Module One

Overview of Corporate Finance (continued)

Chapter 3 - Working With

Financial Statements

.
Learning Objectives (1)
By the end of this module, you should be able to:
A. Identify the ways that firms obtain and use cash as
reported in the Statement of Cash Flows
B. Compute and interpret some common ratios,
C. Assess the determinants of a firm's profitability
D. Identify and explain some of the problems and pitfalls in
financial statement analysis,
Learning Objectives (2)
E. Understand what financial planning is and why firm
should use it
F. Discuss and be able to apply the percentage of sales
approach.
G. Compute the external financing needed to fund a firm’s
growth.
H. Assess the determinants of a firm’s growth -> Understand
how capital structure and dividend policy affect a firm’s
ability to grow
I. Identify and explain some of the problems in planning for
growth
Why do we need to use or
analyze Financial statements?
• Internal uses:
o performance evaluation (managers are frequently
evaluated and rewarded on the basis of accounting
measures of performance, such as revenue growth, profit
margin)
o planning for the future (financial projection, annual
planning, strategic planning, business case etc.)

• External uses:
o evaluation by outside parties (e.g., lenders, potential
investors, investment analysts, large customers)
o evaluation of main competitors
o identifying potential takeover targets or JV
How many reports do the
financial statements consist of?
1. Balance sheet
2. Income statement (or P/L statement)
3. Cash flows statement
CASE STUDY TODAY

• Chuong Duong Beverages Joint Stock Company

(HOSE: SCD)

• Handout: Audited Financial Statement for the year

ended at 31 December 2020.
A CASH FLOW
• Sources of cash are activities that generating cash.
• Uses of cash are activities that involve spending cash.
A Statement of Cash Flows
• Is a statement that summarizes the sources and uses of cash.
• Changes of cash balance in period-year are categorized into 3
groups:
i. Operating activities—includes net profit and changes in
the current accounts (e.g., Working Capital)
ii. Investment activities—includes changes in fixed assets
iii. Financing activities—includes changes in long-term
debt and equity accounts as well as dividends.
There are 02 methods of presenting the statement of CF: direct
vs indirect method.
• The main difference between 02 methods involves the cash
flows from operating activities (i.e., no differences in the cash
flows from investing activities and from financing activities.)
A Statement of Cash Flows -
Direct
The Direct Method
basically lists out
the cash received
and paid by the
company
A Statement of Cash Flows -
Indirect
The Indirect Method
begin from Net Income,
following by the
adjustments needed to
o Convert the accrual
accounting net
income to the cash
flows from operating
activities.
o Take out incomes
not related to
normal operations
B Ratio Analysis
• Financial ratios are determined from a firm’s financials
to help readers gain meaningful information about a
company.

• Used to compare and investigate relationships between

different pieces of financial information, either over time or
between companies.

• Ratios eliminate the size problem.

(e.g.: if you want to compare the operation efficiency between

MWG and FRT by using financial statements’ figures, you will
have a problem because of difference in size. Calculating and
compare financial ratios is a way to avoid this problem)
B 5 common Categories of
Financial Ratios
1. Liquidity— measures the firm’s short-term solvency.
2. Capital structure—measures the firm’s ability to
meet long-run obligations (financial leverage).
3. Asset management (turnover)—measures the
efficiency of asset usage to generate sales.
4. Profitability—measures the firm’s ability to control
expenses.
5. Market value—per-share ratios.
B 1. Liquidity Ratios
• =

o Current ratio (CR) measures a company's ability to pay

short-term obligations (due within 1 year) -> the higher
CR, the better.
o However, too high CR may potentially indicate inefficient
use of cash and other short-term assets.
o Note:
o Current assets are the assets of a company that are
expected to be sold or used as a result of standard
business operations over the next 12 months.
o Current liabilities are a company's short-term financial
obligations that are due within 12 months.
B 1. Liquidity Ratios
• Can you list out the most common current ASSETS that are
found on the balance sheet?
→ cash, cash equivalents, accounts receivable, advance to
suppliers, inventory, marketable securities, pre-paid liabilities,
and other liquid assets.
• Can you list out the most common current LIABILITIES that
are found on the balance sheet?
→ account payables, prepayments by customers, short-term
borrowing, current maturities of long-term debt, other short-term
payables such as dividends, taxes.
B 1. Liquidity Ratios

• Can you estimate Current Ratio of SCD as at 01 Jan and

30 June 2022?
B 1. Liquidity Ratios
• Problem with Current ratio: Inventory is the least liquid asset
(harder to convert into cash as it takes larger efforts to sell or
sometimes to speed up the conversion of inventory to cash,
companies need to sell off products at a discount)

•
o The quick ratio indicates a company's capacity to pay its
=

current liabilities without needing to sell its inventory,

which is more conservative approach to assess liquidity
than current ratio.
• Can you calculate the Quick ratio of SCD as at 01 Jan and 30
June 2022?
B 2. Capital Structure Ratios

•
/ =

* measures gearing or leverage level of a company

/ =

•
* measures the ratio of a company’s assets that are financed by its shareholders
=

•
* indication of the ability the company to service the debt obligations
=

•
* indication of how many years it would take to pay any outstanding interest-bearing debts
=
 2. Capital Structure Ratios
B of SCD as at 01 Jan and 30 June 2022?
Net Debt/Equity????
30 Jun 01 Jan
Interest bearing debts (VND B) 253 174
(Less): Cash, including current & termed deposit -22 -45
Net Debt 231 129
Shareholders' equity (book value) 142 156
Net Debt/Equity 1.6 0.8

1. What would you think about the change in the Net Debt/Equity ratio
of SCD?
2. Why do they need to borrow additional VND80bn in the first 6
months of 2022?
• FS page 30:
https://static2.vietstock.vn/data/HOSE/2022/BCTC/VN/QUY%202/SCD_Baocaotaichinh_6T_2022_So
atxet.pdf
• BOD resolution dated 13 Jan 2022:
https://static2.vietstock.vn/data/HOSE/2022/NGHI%20QUYET%20DHCD/VN/20220127_20220126---
SCD---NQ01-HDQT-vv-trinh-DHDCD-phe-duyet-the-chap-tai-san-vay-von.pdf >>> Link
 2. Capital Structure Ratios
B of SCD as at 01 Jan and 30 June 2022?
Equity multiplier???
30 Jun 01 Jan
Total assets 507 371
Shareholders' equity - book value 142 156
Equity multiplier 3.6 2.3

Net interest cover & Debt to Gross CF for half year (“HY”) 2022 vs HY21?
HY22 HY21
EBIT (VND B) -6.4 -6.7
Interest expense (VND B) 7.4 7.4
Net interest cover (times) -0.9x -0.9x

Interest bearing debts (VND B) 253 174 A

Net profit after tax -13 -14 B
Depreciation+Amortisaion 4 4 C
Debt to Gross CF -28.1x -17.4x = A / (B+C)

What do you think if you put yourself in the shoes of the lender of SCD?
B 3. Turnover Ratios
(or asset utilization ratios)
• =

• =

• =

Question: How would you estimate Payables turnover?

=
B 3. Turnover Ratios
(continued)
• =

• =

* measures value of sales can be generated by employing $1 of asset

Question: how would you interpret this ratio?

Capital intensity ratio:
??= the amount of assets needed to generate $1 in sales
B 4. Profitability Ratios

• =

• ( )=

• ( )=
B 5. Market Value Ratios

• / ( )=

• / ( )=

• / =

EV/EBITDA is one of the most commonly used valuation

metrics, because EBITDA is commonly used as a proxy for
cash flow available to the firm.
C The Du Pont Identity

The Equity multiplier = 1

for an all-equity firm.
=

When debt increases

-> larger Equity multiplier
= ×

-> ROE increases.

E.g: A company with a debt

to asset ratio of 50% would
= ×

have an Equity multiplier =

???
+
= ×

= × (1 + )

ROA Equity multiplier

C The Du Pont Identity
• Further decompose ROE by multiplying the top & bottom by “Sales”

= ×

= × ×

The Du Pont
Identity
= × ×

= × ×

operating efficiency financial leverage asset use efficiency

C The Du Pont Identity
• The Du Pont identity tells us that ROE is determined by:
1. Operating efficiency (How well does it control costs,
manage revenue/product mix and price).
2. Asset use efficiency (How well does it manage its
assets).
3. Financial leverage (choice of optimal debt ratio)

• If ROE is not good enough,

=> then “Du Pont identity” tells you where to start looking for the
reasons.
Problems with Ratio Analysis
• No underlying theory to identify correct ratios to use or
appropriate benchmarks.
• Benchmarking is difficult for diversified firms.
• Firms may use different accounting procedures.
• Firms may have different recording periods.
• One-off events can severely affect financial performance.
 Module One
Overview of Corporate Finance (continued)

Chapter 4 - Long-term Financial

Planning And Growth

.
What is Financial Planning?
• Formulates the ways financial goals to be achieved.

• Requires that decisions be made about an uncertain

future.

• Recall that the goal of the firm is to maximize the market

value of the owner’s equity - growth will result from this
goal being achieved.
Dimensions of Financial Planning
• The planning horizon is the long-range period that the process
focuses on (usually 2 to 5 years).

• Financial planning usually requires three alternative plans (aka

stress test):
o a worst case,
o a normal case and
o a best case.

→ Basically, to answer the question: “What would happen if …?”

Benefits of Planning

• Interactions — create linkages between investment

opportunities and financing choices.

• Options — firm can develop, analyse and compare

different scenarios.

• Avoiding surprises — development of contingency

plans.
Elements of a Financial Plan
1. Assumptions about the economic environment.

2. An externally supplied sales forecast (either an sales figure

or growth rate in sales).

3. Projected financial statements (pro-forma FS).

4. Projected capital spending.

5. Necessary financing arrangements (debt & dividend policy).

6. The ‘PLUG’: sources of external financing needed to deal

with any shortfall (or surplus) in financing and thereby bring
the balance sheet into balance.
Example: Plug
Recent Financial Statements

Income Statement Balance sheet

Sales $100 Assets $50 Debt $20
Costs 90 Equity 30
Net Income $ 10 Total $50 Total $50

Assume that, next year:

1. Sales are projected to rise by 25%, net profit margin
remains unchanged.
2. The debt/equity ratio stays at 2/3
3. Debts and assets grow at the same rate as sales

Could you prepare a forecasted P&L & Balance sheet for next year?
Example: Plug (cont.)
Solution:
Pro-Forma Financial Statements

Income Statement Balance Sheet

Sales $ 125.0 Assets $ 62.5 Debt $25.0
Costs $ 112.5 Equity 37.5
Net profit $ 12.5 Total $ 62.5 Total $ 62.5

What is the plug?

Notice that projected net income is $12.50, but equity only
increases by $7.50.
The difference, $5.00 paid out in cash dividends, is the plug.
You already knew

• What is financial planning?

• Why financial planning is crucial / important to any
business?
• What are required elements of a financial planning?

So, The next question will be:

HOW TO DO?
Percentage of Sales Approach
“a quick and practical way of generating pro-forma FS”

This is a financial planning method in which: accounts are

varied depending on a company forecasted sales level.

Some highlighted terminologies:

• Dividend payout ratio is the amount of cash paid out to

shareholders divided by net profit after tax.

• Retention ratio is the amount of cash retained within the firm

and not paid out as a dividend, divided by net profit after tax
Example: Latest
Financial Performance Statement

Sales $1000
Costs 800 Let’s calculate
Taxable Income 200 1) Dividend payout
Less: Tax (30%) -60 ratio, and
Net profit $ 140 2) Retention ratio

Retained earnings $112

Dividends $28

$28
= = 20%
$140

=>
$
$
= 1 − 20% = 80% = 80%
Example: Pro-Forma
Financial Performance Statement
Assuming that: In the coming year
• Sales will grow by 25%
• Costs will continue to account for 80% of Sales
• Tax rate = 30%

How much the net profit will be?

Sales (projected) $1 250
(Less): Costs (80% of sales) (1 000)
Profit before tax or Taxable Income 250
(Less): Tax (30%) (75)
Net profit $175
Example - Latest
Financial Position Statement
Pro-Forma Financial
Performance Statement – Next steps

Financial position statement or BALANCE SHEET:

• Use the recent Balance sheet to create a pro-forma BS;
▪ assume some items will vary directly with sales (e.g.
cash, AR, AP, inventory, plan & equipment) and
▪ others (e.g. short-term & long-term borrowings,
share capital) do not vary with sales
• Applied the sales growth (%) to the BS items which vary
directly with sales. For those do not, temporarily keep the
balance unchanged.
• Calculate the projected addition to retained earnings
(using Retention ratio)
=> Then we will have a partial pro-forma BS (because
debts are not estimated yet)
Pro-Forma Financial
Performance Statement – Next steps
Financial position statement or Balance sheet:

$ 1,140 $ 140
$ 1,940 $ 140

$ 3,215 $ 215

EXTERNAL FINANCING NEEDED (EFN) >>> $535

Pro-Forma Financial
Performance Statement – Next steps
• Assume that $225 is borrowed via short-term debt

=> the remaining of EFN (i.e. $310) is borrowed via long-

term debt.

• ‘Plug’ figure now distributed and recorded within the

financial position statement.

• A new (complete) pro-forma financial position statement

can be derived.
Pro-Forma Financial
Performance Statement – Next steps

$ 1,110 $310

$ 1,140 $ 140
$ 1,940 $ 140
Pro-Forma Financial
Performance Statement – Next steps
Scenarios analysis:

What happens (to the financial planning) if you are NOT

able to raise extra debts from banks?

Key considerations:
• 25% growth in Sales would not be feasible.
• Need to raise new equity (from current shareholders or
new shareholders)
• Raise corporate bonds
External Financing and
Growth
• EFN and growth are obviously related.

• Assumed all other things being the same: the higher the
rate of growth in sales/assets => the greater the EFN.
It’s now
your turn to practice
Sales $ 500
Costs 400
Taxable Income $ 100
Tax (30%) 30
Net profit $ 70

Retained earnings $ 25
Dividends $ 45

Let’s calculate:
• Net profit margin (p)
• Retention ratio (R)
It’s now
your turn to practice
($) (% of ($) (% of
sales) sales)
Assets Liabilities

Current assets 400 80 Total debt 450 n/a

Non-current 600 120 Owners’ equity 550 n/a

assets
Total assets 1000 200 Total 1000 n/a

Let’s calculate:
• ROA
• ROE
• DE ratio
Ratios Calculated

p (profit margin) = 14%

R (retention ratio) = 35.7%

ROA (return on assets) = 7%

ROE (return on equity) = 12.7%

D/E (debt/equity ratio) = 0.818

Growth

• Assume that next year’s Sales forecasted to be $600.

$100
• Percentage increase in sales: = = 20%
$500
 Changes in Assets

• What level of asset investment is needed, to support sales growth?

• For simplicity, assuming that

• a constant Capital intensity ratio, or percentage increase in
Total assets also 20%
• the firm is at full capacity (i.e. it needs to have new facilities to
service higher growth in sales)

• The indicated increase in total assets required equals: A × g

(where A = ending total assets from the previous period)

• Increase in Total Assets = $1,000 x 20% = $200

• Next question will be: How will the increase in assets be financed?

(1) Retained profits & (2) external financing (e.g. borrowing)

Internal Financing
(Retained profit)
• Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?

• The addition to retained earnings is estimated by expected

net profit multiplied by the Retention ratio.

where: S = previous period’s sales

= S∗p∗R × 1 + g

p = profit margin
R = retention ratio

g = projected increase in sales

• Addition to retained earnings

= $500 x 0.14 x 35.7% × (1+20%) = $30
External Financing
Needed (EFN)
• If the required increase in assets > the internal funding
available (i.e. increase in retained earnings), then the difference
is the external financing needed (EFN).

EFN = Increase in Total Assets – Addition to Retained Earnings

= A*g– S*p*R × (1 + g)
= $200 - $30
= $170 • The firm needs $200 new financing.
• $30 can be raised internally.
• The remainder must be raised externally (EFN)
Relationship between
EFN and sale growth

EFN = − ∗ ∗R + A − ∗ ∗R ×g

= −$500 ∗ 14% ∗ 36% + $1000 − $500 ∗ 14% ∗ 36% × g

= − + ×

• If EFN = 0, g will be ??? g = 2.56%.

• This means that the firm can grow at 2.56% with no EFN
(no extra debt or equity).
 Financial Policy
and Growth
• If the company only grows at 2.56% every year (as example
above): equity will steadily increase (via retained earnings),
while debt remain constant -> D/E decline.

• If D/E declines, the firm has excess debt capacity

(debt capacity is the ability to borrow more to increase assets
value).

• If the firm borrows up to its debt capacity (i.e. up to D/E limit),

what growth can be achieved?
 Sustainable Growth Rate
(SGR)
The sustainable growth rate is the growth rate a firm can
maintain given its debt capacity, ROE and retention ratio are
unchanged. ( ROE  R )
SGR =
(1 − ROE  R )
Continuing from the previous example:
12.7% ∗ 35.7%
SGR =
1 − 12.7% ∗ 35.7%

= 4.75%

The firm can increase sales and assets at 4.75%/ year, without:
• issuing any additional equity and
• changing its debt ratio or payout ratio.
Summary of
Growth Rates
1. Internal growth rate
This growth rate is the maximum growth rate that can
be achieved with no external debt or equity financing.

2. Sustainable growth rate

The SGR is the maximum growth rate that can be
achieved with no external equity financing while
borrowing to maintain a constant D/E ratio.
Important Questions

+ It is important to remember that we are working with

accounting numbers (and financial planning is just a tool)
+ We should ask ourselves some important questions as
we go through the planning process:
• How does our plan affect the timing and risk of our
cash flows?
• Does financial plan point out inconsistencies in our
goals?
• If we follow this plan, would we maximise owners’
wealth?