Tuesday, May 21, 2019

Assessing Compnay’s Financial Health

Assessing a Companys succeeding(a) mo clear upary Health Assessing the long-term monetary health of a partnership is an historic task for management in its formulation of goals and strategies and for outsiders as they pack the extension of consultation, long- term supplier agreements, or an investment in a fraternitys rightfulness. History abounds with examples of companies that embarked upon overly ambitious programs and subsequently discovered that their portfolios of programs could not be financed on acceptable impairment.The outcome frequently was the abandonment of programs in mid-stream at considerable pecuniary, organizational, and human cost. It is the responsibility of management to anticipate hereafter imbalance in the corporate financial system before its severity is reflected in the financials, and to consider corrective action before both time and money atomic number 18 exhausted. The avoidance of bankruptcy is an insufficient standard. Management must ens ure the continuity of the precipitate of funds to all of its strategically most-valuable programs, even in periods of adversity.Figure A provides a conceptualization of the corporate financial system, with a suggested step-by- step process to task whether it give remain in balance over the ensuing 3-5 age. The remainder of this note discusses individually of the steps in the process and then provides an exercise on the sundry(a) financial measures that are useful as part of the analysis. The nett parting of the note demonstrates the relationship between a secures dodging and operating characteristics, and its financial characteristics.Professor Thomas Piper prepared the original version of this note, Assessing a Firms Future pecuniary Health, HBS No. 201-077, which is being replaced by this version prepared by the same author. This note was prepared as the basis for class discussion. Copyright 2010, 2011 President and Fellows of Harvard College. To order copies or reque st authority to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www. hbsp. harvard. edu/educators.This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. 911-412Assessing a Companys Future Financial Health Figure AThe Corporate Financial System Goals whole step 1Strategy Market, Competitive Technology Regulatory and in ope proportionalityn(p) Characteristics Step 2Revenue Outlook growth rate volatility, predictability Step 3Step 4 Investment in AssetsEconomic Performance to support growth profitableness improvement/ alloy in summation management cash flow volatility, predictability Step 5Step 6 External Financing Need soft touch Sources of Finance $ amountl eat uping/investing criteria timing, duration deferability attractiveness of potent to each target source Step 7 Viability of 3-5 Year Plan consistency with goals ach ievable operating plan achievable financing plan Step 8 Stress Test for Viability Under Various scenarios Step 9 Financing and Operating Plan for accepted Year Steps 1, 2 depth psychology of FundamentalsThe corporate financial system is driven by the goals, business unit choices and strategies, market conditions and the operating characteristics. The firms strategy and sales growth in each of its business units will determine the investment in assets needed to support these strategies and the effectiveness of the strategies, combined with the response of competitors and regulators, will 2 Assessing a Companys Future Financial Health911-412 strongly influence the firms competitive and profit performance, its need for external finance, and its access to the debt and virtue markets.Clearly, many of these questions require information beyond that contained in a callers published financial reports. Step 3 Investments to Support the Business Unit(s) Strategy(ies) The business unit str ategies inevitably require investments in accounts receivable, inventories, place equipment, and possibly, acquisitions. Step 3 of the process is an attempt to estimate the amount that will be tied up in each of the asset pillow slips by virtue of sales growth and the improvement/deterioration in asset management.An analyst tail assembly make a rough estimate by ignorevas the past pattern of the collection period, the old age of register, and plant equipment as a share of cost of goods sold and then applying a reasonable value for each to the sales forecast or the forecast of cost of goods sold. Extrapolation of past performance assumes, of course, that the afterlife underlying market, competitive and regulatory drivers will be unchanged from the conditions that influenced the historical performance. Step 4 Future favourableness and Competitive PerformanceStrong sustained profitableness is an important determinant of (1) a firms access to debt and/or equity finance on ac ceptable terms (2) its ability to self-finance growth through the retention of earnings (3) its capacity to place major bets on risky refreshed technologies, markets, and/or products and (4) the valuation of the company. A reasonable starting point is to analyze the past pattern of profitability. 1. What have been the fair direct, geld and volatility of profitability? 2. Is the train of profitability sustainable, stipulation the outlook for the market and for competitive and regulatory pressures? . Is the current level of profitability at the expense of future growth and/or profitability? 4. Has management initiated major profit improvement programs? Are they unique to the firm or are they industry-wide and may be reflected in lower prices rather than higher(prenominal) profitability? 5. Are there any hidden problems, such as suspiciously high levels or buildups of accounts receivable or inventory relative to sales, or a series of unusual transactions and/or accounting changes ? Step 5 Future External Financing NeedsWhether a company has a future external financing need depends on (1) its future sales growth (2) the length of its cash cycle and (3) the future level of profitability and profit retention. quick sales growth by a company with a long cash cycle (a long collection period + high inventories + high plant equipment relative to sales) and low profitability/low profit retention is a recipe for an ever- increasing appetite for external finance, raised in the form of loans, debt issues, and/or sales of shares. Why?Because the rapid sales growth results in rapid growth of an already large level of hail assets. The affix in positive assets is offset partially by an increase in accounts payable and accrued expenses, and by a small increase in owners equity. However, the financing gap is substantial. For example, the company portrayed in Table A requires $126 million of additional external finance by the end of twelvemonth 2010 to finance the increa se in get along assets required to support 25% per year sales growth in a business that is fairly asset intensive. 3 911-412Assessing a Companys Future Financial Health Table A Assuming a 25% Increase in Sales ($ in millions) Assets 2009 2010 Cash $ 12 25% $ 15 Accounts receivable 240 25% 300 Inventories 200 25% 250 Plant equipment 400 25% 500 integrality $852 $1,065 Liabilities and Equity Accounts payable $ hundred 25% $ 125 accrued expenses 80 25% 100 Long-term debt 272 Unchanged 272 Owners equity 400 footnote a 442 intact $852 $ 939 External financing need 0 126 heart $852 $1,065 a It is assumed (1) that the firm earns $60 million (a 15% sacrifice on beginning of year equity) and pays out $18 million as a cash dividend and (2) that there is no required debt repayment in 2010. If, however, the company reduced its sales growth to 5% (and make out assets, accounts payable and accrued expenses increase accordingly by 5%), the need fo r additional external finance would drop from $126 million to $0.High sales growth does not always result in a need for additional external finance. For example, a food retailer that extends no credit to customers, has only eight long time of inventory, and does not own its warehouses and stores, dismiss experience rapid sales growth and not have a need for additional external finance provided it is reasonably profitable. Because it has so few assets, the increase in total assets is largely offset by a corresponding, spontaneous increase in accounts payable and accrued expenses. Step 6 Access to Target Sources of External Finance Having estimated the future financing need, management must identify the target sources (e. g. banks, insurance companies, public debt markets, public equity market) and establish financial policies that will ensure access on acceptable terms. 1. How sound is the firms financial structure, given its level of profitability and cash flow, its level of busin ess risk, and its future need for finance? 2. How will the firm service its debt? To what extent is it counting on refinancing with a debt or equity issue? 3. Does the firm have sensible access on acceptable terms to the equity markets? How many shares could be sold and at what price in good quantify? In a period of adversity? 4. What criteria are utilize by each of the firms target sources of finance to determine whether finance will be provided and, if so, on what terms? 4 Assessing a Companys Future Financial Health911-412The evaluation of a firms financial structure can vary substantially depending on the perspective of the lender/investor. A bank may consider a seasonal credit a very(prenominal) safe bet. Considerable shrinkage can occur in the conversion of inventory into sales and collections without preventing repayment of the loan. In contrast, an investor in the firms 20-year bonds is counting on its sustained health and profitability over a 20-year period. Step 7 Via bility of the 3-5 Year Plan 1. Is the operating plan on which the financial forecasts are based achievable? 2. Will the strategic, competitive, and financial goals be achieved? 3. Will the resources required by the plan be available? 4.How will the firms competitive, organizational, and financial health at the end of the 3-5 years compare with its condition at the outset? Step 8 Stress Test under Scenarios of Adversity Financing plans typically work well if the assumptions on which they are based turn out to be accurate. However, this is an insufficient test in situations marked by volatile and unpredictable conditions. The test of the soundness of a 3-5 year plan is whether the continuity of the flow of funds to all strategically important programs can be maintained under various scenarios of adversity for the firm and/or the capital marketsor at least be maintained as well as your competitors are able to maintain the funding of their programs.Step 9 Current Financing Plan How shou ld the firm meet its financing needs in the current year? How should it balance the benefits of future financing flexibility (by change equity now) versus the temptation to delay the sale of equity by financing with debt now, in hopes of realizing a higher price in the future? The next section of this note is designed to provide familiarity with the financial measures that can be useful in understanding the past performance of a company. Extrapolation of the past performance, if done thoughtfully, can provide valuable insights as to the future health and balance of the corporate financial system.Historical analysis can also identify possible opportunities for improved asset m a n a g e m e n t or margin i m p r o v e m e n t , as well as provide an important, albeit incomplete, basis for evaluating the attractiveness of a business and/or the effectiveness of a management team. Financial Ratios and Financial Analysis The leash primary sources of financial data for a business entity are the income statement, the balance sheet, and the statement of cash flows. The income statement summarizes revenues and expenses over a period of time. The balance sheet is the list of what a company owns (its assets), what it owes (its liabilities), and what has been invested by the owners (owners equity) at a specific point in time.The statement of cash flow categorizes all cash transactions during a specific period of time in terms of cash flows generated or used for operating activities, investing activities, and financing activities. The focus of this section is on performance measures based on the income statements and balance sheets of SciTronicsa medical device company. The measures can be grouped by type(1) 5 911-412Assessing a Companys Future Financial Health profitability measures, (2) activity (asset management) measures, (3) leverage and liquid measures. Please refer to the financial statements of SciTronics as shown in Exhibits 1 and 2 at the end of the note.As yo u work through the questions that follow, please also consider three broad questions 1. What is your assessment of the performance of SciTronics during the 2005-2008 period? 2. Has its financial strength and its access to external sources of finance improved or weakened? 3. What are the 2-3 most important questions you would ask management as the result of your analysis? Sales Growth Sales growth is an important driver of the need to invest in various type assets and of the companys value. It also provides some indication of the effectiveness of a firms strategy and product development activities, and of customer word meaning of a firms products and services. 1.During the four-year period ended December 31, 2008, SciTronics sales grew at a % compound rate. There were no acquisition or divestitures. Profitability Ratio How Profitable Is the Company? Profitability is a necessity over the long-run. It strongly influences (1) the companys access to debt (2) the valuation of the company s car park stock (3) the willingness of management to issue stock and (4) the capacity to self-finance. One measure of profitability of a business is its return on sales, measured by dividing net income by net sales. 1. SciTronics profit as a percentage of sales in 2008 was %. 2. This represented an increase/ moderate from % in 2005.Management and investors often are much elicited in the return get on the funds invested than in the level of profits as a percentage of sales. Companies operating in businesses requiring very little investment in assets often have low profit margins but earn very attractive returns on invested funds. Conversely, there are numerous examples of companies in very capital-intensive businesses that earn miserably low returns on invested funds, despite seemingly attractive profit margins. Therefore, it is useful to examine the return earned on the funds provided by the shareholders and by the investors in the companys wager-bearing debt.To increase the comparability across companies, it is useful to use EBIAT (earnings before interest but after taxes) as the measure of return. The use of EBIAT as the measure of return also allows the analyst to compare the return on invested capital ( work out before the entailment of interest expense), with the companys estimated cost of capital to determine the long-term adequacy of the companys profitability. EBIAT is calculated by multiplying EBIT (earnings before interest and taxes) times (1the middling tax rate). EBIT x ? 1 ? tax rate? Owners? equity plus interest bearing debt 3. SciTronics had a total of $_ of capital at year-end 2008 and earned before interest but after taxes (EBIAT) $ during 2008.Its return on capital was % in 2008 which represented an increase/decrease from the % earned in 2005. 6 Assessing a Companys Future Financial Health911-412 From the viewpoint of the shareholders, an equally important figure is the companys return on equity. Return on equity is calculated by div iding profit after tax by the owners equity. Profit after taxes Owners? equity Return on equity indicates how profitably the company is utilizing shareholders funds. 4. SciTronics had $_ of owners equity and earned $_ after taxes in 2008. Its return on equity was % an improvement/deterioration from the % earned in 2005. Activity Ratios How Well Does the Company Employs Its Assets?The second basic type of financial ratio is the activity ratio. Activity ratios indicate how well a company employs its assets. Ineffective utilization of assets results in the need for more finance, unnecessary interest costs, and a correspondingly lower return on capital employed. Furthermore, low activity ratios or deterioration in the activity ratios may indicate regretful accounts receivable or obsolete inventory or equipment. add up asset turnover measures the companys effectiveness in utilizing its total assets and is calculated by dividing total assets into sales. Net sales Total assets Total ass et turnover for SciTronics in 2008 can be calculated by dividing $ into $ .The turnover improved/deteriora ed from times in 2005 to times in 2008. It is useful to examine the turnover ratios for each type of asset, as the use of total assets may hide important problems in one of the specific asset categories. One important category is accounts receivables. The average collection period measures the number of days that the company must custody on average between the time of sale and the time when it is paid. The average collection period is calculated in two steps. First, divide annual credit sales by 365 days to determine average sales per day Net credit sales 365 days Then, divide the accounts receivable by average sales per day to determine he number of days of sales that are still unpaid Accounts receivable Credit sales per day SciTronics had $ invested in accounts receivables at year-end 2008. Its average sales per day were $ during 2008 and its average collection period was _d ays. This represented an improvement/deterioration from the average collection period of days in 2005. A third activity ratio is the inventory turnover ratio, which indicates the effectiveness with which the company is employing inventory. Since inventory is recorded on the balance sheet at cost (not at 7 911-412Assessing a Companys Future Financial Health ts sales value), it is advisable to use cost of goods sold as the measure of activity. The inventory turnover figure is calculated by dividing cost of goods sold by inventory Cost of goods sold Inventory 3. SciTronics apparently needed $ of inventory at year-end 2008 to support its operations during 2008. Its activity during 2008 as measured by the cost of goods sold was $_ . It therefore had an inventory turnover of times. This represented an improvement/deterioration from times in 2005. An alternative measure of inventory management is days of inventory, which can be calculated by dividing cost of goods sold by 365 days to deter mine average cost of goods sold per day.Days of inventory is calculated by dividing total inventory by cost of goods sold per day. A fourth and final activity ratio is the fixed asset turnover ratio which measures the effectiveness of the company in utilizing its plant and equipment NetsalesNet fixed assets 4. SciTronics had net fixed assets of $ and sales of $ in 2008. Its fixed asset turnover ratio in 2008 was times, an improvement/deterioration from times in 2005. Leverage Ratios How Soundly is the Company Financed? There are a number of balance sheet measures of financial leverage. The various leverage ratios measure the relationship of funds supplied by creditors to the funds supplied by owners.The use of borrowed funds by reasonably profitable companies will improve the return on equity. However, it increases the riskiness of the business and the riskiness of the returns to the stockholders, and can result in financial distress if used in excessive amounts. The ratio of total assets divided by owners equity is an indirect measure of leverage. A ratio, for example, of $6 of assets for each $1 of owners equity indicates that $6 of assets is financed by $1 of owners equity and $5 of liabilities. 1. SciTronics ratio of total assets divided by owners equity increased/decreased from at year end 2005 to at year-end 2008.The same story of increasing financial leverage is told by dividing total liabilities by total assets. 2. At year-end 2008, SciTronics total liabilities were % of its total assets, which compares with % in 2005. Lendersespecially long-term lenderswant reasonable assurance that the company will be able to repay the loan in the future. They are concerned with the relationship between a companys debt and its total economic value. This ratio is called the total debt ratio at market. Total liabilities Total liabilities ? market value of the equity The market value of the equity is calculated by multiplying the number of shares of common stock outstan ding times the market price per share. 8Assessing a Companys Future Financial Health911-412 3. The market value of SciTronics equity was $175,000,000 at December 31, 2008. The total debt ratio at market was . A fourth ratio that relates the level of debt to economic value and performance is the times interest earned ratio. This ratio relates earnings before interest and taxesa measure of profitability and of long-term viabilityto the interest expensea measure of the level of debt. Earnings before interest and taxes Interest expense 4. SciTronics earnings before interest and taxes (operating income) were $_ in 2008 and its interest charges were $ . Its times interest earned was times.This represented an improvement/deterioration from the 2005 level of times. A fifth and final leverage ratio is the number of days of payables. This ratio measures the average number of days that the company is taking to pay its suppliers of raw materials and components. It is calculated by dividing annu al purchases by 365 days to determine average purchases per day yearbook purchases 365 days Accounts payable are then divided by average purchases per day Accounts payable Average purchases per day to determine the number of days purchases that are still unpaid. It is often difficult to determine the purchases of a firm.Instead, the income statement shows cost of goods sold, a figure that includes not only raw materials but also prod and overhead. Thus, it often is only possible to gain a rough idea as to whether or not a firm is becoming more or less dependent on its suppliers for finance. This can be done by tracking the pattern over time of accounts payable as a percent of cost of goods sold. Accounts payable Cost of goods sold 5. SciTronics owed its suppliers $ at year end 2008. This represented % of cost of goods sold and was an increase/decrease from % at year end 2005. The company appears to be more/less prompt in paying its suppliers in 2008 than it was in 2005. 6.The fina ncial riskiness of SciTronics increased/decreased between 2005 and 2008. liquidness Ratios How Liquid is the Company? The fourth basic type of financial ratio is the liquidity ratio. These ratios measure a companys ability to meet financial obligations as they become current. The current ratio, defined as current assets divided by current liabilities, assumes that current assets are much more readily and sure convertible into cash than other assets. It relates these fairly liquid assets to claims that are due within one yearthe current liabilities. 9 911-412Assessing a Companys Future Financial Health Current assets Current liabilities 1.SciTronics held $ of current assets at year-end 2008 and owed $ to creditors due to be paid within one year. Its current ratio was , an increase/decrease from the ratio of at year-end 2005. The quick ratio or acid test is similar to the current ratio but excludes inventory from the current assets Current assets ? Inventory Current liabilities Inve ntory is excluded because it is often difficult to convert into cash (at least at book value) if the company is struck by adversity. 2. The quick ratio for SciTronics at year-end 2008 was _, an increase/decrease from the ratio of at year-end 2005. Profitability RevisitedManagement can improve its return on equity by modify its return on sales and/or its asset turnover and/or by increasing its financial leverage as measured by total assets divided by owners equity. ROE ? Net Income x Sales Sales Total Assets Total Assets x Owners? Equity Each method of improvement differs operationally and in terms of risk. 1. The improvement in SciTronics return on equity from 8. 2% in 2005 to 18. 7% in 2008 resulted from an increase/decrease in its return on sales and an increase/decrease in its asset turnover, and an increase/decrease in its financial leverage. A WarningThe calculated ratios are no more valid than the financial statements from which they are derived. The quality of the financial statements should be assessed and appropriate adjustments made, before any ratios are calculated. Particular attention should be placed on assessing the reasonableness of the accounting choices and assumptions embedded in the financial statements. The Case of the Unidentified Industries The preceding exercise suggests a series of questions that may be helpful in assessing a companys future financial health. It also describes several ratios that are useful in answering some of the questions, especially if the historical trend in these ratios can be reasonably extrapolated.However, it is also important to compare the actual absolute value with some standard to determine whether the company is playacting well. Unfortunately, there is no single current ratio, inventory turnover, or debt ratio that is appropriate to all industries. The operating and competitive characteristics of the companys industry greatly influence its investment in the various types of assets, the riskiness of thes e investments, and the financial structure of its balance sheet. 10 Assessing a Companys Future Financial Health911-412 Try to match the quintet following types of companies with their corresponding balance sheets and financial ratios as shown in Exhibit 3. 1. Electric utility 2. Japanese automobile manufacturer 3. Discount general merchandise retailer 4.Automated test equipment/systems company 5. Upscale apparel retailer In doing the exercise, consider the operating and competitive characteristics of the industry and their implications for (1) the collection period (2) inventory turnover (3) the amount of plant and equipment (4) the profit margins and profitability and (5) the appropriate financing structure. Then identify which one of the five sets of balance sheets and financial ratios best match your expectations, given the difficult economic conditions in 2009. 11 911-412Assessing a Companys Future Financial Health Exhibit 1SciTronics, Inc. consolidated Income Statements 2005 -2008 ($ in thousands) 20042005200620072008 Sales $115,000 $147,000 171,000 $205,000 $244,000 Cost of goods sold 43,000 50,000 63,000 74,000 consummate(a) margin 104,000 121,000 142,000 170,000 Research development 15,000 20,000 26,000 28,000 Sell, general administrative 79,000 92,000 106,000 116,000 Operating income 10,000 9,000 10,000 26,000 Interest expense 1,000 2,000 2,000 2,000 Profit before tax 9,000 7,000 8,000 24,000 Income tax 4,000 2,000 3,000 10,000 Net income $ 5,000 $ 5,000 $ 5,000 $14,000 Exhibit 2SciTronics, Inc. Consolidated Balance Sheet at December 31, 2005-2008 ($ in thousands) 2005 2006 2007 2008 Cash $ 9,000 $ 10,000 $ 15,000 $ 18,000 Accounts receivable 42,000 53,000 61,000 66,000 Inventories 21,000 28,000 30,000 29,000 Other current assets 10,000 13,000 21,000 20,000 Total current assets 82,000 104,000 127,000 133,000 Net property equipment 9,000 12,000 13,000 18,000 Other 2,000 2,000 6,000 8,000 Total assets $93,000 $118,000 $146,000 $159,000 Notes payable $ 3,000 $ 18,000 $ 8,000 $ 10,000 Accounts payable 5,000 6,000 7,000 6,000 Accrued expenses 10,000 13,000 21,000 28,000 Other current liabilities 3,000 3,000 4,000 4,000 Total urrent liabilities 21,000 40,000 40,000 48,000 Long-term senior debt 10,000 9,000 8,000 7,000 Subordinated convertible debt 20,000 20,000 Other liabilities 1,000 3,000 7,000 9,000 Owners equity 61,000 66,000 71,000 85,000 Treasury stock (10,000) Owners equity 61,000 66,000 71,000 75,000 Total liabilities and equity $93,000 $118,000 $146,000 $159,000 12 Assessing a Companys Future Financial Health911-412 Exhibit 3Unidentified Industries Balance Sheet Percentages ABCDE Cash1. 5%14. 4%12. 1%13. 3%11. 0% Receivables4. 63. 830. 939. 811. 8 Inventories1. 824. 613. 74. 716. 7 Other current assets2. 04. 35. 03. 810. 0 Property and equipment (net)74. 549. 634. 122. 120. 3 Other assets 15. 6 3. 4 4. 3 16. 3 30. 2 Total assets100%100%100%100%100% Notes payable5. 3%0. 4% 5. 4%18. 2%1. 4% Accounts payable2. 124. 811. 0 8. 38. 8 Other current liabilities5. 917. 014. 28. 716. 5 Long-term debt33. 610. 034. 323. 121. 7 Other liabilities26. 32. 211. 25. 62. 0Owners equity 26. 8 45. 6 23. 9 36. 1 49. 6 Total100%100%100%100%100% Selected Ratios Net profit/net sales10. 3%1. 5% 5. 1%1. 3%(5. 8%) Return on capital 6. 8%9. 2%12. 6%0. 9%(3. 1%) Return on equity12. 5%10. 8%28. 1%2. 2%(7. 6%) Sales/total assets . 323. 251. 31. 63 . 65 Collection period (days)5248623243 Days of inventory43326231147 Sales/net property equipment. 436. 73. 82. 93. 6 Total assets/equity3. 732. 194. 192. 792. 01 Total liabilities/total assets. 73. 54. 76. 66. 50 Interest-bearing debt/total capital 59%19% 62%53% 32% Times interest earned3. 2 16 6. 0 4. 4NM Current assets/current liabilities . 671. 112. 011. 221. 85 13

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