Accessing a
firm’s future
financial health
Huang,Jing D10808801
Wu, Chia-Yu M11018005
Ilia Konnov M10915816
Yang, Tzu-Yuan M11018013
Nguyen Hoang Mai Chi M10918808
Liao, Ching-Han M11018019
Le Thien An M10921870
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CONTENTS
1.
2.
3.
4.
The purpose of assessing the future financial health of a firm
The process of assessing a firm’s future financial health
Assessing a firm’s future financial health, what financial data we can refer to
Exercise: Unmatched Industries
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THE PURPOSE OF ACCESSING
THE FUTURE FINANCIAL HEALTH
OF THE FIRM
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PURPOSE
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PURPOSE
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company’s
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outsiders
(investors,
business analyst)
THE PROCESS OF ASSESSING THE FIRM’S
FUTURE FINANCIAL HEALTH
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PROCESS
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PROCESS, STEP 1
Step 1 – Goals, Strategies, and Operating
Characteristics
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This step includes:
- Missions
- Goal
- Strategies & Operating Characteristics
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PROCESS, STEP 1
Missions are visions of the entire organization, a big
goal of the company.
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PROCESS, STEP 1
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Goals are plans to be achieved to fulfill the mission.
Goals should be specific, measurable, attainable,
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realistic, and time-bounded
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In a specific period of time and constrained resources,
the company needs to choose to complete a specific goal
for each of the product lines.
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The goals and strategies should be aligned with each
other for each product line
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In order to have suitable strategies, the company should
consider different micro & macro economic aspects
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PROCESS, STEP 2
Step 2 – Outlook for the Firm’s Sales
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The outlook
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The market must have potential for growth to facilitate
an increase in sales and revenue in the future.
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PROCESS, STEP 2
Explore the areas of the corporate financial system
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that are driven by the firm’s goals, strategies, market
conditions, and operating characteristics.
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PROCESS, STEP 3
Step 3 – Investments to Support the
Product-Market Strategy
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Estimate the current value of the investments that
have been made to support the firm’s productmarket strategy.
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PROCESS, STEP 3
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In order to develop an accurate forecast.
Study
patterns with
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good/meaningful ratios or indicators
- A “reasonable value” should be applied to
the sales and the cost of goods sold
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PROCESS, STEP 4
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Step 4 – Future Profitability and Competitive
Performance
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The level of profitability has a strong influence over
several vital financial elements:
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● The ability of access to debt finance
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● The value 90%
of the firm’s common stock and the
willingness to issue it
● The firm’s “sustainable sales growth”
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PROCESS, STEP 4
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Step 4 – Future Profitability and Competitive
Performance
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Is the company strong in terms of customer service, new
product development, retention and development of
product quality, management and employee?
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PROCESS, STEP 5
Step 5 – Future External Financing Needs
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External financing can be in the form of loans, debt
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issues, or the sale of shares of stock.
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The decision of external financing in the future
depends on
- the firm’s future sales growth,
- the length of its cash cycle,
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- future profitability, and profit retention.
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PROCESS, STEP 5
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PROCESS, STEP 5
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Developing income statements and balance sheets for the next two
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to three years can estimate the dollar amount, timing, and the
duration of future external financing needs.
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PROCESS, STEP 6
Step 6 – Access to Target Sources of External Finance
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Target
sources can 25%
include: banks,Progress
public debt markets,
public
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equity markets, or insurance companies.
Target sources evaluating the firm:
- ensure a “good fit” for the lending establishment.
- determine their interest rate and lending terms.
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PROCESS, STEP 6
Basic questions from Step 4 and 5,
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Extra:
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● Does the firm have a good history of paying its suppliers
● What is the firm’s debt ratio?
● Is the firm close to its borrowing limits?
● Does the firm have enough assets that can be sold to pay
the debt
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PROCESS, STEP 7
Step 7 – Viability of the Three to Five Year Plan
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with the firm’s
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debt policy?
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Are the firm’s investment needs, product strategies, and
goals in line with its financing capabilities over the next
three to five years?
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PROCESS, STEP 8
Step 8 – Current Year Financing Plan
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TheProgress
goal is to benefit
future financing
flexibility
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The question is to borrow money or to sell equities now.
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A balance must be maintained depending on market
conditions and future forecasting.
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PROCESS, STEP 9
Step 9 – Stress Test under Scenarios of Adversity
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Ensure the flow of funds to strategic programs can be
maintained in times of adversity.
Reduce the probability of a negative occurrence due to adversity
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Assessing a firm’s future financial health,
what financial data we can refer to
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QUESTION 1
Income Statement
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profit and loss (P&L) statements
Summarizes revenues and expenses over a period of time.
Quarterly & Annual Reports, showing financial trends, comparisons over time.
Accountants, investors and business owners use that information to adjust their behavior.
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QUESTION 1
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Balance Sheet
own (its assets)
owe (its liabilities)
invest by the owners (owners' equity) at a specific point in time.
Assets = Liabilities + Shareholders’ Equity
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QUESTION 2
From figures found on the income statement and the balance sheet, we can calculate the
following types of financial ratios:
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Profitability ratios
Activity ratios
Leverage ratios
Liquidity ratios
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QUESTION 2.1
2.1 Profitability Ratios: How Profitability is the Company?
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Profitability influences:
The access to debt finance
The valuation of the common stock
The willingness to issue common stock
The sustainable growth rate
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QUESTION 2.1
Profitability Ratios from the case:
A. Net Profit Margin: It represents what percentage of sales has turned into profits. For
instance, if a business reports that it achieved a 35% profit margin during the last quarter,
it means that it had a net income of $0.35 for each dollar of sales generated.
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Net Profit Margin =
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QUESTION 2.1
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The deterioration in profitability resulted from an increase in cost of goods sold as a
percentage of sales, and from an increase in operating expenses as a percentage of
sales.
The only favorable factor was the decrease in the federal income tax.
QUESTION 2.1
B. Return on invested capital: It measures the return that an investment generates for those
who have provided capital, and it tells us how good a company is at turning capital into profits.
Earnings before interest but after taxes (EBIAT)
Owners’ equity plus interest - bearing debt
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QUESTION 2
EBIAT
Net Income + Interest expense
Interest-bearing debt
Long-term debt
1995
1532
10442
14.67%
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1999
1824
15249
11.96%
QUESTION 2
C. Return on equity: it tells you how much net income a company generates per dollar of
invested capital. It helps investors understand how efficiently a firm uses its capital to generate
profit.
1995 1999
1171 1307
7692 12193
15.22% 10.72%
Profit after taxes
= Return on equity
Owner’s equity
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QUESTION 2.2
2.2 Activity Ratios: How Well Does a Company Employ Its Assets?
Ineffective utilization of assets
● results in the need for more finance, unnecessary interest costs, and a correspondingly
lower return on capital employed.
● indicate uncollectible accounts receivables or obsolete inventory or equipment.
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QUESTION 2.2
Several types of Activity Ratios from the case:
A. Total asset turnover: measures the efficiency with which a company uses its assets to produce
sales.
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QUESTION 2.2
B. Average Collection Period: it refers to the time it takes, on average,
for the company to receive payments it is owed from clients or customers. The average
collection period must be monitored to ensure a company has enough cash.
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QUESTION 2.2
Step1: Average sales per day (Credit sales per day) = Net credit sales/ 365 days
Step2: Average collection period= Account receivable/ Credit sales per day
Magnetronics had $7,380 invested in accounts receivables at year-end 1999. Its average sales
per day were $133.614 (48,769/365 = 133.614) during 1999 and its average collection period
was 55.234 (7,380/133.614=55.234) days. This represented an improvement from the average
collection period of 58.68 (5,227/32,513÷365=58.68) days in 1995.
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QUESTION 2.2
C. Inventory Turnover Ratio: It is the number of times a company has sold and replenished
its inventory over a specific amount of time, indicating the effectiveness with which the
company is employing inventory. A higher ratio is more desirable than a low one as a high
ratio tends to point to strong sales.
Inventory Turnover Ratio = Cost of goods sold/ Inventory
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1995
19183
4032
4.758
1999
29700
8220
3.613
QUESTION 2.2
D. Fixed Asset Turnover Ratio: measures the effectiveness of the company in utilizing its plant
and equipment.
Fixed Asset Turnover Ratio = Net sales/ Net fixed assets
1995
32513
4073
7.983
1999
48769
5160
9.451
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QUESTION 2.2
To sum up:
The deterioration in Magnetronics’ operating profits as a percentage of total assets between 1995 and
1999 resulted primarily from the increase in cost of goods sold / operating expenses and inefficient
usage of inventory or asset.
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QUESTION 2.3
2.3 Leverage Ratios: How Soundly Is the Company Financed?
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The various leverage ratios measure the relationship of funds supplied by creditors and the
funds supplied by the owners.
A high ratio indicates that the company has taken a large amount of debt than its capacity
and that they will not be able to service the obligations with the on-going cash flows.
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QUESTION 2.3
Several types of Leverage Ratios from the case:
A. Debt Ratio: measures the total funds provided by creditors as a percentage of total assets. If
assets are more than debt, that means it’s rightly leveraged. But if the assets are less than debt,
then the firm needs to look at the utilization of its capital.
Debt Ratio= Total liabilities / Total assets
(Total liabilities include both current and long-term liabilities)
1999
22,780 - 12,193 = 10,587
10,587/22,780 = 46.47%
1995
14,949-7,692 =7,257
7,257/14,949 = 48.55%
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QUESTION 2.3
B. Total debt ratio at market: measures the relationship between total debt and the economic
value of the firm.
Total liabilities
Total liabilities + Market value of the equity
10,587,000/10,587,000+14,275,000 = 42.58%
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QUESTION 2.3
C. Times Interest Earned Ratio: measures a company's ability to meet its debt obligations
based on its current income.
Earnings before interest and taxes
Interest expense
1999:
2,011 + 517 = 2,528
2,528/517 = 4.89
1995:
2,211 + 361 = 2,572
2,572/361 = 7.12
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QUESTION 2.3
D. The number of days of payables: it measures the average number of days that the company is
taking to pay its suppliers of raw materials and components.
Step1: Average purchases per day= Annual purchases/ 365 days
Step2: The number of days of payables= Accounts payable/ Average purchases per day
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The simplified equation is: Account payable/ Cost of goods sold
1999: 2,820/29,700 = 9.49%
1995: 1,615/19,183 = 8.42%
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QUESTION 2.3
To sum up:
● The deterioration in Magnetronics’ profitability, as measured by its return on equity, from
15.2% in 1995 to 10.7% in 1999 resulted from the equity growing faster than net income and
increased expenses (COGS and operating) as a percentage of revenues.
● The financial riskiness of Magnetronics increased between 1995 and 1999.
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QUESTION 2.4
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2.4 Liquidity Ratios: How Liquid Is the Company?
Liquidity Ratios is used to determine a company’s ability to pay its short-term debt
obligations. The metric helps determine if a company can use its current, or liquid,
assets to cover its current liabilities.
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QUESTION 2.4
Several types of Leverage Ratios from the case:
A. Current Ratio: it measures a company's ability to pay short- term obligations or those
due within one year. It tells investors and analysts how a company can maximize the
current assets on its balance sheet to satisfy its current debt and other payables.
Current Ratio = Current Assets / Current Liabilities
Its current ratio was 2.34 (=17620/7531) in 1999, a deterioration from the ratio of 2.41
(=10876/4507) at year end 1995.
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QUESTION 2.4
B. Quick Ratio: it is similar to the current ratio but excludes inventory from the current
assets, because it is often difficult to convert into cash if the company is struck by
adversity.
The quick ratio for Magnetronics at year end 1999 was 1.25 (= 17620-8220/7531), a
deterioration from the ratio of 1.52 (=10876-4032/4507) at year-end 1995.
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Exercise:
Matching
the
Unidentified
Industries?
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Aerospace Manufacturer (A)
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1. Collection period: Company A has the longest collection period (149 days) among the
other companies, and it normally takes Aerospace Manufacturer an amount of time to install
aircrafts, airplanes or rockets that results in a long time to get the installment payment from
the customers.
2. Property and equipment: Company A has the second highest percentage (30.2%) of
property and equipment, because Aerospace Manufacturer requires many machines to
assemble.
3. Inventory turnover: Company A has the second highest inventory turnover (11).
Aerospace Manufacturer company usually produces according to customers’ order, so the
products will be sold as soon as they are made.
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Electric Utility (B) Reasons:
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1. Property and equipment: Company B has the highest property and equipment (66.6%),
because the Electric utility company highly depends on plant and equipment, such as
thousands of electric power poles in the roadsides and thousands of power supplies to
distribute the electricity to the households or the other factories.
2. Inventories: Company B has the lowest inventories(2.0) among the others as Electric
Utility’s main product is electricity(energy).
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Supermarket Chain (C)
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1. Collection period: Company C has the lowest collection period (only 3 days), because
customers normally pay immediately in the supermarket.
2. Account receivable: Company C has the lowest account receivable(2.9%)，because
supermarket could immediately receive money from the customers( the same to collection
period).
3. Property and equipment: Company C has a second highest property and equipment
percentage as supermarket chain has many branches with a lot of products.
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Japanese Trading Company (D)
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1. Property and equipment: Company D has the lowest property and equipment (4.3%),
because trading company usually buy and sell the products without manufacturing.
2. Account receivables and notes payable: Company D has the highest receivables (60.3%)
and notes payable (50.8%), because trading companies as agents connect suppliers and
clients with two-ways credit transactions.
3. Profit margin (net profit/net sales): Company D has the lowest profit margin(.01),
because trading companies don’t own anything but earn their revenue from sales
commissions.
4. Inventory turnover: Company D has the highest inventory turnover(23), because trading
companies often buy products according to the orders.
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Automobile Manufacturer (E)
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1. Inventories: Company E has the highest inventories(48.1). Automobile manufacturing
industry is a highly competitive industry, delivery speed is an important strength, so
automobile manufacturers have to prepare enough products beforehand and they also need to
stock adequate components and parts.
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2. Account payable: Company E has the highest account payable (21.5%), because usually
there is closely coordinated vertical supply chain in automobile manufacturing industry, then
it is easier for automobile manufacturers to cooperate with suppliers on credit.
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THANKS!
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