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

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 TWENTY-NINE
816
FINANCIAL
ANALYSIS AND
PLANNING
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.
817
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
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
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. A study 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.
818 PART IX
Financial Planning and Short-Term Management
1
See 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.
2
LaPorta et al., “Law and Finance,” Journal of Political Economy 106 (December 1998), pp. 1113–1155.
Country Legal Tradition Rating
Sweden Scandinavian 83
United Kingdom English 78
United States English 71
France French 69
Hong Kong English 69

Switzerland German 68
Japan German 65
Germany German 62
South Korea German 62
Mexico French 60
India English 57
Peru French 38
Egypt French 24
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.
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
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 current condition. 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
CHAPTER 29
Financial Analysis and Planning 819
29.2 EXECUTIVE PAPER’S FINANCIAL STATEMENTS
Assets Dec 1998 Dec 1999 Change
Current assets:
Cash & securities 75 110 ϩ35
Receivables 433.1 440 ϩ6.9
Inventory 339.9 350 ϩ10.1
Total current assets 848 900 ϩ52
Fixed assets:
Property, plant, and equipment 929.5 1,000 ϩ70.5
Less accumulated depreciation 396.7 450 ϩ53.3
Net fixed assets 532.8 550 ϩ17.2
Total assets 1,380.8 1,450 ϩ69.2
Liabilities and Shareholders’ Equity Dec 1998 Dec 1999 Change
Current liabilities:
Debt due within 1 year 96.6 100 ϩ3.4
Payables 349.9 360 ϩ10.1
Total current liabilities 446.5 460 ϩ13.5
Long-term debt 425 450 ϩ25
Shareholders’ equity 509.3 540 ϩ30.7
Total liabilities & shareholders’ equity 1,380.8 1,450 ϩ69.2
Other financial information:
Market value of equity 598 708

Average number of shares (millions) 14.16 14.16
Share price ($) 42.25 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
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 liabilities include 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
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
ϭ 900 Ϫ 460 ϭ $440
million
Net working capital ϭ current assets Ϫ current liabilities

820 PART IX
Financial Planning and Short-Term Management
3
The 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.
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
Of this sum $42.5 million went to pay the interest on the short- and long-term
debt (remember debt interest is paid out of pretax income) and a further $49.7 mil-
lion went to the government in the form of taxes. The $74.5 million that was left
over belonged to the shareholders. Executive Paper paid out $43.8 million as divi-
dends and reinvested the remaining $30.7 million in the business.
Sources and Uses of Funds
Table 29.4 shows where Executive Paper raised funds and how it spent them.
4
Be-
side each row in the table we have added a brief note on how the figure is calcu-
lated. We will explain each item in turn.
ϭ 2,
200 Ϫ 1, 980 Ϫ 53.3 ϭ $166.7 million
EBIT ϭ Total revenues Ϫ costs Ϫ depreciation
CHAPTER 29 Financial Analysis and Planning 821
$ Millions

Revenues 2,200
Costs 1,980
Depreciation 53.3
EBIT 166.7
Interest 42.5
Tax 49.7
Net income 74.5
Dividends 43.8
Retained earnings 30.7
Earnings per share, dollars 5.26
Dividend per share, dollars 3.09
TABLE 29.3
The 1999 income statement of Executive Paper
Corporation (figures in $ millions).
4
Notice that in a Sources and Uses of Funds table the different components of net working capital are not
separated out. When we discuss short-term planning in Chapter 30, we will show how to draw up a
Sources and Uses of Cash table, which separates out different items of net working capital.
$ Millions Notes:
Sources:
Net income 74.5 See Table 29.3
Depreciation 53.3 See Table 29.3
Operating cash flow 127.8
Issues of long-term debt 25.0 See Table 29.2: 450 Ϫ 425
Issues of equity 0 See Tables 29.2 and 29.3:
540 Ϫ 509.3 Ϫ (74.5 Ϫ 43.8)
Total sources 152.8
Uses:
Investment in net working 38.5 See Table 29.2: (900 Ϫ 460)
capital Ϫ (848 Ϫ 446.5)

Investment in fixed assets 70.5 See Table 29.2: 1000 Ϫ 929.5
Dividends 43.8 See Table 29.3
Total uses 152.8
TABLE 29.4
Sources and uses of
funds for Executive
Paper Corporation,
1999 (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
Look first at the uses of funds. The money that Executive Paper generates is ei-
ther invested in net working capital and fixed assets or it is paid out to sharehold-
ers as dividends. Thus
Table 29.2 shows that in 1999 Executive Paper started the year with net working
capital of million. By the end of the year it had grown to
million. So the company invested an additional $38.5 million
in working capital. Over the same period fixed assets rose from $929.5 million
to $1,000 million, an increase of $70.5 million. Finally, the income statement in
Table 29.3 shows that Executive Paper distributed $43.8 million as dividends.
Thus, in total, Executive Paper invested or paid out as dividends 38.5 ϩ 70.5
ϩ 43.8 ϭ $152.8 million.
Where did the funds come from? There are two sources—the cash generated

from operations and new money raised from investors:
The income statement shows that in 1999 the company generated $127.8 million
from operations. This included $53.3 million of depreciation (remember deprecia-
tion is not a cash outflow) and $74.5 million of net income. This left a deficiency of
million that Executive Paper needed to raise from the capital
market. You can see from the balance sheet that Executive Paper raised this $25 mil-
lion by an issue of long-term debt (debt increased from $425 million to $450 mil-
lion). Executive Paper did not issue new equity capital in 1999. So why does the
balance sheet show an increase in equity of million? The an-
swer is that this increase in equity came from income that the company retained
and plowed back on behalf of its shareholders
.Ϫ dividends ϭ 74.5 Ϫ 43.8 ϭ $30.7
million2
1retained earnings ϭ net income
540 Ϫ 509.3 ϭ $30.7
152.8 Ϫ 127.8 ϭ $25
ϩ new issues of equity
Total sources of funds ϭ operating cash flow ϩ new issues of long-term debt
900 Ϫ 460 ϭ $440
848 Ϫ 446.5 ϭ $401.5
in fixed assets ϩ dividends paid to shareholders
Total uses of funds ϭ investment in net working capital ϩ investment
822 PART IX
Financial Planning and Short-Term Management
29.3 MEASURING EXECUTIVE PAPER’S FINANCIAL
CONDITION
Executive Paper’s financial statements provide you with the basic information to
assess its current financial standing. However, financial statements typically con-
tain large amounts of data—far more than is contained in the simplified statements
for Executive Paper. To condense these data into a convenient form, financial man-

agers generally focus on a few key financial ratios.
Table 29.5 summarizes the key financial ratios for Executive Paper.
5
We
will explain how to calculate these ratios and use them to shed light on five
questions:
• How much has the company borrowed? Is the amount of debt likely to result
in financial distress?
• How liquid is the company? Can it easily lay its hands on cash if needed?
5
In addition to the ratios that we describe below, Table 29.5 includes a few other ratios that you may well
encounter. Some are simply alternative ways to express the same result; others are variations on a theme.
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
• How productively is the company using its assets? Are there any signs that the
assets are not being used efficiently?
• How profitable is the company?
• How highly is the firm valued by investors? Are investors’ expectations
reasonable?
CHAPTER 29
Financial Analysis and Planning 823
Executive Paper
Paper Industry

†
Leverage Ratios:
Debt ratio (Long-term debt ϩ leases)/(long-term .45 .53
debt ϩ leases ϩ equity)
Debt ratio (including (Long-term debt ϩ short-term debt .50 .56
short-term debt)* ϩ leases)/(long-term debt ϩ short-term debt
ϩ leases ϩ equity)
Debt–equity ratio (Long-term debt ϩ leases)/equity .83 1.12
Times-interest-earned (EBIT ϩ depreciation)/interest 5.2 2.9
Liquidity Ratios:
Net-working-capital- (Current assets Ϫ current liabilities)/total assets .30 .06
to-total assets*
Current ratio Current assets/current liabilities 2.0 1.3
Quick ratio (Cash ϩ short-term securities ϩ receivables)/ 1.2 .7
current liabilities
Cash ratio (Cash ϩ short-term securities)/current liabilities .2 .1
Interval measure* (Cash ϩ short-term securities ϩ receivables)/ 101.4 61.7
(costs from operations/365)
Efficiency Ratios:
Sales-to-assets ratio Sales/average total assets 1.55 .90
Sales-to-net-working- Sales/average net working capital 5.2 14.1
capital*
Days in inventory Average inventory/(cost of goods sold/365) 63.6 59.1
Inventory turnover* Cost of goods sold/average inventory 5.7 6.2
Average collection Average receivables/(sales/365) 72.4 45.9
period (days)
Receivables turnover* Sales/average receivables 5.0 8.0
Profitability Ratios:
Net profit margin (EBIT Ϫ tax)/sales 5.3% Ϫ0.5%
Return on assets (ROA) (EBIT Ϫ tax)/average total assets 8.3% Ϫ0.4%

Return on equity (ROE) Earnings available for common stockholders/ 14.2% Ϫ10.3%
average equity
Payout ratio Dividend per share/earnings per share .6 n.a.
Market-Value Ratios:
Price–earnings ratio (P/E) Stock price/earnings per share 9.5 n.a
Dividend yield Dividend per share/stock price 6.2% 1.8%
Market-to-book ratio Stock price/book value per share 1.3 3.6
TABLE 29.5
Financial ratios for Executive Paper and the paper industry, 1999.
*This ratio is an extra bonus not discussed in Section 29.2.
†
1999 ratios for U.S. paper and allied products.
Source: Compustat.
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
When you calculate a company’s financial ratios, you need some criteria to decide
whether they are a cause for concern or a matter for congratulation. Unfortunately,
there is no “right” set of financial ratios to which all companies should aspire. Take,
for example, the company’s capital structure. Debt has both advantages and dis-
advantages, and, even if there were an optimal level of debt for company A, it would
not be appropriate for company B.
When managers review a company’s financial position, they often start by
comparing the current year’s ratios with equivalent figures for earlier years. It

is also helpful to look at how the company’s financial position measures up to
that of other firms in the same industry. Therefore, in Table 29.5 we have
compared the financial ratios of Executive Paper with those for the U.S. paper
industry.
6
How Much Has Executive Paper Borrowed?
When Executive Paper borrows, it promises to make a series of fixed payments. Be-
cause its shareholders get only what is left over after the debtholders have been
paid, the debt is said to create financial leverage. In extreme cases, if hard times
come, a company may be unable to pay its debts.
The company’s bankers and bondholders also want to make certain that Execu-
tive Paper does not borrow excessively. So, if Executive wishes to take out a new
loan, the lenders will scrutinize several measures of whether the company is bor-
rowing too much and will demand that it keep its debt within reasonable bounds.
Such borrowing limits are stated in terms of financial ratios.
Debt Ratio Financial leverage is usually measured by the ratio of long-term debt
to total long-term capital. Since long-term lease agreements also commit the firm
to a series of fixed payments, it makes sense to include the value of lease obliga-
tions with the long-term debt. For Executive Paper
Another way to say the same thing is that Executive Paper has a debt-to-equity ra-
tio of :
Notice that this measure makes use of book (i.e., accounting) values rather than
market values.
7
The market value of the company finally determines whether
the debtholders get their money back, so you might expect analysts to look at
ϭ 450/540 ϭ .83
Debt– equity ratio ϭ
1long-term debt ϩ value of leases2
equity

450/540 ϭ .83
ϭ 450/1450 ϩ 5402ϭ .45
Debt ratio ϭ
1long-term debt ϩ value of leases2
1long-term debt ϩ value of leases ϩ equity2
824 PART IX
Financial Planning and Short-Term Management
6
Financial ratios for different industries are published by the U.S. Department of Commerce, Dun and
Bradstreet, The Risk Management Association, and others.
7
In the case of leased assets accountants try to estimate the present value of the lease commitments.
In the case of long-term debt they simply show the face value. This can sometimes be very different
from present value. For example, the present value of low-coupon debt may be only a fraction of its
face value. The difference between the book value of equity and its market value can be even more
dramatic.
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
the face amount of the debt as a proportion of the total market value of debt and
equity. On the other hand, the market value includes the value of intangible as-
sets generated by research and development, advertising, staff training, and so
on. These assets are not readily salable, and if the company falls on hard times,
their value may disappear altogether. For some purposes, it may be just as good

to follow the accountant and ignore these intangible assets. This is what lenders
do when they insist that the borrower should not allow the book debt ratio to
exceed a specified limit.
Debt ratios are sometimes defined in other ways. For example, analysts may in-
clude short-term debt or other obligations such as payables. There is a general
point here. There are a variety of ways to define most financial ratios and there is
no law stating how they should be defined. So be warned: Don’t accept a ratio at
face value without understanding how it has been calculated.
Times-Interest-Earned (or Interest Cover) Another measure of financial leverage
is the extent to which interest is covered by earnings before interest and taxes
(EBIT) plus depreciation. For Executive Paper,
8
The regular interest payment is a hurdle that companies must keep jumping if they
are to avoid default. The times-interest-earned ratio measures how much clear air
there is between hurdle and hurdler.
Is Executive Paper’s borrowing in the ballpark of standard practice or is it a mat-
ter for concern? Table 29.5 provides some clues. You can see that the debt ratio is
slightly lower than that of the rest of the paper industry and the times-interest-
earned is significantly higher than that of most companies.
How Liquid Is Executive Paper?
If Executive Paper is borrowing for a short period or has some large bills coming
up for payment, you want to make sure that it can lay its hands on the cash when
it is needed. The company’s bankers and suppliers also need to keep an eye on Ex-
ecutive’s liquidity. They know that illiquid firms are more likely to fail and default
on their debts.
Another reason that analysts focus on liquid assets is that the figures are often
more reliable. The book value of Executive’s newsprint mill may be a poor guide
to its true value, but at least you know what its cash in the bank is worth. Liquid-
ity ratios also have some less desirable characteristics. Because short-term assets
and liabilities are easily changed, measures of liquidity can rapidly become out-of-

date. You may not know what that newsprint mill is worth, but you can be fairly
sure that it won’t disappear overnight.
ϭ
1166.7 ϩ 53.32
42.5
ϭ 5.2
Times-interest-earned ϭ
1EBIT ϩ depreciation2
interest
CHAPTER 29
Financial Analysis and Planning 825
8
The numerator of times-interest-earned can be defined in several ways. Sometimes depreciation is ex-
cluded. Sometimes it is just earnings plus interest, that is, earnings before interest but after tax. This last
definition seems nutty to us, because the point of interest earned is to assess the risk that the firm won’t
have enough money to pay interest. If EBIT falls below interest obligations, the firm won’t have to
worry about taxes. Interest is paid before the firm pays taxes.
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
Current Ratio Executive Paper’s current assets consist of cash and assets that can
readily be turned into cash. Its current liabilities consist of payments that the company
expects to make in the near future. Thus the ratio of the current assets to the current
liabilities measures the margin of liquidity. It is known as the current ratio:

Rapid decreases in the current ratio sometimes signify trouble. However, they can
also be misleading. For example, suppose that a company borrows a large sum
from the bank and invests it in short-term securities. If nothing else happens, net
working capital is unaffected, but the current ratio changes. For this reason it might
be preferable to net off the short-term investments and the short-term debt when
calculating the current ratio.
Quick (or Acid-Test) Ratio Some assets are closer to cash than others. If trouble
comes, inventories may not sell at anything above fire-sale prices. (Trouble typi-
cally comes because customers are not buying and the firm’s warehouse is stuffed
with unwanted goods.) Thus, managers often focus only on cash, short-term secu-
rities, and bills that customers have not yet paid:
Cash Ratio A company’s most liquid assets are its holdings of cash and mar-
ketable securities. That is why analysts also look at the cash ratio:
Of course, these summary measures of liquidity are just that. They are no substi-
tute for detailed plans to ensure that the company can pay its bills. In the next chap-
ter we will describe how companies forecast their cash needs and draw up a short-
term financial plan to deal with any cash shortage.
How Productively Is Executive Paper Using Its Assets?
Financial analysts employ another set of ratios to judge how efficiently the firm is
using its investment in current and fixed assets. Later in the chapter we will look
at the financial implications of Executive’s ambitious plans to expand output, but
understanding the investment in fixed assets and working capital that is needed to
support Executive Paper’s current output may help to uncover any inconsistencies
in these plans for the future.
Sales-to-Assets (or Asset Turnover) Ratio The sales-to-assets ratio shows how
hard the firm’s assets are being put to use:

Sales
average total assets
ϭ

2, 200
11, 380.8 ϩ 1, 4502/2
ϭ 1.55
Cash ratio ϭ
1cash ϩ short-term securities2
current liabilities
ϭ
110
460
ϭ .24
ϭ
110 ϩ 440
460
ϭ 1.20
Quick ratio ϭ
1cash ϩ short-term securities ϩ receivables2
current liabilities
Current ratio ϭ
current assets
current liabilities
ϭ
900
460
ϭ 1.96
826 PART IX Financial Planning and Short-Term Management
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
Assets here are measured as the sum of current and fixed assets. Notice that since
assets are likely to change over the course of a year, we use the average of the as-
sets at the beginning and end of the year. Averages are commonly used whenever
a flow figure (in this case, sales) is compared with a stock or snapshot figure (to-
tal assets).
Notice that for each dollar of investment Executive generates $1.55 of sales, a
much higher figure than other paper companies. There are several possible ex-
planations: (1) Executive uses its assets more efficiently; (2) Executive is working
close to capacity, so that it may be difficult to increase sales without additional
invested capital; or (3) compared with its rivals, Executive produces high vol-
ume, low margin products.
9
You need to dig deeper to know which explanation
is correct. Remember our earlier comment—financial ratios help you to ask the
right questions, not to answer them.
Instead of looking at the ratio of sales to total assets, managers sometimes look
at how hard particular types of capital are being put to use. For example, it turns
out that Executive’s ratio of sales to current assets is less than that of other paper
companies. It is the ratio of Executive’s sales to its fixed assets that sets it apart
from its rivals.
Days in Inventory The speed with which a company turns over its inventory is
measured by the number of days that it takes for the goods to be produced and
sold. First convert the cost of goods sold to a daily basis by dividing by 365.
Then express inventories as a multiple of the daily cost of goods sold:
Notice that Executive Paper appears to have a relatively low rate of inventory
turnover. Perhaps there is scope for economizing on the company’s investment

in inventories.
Average Collection Period The average collection period measures how quickly
customers pay their bills:
The collection period for Executive Paper is somewhat longer than the industry av-
erage. The company may have a conscious policy of offering attractive credit terms
to lure business, but it is worth looking at whether the credit manager is lax in chas-
ing up the slow payers.
ϭ
1433.1 ϩ 4402/2
2,200/365
ϭ 72.4 days
Average collection period ϭ
average receivables
sales Ϭ 365
ϭ
1339.9 ϩ 3502/2
1,980/365
ϭ 63.6 days
Days in inventory ϭ
average inventory
cost of goods sold Ϭ 365
CHAPTER 29
Financial Analysis and Planning 827
9
We will see shortly that this last explanation does not hold up. The paper industry in 1999 earned a
negative profit margin.
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
How Profitable Is Executive Paper?
Net Profit Margin If you want to know the proportion of sales that finds its
way into profits, you look at the profit margin. Thus
10
Return on Assets (ROA) Managers often measure the performance of the firm by
the ratio of income to total assets (income is usually defined as earnings before in-
terest but after taxes). This is known as the firm’s return on assets (ROA) or return
on investment (ROI):
11
Another measure focuses on the return on the firm’s equity:
Executive Paper’s return on assets and equity is in sharp contrast to the rest of the
industry, which provided a negative return in 1999.
It is natural to compare the return earned by Executive Paper with the opportu-
nity cost of capital. Of course, the assets in the financial statements are shown at net
book value, that is, original cost less depreciation.
12
So a low ROA does not necessar-
ϭ
74.5
1509.3 ϩ 5402/2
ϭ .142, or 14.2%
Return on equity 1ROE2ϭ
1earnings available for common stockholders2
average equity
ϭ

1166.7 Ϫ 49.72
11, 380.8 ϩ 1, 4502/2
ϭ .083,
or 8.3%
Return on assets ϭ
1EBIT Ϫ tax2
1average total assets2
Net profit margin ϭ
1EBIT Ϫ tax2
sales
ϭ .053,
or 5.3%
828 PART IX
Financial Planning and Short-Term Management
10
Net profit margin is sometimes measured as net . This ignores the profits that are paid out
to debtholders as interest and should therefore not be used to compare firms with different capital structures.
When making comparisons between firms, it makes sense to recognize that firms which pay more
interest pay less tax. We suggest that you calculate the tax that the company would pay if it were all-
equity-financed. To do this you need to adjust taxes by adding back interest tax shields (interest
tax rate). Using an assumed tax rate of 40 percent,
11
When comparing the returns on total assets of firms with different capital structures, it makes sense
to add back interest tax shields to tax payments (see footnote 10). This adjusted ratio then measures the
returns that the company would have earned if it were all-equity-financed.
One other point about return on assets. Since profits are a flow figure and assets are a snapshot fig-
ure, analysts commonly divide profits by the average of assets at the start and end of the year. The rea-
son that they do this is that the firm may raise large amounts of new capital during the year and then
put it to work. Therefore part of the year’s earnings is a return on this new capital.
However, this measure is potentially misleading and should not be compared closely with the

cost of capital. After all, when we defined the return that shareholders require from investing in the
capital market, we divided expected profit by the initial outlay, not by an average of starting and
ending values.
12
More careful comparisons between the return on assets and the cost of capital need to recognize the
biases in accounting numbers. We discussed these biases in Chapter 12.
ϭ
166.7 Ϫ 349.7 ϩ 1.4 ϫ 42.524
2,200
ϭ 0.45, or 4.5%
Net profit margin ϭ
EBIT Ϫ 1tax ϩ interest tax shields2
sales
payments ϫ marginal
income Ϭ sales
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
ily imply that those assets could be better employed elsewhere. Nor would a high
ROA necessarily mean that you could buy similar assets today and get a high return.
In a competitive industry, firms can expect to earn only their cost of capital. There-
fore, managers whose businesses are earning more than the cost of capital are likely
to earn a pat on the back, while those that are earning a low return may face some
tough questions or worse. Although shareholders like to see their companies earn a

high return on assets, consumers’ groups or regulators often regard a high return as
evidence that the firm is charging excessive prices. Naturally, such conclusions are
seldom cut and dried. There is plenty of room for argument as to whether the return
on assets is properly measured or whether it exceeds the cost of capital.
Payout Ratio The payout ratio measures the proportion of earnings that is paid
out as dividends. Thus
We saw in Section 16.2 that managers don’t like to cut dividends if there is a short-
fall in earnings. Therefore, if a company’s earnings are particularly variable, man-
agement is likely to play it safe by setting a low average payout ratio. When earn-
ings fall unexpectedly, the payout ratio will rise temporarily. Likewise, if earnings
are expected to rise next year, management may feel that it can pay somewhat more
generous dividends than it would otherwise have done.
How Highly Is Executive Paper Valued by Investors?
There is no law that prohibits you from introducing data that are not in the com-
pany accounts. For example, when you are assessing Executive Paper’s efficiency,
you might wish to look at the cost per ton of paper produced. Similarly, an airline
might calculate revenues per passenger mile flown, and so on. If you want to gauge
how highly Executive Paper is valued by investors, then you will need to calculate
ratios that combine accounting and stock market data. Here are three examples.
Price–Earnings Ratio The price–earnings, or P/E, ratio measures the price that in-
vestors are prepared to pay for each dollar of earnings. In the case of Executive Paper
In Section 4.4 we explained that a high P/E ratio may indicate that investors think the
firm has good growth opportunities or that its earnings are relatively safe and there-
fore more valuable. Of course, it may also mean that earnings are temporarily de-
pressed. If a company just breaks even with zero earnings, its P/E ratio is infinite.
Dividend Yield Executive’s dividend yield is simply its dividend as a proportion
of the stock price. Thus
Remember that the return to an investor comes in two forms—dividend yield and
capital appreciation. Executive Paper’s relatively high dividend yield may indicate
Dividend yield ϭ

dividend per share
stock price
ϭ
3.09
50
ϭ .062, or 6.2%
P/E ratio ϭ
stock price
earnings per share
ϭ
50
5.26
ϭ 9.5
Payout ratio ϭ
dividends
earnings
ϭ
43.8
74.5
ϭ .6
CHAPTER 29
Financial Analysis and Planning 829
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
that investors are demanding a relatively high rate of return or that they are not ex-
pecting rapid dividend growth with consequent capital gains.
Market-to-Book Ratio The market-to-book ratio is the ratio of the stock price to
book value per share. For Executive Paper
Book value per share is just stockholders’ book equity divided by the number of
shares outstanding. Book equity equals common stock plus retained earnings—the
net amount that the firm has received from stockholders or reinvested on their be-
half.
13
Thus Executive Paper’s market-to-book ratio of 1.3 means that the firm is
worth 30 percent more than past and present stockholders have put into it.
The Dupont System
Some of the profitability and efficiency ratios that we described above can be
linked in useful ways. These relationships are often referred to as the Dupont sys-
tem, in recognition of the chemical company that popularized them.
The first relationship links the return on assets (ROA) with the firm’s sales-to-
assets ratio and its profit margin:
ROA ϭ
EBIT Ϫ tax
ϭ
sales
ϫ
EBIT Ϫ tax
assets assets sales
↑↑
sales-to- profit
assets ratio margin
All firms would like to earn a higher return on assets but their ability to do so is
limited by competition. If the expected return on assets is fixed by competition,

firms face a trade-off between the sales-to-assets ratio and the profit margin. For
example, fast-food chains, which turn over their capital frequently, also tend to op-
erate on low profit margins. Classy hotels have relatively high margins, but this is
offset by lower sales-to-assets ratios.
Firms often seek to increase their profit margins by becoming more vertically in-
tegrated; for example, they may acquire a supplier or one of their sales outlets. Un-
fortunately, unless they have some special skill in running these new businesses,
they are likely to find that any gain in profit margin is offset by a decline in the
sales-to-assets ratio.
The return on equity (ROE) can be broken down as follows:
↑↑ ↑ ↑
leverage sales-to- profit “debt
ratio assets margin burden”
ratio
ϭ
assets
equity
ϫ
sales
assets
ϫ
EBIT Ϫ tax
sales
ϫ
EBIT Ϫ tax Ϫ interest
1EBIT Ϫ tax2
ROE ϭ
EBIT Ϫ tax Ϫ interest
equity
Market-to-book ratio ϭ

stock price
book value per share
ϭ
50
540/14.16
ϭ 1.3
830 PART IX Financial Planning and Short-Term Management
13
Retained earnings are measured net of depreciation. They represent stockholders’ new investment in
the business over and above the amount needed to maintain the firm’s existing stock of assets.
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
Notice that the product of the two middle terms is the return on assets. This de-
pends on the firm’s production and marketing skills and is unaffected by the fi-
nancing mix. However, the first and fourth terms do depend on the debt–equity
mix.
14
The first term measures the ratio of gross assets to equity, while the last term
measures the extent to which profits are reduced by interest. If the firm is lever-
aged, the first term is greater than 1.0 (assets are greater than equity) and the fourth
term is less than 1.0 (part of the profits are absorbed by interest). Thus, leverage can
either increase or reduce the return on equity. In the case of Executive Paper
So, for Executive Paper the leverage ratio (2.70) more than offsets the debt burden

(.637). Executive’s leverage increases its return on equity.
ϭ 2.70 ϫ 1.55 ϫ .053 ϫ .637 ϭ .14
ROE ϭ leverage ratio ϫ sales-to-assets ratio ϫ profit margin ϫ debt burden
CHAPTER 29
Financial Analysis and Planning 831
14
There is a complication here because the amount of tax paid does depend on the financing mix. We
suggested in footnote 10 that it would be better to add back any interest tax shields to the tax payment
when calculating the firm’s profit margin.
15
The Blitzen Computers example in Section 22.1 illustrates how option theory can be used to quantify
a project’s strategic value.
29.4 FINANCIAL PLANNING
Executive Paper’s financial statements not only help you to understand the past, but
they also provide the starting point for developing a financial plan for the future.
Financial plans begin with the firm’s product development and sales objectives.
For example, Executive Paper’s corporate staff might ask each division to submit
three alternative business plans covering the next five years:
1. A best-case or aggressive growth plan calling for heavy capital investment,
new products, and an increased market share.
2. A normal growth plan in which the division grows with its markets but not
at the expense of its competitors.
3. A plan of retrenchment designed to minimize capital outlays. This is
planning for lean economic times.
Of course, the planners might also look at the opportunities for moving into a
wholly new area where the company can exploit its existing strengths. Often they
may recommend entering the market for strategic reasons, that is, not because the
immediate investment is profitable but because it establishes the firm in the market
and creates options for possibly valuable follow-on investments. In other words,
there is a two-stage decision. At the second stage (the follow-on project) the finan-

cial manager faces a standard capital budgeting problem. But at the first stage proj-
ects may be valuable primarily for the options they bring with them.
15
To see the financial consequences of the business plan, you need to develop fore-
casts of future cash flows. If the likely operating cash flow is insufficient to cover
both the planned dividend payments and the investment in net working capital
and fixed assets, then the firm needs to ensure that it can raise the balance by bor-
rowing or by the sale of additional shares.
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
Cash-flow forecasts should always be subjected to a reality check. For exam-
ple, few companies can expect to continue to earn a high return on their invest-
ment without attracting competition. So firms are likely to find it difficult to
maintain a high return on assets indefinitely. Conversely, those with a low return
on assets may hope for some easing of competitive pressures and the arrival of
more normal returns.
16
When you prepare a financial plan, you shouldn’t look just at the most likely fi-
nancial consequences. You also need to plan for the unexpected. One way to do this
is to work through the consequences of the plan under the most likely set of circum-
stances and then use sensitivity analysis to vary the assumptions one at a time. An-
other approach is to look at the implications of different plausible scenarios.
17

For ex-
ample, one scenario might envisage high interest rates leading to a slowdown in
world economic growth and lower commodity prices. The second scenario might in-
volve a buoyant domestic economy, high inflation, and a weak currency.
832 PART IX
Financial Planning and Short-Term Management
16
For evidence that accounting returns tend to regress toward the mean, see Chapter 10 of K. G. Palepu,
P. M. Healy, and V. L. Bernard, Business Analysis and Valuation, South-Western College Publishing,
Cincinnati, OH, 2nd ed., 2000.
17
For a description of the use of different planning scenarios in the Royal Dutch/Shell group, see
P. Wack, “Scenarios: Uncharted Waters Ahead,” Harvard Business Review 63 (September–October 1985)
and “Scenarios: Shooting the Rapids,” Harvard Business Review 64 (November–December 1985).
29.5 FINANCIAL PLANNING MODELS
Suppose that management has asked you to assume a 20 percent annual growth in
Executive Paper’s sales and profits over the next five years. Can the company re-
alistically expect to finance this out of retained earnings and borrowing, or should
it plan for an issue of equity? Spreadsheet programs are tailor-made for such ques-
tions. Let’s investigate.
The basic sources and uses relationship tells us that
Thus there are four steps to finding how much extra cash Executive Paper will
need and the implications for its debt ratio:
Step 1 Project next year’s operating cash flow (depreciation provision plus net
income) assuming the planned 20 percent increase in revenues. This gives the to-
tal sources of funds in the absence of any new issue of securities. Look, for exam-
ple, at the second column of Table 29.6, which provides a forecast of operating cash
flow in year 2000 for Executive Paper.
Step 2 Project what additional investment in net working capital and fixed assets
will be needed to support this increased activity and how much of the net income

will be paid out as dividends. The sum of these expenditures gives you the total
Ϫ dividends
Ϫ investment in fixed assets
Ϫ investment in net working capital
ϭ operating cash flow
External capital required
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
uses of funds. The second column of Table 29.7 provides a forecast of uses of funds
for Executive Paper.
Step 3 Calculate the difference between the projected operating cash flow (from
Step 1) and the projected uses (Step 2). This is the cash that will need to be raised
from new sales of securities. For example, you can see from Table 29.7 that Execu-
tive Paper will need to issue $158.6 million of debt in 2000 if it is to expand at the
planned rate and not sell more shares.
Step 4 Finally, construct a pro forma balance sheet that incorporates the addi-
tional assets and the increase in debt and equity. This is done in the second col-
umn of Table 29.8. Executive Paper’s equity increases by the additional retained
earnings (net income less dividends), while long-term debt is increased by the
$158.6 million new issue.
Once you have set up the spreadsheet, it is easy to run out your projections for
several years. The final columns in Tables 29.6–29.8 show the pro forma income
statement, sources and uses of funds, and balance sheet for the year 2004, assum-

ing Executive Paper continues to fund a 20 percent annual growth rate solely from
retained earnings and new debt issues. Over the five-year period Executive Paper
would need to borrow an additional $1.2 billion and by year 2004 its debt ratio
would have increased to 67 percent. Most financial managers would regard this as
sailing much too close to the wind, and the debt ratio would probably be above the
limit set by the company’s banks and bondholders.
CHAPTER 29
Financial Analysis and Planning 833
1999 2000 2004
Revenues 2,200 2,640 5,474
Costs (90% of revenues) 1,980 2,376 4,927
Depreciation (10% of fixed assets at start of year) 53.3 55.0 114
EBIT 166.7 209.0 433.4
Interest (10% of long-term debt at start of year) 42.5 45 131.3
Tax (40% of pretax profit) 49.7 65.6 120.8
Net income 74.5 98.4 181.2
Operating cash flow 127.8 153.4 295.3
TABLE 29.6
Latest and pro forma
income statements
for Executive Paper
(figures in $ millions).
1999 2000 2004
Increase in net working capital (NWC) assuming NWC ϭ 20% of revenues 38.5 88 182.5
Investment in fixed assets (FA) assuming FA ϭ 25% of revenues 70.2 165 342.1
Dividend (60% of net income) 45.6 59.0 108.7
Total uses of funds 129.3 312.0 633.4
External capital required ϭ total uses of funds Ϫ operating cash flow 25.0 158.6 338.1
TABLE 29.7
Latest and pro forma statements of sources and uses of funds for Executive Paper (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
The obvious solution for Executive Paper is to issue a mix of debt and equity, but
there are other possibilities that the financial manager may want to explore. One
option may be to hold back dividends during this period of rapid growth, but it
turns out that even a complete dividend freeze would still leave Executive Paper
needing to raise just under $750 million of new funds. An alternative might be to
investigate whether the company could cut back on net working capital. For ex-
ample, we have seen that Executive Paper’s customers take 72 days to pay their
bills. Perhaps more careful control of credit collection could help to economize on
capital.
We stated earlier that financial planning is not just about exploring how to cope
with the most likely outcomes. It also needs to ensure that the firm is prepared for
unlikely ones. For example, the paper industry is notoriously exposed to economic
downturn. So you would certainly wish to check that Executive Paper could cope
with a cyclical decline in sales and profit margins. Sensitivity analysis or scenario
analysis can help you to do so.
Executive Paper’s problem is not unique, for many companies find that rapid
growth can bring burgeoning debt levels. Firms that fail to think through the fi-
nancial consequences of their growth plans are liable to get into BIG trouble. Look,
for example, at the Finance in the News box, which shows how British Telecom’s
attempt to become a global telecom company forced some hard thinking about
how to finance this growth.

Pitfalls in Model Design
The Executive Paper model that we have developed is too simple for practical ap-
plication. You probably have already thought of several ways to improve it—by
keeping track of the outstanding shares, for example, and printing out earnings
and dividends per share. Or you might want to distinguish between short-term
lending and borrowing opportunities, now buried in working capital.
The model that we developed for Executive Paper is known as a percentage of
sales model. Almost all the forecasts for the company are proportional to the fore-
casted level of sales. However, in reality many variables will not be proportional to
sales. For example, important components of working capital such as inventory
and cash balances will generally rise less rapidly than sales. In addition, fixed as-
sets such as plant and equipment are typically not added in small increments as
sales increase. Executive Paper’s plant may well be operating at less than full ca-
pacity, so that the company can initially increase output without any additions to
capacity. Eventually, however, if sales continue to increase, the firm may need to
make a large new investment in plant and equipment.
834 PART IX
Financial Planning and Short-Term Management
1999 2000 2004
Net working capital (20% of revenues) 440 528 1,095
Net fixed assets (25% of revenues) 550 660 1,369
Total net assets 990 1,188 2,463
Long-term debt 450 608.6 1,651
Equity 540 579.4 812
Total long-term liabilities and equity 990 1,188 2,463
TABLE 29.8
Latest and pro forma balance
sheets for Executive Paper
(figures in $ millions).
Brealey−Meyers:

Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
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© The McGraw−Hill
Companies, 2003
But beware of adding too much complexity: There is always the temptation to
make a model bigger and more detailed. You may end up with an exhaustive
model that is too cumbersome for routine use. The fascination of detail, if you
give in to it, distracts attention from crucial decisions like stock issues and divi-
dend policy.
There Is No Finance in Financial Planning Models
Why do we say there is no finance in these corporate financial models? The first
reason is that they usually incorporate an accountant’s view of the world. They
are designed to forecast accounting statements. They do not emphasize the
tools of financial analysis: incremental cash flow, present value, market risk,
and so on.
18
This may not matter as long as everyone recognizes the financial forecasts for
what they are. However, you sometimes hear managers stating corporate goals
in terms of accounting numbers. They may say, “Our objective is to achieve an
835
FINANCE IN THE NEWS
INVESTORS QUESTION BRITISH TELECOM’S
FINANCIAL PLANNING
As the country’s principal telecom supplier, British
Telecom (BT) was a safe, if somewhat uninspiring,
investment. Including short-term loans, its debt ra-

tio was a fairly conservative .38 and the volatility of
its stock returns was well below the average for UK
companies.
All that changed at the end of the 1990s when
BT made a series of foreign acquisitions and paid
several billion pounds for a license to offer third-
generation mobile services in the UK. These expen-
ditures were financed largely by new borrowing, in-
cluding a record $10 billion bond issue in the United
States. By December 2000 BT’s debt had expanded
to £30 billion and the debt ratio had climbed to .71.
To reassure new bondholders BT had agreed that, if
its debt rating were subsequently lowered, it would
increase the interest payment on its bonds. Not long
afterward the rating agencies announced that they
were considering a downgrade, which would in-
crease the cost of servicing BT’s debt.
BT’s aim was to reduce its debt by £10 billion,
and it hoped to achieve this by selling off some re-
cent acquisitions. Unfortunately, as the prices of
high-tech stocks fell away in the spring of 2001, this
plan began to look less and less attractive.
By March 2001 BT’s share price had fallen 70
percent from its high, and anxious investors be-
gan to question whether the company had a co-
herent strategy to deal with its mountain of debt
and to finance the heavy expenditures that would
be needed to exploit its mobile licenses. Various
questions were asked and debated. Should the
company press ahead with its plans to sell off

businesses? Could it live with its high debt ratio
for the time being? Should it seek to build up eq-
uity by cutting its dividend or by issuing new eq-
uity? It was clear that for BT, financial planning
had become central to the company’s survival.
18
Of course, there is no reason that the manager can’t use the output to calculate the present value of the
firm (given some assumption about growth beyond the planning period), and this is sometimes done.
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
annual sales growth of 20 percent,” or “We want a 25 percent return on book eq-
uity and a profit margin of 10 percent.” On the surface such objectives don’t
make sense. Shareholders want to be richer, not to have the satisfaction of a
10 percent profit margin. Also, a goal that is stated in terms of accounting ratios
is not operational unless it is translated back into what the statement means for
business decisions. For example, what does a 10 percent profit margin imply—
higher prices, lower costs, increased vertical integration, or a move into new,
high-margin products?
So why do managers define objectives in this way? In part such goals may be a
mutual exhortation to try harder, like singing the company song before work. But
we suspect that managers are often using a code to communicate real concerns. For
example, the goal to increase sales rapidly may reflect managers’ belief that in-
creased market share is needed to achieve scale economies, or a target profit mar-

gin may be a way of saying that the firm has been pursuing sales growth at the ex-
pense of margins. The danger is that everyone may forget the code and the
accounting targets may be seen as goals in themselves.
The second reason for saying that there is no finance in these planning models
is that they produce no signposts pointing toward optimal decisions. They do not
even tell us which alternatives are worth examining. For example, we saw that Ex-
ecutive Paper is planning for a rapid growth in sales and earnings per share. But is
that good news for the shareholders? Well, not necessarily; it depends on the op-
portunity cost of the capital that Executive Paper needs to invest. If the new in-
vestment earns more than the cost of capital, it will have a positive NPV and add
to shareholder wealth. However, the return that Executive Paper is forecasting to
earn on its new investment is little more than the interest rate on its debt and al-
most certainly below Executive’s cost of capital. In this case the company’s planned
investment will make shareholders worse off, even though the company expects
steady growth in earnings per share.
The capital that Executive Paper needs to raise depends on its decision to pay
out two-thirds of its earnings as a dividend. But the financial planning model
does not tell us whether this dividend payment makes sense or what mixture of
equity or debt the company should issue. In the end the management has to de-
cide. We would like to tell you exactly how to make the choice, but we can’t.
There is no model that encompasses all the complexities encountered in financial
planning.
As a matter of fact, there never will be one. This bold statement is based on
Brealey and Myers’s Third Law:
19
• Axiom: The number of unsolved problems is infinite.
• Axiom: The number of unsolved problems that humans can hold in their
minds is at any time limited to 10.
• Law: Therefore in any field there will always be 10 problems which can be
addressed but which have no formal solution.

Brealey and Myers’s Third Law implies that no model can find the best of all fi-
nancial strategies.
20
836 PART IX Financial Planning and Short-Term Management
19
The second law is presented in Section 12.2.
20
It is possible to build linear programming models that help search for the best strategy subject to spec-
ified assumptions and constraints. These models can be more effective in screening alternative finan-
cial strategies.
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
We started this chapter by noting that financial plans force managers to be consis-
tent in their goals for growth, investment, and financing. Before leaving the topic
of financial planning, we should look at some general relationships between a
firm’s growth objectives and its financing needs.
Recall that Executive Paper ended 1999 with fixed assets and net working cap-
ital of $990 million. In 2000 it plans to plow back $39.4 million, so net assets will
increase by 39.4/990 or 3.98 percent. Thus Executive Paper can grow by 3.98 per-
cent without needing to raise additional capital. The growth rate that a company
can achieve without external funds is known as the internal growth rate. For Ex-
ecutive Paper
We can gain more insight into what determines this growth rate by multiplying the

top and bottom of the expression for internal growth rate by net income and equity
as follows:
In 2000 Executive Paper expects to plow back 40 percent of net income and to
earn a return of 18.22 percent on the equity with which it began the year. At the
start of the year equity finances 54.55 percent of Executive Paper’s net assets.
Therefore
Notice that if Executive Paper wishes to grow faster than this without raising
equity capital, it would need to (1) plow back a higher proportion of its earn-
ings, (2) earn a higher return on equity (ROE), or (3) have a lower debt-to-equity
ratio.
21
Instead of focusing on how rapidly the company can grow without any external
financing, Executive Paper’s financial manager may be interested in the growth
rate that can be sustained without additional equity issues. Of course, if the firm is
able to raise enough debt, virtually any growth rate can be financed. It makes more
sense to assume that the firm has settled on an optimal capital structure which it
will maintain as equity is increased by the retained earnings. Thus the firm issues
only enough debt to keep the debt–equity ratio constant. The sustainable growth rate
is the highest growth rate the firm can maintain without increasing its financial
leverage. It turns out that the sustainable growth rate depends only on the plow-
back rate and the return on equity:
Sustainable growth rate ϭ plowback ratio ϫ return on equity
Internal growth rate ϭ .40 ϫ .1822 ϫ .5455 ϭ .0398,
or 3.98%
ϭ plowback ratio ϫ return on equity ϫ
equity
net assets
Internal growth rate ϭ
retained earnings
net income

ϫ
net income
equity
ϫ
equity
net assets
Internal growth rate ϭ
retained earnings
net assets
ϭ 3.98%
CHAPTER 29
Financial Analysis and Planning 837
29.6 GROWTH AND EXTERNAL FINANCING
21
Notice that the internal growth rate does not stay constant. As the firm plows back earnings, the debt-
to-equity ratio declines and the internal growth rate increases.
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
838 PART IX Financial Planning and Short-Term Management
For Executive Paper,
We first encountered this formula in Chapter 4, where we used it to value the
firm’s equity.
These simple formulas remind us that financial plans need to be consistent.

Firms may grow rapidly in the short term by relying on debt finance, but such
growth cannot be maintained without incurring excessive debt levels.
Sustainable growth rate ϭ .40 ϫ .1822 ϭ .0729,
or 7.29%
SUMMARY
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Managers use financial statements to monitor their own company’s performance,
to help understand the policies of a competitor, or to check on the health of a cus-
tomer. But there is a danger of being overwhelmed by the sheer volume of data.
That is why managers use a few salient ratios to summarize the firm’s leverage,
liquidity, efficiency, profitability, and market valuation. We have described some of
the more popular financial ratios.
We offer the following general advice to users of these ratios:
1. Financial ratios seldom provide answers, but they do help you to ask the right
questions.
2. There is no international standard for financial ratios. A little thought and com-
mon sense are worth far more than blind application of formulas.
3. You need a benchmark for assessing a company’s financial position. Compare
financial ratios with the company’s ratios in earlier years and with the ratios of
other firms in the same business.
Understanding the past is the first step to being prepared for the future. Most
firms prepare a financial plan that describes the firm’s strategy and projects its fu-
ture consequences by means of pro forma balance sheets, income statements, and
statements of sources and uses of funds. The plan establishes financial goals and is
a benchmark for evaluating subsequent performance.
The plan is the end result, but the process that produces the plan is valuable in
its own right. First, planning forces the financial manager to consider the combined
effects of all the firm’s investment and financing decisions. This is important be-
cause these decisions interact and should not be made independently. Second,
planning requires the manager to consider events that could upset the firm’s

progress and to devise strategies to be held in reserve for counterattack when un-
happy surprises occur.
There is no theory or model that leads straight to the optimal financial strategy.
Consequently, financial planning proceeds by trial and error. Many different strate-
gies may be projected under a range of assumptions about the future. The dozens
of separate projections that may be made during this trial-and-error process gen-
erate a heavy load of arithmetic. Firms have responded by developing corporate fi-
nancial planning models to forecast the financial consequences of different strate-
gies. We showed how you can use a simple spreadsheet model to analyze
Executive Paper’s strategies. But remember there is no finance in these models.
Their primary purpose is to produce accounting statements.
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 839
FURTHER
READING
There are some good general texts on financial statement analysis. See, for example:
G. Foster: Financial Statement Analysis, 2nd ed., Prentice-Hall, Inc., Englewood Cliffs,
NJ, 1986.
K. G. Palepu, V. L. Bernard, and P. M. Healy: Business Analysis and Valuation, South-Western
College Publishing, Cincinnati, OH, 2nd ed., 2000.
Three classic articles on the application of financial ratios to specific problems are:
W. H. Beaver: “Financial Ratios as Predictors of Failure,” Empirical Research in Accounting:

Selected Studies, supplement to Journal of Accounting Research, 1966, pp. 77–111.
W. H. Beaver, P. Kettler, and M. Scholes: “The Association between Market-Determined and
Accounting-Determined Risk Measures,” Accounting Review, 45:654–682 (October 1970).
J. O. Horrigan: “The Determination of Long Term Credit Standing with Financial Ratios,”
Empirical Research in Accounting: Selected Studies, supplement to Journal of Accounting Re-
search, 1966, pp. 44–62.
Corporate planning has an extensive literature of its own. Good books and articles include:
G. Donaldson: “Financial Goals and Strategic Consequences,” Harvard Business Review,
63:57–66 (May–June 1985).
G. Donaldson: Strategy for Financial Mobility, Harvard Business School Press, Boston, 1986.
A. C. Hax and N. S. Majluf: The Strategy Concept and Process—A Pragmatic Approach, 2nd ed.,
Prentice-Hall, Inc., Englewood Cliffs, NJ, 1996.
The links between capital budgeting, strategy, and financial planning are discussed in:
S. C. Myers: “Finance Theory and Financial Strategy,” Interfaces, 14:126–137 (January–
February, 1984).
Here are three references on corporate planning models:
W. T. Carleton, C. L. Dick, Jr., and D. H. Downes: “Financial Policy Models: Theory and Prac-
tice,” Journal of Financial and Quantitative Analysis, 8:691–709 (December 1973).
W. T. Carleton and J. M. McInnes: “Theory, Models and Implementation in Financial Man-
agement,” Management Science, 28:957–978 (September 1982).
S. C. Myers and G. A. Pogue: “A Programming Approach to Corporate Financial Manage-
ment,” Journal of Finance, 29:579–599 (May 1974).
QUIZ
1. Table 29.9 gives abbreviated balance sheets and income statements for Weyerhaeuser
Company. Calculate the following ratios:
a. Debt ratio.
b. Times-interest-earned ratio.
c. Current ratio.
d. Quick ratio.
e. Net profit margin.

f. Days in inventory.
g. Return on equity.
h. Payout ratio.
2. There are no universally accepted definitions of financial ratios, but five of the follow-
ing ratios make no sense at all. Substitute the correct definitions.
a. Debt–equity ratio ϭ (long-term debt ϩ value of leases)/(long-term debt ϩ value of
leases ϩ equity)
b. Return on equity ϭ (EBIT Ϫ tax)/average equity
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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
840 PART IX Financial Planning and Short-Term Management
Visit us at www.mhhe.com/bm7e
c. Payout ratio ϭ dividend/stock price
d. Profit margin ϭ (EBIT Ϫ tax)/sales
e. Inventory turnover ϭ sales/average inventory
f. Current ratio ϭ current liabilities/current assets
g. Sales-to-net-working-capital ϭ average sales/average net working capital
h. Average collection period ϭ sales/(average receivables Ϭ 365)
i. Quick ratio ϭ (current assets Ϫ inventories)/current liabilities
3. True or false?
a. A company’s debt–equity ratio is always less than 1.
b. The quick ratio is always less than the current ratio.

c. The return on equity is always less than the return on assets.
d. If a project is slow to reach full profitability, straight-line depreciation is likely to
produce an overstatement of profits in the early years.
e. A substantial new advertising campaign by a cosmetics company will tend to
depress earnings and cause the stock to sell at a low price–earnings multiple.
4. In each of the following cases, explain briefly which of the two companies is likely to
be characterized by the higher ratio:
a. Debt–equity ratio: a shipping company or a computer software company.
b. Payout ratio: United Foods Inc. or Computer Graphics Inc.
Income Statement
Net sales $15,980
Cost of goods sold 12,035
Other expenses 1,412
Depreciation 859
Earnings before interest and tax (EBIT) 1,674
Net interest 351
Tax 483
Earnings $ 840
Dividends 263
Balance Sheet
End of Year Start of Year
Cash and short-term securities 115 1,640
Receivables 1,247 1,296
Inventories 1,499 1,329
Other current assets 427 278
Total current assets 3,288 4,543
Tangible fixed assets 10,427 9,582
Other long-term assets 4,480 4,214
Total assets $18,195 $18,339
Short-term debt 733 909

Payables 921 961
Other current liabilities 1,050 1,083
Total current liabilities 2,704 2,953
Long-term debt and capital leases 5,114 5,100
Other long-term liabilities 3,544 3,113
Common shareholders’ equity 6,832 7,173
Total liabilities $18,195 $18,339
TABLE 29.9
Income statement
and balance sheet
for Weyerhaeuser
Company, 2000
(figures in millions).
Source: Weyerhaeuser
Company, 2000 annual
report.