Financial Planning and the Management of Working Capital

Financial Planning and the Management of Working Capital Topics Covered • Financial Statements • Financial Planning • Growth and External Financing Ex: Executive Paper Corporation • Assess the financial strength of the EPC • Who cares? EPC’s Balance Sheet: Assets (LHS) Dec-01 Assets Current Assets: Cash & Securities Receivables Inventory Total Fixed Assets: P, P, E accum Depr Net Fixed Assets Total Assets Dec-02 diff 75 433.1 339.9 848 110 440 350 900 35 6.9 10.1 52 929.5 396.7 532.8 1,380.80 1000 450 550 1,450.00 70.5 53.3 17.2 69.2 EPC’s Balance Sheet: Liabilities (RHS) Dec-01 Liabilities and Equity Current Liabilities Debt due in 1 year Payable Total current liabilities Long term debt Shareholders equity Total liabilities and equity Dec-02 diff 96.6 349.9 446.5 425.0 509.3 1,380.8 100.0 360.0 460.0 450.0 540.0 1,450.0 3.4 10.1 13.5 25.0 30.7 69.2 Balance Sheet Measures • Net Working Capital (in 2002) = current assets – current liabilities • Company’s Equity (in 2002) = NWC + FA – long-term liab EPC’s Income Statement Revenues Costs Depreciation EBIT Interest Tax Net income Dividend Retained earnings Earnings per share, dollars Dividend per share, dollars $ millions 2,200.00 1,980.00 53.30 166.70 42.50 49.70 74.50 43.80 30.70 5.26 3.09 EPC’s Sources and Uses of Funds Uses: Increase in net working capital Investment Dividends Total uses Sources: Net Income Depreciation Operating cash flow Borrowing Stock issues Total sources 38.50 70.50 43.80 152.80 $ millions 74.50 53.30 127.80 25.00 152.80 Measuring Financial Condition 1. How much money has the company borrowed? 2. How liquid is the company? 3. How productively is the company using its assets? 4. How profitable is the company? 5. How highly is the firm valued by its investors? Amount Borrowed Leverage Ratios long term debt Long term debt ratio = long term debt + equity total liabilities Total debt ratio = total assets long term debt + value of leases Debt Equity ratio = equity Amount Borrowed Coverage Ratios EBIT + depreciati on Times Interest Earned = interest payments Liquidity Ratios current assets Currentratio = currentliabilities Net working capital to total assets ratio Net working capital = Total assets Liquidity Ratios cash + marketable securities+ receivables Quick ratio = currentliabilities cash + marketable securities Cash ratio = currentliabilities cash + marketable securities + receivable s Interval measure = average daily expenditur es from operations Productivity/Efficiency Ratios Sales Asset turnover ratio = Average total assets sales NWC turnover = average net working capital Efficiency Ratios average inventory Days' sales in inventory = cost of goods sold/365 cost of goods sold Inventory turnover ratio = average inventory average receivable s Average collection period = average daily sales Profitability Ratios EBIT - tax Net profit margin = sales EBIT - tax Return on assets = average total assets earnings available for common stock Return on equity = average equity Profitability Ratios dividends Payout ratio = earnings earnings- dividends Plowback ratio = earnings = 1- payout ratio Market Value Ratios stock price PE Ratio = earnings per share dividend per share Dividend yield = stock price stock price Market to book ratio = book value per share The DuPont System • A breakdown of ROE and ROA into component ratios EBIT - taxes ROA = assets EBIT - tax - interest ROE = equity The DuPont System sales EBIT - taxes ROA = x assets sales The DuPont System assets sales EBIT - taxes EBIT - taxes - interest ROE = x x x equity assets sales EBIT - taxes Financial Forecasting Financial Planning Model • Suppose that the company management’s analysis of the industry leads it to forecast 10% annual growth in EPC’s sales and profits over the next 5 years. • Can the company realistically expect to finance its growth out of retained earnings and borrowing? • Should the company plan to issue equity? Financial Planning Model- Step 1 Executive Paper - Latest & Proforma Income Statements 2002 2,200.0 1,980.0 53.3 166.7 42.5 49.7 74.5 127.8 2003 2,640.0 2,376.0 55.0 209.0 45.0 65.6 98.4 153.4 2007 5,474.0 4,927.0 114.0 433.4 131.3 120.8 181.2 295.3 Revenue Costs (90% of revenue) Depreciation (10% of fixed assets) EBIT Interest (10% of LT debt) Tax (40% of pretax profit) Net Income Operating cash flow Financial Planning Model- Step 2 Executive Paper - Latest & Proforma Statemet of Cash Flows 2002 38.5 70.5 44.7 152.8 2003 88 165 59 312 2007 182.5 342.1 108.7 633.4 Increase in NWC (NWC=20% of revenues) Invetment in fixed assets (FA=25% of revenues) Dividends (60% of net income) Total uses of funds Financial Planning Model- Step 3 Executive Paper - Latest & Proforma Statemet of Cash Flows 2002 38.5 70.5 44.7 2003 88 165 59 2007 182.5 342.1 108.7 Increase in NWC (NWC=20% of revenues) Invetment in fixed assets (FA=25% of revenues) Dividends (60% of net income) Financial Planning Model- Step 4 Executive Paper - Latest & Proforma Balance Sheets 2002 440.0 550.0 990.0 450.0 540.0 990.0 2003 528.0 660.0 1,188.0 608.6 579.4 1,188.0 2007 1,095.0 1,369.0 2,463.0 1,651.0 812.0 2,463.0 Net working capital (20% of revenues) Net fixed assets (25% of revenues) Total net assets Long-term debt Equity Total long-term liabilities and equity Downtown Bakery • Andy just started selling his homemade pastries to local restaurants. He made a small initial investment but has big plans. • How much financing will be needed to sustain his growth? • How should he choose the proper financing? Bakery’s Income Statement : Year 0 Income Statement Sales Costs EBIT Interest EBT Taxes Net Income Dividends To Retained Earnings Year 0 $5,000 -$3,000 $2,000 -$200 $1,800 -$900 $900 $400 $500 Percent 100% 60% Item Sales Sales 50% 18% 44% EBT Sales NI Bakery’s Balance Sheet: Year 0 Assets Cash Receivables Inventory Fixed Assets Total Assets Year 0 $200 $1,500 $3,300 $2,000 $7,000 Percent 0.04 0.30 0.66 0.40 1.40 Item Sales Sales Sales Sales Sales Bakery’s Balance Sheet: Year 0 Liabilities & Equity Accounts Payable Notes Payable Accruals Long-term Debt Common Stock Retained Earnings Total Liabilities & Equity Year 0 $500 $1,000 $500 $1,000 $800 $3,200 $7,000 Percent 0.10 0.10 Item Sales Sales Downtown Bakery’s Growth: Assumptions • He anticipates that over time his sales will increase 40% from $5,000 to $7,000. • He does not currently have any excess capacity and will need to increase fixed assets. • All of his assets will grow proportionately with sales growth. • Payables and accruals will grow proportionately with growth in sales. Downtown Bakery’s Growth: Assumptions • Despite growth the Bakery’s profit margin will remain at 18%. • Dividend payout will remain at 44.44%. • Cash, AR, and FA may be directly expressed as a percent of sales. • The firm will hold $1,000 of inventory plus additional inventory equal to 46% of sales. Financial Statement (1st Pass) Income Statement Sales Costs EBIT Interest EBT Taxes Net Income Dividends To Retained Earnings Year 0 $5,000 -$3,000 $2,000 -$200 $1,800 -$900 $900 $400 $500 Forecast Basis Year 1 Financial Statement (1st Pass) Assets Cash Receivables Inventory Fixed Assets Total Assets Year 0 $200 $1,500 $3,300 $2,000 $7,000 Forecast Basis* Year 1 *Total forecast basis = $1,000 + (.04 + .30 + .46 + .40)(Sales) *Total forecast basis = $1,000 + (1.2)(Sales) Financial Statement (1st Pass) Liabilities & Equity Accounts Payable Notes Payable Accruals Long-term Debt Common Stock Retained Earnings Total Liabilities & Equity *From forecasted income statement Year 0 $500 $1,000 $500 $1,000 $800 $3,200 $7,000 Forecast Basis Year 1 Other Factors to Consider • • • Analysis of the forecast Raising the additional funds needed Financing feedback effects Additional Assumptions • Additional funds needed will be raised in equal proportions of debt and equity. • Firm has $2,000 of debt (notes payable and long-term debt) at an interest rate of 10%. • New debt will have a rate of 12% • Firm has 200 shares outstanding. • Dividends will be maintained at $2 per share. • Firm will be able to sell new shares at a net price of $27.50 per share. Financial Statement (2nd Pass) • Debt financing assumptions: – Debt = $550 – New interest = 12% = $66 – Total interest = $266 • Stock financing assumptions: – Firm will issue 20 shares – Dividend = (220)($2) = $440 Financial Statement (2nd Pass) Income Statement Sales Costs EBIT Interest EBT Taxes Net Income Dividends To Retained Earnings W/O $7,000 -$4,200 $2,800 -$200 $2,600 -$1,300 $1,300 $400 $900 Forecast AFN With Financial Statement (2nd Pass) Assets Cash Receivables Inventory Fixed Assets Total Assets W/O $280 $2,100 $4,220 $2,800 $9,400 Forecast AFN With Financial Statement (2nd Pass) Liabilities & Equity Accounts Payable Notes Payable Accruals Long-term Debt Common Stock Retained Earnings Total Liabilities & Equity W/O $700 $1,000 $700 $1,000 $800 $4,100 $8,300 Forecast AFN With Financial Statement (3rd Pass) • Financing feedbacks still occur – Beginning AFN = – Debt = – Stock = – Ending AFN = • Spreadsheets can solve this sort of iterative problem Topics Covered • • • • Credit Management Inventory Management Cash Marketable Securities Working Capital Current assets and liabilities for U.S. manufacturing firms (4th qtr. 2003)…$ billions Currenty Assets Cash Other shirt-term financial investments Accounts receivable Inventories Other current asets Total 203 138 470 455 264 1530 Current Liabilities Short-term loans Accounts payable Accrued income taxes Current payments due on longterm debt Other current liabilities Total 132 356 67 83 575 1214 Net working capital (current assets-current liabilities) = $1530-1214=$316 billion. Working Capital • Net Working Capital – • Cash Conversion Cycle – • Carrying Costs – • Shortage Costs – Terms of Sale • Terms of Sale – Example - 5/10 net 30 510 net 30 - Terms of Sale • A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. • We can calculate the implicit cost of this loan Effective annual rate = 1 + ( discount discounted price ) 365 / extra days credit - 1 Terms of Sale Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? Credit Agreements • Terminology – – – – – – – – – open account promissory note commercial draft sight draft time draft trade acceptance banker’s acceptance irrevocable letter of credit conditional sale Credit Analysis Numerical Credit Scoring categories – Character – Capacity – Capital – Collateral – Condition The Credit Decision The credit decision and its probable payoffs Offer credit Refuse credit The Credit Decision • Based on the probability of payoffs, the expected profit can be expressed as: The break even probability of collection is: Collection Policy Sample aging schedule for accounts receivable Customer's Less than More than 1- 2 months 2 - 3 months Total Owed Name 1 month 3 months A B * * * 10,000 8,000 * * * 0 3,000 * * * 4,000 $40,000 0 0 * * * 6,000 $15,000 0 0 * * * 15,000 $43,000 10,000 11,000 * * * 30,000 $298,000 Z 5,000 Total $200,000 Inventory Management • Components of Inventory – Raw materials – Work in process – Finished goods • Goal = Minimize amount of cash tied up in inventory • Tools used to minimize inventory – Just-in-time – Lean manufacturing Cash • Cash does not pay interest – Move money from cash accounts into short term securities – “Sweep programs” – MMDAs – Concentration banking – Lock-box system Cash How purchases are paid. Percentage of total by payment type for 2002. 100% 80% 60% 40% 20% 0% Direct debits Credit transfers Credit/debit cards Checks UK Canada Germany Netherlands Switzerland Sweden France USA Italy Cash • Electronic Funds Transfer (EFT) • Automated Clearinghouse (ACH) – • International cash management • Compensating balances Marketable Securities Microsoft 2003 cash investments Investment Commercial paper US Govt and agency securities Municipal securities Certificates of deposit Money market mutual funds Foreign govt bonds Corporate notes and bonds Mortgage backed securities Total Amount $0.9 billion 7.3 9.3 0.3 1.3 5.1 16.9 6.3 49.0 $ billion 100 150 200 250 300 50 0 Cd s and time deposits Money-market funds Commercial paper Repos Treasury securities Agency securities Tax-exempt Short Term Assets Short term assets held by US non-financial corporations (1st quarter 2004) Topics Covered • Links Between Long-Term and Short-Term Financing Decisions • Tracing Changes in Cash and Working Capital • Cash Budgeting • A Short-Term Financing Plan • Sources of Short Term Borrowing Firm’s Cumulative Capital Requirement Dollars A B C Cumulative capital requirement Year 1 Year 2 Time Lines A, B, and C show alternative amounts of long-term finance. LA Gear Profit & Assets Sales, income and assets of L.A.Gear 1989-1996 (figures in $ millions) 1989 1990 1991 1992 1993 Sales 617 820 619 430 398 Net income 55 31 -66 -72 -33 Cash & securities Receivables Inventory Current assets Total assets 0 101 140 257 267 3 156 161 338 364 1 112 141 297 326 84 56 62 230 250 28 73 110 220 225 1994 416 -22 50 77 58 194 225 1995 297 -51 36 47 52 138 160 1996 196 -62 34 24 33 93 101 LA Gear Debt & Equity Figures in $millions Bank debt Long-term debt Preffered stock Common equity 1989 37 0 0 168 1990 94 0 0 206 1991 20 0 100 132 1992 0 0 100 88 1993 4 50 100 47 1994 1 50 100 18 1995 1 50 108 -41 1996 0 50 116 -111 Working Capital Simple Cycle of operations Cash Receivables Raw materials inventory Finished goods inventory Changes in Cash & W.C. Example - Dynamic Mattress Company Assets Current Assets Cash Mark Securities Inventory AcctsRecv Total Curr Assets Fixed Assets Gross investment less Depr Net Fixed Assets Total Assets 2003 4 4 0 26 25 55 56 16 40 95 2004 5 5 5 25 30 65 70 20 50 115 Total Liab and owner's equity 95 115 Liabilitie s & Equity Current Liabilitie s Bank Loans AcctsPayable Total Curr Liab Long Term Debt Net Worth 2003 5 20 25 5 65 2004 0 27 27 12 76 Changes in Cash & W.C. Example - Dynamic Mattress Company Income Statement Sales $350 Operating Costs 321 Depreciation EBIT Interest Pretax income . Tax at 50% Net Income 4 25 1 24 12 $12 Assume dividend = $1 mil R.E.=$11 mil Changes in Cash & W.C. Example – Dynamic Mattress Company Sources Issued long term debt Reduced inventorie s Increased accounts payable Cash from operations Net income Depreciati on Total Sources Uses Repaid short term bank loan Invested in fixed assets Purchased marketable securities Increased accounts receivable Dividend Total Uses Increase in cash balance 7 1 7 12 4 $31 5 14 5 5 1 $30 $1 Changes in Cash & W.C. Example - Dynamic Mattress Company Dynamic used cash as follows • Paid $1 mil dividend. • Repaid $5 mil short term bank loan • Invested $14 mil • Purchased $5 mil of marketable securities • Accounts receivable expanded by $5 mil Changes in Cash & W.C. Example - Dynamic Mattress Company Condensed Balance Sheet 2003 30 56 -16 40 70 5 65 70 2004 38 70 -20 50 88 12 76 88 Net working capital Fixed assets: Gross investment Less depreciation Net fixed assets Total net assets Long-term debt Net worth (equity and retained earnings) Long-term liabilities and net worth Changes in Cash & W.C. Example - Dynamic Mattress Company Condensed Balance Sheet Sources: Issued long-term debt Cash from operations: Net income Depreciation 7 12 4 23 Uses: Invested in fixed assets Dividend 14 1 15 8 Increase in net working capital Cash Budgeting Steps to preparing a cash budget Step 1 - Forecast the sources of cash. Step 2 - Forecast uses of cash. Step 3 - Calculate whether the firm is facing a cash shortage or surplus. Cash Budgeting Example - Dynamic Mattress Company Dynamic forecasted sources of cash Quarter Sales, $mil 1st 2nd 3rd 4th 87.50 78.50 116.00 131.00 AR ending balance = AR beginning balance + sales collections Cash Budgeting Example - Dynamic Mattress Company Dynamic collections on AR Qtr 1st 1. Beginning receivables 2. Sales 3. Collections . Sales in current Qtr (80%) . Sales in previous Qtr (20%) Total collections 4. Receivables at end of period . (4 = 1 + 2 - 3) $32.5 $30.7 $38.2 $41.2 70 15.0 85.0 62.8 17.5 80.3 92.8 15.7 108.5 104.8 23.2 128.0 30.0 87.5 2nd 32.5 78.5 3rd 30.7 116.0 4th 38.2 131.0 Cash Budgeting Example - Dynamic Mattress Company Dynamic forecasted uses of cash • Payment of accounts payable • Labor, administration, and other expenses • Capital expenditures • Taxes, interest, and dividend payments Cash Budgeting Example - Dynamic Mattress Company Dynamic cash budget Qtr 1st Sourcesof cash collections on AR other Total Sources Uses of cash payment of AP labor and admin expenses capital expenditures taxes interest, & dividends , Total uses of cash Net cash inflow (sourcesminus uses) 65.0 30.0 32.5 4.0 131.5 $46.5 60.0 30.0 1.3 4.0 95.3 $15.0 55.0 30.0 5.5 4.5 95.0 50.0 30.0 8.0 5.0 93.0 85.0 0.0 85.0 80.3 0.0 80.3 108.5 128.0 12.5 0.0 121.0 128.0 2nd 3rd 4th $26.0 $35.0 Cash Budgeting Example - Dynamic Mattress Company Dynamic short term financing requirements Cash at start of period + Net cash flow = Cash at end of period Min operating cash balance 5 - 41.5 - 56.5 + 26 - 30.5 5 $35.5 - 30.5 + 35 + 4.5 5 $.5 - 46.5 - 15 - 41.5 - 56.5 5 5 Cumulative short termfinancing $46.5 $61.5 required (minimum cash balance minus caash at end of period) A Short Term Financing Plan Example - Dynamic Mattress Company Dynamic forecasted deferrable expenses Quarter 1st 2nd 3rd 4th Amount Deferrable, $mil 52 48 44 40 A Short Term Financing Plan Example – Dynamic Mattress CompanyFinancing Plan 1st New borrowing 1. Bank loan 2. Stretching payables 3. Total Repayments 4. Bank loan 5. Stetched payables 6. Total 7. Net new borrowing 8. Plus securities sold 9. Less securities bought 10. Total cash raised Interest payments: 11. Bank loan 12. Stretching payables 13. Interest on securities sold 14. Net interest paid 2nd 3rd 0.0 0.0 0.0 4th 0.0 0.0 0.0 33.7 0.0 33.7 -33.7 0.0 0.4 -34.1 0.8 0.0 0.1 0.9 38.0 0.0 3.5 19.7 41.5 19.7 0.0 0.0 4.3 0.0 3.6 19.7 0.0 3.5 24.0 41.5 16.2 -24.0 5.0 0.0 0.0 0.0 0.0 0.0 46.5 16.2 -24.0 0.0 0.0 0.0 0.0 1.0 0.2 0.1 1.2 1.0 1.0 0.1 2.0 16. Cash required for operations 46.5 15.0 -26.0 -35.0 17. Total cash required 46.5 16.2 -24.0 -34.1 Sources of Short Term Borrowing • Bank loans – – – – – – • Commercial paper • Medium term notes