Brealey, Myers. Principles of Corporate Finance. 7th edition
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
838 PART IX Financial Planning and Short-Term Management
For Executive Paper,
We first encountered this formula in Chapter 4, where we used it to value the
firm’s equity.
These simple formulas remind us that financial plans need to be consistent.
Firms may grow rapidly in the short term by relying on debt finance, but such
growth cannot be maintained without incurring excessive debt levels.
Sustainable growth rate .40 .1822 .0729,
or 7.29%
SUMMARY
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Managers use financial statements to monitor their own company’s performance,
to help understand the policies of a competitor, or to check on the health of a cus-
tomer. But there is a danger of being overwhelmed by the sheer volume of data.
That is why managers use a few salient ratios to summarize the firm’s leverage,
liquidity, efficiency, profitability, and market valuation. We have described some of
the more popular financial ratios.
We offer the following general advice to users of these ratios:
1. Financial ratios seldom provide answers, but they do help you to ask the right
questions.
2. There is no international standard for financial ratios. A little thought and com-
mon sense are worth far more than blind application of formulas.
3. You need a benchmark for assessing a company’s financial position. Compare
financial ratios with the company’s ratios in earlier years and with the ratios of
other firms in the same business.
Understanding the past is the first step to being prepared for the future. Most
firms prepare a financial plan that describes the firm’s strategy and projects its fu-
ture consequences by means of pro forma balance sheets, income statements, and
statements of sources and uses of funds. The plan establishes financial goals and is
a benchmark for evaluating subsequent performance.
The plan is the end result, but the process that produces the plan is valuable in
its own right. First, planning forces the financial manager to consider the combined
effects of all the firm’s investment and financing decisions. This is important be-
cause these decisions interact and should not be made independently. Second,
planning requires the manager to consider events that could upset the firm’s
progress and to devise strategies to be held in reserve for counterattack when un-
happy surprises occur.
There is no theory or model that leads straight to the optimal financial strategy.
Consequently, financial planning proceeds by trial and error. Many different strate-
gies may be projected under a range of assumptions about the future. The dozens
of separate projections that may be made during this trial-and-error process gen-
erate a heavy load of arithmetic. Firms have responded by developing corporate fi-
nancial planning models to forecast the financial consequences of different strate-
gies. We showed how you can use a simple spreadsheet model to analyze
Executive Paper’s strategies. But remember there is no finance in these models.
Their primary purpose is to produce accounting statements.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
CHAPTER 29 Financial Analysis and Planning 839
FURTHER
READING
There are some good general texts on financial statement analysis. See, for example:
G. Foster: Financial Statement Analysis, 2nd ed., Prentice-Hall, Inc., Englewood Cliffs,
NJ, 1986.
K. G. Palepu, V. L. Bernard, and P. M. Healy: Business Analysis and Valuation, South-Western
College Publishing, Cincinnati, OH, 2nd ed., 2000.
Three classic articles on the application of financial ratios to specific problems are:
W. H. Beaver: “Financial Ratios as Predictors of Failure,” Empirical Research in Accounting:
Selected Studies, supplement to Journal of Accounting Research, 1966, pp. 77–111.
W. H. Beaver, P. Kettler, and M. Scholes: “The Association between Market-Determined and
Accounting-Determined Risk Measures,” Accounting Review, 45:654–682 (October 1970).
J. O. Horrigan: “The Determination of Long Term Credit Standing with Financial Ratios,”
Empirical Research in Accounting: Selected Studies, supplement to Journal of Accounting Re-
search, 1966, pp. 44–62.
Corporate planning has an extensive literature of its own. Good books and articles include:
G. Donaldson: “Financial Goals and Strategic Consequences,” Harvard Business Review,
63:57–66 (May–June 1985).
G. Donaldson: Strategy for Financial Mobility, Harvard Business School Press, Boston, 1986.
A. C. Hax and N. S. Majluf: The Strategy Concept and Process—A Pragmatic Approach, 2nd ed.,
Prentice-Hall, Inc., Englewood Cliffs, NJ, 1996.
The links between capital budgeting, strategy, and financial planning are discussed in:
S. C. Myers: “Finance Theory and Financial Strategy,” Interfaces, 14:126–137 (January–
February, 1984).
Here are three references on corporate planning models:
W. T. Carleton, C. L. Dick, Jr., and D. H. Downes: “Financial Policy Models: Theory and Prac-
tice,” Journal of Financial and Quantitative Analysis, 8:691–709 (December 1973).
W. T. Carleton and J. M. McInnes: “Theory, Models and Implementation in Financial Man-
agement,” Management Science, 28:957–978 (September 1982).
S. C. Myers and G. A. Pogue: “A Programming Approach to Corporate Financial Manage-
ment,” Journal of Finance, 29:579–599 (May 1974).
QUIZ
1. Table 29.9 gives abbreviated balance sheets and income statements for Weyerhaeuser
Company. Calculate the following ratios:
a. Debt ratio.
b. Times-interest-earned ratio.
c. Current ratio.
d. Quick ratio.
e. Net profit margin.
f. Days in inventory.
g. Return on equity.
h. Payout ratio.
2. There are no universally accepted definitions of financial ratios, but five of the follow-
ing ratios make no sense at all. Substitute the correct definitions.
a. Debt–equity ratio (long-term debt value of leases)/(long-term debt value of
leases equity)
b. Return on equity (EBIT tax)/average equity
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
840 PART IX Financial Planning and Short-Term Management
Visit us at www.mhhe.com/bm7e
c. Payout ratio dividend/stock price
d. Profit margin (EBIT tax)/sales
e. Inventory turnover sales/average inventory
f. Current ratio current liabilities/current assets
g. Sales-to-net-working-capital average sales/average net working capital
h. Average collection period sales/(average receivables 365)
i. Quick ratio (current assets inventories)/current liabilities
3. True or false?
a. A company’s debt–equity ratio is always less than 1.
b. The quick ratio is always less than the current ratio.
c. The return on equity is always less than the return on assets.
d. If a project is slow to reach full profitability, straight-line depreciation is likely to
produce an overstatement of profits in the early years.
e. A substantial new advertising campaign by a cosmetics company will tend to
depress earnings and cause the stock to sell at a low price–earnings multiple.
4. In each of the following cases, explain briefly which of the two companies is likely to
be characterized by the higher ratio:
a. Debt–equity ratio: a shipping company or a computer software company.
b. Payout ratio: United Foods Inc. or Computer Graphics Inc.
Income Statement
Net sales $15,980
Cost of goods sold 12,035
Other expenses 1,412
Depreciation 859
Earnings before interest and tax (EBIT) 1,674
Net interest 351
Tax 483
Earnings $ 840
Dividends 263
Balance Sheet
End of Year Start of Year
Cash and short-term securities 115 1,640
Receivables 1,247 1,296
Inventories 1,499 1,329
Other current assets 427 278
Total current assets 3,288 4,543
Tangible fixed assets 10,427 9,582
Other long-term assets 4,480 4,214
Total assets $18,195 $18,339
Short-term debt 733 909
Payables 921 961
Other current liabilities 1,050 1,083
Total current liabilities 2,704 2,953
Long-term debt and capital leases 5,114 5,100
Other long-term liabilities 3,544 3,113
Common shareholders’ equity 6,832 7,173
Total liabilities $18,195 $18,339
TABLE 29.9
Income statement
and balance sheet
for Weyerhaeuser
Company, 2000
(figures in millions).
Source: Weyerhaeuser
Company, 2000 annual
report.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
CHAPTER 29 Financial Analysis and Planning 841
Visit us at www.mhhe.com/bm7e
c. Sales-to-assets ratio: an integrated pulp and paper manufacturer or a paper mill.
d. Average collection period: a supermarket chain or a mail-order company.
e. Price–earnings multiple: Basic Sludge Company or Fledgling Electronics.
5. A firm has $30,000 of inventory. If this represents 30 days’ sales, what is the annual cost
of goods sold? What is the inventory turnover ratio?
6. Keller Cosmetics maintains a profit margin of 4 percent and a sales-to-assets ratio of 3.
a. What is its return on assets?
b. If its debt–equity ratio is 1.0, its interest payments and taxes are each $10,000, and
EBIT is $40,000, what is the return on equity?
7. A firm has a long-term debt–equity ratio of .4. Shareholders’ equity is $1 million. Cur-
rent assets are $200,000, and the current ratio is 2.0. Long-term assets total $1.5 million.
What is the ratio of debt to total long-term capital?
8. Magic Flutes has total receivables of $3,000, which represent 20 days’ sales. Average to-
tal assets are $75,000. The firm’s profit margin is 5 percent. Find the firm’s return on as-
sets and sales-to-assets ratio.
9. Consider this simplified balance sheet for Geomorph Trading:
Current assets 100 60 Current liabilities
280 Long-term debt
Long-term assets 500 70 Other liabilities
190 Equity
600 600
a. Calculate the ratio of debt to equity.
b. What are Geomorph’s net working capital and total long-term capital? Calculate
the ratio of debt to total long-term capital.
10. Airlux Antarctica has current liabilities of $200 million and a crash—sorry—cash ratio
of .05. How much cash and marketable securities does it hold?
11. On average, it takes Microlimp’s customers 60 days to pay their bills. If Microlimp has
annual sales of $500 million, what is the average value of unpaid bills?
12. Executive Paper’s return on equity is higher than its return on assets. Is this always the
case? Explain.
13. True or false?
a. Financial planning should attempt to minimize risk.
b. The primary aim of financial planning is to obtain better forecasts of future cash
flows and earnings.
c. Financial planning is necessary because financing and investment decisions
interact and should not be made independently.
d. Firms’ planning horizons rarely exceed three years.
e. Financial planning requires accurate forecasting.
f. Financial planning models should include as much detail as possible.
14. Table 29.10 summarizes the 2002 income statement and end-year balance sheet of
Drake’s Bowling Alleys. Drake’s financial manager forecasts a 10 percent increase in
sales and costs in 2003. The ratio of sales to average assets is expected to remain at .40.
Interest is forecasted at 5 percent of debt at start of year.
a. What is the implied level of assets at the end of 2003?
b. If the company pays out 50 percent of net income as dividends, how much cash
will Drake need to raise in the capital markets in 2003?
c. If Drake is unwilling to make an equity issue, what will be the debt ratio at the end
of 2003?
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
842 PART IX Financial Planning and Short-Term Management
15. Abbreviated financial statements for Archimedes Levers are shown in Table 29.11. If
sales increase by 10 percent in 2002 and all other items, including debt, increase corre-
spondingly, what must be the balancing item? What will be its value?
16. What is the maximum possible growth rate for Archimedes (see question 15) if the pay-
out ratio is set at 50 percent and (a) no external debt or equity is to be issued? (b) the
firm maintains a fixed debt ratio but issues no equity?
Income Statement
Sales $1,000 (40% of average assets)*
Costs 750 (75% of sales)
Interest 25 (5% of debt at start of year)
†
Pretax profit 225
Tax 90 (40% of pretax profit)
Net income $ 135
Balance Sheet
Assets $2,600 Debt $ 500
Equity 2,100
Total $2,600 Total $2,600
TABLE 29.10
Financial statement for Drake’s
Bowling Alleys, 2002 (figures in
thousands).
*Assets at end-2001 were
$2,400,000.
†
Debt at end-2001 was $500,000.
Income Statement
Sales $4,000
Costs, including interest 3,500
Net income $ 500
Balance Sheet, Year-end
2001 2000 2001 2000
Assets $3,200 $2,700 Debt $1,200 $1,033
Equity 2,000 1,667
Total $3,200 $2,700 Total $3,200 $2,700
TABLE 29.11
Financial statements for Archimedes
Levers, 2001.
PRACTICE
QUESTIONS
1. Look up the latest financial statements for any company on the Market Insight database
(www
.mhhe.com/edumarketinsight) and calculate a sources and uses of funds table
for the latest year. Don’t be put off by the fact that actual financial statements are more
complicated than the simplified ones we showed for Executive Paper.
2. Look up the latest financial statements for any company on the Market Insight data-
base (www
.mhhe.com/edumarketinsight) and calculate the following ratios for the
latest year:
a. Debt ratio.
b. Times-interest-earned.
c. Current ratio.
d. Quick ratio.
e. Net profit margin.
f. Days in inventory.
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
CHAPTER 29 Financial Analysis and Planning 843
Visit us at www.mhhe.com/bm7e
g. Return on equity.
h. Payout ratio.
3. Select a sample of companies with financial statements on the Market Insight database
(www
.mhhe.com/edumarketinsight
) and compare the days in inventory and the aver-
age collection period for receivables. Can you explain these differences?
4. This question reviews some of the difficulties encountered in interpreting accounting
numbers.
a. Give four examples of important assets, liabilities, or transactions which may not
be shown on the company’s books.
b. How does investment in intangible assets, such as research and development,
distort accounting ratios? Give at least two examples.
c. Explain the three ways in which accelerating inflation affects earnings and
profitability ratios based on historical-cost accounting.
5. Use financial ratio analysis to compare two companies chosen from the same industry.
6. Discuss alternative measures of financial leverage. Should the market value of equity
be used or the book value? Is it better to use the market value of debt, the book value,
or the book value discounted at the risk-free interest rate? How should you treat off-
balance-sheet obligations such as pension liabilities? How would you treat preferred
stock, deferred tax reserves, and minority interest?
7. Suppose that at year-end 1999 Executive Paper had unused lines of credit that would
have allowed it to borrow a further $300 million. Suppose also that it used this line of
credit to raise short-term loans of $300 million and invested the proceeds in marketable
securities. Would the company have appeared to be (a) more or less liquid? (b) more or
less highly levered? Calculate the appropriate ratios.
8. How would the following actions affect a firm’s current ratio?
a. Inventory is sold.
b. The firm takes out a bank loan to pay its suppliers.
c. A customer pays its overdue bills.
d. The firm uses cash to purchase additional inventories.
9. Sara Togas sells all its output to Federal Stores. The following table shows selected fi-
nancial data, in millions, for the two firms:
Sales Profits Assets
Federal Stores $100 $10 $50
Sara Togas 20 4 20
Calculate the sales-to-assets ratio, the profit margin, and the return on the two firms.
Now assume that the two companies merge. If Federal continues to sell goods worth
$100 million, how will the three financial ratios change?
10. United Ratio’s common stock has a dividend yield of 4 percent. Its dividend per share
is $2, and it has 10 million shares outstanding. If the market-to-book ratio is 1.5, what is
the total book value of the equity?
11. As you can see, someone has spilled ink over some of the entries in the balance sheet
and income statement of Transylvania Railroad (Table 29.12). Can you use the follow-
ing information to work out the missing entries?
• Financial leverage: .4.
• Times-interest-earned: 8.
• Current ratio: 1.4.
• Quick ratio: 1.0.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
844 PART IX Financial Planning and Short-Term Management
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• Cash ratio: .2.
•
Return on total assets: .18.
• Return on equity: .41.
• Inventory turnover: 5.0.
•
Receivables’ collection period: 71.2 days.
12. Here are some data for five companies in the same industry:
December December
2001 2000
Balance Sheet
Cash
■■■ 20
Accounts receivable
■■■ 34
Inventory
■■■ 26
Total current assets
■■■ 80
Fixed assets, net
■■■ 25
Total
■■■ 105
Notes payable 30 35
Accounts payable 25 20
Total current liabilities
■■■ 55
Long-term debt
■■■ 20
Equity
■■■ 30
Total 115 105
Income Statement
Sales
■■■
Cost of goods sold ■■■
Selling, general, and administrative expenses 10
Depreciation 20
EBIT
■■■
Interest ■■■
Earnings before tax ■■■
Tax ■■■
Earnings available for common stock ■■■
TABLE 29.12
Balance sheet and income
statement of Transylvania Railroad
(figures in $ millions).
Company Code
AB C D E
Net income (millions) $ 10 $ .5 $ 6.67 $ 1 $ 6.67
Total book assets (millions) $300 $30.0 $120.00 $50 $120.00
Shares outstanding (millions) 3 4 2 5 10
Share price $100 $ 5 $ 50 $ 8 $ 10
You have been asked to calculate a measure of the industry price–earnings ratio. Dis-
cuss the possible ways that you might calculate such a measure. Does changing the
method of calculation make a significant difference to the end result?
13. Describe some of the ways that the choice of accounting technique can temporarily de-
press or inflate earnings.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
CHAPTER 29 Financial Analysis and Planning 845
Visit us at www.mhhe.com/bm7e
14. How would rapid inflation affect the accuracy and relevance of a manufacturing com-
pany’s balance sheet and income statement? Does your answer depend on how much
debt the company has issued?
15. In 1970 United Airlines bought four new jumbos for $21.8 million each. These planes
were written down straight-line over 16 years to a residual value of $0.2 million each.
However, they could have been sold in 1986 for about $20 million each.
22
How would
the company’s financial ratios have changed if it had used a depreciation schedule that
more nearly reflected the actual decline in aircraft values?
16. The British food company Ranks Hovis McDougall (RHM) believed that some of
its most valuable assets were its brand names. Yet these assets are not usually
shown on the balance sheet. In 1988 RHM changed its accounting policy to include
the value of brand names and thereby added £678 million (nearly $1.2 billion) to
the balance sheet. Do you think that this change would facilitate comparisons be-
tween firms?
17. Suppose you wish to use financial ratios to estimate the risk of a company’s stock.
Which of those that we have described in this chapter are likely to be helpful? Can you
think of other accounting measures of risk?
18. Look up some firms that have been in trouble. Plot the changes over the preceding years
in the principal financial ratios. Are there any patterns?
19. List the major elements of a completed financial plan.
20. “There is no finance in financial planning models.” Explain.
21. What are the dangers and disadvantages of using a financial model? Discuss.
22. Should a financial plan be considered an unbiased forecast of future cash flows, earn-
ings, and other financial variables? Why or why not?
23. Our model of Executive Paper is an example of a top-down planning model. Some
firms use a bottom-up financial planning model, which incorporates forecasts of rev-
enues and costs for particular products, advertising plans, major investment projects,
and so on. What sort of firms would you expect to use each type, and what would they
use them for?
24. Corporate financial plans are often used as a basis for judging subsequent performance.
What do you think can be learned from such comparisons? What problems are likely to
arise, and how might you cope with these problems?
25. What problems are likely to be encountered in keeping the financial plan up-to-date?
26. The balancing item in the Executive Paper model is borrowing. What is meant by
balancing item? How would the model change if dividends were made the balanc-
ing item instead? In that case how would you suggest that planned borrowing be
determined?
27. Construct a new model for Executive Paper based on your answer to question 26. Does
your model generate a feasible financial plan for 2000? (Hint: If it doesn’t, you may have
to allow the firm to issue stock.)
28. Executive Paper’s financial manager believed that revenues in 2000 would rise by as
much as 50 percent or by as little as 10 percent. Recalculate the pro forma financial state-
ments under these two assumptions. How does the rate of growth in revenues affect the
firm’s borrowing requirement?
22
See M. D. Staunton, Pricing of Airline Assets and Their Valuation by Securities Markets, unpublished PhD
dissertation, London Business School, 1992.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
846 PART IX Financial Planning and Short-Term Management
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29. a. Use the Executive Paper model (Tables 29.6–29.8) to produce pro forma income state-
ments, balance sheets, and sources and uses of funds statements for 2000 and 2001.
Assume business as usual except that sales and costs were planned to expand by
30 percent per year, as were fixed assets and net working capital. The interest rate
was forecasted to remain at 10 percent and stock issues were ruled out. Executive Pa-
per also stuck to its 60 percent dividend payout ratio.
b. What are the firm’s debt ratio and interest coverage under this plan?
c. Can the company continue to finance expansion by borrowing?
30. Table 29.13 shows the 2001 financial statements for the Executive Cheese Company. An-
nual depreciation is 10 percent of fixed assets at the beginning of the year, plus 10 per-
cent of new investment. The company plans to invest a further $200 per year in fixed
assets for the next five years and forecasts that the ratio of revenues to total assets at the
start of each year will remain at 1.75. Fixed costs are expected to remain at $53, and vari-
able costs, at 80 percent of revenue. The company’s policy is to pay out two-thirds of
net income as dividends and to maintain a book debt ratio of 20 percent.
Income Statement
Revenue $1,785
Fixed costs 53
Variable costs (80% of revenue) 1,428
Depreciation 80
Interest (at 11.8%) 24
Taxes (at 40%) 80
Net income $ 120
Sources and Uses of Funds
Sources:
Operating cash flow $ 200
Borrowing 36
Stock issues 104
Total sources $ 340
Uses:
Increase in net working capital $ 60
Investment 200
Dividends 80
Total uses $ 340
Balance Sheet, Year-end
2001 2000
Assets:
Net working capital $ 400 $ 340
Fixed assets 800 680
Total assets $1,200 $1,020
Liabilities:
Debt $ 240 $ 204
Book equity 960 816
Total liabilities $1,200 $1,020
TABLE 29.13
Financial statements for Executive Cheese
Company, 2001 (figures in thousands).
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
CHAPTER 29 Financial Analysis and Planning 847
Visit us at www.mhhe.com/bm7e
a. Construct a model for Executive Cheese like the one in Tables 29.6–29.8.
b. Use your model to produce a set of financial statements for 2002.
31. Table 29.14 contains financial statements for Dynastatics Corporation. Although the
company has not been growing, it now plans to expand and will increase net fixed
assets (that is, assets net of depreciation) by $200 per year for the next five years.
It forecasts that the ratio of revenues to total assets will remain fixed at 1.5. Annual
Income Statement
Revenue $1,800
Fixed costs 56
Variable costs (80% of revenue) 1,440
Depreciation 80
Interest (8% of beginning-of-year debt) 24
Taxable income 200
Taxes (at 40%) 80
Net income $ 120
Dividends $80
Retained earnings $40
Balance Sheet, Year-end
2002 2001
Assets:
Net working capital $ 400 $ 400
Fixed assets 800 800
Total assets $1,200 $1,200
Liabilities and shareholders’ equity:
Debt $ 300 $ 300
Equity 900 900
Total liabilities and shareholders’ equity $1,200 $1,200
TABLE 29.14
Financial statements for Dynastatics
Corporation 2002 (figures in thousands).
Income Statement
Sales $950
Costs 250
EBIT 700
Taxes 200
Net income $500
Balance Sheet, Year-end
2001 2002 2001 2002
Assets $2,700 $3,000 Debt $ 900 $1,000
Equity 1,800 2,000
Total $2,700 $3,000 Total $2,700 $3,000
TABLE 29.15
Financial statements for Eagle Sport
Supply, 2002.