Concept

Review
How do we project the pro forma financial statements?
◦ Growth rate
◦ Financial Ratios
◦ T-account
◦ Other inputs / assumptions

How does firm finance its daily operation?

◦ Uses of fund and sources of fund
◦ Short-term debt from the bank? Longer AP DOH?
◦ “Plug” the Funds needed or excess cash generated

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 Concept Review
Start point: Accounting provides historical information
◦ Evaluate company’s past performance
◦ Use as basis for predicting future performance

Don’t use return as assumption: ROA, ROE and ROIC are simplest measures
of a company’s overall performance, but have some drawbacks
◦ Management can adjust – improve or manipulate – some B/S or I/S items more easily
than others

Assumptions: Future predictions are based on growth, ratios and/or % of

sales
◦ Think when using sales: what is linked directly, what not?
◦ If used, accuracy and volatility of projection are critical
◦ T accounts vs % of sales

“Plug”: With projection, often Assets ≠ Liabilities + Equity

◦ “Plug” of short term lending/funding or cash used to reset the balance

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 Using T-account
BASE: Beginning of Period
+ Additions
– Subtractions
End of Period
Essentially, with each account ask yourself:
◦ What increases the balance?
Where is that information in the case?
◦ What decreases the balance?

Applies to: • Accounts Receivable • Accrued Taxes

• Inventory • Shareholders Equity
• PP&E • Debt accounts
• Accounts Payable

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 Using T-accounts
Account Increases Decreases
Accounts Receivable (Credit) Sales Collections
Inventory Production/Purchases COGS
Net PP&E CAPEX Depreciation
Accounts Payable Purchases Payments
Accrued Taxes Tax Expenses Tax Payments
Net Worth RE, Stock Issued Stock Repurchased

◦ Production relates to manufacturing firms such as Toy World

◦ Purchases relate to distributors/resellers like Clarkson

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 Sustainable Growth
Question: How much (sales) growth can a company achieve and still
maintain its capital structure?
g = b x ROEBOP = b x NIEOP / NWBOP
◦ b is the retention rate = Retentions / NI
◦ Also: b = (1 – p), where p = payout rate = Dividends / NI
◦ ROEBOP is the return on beginning-of-period equity

If the growth in sales exceeds the sustainable growth rate, the company
needs more cash! How to get some?
Change capital structure (leverage) • Improve ROE
• Increase/decrease Debt • Increase profitability – how?
• Issue/repurchase Equity • Increase efficiency – how?

• Change dividend policy (b) • Grow sales at a slower rate

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 ROIC

Interest-bearing debt + Equity

Notes payable @Book Value

Short-term Debt @Market Value
Current-portion of L/T Debt
Long-term Debt
Convertible Debt

Friday, 27 January 2017 10

 EBIAT (NOPLAT)
EBIAT: Earnings Before Interest After Tax
NOPLAT: Net Operating Profit Less Adjusted Taxes
What’s the point?
◦ Remove the impact of financing on earnings
◦ Separate operating and financing considerations

EBIAT = EBIT (1 – Tax Rate)

◦ = EBIT – Implied Taxes w/out Debt (Imaginary!)
◦ DO NOT JUST SUBTRACT TAXES FROM EBIT

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 INVESTED CAPITAL
Invested Capital = Interest-bearing Debt + Equity

Friday, 27 January 2017 12

Balance Sheet
Assets Liabilities + Owners' Equity
Current Assets Current Liabilities
Cash x Working A/P x Automatic
A/R x capital Accrued Expenses x sources
Inventory x Notes Payable x
Current Assets Total xx Automatic Total Current Liabilities xx Interest-
sources Non Current Liabilities bearing debt

Invested Capital
Non Current Assets LT Bank Loan x
NWC
PP&E Gross x TOTAL LIABILITIES XX
Less: Acc. Dep. x Shareholders Equity
PP&E (Net) x Owners Capital x
Intangible Assets x Net Fixed Retained Earnings x
Less: Acc. Amort. x Assets Less: Dividends x
Intangible Assets (Net) x TOTAL OE XX Equity
TOTAL ASSETS XX TOTAL LIABILITIES + SHE XX

Assets = Liabilities + Owner’s Equity

Working Capital + Net Fixed Assets = Automatic sources + Int.-bearing Debt + Equity
NWC + NFA = Invested Capital (Int.-bearing Debt + Equity)

Friday, 27 January 2017 13

 Clarkson 1 – Income Statement
Income Statement Definitions 1993 1994 1995
Sales Sales 2,921 3,477 4,519
Cost of Goods Sold
Beg Inventory 330 337 432
Purchases Purchases 2,209 2,729 3,579
Available 2,539 3,066 4,011
End Inventory 337 432 587
Total Cost of Goods Sold COGs 2,202 2,634 3,424

Gross Profit GP 719 843 1,095

Operating Expenses Op Exp 622 717 940
EBIT EBIT 97 126 155
Interest I 23 42 56
EBT EBT 74 84 99
Taxes Tax 14 16 22
Net Income NI 60 68 77

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 Clarkson 1 – Balance Sheet
Balance Sheet 1993 1994 1995
Cash 43 52 56
Accounts Receivable AR 306 411 606
Inventory Inv 337 432 587
Current Assets 686 895 1,249
PP&E (net) NFA 233 262 388
Total Assets 919 1,157 1,637

NP trade 0 0 127
Accounts Payable AP 213 340 376
Accrued Expenses AE 42 45 75
Loans 160 400 610
Total Liabilities 415 785 1,188
Net worth 504 372 449
Liabilities & Net Worth 919 1,157 1,637

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 Clarkson 1 – DuPont
DuPont Analysis 1993 1994 1995 3-yr Avg
DuPont ROE 11.9% 18.3% 17.1% 15.8%

Margin
Profitability (NI/Sales) 2.1% 2.0% 1.7% 1.9%
Turnover
Activity (Sales/Assets) 3.2 3.0 2.8 3.0
Leverage
Leverage (Assets/Equity) 1.8 3.1 3.6 2.9

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 Clarkson 1 – Activity and
Funds
Activity 1993 1994 1995 3-yr Avg
Turnover 3.18 3.01 2.76 2.98

Cash/Sales 1.5% 1.5% 1.2% 1.4%

AR DOH 38.2 43.1 48.9 43.4
Inv DOH 55.9 59.9 62.6 59.4

NFATO (Sales/NFA) 12.5 13.3 11.6 12.5

Excess funds tied up

target target actual funds
DOH amount amount released
38.2 473 606 133
55.9 524 587 63
Total 196

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 Clarkson 2
How does Clarkson finance its daily operation?
Clarkson 1
Uses of fund 1993 - 1995 Sources of fund 1993 - 1995
Cash 13 NP trade 127
Accounts Receivable 300 Accounts Payable 163
Inventory 250 Accrued Expenses 33
Current Assets 563 Loans 450
PP&E (net) 155 Total Liabilities 773
Net worth -55

Total Assets 718 Liabilities & Net Worth 718

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 Clarkson 2 Projection
AP DOH = 45 days Assumptions
Pro Forma Income Statement
Sales 5,500 5,500 Given in case
- Cost of Goods Sold 4,158 75.6% as % of sales
= Gross Profit 1,342 24.4% Gross margin Gross Profit = Sales – COGS
- Operating Expense 1,150 20.9% as % of sales
= Op Prof before discounts 193 3.5% Operating margin Op Prof = Gross Profit – OpEx
+ discounts earned
= EBIT 193
- Interest 52 13 x 4 interest in 1st quarter is same thru yr
= EBT 141 EBT = EBIT – Int.
- Tax 38 15% ~ 39% rates given in case
= Net Income 102 Net income = EBT - Tax

Tax
1993 1994 1995 average EBT Tax Rate Tax
Net Sales 100.00% 100.00% 100.00% 50 15% 8
25 25% 6
COGS 75.4% 75.8% 75.8% 75.6% 25 34% 9
Gross Margin 24.6% 24.2% 24.2% 24.4% 41 39% 16
Operating Expenses 21.3% 20.6% 20.8% 20.9% 141 38
Operating Margin 3.3% 3.6% 3.4% 3.5%

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 Clarkson 2 Projection
Pro Forma Balance Sheet Assumptions
Uses:
Cash 55 1% of sales, given in case
Accounts Receivable 654 43.40 AR DOH
Inventory 677 59.40 Inventory DOH
PP&E (net) 440 12.50 NFA turnover
Total Assets 1,826

1993 1994 1995 average

AR DOH 38.2 43.1 48.9 43.40 AR DOH = AR(eoy)*365/Sales
Inventory DOH 55.9 59.9 62.6 59.40 Inv. DOH = Inv(eoy)*365/COGS
NFA turnover 12.5 13.3 11.6 12.50 NFA Turnover = Sales / NFA.

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 B/S in 1995
Notes payable, bank

Clarkson 2 Projection Notes payable to Holtz, current portionb

Notes Payable trade
Accounts Payable
Pro Forma Balance Sheet Assumptions Accrued Expenses
Term loan, current portion
Sources:
Current Liabilities
Accounts Payable 524 45 or 10 Given in case
Accrued Expenses 83 1.5% AE / Sales Term loanc
Current Portion LTD 20 20 per year Note payable, Mr. Holtz
Current Liabilities 626 Total Liabilities
Term loan 80 Given in case Net Worth
Total Liabilities & Net Worth
Net Worth 551 From I/S in 1996
Liabilities & NW 1,257

AP DOH = AP(eoy)*365 / Purchase Q:

• Note payable, trade?
Inventory and Purchase Calculations Assuming no overdue as we set
Beginning Inv 587 From B/S in 1995 DOH= 45 or 10
+ Purchases 4,248 • Note payable, Mr. Holtz?
= available 4,835 Paid out in 1996
- Cost of Goods Sold 4,158 From I/S in 1996 • Note payable, bank?
= Ending Inv 677 From B/S in 1996 Assume paid out b/c current
(becomes part of new financing plug)
1993 1994 1995 average B/S: at the point of time (year end of
1996)
AE/SALES 1.4% 1.3% 1.7% 1.5%

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 Clarkson 2 Projection
Pro Forma Balance Sheet AP DOH = 45 days Assumptions
Sources:
Accounts Payable 524 45 or 10 Given in case
Accrued Expenses 83 1.5% AE / Sales
Current Portion LTD 20 10 Semi-annually
Current Liabilities 626
Term loan 80 Given in case
Net Worth 551 NI from 1996 I/S + 1995 SH Equity
Liabilities & NW 1,257
Funds needed from Northwestern National Bank 568

Term Loan 1993 1994 1995 1996

Term loan, current portion 20 20 20 20 A portion that will be paid
Term loanc 140 120 100 80 in next 12 months..

Dr Net Worth Cr
BOY
- +
Dividend Retained earning (NI) From the Net income of 1996

EOY

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 Clarkson 2 Projection
Pro Forma Balance Sheet AP DOH = 45 days
Uses:
Cash 55
Accounts Receivable 654
Inventory 677
PP&E (net) 440
Total Assets 1,826

Sources:
Accounts Payable 524
Accrued Expenses 83
Current Portion LTD 20
Current Liabilities 626
Term loan 80
Net Worth 551
Liabilities & NW 1,258
Funds needed from Northwestern National Bank 568 Plug:
Funds needed = Total Asset – Total
Liabilities & NW

Friday, 3 February 2017 23

 Clarkson 2 Projection
AP DOH = 45 days AP DOH = 10 days Assumptions
Pro Forma Income Statement
Sales 5,500 5,500 5,500 Given in case
- Cost of Goods Sold 4,158 4,158 75.6% as % of sales
= Gross Profit 1,342 1,342 24.4% Gross margin
- Operating Expense 1,150 1,150 20.9% as % of sales
= Op Prof before discounts 193 193 3.5% Operating margin
+ discounts earned 69 2% of AP, given in case
= EBIT 193 261
- Interest 52 52 13 x 4 interest in 1Q x 4
= EBT 141 209
- Tax 38 65 15% ~ 39% rates given in case
= Net Income 102 144

Inventory and Purchase Calculations

Beginning Inv 587 587
+ Purchases 4,248 4,248 Discount = 2% * ( Purchase – 819)
= available 4,835 4,835
- Cost of Goods Sold 4,158 4,158 Subtract first quarter’s
= Ending Inv 677 677 purchase

Friday, 3 February 2017 24

 Clarkson 2 Projection
Pro Forma Balance Sheet AP DOH = 45 days AP DOH = 10 days Assumptions
Uses:
Cash 55 55 1% of sales, given in case
Accounts Receivable 654 654 43.40 AR DOH
Inventory 677 677 59.40 Inventory DOH
PP&E (net) 440 440 12.50 NFA turnover
Total Assets 1,826 1,826
Diff DOH
Sources:
Accounts Payable 524 116 45 or 10 Given in case
Accrued Expenses 83 83 1.5% AE / Sales
Current Portion LTD 20 20 20 per year
Current Liabilities 626 219
Term loan 80 80 Given in case
Net Worth 551 593 From I/S in 1996
Liabilities & NW 1,257 892
Funds needed from Northwestern National Bank568 934
Diff Net income

When choosing a shorter payable period, Clarkson needs

! Exceeds
significantly more funds from the bank.
the ceiling

Friday, 3 February 2017 25

 Summary
Material covered so far:
◦ Know ratios, their significance and limitations
◦ Use them to evaluate company’s past performance
◦ Assess impact of changes in ratios on profitability, liquidity
◦ Use ratios, % of sales and T-accounts to forecast future performance
◦ Identify potential sources of illiquidity
◦ Quantify funding needed or excess cash generated
◦ Compare financed growth to sustainable growth
◦ Create a cash flow statement

Questions?

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