• Are the smae for all companies from corner stroes to MNE's
• Highlights the means by which managers can influence returnon equity
• Consists of three ratios:
  • Profit Margin
  • Asset Turnover
  • Financial Leverage
• Can vary widely across industries depending on technology and business strategies employed

RETURN ON EQUITY (ROE)

• Is a widely used measure of company financial performance
• Equals the product of the profit margin, asset turnover, and financial leverage
• is broadly similar across industries due to competitors
• Suffers from three problems as a performance measure
  • timing problem, business decisions ar forward looking while ROE is a backward looking measure
  • Risk problem because financial decisions involve balancing risk agaisnt return, while ROE only measures return
  • Value problem, owners are interested in return onthe market value of their investment, while ROE measures return on the market value of their investment, while ROE measures return on the account BV which is not solves by measuring market value of equity

• Summarizes asset management performance
• Measures the value of sales generated per dollar invested in assets
• Is a control ratio in that it relates sales, or cost of sales, to a specific asset or liability
  • Other control ratios:
    • Inventory Turnover
    • Collection Period
    • Days Sales in Cash
    • Payables Period
    • Fixed-Asset Turnover

• Summarizes the company's use of debt relative to equity financing
• Adds to owners risk and is thus not something to be maximized
• Is best measured in the form of coverage ratios that relate operating earnings to the annual financial burden imposed by the debt
• Is also measured using balance sheet ratios that relate debt to assets, measured using book or market values.

• Summarizes asset management performance
• Measures teh calue of sales generated per dollar invested in assets.
• Is a control ratio in that it relates sales, or cost of sales, to a specific asset or liability
  • Other Control Ratios are..
    • Inventory Turnover
    • Collection Period
    • Days sales in cash
    • Payables Period
    • Fixed-Asset Turnover

• Is the systematic use of a number of ratios to analyze financial performance
• Involves trend analysis and comparison of company ratios to peer group numbers
• Requires considerable judgement, as there is no single correct value for any ratio

• Reminds managers that more grqoth is not always a blessing an that companies can literally "grow broke"
• Is the maximum rate at which a firm can increase sales without raising new equity or depleting financial resources
• Assumes company debt increases in proportion to equity
• Equals the prodcut of four ratios:
  • Profit margin
  • Retention Ratio
  • Asset Turnover
  • Financial leverage, defined as assets divided by beginning of period equity
• Also equals the firm's retention ratio times return on beginning of period equity
• Declines with inflation whenever managers and creditors do not understand the effects of inflation on historical cost financial statements

• Causes one or more of the defining ratios to change
• Must be anticipated and planned for
• Can be managed by:
  • Increasing financial leverage
  • Reducing the dividend payout ratio
  • Pruning away marginal activities, product or customers
  • Outsourcing some or all of production
  • Increasing prcies
  • Merging with a "cash cow"
  • Selling new equity

• Produces excess cash that can enhance a girms appeal as a takeover target
• Forces management to find productive uses for the excess cash, such as...
  • Reducing financial leverage
  • Returning the money to shareholders
  • Cutting Prices
  • "Buying growth" by acquiring rapidly growing firms in need of cash

• Has on average been a use of cash to American companies for most of the past 20 years, meaning firms have retired more equity than the have issued
• Is an important soruce of cash to a number of smaller, rapidly growing companies with exciting prospects
• Among other reasons is seldom used because
  • Companies in the aggregate have no needed the additional cash
  • Issues costs of equity are high relative to those of debt
  • New equity tends to reduce earnings per share, something most managers loathe
  • Mangers commonly beleive their current share price is unreasonably low and they can get a better price by waiting
  • Equity is percieved as an unreliable source of financing, not something a prudent manager should count on

• Are the principal means by which operating managers can predict the financial implications of their decisions
• Are predictions of what a company's financial statements will look like atht the end of the forecast period
• Are used to estimate a company's future need for external funding and a great way to test the feasibility of current operating plans
• Are often based on percent-of-sales forecasts that assume many balnace sheet and income statement entries
• Generate forecasts that are strictly applicable only on the forecast date and thus require care when dealing with seasonal businesses
• Involve four steps:
  1. Review of past financial statementsto identify quantities that have varied in proportion to sales history
  2. Careful project of future sales
  3. Preperation of independent projections of quantities, such as fixed plant and equipment that have not varied in proportion to sales historically.
  4. Testing the sensitivity of forecast results to variations in projected sales

• Project external funding required as the difference between anticipated sources and uses of cash over the forecast period
• Yield the same need for external funding as a pro forma projection, given the same assumptions.
• Are less informative than pro forma forecasts because they do no provide information useful for evaluating how best to meet the indicated need for financing

Cash Budgets

• Project the change in cash balance over the forecast period as the difference between anticipated cash receipts and disbursements
• Rely on cash rather than accrual accounting
• Yield the same need for external funding as a pro forma projection, given the same assumptions
• Commonly used for short-term forecasts ranging from a day to a month
• Are less informative than pro forma forecasts but easier for accounting neophytes to understand

• Sensitivity analysis: change one uncertain input at a time and observe how the forecasts change
• Scenario Analysis: make coordinated changes in several inputs to mirror the occurence of a particular scenario, such as loss of a major customer, or a major recession
• Simulation: assign probability distributions to a number of uncertain inputs and use a computer to generate a distribution of possible outcomes

• Involves three continuing cycles:
  • A strategic planning cycle in which senior management is most active
  • An operation cycle in which divisional managers translate qualitative strategic goals into concrete plans
  • A budgeting cycle that essentially puts a price tag on the operational plans
  • Relies on the techniques of financial forecasting and planning to an increasing degree in each cycle

• Remember that depriaction is not a cash flow
• Concentrate on cash flows after taxes. Stay alert for differences between tax depreciation an depreciation used in reports to shareholders
• Exclude debt interest or the cost of repaying a loan from the project cash flows. This enables you to seperate the investment from the financing decision
• Remember the investment in working capital. As sales increase, the firm may need to make additional investments in working capital, as as the project comes to an end, it will recover those investments
• Beware of allocated overhead charges for heat, light, and so on. These may not reflect the incremental costs of the project

• Include all indirect effects of the project, such as its impct on the sales of the firms other products
• Forget sunk costs
• include opportunity costs, such as the value of land that you would otherwise sell

• If cash flows are forecasted in nominal terms, use a nominal discount rate
• Discount real cash flows at a real rate

• Is a fundamental finacial variable affecting return on equity and sustainable growth
• Involves the substitution of fixed cost debt financing for variable cost equity
• Like operating leverage increases breakeven but increases the rate of earnings per share growth once breakeven is achieved
• Increases expected return and risk to owners
• Increases expected ROE and EPS as well as their variability
• Creates a wide array of risk-return combinations out a single risky investment

• Stress test pro forma forecasts
• Estimate coverage ratios at differing debt levels
• Interpret coverage ratios in light of variability of operating income, the coverage ratios of peers, and across different bond ratings

• Assess projected income statements under different economic conditions
• Prepare a range of earnings chart noting the increase in EPS and ROE at the projected EBIT level and the proximity of expected EBIT to the "cross-over" value