FM-474

Managerial Finance

Professor Daniel Paravisini

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 Plan for Today
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Basics of Financial Statements

• Balance sheet
• Income statement
Wilson Lumber Analysis
• Diagnostics using operating and financial ratios
• Uses and sources of funds
• Sustainable growth
• Planning for the future: pro-forma financial statements

Problem Set

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 From Course FAQ
Q: Will a formula sheet be provided in the exam?

A: The only formulas that will be provided (if needed) are the formulas for
the unlevering/relevering of the betas, as we have not discussed their
derivation in class (for those who are interested, I have uploaded a
separate file on Moodle explaining the derivation of these formulas). You
need to know all the other formulas we covered.

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 FINANCIAL STATEMENT ANALYSIS

BACKGROUND READING: BERK & DEMARZO, CH. 2

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Components of Financial Statements
• Balance Sheet
– Takes “snapshot” of company assets and liabilities at a
specific point in time

• Income Statement
– Presents the flow of income generated from operations
between two dates

• Statement of Cash Flows

– Reports the cash flows in and out of the company from
operating, investing, and financing activities between two
dates

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 Balance Sheet
v Golden rule: Total Assets = Total Liabilities + Equity

Wilson Lumber, 1984 ($000s)

Assets Liabilities
Cash 29 Debt, current portion 5
Accounts Receivable 222 Note Payable – Bank 163
Inventory 292 Accounts Payable 179
Accrued Expenses 27
Current Assets 543 Current Liabilities 374
Long Term Debt 35
Property, Plant, Equip. 110 Equity 244
Total Assets 653 Total Liab. + Equity 653

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 Income Statement
• Measures accrued revenues and expenses; generates a
bottom line Net Income number
• In turn, Net Income is related to the balance sheet through
its (positive) effect on Equity

Wilson Lumber, 1984 ($000s)

Sales 1,884
Cost of Goods Sold 1,364
Gross Profit 520
Operating Expenses 460
Earnings before Interest and Taxes (EBIT) 60
Interest Expense 23
Net Income before Taxes 37
Taxes 6
Net Income 31

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 Cash vs. Accrual Accounting
• Cash accounting only considers transactions in which there are cash
receipts or disbursements
– If you don’t get the money it’s not a revenue, and if you don’t
write a check it’s not an expense

• Accrual accounting – used in GAAP (Generally Accepted Accounting

Principles) and IFRS (International Finance Reporting Standards) –
focuses on transactions that will have cash consequences, whether
immediately or in the future
– Say you sell a product today
• You will get paid next month
• You incurred the production costs last month
– The matching principle underlying accrual accounting records
the revenues and expenses at the time of the sales transaction
even if there are no immediate cash consequences

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 Example 1: Inventory Purchase
• Wilson pays cash for $100k of lumber inventory on March 1

• Does this amount get expensed on March 1?

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 Example 1: Inventory Purchase
• Although the cash was paid, an increase in inventory is not an
expense and does not affect the income statement when
purchased

• By purchasing the lumber, Wilson reduces cash and increases

inventory, thus maintaining the same level of total assets

• The inventory purchase only affects the income statement

when the inventory is sold

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 Example 1: Inventory Purchase
(assume taxes = 0 for simplicity)
Upon Purchase of Inventory for $100k:
BALANCE SHEET INCOME STATEMENT
Cash $100k No impact
Inventory $100k
Total assets: Unchanged

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 Example 1b: Sale
• On March 2 Wilson sells $100k worth of lumber inventory
for $120k, client will pay in 30 days

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 Example 1: Inventory Purchase
(assume taxes = 0 for simplicity)
Upon Purchase of Inventory for $100k:
BALANCE SHEET INCOME STATEMENT
Cash $100k No impact
Inventory $100k
Total assets: Unchanged

Upon Sale of Inventory for $120k:

BALANCE SHEET INCOME STATEMENT

AR $120k Revenues $120k
Inventory $100k Cost of goods sold $100k
Total assets: $20k Net Income $20k

Retained Earnings: $20k

Equity: $20k
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 Example 2: Prepaid Expenses and
Services Rendered
• Wilson employs a company to sharpen, maintain, and
repair the saws and mills on a monthly basis. The
company charges Wilson $120k per year, payable at
the beginning of the year.

• In what period does the $120k affect the income

statement?

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 Example 2: Prepaid Expenses and
Services Rendered
• Because the service is rendered over 12 months, Wilson expenses
$10k each month over the course of the agreement

• Income Statement Effect: Agreement shows up as $10k of

operating expenses on the monthly income statement

• Balance Sheet Effect:

– Liabilities: $10k of operating expense reduces Retained earnings (Equity)
by $10k
– Assets: Prepaid Expenses (the opposite of Accrued Expenses) increases
by $110k and Cash falls by $120k, lowering Total Assets by $10k
ð The Golden Rule is obeyed

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Example 2: Prepaid Expenses and
Services Rendered
BALANCE SHEET INCOME STATEMENT
Cash $120k Oper. Expense: $10k
Prepaid exp. $110k Net Income: $10k
Total assets: $10k

Retained Earnings: $10k

Equity: $10k

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 Example 3: Capitalization and
Depreciation
• Wilson purchases a $10,000 saw for the mill and pays in
cash

• Do these $10,000 get expensed in the year that the saw is

purchased, i.e., do they show up as an operating expense?

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 Example 3: Capitalization and
Depreciation
• If the machine purchase is capitalized (recorded as Property, Plant,
and Equipment), none of it is expensed in the current period

• The asset is depreciated gradually over its “useful life” (as

determined by various accounting standards)
– The depreciation decreases the book value of the asset
– The depreciation is recorded as an expense in the period incurred

• Example:
– If the “useful life” is 10 years, the book value of the asset would be
$9,000 at the end of year 1, and depreciation expense during the first
year would be $1,000

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 Example 3: Capitalization and
Depreciation
Upon Purchase of Equipment:
BALANCE SHEET INCOME STATEMENT
Cash $10k No impact
PPE $10k
Total assets: Unchanged

After year 1:

BALANCE SHEET INCOME STATEMENT

PPE $1k Depreciation Exp. $1k
Total assets: $1k Net Income $1k

Retained Earnings: $1k

Equity: $1k

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WILSON LUMBER

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 The Lumber Business
• Commodity business ð Price + “Service”

• Two types of service provided to customers (contractors):

(1) Inventories:
Ø Contractors need stock on hand
Ø Buy in bulk to get discounts
Ø But: Inventories are tying up capital

(2) Accounts Receivable (A/R):

Ø Contractors need credit
Ø Needs to be “re-financed” by Wilson
Balance Sheet 1984
• Essentially: Assets = A/R + Inventories A/R 222
Inv. 292
PPE 110

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 How Well Is Wilson Doing?
1981 1982 1983 1984 1985 (Q1)
Sales 762 1,187 1,408 1,884 2,500 (est.)
Sales Growth
EBIT 35 43 60 15
EBIT/Sales
Profit (after tax) 21 24 31 6
Profit Growth

Net Worth 168 189 213 244 250

ROE*

Total Assets 418 515 653 767

ROA**
* ROE = Growth in Net Worth = Net Income / Net Worth (of past year)
** ROA = Net Income / Total Assets (of past year)

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 How Well Is Wilson Doing?
1981 1982 1983 1984 1985 (Q1)
Sales 762 1,187 1,408 1,884 2,500 (est.)
Sales Growth 56% 19% 34% 33%
EBIT 35 43 60 15
EBIT/Sales 2.95% 3.05% 3.18% 2.99%
Profit (after tax) 21 24 31 6
Profit Growth 14% 29%

Net Worth 168 189 213 244 250

ROE* 12.5% 12.7% 14.6%

Total Assets 418 515 653 767

ROA** N/A 5.7% 6.0%
* ROE = Growth in Net Worth = Net Income / Net Worth (of past year)
** ROA = Net Income / Total Assets (of past year)

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 Is there a problem?
• Wilson is expanding rapidly

• Running up against bank credit limit

• Is this something to be worried about?

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 Leverage is Up, Way Up
1982 1983 1984 1985
Liabilities / Equity 1.2 1.4 1.7 2.1
Liabilities / Assets 54.8% 58.6% 62.6% 67.4%
Interest Coverage * 3.9 3.1 2.6 2.1
Current Ratio ** 1.8 1.6 1.5 1.4

* Interest Coverage = EBIT / Interest

** Current Ratio = Current Assets / Current Liabilities

Why? What’s happening?

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 Sources and Uses of Funds?

• Where is Wilson getting money from?

• Where is Wilson using money?

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Sources & Uses of Funds
1982 1985 Use Source
Assets
Cash 41 24 17
A/R 120 241 121
Inv. 167 389 222
Fixed 90 113 23
418 767

Liabilities
Bank Loan 0 173 173
Stark 75 0 75
Trade Credit 87 280 193
Accrued Exp. 17 25 8
Long Term Debt 50 39 11
Net Worth 189 250 61
418 767 452 452
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Sources & Uses of Funds
1982 1985 Use Source
Assets
Cash 41 24 17
A/R 120 241 121
Inv. 167 389 222
Fixed 90 113 23
418 767

Liabilities
Bank Loan 0 173 173
Stark 75 0 75
Trade Credit 87 280 193
Accrued Exp. 17 25 8
Long Term Debt 50 39 11
Net Worth 189 250 61
418 767 452 452
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What Does the Increase in A/R and Inventories Mean?
• Can inventories be too high?
– Yes – inefficient inventory management, stock that doesn’t sell

• Can inventories be too low?

– Yes – sales are lost if lumber is not on hand

• Is the firm run well?

– It is profitable, but are there signs efficiency declining

• How can we tell?

– Ratios help once again
Ø Operating ratios (rather than financial ratios)

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 Operating Ratios:

1982 1983 1984 1985 (Q1)

Days of Inventory =
(INV/COGS) x 365 71.2 82.8 78.1 97.3

Collection Period =
(AR/Sales) x 365 36.9 40.2 43 43.8

Payable Period =
(AP/Purchases) x 365 35.5 45.9 45.8 55.3

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What Drives Wilson’s Funding Needs?

1) Growth Key Point:

Growth + Low Profitability

2) Poor control of assets ð Financing Need

Mechanically: If your profits

3) Low profitability are not enough to fund your
relative to growth growth, you need outside
financing
Mostly 1) and 3)

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 The Concept of “Sustainable
Growth”
• Sustainable growth: How fast can you grow the company without
increasing the leverage ratio and without issuing new equity?

• Growth is “sustainable” if growth rate of assets, g, satisfies:

g £ ROE

• This assumes zero dividends. With a dividend payout rate of d, i.e.,

a retention ratio of 1-d, the sustainable growth rate becomes:

g £ ROE (1-d)
= growth rate of Net Worth

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 Sustainable Growth (cont.)
• You can grow faster than your sustainable growth rate - many
companies do!

Ø Any large company has grown faster than its sustainable growth
rate at some point

• But growing that fast you must do one of the following:

Ø Increase leverage ratio
Ø Issue new equity
Ø (Cut dividends)

• Firms that grow slowly relative to ROE accumulate cash

– Unless they buy back stock or pay out dividends

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Example (close to Wilson Lumber)
• ROE = 15%, Leverage Ratio = 2/3
• You pay no dividends and cannot raise additional equity
a But: You try to grow at 25%

Debt Debt
Assets
Assets 600 ?
900 1,125

Equity Equity
300 345

• Debt has to grow to 780 to support 25% growth in the assets.

ð Debt must grow by 30%, and the leverage ratio increases!

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 Wilson’s Cash Cycle
Buy wood Sell it Get paid

80 days 44 days
(Inventories) (A/R)

• Somebody must finance the lumber for 124 days.

• How long does Wilson have to fund it?

– Depends on when he pays his suppliers:
• If after 50 days, then 74 days
• If after 10 days, then 114 days

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 Is Trade Credit Cheap?
Buy $1,000 (2% discount for payments withing 10 days):

• Simple (not-compounded) interest for going from 10 to 30 days:

$20 365 days
´ = 37.2% annualized
$980 20 days

• If go to 50 days (assuming same price of $1,000):

$20 365 days
´ = 18.6%
$980 40 days

• Break even at 14%: Would need 53.2 days

$20 365 days
´ = 14%
$980 53.2 days

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 How large a loan does Wilson need?
• How much does Wilson need to borrow to fund his business?

v To assess Wilson’ growth plan, we need to forecast

Ø Income Statement
Ø Balance Sheet

v To produce “Pro Forma Statements” we make assumptions about

future Sales and profitability
v All other variables (both assets and liabilities) follow from the sales
and profitability forecasts (and our assumptions)

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 Wilson Lumber
Planning for the future
• Pro Forma Balance Sheet and Income Statement for 1985:

– Assume sales hit $2.5m in 1985 and A/P down to 10 days (so
Wilson gets to take the trade discount)
– Assume all other asset categories (cash, inventory, PP&E, ...) grow
proportionally with sales
– Assume operating profitability (without the trade discount) doesn’t
change

• Use the projected Balance Sheet for 1985 to see how large a bank loan
Mr. Wilson needs
– Is the $325,000 loan he asks for sufficient?

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 Financial Forecasts, 1985
Scenario (a): 10 days A/P Period. 2.5m Sales in 1985
1984 1985
Sales 1,884 2,500
Operating Profit (3% of sales) 60 ?
Discount of 2% - ?
Interest 23 ?
Pretax profits 37 ?
Taxes 6 ?
Profit After Taxes 31 ?

Cash 29 ?
A/R 222 ?
Inventory 292 ?
PP&E 110 ?
Total 653 ?

A/P 179 ?
Accrued Expenses 27 ?
Current Portion of LT Debt 5 ?
Bank Debt 163 ?
LT Debt 35 ?
Equity 244 ?
Total 653 ?
 Forecast Assumptions
Income Statement
• Sales Growth (a) 25% and (b) 14%, starting from $2.5m in 1985
• COGS 72% of Sales
• Operating Profit 3% of Sales
• Purchase Discount 2% of COGS
• Interest Rate on Borrowings 14%
• Tax Rate 20%

Balance Sheet
• Cash grows with Sales
• A/R 12% of Sales
• Inventory 16% of Sales
• PP&E grow with Sales
• A/P from Payables period of 10 days assuming that Purchases are 75% of Sales
• Accrued Expenses 1.5% of Sales

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Use Ratios to Support Assumptions

1982 1983 1984

COGS/Sales 72.0% 71.4% 72.4%
EBIT/Sales 2.9% 3.1% 3.2%
Tax Rate 19.2% 17.2% 16.2%
End Inv/Sales 14.1% 16.2% 15.5%
AR/Sales 10.1% 11.0% 11.8%
Purchases/Sales 75.3% 75.7% 75.8%
Acc Exp/Sales 1.4% 1.5% 1.4%

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 Financial Forecasts, 1985
Scenario (a): 10 days A/P Period. 2.5m Sales in 1985
1984 1985
Sales 1,884 2,500
Operating Profit (3% of sales) 60 75
Discount (2%x72%) - 18
Interest (14% of borrowings) 23 ?
Pretax profits 37 ?
Taxes (20%) 6 ?
Profit After Taxes 31 ?

Cash (grow with sales after 1984) 29 38

A/R (12% of sales) 222 300
Inventory (16% of sales) 292 400
PP&E (grow with sales after 1984) 110 146
Total 653 884

A/P (10/365 x 75%) 179 51

Accrued Expenses (1.5% of sales) 27 38
Current Portion of LT Debt 5 5
Bank Debt 163 ?
LT Debt 35 30
Equity 244 ?
Total 653 884
Interest Exp. (for 1985) = [(40+35)/2 + (163+?)/2] * 14% (for other years) = Avg. Balance * 14%
 Financial Forecasts, 1985
Scenario (a): 10 days A/P Period. 2.5m Sales in 1985
1984 1985
Sales 1,884 2,500
Operating Profit (3% of sales) 60 75
Discount (2%x72%) - 18
Interest (14% of borrowings) 23 50
Pretax profits 37 43
Taxes (20%) 6 9
Profit After Taxes 31 34

Cash (grow with sales after 1984) 29 38

A/R (12% of sales) 222 300
Inventory (16% of sales) 292 400
PP&E (grow with sales after 1984) 110 146
Total 653 884

A/P (10/365 x 75%) 179 51

Accrued Expenses (1.5% of sales) 27 38
Current Portion of LT Debt 5 5
Bank Debt 163 482
LT Debt 35 30
Equity 244 278
Total 653 884
Interest Exp. (for 1985) = [(40+35)/2 + (163+?)/2] * 14% (for other years) = Avg. Balance * 14%
 Financial Forecasts, 1985-88 Scenario (a): 25% growth and 10 days A/P Period
1985 1986 1987 1988
Sales (grow @ 25%) 2,500 3,125 3,906 4,883
Operating Profit (3% of sales) 75 94 117 146
Discount (2%x72%) 18 45 56 70
Interest (14% of borrowings) 50 83 108 139
Pretax profits 43 56 66 78
Taxes (20%) 9 11 13 16
Profit After Taxes 34 44 53 62
Cash (grow with sales after 1984) 38 48 60 75
A/R (12% of sales) 300 375 469 586
Inventory (16% of sales) 400 500 625 781
PP&E (grow with sales after 1984) 146 182 228 285
Total 884 1,106 1,382 1,727
A/P (10/365 x 75%) 51 64 80 100
Accrued Expenses (1.5% of sales) 38 47 59 73
Current Portion of LT Debt 5 5 5 5
Bank Debt 482 642 843 1,096
LT Debt 30 25 20 15
Equity 278 322 375 437
Total 884 1,106 1,382 1,727

Current Ratio 7.9 8.0 8.0 8.1

Interest Coverage 1.8 1.7 1.6 1.6
Liabilities/Equity 2.2 2.4 2.7 2.9
Liabilities/Assets 69% 71% 73% 75%
ROE (start of year) 14% 16% 16% 17%
Discount (for 1985) = [2% * 72% * 2,500] / 2, since already six months into 1985
 Financial Forecasts, 1985-88 Scenario (b): 14% growth and 10 days A/P Period
1985 1986 1987 1988
Sales (grow @ 14%) 2,500 2,850 3,249 3,704
Operating Profit (3% of sales) 75 86 97 111
Discount (2%x72%) 18 41 47 53
Interest (14% of borrowings) 50 77 88 101
Pretax profits 43 49 56 64
Taxes (20%) 9 10 11 13
Profit After Taxes 34 39 45 51
Cash (grow with sales after 1984) 38 44 50 57
A/R (12% of sales) 300 342 390 444
Inventory (16% of sales) 400 456 520 593
PP&E (grow with sales after 1984) 146 166 190 216
Total 884 1,008 1,149 1,310
A/P (10/365 x 75%) 51 59 67 76
Accrued Expenses (1.5% of sales) 38 43 49 56
Current Portion of LT Debt 5 5 5 5
Bank Debt 482 559 646 745
LT Debt 30 25 20 15
Equity 278 317 362 413
Total 884 1,008 1,149 1,310

Current Ratio 7.9 7.9 8.0 8.0

Interest Coverage 1.8 1.6 1.6 1.6
Liabilities/Equity 2.2 2.2 2.2 2.2
Liabilities/Assets 69% 69% 68% 68%
ROE (start of year) 14% 14% 14% 14%
Discount (for 1985) = [2% * 72% * 2,500] / 2, since already six months into 1985
 Pro Forma Statements:
The approach:
1. Assume growth in sales.
2. Forecast assets.
3. Forecast Non-bank liabilities & guess Net Worth.
4. Difference = Bank Loan = “Bank Plug”
5. Using this plug, get Net Income.
6. Calculate Net Worth. If same as forecast, stop
7. Otherwise,
Ÿ Use revised Net Worth to get new “Bank Plug”
Ÿ Repeat until you converge.

Keep in mind: All we want are rough approximations.

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 Key Point # 1
• You cannot always achieve all goals simultaneously

• You must be internally consistent, i.e., set a financial policy that

is consistent with your product market strategy

• In particular, you cannot set your financial policy and business

strategy separately

• If your business strategy calls for 25% growth in sales and assets,
then you better have a financing strategy in place that is able to
support this!

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 Key Point # 2

• The concept of Sustainable Growth is binding only if you cannot

or will not raise equity, and you cannot let your leverage ratio
increase

• Otherwise, it only tells you whether you will have to issue equity
(assuming you do not want to increase the leverage ratio)

• Mr. Wilson needs to either slow down the growth in sales and
assets, or bring in a new partner with new equity!

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