mcs-ch3- financial goal setting

7/22/2019 MCS-CH3- Financial Goal Setting

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Financial Goal Setting

January, 2014

By: Prachi Kulkarn


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inancialGoalSetting

Financial Goal Setting includes estimating the

amount of capital to be raised by the firm andthe proportionate amount of securities andlaying down the policies as to the administrationof the financial plan.


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inancialGoalSetting Financial Forecasting

Forecasting is the formal process of predicting future

events which are going to affect significantly the

functioning of the organisation.

It implies the techniques of determining in advance

i) Requirement of Funds

ii) Utilisation of Funds


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inancialGoalSetting

FinancialForecasting


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inancialGoalSetting Techniques of Financial Forecasting

i. Percentage of Sales Method

ii. Days Sales Method

iii. Simple Linear Regression Method

iv. Multiple Regression Method

v. Projected Fund Flow Statement

vi. Projected Cash Flow Statement

vii.Projected Income Statement

viii. Projected Balance Sheet


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i. Percentage of Sales Method:

Level of sales significantly impacts financial needs ofa business. Hence, different items of expenses such asselling and distribution expenses, material cost, wages etccan be predicted with the help of sales forecast. Balance

sheet items such as debtors, creditors can also beascertained as a percentage to sales.Proper understanding of relationship between sales andbalance sheet items is a prerequisite.


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ii. Days Sales Method:

It is a traditional technique used to forecast balancesheet items based on number of days sales.e.g. Debtors turnover ratio, creditors turnover ratio,inventory turnover ratio etc.

iii. Simple Linear Regression Method:

Values of dependent variables (assets and liabilitiesare estimated on the basis of values of independent

variables (sales). Most of the balance sheet items areprojected one by one based on regression line.


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iv. Multiple Regression Method:

It is used when behavior of one variable is dependenton more than one factor. Sales is a function of severalvariables such as ad-spend, competitors ad-spend, growthin the industry from which a particular product derives

demand.

v: Projected Financial Statements:

Few key factors are projected and then others are

derived from those. This way income statement, balancesheet, cash flow statement and funds flow statement canbe projected.


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inancialGoalSetting

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Examples of Financial Forecasting

Income Statement

Y/E Mar, Rs mn FY05 FY06 FY07 FY08E FY09E

Net sales 171,539 200,915 266,500 298,175 341,649

Growth, % 32.6 17.1 32.6 11.9 14.6

Op. Other income 2,652 5,764 7,548 5,266 5,793

Total income 174,191 206,679 274,047 303,441 347,441

Operating expenses 152,480 180,778 242,215 270,411 308,689

EBITDA 21,710 25,901 31,832 33,030 38,752

Growth, % 17.9 19.3 22.9 3.8 17.3

Margin, % 12.5 12.5 11.6 10.9 11.2

Depreciation 4,502 5,209 5,863 6,895 8,783

EBIT 17,209 20,691 25,969 26,134 29,969

Growth % 18.0 20.2 25.5 0.6 14.7

Margin, % 10.0 10.3 9.7 8.8 8.8Interest received 637 671 554 1,000 750

Interest paid 2,178 2,935 3,685 4,308 4,294

Net interest 1,542 2,264 3,131 3,308 3,544

Other Non-operating Income 851 607 1,588 2,027 2,149

Pre-tax profit 16,519 19,035 24,427 24,853 28,574

Tax provided 4,150 5,245 6,597 6,089 7,001

MF Global PAT 12,369 13,790 17,830 18,764 21,573

Growth, % 60.8 11.5 29.3 5.2 15.0

Reported PAT 12,369 15,289 19,134 20,823 21,573

Equity Accounting PAT 13,758 15,959 21,378 22,595 25,997

EOI: Gains/(Losses) 0 1500 1305 2059 0

Unadj. shares (m) 362 383 385 407 407

Wtd avg shares (m) 362 383 385 407 407

Balance Sheet


Cash & bank 20,050 11,194 8,268 23,523 8,951

Marketable securities at cost13,473 4,647 3,351 3,351 3,351

Debtors 7,986 7,158 7,822 9,803 11,232

Inventory 16,014 20,122 25,010 28,592 32,761

Loans & advances 26,749 58,077 60,260 61,760 63,260

Other current assets 61 61 59 59 59

Total current assets 50,810 85,418 93,151 100,214 107,312

Investments 15,648 15,504 21,420 27,420 33,670

Gross fixed assets 66,120 79,716 87,758 132,891 159,891

Less: Depreciation 34,543 44,015 48,945 55,841 64,624

Add: Capital WIP 5,388 9,512 25,133 12,000 15,000

Net fixed assets 36,965 45,212 63,946 89,051 110,267

Non-current assets 47,142 54,633 77,598 108,703 136,169

Total assets 131,475 155,893 182,367 235,790 255,783

Current liabilities 54,146 59,003 59,935 63,684 69,552

Provisions 11,261 12,150 13,643 15,578 16,484

Total current liabilities 65,407 71,154 73,578 79,262 86,036

Non-current liabilities 24,954 29,368 40,091 56,588 56,588

Total liabilities 90,361 100,522 113,669 135,850 142,624

Paid-up capital 3,618 3,829 3,854 4,071 4,071

Reserves & surplus 37,496 51,542 64,843 95,869 109,088

Shareholders equity 41,114 55,371 68,698 99,940 113,159

Total equity & liabilities131,475 155,893 182,367 235,790 255,783

Source: Company, MF Global India Research Estimates


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Financials

Cash Flow


PBT 16,519 19,035 24,427 24,853 28,574

Depreciation, amortisation 4,502 5,209 5,863 6,895 8,783

Chg in working capital -2,701 -28,862 -5,308 -1,379 -324

Total taxes paid -4,150 -5,245 -6,597 -6,089 -7,001

Other operating activities 244 700 512 0 0

Other non-operating activities 0 -144 1,305 2,059 0

CF from operating activities 14,414 -9,307 20,201 26,339 30,033

Capital expenditure -8,989 -13,457 -24,596 -32,000 -30,000

Chg in investments -2,768 144 -5,915 -6,000 -6,250

Chg in marketable securities 4,215 8,825 1,297 0 0

Other investing activities 177 1,643 498 0 0

CF from investing activities -7,365 -2,845 -28,717 -38,000 -36,250

Free cash flow 7,050 -12,151 -8,516 -11,661 -6,217Equity raised/(repaid) -2,025 3,759 1,102 17,846 0

Debt raised/(repaid) 12,357 4,414 10,723 16,496 0

Dividend (incl tax) -5,156 -5,678 -6,764 -7,426 -8,354

Other financial activities 121 800 527 0 0

CF from financing activities 5,296 3,295 5,588 26,916 -8,354

Net chg in cash (a)+(b)+c 12,346 -8,856 -2,928 15,255 -14,571

Per-share data


MF Global EPS (INR) 34 36 46 46 53Equity Account. MF Global EPS(INR) 38.0 41.7 55.5 55.5 63.9Growth, % 48.3 9.6 33.1 0.1 15.1

Book NAV/share (INR) 113.1 144.3 178.0 245.2 277.7

FDEPS (INR) 34.2 36.0 43.8 46.1 53.0CEPS (INR) 46.6 49.6 61.5 63.0 74.6

CFPS (INR) 38.2 -25.9 47.8 54.7 68.5

DPS (INR) 12.5 13.0 15.0 16.0 18.0

Ratios

Y/E Mar FY05 FY06 FY07 FY08E FY09E

Return on assets (%) 11.5 10.4 11.5 9.9 9.6Return on equity (%) 32.3 28.7 28.8 22.3 20.3Return on Invested capital (%) 48.5 28.5 22.5 17.7 16.5RoIC/Cost of capital (x) 3.5 2.0 1.6 1.2 1.1RoIC - Cost of capital (%) 34.5 14.3 8.4 3.5 2.1Return on capital employed (%) 23.0 21.5 21.0 16.9 15.7Cost of capital (%) 14.0 14.2 14.1 14.3 14.5RoCE - Cost of capital (%) 9.0 7.3 7.0 2.6 1.3

Operating cash flow/Total debt (x) 1.3 (0.3) 0.5 0.7 0.4Total debt/Equity (x) 0.6 0.5 0.6 0.6 0.5

Asset turnover (x) 3.9 3.8 3.7 3.1 3.2

Sales/Total assets (x) 2.1 2.0 1.9 1.7 1.8Sales/Net FA (x) 3.9 4.0 4.2 3.5 3.7Working capital/Sales (x) 0.0 0.0 0.0 0.0 0.0Receivable days 5 7 11 11 12Inventory days 30 40 38 38 40Payable days 62 63 57 60 60Current ratio (x) 1.3 1.3 1.3 1.2 1.2Quick ratio (x) 0.8 0.7 0.7 0.7 0.7Interest cover (x) 154.4 8.4 1.5 0.8 1.3Dividend cover (x) 4.5 3.8 5.0 4.9 5.0

PER (x) 10.4 12.3 21.6 25.3 16.8PEG (x) 2 yr CAGR 1.6PCE (x) 6.3 6.8 9.3 8.6 6.8PCF (x) 7.3 55.2 54.7 14.9 17.5Price/Book (x) 2.3 2.1 1.9 1.8 1.7Yield (%) 2.1 2.1 0.9 0.8 1.2EV/Net sales (x) 0.5 0.5 0.5 0.5 0.5EV/EBITDA (x) 6.9 8.1 13.5 12.8 10.2EV/EBIT (x) 12.0 15.0 37.2 51.8 32.9EV/NOPLAT (x) 17.4 21.7 50.7 69.1 42.7EV/CE 1.5 1.4 1.3 1.3 1.2EV/IC (x) 2.0 2.0 1.8 1.6 1.5

Source: Company, MF Global India Research Estimates


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lGoalSetting Benefits of Financial Forecasting

I) Information for Financial Decision Making

Ii) Control Device for Financial discipline

Iii) Help for successful financial planning

Iv) Help for Preparation of Financial plan according to change in

economic environment and business situation

V) Enables optimum utilisation of funds

Vi) Enable Firm to Plan for its Growth and Financial Needs

Vii) Provides Warning to the Management

Viii) Help to Adopt appropriate Financial Policies


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FinancialgO ls


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lGoalSetting Financial Goals

i) EVA

ii) Free Cash Flow

iii) Return on Net Worth

iv) Price Earning Ratiov) Earning Per Share

vi) Return on Investment

R t R ti


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Return Ratios

EARNING PER SHARE : EPS indicates the quantum of net profit of the

year that would be ranking for dividend for each share of the

company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity

Shares

PRICE EARNING RATIO : PE Ratio indicates the number of times the

Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share

R t R ti


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lGoalSetting

Return Ratios

RETRUN ON ASSETS : Net Profit after Taxes/Total Assets

RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share

capital and long term funds provided by the owners and the

creditors of the firm at the beginning and end of the accounting

period.RETRUN ON EQUITY (ROE) :Net Profit after Taxes / Tangible Net Worth


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lGoalSetting The DuPont System

Profit Margin Total Asset Turnover

ROA Equity Multiplier

ROE


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ROE

Networth

AssetsTotal

AssetsTotal

IncomeNetMultiplierEquityROAROE


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ROE

AssetsTotal

Sales

Sales

IncomeNetTurnoverAssetTotalMarginProfitROA


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ROE

EquityCommonAssetsTotal

AssetsTotalSales

SalesIncomeNet

MultiplierEquityTurnoverAssetTotalMarginProfitROE


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Du Pont Chart


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EV


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lGoalSetting EVA (Economic Value Added)

EVA (Economic Value Added) was developed by a

New York Consulting firm, Stern Steward & Co in 1982to promote value-maximizing behavior in corporatemanagers.

Economic value added (EVA) is an internalmanagement performance measure that compares netoperating profit after tax to total cost of capital.

It is a single, value-based measure that was intended toevaluate business strategies, capital projects and tomaximize long-term shareholders wealth.


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EVA sets managerial performance target and links

it to reward systems. The single goal ofmaximizing shareholder value helps to overcomethe traditional measure problem, where differentmeasures are used for different purposes with

inconsistent standards and goal.


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lGoalSetting Interpreting EVA

Assume that Company XYZ has the following

components to use in the EVA formula:- NOPAT = Rs. 33,80,000

- Capital Investment = Rs. 13,00,000

- WACC = .056 or 5.60%

EVA (Rs)= 33,80,000 - (13,00,000 x .056) = 33,07,200

The positive number tells us that Company XYZ more

than covered its cost of capital. A negative numberindicates that the project did not make enough profit tocover the cost of doing business.

C i d


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lGoalSetting How Companies Have Used EVA

Name Timeframe Use of EVA

The Coca-

Cola Co.

Early 1980s Focused business managers on increasing

shareholder value

AT&T Corp.1994 Used EVA as the lead indicator of a

performance measurement system that included"people value added" and "customer value

added"

IBM 1999 Conducted a study with Stern Stewart that

indicated that outsourcing IT often led to short-

term increases in EVAHerman

Miller Inc.

Late 1990s Tied EVA measure to senior managers' bonus

and compensation system


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inancialGoalSetting 4 Ms of EVA

Measurement

EVA is the most accurate measure of corporateperformance over any given period

Management SystemEVA system covers the full range of managerial

decisions Motivation bonuses and compensation can be decided on the basis

of EVA

MindsetEVA system also facilitates decentralized decisionmaking

Th EVA C t f P fit bilit


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inancialGoalSetting The EVA Concept of Profitability

EVA = Net Operating Profit After Tax (NOPAT)

Capital Charge on Capital Employed, Or

EVA = (RoCE WACC) x Capital Employed

NOPAT = PAT + interest ( 1-t) +/- Accounting Adjustments

Capital Charge = WACC x Capital Employed

Capital Employed = Equity + Interest Bearing Liabilities

l l CC?


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inancialGoalSetting How to calculate WACC?

27

C t f E it d CAPM


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inancialGoalSetting Cost of Equity under CAPM

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Calculation of NOPAT


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inancialGoalSetting Calculation of NOPAT

PAT needs following adjustments to arrive at NOPATA. Financial Anomaly:Interest is treated as expense whereas dividend

is not. NOPAT is the profit of an unlevered company or firm.

B. Accounting Anomaly:Arise due to accounting assumptions for:depreciation, COGS, lease, amortisations and deferred tax (flexibilityto adopt policy by Generally Accepted Accounting Principles). The

idea is that you are figuring out the income from continuingoperations. Profits from R and D and strategic investments aretheoretically realized over time.Useful Tutorial:http://www.youtube.com/watch?v=7fTUnZvDMKM



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Balance Sheet As on 31 Mar, 2011 Income Statement for FY10-11

Equity (Rs. 5 each) 200,000 Sales 200000Reserves 300,000 Less:

10% Bonds 200,000 COGS 25000

Creditors 50,000 Interest on CD 20000

8% Long Term Loans 150,000 Interest on LTD 12000900,000 Expenses 20000

Cash 450,000 Depreciation 50000

Stock 100,000 127000

Debtors 200,000 PBT 73000Fixed Assets 150,000 Tax 21900

900,000 PAT 51100



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Balance Sheet As on 31 Mar, 2011 Income Statement for FY10-11 PAT 51100

Equity (Rs. 5 each) 200,000 Sales 200000 Add

Reserves 300,000 Less: Interest * (1-t) 22400

10% Bonds 200,000 COGS 25000 NOPAT 73500

Creditors 50,000 Interest on CD 20000 PAT 51100

8% Long Term Loans 150,000 Interest on LTD 12000 Add

900,000 Expenses 20000 Interest 32000

Cash 450,000 Depreciation 50000 Less Tax Shield 9600

Stock 100,000 127000 NOPAT 73500

Debtors 200,000 PBT 73000 EBIT 105000

Fixed Assets 150,000 Tax 21900 Less Tax 31500

900,000 PAT 51100 NOPAT 73500

Ke 20%

Capital Employed Cost of Capital CoC (1-t) Charge on Capital Employed

Equity 500,000 20% 20.0% 100,000

10% Bonds 200,000 10% 7.0% 14,0008% Long Term Loans 150,000 8% 5.6% 8,400

122,400

EVA -48,900RoE (PAT / NW) 10.2%

EPS 1.28

Strategies for increasing EVA


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inancialGoalSetting Strategies for increasing EVA

Increase the return on existing projects (improve

operating performance) Invest in new projects that have a return greater than

the cost of capital Use less capital to achieve the same return

Reduce the cost of capital Liquidate capital or curtail further investment in sub-

standard operations where inadequate returns arebeing earned

g Advantages of EVA


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inancialGoalSetting Advantages of EVA

EVA eliminates economic distortions of GAAP to focus

decisions on real economic results EVA provides for better assessment of decisions that

affect balance sheet and income statement or tradeoffsbetween each through the use of the capital charge

against NOPAT EVA decouples bonus plans from budgetary targets EVA covers all aspects of the business cycle EVA aligns and speeds decision making, and enhances

communication and teamwork

g


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Goal congruence of managerial and shareholder goals

achieved by tying compensation of managers andother employees to EVA measures

Better goal congruence than ROI Annual performance measured tied to executive

compensation Provision of correct incentives for capital employed Long-term performance that is not compromised in

favor of short-term results

Provision of significant information value beyondtraditional measures of EPS, ROA and ROE

g


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Effectively helps to explain the ability of a company to

generate clear surplus. Super profit can be calculated as the difference

between EVA of a company and EVA of a marketleader.

EVA can be linked to valuation of goodwill and shares.

g Limitations of EVA


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inancialGoalSetting Limitations of EVA

EVA does not control for size differences across

plants or divisions. EVA is based on financial accounting methods that

can be manipulated by managers.

EVA may focus on immediate results whichdiminishes innovation.

EVA provides information that is obvious but offersno solutions in much the same way as historical

financial statements do.

g


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inancialGoalSetting

Return Ratios:ROCE, ROE, ROI

g Return on Capital Employed


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inancialGoalSettin

Return on Capital Employed

It is the return earned on Capital Employed in Business

ROCE = EBIT / Capital Employed

= EBIT / (Equity + Non-current liabilities)

= EBIT / (Total Assets - Current Liabilities)

ROI = Profit from investment X 100

Investment

ng Uses of ROI


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inancialGoalSettin

Uses of ROI

i)To measure operating performance of Firm.

ii) To evaluate and control of Capital expenditureprojectsiii) To make Profit Planningiv) To analyse the profit by operating divisions

v) To analyse the profit by product linevi) Pricing of new projectvii) To analyse major cost areasviii) To determine the relative profiability of different

projects

ng Ways to Improve ROI


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inancialGoalSettin

Ways to Improve ROI

i) Increase Sale Price

ii) Reduce Costs

iii) Reduce Capital Employed

iv) Increase Profit

v) Optimising Profit Mix

Vi) Maximising the Capital Ultisation

ng Limitation of ROI


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Limitation of ROI

i) Manipulation

Ii) Different bases for computation

Iii) Emphasis on Short Term Profits

Iv) Poor Measure

V) Common Asset Allocation

ng


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inancialGoalSettin

OtherFinancial goals

ng Free Cash Flow


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inancialGoalSettin

Free cash flow (FCF) represents the cash that a

company is able to generate after laying out themoney required to maintain or expand its asset base.

Free cash flow is important because it allows acompany to pursue opportunities that enhance

shareholder value. Without cash, it's toughto develop new products, make acquisitions, paydividends and reduce debt.

ng Free Cash Flow


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inancialGoalSetti

Net Income

+ Amortisation/ Depreciation

- Changes in Working Capital

- Capital Expenditure

= Free Cash Flow

ng Return on Net Worth


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= Net Profit (PAT) X 100

Net Worth

ing Price Earning Ratio ( P/E Ratio)


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g ( )

Price Earning Ratio is an overall measure of the

desirability of the company,

It is a popular tool of valuation of equity.

PE Ratio = Market Price of SharesEPS

ing Earning Per Share (EPS)


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EPS is the Profit earned by each equity Share

This is the most important ratio the investors

EPS = PAT Pref DividendNo. of Equity Shares

ting Cash EPS


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This is a more reliable yardstick for measurement of

performance of companies.

This helps in estimating the companys capacity to pay

dividend to equity shareholders

CASH EPS = PAT + Depreciation - PD

No. of Equity Shares

ting Sensitivity Analysis


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Sensitivity Analysis is a modeling procedure used in

forecasting. Scenario AnalysisWhat If Many companies produce plans reflecting different

scenarios what if

Gives planners a feel for the impact of assumptions notcoming true. E.g. in steel industry, input i.e metal prices play

important role in projections. So one has to havemultiple price assumptions while forecasting thefinancials.

ting Sensitivity Analysis - Procedure


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List the key factors or parameters.

Attach the most likely values to each of the parametersand predict the most likely level of profit. Calculate the effect of varying the values of all or

selected parameters.

List the outcomes of the alternative assumptions andmake a subjective assessment of their likelihood. Draw conclusions for the purpose of deciding course of

action.

ting Sensitivity Analysis - Example


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From the following project details calculate the

sensitivity of the-

Project cost-Annual Cash Flow-Cost of capital

Which variable is more sensitive?Project cost Rs.12,00,000, Annual cash flow

Rs.4,50,000, Life of the project 4 years, cost of capital14%. The annuity factor @ 14% for 4 years is 2.9137 andat 18% for 4 years is 2.6667.

tting Sensitivity Analysis - Example


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(a) Calculation of NPV:PV of Annual Cash Flows

(4,50,000 x 2.9137) 13,11,165Less: Project Cost 12,00,000NPV 1,11,165

(b) Sensitivity for project cost:If the project cost is increased by Rs.1,11,165, the NPV of the project

will become zero. Hence, sensitivity for project cost is:1,11,165 x 100 / 12,00,000 = 9.26%

(c) Sensitivity for annual cash flow:If the annual cash flow is decreased by Rs.1,11,165, the NPV of the

project will become zero. Hence, sensitivity for annual cash flow is:1,11,165 x 100 / 13,11,165 = 9.26%

tting Sensitivity Analysis - Example


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(d) Sensitivity for cost of capital:Assuming x the cumulative annuity factor which gives zero NPV

So, 4,50,000x 12,00,000 = 0x = 2.6667 (same as at 18%)

Hence, sensitivity for cost of capital is: (18-14) x 100 / 14 = 29%

(e) The cash inflow is more sensitive, as only 8.48% change in cashinflow will make the NPV of the project zero.

tting


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mcs-ch3- financial goal setting

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