Financial Management
Essentials You Always Wanted To Know
Self-Learning Management Series
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Financial Management Essentials You Always Wanted To Know
Published by Vibrant Publishers at Smashwords
Copyright 2011 Vibrant Publishers, USA.
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About the Author
Kalpesh Ashar, a management consultant and corporate trainer holds an M.B.A. (Dean's Award Winner) from S.P. Jain Institute of Management & Research, one of Asia’s top B-Schools, and an Engineering degree with Honours in Electronics. He has over 13 years of experience in large corporations and start-ups in Asia, U.S.A and Europe.
Kalpesh has worked in the capacity of Senior Manager and Program Manager and is passionate about writing on management subjects. While mentoring managers and management students, he realized the need for a series of management books based on quick self-learning. He has authored 10 titles in this series that gives a jump start to managers in understanding all aspects of a business. His technology background gives him a good understanding of the management learning needs of non-M.B.A. graduates. Accordingly, he has authored the titles in this series in a simple to understand manner.
Kalpesh conducts corporate trainings in management subjects and also works as a management consultant for growing companies. He is also affiliated with top business schools in India as a visiting faculty. He is well known as a great mentor in the companies he has worked in and has also received “Best Manager” award.
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Other titles in Self-Learning Management Series
Marketing Management Essentials
Financial Management Essentials
Financial Accounting Essentials
Organisational Behavior Essentials
Enterpreneurship Essentials
Cost Accounting & Management Essentials
Business Strategies Essentials
Supply Chain Management Essentials
Principles of Management Essentials
Consumer Buyer Behavior Essentials
For updated list visit http://www.vibrantpublishers.com
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Table of Contents
1. Introduction to Financial Management
2. Financial Statement Analysis
Common-size Financial Statements
Cost of Retained Earnings (ks)
Weighted Average Cost of Capital (WACC)
Estimating Cash Flows over Life of Project
Modified Internal Rate of Return (MIRR)
Usage of Capital Budgeting Methods
Current Asset Investment Policies
Current Asset Financing Approaches
7. Distribution to Shareholders
Factors in setting Dividend Distribution Policy
Dividend Reinvestment Plan (DRIP)
Stock Splits and Stock Dividends
8. Forecasting Financial Statements
Step 2 - Forecast Income Statement
Step 3 - Forecast Balance Sheet - 1st Pass
Step 4 - Raising Additional Funds Needed (AFN)
Step 5 - Forecast Balance Sheet - 2nd Pass
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CHAPTER 1: Introduction to Financial Management
Financial Management is a field of finance that deals with the use of financial information of a company to take decisions. The diagram below shows the steps in the analysis of financial information.
Financial Accounting is a field that deals with the preparation of financial statements (refer the book “Financial Accounting Essentials You Always Wanted to Know” of this series).
Financial Management uses this information to first analyze the company’s health and then to take appropriate decisions.
Consider, for example, the Balance Sheet and Income Statement of two companies as below:
From the above financial statements, it is evident that both the companies have the same Net Income ($12 million). Following questions arise:
a) As a banker, is this information enough to extend a loan to both the companies?
b) As an investor, does this mean goods returns?
c) As a manager, are these returns the best in the industry?
Just by looking at the individual numbers in the financial statements it is not possible to answer the above questions. In order to answer them one needs to do financial statement analysis that looks at a combination of numbers that provides more information. This analysis compares a combination of financial numbers (ratios) over a period of time for a company and also compares these with other companies in the same industry. This analysis is done using two tools given below:
a) Ratio analysis
b) Common-size financial statements
Using the data from the financial statement analysis companies make appropriate decisions to ensure that they meet their ultimate business objective – maximization of their stock price. The decisions are taken in the following areas:
a) Cost of Capital
b) Capital Budgeting
c) Working Capital Management
d) Capital Structure & Leverage
e) Dividend Policy
Finally, companies use Pro forma financial statement to do a what-if analysis and estimate their financial statements for the next period (quarter / year). Companies also use financial control systems to maintain control on their financial decisions.
The later chapters describe each of the above areas in detail, starting with the financial statement analysis, followed by financial decision making, and finally forecasting financial statements.
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CHAPTER 2: Financial Statement Analysis
Analysis of Financial Statements is done using financial ratios and common-size financial statements. In this chapter we shall discuss both techniques in detail.
The financial statements of a company report the company’s position at a given point in time (Balance Sheet) and its operations over a period of time (Income Statement and Statement of Cash Flows). This data can be used by the company’s management, bankers and investors to predict future and to plan actions to improve it. But this analysis is more useful when done using financial ratios instead of individual numbers from the financial statements. For example, consider a company paying $100,000 interest on its debt of $1,000,000, and another company paying $50,000 interest on its debt of $700,000. If one needs to know which company is financially stronger then it is done by comparing the company’s interest expense with respect to its debt, studying the company’s debt with respect to its total assets, comparing the interest paid against the income of the company and comparing its debt structure with that of other firms in the same industry.
In order to do the above analysis, ratios are to be formed using data from the balance sheet, income statement and the statement of cash flows of the company. There are several ratios that exist and each has a different purpose. Some ratios involve only balance sheet items or income statement items or items from the statement of cash flows. Others involve a combination of items from these three statements. In the sections below we see how ratios are computed and used for decisions making with the help of financial statements of AllFresh food producing company:
Liquidity Ratios
These ratios provide an idea of the liquidity position of a company. They are important to know whether the company would be able to pay off its debts as they become due – interest, loan payments, accounts payable etc. Two liquidity ratios described below are commonly used.
Current Ratio
Current ratio = Current Assets / Current Liabilities
For AllFresh, Current ratio = $100 million / $30 million = 3.33
This means that current assets of AllFresh cover over 3 times its current liability payments.
In order to know whether this value is good or bad one needs to get the industry average figure. We further find that the industry average is 5.0. It means that AllFresh has a lower than average current ratio, which could mean lower than expected liquidity. This ratio is frequently used by lenders, like banks, before extending a loan.
Quick (Acid Test) Ratio
Quick ratio = (Current Assets – Inventories) / Current Liabilities
For AllFresh, Quick ratio = ($100 million – $60 million) / $30 million = 1.33
This ratio assumes that inventory could be difficult to convert into cash at short notice and hence removes it from the current assets for knowing a company’s liquidity position.
Once again a comparison is needed with the industry average to compare. If the industry average is 1.0, it means that AllFresh has a stronger liquidity position when computed using quick ratio.
Asset Management Ratios
These ratios show how well the company is managing its assets. These are also called efficiency ratios. Commonly used ones are given below:
Inventory Turnover Ratio
Inventory Turnover ratio = Sales / Inventory
For AllFresh, Inventory Turnover ratio = $300 million / $60 million = 5.0
This ratio tells us how well the company is managing its inventory against the sales it has. We can take an average of the inventory over the year as inventory mentioned in the balance sheet is at a particular point of time and that value could give incorrect results if inventory has suddenly increased or decreased. A higher value of this ratio is generally preferable as it means that the company is holding lower inventory.
If the industry average is 4.0, then AllFresh has a better value of inventory turnover ratio. It means that it is carrying lower inventory than its competitors for the same sales volume.
Days Sales Outstanding
Days Sales Outstanding = Accounts receivable / Sales per day
For AllFresh = $20 million / ($300 million/ 365) = 24.33 days
Days Sales Outstanding (DSO) is the average number of days that a company takes to make collection of its receivables. A lower number means it is able to collect the payments more promptly.
If the industry average is 20 days, then AllFresh is taking longer than other companies and can look at improving the receivables collection mechanism.
Asset Turnover Ratio
Asset Turnover ratio = Sales / Total Assets
For AllFresh = $300 million / $200 million = 1.5
Every company invests in assets in order to generate sales and profits. This measure is about how successful the company is in doing this. A higher asset turnover ratio indicates better asset utilization.
If the industry is having 1.25 as their average asset turnover ratio, it means that AllFresh is better than other companies in producing sales from its assets.
Leverage (Debt Management) Ratios
Companies have mainly two modes of raising capital – debt and equity. Both ways have their pros and cons which will be discussed in the later chapters. Lenders and investors use debt management ratios to see how risky the company’s capital structure is and how it stands against the industry’s norms. Below are the most frequently used ratios:
Debt Ratio
Debt ratio = Total Liabilities / Total Assets
For AllFresh, Debt ratio = $100 million / $200 million = 0.5 or 50%
This ratio tells the company’s creditors and lenders how risky it is to lend to the company. They would prefer a lower debt ratio. If the industry average debt ratio is 0.6, then creditors would be happy to lend to AllFresh as it has a lower debt ratio as compared to its competitors. The amount of debt and equity taken by a company largely depends on the industry it belongs to. Some industries, like power production, have several capital assets that can be used to take cheaper secured loans. Hence, they are generally high on debt and therefore have a higher debt ratio. Services industries, on the other hand, have few physical assets that can be mortgaged. Hence, they generally have lower debt ratio.
Debt-to-Equity Ratio
Debt-to-equity ratio = Total Liabilities / Stockholders’ Equity
For AllFresh, Debt-to-equity ratio = $100 million / $100 million = 1.0
A debt-to-equity ratio of 1.0 means the company has equal amount of liabilities and equity. This ratio is seen by creditors and lenders and they would prefer it to be low. Equity investors of the company would like this to be high as the additional debt (liability) taken by the company can lead to greater profits and hence, better returns for common stockholders. This is called leverage.
Times Interest Earned (TIE)
TIE = EBIT / Interest expense
For AllFresh, TIE = $18 million / $7 million = 2.57
This ratio gives a comparison of the company’s earnings against its interest expense for the debt it has taken. In the above case, AllFresh has enough earnings to serve its interest expense 2.57 times. Lenders would like this to be high as it means that they are better covered on the interest payments.
Profitability Ratios
These show how profitable the company is in doing business. Profitability can be computed using various bases – equity, assets and sales. Accordingly, there are several ratios as below:
Return on Equity (ROE)
ROE = Net Income / Stockholders’ Equity
For AllFresh, ROE = $10 million / $100 million = 0.1 or 10%
This is the most important and the most frequently looked at ratio. It gives the amount a common stockholder gets when investing in the company. In the above case, a stockholder received 10% returns on his investment in the year 2010. This measure would have a direct impact on the company’s stock price.
If the industry average ROE is 9%, then AllFresh is considered to be giving higher returns and hence, would be preferred by stockholders over its competitors.
Return on Assets (ROA)
ROA = Net Income / Total Assets
For AllFresh, ROA = $10 million / $200 million = 0.05 or 5%
This ratio determines how much profit the company is making using the assets it has. It gives the company’s efficiency in using its assets.
If the industry average happens to be 7% then AllFresh is not utilizing its assets as well as its competitors.
Return on Sales (ROS)
ROS = Net Income / Sales
For AllFresh, ROS = $10 million / $300 million = 0.0333 or 3.33%
This ratio is often referred to as the sales margin or profit margin. For every dollar of sales, AllFresh is earning about 3 cents. This needs to be seen in light of industry average. Some industries have a lower profit margin but higher sales volume.
If the industry average is 2.5% then AllFresh has a better return on sales.
Basic Earning Power (BEP)
BEP = EBIT / Total Assets
For AllFresh, BEP = $18 million / $200 million = 0.09 or 9%
This ratio shows the raw earning power of a company without getting influenced by its taxes and leverage (debt). Different companies in the same industry may have different tax situations and debt structure. This ratio is useful when comparing such companies.
Market Value Ratios
When a company’s stock price is compared to other values, such ratios are called market value ratios. They give useful insight into what the investors think about the company.
Price / Earnings Ratio (P/E)
P/E ratio = Market Price per share / Earnings per share
For AllFresh, assume that the current stock price is $20
Earnings per share = Net Income / Number of common shares = $10 million / 10 million = $1
Hence, P/E ratio = $20 / $1 = 20
P/E ratio shows how much the investors are willing to pay per dollar of company’s profit. A higher P/E ratio means that the investors see strong growth prospects in the company.
If the industry average P/E ratio is 15 then it means that investors are looking at AllFresh to provide better growth than its competitors.
Market / Book Ratio (M/B)
M/B ratio = Market Price per share / Book value per share
For AllFresh, assume current stock price is $20
Book value per share = Total Common Equity / Number of common shares = $100 million / 10 million = $10
Hence, M/B ratio = $20 / $10 = 2
This ratio is also a measure of how much the investors expect the company to grow and are willing to invest. A higher value of M/B ratio means that the investors are willing to pay more to buy the company’s stock.
If the industry average is 1.8 then it means that the investors are willing to pay more for AllFresh than its competitors as they expect better returns.
Cash Flow Ratios
Until now all ratios described above have been either on balance sheets items, income statement items or on the market price of the stock. There are also some important ratios based on cash flows of a company. These ratios give vital information as statement of cash flows is the only financial statement that gives “real” values. Both, balance sheet and income statement have values that are either based on estimates or on historical costs.
Cash Flow to Net Income Ratio
Cash Flow to Net Income ratio = Cash from Operating Activities / Net Income
For AllFresh, Cash Flow to Net Income ratio = $10 million / $10 million = 1
This ratio shows as to what extent the company has used accrual accounting assumptions and adjustments in computing its Net Income. It will generally be equal to or greater than 1 due to non-cash expenses like depreciation and amortization. A company should have a stable cash flow to net income ratio over years unless there has been a significant change in its accounting assumptions.
It may be noted that cash flow from operations is used to compute this ratio. Hence, a lower value of this ratio will also highlight those companies that are not having adequate cash inflow from normal business activities which could lead to cash problems in future.
Cash Flow Adequacy Ratio
Cash Flow Adequacy ratio = Cash from Operating Activities / Cash used in Investing Activities
For AllFresh, Cash Flow Adequacy ratio = $10 million / $20 million = 0.5
This ratio tells us whether a company is able to generate enough cash to pay for all its investing activities. It would be greater than 1 for a “cash cow” that is able to pay for its capital expansion using cash generated from operations alone. It does not need any further financing in form of debt or equity. AllFresh is not a cash cow.
Cash Times Interest Earned Ratio
Cash Times Interest Earned ratio = Cash earned before Interest and Tax / Interest expense
where, Cash earned before Interest and Tax = Cash from Operating Activities + Interest expense + Income tax expense
For AllFresh, Cash earned before Interest and Tax = $10 million + $7 million + $1 million = $18 million
Hence, Cash Times Interest Earned ratio = $18 million / $7 million = 2.57
This ratio is similar to TIE described above but it takes cash instead of net income. Hence, this is a more accurate measure of how well can the company covers its interest expenses. AllFresh generates cash that is enough to pay 2.57 times its interest expense for the year. In this case it turns out that AllFresh’s TIE ratio and Cash Times Interest Earned ratio are the same. This is because the company has paid the same amount of cash in interest expense and income tax expense as it has accrued in its Income statement. But these two values could differ and in such cases, Cash Times Interest Earned ratio would give a better visibility to the company’s cash strength to pay for interest and income tax.
DuPont Framework
This framework is used to break and analyze a company’s Return on Equity (ROE), which is the ultimate ratio that investors look at. Return on Equity is given as:
ROE = Net Income / Stockholders’ Equity
A company borrows money from stockholders and invests that in Assets that help the company generate Sales which finally generate profit. This gives us the below three entities:
Borrowing from Stockholders to invest in Assets
Assets-to-Equity ratio = Total Assets / Stockholders’ Equity
Assets help generate Sales
Asset Turnover ratio = Sales / Total Assets
Sales generate Profit
Return on Sales = Net Income / Sales
If we combine all the three entities above, we get ROE as below:
ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Stockholders’ Equity)
i.e. ROE = Profitability x Efficiency x Leverage
The above expanded ROE equation helps us understand where the company needs to improve if its ROE is low. Does the company have lower profitability, or lower efficiency, or lower leverage? It can also be a combination of some or all of these. With this new insight the company can take steps for improvement.
Let’s take an example. Company ABC has an ROE of 12%, whereas, its competitor, XYZ, has an ROE of 15%. Company ABC needs to find out how to improve its ROE. Hence, it finds out the three other ratios – Profitability, Efficiency and Leverage. Below is the data available:
ROE of ABC = 5% x 0.8 x 3.0 = 12%
ROE of XYZ = 5% x 0.6 x 5.0 = 15%
From the above data it is clear that ABC is actually more efficient than XYZ in generating sales for the assets that it holds. Its profitability is also equal to that of XYZ. However, its leverage is lower. This means that ABC is unable to generate enough assets against its equity investment. One way of doing this is by taking up more debt and converting that money into assets. This technique is called leveraging.
Benchmarking
All the ratios seen in the previous section need to be seen with respect to other companies in the same industry. That is when a company can see if it needs to make any changes in its capital structure, margins etc. This activity is called benchmarking. It involves comparison against the best in the industry and trying to match the performance.
Companies also need to continuously benchmark against their own performance over the years. For example, if a company has an ROE of 10% in one year and 8% in the next, it needs to find the reason for this change. Ratios are expected to remain stable across years unless there has been a significant change in the company’s business, capital structure or the market itself.
Limitation of Financial Ratios
Although financial ratios are a powerful tool to analyze companies, they come with several limitations as below:
a) Different companies follow different accounting practices. This makes direct comparison difficult. Sometimes, even when a company changes its own accounting practices it becomes difficult to compare with ratios from the previous years.
b) It is often difficult to classify values of ratios as being good or bad. If a company has a lower profit margin (lower ROS) than its competitors it may not always be bad if that lower margin is able to generate higher sales volume.
c) Conglomerates do business in various diversified industries. This makes it difficult to benchmark them against any single industry. Similar difficulty is faced by other companies when trying to benchmark against a conglomerate.
d) Values of assets and liabilities in a company’s balance sheet are carried at historical costs. This can bring in significant difference between the ratios of old and new companies.