Sustainable Growth and Financial

Statement Analysis

2007 Forecasts
2007 Pro Forma Income State.
Sales
150
Costs
135
Net Income
15
Dividends
6
Ret. Earnings
9

2006 Income Statement

Sales
100
Costs
90
Net Income
10
Dividends
4
Ret. Earnings
6
2006 Balance Sheet
Liabilities

100

Equity

100

Assets 200

2007 Pro Forma Balance Sheet

Liabilities 150
Assets 300
Equity
109
whoops!

External Funds Needed (EFN)

2007 Pro Forma Income State.
Sales
150
Costs
135
Net Income
15
Dividends
6
Ret. Earnings
9
2007 Pro Forma Balance Sheet
Liabilities 150
Assets 300
Equity
109
Total
300
Total
259

There is a funding shortfall

of 41 (A = 300, L&NW =
259)

This must be made up by:

1.
2.
3.

Issuing new equity

Allowing the ratio of
liabilities/sales to rise
Some combination of (1)
and (2)

EFN More Generally (Eq. 3.22, p. 70)

Assets
Liabilities
EFN
Sales
Sales PM (Pr ojectedSales)(b)
Sales
Sales
41 2(50) 1(50) .10(150)(.6)

PM = Net Profit Margin

b = retention ratio (retained earnings/net income)

Sustainable Growth Rate

Growth rate in sales = g (i.e., S1 = (1+g)S0 and S = S1
S0 = gS0
At what rate can we grow without issuing new equity or
allowing liabilities/sales to increase (e.g., EFN = 0)?

assets
liab.
EFN 0
gS 0
gS 0 PM (1 g ) S 0b
sales
sales
assets liab.
g(

PMb) PMb
sales sales
equity
ROEb
g(
PMb) PMb g
sales
1 ROEb

Dells Working Capital

How did Dell fund 52% growth in sales for 1996?
Use 1995 data to forecast 1996 balance sheet and
compare with 1996 actual
Can Dell sustain another year of 50% sales growth
without issuing new equity or increasing its debt
ratio?
What role does Dells cash conversion cycle play in
its funding needs?

How Can We Assess and Explain

Financial Performance?

Financial Ratio Types

Market Value
Profitability
Asset Management
Leverage
Liquidity

Market Value Ratios

Examples: Marketto-Book; PriceEarnings
Questions: How do
securities markets
value the companys
assets? Earnings?

Profitability Ratios
Examples: Return on
assets, equity, invested
capital; gross, net profit
margin
Questions: How profitable
is the company per dollar
invested in the business;
per dollar of sales?

Asset Management Ratios

Examples: asset turnover,
days sales in receivables,
inventory turnover, days sales
in payables
Questions: How efficiently
does the company use its
assets? How long does it take
assets or liabilities to turn into
cash?

Financial Leverage Ratios

Examples: Debt/assets;
Debt/equity; Interest
coverage
Questions: How much of
a burden does debt pose
relative to assets, equity
or cash flow? How risky
is the company?

Liquidity Ratios
Examples: Current ratio,
quick ratio, interval
measure
Questions: How easily can
the company meet its
immediate cash
requirements? How risky
is the company?

Financial Ratios Relative to What?

By themselves, financial ratios have no
meaning. We need to compare to:
Past data for the same company
Data for similar companies (e.g., same
industry)
Other ratios (i.e., DuPont ratios, Cash
Conversion Cycle)

Does One Trend Coincide with Another?

DuPont Ratios
Net Income x Sales x Assets = Net Income
Sales
Assets Equity
Equity

Net profit
margin

Asset x Equity =
turnover multiplier

ROE

Like-A-Weed mini-case
How is Like-A-Weed
doing?
Why is the net profit
margin declining?
Does the company have a
financial or an operating
problem?
What should Like-A-Weed
do?