Assessing Compnay’s Financial Health

Assessing a Companys succeeding(a) pecuniary wellness Assessing the long-run pecuniary health of a lodge is an important task for focusing in its expression of goals and strategies and for give awaysiders as they consider the extension of reliance, long- term supplier agreements, or an coronation in a attach tos paleness. Hi falsehood abounds with examples of companies that embarked upon overly ch eitherenging programs and subsequently discovered that their portfolios of programs could not be financed on accept subject hurt.The force frequently was the abandonment of programs in mid-stream at considerable pecuniary, organizational, and human cost. It is the duty of management to anticipate future im brace in the corporate mo terminalary system originally its severity is reflected in the financials, and to consider corrective action mechanism before both time and m onenessy atomic number 18 exhausted. The avoidance of failure is an insufficient standard. Manage ment must ensure the continuity of the flow of notes to all of its strategically important programs, even in periods of adversity.Figure A provides a conceptualization of the corporate financial system, with a suggested step-by- step process to appreciate whether it ordain remain in offset over the ensuing 3-5 classs. The dispute of this note discusses each of the steps in the process and then provides an action on the various financial sums that are useful as office of the analysis. The final section of the note demonstrates the relationship surrounded by a fasts strategy and in ope symmetryn(p) characteristics, and its financial characteristics.Professor Thomas Piper lively the original version of this note, Assessing a Firms prox fiscal Health, HBS No. 201-077, which is being reset(p) by this version prepared by the equivalent author. This note was prepared as the basis for class discussion. Copyright 2010, 2011 president and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, hold open Harvard crease School Publishing, Boston, MA 02163, or go to www. hbsp. harvard. edu/educators.This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. 911-412Assessing a Companys coming(prenominal) Financial Health Figure AThe Corporate Financial System Goals tincture 1Strategy Market, Competitive Technology Regulatory and Operating Characteristics musical note 2Revenue Outlook appendage rate volatility, predictability Step 3Step 4 Investment in AssetsEconomic Performance to support offsetfavourableness utility/ declination in summation management notes flow volatility, predictability Step 5Step 6 outdoor(a) finance NeedTarget Sources of Finance $ get alonglending/investing criteria timing, du balancen deferability attractor of potent to each derriere source Step 7 Viability of 3-5 str atum Plan consistency with goals achievable run plan achievable financial support plan Step 8 Stress Test for Viability Under sundry(a) scenarios Step 9 Financing and Operating Plan for ongoing category Steps 1, 2 Analysis of FundamentalsThe corporate financial system is goaded by the goals, assembly line unit choices and strategies, market conditions and the operating characteristics. The firms strategy and gross revenue growth in each of its backup units will form the investment in summations unavoidablenessed to support these strategies and the force of the strategies, feature with the response of competitors and regulators, will 2 Assessing a Companys Future Financial Health911-412 powerfully influence the firms competitive and profit procedure, its need for extraneous finance, and its access to the debt and integrity markets.Clearly, many of these questions require information beyond that contained in a companys published financial reports. Step 3 Investments t o Support the Business Unit(s) Strategy(ies) The business unit strategies inevitably require investments in accounts receivable, inventories, kit and boodle equipment, and possibly, acquisitions. Step 3 of the process is an attempt to depend the amount that will be tied up in each of the asset graphic symbols by virtue of gross gross revenue growth and the improvement/ admixture in asset management.An analyst can make a rough estimate by studying the recent pattern of the collection period, the old age of take stock, and plant equipment as a percent of cost of goodlys sell and then applying a reasonable value for each to the gross sales foretell or the forecast of cost of goods exchange. Extrapolation of away performance assumes, of course, that the future underlying market, competitive and regulative drivers will be unchanged from the conditions that influenced the historical performance. Step 4 Future Profitability and Competitive PerformanceStrong sustained favourab leness is an important determinant of (1) a firms access to debt and/or justness finance on acceptable terms (2) its ability to self-finance growth through with(predicate) the retention of scratch (3) its strength to place major bets on risky new technologies, markets, and/or products and (4) the valuation of the company. A reasonable starting point is to analyze the past pattern of profitability. 1. What have been the middling train, trend and volatility of profitability? 2. Is the level of profitability sustainable, given the outlook for the market and for competitive and regulatory pressures? . Is the authorized level of profitability at the expense of future growth and/or profitability? 4. Has management initiated major profit improvement programs? Are they unparalleled to the firm or are they industry-wide and may be reflected in start prices rather than higher profitability? 5. Are there any hush-hush problems, such as suspiciously high levels or buildups of accounts receivable or strain sexual congress to sales, or a series of unusual minutes and/or accounting changes? Step 5 Future orthogonal Financing NeedsWhether a company has a future orthogonal financial backing need depends on (1) its future sales growth (2) the length of its cash round and (3) the future level of profitability and profit retention. Rapid sales growth by a company with a long cash daily round (a long collection period + high inventories + high plant equipment relative to sales) and low profitability/low profit retention is a normal for an ever- increasing appetite for external finance, raised in the form of loans, debt issues, and/or sales of shares. Why?Because the quick sales growth results in rapid growth of an already large level of sum up assets. The increase in hit assets is offset partially by an increase in accounts collectable and accrued expenses, and by a small increase in possessors truth. However, the pay gap is substantial. For example, t he company portrayed in Table A requires $126 trillion of additional external finance by the end of year 2010 to finance the increase in join assets required to support 25% per year sales growth in a business that is fairly asset intensive. 3 911-412Assessing a Companys Future Financial Health Table A Assuming a 25% Increase in gross sales ($ in millions) Assets 2009 2010 Cash $ 12 25% $ 15 Accounts receivable 240 25% triple hundred Inventories 200 25% 250 Plant equipment 400 25% 500 rack up $852 $1,065 Liabilities and Equity Accounts payable $ one hundred 25% $ 125 Accrued expenses 80 25% 100 Long-term debt 272 Unchanged 272 Owners fairness 400 footnote a 442 nub $852 $ 939 External backing need 0 126 enumerate $852 $1,065 a It is assumed (1) that the firm relieve oneselfs $60 million (a 15% perish on beginning of year equity) and pays out $18 million as a cash dividend and (2) that there is no required debt repayment in 201 0. If, however, the company reduced its sales growth to 5% (and issuance assets, accounts payable and accrued expenses change magnitude accordingly by 5%), the need for additional external finance would drop from $126 million to $0.High sales growth does not always result in a need for additional external finance. For example, a food retailer that extends no credit to customers, has only viii days of inscription, and does not own its warehouses and stores, can experience rapid sales growth and not have a need for additional external finance provided it is approximatelywhat profitable. Because it has so few assets, the increase in total assets is largely offset by a corresponding, spontaneous increase in accounts payable and accrued expenses. Step 6 Access to Target Sources of External Finance Having estimated the future backing need, management must locate the target sources (e. g. banks, insurance companies, public debt markets, public equity market) and establish financia l policies that will ensure access on acceptable terms. 1. How sound is the firms financial structure, given its level of profitability and cash flow, its level of business risk, and its future need for finance? 2. How will the firm service its debt? To what bound is it counting on refinancing with a debt or equity issue? 3. Does the firm have assured access on acceptable terms to the equity markets? How many shares could be sold and at what price in good times? In a period of adversity? 4. What criteria are utilise by each of the firms target sources of finance to determine whether finance will be provided and, if so, on what terms? 4 Assessing a Companys Future Financial Health911-412The evaluation of a firms financial structure can vary substantially depending on the perspective of the loaner/investor. A bank may consider a seasonal credit a very safe bet. Considerable shrinkage can pass by in the conversion of register into sales and collections without preventing repayment of the loan. In contrast, an investor in the firms 20-year bonds is counting on its sustained health and profitability over a 20-year period. Step 7 Viability of the 3-5 Year Plan 1. Is the operating plan on which the financial forecasts are based achievable? 2. leave alone the strategic, competitive, and financial goals be achieved? 3. Will the resources required by the plan be available? 4.How will the firms competitive, organizational, and financial health at the end of the 3-5 years compare with its condition at the outset? Step 8 Stress Test under Scenarios of Adversity Financing plans typically work intimately if the assumptions on which they are based turn out to be accurate. However, this is an insufficient test in situations marked by vapourisable and unpredictable conditions. The test of the soundness of a 3-5 year plan is whether the continuity of the flow of cash in hand to all strategically important programs can be maintained under various scenarios of adversity f or the firm and/or the chief city marketsor at least be maintained as salutary as your competitors are able to maintain the funding of their programs.Step 9 present-day(prenominal) Financing Plan How should the firm meet its financing needs in the live year? How should it counter sense of equilibrium the benefits of future financing flexibility (by interchange equity now) versus the temptation to delay the sale of equity by financing with debt now, in hopes of realizing a higher price in the future? The adjacent section of this note is designed to provide familiarity with the financial measures that can be useful in understanding the past performance of a company. Extrapolation of the past performance, if done thoughtfully, can provide valuable insights as to the future health and balance of the corporate financial system.Historical analysis can also identify possible opportunities for amend asset m a n a g e m e n t or margin i m p r o v e m e n t , as closely as provide a n important, albeit incomplete, basis for evaluating the attractiveness of a business and/or the effectiveness of a management team. Financial Ratios and Financial Analysis The three primary sources of financial data for a business entity are the income statement, the balance sheet, and the statement of cash flows. The income statement summarizes revenues and expenses over a period of time. The balance sheet is the list of what a company owns (its assets), what it owes (its liabilities), and what has been invested by the owners (owners equity) at a specific point in time.The statement of cash flow categorizes all cash transactions during a specific period of time in terms of cash flows generated or use for operating activities, investing activities, and financing activities. The focus of this section is on performance measures based on the income statements and balance sheets of SciTronicsa medical device company. The measures can be grouped by typesetters case(1) 5 911-412Assessin g a Companys Future Financial Health profitability measures, (2) legal action (asset management) measures, (3) leverage and liquidity measures. Please refer to the financial statements of SciTronics as shown in Exhibits 1 and 2 at the end of the note.As you work through the questions that follow, please also consider three broad questions 1. What is your assessment of the performance of SciTronics during the 2005-2008 period? 2. Has its financial strength and its access to external sources of finance improved or weakened? 3. What are the 2-3 most important questions you would ask management as the result of your analysis? sales Growth sales growth is an important driver of the need to invest in various type assets and of the companys value. It also provides nearly indication of the effectiveness of a firms strategy and product development activities, and of customer acceptance of a firms products and services. 1.During the four-year period ended December 31, 2008, SciTronics sal es grew at a % compound rate. There were no acquisition or divestitures. Profitability Ratio How Profitable Is the Company? Profitability is a extremity over the long-run. It strongly influences (1) the companys access to debt (2) the valuation of the companys leafy vegetable stock (3) the willingness of management to issue stock and (4) the capacity to self-finance. One measure of profitability of a business is its fall back on sales, measured by dividing net income by net sales. 1. SciTronics profit as a percentage of sales in 2008 was %. 2. This equal an increase/ reduction from % in 2005.Management and investors a lot are much use uped in the return get on the funds invested than in the level of profits as a percentage of sales. Companies operating in businesses requiring very little investment in assets a great deal have low profit margins but earn very attractive returns on invested funds. Conversely, there are numerous examples of companies in very bully-intensive b usinesses that earn miserably low returns on invested funds, despite ostensibly attractive profit margins. Therefore, it is useful to examine the return earned on the funds provided by the shareholders and by the investors in the companys liaison-bearing debt.To increase the comparability across companies, it is useful to use EBIAT (earnings before interest but after measurees) as the measure of return. The use of EBIAT as the measure of return also allows the analyst to compare the return on invested jacket (calculated before the deduction of interest expense), with the companys estimated cost of capital to determine the long-run adequacy of the companys profitability. EBIAT is calculated by multiplying EBIT (earnings before interest and taxes) times (1the sightly tax rate). EBIT x ? 1 ? tax rate? Owners? equity plus interest bearing debt 3. SciTronics had a total of $_ of capital at year-end 2008 and earned before interest but after taxes (EBIAT) $ during 2008.Its return on capital was % in 2008 which represented an increase/ falling off from the % earned in 2005. 6 Assessing a Companys Future Financial Health911-412 From the viewpoint of the shareholders, an equally important externalize is the companys return on equity. fleet on equity is calculated by dividing profit after tax by the owners equity. Profit after taxes Owners? equity Return on equity indicates how profitably the company is utilizing shareholders funds. 4. SciTronics had $_ of owners equity and earned $_ after taxes in 2008. Its return on equity was % an improvement/ deterioration from the % earned in 2005. Activity Ratios How Well Does the Company Employs Its Assets?The second rudimentary type of financial ratio is the activity ratio. Activity ratios indicate how well a company employs its assets. Ineffective utilization of assets results in the need for much finance, unnecessary interest costs, and a correspondingly lower return on capital employed. Furthermore, low activity rati os or deterioration in the activity ratios may indicate uncollectible accounts receivable or obsolete neckcloth or equipment. Total asset perturbation measures the companys effectiveness in utilizing its total assets and is calculated by dividing total assets into sales. Net sales Total assets Total asset dollar volume for SciTronics in 2008 can be calculated by dividing $ into $ .The turnover improved/deteriora ed from times in 2005 to times in 2008. It is useful to examine the turnover ratios for each type of asset, as the use of total assets may hide important problems in one of the specific asset categories. One important category is accounts receivables. The average collection period measures the egress of days that the company must holdup on average between the time of sale and the time when it is paid. The average collection period is calculated in two steps. First, divide annual credit sales by 365 days to determine average sales per day Net credit sales 365 days Then, divide the accounts receivable by average sales per day to determine he number of days of sales that are still unpaid Accounts receivable recognise sales per day SciTronics had $ invested in accounts receivables at year-end 2008. Its average sales per day were $ during 2008 and its average collection period was _days. This represented an improvement/deterioration from the average collection period of days in 2005. A trinity activity ratio is the inventory turnover ratio, which indicates the effectiveness with which the company is employing inventory. Since inventory is recorded on the balance sheet at cost (not at 7 911-412Assessing a Companys Future Financial Health ts sales value), it is surmount(predicate) to use cost of goods sold as the measure of activity. The inventory turnover figure is calculated by dividing cost of goods sold by inventory Cost of goods sold Inventory 3. SciTronics apparently needed $ of inventory at year-end 2008 to support its operations during 2008. Its activity during 2008 as measured by the cost of goods sold was $_ . It therefore had an inventory turnover of times. This represented an improvement/deterioration from times in 2005. An alternative measure of inventory management is days of inventory, which can be calculated by dividing cost of goods sold by 365 days to determine average cost of goods sold per day.Days of inventory is calculated by dividing total inventory by cost of goods sold per day. A fourth and final activity ratio is the set(p) asset turnover ratio which measures the effectiveness of the company in utilizing its plant and equipment NetsalesNet fixed assets 4. SciTronics had net fixed assets of $ and sales of $ in 2008. Its fixed asset turnover ratio in 2008 was times, an improvement/deterioration from times in 2005. leverage Ratios How Soundly is the Company Financed? There are a number of balance sheet measures of financial leverage. The various leverage ratios measure the relationship of funds supplied by creditors to the funds supplied by owners.The use of borrowed funds by fairly profitable companies will improve the return on equity. However, it increases the riskiness of the business and the riskiness of the returns to the stockholders, and can result in financial distress if used in excessive amounts. The ratio of total assets divided by owners equity is an indirect measure of leverage. A ratio, for example, of $6 of assets for each $1 of owners equity indicates that $6 of assets is financed by $1 of owners equity and $5 of liabilities. 1. SciTronics ratio of total assets divided by owners equity increased/ rock-bottom from at year end 2005 to at year-end 2008.The same story of increasing financial leverage is told by dividing total liabilities by total assets. 2. At year-end 2008, SciTronics total liabilities were % of its total assets, which compares with % in 2005. Lendersespecially long-term lenderswant reasonable assurance that the company will be able to repay the loa n in the future. They are concerned with the relationship between a companys debt and its total economic value. This ratio is called the total debt ratio at market. Total liabilities Total liabilities ? market value of the equity The market value of the equity is calculated by multiplying the number of shares of common stock outstanding times the market price per share. 8Assessing a Companys Future Financial Health911-412 3. The market value of SciTronics equity was $175,000,000 at December 31, 2008. The total debt ratio at market was . A fourth ratio that relates the level of debt to economic value and performance is the times interest earned ratio. This ratio relates earnings before interest and taxesa measure of profitability and of long-term viabilityto the interest expensea measure of the level of debt. Earnings before interest and taxes Interest expense 4. SciTronics earnings before interest and taxes (operating income) were $_ in 2008 and its interest charges were $ . Its tim es interest earned was times.This represented an improvement/deterioration from the 2005 level of times. A fifth and final leverage ratio is the number of days of payables. This ratio measures the average number of days that the company is winning to pay its suppliers of raw materials and components. It is calculated by dividing annual purchases by 365 days to determine average purchases per day Annual purchases 365 days Accounts payable are then divided by average purchases per day Accounts payable total purchases per day to determine the number of days purchases that are still unpaid. It is often difficult to determine the purchases of a firm.Instead, the income statement shows cost of goods sold, a figure that includes not only raw materials but also labor and overhead. Thus, it often is only possible to gain a rough idea as to whether or not a firm is becoming more or less dependent on its suppliers for finance. This can be done by tracking the pattern over time of accounts pa yable as a percent of cost of goods sold. Accounts payable Cost of goods sold 5. SciTronics owed its suppliers $ at year end 2008. This represented % of cost of goods sold and was an increase/ accrue from % at year end 2005. The company appears to be more/less prompt in paying its suppliers in 2008 than it was in 2005. 6.The financial riskiness of SciTronics increased/decreased between 2005 and 2008. Liquidity Ratios How Liquid is the Company? The fourth radical type of financial ratio is the liquidity ratio. These ratios measure a companys ability to meet financial obligations as they become live. The on-line(prenominal) ratio, defined as current assets divided by current liabilities, assumes that current assets are much more readily and certainly interchangeible into cash than other assets. It relates these fairly liquid assets to claims that are due within one yearthe current liabilities. 9 911-412Assessing a Companys Future Financial Health Current assets Current liabilitie s 1.SciTronics held $ of current assets at year-end 2008 and owed $ to creditors due to be paid within one year. Its current ratio was , an increase/decrease from the ratio of at year-end 2005. The quick ratio or pane of glass test is similar to the current ratio but excludes inventory from the current assets Current assets ? Inventory Current liabilities Inventory is excluded because it is often difficult to convert into cash (at least at book value) if the company is struck by adversity. 2. The quick ratio for SciTronics at year-end 2008 was _, an increase/decrease from the ratio of at year-end 2005. Profitability RevisitedManagement can improve its return on equity by improving its return on sales and/or its asset turnover and/or by increasing its financial leverage as measured by total assets divided by owners equity. hard roe ? Net Income x Sales Sales Total Assets Total Assets x Owners? Equity Each method of improvement differs operationally and in terms of risk. 1. The impro vement in SciTronics return on equity from 8. 2% in 2005 to 18. 7% in 2008 resulted from an increase/decrease in its return on sales and an increase/decrease in its asset turnover, and an increase/decrease in its financial leverage. A WarningThe calculated ratios are no more valid than the financial statements from which they are derived. The quality of the financial statements should be assessed and sequester adjustments made, before any ratios are calculated. Particular attention should be placed on assessing the reasonableness of the accounting choices and assumptions embedded in the financial statements. The fibre of the Unidentified Industries The preceding exercise suggests a series of questions that may be helpful in assessing a companys future financial health. It also describes several ratios that are useful in answering some of the questions, especially if the historical trend in these ratios can be reasonably extrapolated.However, it is also important to compare the act ual absolute value with some standard to determine whether the company is performing well. Unfortunately, there is no ace current ratio, inventory turnover, or debt ratio that is appropriate to all industries. The operating and competitive characteristics of the companys industry greatly influence its investment in the various types of assets, the riskiness of these investments, and the financial structure of its balance sheet. 10 Assessing a Companys Future Financial Health911-412 Try to match the five next types of companies with their corresponding balance sheets and financial ratios as shown in Exhibit 3. 1. electric utility 2. Japanese automobile manufacturer 3. Discount prevalent switch retailer 4.Automated test equipment/systems company 5. Upscale apparel retailer In doing the exercise, consider the operating and competitive characteristics of the industry and their implications for (1) the collection period (2) inventory turnover (3) the amount of plant and equipment (4 ) the profit margins and profitability and (5) the appropriate financing structure. Then identify which one of the five sets of balance sheets and financial ratios best match your expectations, given the difficult economic conditions in 2009. 11 911-412Assessing a Companys Future Financial Health Exhibit 1SciTronics, Inc. Consolidated Income Statements 2005-2008 ($ in thousands) 20042005200620072008 Sales $115,000 $147,000 171,000 $205,000 $244,000 Cost of goods sold 43,000 50,000 63,000 74,000 Gross margin 104,000 121,000 142,000 170,000 Research development 15,000 20,000 26,000 28,000 Sell, general administrative 79,000 92,000 106,000 116,000 Operating income 10,000 9,000 10,000 26,000 Interest expense 1,000 2,000 2,000 2,000 Profit before tax 9,000 7,000 8,000 24,000 Income tax 4,000 2,000 3,000 10,000 Net income $ 5,000 $ 5,000 $ 5,000 $14,000 Exhibit 2SciTronics, Inc. Consolidated Balance tabloid at December 31, 2005-2008 ($ in thousan ds) 2005 2006 2007 2008 Cash $ 9,000 $ 10,000 $ 15,000 $ 18,000 Accounts receivable 42,000 53,000 61,000 66,000 Inventories 21,000 28,000 30,000 29,000 Other current assets 10,000 13,000 21,000 20,000 Total current assets 82,000 104,000 127,000 133,000 Net property equipment 9,000 12,000 13,000 18,000 Other 2,000 2,000 6,000 8,000 Total assets $93,000 $118,000 $146,000 $159,000 Notes payable $ 3,000 $ 18,000 $ 8,000 $ 10,000 Accounts payable 5,000 6,000 7,000 6,000 Accrued expenses 10,000 13,000 21,000 28,000 Other current liabilities 3,000 3,000 4,000 4,000 Total urrent liabilities 21,000 40,000 40,000 48,000 Long-term senior debt 10,000 9,000 8,000 7,000 Subordinated interchangeable debt 20,000 20,000 Other liabilities 1,000 3,000 7,000 9,000 Owners equity 61,000 66,000 71,000 85,000 Treasury stock (10,000) Owners equity 61,000 66,000 71,000 75,000 Total liabilities and equity $93,000 $118,000 $146,000 $159,000 12 Asses sing a Companys Future Financial Health911-412 Exhibit 3Unidentified Industries Balance Sheet Percentages ABCDE Cash1. 5%14. 4%12. 1%13. 3%11. 0% Receivables4. 63. 830. 939. 811. 8 Inventories1. 824. 613. 74. 716. 7 Other current assets2. 04. 35. 03. 810. 0 Property and equipment (net)74. 549. 634. 122. 120. 3 Other assets 15. 6 3. 4 4. 3 16. 3 30. 2 Total assets100%100%100%100%100% Notes payable5. 3%0. 4% 5. 4%18. 2%1. 4% Accounts payable2. 124. 811. 0 8. 38. 8 Other current liabilities5. 917. 014. 28. 716. 5 Long-term debt33. 610. 034. 323. 121. 7 Other liabilities26. 32. 211. 25. 62. 0Owners equity 26. 8 45. 6 23. 9 36. 1 49. 6 Total100%100%100%100%100% Selected Ratios Net profit/net sales10. 3%1. 5% 5. 1%1. 3%(5. 8%) Return on capital 6. 8%9. 2%12. 6%0. 9%(3. 1%) Return on equity12. 5%10. 8%28. 1%2. 2%(7. 6%) Sales/total assets . 323. 251. 31. 63 . 65 Collection period (days)5248623243 Days of inventory43326231147 Sales/net property equipment. 436. 73. 82. 93. 6 Total assets/eq uity3. 732. 194. 192. 792. 01 Total liabilities/total assets. 73. 54. 76. 66. 50 Interest-bearing debt/total capital 59%19% 62%53% 32% Times interest earned3. 2 16 6. 0 4. 4NM Current assets/current liabilities . 671. 112. 011. 221. 85 13