GROWTH It is nearly impossible for a company to remain
completely unchanged for some long stretch of time E.g. Management
changes, technology is improved, accidents may happen. One such
change is growth. Companies may grow too slowly they may fail to
incorporate new ideas into their business and fall behind the
competition E.g. Bought for $580 million sold for just $35 Million
recently. Companies may grow too fast ill-advised explosive growth
can be harmful or indeed detrimental. What are the Effects of
Growth and how can we plan for it?
Slide 3
FINANCIAL FORECASTING Just like successful students are able to
forecast ahead and plan their studying schedules accordingly during
finals week, successful businesses must be able to anticipate
financing needs long before they are required. Two General
Financial Forecasting Methods: Rely on Cash flow analysis Rely upon
Balance Sheet Analysis Same Goal: Will our business have enough
funding sources to cover our costs? The result is typically a
Surplus of funding or a shortfall. Extra or not enough
Slide 4
CASH BUDGETING Cash Budgeting Analysis consists of summing
expected revenues and subtracting expected cast costs. A surplus
occurs when an more funding comes than goes out. A deficit occurs
when more funding goes out than comes in. We routinely use this
sort of analysis in our daily life Do I have enough money in my
purse or wallet to eat dinner tonight? Do example 1 p. 72 and 73 on
your own for practice. Is Cash Budgeting without difficulty?
Absolutely not! What happens if our forecasts are faulty? What if I
think I will be paid $100 next week when I am actually only going
to receive $50? Cash Flow budgeting is excessively detailed at
times long range cash budgeting analysis is difficult because
detailed cash flow forecasts are difficult to obtain. Do I know how
much my income will be in great detail 2 years from now? Hence the
use of Balance Sheets!
Slide 5
BALANCE SHEET FORECASTS Remember the previous accounting
identity: Total Assets = Total Liabilities + Shareholders equity
Balance sheet forecasting utilizes this identity by predicting
future total assets and future total liabilities and shareholders
equity and calculating the difference. Whatever difference arises
is considered the External Financing Needs (EFN.) Positive EFN
suggests insufficient funds to finance the companys expected assets
additional financing should be sought out. Negative EFN suggests a
surplus of funding they have more than enough to finance expected
assets
Slide 6
BALANCE SHEET FORECASTS Consider the following company and its
balance sheet shown below: Sales = $2,500 and COGS = $1,875. The
company realizes that if they cut by 30 days the length of time
that inventory stays on the shelf before it is sold, and if all
else remains the same, the company reduces the amount of inventory
required. What effect does this inventory change have upon external
financing needs? Solution: Step 1 calculate length of time
inventory stays on shelf Step 2 calculate shelf life after policy
change and solve for Balance Sheet Inventory Step 3 Calculate
EFN
Slide 7
BALANCE SHEET FORECASTS In the previous example we have a
surplus of funding? What must then happen to our hypothetical
Balance Sheet? Can our final Balance sheet have an EFN unequal to
zero? IT IS IMPOSSIBLE! We must somehow incorporate the surplus or
shortfall into our final balance sheet to equalize total assets and
total liabilities plus shareholders equity. We can
increase/decrease cash holdings, or increase/decrease dividends
paid, etc.
Slide 8
INTERNAL FINANCING Recall the discussion about New Retained
Earnings not all of our Net Income must be paid out as Dividends.
The company can choose to retain those earnings and plug them back
into the company. A company can diminish EFN by using Internal
Financing, or relying upon NRE. Forecasting when internal financing
is available necessitates the availability of a forecast for
expected futures sales. Steps to Calculating EFN: 1.Given expected
future sales calculate necessary Total Assets required. 2.Forecast
future Total Liabilities and Shareholders equity. SE will increase
because expected sales creates NRE. 3.Compute EFN as the difference
between TA and TL+SE Example 3 In Class
Slide 9
NATURAL GROWTH RATES So given you can grow too slow or too
fast, what is the appropriate amount of growth? There is no hard
and fast answer but be can rely upon two baseline cases to provide
some insight. Growth relying solely on Internal Financing
Sustainable Growth Rate
Slide 10
GROWTH RELYING UPON INTERNAL FINANCING We can easily answer how
fast a company can grow relying solely upon internal financing by
adopting the reasonable assumption that several of the companys
most important financial ratios are stable. The above requires the
following to be constant: Asset Turnover Ratio Net Profit Margin
Dividend Payout Ratio
Slide 11
SUSTAINABLE GROWTH RATE Businesses typically target a
particular Debt-to-equity ratio as desirable. Reliance upon the
Internal Growth rate is problematic in that over time the
Debt-to-equity ratio declines thus we move further away from our
target. A slight modification results in the following: As before
all of this information can be found on the balance sheet or the
income statement. Work Example 6 In Class
Slide 12
CASH FLOW A companys accounting earnings on the income
statement equals Net Income. This is a flow. Note however, that
analysts may want other flow measures (E.g. company cash flow to
investors.) Analysts like information regarding the distribution of
a companys wealth; various cash flows illustrate this distribution.
What is the net amount of wealth the company transfers to
shareholders? How does it change? What is the net cash flow to
Lenders or Creditors? How does it change? Sum these together and we
have the total cash flow to the financial markets. Why might an
analyst be interested in knowing the cash flow to capitalists?
Slide 13
OTHER CASH FLOW MEASURES Modern capitalist theory suggests that
in perfect markets principal and assets profits ultimately return
to financial markets. Thus: Similar justification for analyzing
Cash Flow To Capitalists applies to Cash Flow from Assets:
Capitalists must believe a company will yield sufficient Cash Flow
from Assets to justify investments. Using information from the
income statement we can substitute into the above equation and
get:
Slide 14
OTHER CASH FLOW MEASURES Many times analysts want a measure of
cash flow resulting directly from the companys ordinary operations:
If an analysts suspects unusually high taxes he or she may simply
look at EBITDA. Nevertheless, Cash Flow from Operations is often
portrays a better picture than Net Income of financial health and
wealth creation. Combine 3.9 and 3.10 yields:
Slide 15
OTHER CASH FLOW MEASURES Many analysts may also be interested
in the companys Cash Surplus the change in cash from one balance
sheet to the next.
Slide 16
HOMEWORK After this Chapter you have all the necessary
knowledge to complete exam 1. Please exercise due diligence when
deciding when to take the exam! EFN2b, EFN3a, GR1, GR4, BA3a, GR2d,
GR3b, BA14, EFn1b, CF2, CF1c, CF3a, Due: Wednesday! Do not leave
all for the last minute.