Financial Analysis for Strategic Management Seminar
Rex C. Mitchell, Ph.D.

You can not hope to do strategic management work for an organization without understanding its financial condition, which requires analysis of the financial data available. You need to do financial analysis as part of your diagnosis. Your analysis and conclusions will be useful also when you proceed to formulation and implementation. However, don't panic, you do not need sophisticated, esoteric skills in financial analysis for this course, or even most applied strategic management.

There are two main aspects of financial analysis for strategic management: historical and future. Each requires some modest calculations plus, most importantly, comparisons and thought to develop conclusions from your numbers.

HISTORICAL ANALYSIS

For cases, you start with the financial data provided, usually balance sheets and income statements for several years. You can learn some things by inspection, e.g., general trends. Pay particular attention to trends in sales, COGS (cost of goods sold), net profits, liabilities, shareholder equity, and total assets. It can be useful to convert the statements to common size statements by expressing the entries in the income statements as percentages of sales and the entries in the balance sheets as percentages of total assets; this makes it much easier to identify trends and compare with competitors.

Next, you should do some ratio analysis, looking at some of the key ratios in each of the four main categories (profitability, leverage, liquidity, activity) plus a few other ratios - all over several years. You should understand why it is important to look at each of these types of ratios (specifically, the first four). Ratios provide additional insight about trends in the financial condition of the company. Which ratios you choose may vary somewhat, depending on your preferences and, especially, what competitor/industry financial data you have for comparison. For the class, usually 1-2 ratios for each category will be sufficient. Here are some ratios I often like to consider:

1. Profitability Ratios:
All organizations should care about profits or the equivalent. Even non-profits must maintain a stable balance between revenue and costs, often setting goals to increase their reserves. Average profitability levels vary widely for different industries. In a good year, the average net profit margin for all U.S. manufacturing firms is in the range of 5 percent and the average ROI is in the range of 15 percent.

1. net profit margin: widely used for comparisons, shows ability of a firm to keep its costs in line with its selling prices (calculation: net profit after taxes/sales)
2. return on stockholders' equity (ROE): commonly used as a general indicator of return on the book value of shareholders' investment; not appropriate for comparing high-leverage firms with low-leverage firms; watch out for different definitions of "equity" (net profit after taxes/shareholders' equity {which is sometimes called "net worth" or "book value"})
3. return on investment (also "return on total assets") (ROI): another, more comprehensive measure of return on investment, showing the return on all the assets under the control of management, regardless of source of financing (net profit after taxes/total assets)

2. Leverage Ratios
Leverage refers to the use of debt in a firm's capital structure. A highly leveraged firm will have a large amount of debt relative to stockholders' equity. Higher leverage increases the potential return on equity during good times, but also increases the risk during bad times. Leverage is an important indicator of a firm's ability to obtain additional funds through debt financing.

1. debt to equity: measures the relative amount of financing from debt (creditors) to that from equity (owners); as a very rough guideline, should not exceed about 1.0 (total debt/shareholders' equity) {...sometimes you will find data for total liabilities/shareholders' equity}
2. debt to assets: an alternative to #a; usually pick #a or this (#b) depending on comparative data available (total debt/total assets)
3. times interest earned: indicator of ability to meet interest payments; especially important for highly leveraged firms (profit before interest and taxes/interest expense)

3. Liquidity Ratios
This indicates the ability of a firm to meet its short-term financial obligations. Excessively low ratios indicate problems. Excessively high ratios indicate the firm is over-conservative in using its current assets wisely.

1. current ratio: shows the firm's ability to pay its short-term liabilities from its short- term assets (current assets/current liabilities)
2. quick or acid test ratio: shows the firm's ability to pay its short-term liabilities from highly liquid assets, omitting inventories, which may require time and deep discounts to liquidate (the usual definition is [current assets - inventories]/current liabilities) and I won't mark it wrong it you use it. However, since this can include prepaid expenses and other current assets, which are generally considered to be even less liquid than inventory, it is better to define quick ratio as ([cash+marketable securities+accounts receivable]/current liabilities)

4. Activity Ratios
These are various indicators of how efficiently a firm is using its assets in its operations.

1. inventory turnover: indicates how efficiently a firm is controlling its inventories; however, very high inventory turnover ratios (very low inventories) can produce "opportunity losses" in sales; "good" ranges for this ratio vary widely between industries and market conditions (sales/inventory) [...notes: (a) an alternative is to look at COGS/inventory, (b) probably should focus on finished goods inventory, (c) if available, use average inventory]
2. asset turnover: indicates how effective a firm is in generating sales with its assets; this ratio will vary with the capital intensity of each industry and firm (sales/total assets)
3. Average collection period or accounts receivable turnover ratio: indicates how quickly, in days, a firm is collecting on its credit sales; depends on firm and industry - best to compare firm with industry and trends over time ( [365 x accounts receivable]/sales)

5. "Other" Ratios
If you have data, there are other ratios of interest, including the following.

1. dividend payout: how much of net profits are paid out as dividends; younger and/or fast-growing firms typically pay no dividends; this ratio may vary when earnings do, as firms try to avoid reductions in dividends/share (dividends/net profit after taxes)
2. price/earnings indicates the investor market's evaluation of a stock's worth relative to its earnings (market price per share/earnings per share)

Sometimes it is useful to use Altman's Bankruptcy Formula (see W&H last chapter) in addition to the main analysis outlined above. Note that the text has an error in this formula (i.e., the coefficients as given are for all five variables as ratios, not as percentages). The equation and definitions should be:

 Z = 1.2a + 1.4b + 3.3c + 0.6d + 1.0e
where:
a = working capital/total assets (this and all five variables as ratios)
b = cumulative retained earnings/total assets
c = earnings before interest & taxes (EBIT)/total assets
d = market value of equity/total liabilities
e = sales/total assets

Scores below 1.8 indicate significant credit/stability problems; scores above 3.0 indicate a healthy firm. Scores between 1.8 and 3.0 are in a grey area with question marks.

Now, What Do I Do With All These Numbers?

After computing selected ratios for the last several years, you need to do two things to extract meaning and conclusions from the ratios: (a) look at the trends over time, and (b) compare them with ratios from key competitors or industry averages. It is absolutely vital to go beyond computing ratios to look at the trends and compare both their ratios and the trends with those for typical competitors or industry averages during the same time periods. There are many sources of comparative information, both in the library and on the internet (see the Sources for Financial Data module plus the appendix in H&W for suggestions). It is necessary to make such comparisons to derive meaning from the numbers; otherwise, you have wasted your time. You need to reach and state a conclusion about the company's overall financial health, plus specifics - looking for significant strengths and/or weaknesses. Where there is a weakness or something seems off, dig deeper. This is important both in understanding where the company is, and later, in adding realism to your formulation and implementation. Such comparisons and conclusions can help you understand:

• the firm's position in its industry
• the degree to which strategic objectives are being accomplished
• the firm's vulnerability to decreases in revenue
• the risk of corporate failure
• the firm's ability to react to unforseen changes in the environment
• the future borrowing power and growth potential
• the feasibility of potential strategy initiatives

FUTURE ANALYSIS

After analysis of the historical financial data, it also is important to look at the future, primarily to estimate needs and potential ability to raise strategic funds. This section outlines two ways to look at this issue: formulas for estimating sustainable growth, and forecast models.

Formulas for Estimating Sustainable Growth/

There is a variety of such formulas in the literature, giving sometimes quite different estimates. Here are four from which you can choose: (1) Index of sustainable growth (W&H, section 11.4) rewritten slightly:

 g = 100ra(1 + L)/[A - ra(1 + L)]

(2) A second approach (Higgins, Analysis for Financial Management, 1992, p.119) is to maintain that a company's sustainable growth rate is nothing more than its growth rate in owners' equity:

 g = 100rb

(3) The Boston Consulting Group starts with the premise that the rate of growth is equal to the firm's return on equity, corrected for dividends paid:

 g = 100r[L(c - i) + c]

(4) A similar equation is given by Rowe, et al. (Strategic Management, 1994, p.375), explaining that a company's sustainable growth rate is limited by (a) the rate at which it can generate the funds necessary to achieve its growth targets and (b) the return it can expect to earn on these funds:

 g = 100r[L(d - i) + d]

where:
g = the maximum sustainable growth rate (%) without external capital or changes in the current financial performance
A = total assets/sales [note: this & all following variables are as decimals, not percentages)
a = earnings before taxes/sales
b = net profit (after interest and taxes)/shareholders' equity (same as net worth or book value)
c = profit before taxes/total assets
d = profit before interest and taxes (EBIT)/total assets
i = average interest rate on total debt (as a decimal, not %)
L = total liabilities/shareholders' equity
r = earnings retention rate = 1 - dividends/net profit

Example of a Simple Strategic Cash Flow Forecast Model

A different way to gain perspective on a company's need to raise additional funds for strategic growth is to construct a model. Even a very simple one, such as that illustrated below, can provide an indication of a company's ability to support growth without additional sources of capital. The example projects future cash flows or sources and uses for strategic funds for the Maytag case over the five years following 1995. You could get much more sophisticated in modeling, with consideration of other accounts, nonlinear relationships, specific sales and capital plans, etc. You also can make use of a spreadsheet program to simplify the arithmetic and make it easy to consider various "what if" options.

This model considers five accounts, and makes assumptions that relate each to sales: sources are net earnings and depreciation; uses are dividends and increases in fixed assets (FA) and working capital (WC). The net requirement for additional strategic funds beyond what can be funded from operations in a particular year is:

 Increase from previous yr. in (FA + WC) + Dividends - Earnings - Depreciation

If the requirement for additional funds turns out to be negative, this means that a surplus of funds is available from operations.

Assumptions for this specific situation:

• FA (fixed assets)/sales = constant = 0.46 (equal to the mean for the last 4 yrs, 0.464, 0.432, 0.485, 0.456)
• WC (working capital)/sales = 0.178 (mean of last two years: 0.179, 0.177 ...previous two were 0.136, 0.149, so used two most recent years)
• Dividends/sales = 0.0184 (based on recent increase to \$0.14/sh-quarter on approx. 100 million sh. after repurchases)
• Net earnings/sales = 0.03 (has been -0.007, 0.044, 0.017, -0.10 ...so this is a positive guess)
• Depreciation/sales = 0.016 (mean of last four: 0.0011, 0.0210, 0.0248, 0.0172) - **note that you need to calculate depreciation booked in a given year from the difference in accumulated depreciation from the previous to the current year, as given in a balance sheet
• ...which is equivalent to assuming Depr./FA = constant
• Sales will increase at a rate of 2%/year (given flat history + mature USA industry at 1-2%/yr)

Forecast/projection (in \$millions):

 Actual Fcast 5-yr 1995 1996 1997 1998 1999 2000 Total Sales 3040 3101 3163 3226 3291 3356 Fixed assets 1412 1426 1455 1484 1514 1544 Working capital 543 552 563 574 586 597 Dividends 56 57 58 59 61 62 297 Net earnings (20.5) 93 95 97 99 101 485 Depreciation 3.3 50 51 52 53 54 260 Requirement for add'l strategic funds -- (63) (48) (50) (49) (52) (262)

The left column in the table contains the financial values from the case for the most recent year (note that working capital is Current Assets minus Current Liabilities); also the depreciation is that for the most recent year, NOT "accumulated depreciation" ...you can calculate this year's depreciation by subtracting last year's accumulated depreciation from this year's accumulated depreciation). The rest of the numbers in the table are calculated as follows:

• The top line for sales is calculated from the assumed 2%/year increase, e.g., the sales for 1996 = 1.02 x 3040 = 3101 (you could do "what if" calculations with various other assumed sales growth rates)
• The next five lines are calculated for each year from the sales forecast for that year and the assumptions given earlier, e.g., the fixed assets for 1997 = 3163 x 0.46 = 1455
• The bottom line (net requirement to raise additional strategic funds) is calculated for each year from the five figures calculated for that year in the previous step, using the equation given near the beginning of this section, e.g., the net requirement for 1998 is:  Requirement = Increase from previous yr. in (FA + WC) + Dividends - Earnings - Depreciation Requirement = (1484-1455) + (574-563) + 59 - 97 - 52 = -50

This means (within the assumptions of this simple model, and with a modest growth rate of 2%) that we would expect to have a surplus of about \$63 million in strategic funds for 1996, and further surpluses during the following four years (1997-2000).

In cases where it appears that additional strategic funds will need to be obtained, there are a number of different possibilities, each with advantages and disadvantages which you should understand:

• Debt in various forms
• Equity in various forms
• Externally oriented changes to increase earnings (e.g., increasing sales that are profitable)
• Internal changes to increase earnings, especially reducing costs
• Reduction in dividends (hard to do without serious consequences)
• (Selective) mergers, joint ventures

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