.
Of course, whatever method we use, the results are only as meaningful or reliable as the
assumptions about sales and production that went into the numbers.
Financial forecasting allows the financial manager to anticipate events before they
occur, particularly the need for raising funds externally. An important consideration is
that growth may call for additional sources of financing because profit is often inadequate
to cover the net buildup in receivables, inventory, and other asset accounts. A systems
approach is necessary to develop pro forma statements. We first construct a pro forma
income statement based on sales projections and the production plan, then translate this
material into a cash budget, and finally assimilate all previously developed material into a
pro forma balance sheet.
An alternative to tracing cash and accounting flows to determine financial needs
is to assume that accounts on the balance sheet will maintain a given percentage
relationship to sales. We can then indicate a change in the sales level and ascertain our
related financing needs. This is known as the percent-of-sales method. Regardless of
what method is used to forecast the future financial needs of the firm (whether it is pro
forma financial statements or the percent-of-sales method), the end product is the
determination of the amount of new funds needed to finance the activities of the firm. For
firms that are in highly seasonal businesses, it is particularly important to identify peaks
and slowdowns in the activities of the firm and the associated financial requirements.
i. Leverage in a Business
Embarking on the journey of starting a business is both exhilarating and daunting,
filled with opportunities and challenges. As I consider the prospect of manufacturing and
marketing industrial parts such as ball bearings, wheels, and casters, I recognize the
significance of two primary decisions that will shape the trajectory of the venture:
product selection and market strategy.
The first critical decision revolves around the selection of industrial parts to
manufacture and market. Conducting thorough market research and feasibility studies is
paramount to identify the demand, competition, and potential profitability of each
product category. While ball bearings, wheels, and casters are essential components in
various industries, each presents unique considerations in terms of production
complexity, market demand, and competitive landscape.
As foundational components used in machinery and equipment across industries
such as automotive, aerospace, and manufacturing, ball bearings offer a broad market
potential. However, competition from established manufacturers and the need for
precision engineering may pose challenges in entering this segment.
Wheels find applications in diverse sectors, including material handling,
transportation, and industrial machinery. The versatility of wheels makes them a
compelling product category, with opportunities to target niche markets and customize
offerings to meet specific customer requirements.
Casters: Casters, featuring wheels mounted to frames, offer mobility solutions for
a wide range of applications, including furniture, medical equipment, and industrial carts.
This segment presents opportunities to innovate with advanced materials, designs, and
functionalities to cater to evolving customer needs.
As I contemplate the opportunity to start a business manufacturing and marketing
industrial parts, careful consideration of product selection and market strategy is
paramount. By evaluating the demand, competition, and strategic fit of each product
category and devising a comprehensive market strategy aligned with target markets and
distribution channels, the business can position itself for sustainable growth and success
in the dynamic industrial landscape. While challenges and uncertainties lie ahead, the
prospect of creating value, serving customers, and realizing entrepreneurial aspirations
fuels my determination to embark on this exciting journey.
First, you must determine the amount of fixed cost plant and equipment you wish
to use in the production process. By installing modern, sophisticated equipment, you can
virtually eliminate labor in the production of inventory. At high volume, you will do quite
well, as most of your costs are fixed. At low volume, however, you could face difficulty
in making your fixed payments for plant and equipment. If you decide to use expensive
labor rather than machinery, you will lessen your opportunity for profit, but at the same
time you will lower your exposure to risk (you can lay off part of the workforce).
Second, you must determine how you will finance the business. If you rely on
debt financing and the business is successful, you will generate substantial profits as an
owner, paying only the fixed interest costs of debt. Of course, if the business starts off
poorly, the contractual obligations related to debt could mean bankruptcy. As an
alternative, you might decide to sell equity rather than borrow, a step that will lower your
own profit potential (you must share with others) but minimize your risk exposure.
As I contemplate the opportunity to start a business manufacturing and marketing
industrial parts, the strategic utilization of leverage emerges as a critical consideration in
shaping the trajectory of the venture. Leveraging growth involves making explicit
decisions regarding both operating and financial leverage, each of which carries
implications for the company's risk profile, profitability, and long-term sustainability. In
this exploration, we delve into the dynamics of operating and financial leverage,
examining their individual effects and the combined impact on the business.
Understanding Operating Leverage: Operating leverage refers to the extent to
which fixed costs are present in the company's cost structure relative to variable costs. By
committing to a heavy investment in fixed assets and infrastructure, businesses incur
fixed costs that remain constant regardless of the level of production or sales. As
production volumes increase, the contribution margin per unit sold expands, leading to
proportionately higher operating income due to economies of scale. However, in periods
of low sales or underutilization of capacity, fixed costs can weigh heavily on profitability,
amplifying losses.
In the context of manufacturing industrial parts, decisions regarding the level of
automation, investment in specialized equipment, and scale of production facilities
directly influence the degree of operating leverage. Opting for advanced manufacturing
processes and large-scale production facilities increases fixed costs but also enhances
production efficiency and economies of scale. Conversely, a more conservative approach
focusing on manual labor and smaller production capacities reduces fixed costs but may
limit scalability and competitive advantages.
Exploring Financial Leverage: Financial leverage, on the other hand, pertains to
the use of debt financing to magnify returns to shareholders. By leveraging debt,
businesses can amplify their investment returns through the use of other people's money,
thereby increasing the potential for higher profitability and shareholder wealth. However,
financial leverage also introduces interest obligations and debt repayment requirements,
which can strain cash flow and increase financial risk, particularly in periods of economic
downturns or unexpected disruptions.
In the context of starting a business manufacturing industrial parts, decisions
regarding financing options and capital structure play a crucial role in determining the
level of financial leverage. Opting for debt financing through bank loans or issuing
corporate bonds provides access to additional capital to fund initial investments in
production facilities, equipment, and working capital. However, careful consideration
must be given to the company's ability to service debt obligations, manage interest
expenses, and maintain financial flexibility amidst changing market conditions.
Examining the Combined Effect of Leverage: The combined effect of operating
and financial leverage manifests in the company's overall risk-return profile and
profitability. When operating and financial leverage are effectively aligned, businesses
can achieve synergistic benefits, with higher production volumes leading to increased
revenues and profitability, which, in turn, enhances the return on equity for shareholders.
However, mismatches or excessive reliance on leverage can amplify risks and
vulnerabilities, exposing the business to financial distress or insolvency in adverse
scenarios.
Conclusion: In the dynamic landscape of business decision-making, leveraging
growth through operating and financial leverage presents both opportunities and
challenges. By carefully evaluating the trade-offs associated with fixed costs, production
capacity, debt financing, and capital structure, entrepreneurs can optimize leverage to
enhance profitability, drive growth, and create long-term value for stakeholders.
However, prudent risk management, financial discipline, and strategic agility are
essential to navigate the complexities of leverage and steer the business towards
sustainable success.
j. Operating Leverage
How much will changes in volume affect cost and profit? At what point does the
firm break even? What is the most efficient level of fixed assets to employ in the firm? A
break-even chart is presented in answer some of these questions. The number of units
produced and sold is shown along the horizontal axis, and revenue and costs are shown
along the vertical axis.
Since we are getting a $1.20 contribution toward covering fixed costs-from each
unit sold, minimum sales of 50,000 units will allow us to cover our fixed costs (50,000
units × $1.20 = $60,000 fixed costs). Beyond this point, we move into a highly profitable
range in which each unit of sales brings a profit of $1.20 to the company. As sales
increase from 50,000 to 60,000 units, operating profits increase by $12,000, as indicated
in Table 5-2; as sales increase from 60,000 to 80,000 units, profits increase by another
$24,000; and so on. As further indicated, at low volumes such as 40,000 or 20,000 units
our losses are substantial ($12,000 and $36,000 in the red).
It is assumed that the firm depicted operating with a high degree of leverage. The
situation is analogous to that of an airline that must carry a certain number of people to
break even but beyond that point is in a very profitable range. This has certainly been the
case with Southwest Airlines, which has its home office in Dallas, Texas, but also flies to
many other states. The airline systematically offers lower fares than American, Delta, and
other airlines to ensure maximum capacity utilization.
It is assumed that the firm depicted is operating with a high degree of leverage.
The situation is analogous to that of an airline that must carry a certain number of people
to break even but beyond that point is in a very profitable range. This has certainly been
the case with Southwest Airlines, which has its home office in Dallas, Texas, but also
flies to many other states. The airline systematically offers lower fares than American,
Delta, and other airlines to ensure maximum capacity utilization.
With fixed costs reduced from $60,000 to $12,000, the loss potential is small.
Furthermore, the break-even level of operations is a comparatively low 30,000 units.
Nevertheless, the use of a virtually unleveraged approach has cut into the potential
profitability of the more conservative firm.
Whether management follows the path of the leveraged firm or of the more
conservative firm depends on its perceptions of the future. If the vice president of finance
is apprehensive about economic conditions, the conservative plan may be undertaken. For
a growing business in times of relative prosperity, management might maintain a more
aggressive, leveraged position. The firm’s competitive position within its industry will
also be a factor. Does the firm desire to merely maintain stability or to become a market
leader? To a certain extent, management should tailor the use of leverage to meet its own
risk-taking desires. Those who are risk-averse (prefer less risk to more risk) should
anticipate a particularly high return before contracting for heavy fixed costs. Others, less
averse to risk, may be willing to leverage under more normal conditions. Simply taking
risks is not a virtue—our prisons are full of risk takers. The important idea, which is
stressed throughout the text, is to match an acceptable return with the desired level of
risk.
Our discussion to this point has dealt with break-even analysis in terms of
accounting flows rather than cash flows. For example, depreciation has been implicitly
included in fixed expenses, but it represents a noncash accounting entry rather than an
explicit expenditure of funds. To the extent that we were doing break-even analysis on a
strictly cash basis, depreciation would be excluded from fixed expenses. In the previous
example of the leveraged firm in Formula 5-1, if we eliminate $20,000 of “assumed”
depreciation from fixed costs, the break-even level is reduced from 50,000 units to
33,333 units.
Other adjustments could also be made for noncash items. For example, sales may
initially take the form of accounts receivable rather than cash, and the same can be said
for the purchase of materials and accounts payable. An actual weekly or monthly cash
budget would be necessary to isolate these items. While cash break-even analysis is
helpful in analyzing the short-term outlook of the firm, particularly when it may be in
trouble, break-even analysis is normally conducted on the basis of accounting flows
rather than strictly cash flows. Most of the assumptions throughout this are based on
concepts broader than pure cash flows.
Highly leveraged firms, such as Ford Motor Company or American Airlines, are
likely to enjoy a substantial increase in income as volume expands, while less leveraged
firms will participate in an increase to a lesser extent. Degree of operating leverage
should be computed only over a profitable range of operations. However, the closer DOL
is computed to the company break-even point, the higher the number will be due to a
large percentage increase in operating income.
Throughout our analysis of operating leverage, we have assumed that a constant
or linear function exists for revenues and costs as volume changes. For example, we have
used $2 as the hypothetical sales price at all levels of operation. In the “real world,”
however, we may face price weakness as we attempt to capture an increasing market for
our product, or we may face cost overruns as we move beyond an optimum-size
operation. Relationships are not so fixed as we have assumed.
k. Combining Operating and Financial Leverage
If both operating and financial leverage allow us to magnify our returns, then we
will get maximum leverage through their combined use in the form of combined
leverage. We have said that operating leverage affects primarily the asset structure of the
firm, while financial leverage affects the debt-equity mix. From an income statement
viewpoint, operating leverage determines return from operations, while financial leverage
determines how the “fruits of our labor” will be allocated to debt holders and, more
importantly, to stockholders in the form of earnings per share. We assumed in both cases
a high degree of operating and financial leverage (i.e., the leveraged firm). The sales
volume is 80,000 units.
You will observe, first, that operating leverage influences the top half of the
income statement—determining operating income. The last item under operating
leverage, operating income, then becomes the initial item for determining financial
leverage. “Operating income” and “Earnings before interest and taxes” are one and the
same, representing the return to the corporation after production, marketing, and so forth
—but before interest and taxes are paid. In the second half of the income statement, we
show the extent to which earnings before interest and taxes are translated into earnings
per share. A graphical representation of these points.
l. Degree of Combined Leverage
Understanding the intricacies of how changes in sales volume impact a company's
bottom line is crucial for strategic decision-making and financial planning. In this
analysis, we delve into the comprehensive evaluation of operating and financial leverage
to illustrate the implications of varying sales volumes on earnings per share (EPS). By
examining the entire income statement, we can gain deeper insights into the dynamics at
play and how different levels of sales volume affect profitability.
Exploring Operating and Financial Leverage: Operating leverage refers to the
extent to which fixed costs are present in a company's cost structure. A high degree of
operating leverage means that a company has a significant portion of fixed costs relative
to variable costs. Financial leverage, on the other hand, relates to the use of debt
financing to magnify returns to shareholders. Both operating and financial leverage can
amplify profitability when sales increase but can also exacerbate losses when sales
decline.
Impact on Earnings per Share: To illustrate the impact of changes in sales volume
on EPS, we'll examine a scenario where a company's sales increase from $160,000
(80,000 units) to $200,000 (100,000 units). By utilizing, which outlines the entire income
statement, we can comprehensively analyze how the change in sales volume affects
various components and ultimately, EPS.
Sales Increase Scenario Analysis: When sales increase from $160,000 to
$200,000, several factors come into play. Firstly, higher sales revenue leads to a
proportional increase in variable costs, such as raw materials and direct labor. However,
fixed costs, including rent, salaries, and depreciation, remain unchanged in the short term
due to their nature.
Operating Leverage Effect: With a high degree of operating leverage, the
company experiences a magnified impact on operating income as sales increase. This is
because fixed costs remain constant, leading to a higher contribution margin and
ultimately, higher operating income. The percentage increase in operating income
surpasses the percentage increase in sales due to the leverage effect.
Financial Leverage Effect: Simultaneously, financial leverage further amplifies
the impact on EPS. As operating income increases, the company's interest expense
remains constant, resulting in a higher net income. This magnification of net income due
to financial leverage contributes to a greater increase in EPS compared to the percentage
increase in operating income.
Combined Leverage Analysis: By combining operating and financial leverage
effects, we can observe a synergistic impact on EPS. The combined leverage accentuates
the positive effects of increased sales volume on profitability, enhancing shareholder
value.
Conclusion: In conclusion, analyzing the impact of changes in sales volume on
EPS requires a comprehensive understanding of operating and financial leverage. By
examining the entire income statement and considering the interplay between fixed and
variable costs, we can gain valuable insights into how changes in sales volume affect
profitability. This analysis aids in strategic decision-making and financial planning,
enabling companies to optimize their performance and maximize shareholder value.
In a sense, we are piling risk on risk as the two different forms of leverage are
combined. Perhaps a firm carrying heavy operating leverage may wish to moderate its
position financially, and vice versa. One thing is certain—the decision will have a major
impact on the operations of the firm.
Leverage may be defined as the use of fixed cost items to magnify returns at high
levels of operation. Operating leverage primarily affects fixed versus variable cost
utilization in the operation of the firm. An important concept—degree of operating
leverage (DOL)—measures the percent change in operating income as a result of a
percent change in volume. The heavier the utilization of fixed cost assets, the higher DOL
is likely to be.
Financial leverage reflects the extent to which debt is used in the capital structure
of the firm. Substantial use of debt will place a great burden on the firm at low levels of
profitability, but it will help magnify earnings per share as volume or operating income
increases. We combine operating leverage and financial leverage to assess the impact of
all types of fixed costs on the firm. There is a multiplier effect when we use the two
different types of leverage. Because leverage is a two-edged sword, management must be
sure the level of risk assumed is in accord with its desires for risk and its perceptions of
the future. High operating leverage may be balanced off against lower financial leverage
if this is deemed desirable, and vice versa.
