Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 29 pot

Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 CHAPTER TWENTY-NINE 816 FINANCIAL ANALYSIS AND PLANNING Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 A CAMEL LOOKS like an animal designed by a committee. If a firm made all its financial decisions piece- meal, it would end up with a financial camel. Therefore, smart financial managers consider the over- all effect of financing and investment decisions and ensure that they have the financial strategies in place to support the firm’s plans for future growth. Knowing where you stand today is a necessary prelude to contemplating where you might be in the future. Therefore we start the chapter with a brief review of a company’s financial statements and we show how you can use these statements to assess the firm’s overall performance and its current financial standing. To produce order out of chaos, financial analysts calculate a few key financial ratios that summa- rize the company’s financial strengths and weaknesses. These ratios are no substitute for a crystal ball, but they do help you to ask the right questions. For example, when the firm needs a loan from the bank, the financial manager can expect some searching questions about the firm’s debt ratio and the proportion of profits that is absorbed by interest. Likewise, financial ratios may alert senior man- agement to potential problem areas. If a division is earning a low rate of return on its capital or its profit margins are under pressure, you can be sure that management will demand an explanation. Growing firms need to invest in working capital, plant and equipment, product development, and so on. All this requires cash. We will, therefore, explain how firms use financial planning models to help them understand the financial implications of their business plans and to explore the conse- quences of alternative financial strategies. Our focus in this chapter is on the long-term future. For example, firms may have a planning hori- zon of 5 or 10 years. In the next chapter we will look at how firms also develop more detailed strate- gies to ensure that they can get safely through the next few months. 817 29.1 FINANCIAL STATEMENTS Public companies have a variety of stakeholders, such as shareholders, bondhold- ers, bankers, suppliers, employees, and management. All these stakeholders need to monitor the firm and to ensure that their interests are being served. They rely on the company’s financial statements to provide the necessary information. When reviewing a company’s financial statements, it is important to remember that accountants still have a fair degree of leeway in reporting earnings and book val- ues. For example, accountants have discretion in the way they treat intangible assets, such as patents or franchises. Some believe that including these items on the balance sheet provides the best measure of the company’s value as a going concern. Others take a more conservative approach and exclude intangible assets. They reason that, if the firm were liquidated, these assets would be largely valueless. Although accountants around the world are working toward common prac- tices, there are considerable variations in the accounting rules of different coun- tries. In Anglo-Saxon countries such as the United States or the UK which have large and active equity markets, the rules have been designed with the shareholder very much in mind. By contrast, in Germany the focus of accounting standards is to verify that the creditors are properly protected. Ray Ball has pointed out that differences between German and U.S. practice also arise because “German laws and institutional arrangements closely link German corporations’ reported earnings to their dividend payments and to bonuses paid Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 to managers and employees alike. The economic role of reported earnings is anal- ogous to an annually-baked pie that is divided among the important stakeholders (government, employees, shareholders and managers alike), the size of the pie having first been determined with prudential regard for the financial stability of the corporation Reporting a loss would eliminate bonus, dividend and tax dis- tributions, to the chagrin of all the stakeholders.” 1 Another difference is the way that taxes are shown in the income statement. For example, in Germany taxes are paid on the published profits and the depre- ciation method must therefore be approved by the revenue service. That is not so in Anglo-Saxon countries, where the numbers shown in the published accounts are generally not the basis for calculating the company’s tax payments. For in- stance, the depreciation method used to calculate the published profits may dif- fer from the depreciation method used by the tax authorities. Sometimes the effect of these differences in accounting rules can be substantial. When the German car manufacturer, Daimler-Benz, decided to list its shares on the New York Stock Exchange in 1993, it was required to revise its accounting practices to conform to U.S. standards. While it reported a modest profit in the first half of 1993 using German accounting rules, it reported a loss of $592 million under U.S. rules, primarily because of differences in the treatment of reserves. Countries also differ in the amount and accuracy of the information disclosed in a company’s financial statements. For example, the Russian company, Lukoil, owns some of the largest oil reserves in the world and has 120,000 employees. Yet until re- cently its income statement reported just four numbers, with no accompanying notes. A study by LaPorta et al. rated a sample of countries on the quality of their ac- counting standards. 2 Table 29.1 provides an extract from their results. In general, they concluded that company accounts were more informative in those countries with a Scandinavian or English legal tradition and less so in those with a French or German tradition. However, there was a huge variation within each of these groups. 818 PART IX Financial Planning and Short-Term Management 1 See R. J. Ball, “Daimler-Benz (DaimlerChrysler) AG: Evolution of Corporate Governance from a Code- law ‘Stakeholder’ to a Common-law ‘Shareholder Value’ System,” Graduate School of Business, Uni- versity of Chicago. 2 LaPorta et al., “Law and Finance,” Journal of Political Economy 106 (December 1998), pp. 1113–1155. Country Legal Tradition Rating Sweden Scandinavian 83 United Kingdom English 78 United States English 71 France French 69 Hong Kong English 69 Switzerland German 68 Japan German 65 Germany German 62 South Korea German 62 Mexico French 60 India English 57 Peru French 38 Egypt French 24 TABLE 29.1 Country ratings on quality of accounting standards (a high figure indicates high quality). Source: LaPorta et al., “Law and Finance,” Journal of Political Economy 106 (December 1998), 1113–1155. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 Your task is to assess the financial standing of the Executive Paper Corporation. Perhaps you are a financial analyst with Executive Paper and are helping to de- velop a five-year financial plan. Perhaps you are employed by a rival company that is contemplating a takeover bid for Executive Paper. Or perhaps you are a banker who needs to assess whether the bank should lend to the company. In each case your first step is to assess the company’s current condition. You have before you the latest balance sheet, income statement, and sources and uses of funds. The Balance Sheet Executive Paper’s balance sheet in Table 29.2 provides a snapshot of the company’s assets and the sources of the money used to buy those assets. The items in the balance sheet are listed in declining order of liquidity. For ex- ample, you can see that the accountant lists first those assets which are most likely to be turned into cash in the near future. They include cash itself, marketable securities and receivables (that is, bills to be paid by the firm’s customers), and CHAPTER 29 Financial Analysis and Planning 819 29.2 EXECUTIVE PAPER’S FINANCIAL STATEMENTS Assets Dec 1998 Dec 1999 Change Current assets: Cash & securities 75 110 ϩ35 Receivables 433.1 440 ϩ6.9 Inventory 339.9 350 ϩ10.1 Total current assets 848 900 ϩ52 Fixed assets: Property, plant, and equipment 929.5 1,000 ϩ70.5 Less accumulated depreciation 396.7 450 ϩ53.3 Net fixed assets 532.8 550 ϩ17.2 Total assets 1,380.8 1,450 ϩ69.2 Liabilities and Shareholders’ Equity Dec 1998 Dec 1999 Change Current liabilities: Debt due within 1 year 96.6 100 ϩ3.4 Payables 349.9 360 ϩ10.1 Total current liabilities 446.5 460 ϩ13.5 Long-term debt 425 450 ϩ25 Shareholders’ equity 509.3 540 ϩ30.7 Total liabilities & shareholders’ equity 1,380.8 1,450 ϩ69.2 Other financial information: Market value of equity 598 708 Average number of shares (millions) 14.16 14.16 Share price ($) 42.25 50.00 TABLE 29.2 The balance sheet of Executive Paper Corporation (figures in $ millions). Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 inventories of raw materials, work in process, and finished goods. These assets are all known as current assets. The remaining assets on the balance sheet consist of long-term, usually illiquid, assets such as pulp and paper mills, office buildings, and timberlands. The balance sheet does not show up-to-date market values of these long-term assets. Instead, the accountant records the amount that each asset originally cost and then, in the case of plant and equipment, deducts a fixed annual amount for depreciation. The balance sheet does not include all the company’s assets. Some of the most valuable ones are intangible, such as patents, reputation, a skilled management, and a well- trained labor force. Accountants are generally reluctant to record these assets in the balance sheet unless they can be readily identified and valued. Now look at the right-hand portion of Executive Paper’s balance sheet, which shows where the money to buy the assets came from. 3 The accountant starts by look- ing at the liabilities, that is, the money owed by the company. First come those lia- bilities that need to be paid off in the near future. These current liabilities include debts that are due to be repaid within the next year and payables (that is, amounts owed by the company to its suppliers). The difference between the current assets and current liabilities is known as the net current assets or net working capital. It roughly measures the company’s poten- tial reservoir of cash. For Executive Paper in 1999 The bottom portion of the balance sheet shows the sources of the cash that was used to acquire the net working capital and fixed assets. Some of the cash has come from the issue of bonds and leases that will not be repaid for many years. After all these long-term liabilities have been paid off, the remaining assets belong to the common stockholders. The company’s equity is simply the total value of the net working capital and fixed assets less the long-term liabilities. Part of this equity has come from the sale of shares to investors and the remainder has come from earn- ings that the company has retained and invested on behalf of the shareholders. Table 29.2 provides some other financial information about Executive Paper. For example, it shows the market value of the common stock. It is often helpful to com- pare the book value of the equity (shown in the company’s accounts) with the mar- ket value established in the capital markets. The Income Statement If Executive Paper’s balance sheet resembles a snapshot of the firm at a particular point in time, its income statement is like a video. It shows how profitable the firm has been over the past year. Look at the summary income statement in Table 29.3. You can see that during 1999 Executive Paper sold goods worth $2,200 million and that the total costs of producing and selling these goods were $1,980 million. In addition to these out-of- pocket expenses, Executive Paper also made a deduction of $53.3 million for the value of the fixed assets used up in producing the goods. Thus Executive Paper’s earnings before interest and taxes (EBIT) were ϭ 900 Ϫ 460 ϭ $440 million Net working capital ϭ current assets Ϫ current liabilities 820 PART IX Financial Planning and Short-Term Management 3 The British and Americans can never agree whether to keep to the left or the right. British accountants list liabilities on the left and assets on the right. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 Of this sum $42.5 million went to pay the interest on the short- and long-term debt (remember debt interest is paid out of pretax income) and a further $49.7 mil- lion went to the government in the form of taxes. The $74.5 million that was left over belonged to the shareholders. Executive Paper paid out $43.8 million as divi- dends and reinvested the remaining $30.7 million in the business. Sources and Uses of Funds Table 29.4 shows where Executive Paper raised funds and how it spent them. 4 Be- side each row in the table we have added a brief note on how the figure is calcu- lated. We will explain each item in turn. ϭ 2, 200 Ϫ 1, 980 Ϫ 53.3 ϭ $166.7 million EBIT ϭ Total revenues Ϫ costs Ϫ depreciation CHAPTER 29 Financial Analysis and Planning 821 $ Millions Revenues 2,200 Costs 1,980 Depreciation 53.3 EBIT 166.7 Interest 42.5 Tax 49.7 Net income 74.5 Dividends 43.8 Retained earnings 30.7 Earnings per share, dollars 5.26 Dividend per share, dollars 3.09 TABLE 29.3 The 1999 income statement of Executive Paper Corporation (figures in $ millions). 4 Notice that in a Sources and Uses of Funds table the different components of net working capital are not separated out. When we discuss short-term planning in Chapter 30, we will show how to draw up a Sources and Uses of Cash table, which separates out different items of net working capital. $ Millions Notes: Sources: Net income 74.5 See Table 29.3 Depreciation 53.3 See Table 29.3 Operating cash flow 127.8 Issues of long-term debt 25.0 See Table 29.2: 450 Ϫ 425 Issues of equity 0 See Tables 29.2 and 29.3: 540 Ϫ 509.3 Ϫ (74.5 Ϫ 43.8) Total sources 152.8 Uses: Investment in net working 38.5 See Table 29.2: (900 Ϫ 460) capital Ϫ (848 Ϫ 446.5) Investment in fixed assets 70.5 See Table 29.2: 1000 Ϫ 929.5 Dividends 43.8 See Table 29.3 Total uses 152.8 TABLE 29.4 Sources and uses of funds for Executive Paper Corporation, 1999 (figures in $ millions). Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 Look first at the uses of funds. The money that Executive Paper generates is ei- ther invested in net working capital and fixed assets or it is paid out to sharehold- ers as dividends. Thus Table 29.2 shows that in 1999 Executive Paper started the year with net working capital of million. By the end of the year it had grown to million. So the company invested an additional $38.5 million in working capital. Over the same period fixed assets rose from $929.5 million to $1,000 million, an increase of $70.5 million. Finally, the income statement in Table 29.3 shows that Executive Paper distributed $43.8 million as dividends. Thus, in total, Executive Paper invested or paid out as dividends 38.5 ϩ 70.5 ϩ 43.8 ϭ $152.8 million. Where did the funds come from? There are two sources—the cash generated from operations and new money raised from investors: The income statement shows that in 1999 the company generated $127.8 million from operations. This included $53.3 million of depreciation (remember deprecia- tion is not a cash outflow) and $74.5 million of net income. This left a deficiency of million that Executive Paper needed to raise from the capital market. You can see from the balance sheet that Executive Paper raised this $25 mil- lion by an issue of long-term debt (debt increased from $425 million to $450 mil- lion). Executive Paper did not issue new equity capital in 1999. So why does the balance sheet show an increase in equity of million? The an- swer is that this increase in equity came from income that the company retained and plowed back on behalf of its shareholders .Ϫ dividends ϭ 74.5 Ϫ 43.8 ϭ $30.7 million2 1retained earnings ϭ net income 540 Ϫ 509.3 ϭ $30.7 152.8 Ϫ 127.8 ϭ $25 ϩ new issues of equity Total sources of funds ϭ operating cash flow ϩ new issues of long-term debt 900 Ϫ 460 ϭ $440 848 Ϫ 446.5 ϭ $401.5 in fixed assets ϩ dividends paid to shareholders Total uses of funds ϭ investment in net working capital ϩ investment 822 PART IX Financial Planning and Short-Term Management 29.3 MEASURING EXECUTIVE PAPER’S FINANCIAL CONDITION Executive Paper’s financial statements provide you with the basic information to assess its current financial standing. However, financial statements typically con- tain large amounts of data—far more than is contained in the simplified statements for Executive Paper. To condense these data into a convenient form, financial man- agers generally focus on a few key financial ratios. Table 29.5 summarizes the key financial ratios for Executive Paper. 5 We will explain how to calculate these ratios and use them to shed light on five questions: • How much has the company borrowed? Is the amount of debt likely to result in financial distress? • How liquid is the company? Can it easily lay its hands on cash if needed? 5 In addition to the ratios that we describe below, Table 29.5 includes a few other ratios that you may well encounter. Some are simply alternative ways to express the same result; others are variations on a theme. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 • How productively is the company using its assets? Are there any signs that the assets are not being used efficiently? • How profitable is the company? • How highly is the firm valued by investors? Are investors’ expectations reasonable? CHAPTER 29 Financial Analysis and Planning 823 Executive Paper Paper Industry † Leverage Ratios: Debt ratio (Long-term debt ϩ leases)/(long-term .45 .53 debt ϩ leases ϩ equity) Debt ratio (including (Long-term debt ϩ short-term debt .50 .56 short-term debt)* ϩ leases)/(long-term debt ϩ short-term debt ϩ leases ϩ equity) Debt–equity ratio (Long-term debt ϩ leases)/equity .83 1.12 Times-interest-earned (EBIT ϩ depreciation)/interest 5.2 2.9 Liquidity Ratios: Net-working-capital- (Current assets Ϫ current liabilities)/total assets .30 .06 to-total assets* Current ratio Current assets/current liabilities 2.0 1.3 Quick ratio (Cash ϩ short-term securities ϩ receivables)/ 1.2 .7 current liabilities Cash ratio (Cash ϩ short-term securities)/current liabilities .2 .1 Interval measure* (Cash ϩ short-term securities ϩ receivables)/ 101.4 61.7 (costs from operations/365) Efficiency Ratios: Sales-to-assets ratio Sales/average total assets 1.55 .90 Sales-to-net-working- Sales/average net working capital 5.2 14.1 capital* Days in inventory Average inventory/(cost of goods sold/365) 63.6 59.1 Inventory turnover* Cost of goods sold/average inventory 5.7 6.2 Average collection Average receivables/(sales/365) 72.4 45.9 period (days) Receivables turnover* Sales/average receivables 5.0 8.0 Profitability Ratios: Net profit margin (EBIT Ϫ tax)/sales 5.3% Ϫ0.5% Return on assets (ROA) (EBIT Ϫ tax)/average total assets 8.3% Ϫ0.4% Return on equity (ROE) Earnings available for common stockholders/ 14.2% Ϫ10.3% average equity Payout ratio Dividend per share/earnings per share .6 n.a. Market-Value Ratios: Price–earnings ratio (P/E) Stock price/earnings per share 9.5 n.a Dividend yield Dividend per share/stock price 6.2% 1.8% Market-to-book ratio Stock price/book value per share 1.3 3.6 TABLE 29.5 Financial ratios for Executive Paper and the paper industry, 1999. *This ratio is an extra bonus not discussed in Section 29.2. † 1999 ratios for U.S. paper and allied products. Source: Compustat. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 When you calculate a company’s financial ratios, you need some criteria to decide whether they are a cause for concern or a matter for congratulation. Unfortunately, there is no “right” set of financial ratios to which all companies should aspire. Take, for example, the company’s capital structure. Debt has both advantages and dis- advantages, and, even if there were an optimal level of debt for company A, it would not be appropriate for company B. When managers review a company’s financial position, they often start by comparing the current year’s ratios with equivalent figures for earlier years. It is also helpful to look at how the company’s financial position measures up to that of other firms in the same industry. Therefore, in Table 29.5 we have compared the financial ratios of Executive Paper with those for the U.S. paper industry. 6 How Much Has Executive Paper Borrowed? When Executive Paper borrows, it promises to make a series of fixed payments. Be- cause its shareholders get only what is left over after the debtholders have been paid, the debt is said to create financial leverage. In extreme cases, if hard times come, a company may be unable to pay its debts. The company’s bankers and bondholders also want to make certain that Execu- tive Paper does not borrow excessively. So, if Executive wishes to take out a new loan, the lenders will scrutinize several measures of whether the company is bor- rowing too much and will demand that it keep its debt within reasonable bounds. Such borrowing limits are stated in terms of financial ratios. Debt Ratio Financial leverage is usually measured by the ratio of long-term debt to total long-term capital. Since long-term lease agreements also commit the firm to a series of fixed payments, it makes sense to include the value of lease obliga- tions with the long-term debt. For Executive Paper Another way to say the same thing is that Executive Paper has a debt-to-equity ra- tio of : Notice that this measure makes use of book (i.e., accounting) values rather than market values. 7 The market value of the company finally determines whether the debtholders get their money back, so you might expect analysts to look at ϭ 450/540 ϭ .83 Debt– equity ratio ϭ 1long-term debt ϩ value of leases2 equity 450/540 ϭ .83 ϭ 450/1450 ϩ 5402ϭ .45 Debt ratio ϭ 1long-term debt ϩ value of leases2 1long-term debt ϩ value of leases ϩ equity2 824 PART IX Financial Planning and Short-Term Management 6 Financial ratios for different industries are published by the U.S. Department of Commerce, Dun and Bradstreet, The Risk Management Association, and others. 7 In the case of leased assets accountants try to estimate the present value of the lease commitments. In the case of long-term debt they simply show the face value. This can sometimes be very different from present value. For example, the present value of low-coupon debt may be only a fraction of its face value. The difference between the book value of equity and its market value can be even more dramatic. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial Analysis and Planning © The McGraw−Hill Companies, 2003 the face amount of the debt as a proportion of the total market value of debt and equity. On the other hand, the market value includes the value of intangible as- sets generated by research and development, advertising, staff training, and so on. These assets are not readily salable, and if the company falls on hard times, their value may disappear altogether. For some purposes, it may be just as good to follow the accountant and ignore these intangible assets. This is what lenders do when they insist that the borrower should not allow the book debt ratio to exceed a specified limit. Debt ratios are sometimes defined in other ways. For example, analysts may in- clude short-term debt or other obligations such as payables. There is a general point here. There are a variety of ways to define most financial ratios and there is no law stating how they should be defined. So be warned: Don’t accept a ratio at face value without understanding how it has been calculated. Times-Interest-Earned (or Interest Cover) Another measure of financial leverage is the extent to which interest is covered by earnings before interest and taxes (EBIT) plus depreciation. For Executive Paper, 8 The regular interest payment is a hurdle that companies must keep jumping if they are to avoid default. The times-interest-earned ratio measures how much clear air there is between hurdle and hurdler. Is Executive Paper’s borrowing in the ballpark of standard practice or is it a mat- ter for concern? Table 29.5 provides some clues. You can see that the debt ratio is slightly lower than that of the rest of the paper industry and the times-interest- earned is significantly higher than that of most companies. How Liquid Is Executive Paper? If Executive Paper is borrowing for a short period or has some large bills coming up for payment, you want to make sure that it can lay its hands on the cash when it is needed. The company’s bankers and suppliers also need to keep an eye on Ex- ecutive’s liquidity. They know that illiquid firms are more likely to fail and default on their debts. Another reason that analysts focus on liquid assets is that the figures are often more reliable. The book value of Executive’s newsprint mill may be a poor guide to its true value, but at least you know what its cash in the bank is worth. Liquid- ity ratios also have some less desirable characteristics. Because short-term assets and liabilities are easily changed, measures of liquidity can rapidly become out-of- date. You may not know what that newsprint mill is worth, but you can be fairly sure that it won’t disappear overnight. ϭ 1166.7 ϩ 53.32 42.5 ϭ 5.2 Times-interest-earned ϭ 1EBIT ϩ depreciation2 interest CHAPTER 29 Financial Analysis and Planning 825 8 The numerator of times-interest-earned can be defined in several ways. Sometimes depreciation is ex- cluded. Sometimes it is just earnings plus interest, that is, earnings before interest but after tax. This last definition seems nutty to us, because the point of interest earned is to assess the risk that the firm won’t have enough money to pay interest. If EBIT falls below interest obligations, the firm won’t have to worry about taxes. Interest is paid before the firm pays taxes. [...]... 1985) Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX Financial Planning and Short−Term Management © The McGraw−Hill Companies, 2003 29 Financial Analysis and Planning 833 CHAPTER 29 Financial Analysis and Planning 1999 Revenues Costs (90% of revenues) Depreciation (10% of fixed assets at start of year) EBIT Interest (10% of long-term debt at start of year) Tax (40% of pretax profit)... the future Sales-to-Assets (or Asset Turnover) Ratio The sales-to-assets ratio shows how hard the firm’s assets are being put to use: 2, 200 Sales ϭ ϭ 1.55 average total assets 11, 380.8 ϩ 1, 4502/2 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX Financial Planning and Short−Term Management 29 Financial Analysis and Planning © The McGraw−Hill Companies, 2003 CHAPTER 29 Financial Analysis... $53, and variable costs, at 80 percent of revenue The company’s policy is to pay out two-thirds of net income as dividends and to maintain a book debt ratio of 20 percent Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX Financial Planning and Short−Term Management © The McGraw−Hill Companies, 2003 29 Financial Analysis and Planning CHAPTER 29 Financial Analysis and Planning TA B... but five of the following ratios make no sense at all Substitute the correct definitions a Debt–equity ratio ϭ (long-term debt ϩ value of leases)/(long-term debt ϩ value of leases ϩ equity) b Return on equity ϭ (EBIT Ϫ tax)/average equity QUIZ Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 840 PART IX IX Financial Planning and Short−Term Management Financial Planning and Short-Term Management... Debt–equity ratio: a shipping company or a computer software company b Payout ratio: United Foods Inc or Computer Graphics Inc Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX Financial Planning and Short−Term Management 29 Financial Analysis and Planning © The McGraw−Hill Companies, 2003 CHAPTER 29 Financial Analysis and Planning 841 c Sales-to-assets ratio: an integrated pulp and paper... assets is fixed by competition, firms face a trade-off between the sales-to-assets ratio and the profit margin For example, fast-food chains, which turn over their capital frequently, also tend to operate on low profit margins Classy hotels have relatively high margins, but this is offset by lower sales-to-assets ratios Firms often seek to increase their profit margins by becoming more vertically integrated;... costs of removal of an oil pipeline and environmental restoration of the pipeline route There are many ways to calculate a debt ratio for Geomorph Suppose you are evaluating the safety of Geomorph’s debt and want a debt ratio for comparison with the ratios of other companies in the same industry Would you calculate the ratio in terms of Brealey−Meyers: Principles of Corporate Finance, Seventh Edition. .. 2003 29 Financial Analysis and Planning PART IX Financial Planning and Short-Term Management How Profitable Is Executive Paper? Net Profit Margin If you want to know the proportion of sales that finds its way into profits, you look at the profit margin Thus10 Net profit margin ϭ 1EBIT Ϫ tax2 ϭ 053, or 5.3% sales Return on Assets (ROA) Managers often measure the performance of the firm by the ratio of. .. Times-interest-earned c Current ratio d Quick ratio e Net profit margin f Days in inventory Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX Financial Planning and Short−Term Management © The McGraw−Hill Companies, 2003 29 Financial Analysis and Planning CHAPTER 29 Financial Analysis and Planning 843 g Return on equity h Payout ratio 3 Select a sample of companies with financial statements on the... earnings, the debtto-equity ratio declines and the internal growth rate increases 837 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 838 PART IX IX Financial Planning and Short−Term Management 29 Financial Analysis and Planning © The McGraw−Hill Companies, 2003 Financial Planning and Short-Term Management For Executive Paper, Sustainable growth rate ϭ 40 ϫ 1822 ϭ 0 729, or 7 .29% We first . ϭ dividends earnings ϭ 43.8 74.5 ϭ .6 CHAPTER 29 Financial Analysis and Planning 829 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial. balance by bor- rowing or by the sale of additional shares. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 29. Financial. number of shares (millions) 14.16 14.16 Share price ($) 42.25 50.00 TABLE 29. 2 The balance sheet of Executive Paper Corporation (figures in $ millions). Brealey−Meyers: Principles of Corporate Finance,