Fin 501 Managerial Finance
Class# 7532 M6:15p-9:00p
Andras Fekete
PNC’s Financial Analysis and Forecasting
Case 5
Due: November 27th, 2006
Prepared for Dr. James Haskins
November 27th, 2006
TABLE OF CONTENTS
List of Figures ........................................................................................................................3
Executive Summary ...............................................................................................................4
Introduction ............................................................................................................................5
Statement of Opportunities and Problems .............................................................................6
Methodology ..........................................................................................................................7
Analysis (qualitative and quantitative) ..................................................................................14
Summary and Conclusions ....................................................................................................23
Recommendations ..................................................................................................................24
Works Cited ...........................................................................................................................25
Appendix A ............................................................................................................................26
Appendix B ............................................................................................................................52
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LIST OF TABLES
Table 1: DuPont model chart .................................................................................................27
Table 2: DuPont analysis .......................................................................................................28
Table 3: Financial statements.................................................................................................31
Table 4: Ratio analysis ...........................................................................................................34
Table 5: PNC’s EVA and MVA ...........................................................................................39
Table 6: PNC’s projected sales for 2005 ..............................................................................42
Table 7: PNC’s Pro Forma financial statements for 2005 under different scenarios ............43
Table 8: PNC’s AFN calculation with AFN formula ............................................................47
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Executive Summary
As of 2004 PNC has the following concerns regarding financial analysis and forecasting:
- identify the strengths and weaknesses of the company and take adequate actions
- identify the cause of low ROE and make corrections
- consider refunding the high cost long-term debt
- determine AFN for the next year
- estimate the affect of excess capacity and increase production to full capacity
- develop an effective incentive compensation plan
A possible way to find solutions:
Conduct a detailed financial analysis on PNC’s current statements using historical
common size statements, valuation ratios, and DuPont analysis. Find the weaknesses and
eliminate them. Find the strengths and use them to gain competitive edge. Examine the
contributors of ROE (net income, common equity) and improve the ratio. The DuPont
analysis can help in this process, since it calculates ROE from a different aspect.
Consider alternative methods to measure performance (ROE, ROIC, EVA, MVA, EPS)
and chose the best for evaluating performance.
Calculate pro forma financial statements so additional funds needed can be determined.
Make the forecast as accurate as possible considering financial feedbacks and
incorporating existing excess capacity. The value of AFN will help to determine if the
company can finance the retirement of its long-term debt.
During this process we will get answers for all issues mentioned above.
General recommendations:
The major weakness that has to be resolved is the high operation costs. The production
records have to be analyzed and the cost lowered. The other weakness is the high WACC
that will change with the retirement of the debts.
Some of the strengths that PNC should closely monitor and build on: fast growing total
sales revenue, efficient inventory management, effective revenue collection.
The most appropriate performance measure is MVA for PNC because it indicates how
much wealth the company created relative to the invested capital. This measurement is
applicable only for top management; detailed business plan should be developed and used
to measure performance in all level of the organization.
The ROE is lower than the industry average because of the high operation costs, it was
mentioned before.
Calculate pro forma statements using percentage per sales method and adjust for financial
feedback and excess production capacity. The result is a lot of generated funds. This will
help financing the retirement of old debt.
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Introduction
Powerline Network Corporation (PNC) was founded in California in 1993.The
company has grown globally in the electronics industry. They manufacture computer
chips that can transmit digital signals over electric power lines to create network
connections. It is a special chip that enables the computer to use the wiring of the house
to build wireless connection with the network.
In the beginning the company was struggling because it could not produce
reliable chips. The design was good but the problems with manufacturing and the
correction of these problems increased the price.
In 2002 PNC contracted a Taiwanese company that set aside the previously
existing manufacturing problems. This way the business could set competitive prices and
expand in the market. PNC started to grow really fast because lot of manufacturers begun
to use their chips in electronic goods. Unfortunately there is no financial professional
among the directors, so the CEO decided to conduct a series of presentation for the board
of directors about financial management. This session will cover the issue of the cost of
capital, financing the company. Despite of current expansion PNC’s growth rate expected
to slow down to a sustainable level due to research and development expenses. The
development is necessary to keep the competitive advantage and built modified chips that
can be used in different products.
The series of presentation that initiated by Ray Reed, the CEO of the company
aimed to educate the board of directors in financial decision making. This session will
deal with financial analysis and forecasting.
Sue Chung and her team were assigned to introduce the topic to the directors
and educate them in a way that they will be able to make valuable decision in some
current topics and understand financial planning.
As we go along with the introduction of recent issues, the team will explain
new definitions and concepts as well as offer alternative ways to solutions. Sue and the
team will also present suggested solutions with their benefits and possible drawbacks.
In this season we will discuss why stock prices have performed as they have, and the
analysis of certain ratios, and benchmarking. We also introduce and discuss a number of
performance measures and situations they most appropriate. Finally, several forecasting
methods will be discussed with pointing out pros and cons’. The proper use of pro forma
statements will be emphasized and limitations of forecasting will be explained.
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Statement of Opportunities and Problems
The purpose of this paper is to point out actual problem and opportunities at PNC and
find the way to make the most out of them.
There has been four major problems and four major opportunities identified.
Problems
There is an effort of the board’s Compensation Committee to set up an effective and
reliable compensation system. The difficulty is to find the best measurement and that how
this measurement will affect the managers actions, decision making process. Can it lead
to actions that are detrimental to the firm in the long run?
PNC’s return on equity (ROE) is below the benchmark average. Why is this situation
exists and what can be done to change it?
Interest rates are decreased since PNC’s debt was issued. So now, the interest rate of this
debt is above the market interest rate. The company is considering a plan to refund the
debt. Will PNC have the necessary funds for the refunding and how will it convince its
lenders?
The last problem is in close relation to the previous one, but has key importance.
Executives want to know how much external financing will be needed in the next year, or
perhaps, how much extra funds will be available. It can be calculated from the projected
financial statements.
Opportunities
The strengths and weaknesses of the company has not been clearly identified. A detailed
financial analysis is required to find the real strengths and weaknesses. Weaknesses
should be corrected and strengths should be utilized. The proportion effect of these
factors on the bottom line should also be explored to rank them for priority purposes.
An accurate forecast that incorporates the company strengths and weaknesses will greatly
enhance financial planning. In order to get useful results the input data has to be valid and
accurate, and the forecasting process has to be complete and precise.
The third opportunity is still in the forecasting procedure, in particular the usefulness of
the forecasted data. It should be easy to read, easy to understand and the model has to be
simple and flexible enough that changes can be made in it in “real time” during the
planning process.
The last is a huge opportunity that has to be recognized. “Based on discussion with the
VP for manufacturing, it appears that we may have some excess production capacity…”
A sharp increase on the bottom line figures can be realized by running in full capacity,
since the increase in sales does not require any additional fixed assets.
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Methodology (Model & Approach)
DuPont Analysis
The DuPont Model is a technique that can be used to analyze the profitability of a
company using traditional performance management tools. To enable this, the DuPont
model integrates elements of the Income Statement with those of the Balance Sheet.
Calculation of DuPont. Formula
Return on Assets = Net Profit Margin x Total Assets Turnover =
= Net Operating Profit After Taxes / Sales x Sales / Total Assets
Assumptions of the DuPont method. Conditions
- Accounting numbers are reliable.
Usage of the DuPont Framework. Applications
 The model can be used by the purchasing department or by the sales department
to examine or demonstrate why a given ROA was earned.
 Compare a firm with its colleagues.
 Analyze changes over time.
 Teach people a basic understanding how they can have an impact on the company
results.
 Show the impact of professionalizing the purchasing function.

Steps in the DuPont Method. Process
1. Collect the business numbers (from the finance department).
2. Calculate (use a spreadsheet).
3. Draw conclusions.
4. If the conclusions seem unrealistic, check the numbers and recalculate.
In this case to evaluate the return on equity just simply multiply the DuPont ROA by the
equity multiplier, which is total assets / total common equity (TA/CE).
The equation will be modified as follows:
(NI/Sales) x (Sales/TA) x (TA/CE) = ROE
(See Table 2)
Financial Statement and Ratio Analysis
(See Tables 3 and 4)
Common Size Financial Statements
Common size ratios are used to compare financial statements of different-size companies,
or of the same company over different periods. By expressing the items in proportion to
some size-related measure, standardized financial statements can be created, revealing
trends and providing insight into how the different companies compare.
The common size ratio for each line on the financial statement is calculated by dividing
the income statement items by the total revenues and the balance sheet item by the total
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assets. The balance sheet items can also be divided by sales revenues and income
statement items by total assets to get an idea of how assets and sales are related. These
common size statements are useful for identifying trends and for comparisons among
companies that differ in size.
Comparisons Between Companies (Cross-Sectional Analysis)
Common size financial statements can be used to compare multiple companies at the
same point in time. A common-size analysis is especially useful when comparing
companies of different sizes. It often is insightful to compare a firm to the best
performing firm in its industry (benchmarking). A firm also can be compared to its
industry as a whole. To compare to the industry, the ratios are calculated for each firm in
the industry and an average for the industry is calculated. Comparative statements then
may be constructed with the company of interest in one column and the industry averages
in another. The result is a quick overview of where the firm stands in the industry with
respect to key items on the financial statements.
Limitations
As with financial statements in general, the interpretation of common size statements is
subject to many of the limitations in the accounting data used to construct them. For
example:
•
Different accounting policies may be used by different firms or within the same
firm at different points in time. Adjustments should be made for such differences.
•
Different firms may use different accounting calendars, so the accounting periods
may not be directly comparable.
The structure of PNC’s financial statements
To set up a dynamic, flexible model, the least amount of inputs is used. In the excel
spreadsheet grey fields indicate the given inputs (independent variables) and the white
field values derived from the inputs (dependent variables). This way, any changes in any
input will change the whole model accordingly.
The explanation of some item calculated on the spread sheet (obvios calculation are
omitted):
Net Operating Capital = Total assets – ST securities
Net Working Capital = Current assets – Current liabilities
Ratios:
Earnings per Share = Net income / shares outstanding
Dividend Payout Ratio = Dividend per share * Shares outstanding / Net income
Book value per share = Total common equity / Shares outstanding
Price per Earnings = Market stock price / EPS
EVA = NOPAT – CAPITAL CHARGE (INVESTED DEBT AND EQUITY * WACC)
MVA = Company’s Market Value – Invested Capital
Company’s Market Value = number of shares outstanding x common stock market price
Net Operating Income After Tax (NOPAT) = Operating income (EBIT) * (1-Tax rate)
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Invested Debt and Equity = Net Operating Capital
Free Cash Flow (FCF) = NOPAT – change in net operating capital + change in current
liabilities
Days Sales Outstanding = Account receivable / (Sales revenues / 365)
Interest Coverage Ratio = EBITDA / Interest expense
EBITDA = EBIT + Depreciation
Rate on Invested Capital (ROIC) = NOPAT / Net operating capital
Financial ratio analysis groups the ratios into categories which tell us about different
facets of a company's finances and operations. An overview of some of the categories of
ratios is given below.
-
Leverage Ratios show the extent that debt is used in a company's capital
structure.
- Liquidity Ratios give a picture of a company's short term financial
situation or solvency.
- Operational Ratios use turnover measures to show how efficient a
company is in its operations and use of assets.
- Profitability Ratios which use margin analysis and show the return on
sales and capital employed.
- Solvency Ratios which give a picture of a company's ability to generate
cash flow and pay it financial obligations.
It is imperative to note the importance of the proper context for ratio analysis. Like
computer programming, financial ratio is governed by the GIGO law of "Garbage
In...Garbage Out!" A cross industry comparison of the leverage of stable utility
companies and cyclical mining companies would be worse than useless. Examining a
cyclical company's profitability ratios over less than a full commodity or business cycle
would fail to give an accurate long-term measure of profitability. Using historical data
independent of fundamental changes in a company's situation or prospects would predict
very little about future trends. For example, the historical ratios of a company that has
undergone a merger or had a substantive change in its technology or market position
would tell very little about the prospects for this company.
Credit analysts, those interpreting the financial ratios from the prospects of a lender,
focus on the "downside" risk since they gain none of the upside from an improvement in
operations. They pay great attention to liquidity and leverage ratios to ascertain a
company's financial risk. Equity analysts look more to the operational and profitability
ratios, to determine the future profits that will accrue to the shareholder.
Although financial ratio analysis is well-developed and the actual ratios are well-known,
practicing financial analysts often develop their own measures for particular industries
and even individual companies. Analysts will often differ drastically in their conclusions
from the same ratio analysis.
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Measurements
What is EVA?
Eva measures internal and external company operating performance, funds the credit
initiative, constraints, and challenges. It can be tied to evaluating employee performance
and success by developing a goal oriented compensation package based on an incentive
reward system that links cause and effect accountability. The EVA results should be
made available to all managers and employees to be used as a performance measurement
and management that is directly calculated and applied.
Earnings, operations performance, return on capital invested are measured and compared
to profits. They are then compared with the cost of debt and equity to fund operations.
EVA = NOPAT – CAPITAL CHARGE (INVESTED DEBT AND EQUITY * WACC)
The excess EVA equals profit. The initial implementation of EVA values current
operations then subsequent new projects are measured with decision being made on
whether the accounting numbers are justified to go forward with the project. If the cost
of the project exceeds the value added, the project should not go forward since adding
shareholder value is the bottom line goal of the company.
3 Goals:
- Improve customer satisfaction (improved service)
- Strengthen employee and company effectiveness
- Improve financial performance
Challenges:
Capital investments
Continuous profitability improvement
Management tool:
Employee evaluation and compensation (set goals, measure progress, and
continuous improvement by updating goals…)
Pitfalls
A full implementation of EVA may not be a good fit for all organization. The initial
foundation effort may be more than your organization requires. In a market that has all
business severely under pressure leaving little extra time, energy or finances to overhaul
the accounting, budgeting and employee compensation process, a modified version may
be a more appropriate fit.
Other shortcomings include: sacrifices to be made for the long-term capital growth when
short term improvements are necessary; secondly manager’s will have a tendency to
invest in projects that have positive EVA at the risk of not focusing on company or
competitive value added; thirdly since EVA is balance sheet driven the value returned
may not in fact increase the balance sheet; fourthly managers may be distracted away
from critical operating and strategic issues.
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EVA, WACC and NOPAT calculations may be subjective. In addition the measurement
of management and departmental units separately requires an accounting system change
that is costly and time consuming.
Market Value Added - MVA
MVA is calculation that shows the difference between the market value of a company
and the capital contributed by investors (both bondholders and shareholders). In other
words, it is the sum of all capital claims held against the company plus the market value
of debt and equity.
Calculated as: MVA = Company’s Market Value – Invested Capital
Company’s Market Value = number of shares outstanding x common stock market price
The higher the MVA, the better. A high MVA indicates the company has created
substantial wealth for the shareholders. A negative MVA means that the value of
management's actions and investments are less than the value of the capital contributed to
the company by the capital market (or that wealth and value have been destroyed).
See table 5.
Forecasting
Forecasting is the process of analyzing current and historical data to determine future
trends. For example stock analysts use various forecasting methods to determine future
stock price movements, earnings, etc. Economists use forecasting techniques in order to
determine future economic trends.
The financial forecasting has three important uses:
- Forecast the amount of external financing that will be required
- Evaluate the impact that changes in the operating plan have on the value
of the firm
- Set appropriate targets for compensation plans
Forecasting can be qualitative (jury of executive opinion, sales force composite, delphi
method, consumer market survey) or quantitative (time series: moving averages,
smoothing coefficients, regression, other). Financial projections should be quantitative
with qualitative adjustment according to non-quantifiable circumstances.
At the first step only projected sales will be determined.
There are a number of methods to make such projection, but only a few will be discussed
for different reasons.
1. The historical data can have 3 characteristics:
- trend (if there is a clear increasing or decreasing pattern with some
anomaly)
- seasonality (data changes in certain periods)
- periodic cycles (there is a repeating pattern independent from seasons)
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A set of data can have all of the above characteristics at the same time. Working with
such data set requires advanced forecasting techniques.
The percentage of sales forecasting method based on the relation of different statement
items to the total sales revenue. A good estimate of the sales revenue is essential since all
other projection is based on that. In our case the projected sales growth is given as well as
the necessary ratios.
The movement of the market and the competitors are unpredictable, and has a big impact
on PNC’s performance. That is the reason why PNC’s management set four different
scenarios and would like to examine the financial impacts for each situation.
(See the projected statements for each scenario in table 7.)
The table was constructed in the following way:
1. Identify each item for the statements
2. Copy actual values (2004) into the firs column
3. Calculate sales revenues using sales growth rate
4. Calculate forecasted (2005) “inputs” for each scenario by multiplying
sales with the corresponding ratio
5. Copy all the formulas from the inputs sheet to get the dependent variables
for each scenarios
6. Balance the balance sheet:
a) calculate the difference between total assets and total equity and liability
b) calculate AFN by subtracting ST securities from this difference
Assumptions: any additional funds needed would be obtained as ST loans
Any excess funds generated would be invested in ST securities
The assumption made were necessary to make the projections and that all of the scenarios
will be consistent and comparable. The other assumptions were given, like most of the
things held constant: no common dividend will be paid, and interest and tax rates will be
consistent.
Adjustments
Definition
Excess capacity refers to a situation where a firm is producing at a lower scale of output
than it has been designed for.
It exists when marginal cost is less than average cost and it is still possible to decrease
average (unit) cost by producing more goods and services. Excess capacity may be
measured as the increase in the current level of output that is required to reduce unit costs
of production to a minimum. Excess capacity is a characteristic of natural monopoly or
monopolistic competition. It may arise because as demand increases, firms have to invest
and expand capacity in lumpy or indivisible portions. Firms may also choose to maintain
excess capacity as a part of a deliberate strategy to deter or prevent entry of new firms.
(Glossary, 1993)
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The capacity level is expressed as a utilization level of the fixed assets in percentage.
If there is excess capacity sales can be increased without increasing fixed assets. The
amount of sales that the current net assets can support is calculated with the following
formula:
Sales with full capacity = Actual sales / % of capacity
To demonstrate the application of this method assume that PNC actual output is 80% of
the full capacity (all is given is that there is a significant excess capacity at PNC)
The formula will be the following:
82,739 / 0.8 = 103,423
CALCULATING AFN
the following formula-generated AFN highlights the relationship between sales growth
and financial requirements.
AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)
Where,
 A*/S0: assets required to support sales; called capital intensity ratio.
 S: increase in sales.
 L*/S0: spontaneous liabilities ratio
 M: profit margin (Net income/sales)
 RR: retention ratio; percent of net income not paid as dividend.
See PNC’s AFN calculation in table 9
Financial feedback is the phenomenon that the funds used to finance AFN will increase
interest unless it is solely from non-interest bearing liabilities that is very limited. Interest
expense then will lower net income and retained earning. After these changes we will be
short of fund by the amount of interest on the added loans, so add some more fund and
feed back again. Repeat this until the balance sheet is balanced. When the AFN is small
enough it can be financed from other sources like retained earnings or marketable
securities.
This balancing game was played manually not too many years ago, but nowadays the
interactive models and spreadsheets allow automatic incorporation of the feedbacks. In
excel, there is a calculation option that runs a 100 iterations that can make the balance
sheet balanced.
According to the given information Sue’s forecast model should be appropriate. In this
report only data given used for the percentage of sales method and the balance sheet is
balanced. If Sue had a similar model that should take into account the financial feedback
too.
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Analysis (Qualitative and Quantitative)
DuPont Analysis
(See Table 2)
The goal is to reach higher ROE. The trend of the ROE is really good since it has been
increasing fast in the last years, but take a look at the contributing numbers.
Operating Efficiency: Total Asset Turnover (TATO: Sales/Total Assets)
Turnover or efficiency ratios are important because they indicate how well the assets of a
firm are used to generate sales and/or cash. While profitability is important, it does not
always provide the complete picture of how well a company provides a product or
service. A company can be very profitable, but not too efficient. Profitability is based
upon accounting measures of sales revenue and costs. Such measures are generated using
the matching principle of accounting, which records revenue when earned and expenses
when incurred. Hence, the gross profit margin measures the difference between sales
revenue and the cost of goods actually sold during the accounting period. The goods sold
may be entirely different from the goods produced during that same period. Goods
produced but not sold will show up as inventory assets at the end of the year. A firm with
abnormally large inventory balances is not performing effectively, and the purpose of
efficiency ratios is to reveal that fact.
The total asset turnover (TATO) ratio measures the degree to which a firm generates
sales with its total asset base. As in the case of net profitability, the most comprehensive
measure of performance in this particular area is being employed in the DuPont ratio
(other measures being fixed asset turnover, working capital turnover, inventory and
receivables turnover). In some cases useing average assets in the denominator could
eliminate the bias in the ratio calculation.
Financial ratio bias is commonly present when combining items from both the balance
sheet and income statement. For example, TATO uses income statement sales in its
numerator and balance sheet assets in the denominator. Income statement items are flow
variables measured over a time interval, while balance sheet items are measured at a
fixed point in time. In cases where the firm has been involved in major change, such as
an expansion project, balance sheet measures taken at the end of the year may
misrepresent the amount of assets available and/or in use over the course of the year.
Taking a simple average for balance sheet items (i.e., ((beginning + ending)/2)) will
control for at least some of this bias and provide a more accurate and meaningful ratio.
The limiting assumption is that the change in the balance sheet occurred evenly over the
course of the year, which may not always be the case.
Leverage: The Leverage Multiplier (Total Assets/Common Equity)
Leverage ratios measure the extent to which a company relies on debt financing in its
capital structure. Debt is both beneficial and costly to a firm. The cost of debt is lower
than the cost of equity, an effect which is enhanced by the tax deductibility of interest
payments in contrast to taxable dividend payments and stock repurchases. If debt
proceeds are invested in projects which return more than the cost of debt, owners keep
the residual, and hence, the return on equity is "leveraged up." The debt sword, however,
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cuts both ways. Adding debt creates a fixed payment required of the firm whether or not
it is earning an operating profit, and therefore, payments may cut into the equity base.
Further, the risk of the equity position is increased by the presence of debt holders having
a superior claim to the assets of the firm.
The leverage multiplier employed in the DuPont ratio is directly related to the proportion
of debt in the firm's capital structure.
Just like in the case of TATO, averages can be used to control potential bias caused by
the end-of-year values.
Profitability: Net Profit Margin (NPM: Net Income/Sales)
Profitability ratios measure the rate at which either sales or capital is converted into
profits at different levels of the operation. The most common are gross, operating and net
profitability, which describe performance at different activity levels. Of the three, net
profitability is the most comprehensive since it uses the bottom line net income in its
measure.
A proper analysis of this ratio would include at least three to five years of trend and
cross-sectional comparison data. The cross sectional comparison can be drawn from a
variety of sources. Most common are the Dun & Bradstreet Index of Key Flnancial
Ratios and the Robert Morris Associates (RMA) Annual Statement Studies. Each of these
volumes provide key ratios estimated for business establishments grouped according to
industry (i.e., SIC codes). More will be discussed in regard to comparisons as our
example is continued below.
Combination and Analysis of the Results
The TATO reached the benchmark by 2004. The inventory control and the supply chain
efficiency is up to the industry average. It is the result of the fast growing sales that can
be devotet to good location, effective sales and marketing efforts or good product quality.
If the amount of sales keeps growing with this trend it will be one of the major streghts of
PNC.
The companiy’s management of financing performs well compare to the industry. A
helthy ratio of debts and equity should be maintaned. PNC’s return on equity is appealing
but the greater ratio of debt means greater risk to stockholders. As long as the company
can keep the balance and has the funds to meet their obligations this multiplier is an
adventege for PNC.
The profitabily index is the reason that PNC’s ROE falls under the industry average. This
is a komplex value that incorporates revenues and expenditures. Since revenues are
growing with a fast rate, the problem could be the expenditures. PNC might be able to
further improve it’s profit margin by reducing costs. It has been a weakness of the
company, but the trend shows fast improvement.
Financial Statement and Ratio Analysis
See tables 3 and 4.
Analyzing the Financial Statements
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Income Statement
The dollar amount of sales is four times of the total assets compared to the three fold
difference in the leading competitors. This means that PNC can make more sales with
less resource. This is definitely a big advantage.
The ratio of net income (NI)/total assets is good, it can support more growth or higher
dividend but the NI/sales ratio is lower than it is for the competitors that indicate high
operating costs or low product price. It is definitely a problem waiting for solution.
The value of the NI ratio originated from the high operating cost and low operating
income ratios.
Balance Sheet
The higher ST securities ratio means increased liquidity but does not contribute to
production. It can help the company to take advantage of unexpected opportunities by
converting them into cash.
The inventory ratio has great importance in every manufacturing or retail business. High
inventory greatly increases costs; low inventory can lead to stockouts. Apparently, the
inventory cost is NOT the reason of PNC’s high op cost.
Liabilities:
The total current liability balance of PNC is close to the benchmark, but accruals are
higher and A/P is lower which indicates that PNC satisfies most of its creditors by paying
them quick. PNC has no notes payable due. Just like the ST securities it can help the
company to stay flexible by maintaining the opportunity to accumulate payables in a case
of unexpected activity financing.
The preferred and common stocks are the most expensive instruments of financing. PNC
has a significantly higher ratio of these stocks, which is probably the reason of PNC’s
higher WACC. On the other hand, these instruments are needed to maintain the target
capital structure to ensure the stability. PNC have not paid common dividends in the past
years and its retained earnings are still low. Stockholders would like to see higher RE and
also some dividends paid out in the near future. For that, higher NI is necessary.
I would like to point out PNC’s strengths and weaknesses as they appear on the ratios
rather than introducing each and every ratios and explaining their role in the business.
The earnings per share ratio is mainly useful for companies with publicly traded shares.
Most companies will quote the earnings per share in their financial statements saving you
from having to calculate it yourself. By itself, EPS does not really tell you a whole lot.
But if you compare it to the EPS from a previous quarter or year it indicates the rate of
growth a companies earnings are growing (on a per share basis). The higher the ratio is
the better the company performs. PNC shows fast improvement.
PNC’s dividend payout ratio is zero, in other words they do not pay a dividend to its
shareholders. This is the case for most high growth firms; their profits are better spent by
reinvesting in the firms activities rather than as a cash payout to shareholders. In fact a
majority of corporations have elected to pay out less of their earnings as dividends,
perhaps because corporate rates of return on reinvested capital are higher these days, but
it could also be that dividends are doubly taxed in some jurisdictions.
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Since the retained earnings are well reinvested the company grows fast, which means
increasing company value, hence increasing stock price. But some of the stockholders
like to get some return in every period. They might invest in the competitor companies.
The stock price is not really a ratio, but it is an important indicator of the company’s
market price. Increasing stock market price indicates that the company is perceived as a
stabile, profitable entity. It makes positive impression to creditors.
Sometimes referred to as the multiple, the idea behind the P/E ratio is that it is a
prediction or more likely an expectation of the company's performance in the future. The
P/E ratio for the overall market averages around 20 (Price, 2006), so as you can see
PNC’s was much higher than this. In other words the market was expecting big things
from PNC over the past years. In 2004 the expectations seems to be lower.
One thing to remember is that if a company has a low P/E ratio it does not necessarily
mean that it is undervalued. The P/E does not dictate the stock price, in fact a low P/E
could mean that the company's earning are flat or growing slowing, they could also be in
financial trouble. In fact the P/E ratio does not tell a whole lot, but it is useful to compare
the P/E ratios of other companies in the same industry, or to the market in general, or
against the company's own historical P/E ratios.
PNC’s stock was probably undervalued in the past, but the stock price is close its real
value by now.
What is WACC?
Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see how much
interest the company has to pay for every dollar it finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is
often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate discount rate to use for cash
flows with risk that is similar to that of the overall firm.
As mentioned above PNC’s higher WACC caused by the high ratio of equity, but it is not
far off the benchmark. The managers might want to consider issuing more debt in the
future but stay consistent with the target capital structure.
The Net Operating Profit After Tax is an estimate of what a company would earn if it did
not have any debt, equal to operating income times (1 minus the tax rate). For companies
which use leverage, NOPAT is an alternative measure for measuring operating
efficiency. NOPAT is frequently used for calculating Economic Value Added (EVA).
PNC’s NOPAT is increasing fast with the increase in sales. The benchmark companies’
NOPAT value is probably a typo, because their op income/sales ratio is higher and the
tax rate should be the same. The trend in the increasing NOPAT is attractive.
The operating cost/sales ratio is decreasing but still high compared to the competitors. As
mentioned earlier, decreasing operating cost could be the best tool to gain significant
competitive advantage.
17
The Days Sales Outstanding ratio explains the average time it takes to receive payment
on sales. PNC seems to do well in collecting payments. However the too strict collection
terms can turn customers to other companies.
Inventory/sales ratio reveals that the operating cost problem is not originated from
extensive inventory costs. So, the management should look for other causes. Another
informative ratio would be the inventory turnover ratio, but it can not be calculated
without the value of cost of goods sold.
The fixed assets/sales value gives an idea about how the company uses its resources. This
is an important asset management efficiency ratio. By 2004, PNC reached the benchmark
and as the operation manager reported there was still some excess production capacity.
Reaching full utilization PNC can get a leap ahead of its competitors.
PNC’s debt/asset ratio is fairly low, meaning that its assets are financed more through
equity rather than debt. Companies with high ratios are placing themselves at risk,
especially in an increasing interest rate market. Creditors are bound to get worried if the
company is exposed to a large amount of debt and may demand that the company pay
some of it back. PNC’s ratio reached the benchmark. The increasing ratio could lower the
WACC as well as the company’s stability.
The amount of the preferred stock the company issues depends on financing issues.
Preferred stock is costly for the company and the common stockholders do not like it
either. In case of bankruptcy preferred stockholders have a claim on the company prior
the common stockholders, they also get their dividends first. PNC should find the way to
finance its activities through debts and common stock.
The common stockholder equity to assets ratio is the other side of the debt/asset ratio. If
it is too high it leads to expensive WACC, but if it is too low it decreases equity/liability
ratio. Managers have to maintain these ratios balanced according to the pre-determined
capital structure.
PNC’s interest coverage is good, but not as good as it is for the competitors. PNC does
not have much debt, but the one it has probably expensive. Maybe market interest rates
decreased since the issuance of the bonds. The company should consider retiring those
bonds and issue new ones. Companies with a ratio below 1 could run into serious trouble
servicing its loan payments and are considered to be a high risk of defaulting.
18
Measurements
EVA and MVA
(See Table 5)
In the past few years, many highly successful organizations have begun using MVA and
EVA as measures of financial performance. MVA measures managerial effectiveness
since an organization's inception, and EVA measures managerial effectiveness during a
given year. That is the reason of the big difference. PNC might not be effective in these
years in the aspect of long term value added, but still effective in creating overall
stockholders’ value. As an indicator of corporate effectiveness in maximizing shareholder
wealth, MVA is most appropriate for investor-owned firms. Though it can be applied to
investor-owned organizations, EVA also can be used by not-for-profit organizations and
measures how well managers are maximizing the economic value of the organization's
capital. Once healthcare financial managers understand the rationale and potential uses of
these measures, they may find them more helpful for measuring an organization's
economic profit than accounting profitability measures, which account for the cost of
debt but not the cost of equity.
EVA and MVA are one of the best methods to measures company performance, hence
top management effectiveness. These measures take into account the cost of capital
unlike accounting profitability measures. Other measures could be the return on invested
capital (ROIC) or return on equity (ROE), but these can be easily influenced by the
capital structure. The MVA as a komplex measurement consider riskiness and costs of
capital.
For PNC MVA should be choosen over EVA for two reasons.
The company is relativly new and the industry is very dinamic. It would not make much
sense to measure how well management manages the resources to give the best return in
the long run. The emphasis has to be more on the realized opportunities and on the effort
to gain competitive advantage and capture market share. These effort might result in
negative EVA for any given year.
PNC is a for profit company that is expected to show good result for period to period and
satisfy its creditors. The company’s MVA is increasing consistently from year to year and
expected to continue this trend in the future due to the increasing stock price.
Only top management can be evaluated with this metod, since it measures overall
business performance. For departments, it has to be modified or other measures can be
used.
There are some informative accounting ratios available to measure departments or even
people’s performance. For the middle management or department level the calculated
accounting ratios are good measurements. However, The most sensitive point of these
measures to set realistic goals, and consider environmental changes at the evaluation.
Accurate information is essential for forecasting, benchmarking and to give the right
amount of incentives to the right people.
Compensation is a separate science today. The challenge is to find the best performance
measure and set the benchmark, but it is only the beginning, then the plan needs to be
adjusted and the performance evaluated.
19
The danger is that employees/managers are tend to modify, even make up numbers to get
better incentives. One example could be Enron, where top efficers “forgat” to follow the
full disclosure principle. An other example could be Coca-Cola, where sales managers
sent out numerous trucks on December 31th (that were returned on January 1st) just to get
better year end figures.
The point is that employees of all position might take actions for incentives that will hurt
the company in the long-run.
The solution can be a good monitoring system, policies, and regulations. Also, all
employees should be involved in the planning and decision making process to an extent
so that they understand the importance of the relevant information and the effect of the
companiy’s overall performance.
Forecasting
In PNC’s historical sales data an increasing trend easily noticeable. Seasonality and
periodic cycles are not likely to effect sales. PNC’s background information states that
after the initial problems the company has been growing fast but this growth expected to
slow down. It does not seem to be periodic. To identify seasonality monthly data would
be required.
For data with trend the regression analysis is adequate, averaging methods more accurate
with constant demand or applying with other methods. For example calculating the sales
growth rate might result in a derived data set that averaging method can be applied on.
Two alternative forecast method were used to compare projected sales.
a. Regression by using TREND function in Excel
b. Average growth rate
(See table 6.)
There is a big difference between the two forecasted values. There are several methods
available to measure forecast accuracy:
- Cumulative sum of Forecast Error (CFE): Indicates bias or direction of errors
- Mean Absolute Deviation (MAD): Indicates magnitude of errors
- Mean Squared Error (MSE): Emphasizes large errors
- Mean Absolute Percent Error (MAPE): Allows comparison of forecasts using different
data
The calculated MSE indicates that there is a big difference between PNC’s forecasted and
actual sales in 2004, but evaluating the 2005 forecast the trend analysis seems more
reasonable; first, because the growth is expected to slow down, second, because
conservative values should be used.
Common financial forecasting methods are:
- percentage of sales
- percentage of assets
- percentage of growth
20
In the case of the firs two methods the total sales revenue or the amount of total assets is
forecasted and all other items adjusted to this base item considering current relations or
expected relations between the item in question and the base item.
The percentage of growth method allows each item on the statements to grow
independently with a rate defined by historical data.
Later the percentage of sales method is discussed in more detail.
Percentage of sales forecasting method
Evaluation of the results
With no ratio analysis just looking at the statements and the projected ratios that the
forecast was based on, one can conclude the followings.
The earnings per share ratio is a good value to start with, because it is an overall
performance measurement. It will have a good value in the most likely case and even
better if the company reaches the benchmark. Its value in the best and the worst cases is
significantly different. Let’s find the reasons.
In the worst case sales only grow by 10%. The ratio of fixed assets to sales up to 25%,
and the costs of sales take away 95% of the revenue. These changes alone can push the
company into serious problems. The forth problem is the cost of inventory that
contributes to the total expenditures. Inventory management has been strength of PNC,
and now it appears to be crucial. All these ratios measure efficiency; if the company is
not able to operate efficiently it will have to close its doors very soon.
Other hits on the company are the increase of interest rate on notes payable, dramatic
increase of current liabilities, and uncollected sales revenue. All the listed issues has been
strengthen the company, the effect of turning this into weaknesses is disastrous.
In the best case there is only three important item that significantly differ from the most
likely cases, but these are really the key items.
7. Cash cost decreases from 90% to 88%. This 2% difference results close to
$2,000,000 in saving in the given scenario that contributes with an extra
$1,200,000 to the bottom line!!!
8. If the fixed assets can be utilized more efficiently, sales will raise without
substantial cost increase.
9. Sales are the core deriving sources of the company. PNC receives all its
revenue through sales. Increasing sales with 20% instead of 15% makes a
huge difference. Looking at the historical sales data it does not seem to be
impossible to reach that goal, in fact, in the past two years PNC had 50
and 75% growth respectively!
Summary
PNC’s management really needs to monitor those performances, those aspects of the
business that were mentioned above. PNC has to catch up with the competitors in the
areas it is having trouble with and maintain or increase advantage in its strengths.
21
Adjustments
The interpretation of the result is that PNC will not need any additional fixed asset until
sales exceed $103,423,000. In the given scenarios the company has enough fixed asset to
support all the forecasted sales, so there will be no new fixed assets needed.
How would this excess capacity affect the PNC’s AFN in the coming year?
Let’s take the base case as an example.
The previously projected increase in fixed assets was $2,711,000.
Since no new fixed assets will be needed, AFN will fall by $2,711,000, to
$377,000 - $2,711,000 = -$2,334,000
turning to additional funds needed to extra funds generated.
All scenarios should be adjusted the same way. It will be up to the management how they
want to allocate these funds.
Additional Funds Needed
AFN
Compare to:
AFN
$1,797
$1,797
$377
$350
$3,092
$502
($3,881)
$10,623
The difference in results from the two methods is huge.
The reason is the difference in the assumptions.
On the second method (AFN formula) the basic assumption is that the ratios remain the
same. The only thing change is the sales revenue. In contradiction, the first method
(percentage of sales) set different ratios calculating expected changes and performance.
22
Summary & Conclusions
For a dynamic company that going through changes, like PNC, forecasting is extremely
difficult. Forecasting is nothing else but an educated guess, but it will give a direction for
financial planning. So, we should take our best guess. There are less complicated
methods available but the most appropriate one for PNC is the percentage of sales
forecasting method because it incorporates the company strengths and weaknesses. The
PoS method also allows us to adjust forecasts to financial feedbacks.
For performance evaluation and benchmarking the average of the leading 8 companies in
the industry is not the best choice because in some areas PNC already outperforms its
competitors. The other factor is that the competitors’ performance might not be the
optimal one. Market value added should be a good choice because it measures the overall
wealth created throughout the years of operation. That is one thing that stockholders want
to know, but other measures can be used too, like EPS or EVA. The point is that it should
not affect managerial decisions negatively.
In order to operate in a efficient manner management should use and monitor closely
PNC’s core competencies: sales revenue, inventory management, collectibles. These
factors have a key role in determining the bottom line. The other area that PNC has a lot
to improve in is the cost reduction for lower operating costs.
23
Recommendations
Increase ROE:
The profitabily index is the reason that PNC’s ROE falls under the industry average. This
is a komplex value that incorporates revenues and expenditures. Since revenues are
growing with a fast rate, the problem could be the expenditures. PNC might be able to
further improve it’s profit margin by reducing costs. It has been a weakness of the
company, but the trend shows fast improvement.
Increase profitability:
Instant improvement can be achieved by lowering operation costs. The financial analysis
has been performed to identify key factors in the production. Forecast was calculated to
study the role and the affect of the key factors on the business. Now that we know all of
these, directions should be set for improvement and improving operation process should
be closely monitored to ensure desired results and make adjustments as necessary.
Performance evaluation:
In the past few years, many highly successful organizations have begun using MVA and
EVA as measures of financial performance. MVA measures managerial effectiveness
since an organization's inception, and EVA measures managerial effectiveness during a
given year.
As an indicator of corporate effectiveness in maximizing shareholder wealth, MVA is
most appropriate for investor-owned firms. Once managers understand the rationale and
potential uses of these measures, they may find them more helpful for measuring an
organization's economic profit than accounting profitability measures, which account for
the cost of debt but not the cost of equity.
The forecast should play a role in the compensation plan to the extent that it can provide
goals and will be the basic of a comparison to the next year actual statements for the
performance evaluation. However, it can only be used for the evaluation of the top
management since it measures total outcomes and general ratios.
The statements are more useful when used as guidelines only. After identifying strengths
and weaknesses, and reasonable goals have been set, a detailed implementation plan
should be developed that can be the ultimate guide and measurement for every level in
the organization.
Funds allocation:
When operating at full capacity PNC will generate significant amount of funds. These
funds should be spent to refund long-term debt. Then it will lower the cost of debt,
therefore WACC. This action can save a lot of money in the long-run.
24
Works Cited
“Brigham & Ehrhardt PowerPoint Slides” by Eugene F. Brigham & Michael C. Ehrhardt,
2005.
“Cases in Financial Management”, Brigham, Eugene F. and Buzzard, Christopher.,
(2004). Mason, Ohio: South-Western.
“DuPont Model” by Cees A.J. Wiegel MBA, Montal Consultancy, 2006. Accessed from
http://www.12manage.com/methods_DuPont_model.html
“Economic Value Added (EVA)”, Understanding Financial, 2006. Accessed from
http://www.understandingfinancials.com/eva.htm
“Financial analysis with the DuPont ratio: A useful compass” Credit & Financial
Management Review, Second Quarter 1998 by Isberg, Steven C. Accessed from
http://www.findarticles.com/p/articles/mi_qa3857/is_199804/ai_n8799612
“Glossary of Industrial Organisation Economics and Competition Law”, by R. S.
Khemani and D. M. Shapiro, 1993. Accessed from
http://stats.oecd.org/glossary/detail.asp?ID=3209
“Price to Earnings Ratio - P/E Ratio” Investopedia, 2006, accessed from
http://www.investopedia.com/university/ratios/peratio.asp
25
APPENDIX A
ANSWERS FOR DIRECTED VERSION QUESTIONS
1. Do a DuPont analysis for PNC. What can you conclude from this analysis?
What is the DuPont Model? Description
The DuPont Model is a technique that can be used to analyze the profitability of a
company using traditional performance management tools. To enable this, the DuPont
model integrates elements of the Income Statement with those of the Balance Sheet.
Origin of the DuPont Model. History
The DuPont model of financial analysis was made by F. Donaldson Brown, an electrical
engineer who joined the giant chemical company's Treasury department in 1914. A few
years later, DuPont bought 23 percent of the stock of General Motors Corp. and gave
Brown the task of cleaning up the car maker's tangled finances. This was perhaps the first
large-scale reengineering effort in the USA. Much of the credit for GM's ascension
afterward belongs to the planning and control systems of Brown, according to Alfred
Sloan, GM's former chairman. Ensuing success launched the DuPont model towards
prominence in all major U.S. corporations. It remained the dominant form of financial
analysis until the 1970s.
Calculation of DuPont. Formula
Return on Assets = Net Profit Margin x Total Assets Turnover =
= Net Operating Profit After Taxes / Sales x Sales / Total Assets
Usage of the DuPont Framework. Applications
 The model can be used by the purchasing department or by the sales department
to examine or demonstrate why a given ROA was earned.
 Compare a firm with its colleagues.
 Analyze changes over time.
 Teach people a basic understanding how they can have an impact on the company
results.
 Show the impact of professionalizing the purchasing function.

Steps in the DuPont Method. Process
- Collect the business numbers (from the finance department).
- Calculate (use a spreadsheet).
- Draw conclusions.
- If the conclusions seem unrealistic, check the numbers and recalculate.
26
Table 1, DuPont Model Chart
Strengths of the DuPont Model. Benefits
 Simplicity. A very good tool to teach people a basic understanding how they can
have an impact on results.
 Can be easily linked to compensation schemes.
 Can be used to convince management that certain steps have to be taken to
professionalize the purchasing or sales function. Sometimes it is better to look
into your own organization first. In stead of looking for company takeovers in
order to compensate lack of profitability by increasing turnover and trying to
achieve synergy.
Limitations of the DuPont analysis. Disadvantages
 Based on accounting numbers, which are basically not reliable.
 Does not include the Cost of Capital.
 Garbage in, garbage out.
27
Assumptions of the DuPont method. Conditions
 Accounting numbers are reliable. (DuPont, 2006)
In this case to evaluate the return on equity just simply multiply the DuPont ROA by the
equity multiplier, which is total assets / total common equity (TA/CE).
The equation will be modified as follows:
(NI/Sales) x (Sales/TA) x (TA/CE) = ROE
Table 2, DuPont analysis
DuPont Analysis
TATO
assets/common equity
Profit margin
DuPont ROE
2002
1.50
1.58
1.41%
3.35%
PNC
Benchmark
2003
2004
2004
1.96
2.83
2.85
1.75
1.77
1.62
2.00% 2.52%
3.18%
6.84% 12.62%
14.70%
The goal is to reach higher ROE. The trend of the ROE is really good since it has been
increasing fast in the last years, but take a look at the contributing numbers.
Operating Efficiency: Total Asset Turnover (TATO: Sales/Total Assets)
Turnover or efficiency ratios are important because they indicate how well the assets of a
firm are used to generate sales and/or cash. While profitability is important, it does not
always provide the complete picture of how well a company provides a product or
service. A company can be very profitable, but not too efficient. Profitability is based
upon accounting measures of sales revenue and costs. Such measures are generated using
the matching principle of accounting, which records revenue when earned and expenses
when incurred. Hence, the gross profit margin measures the difference between sales
revenue and the cost of goods actually sold during the accounting period. The goods sold
may be entirely different from the goods produced during that same period. Goods
produced but not sold will show up as inventory assets at the end of the year. A firm with
abnormally large inventory balances is not performing effectively, and the purpose of
efficiency ratios is to reveal that fact.
The total asset turnover (TATO) ratio measures the degree to which a firm generates
sales with its total asset base. As in the case of net profitability, the most comprehensive
measure of performance in this particular area is being employed in the DuPont ratio
(other measures being fixed asset turnover, working capital turnover, inventory and
receivables turnover). In some cases useing average assets in the denominator could
eliminate the bias in the ratio calculation.
Financial ratio bias is commonly present when combining items from both the balance
sheet and income statement. For example, TATO uses income statement sales in its
numerator and balance sheet assets in the denominator. Income statement items are flow
variables measured over a time interval, while balance sheet items are measured at a
fixed point in time. In cases where the firm has been involved in major change, such as
an expansion project, balance sheet measures taken at the end of the year may
misrepresent the amount of assets available and/or in use over the course of the year.
28
Taking a simple average for balance sheet items (i.e., ((beginning + ending)/2)) will
control for at least some of this bias and provide a more accurate and meaningful ratio.
The limiting assumption is that the change in the balance sheet occurred evenly over the
course of the year, which may not always be the case.
Leverage: The Leverage Multiplier (Total Assets/Common Equity)
Leverage ratios measure the extent to which a company relies on debt financing in its
capital structure. Debt is both beneficial and costly to a firm. The cost of debt is lower
than the cost of equity, an effect which is enhanced by the tax deductibility of interest
payments in contrast to taxable dividend payments and stock repurchases. If debt
proceeds are invested in projects which return more than the cost of debt, owners keep
the residual, and hence, the return on equity is "leveraged up." The debt sword, however,
cuts both ways. Adding debt creates a fixed payment required of the firm whether or not
it is earning an operating profit, and therefore, payments may cut into the equity base.
Further, the risk of the equity position is increased by the presence of debt holders having
a superior claim to the assets of the firm.
The leverage multiplier employed in the DuPont ratio is directly related to the proportion
of debt in the firm's capital structure.
Just like in the case of TATO, averages can be used to control potential bias caused by
the end-of-year values.
Profitability: Net Profit Margin (NPM: Net Income/Sales)
Profitability ratios measure the rate at which either sales or capital is converted into
profits at different levels of the operation. The most common are gross, operating and net
profitability, which describe performance at different activity levels. Of the three, net
profitability is the most comprehensive since it uses the bottom line net income in its
measure.
A proper analysis of this ratio would include at least three to five years of trend and
cross-sectional comparison data. The cross sectional comparison can be drawn from a
variety of sources. Most common are the Dun & Bradstreet Index of Key Flnancial
Ratios and the Robert Morris Associates (RMA) Annual Statement Studies. Each of these
volumes provide key ratios estimated for business establishments grouped according to
industry (i.e., SIC codes). More will be discussed in regard to comparisons as our
example is continued below.
Combination and Analysis of the Results
The TATO reached the benchmark by 2004. The inventory control and the supply chain
efficiency is up to the industry average. It is the result of the fast growing sales that can
be devotet to good location, effective sales and marketing efforts or good product quality.
If the amount of sales keeps growing with this trend it will be one of the major streghts of
PNC.
The companiy’s management of financing performs well compare to the industry. A
helthy ratio of debts and equity should be maintaned. PNC’s return on equity is appealing
but the greater ratio of debt means greater risk to stockholders. As long as the company
can keep the balance and has the funds to meet their obligations this multiplier is an
adventege for PNC.
29
The profitabily index is the reason that PNC’s ROE falls under the industry average. This
is a komplex value that incorporates revenues and expenditures. Since revenues are
growing with a fast rate, the problem could be the expenditures. PNC might be able to
further improve it’s profit margin by reducing costs. It has been a weakness of the
company, but the trend shows fast improvement.
2. Now consider in more detail PNC’s historical common size financial statement and its
asset management, debt management, profitability, and market valuation ratios. Can
you identify any significant weaknesses, and if so, what corrective actions should
management take?
Common Size Financial Statements
Common size ratios are used to compare financial statements of different-size companies,
or of the same company over different periods. By expressing the items in proportion to
some size-related measure, standardized financial statements can be created, revealing
trends and providing insight into how the different companies compare.
The common size ratio for each line on the financial statement is calculated by dividing
the income statement items by the total revenues and the balance sheet item by the total
assets. The balance sheet items can also be divided by sales revenues and income
statement items by total assets to get an idea of how assets and sales are related. These
common size statements are useful for identifying trends and for comparisons among
companies that differ in size.
Comparisons Between Companies (Cross-Sectional Analysis)
Common size financial statements can be used to compare multiple companies at the
same point in time. A common-size analysis is especially useful when comparing
companies of different sizes. It often is insightful to compare a firm to the best
performing firm in its industry (benchmarking). A firm also can be compared to its
industry as a whole. To compare to the industry, the ratios are calculated for each firm in
the industry and an average for the industry is calculated. Comparative statements then
may be constructed with the company of interest in one column and the industry averages
in another. The result is a quick overview of where the firm stands in the industry with
respect to key items on the financial statements.
Limitations
As with financial statements in general, the interpretation of common size statements is
subject to many of the limitations in the accounting data used to construct them. For
example:
•
Different accounting policies may be used by different firms or within the same
firm at different points in time. Adjustments should be made for such differences.
•
Different firms may use different accounting calendars, so the accounting periods
may not be directly comparable.
30
Table 3, Financial Statements
Income Statements, PNC and Industry ($ in
Thousands)
PNC (2004)
Sales revenues
Cash op costs
Depreciation
Total op costs
Op Income
(EBIT)
Interest
Taxable Income
Taxes
Pfd dividends
Net Income
% of
% of
assets
sales
393.92% 100.00%
355.78% 90.32%
17.23%
4.38%
373.01% 94.69%
20.91%
3.30%
17.61%
7.04%
0.63%
9.94%
5.31%
0.84%
4.47%
1.79%
0.16%
2.52%
Benchmark
Companies
% of
% of
assets
sales
284.86%
100.00%
254.27%
89.26%
12.82%
4.50%
267.09%
93.76%
17.77%
2.28%
15.49%
6.20%
0.23%
9.07%
6.24%
0.80%
5.44%
2.18%
0.08%
3.18%
Balance Sheets, PNC and Industry ($ in Thousands)
Benchmark
PNC (2004)
Companies
% of
% of
% of
% of
assets
sales
assets
sales
Cash
2.14%
0.76%
2.85%
1.00%
ST securities
2.14%
0.76%
0.01%
0.01%
A/R
13.18%
4.66% 14.24%
5.00%
Inv.
20.61%
7.28% 25.64%
9.00%
Current assets
38.07% 13.45% 42.74%
15.01%
Net fixed assets
61.93% 21.87% 57.26%
20.10%
Total assets
100.00% 35.32% 100.00%
35.11%
A/P
1.80%
0.64%
2.85%
1.00%
Accruals
2.44%
0.86%
1.41%
0.50%
Notes payable
0.00%
0.00%
0.94%
0.33%
Current liabilities
4.25%
1.50%
5.20%
1.83%
Long-term debt
31.62% 11.17% 29.99%
10.53%
Total liabilities
35.86% 12.67% 35.19%
12.36%
Preferred stock
3.10%
1.09%
(6%)
7.55%
2.67%
Common stock
29.12% 10.29% 12.82%
4.50%
Retained earnings
27.46%
9.70% 48.88%
17.16%
Total com equity
56.58% 19.99% 61.70%
21.66%
Total
100.00%
35.11%
liabs+equity
100.00% 35.32%
31
Legend:
Green: strength
Red: weakness
No Color: natural -> close to industry average
Analyzing the Financial Statements
Income Statement
The dollar amount of sales is four times of the total assets compared to the three fold
difference in the leading competitors. This means that PNC can make more sales with
less resource. This is definitely a big advantage.
The ratio of net income (NI)/total assets is good, it can support more growth or higher
dividend but the NI/sales ratio is lower than it is for the competitors that indicate high
operating costs or low product price. It is definitely a problem waiting for solution.
The value of the NI ratio originated from the high operating cost and low operating
income ratios.
Balance Sheet
The higher ST securities ratio means increased liquidity but does not contribute to
production. It can help the company to take advantage of unexpected opportunities by
converting them into cash.
The inventory ratio has great importance in every manufacturing or retail business. High
inventory greatly increases costs; low inventory can lead to stockouts. Apparently, the
inventory cost is NOT the reason of PNC’s high op cost.
Liabilities:
The total current liability balance of PNC is close to the benchmark, but accruals are
higher and A/P is lower which indicates that PNC satisfies most of its creditors by paying
them quick. PNC has no notes payable due. Just like the ST securities it can help the
company to stay flexible by maintaining the opportunity to accumulate payables in a case
of unexpected activity financing.
The preferred and common stocks are the most expensive instruments of financing. PNC
has a significantly higher ratio of these stocks, which is probably the reason of PNC’s
higher WACC. On the other hand, these instruments are needed to maintain the target
capital structure to ensure the stability. PNC have not paid common dividends in the past
years and its retained earnings are still low. Stockholders would like to see higher RE and
also some dividends paid out in the near future. For that, higher NI is necessary.
Ratio Analysis
Financial ratio analysis is the calculation and comparison of ratios which are derived
from the information in a company's financial statements. The level and historical trends
of these ratios can be used to make inferences about a company's financial condition, its
operations and attractiveness as an investment.
Financial ratios are calculated from one or more pieces of information from a company's
financial statements. For example, the "gross margin" is the gross profit from operations
divided by the total sales or revenues of a company, expressed in percentage terms. In
32
isolation, a financial ratio is a useless piece of information. In context, however, a
financial ratio can give a financial analyst an excellent picture of a company's situation
and the trends that are developing.
A ratio gains utility by comparison to other data and standards. For example, a gross
profit margin for a company of 25% is meaningless by itself. If we know that this
company's competitors have profit margins of 10%, we know that it is more profitable
than its industry peers which are quite favorable. If we also know that the historical trend
is upwards, for example has been increasing steadily for the last few years, this would
also be a favorable sign that management is implementing effective business policies and
strategies.
Financial ratio analysis groups the ratios into categories which tell us about different
facets of a company's finances and operations. An overview of some of the categories of
ratios is given below.
-
Leverage Ratios show the extent that debt is used in a company's capital
structure.
Liquidity Ratios give a picture of a company's short term financial
situation or solvency.
Operational Ratios use turnover measures to show how efficient a
company is in its operations and use of assets.
Profitability Ratios which use margin analysis and show the return on
sales and capital employed.
Solvency Ratios which give a picture of a company's ability to generate
cash flow and pay it financial obligations.
It is imperative to note the importance of the proper context for ratio analysis. Like
computer programming, financial ratio is governed by the GIGO law of "Garbage
In...Garbage Out!" A cross industry comparison of the leverage of stable utility
companies and cyclical mining companies would be worse than useless. Examining a
cyclical company's profitability ratios over less than a full commodity or business cycle
would fail to give an accurate long-term measure of profitability. Using historical data
independent of fundamental changes in a company's situation or prospects would predict
very little about future trends. For example, the historical ratios of a company that has
undergone a merger or had a substantive change in its technology or market position
would tell very little about the prospects for this company.
Credit analysts, those interpreting the financial ratios from the prospects of a lender,
focus on the "downside" risk since they gain none of the upside from an improvement in
operations. They pay great attention to liquidity and leverage ratios to ascertain a
company's financial risk. Equity analysts look more to the operational and profitability
ratios, to determine the future profits that will accrue to the shareholder.
Although financial ratio analysis is well-developed and the actual ratios are well-known,
practicing financial analysts often develop their own measures for particular industries
33
and even individual companies. Analysts will often differ drastically in their conclusions
from the same ratio analysis.
Table 4, Ratio Analysis
Ratios and Other Financial Data
PNC
Benchmark
2002
2003
2004
2004
Shares outsanding
2,589.0
2,600.0 2,626.2
Earnings pers share
$0.17
$0.36
$0.79
Dividends per share
$0.00
$0.00
$0.00
Dividend payout ratio
0.00%
0.00%
0.00%
20%
Dividend growth rate
#DIV/0! #DIV/0!
8.30%
Stock price, EOY
$10.50
$12.60
$21.00
Book value per share
$5.14
$5.33
$6.30
P/E
61.09
34.59
26.42
30.1
Price/Book ratio
2.04
2.37
3.34
4.2
EVA
($1,345) ($1,057) ($333)
MVA
$13,888
$18,911 $38,615
Beta coefficient
1.42
1.62
1.35
1.35
Market risk premium
5.00%
5.00%
5.00%
5.00%
Risk-free rate
5.00%
4.70%
4.80%
4.80%
Tax rate (fed+state)
40.00%
40.00% 40.00%
40.00%
WACC
10.38%
10.38% 10.38%
10.00%
Free Cash flow
($1,488) ($2,188)
NOPAT
$782
$1,380
$2,635
$3.74
Operating cost/sales
95.86%
95.14% 94.69%
93.76%
Deprec./fixed assets
20.00%
20.00% 20.00%
22.4%
DSO
23.4
21.5
17.0
18.3
Receivable/sales
6.4%
5.9%
4.7%
5.0%
Inv./sales
11.5%
10.6%
7.3%
9.0%
Fixed assets/sales
46.1%
32.1%
21.9%
20.1%
Interest rate on debt
7.5%
7.0%
7.5%
7.0%
Pfd dividend yield
6.0%
6.0%
6.0%
6.0%
Debt/assets
27.7%
33.9%
35.9%
35.2%
Pfd stock/assets
9.0%
8.8%
7.5%
3.1%
Common/assets
63.3%
57.3%
56.6%
61.7%
EBITDA/Interest
11.2
10.5
11.6
13.4
TIE
3.5
4.5
6.3
7.8
Current ratio
7.81
9.54
8.96
8.20
ROIC
3.82%
5.88%
9.21%
ROE
3.35%
6.84%
12.62%
14.7%
DuPont Analysis
TATO
1.50
1.96
2.83
2.85
assets/common equity
1.58
1.75
1.77
1.62
Profit margin
1.41%
2.00%
2.52%
3.18%
DuPont ROE
3.35%
6.84%
12.62%
14.70%
34
I would like to point out PNC’s strengths and weaknesses as they appear on the ratios
rather than introducing each and every ratios and explaining their role in the business.
The earnings per share ratio is mainly useful for companies with publicly traded shares.
Most companies will quote the earnings per share in their financial statements saving you
from having to calculate it yourself. By itself, EPS does not really tell you a whole lot.
But if you compare it to the EPS from a previous quarter or year it indicates the rate of
growth a companies earnings are growing (on a per share basis). The higher the ratio is
the better the company performs. PNC shows fast improvement.
PNC’s dividend payout ratio is zero, in other words they do not pay a dividend to its
shareholders. This is the case for most high growth firms; their profits are better spent by
reinvesting in the firms activities rather than as a cash payout to shareholders. In fact a
majority of corporations have elected to pay out less of their earnings as dividends,
perhaps because corporate rates of return on reinvested capital are higher these days, but
it could also be that dividends are doubly taxed in some jurisdictions.
Since the retained earnings are well reinvested the company grows fast, which means
increasing company value, hence increasing stock price. But some of the stockholders
like to get some return in every period. They might invest in the competitor companies.
The stock price is not really a ratio, but it is an important indicator of the company’s
market price. Increasing stock market price indicates that the company is perceived as a
stabile, profitable entity. It makes positive impression to creditors.
Sometimes referred to as the multiple, the idea behind the P/E ratio is that it is a
prediction or more likely an expectation of the company's performance in the future. The
P/E ratio for the overall market averages around 20 (Price, 2006), so as you can see
PNC’s was much higher than this. In other words the market was expecting big things
from PNC over the past years. In 2004 the expectations seems to be lower.
One thing to remember is that if a company has a low P/E ratio it does not necessarily
mean that it is undervalued. The P/E does not dictate the stock price, in fact a low P/E
could mean that the company's earning are flat or growing slowing, they could also be in
financial trouble. In fact the P/E ratio does not tell a whole lot, but it is useful to compare
the P/E ratios of other companies in the same industry, or to the market in general, or
against the company's own historical P/E ratios.
PNC’s stock was probably undervalued in the past, but the stock price is close its real
value by now.
What is WACC?
Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see how much
interest the company has to pay for every dollar it finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is
often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate discount rate to use for cash
35
flows with risk that is similar to that of the overall firm.
As mentioned above PNC’s higher WACC caused by the high ratio of equity, but it is not
far off the benchmark. The managers might want to consider issuing more debt in the
future but stay consistent with the target capital structure.
The Net Operating Profit After Tax is an estimate of what a company would earn if it did
not have any debt, equal to operating income times (1 minus the tax rate). For companies
which use leverage, NOPAT is an alternative measure for measuring operating
efficiency. NOPAT is frequently used for calculating Economic Value Added (EVA).
PNC’s NOPAT is increasing fast with the increase in sales. The benchmark companies’
NOPAT value is probably a typo, because their op income/sales ratio is higher and the
tax rate should be the same. The trend in the increasing NOPAT is attractive.
The operating cost/sales ratio is decreasing but still high compared to the competitors. As
mentioned earlier, decreasing operating cost could be the best tool to gain significant
competitive advantage.
The Days Sales Outstanding ratio explains the average time it takes to receive payment
on sales. PNC seems to do well in collecting payments. However the too strict collection
terms can turn customers to other companies.
Inventory/sales ratio reveals that the operating cost problem is not originated from
extensive inventory costs. So, the management should look for other causes. Another
informative ratio would be the inventory turnover ratio, but it can not be calculated
without the value of cost of goods sold.
The fixed assets/sales value gives an idea about how the company uses its resources. This
is an important asset management efficiency ratio. By 2004, PNC reached the benchmark
and as the operation manager reported there was still some excess production capacity.
Reaching full utilization PNC can get a leap ahead of its competitors.
PNC’s debt/asset ratio is fairly low, meaning that its assets are financed more through
equity rather than debt. Companies with high ratios are placing themselves at risk,
especially in an increasing interest rate market. Creditors are bound to get worried if the
company is exposed to a large amount of debt and may demand that the company pay
some of it back. PNC’s ratio reached the benchmark. The increasing ratio could lower the
WACC as well as the company’s stability.
The amount of the preferred stock the company issues depends on financing issues.
Preferred stock is costly for the company and the common stockholders do not like it
either. In case of bankruptcy preferred stockholders have a claim on the company prior
the common stockholders, they also get their dividends first. PNC should find the way to
finance its activities through debts and common stock.
The common stockholder equity to assets ratio is the other side of the debt/asset ratio. If
it is too high it leads to expensive WACC, but if it is too low it decreases equity/liability
36
ratio. Managers have to maintain these ratios balanced according to the pre-determined
capital structure.
PNC’s interest coverage is good, but not as good as it is for the competitors. PNC does
not have much debt, but the one it has probably expensive. Maybe market interest rates
decreased since the issuance of the bonds. The company should consider retiring those
bonds and issue new ones. Companies with a ratio below 1 could run into serious trouble
servicing its loan payments and are considered to be a high risk of defaulting.
For DuPont analysis, please see “Question 1.”
4. Calculate PNC’s MVA (market value added) and EVA (economic value added) for
2004. Are MVA and EVA consistent with one another, and if not, how can the
inconsistency be explained? How do you interpret these figures, and how should
management use them?
What is EVA?
Eva measures internal and external company operating performance, funds the credit
initiative, constraints, and challenges. It can be tied to evaluating employee performance
and success by developing a goal oriented compensation package based on an incentive
reward system that links cause and effect accountability. The EVA results should be
made available to all managers and employees to be used as a performance measurement
and management that is directly calculated and applied.
Earnings, operations performance, return on capital invested are measured and compared
to profits. They are then compared with the cost of debt and equity to fund operations.
EVA = NOPAT – CAPITAL CHARGE (INVESTED DEBT AND EQUITY * WACC)
The excess EVA equals profit. The initial implementation of EVA values current
operations then subsequent new projects are measured with decision being made on
whether the accounting numbers are justified to go forward with the project. If the cost
of the project exceeds the value added, the project should not go forward since adding
shareholder value is the bottom line goal of the company.
EVA was originated by the Stern Stewart company in 1982’s. The Stern Stewart “Four
Ms” [1] are:
1. Measurement – designing a measure of value creation that best reflects
economic reality in a particular industry.
2. Management—developing policies, procedures and tools which link
decision-making to the measure of value-creation.
3. Motivation—establishing incentive plans that simulate ownership by
giving managers a share of value created.
4. Mindset—increasing the business literacy of employees through training
and communications.
37
The customary method of measuring budget performance is through short-term
profitability of operating performance and return on investment ratios. Eva focuses on
creating long term value on total assets and operational investments (as well as other
investment vehicles).
Accounting and budgeting organization should enable scrutiny regarding budget
decisions – did decision increase, decrease or maintain EVA?
3 Goals:
- Improve customer satisfaction (improved service)
- Strengthen employee and company effectiveness
- Improve financial performance
Challenges:
Capital investments
Continuous profitability improvement
Management tool:
Employee evaluation and compensation (set goals, measure progress, and
continuous improvement by updating goals…)
Pitfalls
A full implementation of EVA may not be a good fit for all organization. The initial
foundation effort may be more than your organization requires. In a market that has all
business severely under pressure leaving little extra time, energy or finances to overhaul
the accounting, budgeting and employee compensation process, a modified version may
be a more appropriate fit.
Other shortcomings include: sacrifices to be made for the long-term capital growth when
short term improvements are necessary; secondly manager’s will have a tendency to
invest in projects that have positive EVA at the risk of not focusing on company or
competitive value added; thirdly since EVA is balance sheet driven the value returned
may not in fact increase the balance sheet; fourthly managers may be distracted away
from critical operating and strategic issues.
EVA, WACC and NOPAT calculations may be subjective. In addition the measurement
of management and departmental units separately requires an accounting system change
that is costly and time consuming.
Market Value Added - MVA
MVA is calculation that shows the difference between the market value of a company
and the capital contributed by investors (both bondholders and shareholders). In other
words, it is the sum of all capital claims held against the company plus the market value
of debt and equity.
38
Calculated as: MVA = Company’s Market Value – Invested Capital
Company’s Market Value = number of shares outstanding x common stock market price
The higher the MVA, the better. A high MVA indicates the company has created
substantial wealth for the shareholders. A negative MVA means that the value of
management's actions and investments are less than the value of the capital contributed to
the company by the capital market (or that wealth and value have been destroyed).
Table 5, PNC’s EVA and MVA:
EVA
MVA
2002
($1,345)
$13,888
PNC
2003
($1,057)
$18,911
2004
($333)
$38,615
Summary
In the past few years, many highly successful organizations have begun using MVA and
EVA as measures of financial performance. MVA measures managerial effectiveness
since an organization's inception, and EVA measures managerial effectiveness during a
given year. That is the reason of the big difference. PNC might not be effective in these
years in the aspect of long term value added, but still effective in creating overall
stockholders’ value. As an indicator of corporate effectiveness in maximizing shareholder
wealth, MVA is most appropriate for investor-owned firms. Though it can be applied to
investor-owned organizations, EVA also can be used by not-for-profit organizations and
measures how well managers are maximizing the economic value of the organization's
capital. Once healthcare financial managers understand the rationale and potential uses of
these measures, they may find them more helpful for measuring an organization's
economic profit than accounting profitability measures, which account for the cost of
debt but not the cost of equity.
4. PNC has an incentive compensation plan that is used to reward its operating division
managers and its corporate executives. Discuss the use of metrics such as those you
calculated in compensation plans. Should the same or different criteria be used to
judge division managers versus corporate executives? Would it be appropriate to
compensate non-management employees using the same criteria as managers? Is
there a danger that incentive compensation plans can lead to actions that are
detrimental to the firm in the long run, and if so, what can be done to head off this
potential problem?
EVA and MVA are one of the best methods to measures company performance, hence
top management effectiveness. These measures take into account the cost of capital
unlike accounting profitability measures. Other measures could be the return on invested
capital (ROIC) or return on equity (ROE), but these can be easily influenced by the
capital structure. The MVA as a komplex measurement consider riskiness and costs of
capital.
39
For PNC MVA should be choosen over EVA for two reasons.
The company is relativly new and the industry is very dinamic. It would not make much
sense to measure how well management manages the resources to give the best return in
the long run. The emphasis has to be more on the realized opportunities and on the effort
to gain competitive advantage and capture market share. These effort might result in
negative EVA for any given year.
PNC is a for profit company that is expected to show good result for period to period and
satisfy its creditors. The company’s MVA is increasing consistently from year to year and
expected to continue this trend in the future due to the increasing stock price.
Only top management can be evaluated with this metod, since it measures overall
business performance. For departments, it has to be modified or other measures can be
used.
There are some informative accounting ratios available to measure departments or even
people’s performance. For the middle management or department level the calculated
accounting ratios are good measurements. However, The most sensitive point of these
measures to set realistic goals, and consider environmental changes at the evaluation.
Accurate information is essential for forecasting, benchmarking and to give the right
amount of incentives to the right people.
Compensation is a separate science today. The challenge is to find the best performance
measure and set the benchmark, but it is only the beginning, then the plan needs to be
adjusted and the performance evaluated.
The danger is that employees/managers are tend to modify, even make up numbers to get
better incentives. One example could be Enron, where top efficers “forgat” to follow the
full disclosure principle. An other example could be Coca-Cola, where sales managers
sent out numerous trucks on December 31th (that were returned on January 1st) just to get
better year end figures.
The point is that employees of all position might take actions for incentives that will hurt
the company in the long-run.
The solution can be a good monitoring system, policies, and regulations. Also, all
employees should be involved in the planning and decision making process to an extent
so that they understand the importance of the relevant information and the effect of the
companiy’s overall performance.
40
5. Discuss the pros and cons of the different ways historical data can be used for
forecasting purposes. Based strictly on the data in Table 10-4, what is the best
forecast for 2005 sales revenues? What other information should be considered when
making the sales forecast?
Forecasting is the process of analyzing current and historical data to determine future
trends. For example stock analysts use various forecasting methods to determine future
stock price movements, earnings, etc. Economists use forecasting techniques in order to
determine future economic trends.
The financial forecasting has three important uses:
- Forecast the amount of external financing that will be required
- Evaluate the impact that changes in the operating plan have on the value
of the firm
- Set appropriate targets for compensation plans
Forecasting can be qualitative (jury of executive opinion, sales force composite, delphi
method, consumer market survey) or quantitative (time series: moving averages,
smoothing coefficients, regression, other). Financial projections should be quantitative
with qualitative adjustment according to non-quantifiable circumstances.
At the first step only projected sales will be determined.
There are a number of methods to make such projection, but only a few will be discussed
for different reasons.
The historical data can have 3 characteristics:
- trend (if there is a clear increasing or decreasing pattern with some
anomaly)
- seasonality (data changes in certain periods)
- periodic cycles (there is a repeating pattern independent from seasons)
A set of data can have all of the above characteristics at the same time. Working with
such data set requires advanced forecasting techniques.
In PNC’s historical sales data an increasing trend easily noticeable. Seasonality and
periodic cycles are not likely to effect sales. PNC’s background information states that
after the initial problems the company has been growing fast but this growth expected to
slow down. It does not seem to be periodic. To identify seasonality monthly data would
be required.
For data with trend the regression analysis is adequate, averaging methods more accurate
with constant demand or applying with other methods. For example calculating the sales
growth rate might result in a derived data set that averaging method can be applied on.
Two alternative forecast method were used to compare projected sales.
a. Regression by using TREND function in Excel
b. Average growth rate
41
Table 6, PNC’s projected sales for 2005
Sales
growth
avrg
Sales, 2000-2004
(000)
rate
TREND
growth
2000 $17,000
2001 $29,000
70.59%
2002 $31,506
8.64%
$41,000
70.59%
2003 $47,342
50.26%
$40,341
39.61%
2004 $82,739
74.77%
$54,595
43.16%
2005
?
#VALUE!
51.07%
$86,463
310,410,035
MSE
average
$49,471
$43,987
$67,777
$124,990
185,949,195
There is a big difference between the two forecasted values. There are several methods
available to measure forecast accuracy:
- Cumulative sum of Forecast Error (CFE): Indicates bias or direction of errors
- Mean Absolute Deviation (MAD): Indicates magnitude of errors
- Mean Squared Error (MSE): Emphasizes large errors
- Mean Absolute Percent Error (MAPE): Allows comparison of forecasts using different
data
The calculated MSE indicates that there is a big difference between PNC’s forecasted and
actual sales in 2004, but evaluating the 2005 forecast the trend analysis seems more
reasonable; first, because the growth is expected to slow down, second, because
conservative values should be used.
Common financial forecasting methods are:
- percentage of sales
- percentage of assets
- percentage of growth
In the case of the firs two methods the total sales revenue or the amount of total assets is
forecasted and all other items adjusted to this base item considering current relations or
expected relations between the item in question and the base item.
The percentage of growth method allows each item on the statements to grow
independently with a rate defined by historical data.
Later the percentage of sales method is discussed in more detail.
42
6. The percentage of sales forecasting method calls for specifying the relationship between
various assets, liabilities, and costs to sales, then estimating sales for the coming year,
and then estimating the future values of asset, liability, and cost items. Those
estimates can then be used to construct projected financial statements. One can then
use those statements to calculate forecasted EPS and the firm’s future financial ratios.
Use the data provided in the end-of-case tables to forecast PNC’s performance under
the four alternative scenarios, and then discuss your results.
The percentage of sales forecasting method based on the relation of different statement
items to the total sales revenue. A good estimate of the sales revenue is essential since all
other projection is based on that. In our case the projected sales growth is given as well as
the necessary ratios.
The movement of the market and the competitors are unpredictable, and has a big impact
on PNC’s performance. That is the reason why PNC’s management set four different
scenarios and would like to examine the financial impacts for each situation.
See the projected statements for each scenario in table 7 below.
Table 7, PNC’s Pro Forma financial statements for 2005 under different scenarios
Balance Sheets, PNC and Industry ($ in
Thousands)
Actual (2004) Base
Benchmark Best
Worst
Cash
$625
$723
$951
$993
$455
ST securities
$625
A/R
$3,852
$4,434
$4,757
$3,971
$9,101
Inv.
$6,023
$6,927
$8,563
$6,950
$13,652
Current assets
$11,125
$12,084
$14,272
$11,914
$23,208
Net fixed assets
$18,098
$20,809
$19,125
$18,864
$22,753
Total assets
$29,223
$32,893
$33,398
$30,779
$45,962
A/P
$527
$609
$951
$993
$4,551
Accruals
$714
$818
$476
$993
$2,730
Notes payable
$0
Current liabilities
$1,241
$1,427
$1,427
$1,986
$7,281
Long-term debt
$9,239
$9,239
$9,239
$9,239
$9,239
Total liabilities
$10,480
$10,666
$10,666
$11,225
$16,520
Preferred stock (6%)
$2,206
$2,206
$2,206
$2,206
$2,206
Common stock
$8,510
$8,510
$8,510
$8,510
$8,510
Retained earnings
$8,026
$10,509
$11,040
$12,094
$7,477
Total com equity
$16,536
$19,019
$19,550
$20,604
$15,987
Total liabs+equity
$29,222
$31,891
$32,422
$34,035
$34,714
Difference
$1,002
$975
($3,256)
$11,248
Net Operating Capital
$28,598
$32,893
$33,398
$30,779
$45,962
NWC
$9,884
$10,657
$12,845
$9,929
$15,927
AFN
$377
$350
($3,881)
$10,623
(positive AFN calls for addition funds that will increase NP while ST sec. are sold, negative
AFN is the value of ST sec. while NP $0)
43
Income Statements, PNC and Industry ($ in Thousands)
Actual
Base
Benchmark
(2004)
Sales revenues
$82,739
$95,150
$95,150
Cash op costs
$74,727
$85,939
$84,931
Depreciation
$3,620
$4,158
$4,282
Total op costs
$78,347
$90,097
$89,212
Op Income (EBIT)
$4,392
$5,052
$5,937
Interest
$693
$693
$693
Taxable Income
$3,699
$4,360
$5,244
Taxes
$1,480
$1,744
$2,098
Pfd dividends
$132
$132
$132
Net Income
$2,087
$2,483
$3,014
Best
Worst
$99,287
$87,372
$4,220
$91,592
$7,695
$693
$7,002
$2,801
$132
$4,069
$91,013
$86,462
$4,551
$91,013
$0
$693
($693)
($277)
$132
($548)
Shares outstanding
EPS
$2,626
$1.55
$2,626
($0.21)
Assumptions:
2,626
$0.79
$2,626
$0.95
$2,626
$1.15
any additional funds needed would be obtained as ST
loans
any excess funds generated would be invested in ST
securities
The assumption made were necessary to make the projections and that all of the scenarios
will be consistent and comparable. The other assumptions were given, like most of the
things held constant: no common dividend will be paid, and interest and tax rates will be
consistent.
Evaluation of the results
With no ratio analysis just looking at the statements and the projected ratios that the
forecast was based on, one can conclude the followings.
The earnings per share ratio is a good value to start with, because it is an overall
performance measurement. It will have a good value in the most likely case and even
better if the company reaches the benchmark. Its value in the best and the worst cases is
significantly different. Let’s find the reasons.
In the worst case sales only grow by 10%. The ratio of fixed assets to sales up to 25%,
and the costs of sales take away 95% of the revenue. These changes alone can push the
company into serious problems. The forth problem is the cost of inventory that
contributes to the total expenditures. Inventory management has been strength of PNC,
and now it appears to be crucial. All these ratios measure efficiency; if the company is
not able to operate efficiently it will have to close its doors very soon.
Other hits on the company are the increase of interest rate on notes payable, dramatic
increase of current liabilities, and uncollected sales revenue. All the listed issues has been
strengthen the company, the effect of turning this into weaknesses is disastrous.
44
In the best case there is only three important item that significantly differ from the most
likely cases, but these are really the key items.
1. Cash cost decreases from 90% to 88%. This 2% difference results close to
$2,000,000 in saving in the given scenario that contributes with an extra
$1,200,000 to the bottom line!!!
2. If the fixed assets can be utilized more efficiently, sales will raise without
substantial cost increase.
3. Sales are the core deriving sources of the company. PNC receives all its
revenue through sales. Increasing sales with 20% instead of 15% makes a
huge difference. Looking at the historical sales data it does not seem to be
impossible to reach that goal, in fact, in the past two years PNC had 50
and 75% growth respectively!
Summary
PNC’s management really needs to monitor those performances, those aspects of the
business that were mentioned above. PNC has to catch up with the competitors in the
areas it is having trouble with and maintain or increase advantage in its strengths.
45
7. Now consider the one director’s question about excess capacity. If a significant amount
of excess capacity does exist, how can that fact be incorporated into the forecast?
Definition
Excess capacity refers to a situation where a firm is producing at a lower scale of output
than it has been designed for.
It exists when marginal cost is less than average cost and it is still possible to decrease
average (unit) cost by producing more goods and services. Excess capacity may be
measured as the increase in the current level of output that is required to reduce unit costs
of production to a minimum. Excess capacity is a characteristic of natural monopoly or
monopolistic competition. It may arise because as demand increases, firms have to invest
and expand capacity in lumpy or indivisible portions. Firms may also choose to maintain
excess capacity as a part of a deliberate strategy to deter or prevent entry of new firms.
(Glossary, 1993)
The capacity level is expressed as a utilization level of the fixed assets in percentage.
If there is excess capacity sales can be increased without increasing fixed assets. The
amount of sales that the current net assets can support is calculated with the following
formula:
Sales with full capacity = Actual sales / % of capacity
To demonstrate the application of this method assume that PNC actual output is 80% of
the full capacity (all is given is that there is a significant excess capacity at PNC)
The formula will be the following:
82,739 / 0.8 = 103,423
The interpretation of the result is that PNC will not need any additional fixed asset until
sales exceed $103,423,000. In the given scenarios the company has enough fixed asset to
support all the forecasted sales, so there will be no new fixed assets needed.
How would this excess capacity affect the PNC’s AFN in the coming year?
Let’s take the base case as an example.
The previously projected increase in fixed assets was $2,711,000.
Since no new fixed assets will be needed, AFN will fall by $2,711,000, to
$377,000 - $2,711,000 = -$2,334,000
turning to additional funds needed to extra funds generated.
All scenarios should be adjusted the same way. It will be up to the management how they
want to allocate these funds.
46
8. Now consider the director’s question about the AFN formula versus the forecasted
financial statement method for forecasting future needs for funds. For PNC, do these
two procedures produce the same results? If not, why do differences arise?
CALCULATING AFN
the following formula-generated AFN highlights the relationship between sales growth
and financial requirements.
AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)
Where,
 A*/S0: assets required to support sales; called capital intensity ratio.
 S: increase in sales.
 L*/S0: spontaneous liabilities ratio
 M: profit margin (Net income/sales)
 RR: retention ratio; percent of net income not paid as dividend.
See PNC’s AFN calculation in table 8 below
Table 8, PNC’s AFN calculation with the AFN formula
Actual
Base
Benchmark
Best
(2004)
capital intensity
ratio
35.32%
35.32%
35.32%
35.32%
increase in sales
$12,411
$12,411
$16,548
1x2
$4,383
$4,383
$5,845
spontaneous liab.
ratio
1.50%
1.50%
1.50%
1.50%
2x3
$186
$186
$248
profit margin
2.52%
2.52%
2.52%
2.52%
sales
$95,150
$95,150
$99,287
retention ratio
1
1
1
1
4x5x6
2401
2401
2505
$1,797
$1,797
$3,092
AFN
Compare to:
AFN
$377
$350 ($3,881)
Worst
35.32%
$8,274
$2,922
1.50%
$124
2.52%
$91,013
1
2296
$502
$10,623
The difference in results from the two methods is huge.
The reason is the difference in the assumptions.
On the second method (AFN formula) the basic assumption is that the ratios remain the
same. The only thing change is the sales revenue. In contradiction, the first method
(percentage of sales) set different ratios calculating expected changes and performance.
47
9. Now consider the director’s question about longer-term forecasts. For PNC, what is
the optimal length of the forecast period? How could Sue’s model be adapted to
produce a 5-year forecast? Would you suggest that she actually make a longer-run
forecast?
Longer-term forecast is possible, but the accuracy of the values are questionable. For an
old company with consistent production and demand, or consistent changes in those is
possible to calculate future statements within acceptable range. For PNC, there has been
so many changes and new changes coming up that forecasting for more than two years in
advance is impossible. One year forecast is necessary and that should be as accurate as
possible. Second year projection can be made, but should not be treated as decision
criteria, more like a guideline. After the first year past, the second year projections can be
adjusted or new forecast can be calculated. The other factor that makes the forecast
ambiguous for NPC is the change in dividend payouts. In the coming years the company
would like to pay dividends to common stockholders which cause substantial changes in
funds management. The management also considers to retire some of the outstanding
long-term debt, which will change the capital structure and the cost of capital which work
like a frame for financial decisions.
For the reasons above I do not suggest that Sue to make longer-run forecast. There is
already four possible scenarios that each can branch out for four more scenarios in the
second year and so 16 different forecasts is certainly a big uncertainty.
Besides, the computer industry that PNC is in is changing rapidly and no one knows
where the market will move and what the competitors will do.
48
10. Now consider the director’s question about the assumptions that any funds needed
will be obtained as short-term loans and any excess funds generated will be invested
in marketable securities. Are these reasonable assumptions for purposes of this
forecast?
As it was mention earlier the assumptions seems reasonable for NPC because it is easy to
work with and gives flexibility to the company. Examining the given assumptions for the
scenario analysis it appears that the interest rate is the same on short-term loans than it is
on long-term loans except in the worst case.
If the situation would be an expansion or investment in long-term projects (like R&D)
that are not expected to pay off in one year, it would not be a smart thing to fund them
with short-term loans. For PNC it is not the case, in fact, they work on stability, to secure
market share, and the position of the company in the industry.
These are the assumptions that usually made for forecasting unless there are particular
cash flows predetermined.
The purpose of this forecast is three fold:
1. Identify the strengths and weaknesses of the company and make changes
accordingly
2. to help to set up an effective incentive compensation plan with reasonable goals
and fair compensations
3. the company’s outstanding long-term debt is too costly, so management wants to
refund it
For all these purposes the generated funds best kept in cash equivalents. PNC does not
want to issue more bonds, they want to retire them. When companies issue bonds they
issue them in batches and that might raise more funds than needed (lumpy assets).
49
11. Now consider the director’s question about financing feedbacks. Explain what
“financing feedbacks” are, and discuss whether or not the procedure Sue used is
appropriate for this particular forecast.
Financial feedback is the phenomenon that the funds used to finance AFN will increase
interest unless it is solely from non-interest bearing liabilities that is very limited. Interest
expense then will lower net income and retained earning. After these changes we will be
short of fund by the amount of interest on the added loans, so add some more fund and
feed back again. Repeat this until the balance sheet is balanced. When the AFN is small
enough it can be financed from other sources like retained earnings or marketable
securities.
This balancing game was played manually not too many years ago, but nowadays the
interactive models and spreadsheets allow automatic incorporation of the feedbacks. In
excel, there is a calculation option that runs a 100 iterations that can make the balance
sheet balanced.
According to the given information Sue’s forecast model should be appropriate. In this
report only data given used for the percentage of sales method and the balance sheet is
balanced. If Sue had a similar model that should take into account the financial feedback
too.
50
12. How should PNC’s top management team use the forecasted results? Should the
forecasted results play a role in the firm’s compensation plan? Should the results be
shared with bankers and other lenders or with equity analysts and stockholders
generally?
The results of the forecast give a good idea to the management about the expected cash
flows and year end result. It also embodies a desired situation that PNC would like to be
after the planned changes successfully implemented. It helps determine the funds needed
or funds generated in the next year so the management make plans to finance the business
or allocate extra resources. Financial forecasts are also useful tools to communicate
towards creditors especially when they communicate positive changes. The point is, that
the creditors can see, that key issues has been identified and appropriate actions has been
taken.
That is the reason why forecast should be available for any creditor. Creditors tend to do
forecast anyway before they make an investment decision, and their forecast will be
much conservative than the company’s forecast.
Particularly, PNC’s pro forma statements should be shared because it shows good result
the net income sales growth and EPS values should be appealing for creditors. PowerLine
Network Corporation should be classified as a stabile company with consistent earnings,
profitability, and decent liquidity and solvency ratios that measure up with the industry
average.
The forecast should play a role in the compensation plan to the extent that it can provide
goals and will be the basic of a comparison to the next year actual statements for the
performance evaluation. However, it can only be used for the evaluation of the top
management since it measures total outcomes and general ratios.
The statements are more useful when used as guidelines only. After identifying strengths
and weaknesses, and reasonable goals have been set, a detailed implementation plan
should be developed that can be the ultimate guide and measurement for every level in
the organization.
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APPENDIX B
TREND
Show All
Returns values along a linear trend. Fits a straight line (using the method of least squares)
to the arrays known_y's and known_x's. Returns the y-values along that line for the array
of new_x's that you specify.
Syntax
TREND(known_y's,known_x's,new_x's,const)
Known_y's is the set of y-values you already know in the relationship y = mx + b.
If the array known_y's is in a single column, then each column of known_x's is
interpreted as a separate variable.
If the array known_y's is in a single row, then each row of known_x's is
interpreted as a separate variable.
Known_x's is an optional set of x-values that you may already know in the relationship
y = mx + b.
The array known_x's can include one or more sets of variables. If only one
variable is used, known_y's and known_x's can be ranges of any shape, as long as
they have equal dimensions. If more than one variable is used, known_y's must be
a vector (that is, a range with a height of one row or a width of one column).
If known_x's is omitted, it is assumed to be the array {1,2,3,...} that is the same
size as known_y's.
New_x's are new x-values for which you want TREND to return corresponding yvalues.
New_x's must include a column (or row) for each independent variable, just as
known_x's does. So, if known_y's is in a single column, known_x's and new_x's
must have the same number of columns. If known_y's is in a single row,
known_x's and new_x's must have the same number of rows.
If you omit new_x's, it is assumed to be the same as known_x's.
If you omit both known_x's and new_x's, they are assumed to be the array
{1,2,3,...} that is the same size as known_y's.
Const is a logical value specifying whether to force the constant b to equal 0.
If const is TRUE or omitted, b is calculated normally.
If const is FALSE, b is set equal to 0 (zero), and the m-values are adjusted so that
52
y = mx.
Remarks
For information about how Microsoft Excel fits a line to data, see LINEST.
You can use TREND for polynomial curve fitting by regressing against the same
variable raised to different powers. For example, suppose column A contains yvalues and column B contains x-values. You can enter x^2 in column C, x^3 in
column D, and so on, and then regress columns B through D against column A.
Formulas that return arrays must be entered as array formulas.
When entering an array constant for an argument such as known_x's, use commas
to separate values in the same row and semicolons to separate rows.
Example
The example may be easier to understand if you copy it to a blank worksheet.
How to copy an example
1. Create a blank workbook or worksheet.
2. Select the example in the Help topic.
Note Do not select the row or column headers.
Selecting an example from Help
3. Press CTRL+C.
4. In the worksheet, select cell A1, and press CTRL+V.
5. To switch between viewing the results and viewing the formulas that return the
results, press CTRL+` (grave accent), or on the Tools menu, point to Formula
Auditing, and then click Formula Auditing Mode.
The first formula shows corresponding values to the known values. The second formula
predicts the next months values, if the linear trend continues.
A
Month
1 1
$133,890
B
Cost
C
Formula (Corresponding Cost)
=TREND(B2:B13,A2:A13)
53
2
3
4
5
6
7
8
9
10
11
12
13
2
$135,000
3
$135,790
4
$137,300
5
$138,130
6
$139,100
7
$139,900
8
$141,120
9
$141,890
10
$143,230
11
$144,000
12
$145,290
Month
Formula (Predicted Cost)
13
=TREND(B2:B13,A2:A13,A15:A19)
14
15
16
17
Note The formula in the example must be entered as an array formula. After copying the
example to a blank worksheet, select the range C2:C13 or B15:B19 starting with the
formula cell. Press F2, and then press CTRL+SHIFT+ENTER. If the formula is not
entered as an array formula, the single results are 133953.3333 and 146171.5152.
54