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

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 C H A P T E R T W E N T Y - N I N E F I N A N C I A L ANALYSIS AND P L A N N I N G 816 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. 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 817 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 818 PART IX Financial Planning and Short-Term Management 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. Astudy 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. 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. Country Sweden United Kingdom United States France Hong Kong Switzerland Japan Germany South Korea Mexico India Peru Egypt Legal Tradition Rating Scandinavian 83 English 78 English 71 French 69 English 69 German 68 German 65 German 62 German 62 French 60 English 57 French 38 French 24 1See 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. 2LaPorta et al., “Law and Finance,” Journal of Political Economy 106 (December 1998), pp. 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 CHAPTER 29 Financial Analysis and Planning 819 29.2 EXECUTIVE PAPER’S FINANCIAL STATEMENTS 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 currentcondition. 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 Assets Current assets: Cash & securities Receivables Inventory Total current assets Fixed assets: Property, plant, and equipment Less accumulated depreciation Net fixed assets Total assets Liabilities and Shareholders’ Equity Current liabilities: Debt due within 1 year Payables Total current liabilities Long-term debt Shareholders’ equity Total liabilities & shareholders’ equity Other financial information: Market value of equity Average number of shares (millions) Share price ($) Dec 1998 75 433.1 339.9 848 929.5 396.7 532.8 1,380.8 Dec 1998 96.6 349.9 446.5 425 509.3 1,380.8 598 14.16 42.25 Dec 1999 Change 110 35 440 6.9 350 10.1 900 52 1,000 70.5 450 53.3 550 17.2 1,450 69.2 Dec 1999 Change 100 3.4 360 10.1 460 13.5 450 25 540 30.7 1,450 69.2 708 14.16 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 820 PART IX Financial Planning and Short-Term Management 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 liabilitiesinclude 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 Net working capital current assets current liabilities 900 460 $440 million 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 3The 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. ... - tailieumienphi.vn