Q1-Explain how the EBIT Chart works (inputs determining the outputs-the two lines on the chart

Case Leahy Bread Company (LBC) in Cohen Finance Workbook, page 111( a 'caselette') SEE THE IS/BS MODEL & FLOW DIAGRAM TABS- YOU ARE NOW WORKING ON THE RED-COLORED ANALYSIS Learning Objectives 1 Learn the debt versus equity analysis as depicted in the Flow Diagram 2 Interpret an EBIT chart highlighting the indifference level of EBIT 3 Interpret the debt capacity analysis Consider the numerous, sometimes conflicting elements in the financing decision as summarized by the FRICTO acronym - income, risk, control, marketability, flexibility, and timing. 4 Make the debt vs. equity decision Reading 1 Read Cohen Finance Workbook Chapter 7 through top half of page 121. 2 Focus on the Leahy Bread Company analysis to learn how the DEBT vs. EQUITY FINANCING template works. The Debt vs Equity Financing tab on the Assignment 6 Template is the same template worked out for Leahy in the book.. Questions All data in the DEBT vs. EQUITY FINANCING template is entered for you in cells B3.B12 and row 65. You are asked to interpret the template; there are no data entries to make. 1 Explain how the EBIT Chart works (inputs determining the outputs-the two lines on the chart and the indifference point) in YOUR OWN WORDS. 2 Page 112 of the book shows LBCs forecast. Discuss the range of likely EBITs and relate them to the indifference EBIT - in your opinion, will future EBIT be lower than or higher than indifference EBIT? 3 Explain the meaning of the debt capacity calculation at row 62. 4 Recommend either debt or equity for the $392,675 financing and explain your reasoning. Frame your answer using the FRICTO framework, p 119 in the book, citing specifics from the analysis. Group work is encouraged...but...when you write your answers in this template, the work must be your own independent work. Doing otherwise violates academic integrity rules. THERE IS NO SINGLE CORRECT ANSWER. THE PURPOSE OF THE ASSIGNMENT IS TO LEARN THE PROCESS OF FINANCING WITH DEBT AND EQUITY. PERFECTION IS NOT EXPECTED. THIS IS WORK-IN-PROCESS; NOT FINISHED PRODUCT...I.E., A LEARNING EXPERIENCE. BUT, YOU MUST MAKE A CLEAR RECOMMENDATION BASED ON THE RESULTS OF THE ANALYSIS. INCOME STATEMENT Revenue Cost of sales Gross profit Other operating income Other operating expenses Total cost and expenses Operating profit (EBIT) Interest, finance costs Profit before tax Income tax Net profit after tax Dividends Reinvested in the business BALANCE SHEET ASSETS LIABILITIES AND EQUITY Current assets Current liabilities Cash Trade payables Investments Other accruals Trade receivables Tax liabilities Inventories Short-term loans, leases Non-current assets Non-current liabilities Property, plant & equipmentLoans, debt, leases due after 1 year Investment property Retirement benefit obligation Goodwill Deferred tax liabilities Total non-current liabilities WORKING CAPITAL spontaneous change with revenue ?what levels of ca, cl, s-t loans? CAPITAL BUDGETING ?what projects to accept? FINANCING ?what is the debt capacity? COST OF DEBT K-WACC Stockholder's equity (Net worth) Preferred stock Common stock Additional paid-in-capital Retained earnings OPERATING LEVERAGE FINANCIAL LEVERAGE Total assets Total liabilities & equity COST OF EQUITY VALUATION CASH FLOW COST OF CAPITAL ANALYSIS STEPS: 1-HISTORICAL RATIOS FINANCING 4-FORECAST & EFN 5-EQUITY VALUATION DEBT EQUITY DEBT 2-K-WACC 3-CAPITAL BUDGETING HISTORICAL RATIOS I/S & B/S FORECAST LONG-FORM FORECAST I/S, B/S, & RATIOS EFN EQUITY EBIT CHART 6-FINANCING income CAPITAL BUDGETING OP & CAP NATCF, NPV, IRR, PAYBACK K-WACC VALUATION ENTERPRISE VALUE USING FREE CASH FLOW MARKET MULTIPLES: P/E, MV/BV, REV, EBIT risk control mktblty flexblty timing A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 B C D E F G H I J K L M FINANCING (DEBT-EQUITY) DECISION Leahy Bread Company ANSWER BOXES BEGIN AT ROW 74 Inputs: External Financing Needed 392,675 from forecast Existing Common Shares 7,500 from company info Existing Long-Term Debt 300,000 from most recent historical balance sheet Interest Rate on Existing Debt 7.0% from company info Interest Rate on New Debt 9.0% given Boom EBIT 300,000 arbitrarily above optimistic forecast Bust EBIT 50,000 arbitrarily below pessimistic forecast Income Tax Rate 35.0% from income statement Share Price $100.00 from market info Equity 528,741 from most recent historical balance sheet Results: IF DEBT IS USED IF EQUITY IS USED BOOM BUST BOOM BUST 300,000 50,000 300,000 50,000 (21,000) (21,000) (21,000) (21,000) (35,341) (35,341) 0 0 243,659 (6,341) 279,000 29,000 (85,281) 2,219 (97,650) (10,150) 158,379 (4,121) 181,350 18,850 7,500 7,500 7,500 7,500 0 0 3,927 3,927 $21.12 $(0.55) $15.87 $1.65 5.3 0.9 14.3 2.4 EBIT Interest expense - old Interest expense - new Profit before tax Income tax Net profit Shares Shares - new Earnings per share Coverage ratio EBIT CHART $ 25.00 $ 20.00 $ 15.00 EPS $ 10.00 $ 5.00 $ 0.00 debt EPS 50000 ($ 5.00) 300000 EBIT EBIT debt EPS equity EPS 50000 ($0.55) $1.65 300000 $21.12 $15.87 Indifference point calculation: Common shares Income tax rate Interest expense Debt 7,500 35.0% 56,341 Equity 11,427 35.0% 21,000 EBIT Interest expense EBT Income tax EAT EPS 123,841 56,341 67,500 23,625 43,875 $5.85 123,841 Indifference EBIT 21,000 102,841 35,994 66,846 $5.85 Indifference EPS Debt capacity calculation: Bust EBIT 50,000 Interest coverage ratio per rating 5.9 AVAILABLE FOR INTEREST 8,475 Interest rate 9.0% DEBT CAPACITY 94,162 Existing debt 300,000 EXCESS DEBT CAPACITY -205,838 Boom 300,000 5.9 50,847 9.0% 564,972 300,000 264,972 Indiff. 123,841 5.9 BBB rating chosen 20,990 9.0% Credit rating 233,222 Interest coverage ratio 300,000 Debt ratio - approximate -66,778 AAA 27.3 12.6% Q1-Explain how the EBIT Chart works (inputs determining the outputs-the two lines on the chart and the indifference point) in YOUR OWN WORDS. Q2-Page 112 of the Cohen Finance Workbook shows LBCs forecast. Discuss the range of likely EBITs and relate them to the indifference EBIT - in your opinion, will future EBIT be lower than or higher than indifference EBIT? Q3-Explain the meaning of the debt capacity calculation at row 62. Q4-Recommend either debt or equity for the $392,675 financing and explain your reasoning. Frame your answer using the FRICTO framework, p 119 in the Cohen Finance Workbook, citing specifics from the analysis. AA A BBB BB B CCC 18 10.4 5.9 3.4 1.5 0.5 36.1% 38.4% 43.7% 51.9% 74.9% 100.6% \f2 FINANCIAL ANALYSIS AND DECISION MAKING: HANDBOOK & TEMPLATES Neil G. Cohen, DBA, CFA School of Business The George Washington University Washington, DC USA ngcohen@gwu.edu 2014 Neil G. Cohen. All rights reserved. 21 April 2014 3 TABLE OF CONTENTS CHAPTER 1 - USING FINANCIAL STATEMENTS INTELLIGENTLY The Close Relationship between Finance and Accounting: The IS/BS Model Structure and Terminology Issues Reliability of Financial Statements - Bogus or Accurate? ! " #$ #% CHAPTER 2 - FINANCIAL STATEMENT ANALYSIS WITH RATIOS Purpose of Financial Ratios Diagnostic Metrics Taxonomy of Financial Ratios The DuPont Formula Ratio Interpretation Template Operating Leverage and Breakeven Levels &' &( &% CHAPTER 3 - FORECASTING FINANCIAL STATEMENTS & DETERMINING EXTERNAL FINANCING NEEDED Percentage-of-Sales Forecasting of Financial Statements & Determining External Financing Needed The Short-Form Forecasting Model Interpreting External Financing Needed )) )) '' CHAPTER 4 - FINANCIAL ARITHMETIC - THE TIME VALUE OF MONEY Basics of Time Value of Money Tables for Compounding & Discounting Automating the Calculations Using HandyCalc '% ") "* CHAPTER 5 - CAPITAL BUDGETING & COST OF CAPITAL Overview of Capital Budgeting Calculate the Discount Rate - Weighted Average Cost of Capital (k wacc) Calculate Decision Criteria: Net Present Value, Profitability Index, Internal Rate of Return, Payback Period CHAPTER 6 - EQUITY VALUATION The Basics Dividend Discount Model (DDM) Free Cash Flow Equity Valuation (FCF) Model Market Multiples Equity Valuation Model Nine Elements in the Equity Valuation Process - A Summary $# (+ (% *( %* %% #+& #+$ CHAPTER 7 - DEBT VS. EQUITY FINANCING & LEASE VS. BORROW-TO-BUY ANALYSIS The Debt vs. Equity Decision The Lease vs. Borrow-to-Buy Decision #+( # 4 The image on the book cover depicts five key concepts in financial decision-making: Return and Risk, always considered together, refer to the duality at the root of finance theory, where return is a rate of return on investment and risk is the variability over time in that rate of return. Growth is the objective of (most) businesses, to grow revenues, profits, and the value of the business. Sustainability refers to the hope that growth in revenues, profits, and stock price will continue into the future. Cash Is King! (the king's crown) refers to the maxim that if it's not cash money (the stack of money), it's not real. The accountant's measurement of net income and retained earnings do not represent money that can be spent (the cigar box, where the money is kept in a small business); only cash can be spent. 5 CHAPTER 1 USING FINANCIAL STATEMENTS INTELLIGENTLY The Close Relationship between Finance and Accounting: The IS/BS Model Introduction Learning Objectives 1. Understand the layout and terminology of an income statement 2. Understand the layout and terminology of a balance sheet 3. Understand the layout and terminology of a cash flow statement 4. Understand the link between the income statement and balance sheet 5. Understand why Cash is King! Accounting is a Foreign Language This is a discussion about linguistics - you are learning a foreign language - with all the challenges that involves: irregularities, too many synonyms - and code switching, which to a linguist, is changing from one language to another in the same sentence or paragraph. Accountants and financial analysts don't make it easy for users of financial statements, with so many different terms and formats for presenting financial statements. This makes it frustrating for learners. Relax about it; as in language learning, practice and repetition is the key. You will get better at it as you go along. It's a skill, and building a skill takes time. Cash Basis versus Accrual Accounting Accrual accounting records all transactions, whether or not cash has changed hands. For example, if you pay employees every two weeks, the salary due them accrues day-by-day on your books as a current liability you owe to them. Similarly, if you obtained inventory on credit, then sell it to your own customer before you pay your supplier for it, the cost of the goods sold includes the cost of those items. Cash basis means that transactions are recorded only when cash changes hands: merchandise is sold for cash or an employee's salary is paid in cash. This means that when merchandise is sold on credit, or when raw materials are bought from suppliers on credit, no record of the transaction goes into the company's books if the cash basis is used. Accordingly, an income statement drawn at any given time, under the cash basis, will not reflect all of the business's transactions, and may provide a misleading picture of business performance. Under accrual accounting, such transactions must be included, as they should be, because they are costs of doing business. Under the cash basis, they would be excluded, understating the cost of doing business and overstating income tax and profit. Some businesses, especially those dealing in services rather than products and where cash is paid, can operate on the cash basis without great danger of having distorted financial statements. It is required under the accounting law, however, that most businesses use accrual accounting. This accounting method matches sales revenue against those 6 expenses incurred which generated the revenue for the accounting period, whether or not cash has changed hands. The IS/BS Model Financial statements describe the operations of a business - the scorecard for the business. Shown above is a summary diagram of the Income Statement/Balance Sheet accounting model of the business - organizing financial data so the performance of the business can be measured and controlled. The accounting model consists of the income statement, the balance sheet, and the cash flow statement, each of which is discussed in the material that follows. The information in financial statements is summarized with financial ratios, the subject of Chapter 2. Don't worry about that now. Gain a solid understanding of the financial statement terminology and structure - first things first! View the balance sheet as a snapshot of a business, freezing action at a moment in time. It lists the dollar amount in each asset, liability, and equity account. In contrast, view the income statement as a moving picture summarizing the flow of revenues and expenses during the period of time. Where the balance sheet is written as of an ending date (the moment in time), the income statement is written to cover a period of time (month, quarter, year). The balance sheet and the income statement are linked when the profit retained in the business, shown on the final line of the income statement, is added to the equity section of the balance sheet, increasing the owner's investment in the business, or decreasing it if there is a loss. 7 Balance Sheet is a SNAPSHOT of account balances FROZEN at a POINT in time Income Statement is a MOVING PICTURE of transactions FLOWING over a PERIOD of time ASSETS = LIABILITIES + EQUITY COMMON EQUITY = COMMON STOCK + RETAINED EARNINGS The universal accounting equation is shown in the box above: Assets equal liabilities plus equity. Look at the income statement/balance sheet model and relate what you see in the box, the accounting equation, to the structure of the financial statements depicted in the model. Since the last line on the income statement summarizes the results of running the business during a period of time....sales revenue minus expenses minus taxes minus dividends equals profit reinvested in the business....that profit reinvested is transferred into the equity account on the balance sheet. The balance sheet then portrays the position of the business at a moment in time at the end of the accounting period. An accountant is obligated to prepare financial statements that truly and fairly portray the results of business operations, following accounting principals and the law. No matter what country is involved, these are the fundamental principles: the business is assumed to be a going concern completeness truth clarity of presentation consistency with prior year agreement with closing balance sheet of previous year accrual accounting with matching of revenue and expenses prudence disclosures individual valuation of assets and liabilities inter period allocation of income and expense You will soon realize that formats and terminology for financial statements vary widely. To keep the focus clear and unambiguous, the formats used throughout this book are a 8 composite of illustrative financial statements from United States Generally Accepted Accounting Principles (USGAAP), International Accounting Standards (IAS), and International Financial Reporting Standards (IFRS)1. This approach minimizes confusion for those who are learning about financial statements for the first time. As your skills develop and your understanding deepens, you will be able to work with any format and terminology that comes your way, because USGAAP, IAS, and IFRS are variations on the same theme. Layout and Terminology of the Income Statement 1 Revenue is also called sales, net sales, or turnover in some countries. Cost of sales, sometimes called cost of goods sold (CGS), is the cost to the business of either buying and/or producing the goods/services it sells. It includes wages, cost of operating a factory, depreciation, and other direct and indirect production costs. Cost of sales is a combination of fixed and variable costs. Sales minus cost of sales equals gross profit, also called gross margin. It represents the amount remaining to cover general overhead expenses after deducting the cost of making or buying the goods that are sold. A concise, clearly written article on IFRS is \"Illustrative Financial Statements Presentation and Disclosure Checklist: International Financial Reporting Standard for Small and Medium-Sized Entities.\" Find it on this website: http://www.ifrs.org/IFRS+for+SMEs/IFRS+for+SMEs+and+related+material.htm 9 Distribution costs, sometimes called selling costs, are those connected with sales and marketing activity. Administrative costs are the general overhead of the business. Research and development expense can be included here or given a separate account title of its own. Although distinctions between fixed cost and variable cost are rarely found in published financial statements, you can think of distribution costs as more variable than administrative costs - although both categories include both fixed and variable components. Depreciation and amortization expense recognizes the usage of fixed assets such as buildings (but not land, which is not depreciated), machines, and equipment. Many income statements do not show depreciation expense as a separate item. Instead, it is included as part of cost of sales, distribution costs, administrative costs, etc. Remember that depreciation is a non-cash charge. An expense such as paying salary to workers means that cash is paid out - a cash charge. Depreciation is a non-cash charge because no cash is paid out. It is an expense that recognizes the use of previously purchased fixed assets. Depreciation and amortization expense is linked to the balance sheet when the annual expense is added to the account for accumulated depreciation and amortization on the balance sheet. For example, an asset is purchased for $1,000 to be depreciated over 10 years. Each year there is $100 depreciation expense on the income statement. After the first year, the fixed asset is booked at $900, the $1,000 purchase price minus $100 depreciation for the first year. After ten years, the fixed asset will be valued at $0 because $100 of depreciation for each of 10 years accumulates to $1,000. Other operating costs is a catch-all account for other items Restructuring costs will be zero unless these non-recurring costs occur. Profit from operations is gross profit less all operating expenses. This account is also called earnings before interest and taxes (EBIT). It is also called operating profit, and is sometimes it is called trading profit. Interest, financing expense is interest paid on borrowed money. Income from investments is non-operating income Disposal of operations will be zero unless these non-recurring costs occur. Profit before tax is the sum of operating profit or loss, financial profit or loss, and extraordinary items. Income tax is income tax. Profit after tax is profit before tax minus income tax. This is the so-called bottom line of an income statement, the figure showing how well the business has performed during the accounting period. Minority interest, other provides a place to enter these special categories, if relevant. Dividends means cash dividends paid to owners Other is a catch-all category Reinvested in the business also called increase in retained earnings, which is transferred to the balance sheet to show the increase (or decrease if a loss occurs) in the stockholder's equity from the current period's activity. 10 Layout and Terminology of the Balance Sheet 11 Assets are listed in order of liquidity (that is, the ease with which the asset can be converted into cash). Liabilities are listed according to the priority claims of creditors. Equity is the difference between assets and liabilities; it represents the book value of the owner's equity in the business. It is called book value because it is the amount on the books. It has little or nothing to do with the market value of the business, as you will see later in the course. Equity is considered a residual because it is the amount remaining after what is owed (liabilities) is subtracted from what is owned (assets). Current assets: Cash & equivalents includes the cash in the till, cash in the bank, and highly liquid, high quality securities with short maturities Investments are liquid investments, usually securities Trade receivable, also called accounts receivable, is the total amount of money owed to your company by the customers who have purchased goods or services on credit. The credit terms may be very short, such as 15 days, or very long, up to one year. If you know from past experience that a certain percentage of these accounts, say 2%, will never be collected, the accounts receivable entry should be net of the estimate of uncollectible accounts. Deduct an estimate of bad debts to get net accounts receivable. Inventory means goods available for sale to customers, and includes all costs involved in producing or obtaining them. In manufacturing, it is divided into three categories: raw materials, work-in-progress, and finished goods. Include only goods available for sale; office supplies, spare parts for production equipment, and gasoline for delivery trucks may not be classified as inventory items. Other current assets is a catchall category. Non-current assets, also called fixed assets: Property, plant and equipment-gross are assets with useful lives in excess of one year. Note that land is not depreciated - it does not wear out or get used up. Accumulated depreciation and amortization is the aggregate, cumulative depreciation and amortization expense from all income statements, year-by-year. Property, plant, and equipment-net is property, plant and equipment less accumulated depreciation and amortization. Investment property is ambiguous and depends on the situation, likely to be an ownership interest in another business Goodwill is the excess of market value paid over book value in an acquisition. It may also include intangibles such as intellectual property or trademarks. Other is a catchall category. Current liabilities: Trade and other payables, also called accounts payable, is the amount of money owed to suppliers for goods or services bought on credit. The credit terms can be very short, say 10 days, or up to one year, and still be considered a current liability. This account is vendor financing. Retirement benefit obligation is pension payments due to retired employees within one year. Tax liabilities, also called income tax payable or accrued taxes, is the income tax due to governments within one year. Leases due in 1 year is short-term lease payments due Loan, debt due in 1 year is the principal amount of borrowings due in one year. 12 Other is a catchall category. Non-current liabilities, sometimes called long-term debt: Retirement benefit obligation is aggregate pension payments due to retired employees. Deferred tax liabilities are the reconciling entry between the income tax calculated on GAAP taxable income and the income tax calculated on the income tax return. An alternative definition is the difference between taxes due and taxes paid under different accounting regimes, such as accelerated depreciation used on the tax return and straight-line depreciation used on GAAP financial statements. Finance leases due after 1 year is the present value of future lease payments. Loans, debts due after 1 year is the principal amounts of borrowings. Other is a catchall category. Shareholder's equity (Net worth): Preferred stock is the par value of preferred shares outstanding. Common stock is the par value of shares issued to shareholders. Additional paid-in capital is the difference between the amount the investor paid for shares issued and the par value of the shares when the shares were issued. In modern accounting, common stock and paid-in-capital can be summed, to represent the money paid by owners when the shares were issued to them. Other is a catchall category. Retained earnings is accumulated profit (loss) since the business started. It is increased (decreased) each year when profits reinvested in the business (from the income statement) are added to the previous balance of accumulated profits on the balance sheet. (Treasury stock is a deduction for common stock repurchased by the corporation. It is a misnomer because stock repurchase reduces shares outstanding - repurchased shares no longer exist after they are repurchased - they are cancelled - therefore, treasury stock does not exist and does not appear as an entry on this balance sheet. Total equity (also called net worth) is the sum of preferred stock, common stock, additional paid-in-capital, other, and retained earnings Minority interest is a catchall category. The Link between Income Statement and Balance Sheet The above sections discussed the income statement and the balance sheet independently. From now on, the two financial statements will be discussed as a set, because one cannot be interpreted without the other. From our discussion of income statements, you should remember that the bottom line is profit after tax minus dividends: profit reinvested in the business. This is the result of the moving picture of business operations for the year (or quarter or month). How do the results of the moving picture get into the snapshot shown by the balance sheet? The answer is simple: profit (loss) reinvested in the business, shown at the bottom of the income statement, is added to the accumulated profit (loss) on the balance sheet. 13 Keep in mind that : income statement reinvested profit is for only one period of time - the period for that particular income statement only. reinvested profit on the balance sheet is the accumulation of all reinvested profits from all the income statements since the business began. Similarly, keep in mind that: depreciation and amortization expense on the income statement is for that period only. accumulated depreciation and amortization on the balance sheet is the cumulative depreciation expense from all the income statements. Learn not to confuse depreciation expense (income statement) with accumulated depreciation (balance sheet). Eventually, accumulated depreciation reduces the book value of an asset to zero; signifying that is has been fully depreciated. Profit versus Cash Profit after tax is not the same as cash (unless cash basis accounting is used). Profit is a measurement of revenue minus expenses minus tax transactions, as defined by GAAP rules for accrual accounting, whether or not cash changes hands. As actual cash is collected, some goes to pay expenses, some goes to increase assets, some goes to pay liabilities, and some goes to pay dividends. A growing business almost always spends more cash than it receives, using external funds to close the gap. Therefore, please, never confuse cash with profit - they are not the same. A business with large and growing profit often has a cash deficit until it raises money from debt or equity financing. Material presented in subsequent weeks will emphasize why CASH IS KING. Cash is money. A firm can have positive net profit yet still go out of business because of a lack of cash .A business can invest money in working capital and fixed assets, or use the money to repay debt and give dividends to shareholders. Profit and retained earnings are creatures of accounting methods, not money. Lots of effort will be made during the weeks that follow to clarify this notion further. It is one of your key learning objectives - you can't afford to misunderstand it. Layout and Terminology of the Cash Flow Statement Cash flow statements are also called: Statement of sources and uses of funds Statement of sources and application of funds Statement of funds flows Statement of changes in financial position Funds statement Although there are variations in the layouts of cash flow statements, all of them are used as a bridge between the income statement and the balance sheet, for the purpose of tracing how funds were used and where those funds came from. A cash flow statement shown on the following page is derived from the income statement and balance sheet - it is not a unique statement. It rearranges the income statement and balance sheet data. 14 15 Classification of Sources and Uses of Funds The table below shows a simple summary for understanding the difference between a source and a use of funds. ASSET LIABILITY + EQUITY increases in these accounts are USES of funds increases in these accounts are SOURCES of funds decreases in these accounts are SOURCES of funds decreases in these accounts are USES of funds The cash flow statement summarizes the where got-where gone situation - sources and uses of funds. It is divided into three categories, operating activities, investing activities, and financing activities. The sum of cash inflows and outflows is the annual increase or decrease in cash. That figure, adjusted for the effect of foreign exchange rate changes and the cash balance at the beginning of the year, gives the cash balance at the end of the year. Operating activities are income statement flows. GAAP requires interest paid to be entered in this category, even though it seems more like an investment activity. Net cash provided by operating activities is sometimes abbreviated CFFO, Cash Flow From Operations. Investing activities represent increases or decreases in balance sheet asset accounts. Financing activities are increases or decreases in balance sheet liability or equity accounts adjusted by Dividends from the income statement. Know the three parts of the Cash Flow Statement, as it is shown above, know that it is derived from the income statement and balance sheet and is not a unique statement, and know the source/use definitions in the table above. Your primary effort should be placed on the income statement and balance sheet. Summary You must know, intimately, the format and terminology of income statements and balance sheets, however boring it may seem at this early point in the course. These statements are the way we portray the companies we are talking about. Above all, you must appreciate that net income on the income statement does not represent cash. It sounds silly to say it, but, only cash (on the balance sheet) is cash. It is the only money you can spend. You can't spend profit and you can't spend retained earnings. They may be accounting accruals, creations of accounting rules, but they are not cash. That's why we say Cash is King! There will be a lot more said about this as the course rolls on. 16 Structure and Terminology Issues Learning Objectives 1. Realize that financial statements are presented in many variations with no standard format 2. Realize that terminology of financial statements in full of synonyms and ambiguity 3. Learn to look for the context of the financial statements and interpret the details accordingly Be Aware of Multiple Layouts for Financial Statements You might expect published financial statements to follow a rigid layout where all income statements and balance sheets have the same format, with the same titles presented in the same order. Although accounting standards specify a detailed order of presentation and set of account titles, considerable variations from this layout are found in practice. You should not be bothered by variations from the system of accounts presented in the accounting standard. What you need to know is the logic of how the financial statements are organized and how they fit together, and to be flexible enough to interpret the context of what is presented. It's frustrating for the learner, I know, but it will become clear once you reach a critical mass of knowledge. Be Aware of Different Words Used to Name the Same Account Titles Account names in financial statements can have more than one name, causing confusion when you look at statements from different companies in different countries. You must be aware of the synonyms because they occur so often. For example, profit after tax can also be called either after tax profit, net profit, earnings after tax, or net income...all synonyms. You must be aware of the synonyms because they occur so often. For example, profit after tax can also be called either after tax profit, net profit, earnings after tax, or net income...all synonyms. You must be aware of the synonyms because they occur so often. We don't know if authors use terminology shifts on purpose to test your ability to be flexible, or if they are merely being careless. There is no nationwide or worldwide organization that decrees standard terminology. Normally, you can determine the meaning of an unfamiliar term from the context. Alternatively, use the list of synonyms. Listed as: below are groups of synonyms for terms that are used interchangeably, categorized income statement balance sheet other 17 Income statement (profit and loss statement): Revenue Sales Turnover Gross profit (money terms) Gross margin (percentage) Contribution margin Operating profit Earnings before interest and taxes (EBIT) Trading profit Pre-tax profit Profit before tax Earnings before tax Income before tax After-tax profit Profit after tax Earnings after tax Net income Net profit Balance sheet (position statement): Return on equity (ROE) Return on shareholder's investment Return to owners Share capital Common shares Common stock Invested capital Paid-in capital Stated value Additional paid-in value Excess over par Accumulated surplus Retained earnings Reinvested profit Earned surplus Balance sheet profit 18 Other: Leverage Financial Leverage Gearing Capital budgeting Investment decision Cost-benefit analysis Project analysis Summary This discussion made you aware of the too-numerous synonyms involved in financial statement terminology. We might wish for more consistency, but know that we won't get it, and must be ready to deal with financial statements as we find them. As you gain experience as a user of financial statements, familiarity with the context will permit you to interpret them properly in spite of terminology and format shifts. 19 Reliability of Financial Statements - Bogus or Accurate? Learning Objectives 1. Understand purpose of financial statements 2. Understand why many financial statements are bogus Is the Measuring Device Rigid or Elastic? Now that you have begun to master the terminology and structure of financial statements, do a reality check about the usefulness of this information. First off, think about this metal ruler. One inch is always one-inch long. The aluminum does not stretch or shrink. It always stays the same. The user of the ruler relies that the measuring device is consistent. Second off, think of the elastic band in these sweat pants. The tag inside says the size is 34, but you can stretch them to a 38 at least, or you can shrink them to maybe a 32 or 30. 20 Are the accounting principles that lie behind financial statements more like the aluminum ruler or the sweat pants' waistband? We might like it better if the answer was ruler - but that is the wrong answer. At their best, financial statements are put together using rules with lots of flexibility. If this shocks you, give it some thought. You don't want to be an overly trusting and nave user of financial statements. Accounting fraud is vigorously prosecuted all over the world. Huge fines are paid. Huge out-of-court settlements are paid by offending accounting firms when users financial statements successfully claim that they relied on those statements and were materially misled. Jail terms for perpetrators of accounting fraud are not unusual. Although the link below is about the law in the United States, it is included for your reference: http://www.sarbanes-oxley-forum.com/ Summary Published financial statements are not what they seem. Don't be reticent about taking them with a grain of salt. Even in the absence of covert fraud, there is a lot of bogus information in financial statements. It's healthy to view them as instruments used by corporations to put their best foot forward. 21 CHAPTER 2 FINANCIAL STATEMENT ANALYSIS WITH RATIOS Financial ratio analysis summarizes the data from the income statement and balance sheet so you can measure the performance of a business. Also, ratios are the basis for making forecasts of future operations. Learning Objectives 1. Interpret a financial statement using financial ratios 2. Understand the difference between comparisons of historical trends within a company and comparisons of ratios between companies 3. Understand the power of the DuPont formula 4. Understand the limitations of financial ratio analysis 5. Perform financial ratio analysis in an Excel spreadsheet Purpose of Financial Ratios - Diagnostic Metrics Think of financial ratios as measures of the relative health or sickness of a business. Just as a physician takes readings of a patient's temperature, blood pressure, heart rate, and blood count, a manager takes readings of a firm's liquidity, leverage, efficiency, profitability, and growth. Where the physician compares the readings to generally accepted guidelines such as a temperature of 98.6 degrees as normal, the manager uses trends over time within the company comparisons to peer companies and industry benchmarks. By itself, a financial ratio means little. Its meaning comes from making the proper comparisons. As you look at the discussion below, keep track of where the input figures for the ratios come from. Some ratios are made up of income statement figures, some are made up of balance sheet figures, and others use figures from both income statement and balance sheet. The RATIO INTERPRETATION template lists each ratio by name, and also shows its numerator and denominator, a useful display to help you remember the ratios and see their sources. In interpreting a ratio, remember that it results from many inputs. You may not be able to say that the ratio is bad, for example, solely because the numerator is too high. Instead, the problem may be that the denominator is the cause of the problem rather than the numerator. Be careful about jumping to conclusions before you examine all of the inputs making up the ratio. Taxonomy of Financial Ratios The ratios are listed in these categories: Liquidity Leverage Efficiency/Asset-Use 22 Profitability DuPont Formula - a summary model including three of the above ratios, leverage, efficiency, and profitability (but not liquidity) multiplied together resulting in return on equity Growth rates Liquidity Ratios Liquidity ratios measure the ability of the company to pay its bills. A liquid asset is one that can be converted to cash quickly without suffering a loss of value. Remember that assets are listed in the balance sheet in increasing order of relative liquidity. Keep in mind that current assets are uses of funds - increasing them means increased investment in the business, and vice versa. Similarly, current liabilities are sources of funds, such as supplier credit...increases provide more available funds to invest in the business. The current ratio compares current assets to current liabilities to show by how much current assets (cash plus accounts receivable plus inventories) exceeds current liabilities (bills that must be paid relatively soon). A lower current ratio means that you are in a riskier position, because fewer liquid assets will be there to cover current debts. A high ratio means greater liquidity. But a high ratio may also mean that you have too much invested in current assets. Remember, finance involves trade-offs. You may sleep better at night knowing that the current ratio is high and you are in not danger of becoming insolvent (running out of liquid assets so bills cannot be paid). The other side of the issue is that excessive investment in current assets reduces your rate of return, because more assets mean greater investment, the denominator in the rate of return calculation. The quick ratio, sometimes called the acid-test ratio, is similar to the current ratio. The difference is that inventory, the least liquid current asset, is deducted from the numerator of the fraction, because inventory can be liquidated less quickly than cash or accounts receivable. Day's sales in receivables, also called collection period, measured in number of days, shows how long it takes to collect from customers who get credit. The smaller the number of days, the more efficient the collections, and the less money must be invested in offering credit to customers. If customers demand relaxed credit terms, keeping receivables too low may reduce sales. The numerator of the fraction is net receivables (after deducting uncollectible accounts). The denominator is sales divided by 365, which gives sales per day. Day's cost of goods sold in inventory shows how many days of production (or purchases from vendors) is invested in inventory. The smaller the number of days, the better, because it means less money invested in inventory. The risk of stockouts must be considered; if inventory is too low, sales might fall when orders can't be filled. Another way to measure the same thing is inventory turnover. It shows how many times inventory is sold (turns over) each year, a measure of inventory efficiency. The higher the ratio the better, because it implies a smaller inventory for the level of sales, and a smaller inventory means that less money is invested in the business, raising rate of return. A ratio that is too low might imply the risk of running out of inventory and losing sales. A ratio measured in days, like day's cost of goods sold in inventory, is easy to interpret because 45 days vs. 90 days is easily interpreted. Day's cost of sales in payables, also called payment period, measured in number of days, shows how long it takes to pay suppliers who offer credit. The smaller the number of days, the quicker the suppliers are getting paid. The 23 numerator of the fraction is net payables. The denominator is cost of sales divided by 365, which gives cost of sales per day. Leverage Ratios Leverage ratios measure the use of borrowed money. They are measures of financial risk, which means the likelihood of insolvency or bankruptcy if you are unable to pay debts such as interest payments and repayment of loan principal. High leverage ratios are not automatically considered bad but should be interpreted as indications that the manager decided to use debt aggressively. The hope is to grow faster or increase profits by putting borrowed money to work. This is a reasonable goal. Understand that such a strategy involves risk. You must consider the risk-return trade-off in deciding how much debt is acceptable. Long-term debt to total capital compares the sum of long-term liabilities in the numerator to the sum of long-term liabilities plus equity in the denominator. The higher the ratio, the greater the use of borrowing, and the greater the financial risk. IAS requires that financial leases be included in long-term liabilities. Long-term debt to equity is the ratio of permanent debt financing to the funds supplied by owners. Remember that the funds supplied by owners, equity, includes money paid for shares when it was issued combined with all accumulated profits reinvested in the business during its entire history. Times interest earned (coverage ratio) indicates how easy or how hard it is to cover fixed interest payments on borrowed money. The numerator of the fraction is the funds available to pay interest, what remains after all operating expenses are deducted from revenue, i.e., EBIT. The denominator of the fraction is interest that must be paid. Think of it as the number of times the funds available for interest payments cover the interest that must be paid. The higher the coverage ratio, the safer, the greater the cushion available if EBIT falls. Full burden coverage restates the times interest earned ratio to include lease payments. Times interest earned considers only the interest expense part of borrowing. Full burden treats leases as fixed expenses just like debt, providing a more comprehensive indicator about whether operating profit is sufficient to service both leases and debt. Efficiency/Asset-Use Ratios The purpose of your business is to generate revenue and profits. Therefore, you invest in assets to create the business and produce the product or service you sell. So you want to measure how good you are at using assets to generate revenue, hence the efficiency ratios. Fixed asset turnover measures the efficiency of fixed assets in generating revenue. This is a turnover ratio, so a higher result is a good result. Total asset turnover measures the overall asset efficiency. Profitability Ratios Profitability ratios measure profit in relation to the income statement and balance sheet. Gross margin measures how much of each euro of revenue is left after cost of goods sold is deducted. It is a measure of how much is left to pay other expenses after the cost of making or buying the goods is deducted, before consideration of other operating expenses. 24 Operating profit margin measures what is left after all operating expenses are deducted from the revenue figure. Return on sales (ROS) compares profit after tax to sales. It shows how much of each euro of sales is left after all expenses, including income taxes, are paid. It does not consider repayment of debt principal, which is not an expense Return on assets (ROA) compares profit after tax to total assets. Return on equity (ROE) compares profit after tax to the funds supplied by owners, equity. This may be the most important number from the viewpoint of the owner, because it measures the rate of return on the money invested in the business. Return on invested capital (ROIC) compares EBIT after tax to the assets used to generate sales. Where ROS and ROA are dependent on and biased by the extent of debt financing used, because the numerator is profit after tax, ROIC is a performance metric independent of financing, because its numerator is after tax EBIT - no interest expense is considered in the calculation as it is in ROS and ROA. In the table below, Company A has earnings after tax (net income) of $18 with a ROE of 18%, while Company B has 4 times the earnings after tax but a ROE of 7.2%, less than one-half that of Company A. The bottom three lines of the example show three rate of return metrics. Company B's are all the same because it has no debt (financial leverage). The ROIC measure removes the impact of the financial policy differences - an important lesson. The DuPont Formula The DuPont formula is a powerful diagnostic tool because it decomposes Return on Equity (ROE) into three components. It is a concise and focused look at how profitability, leverage, and efficiency combine to determine the return on equity (ROE) of a business. The three terms are multiplicative, their product being ROE. The terms are: 1. 2. 3. 4. Profitability = Net Income Sales Efficiency = Sales Total Assets Leverage = Total Assets Shareholders' equity, generating #4: Return on Equity (ROE) = Net Income Equity 25 The DuPont formula explained above describes a three-component approach. The following describes a five-component approach that decomposes the profitability ratio into interest burden and tax burden so these two additional components can be examined separately. 1. Operating Profit Margin = EBIT Sales 2. Interest Burden = Before Tax Profit Net Income 3. Tax Burden = Net Income Before Tax Profit 4. Leverage = Total Assets Equity 5. Efficiency = Sales Total Assets, generating #6: 6. Return on Equity = Net Income Equity Growth Rates Growth rates provide percentage figures to measure growth over time in sales, expenses, profits, assets, or any other entry on the financial statements. Each is the percentage change from one year to the next. It is useful to compare growth rates of one account over different periods, and to compare growth rates for several accounts for the same time period, to uncover the relative changes. Warnings in Using Financial Ratios Warning signs are always posted when financial ratio analysis is underway. Several of the warnings follow. Please keep them in mind, because the quality of the conclusions you draw from a ratio analysis is important. They may be the basis of significant business decisions. Comparisons are relative. Understand the reasons behind changes in the trend of a ratio. Economic causes or industry causes may be the driving force rather than causes within your company. Do not get caught in the trap of thinking that differences in absolute dollar amounts are always significant ones. Be aware of the difference between relative comparisons and absolute comparisons, hence the year-to-year percentage changes shown the table above. Seasonal trends must be identified to avoid misinterpretation of the ratios. Some ratios will rise and fall during the year, as a result of seasonal influences that repeat year after year. Therefore, a change in a ratio from one quarter of the year to the next may be normal. Compare ratios using common time periods. Avoid comparing ratios using annual data to those using quarterly or semiannual data, unless adjustments are made. When significant changes in the underlying economic, industry, or company relationships have taken place during the periods of comparison, be extremely wary about drawing conclusions that will be used to plan for the future. When earnings per share figures are calculated and compared, you must remember to make adjustments for changes in the number of shares issued and outstanding from year to year (the number of shares changes when new shares are issued or repurchased, or when a split occurs). The denominator of the earnings-per-share calculation for all periods must contain the number of shares outstanding for the most recent time period. Unless the calculation is made using this number, the earnings-per-share data will be useless. The list of ratios for liquidity, leverage, efficiency, and profitability includes 16 ratios. What happens if many of them show adverse changes from year to year? Be aware 26 that only one weak factor could be the driving force behind every weak ratio, so be careful about considering driving factors and resulting factors. For example, a business with too much borrowing will have too much interest, so all debt ratios will be weak - all caused by the same thing. In the DuPont formula, if both efficiency and profitability are constant, and debt is rising, ROE will rise, which should not be interpreted as a strength, but a weakness. If the increase in debt is caused by strongly growing revenue, is it a bad thing or a good thing? It may be either - a matter of context provided by other information. These relationships are circular. It is dangerous to consider ratios as independent factors. Ratios often pose questions for further investigation rather than giving you the answer to questions. It is often necessary to look back at the numbers in the income statement and the balance sheet to properly interpret the result. 27 Ratio Interpretation Template (best viewed at 175% magnification or see Template Set.xls) A 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 B YEAR C D E F G H 2010 2011 TREND PRELIMINARY INTERPRETATION NUMERATOR DEMONINATOR Liquidity Ratios Current ratio Quick ratio Days sales in receivables Days cost of sales in inventory Days cost of sales in payables 1.6 1.1 75.4 59.9 47.6 1.3 0.8 56.3 54.0 65.0 -21% -21% -25% -10% 37% Leverage Ratios Long-term debt to total capital Long-term debt to equity Times interest earned Full burden coverage 57.9% 137.4% 1.8 1.5 45.5% 83.5% 3.8 3.1 -21% -39% 109% 107% 1.2 0.8 1.4 1.0 23.9% 6.8% 2.7% 2.2% 6.8% 4.7% 34.9% 11.3% 8.6% 8.5% 21.2% 9.4% 46% 65% 216% 283% 212% 100% positive, positive, positive, positive, positive, positive, 6.8% 2.7% 0.8 3.1 6.8% 21.3% 8.6% 1.0 2.5 21.2% 212% 216% 21% -19% 212% positive, big improvement positive, better turnover positive, less financial risk calculation check to verify row 121 Efficiency (Asset-Use) Ratios Fixed asset turnover Total asset turnover Profitability Ratios Gross margin Operating profit margin Return on sales Return on total assets (ROA) Return on equity (ROE) Return on invested capital (ROIC) DuPont Formula - ROE Profitability Efficiency Leverage ROE Check Compound Annual Growth Rates Revenues Gross profit Operating profit (EBIT) Total assets 40.8% 105.7% 131.9% 16.0% negative, less liquidity negative, less liquidity positive, quicker collections positive, faster turnover negative, paying more slowly current assets curr assets-inventory receivables inventory payables current liabilities current liabilities revenue/365 days cost of sales/365 days cost of sales/365 days positive, less financial risk positive, less financial risk positive, better coverage positive, better coverage l-t leases+loans+debt l-t leases+loans+debt operating profit (EBIT) oper profit + lease exp l-t leases+loans+debt+equity equity finance costs finance costs + (lease exp/[1-tax rate]) revenue revenue total non-current assets total assets gross profit operating profit (EBIT) net profit net profit net profit EBIT*I1-tax rate) revenue revenue revenue total assets equity total assets 19% positive, faster turnover 21% positive, faster turnover big improvement bigger improvement still bigger improvement still bigger improvement big improvement big improvement profitability x efficiency x leverage net profit revenue revenue total assets total assets equity net profit equity 2010 2010 2010 2010 - 2009 2009 2009 2009 2009 2009 2009 2009 First, look only at the DuPont Formula ratios Table in rows 121-125. You see the decomposition of ROE, which more-than-tripled from 6.8% to 21.3%. Profitability went up, about three times. Efficiency went up 21%, and leverage went down 19% (reducing leverage is good from a default risk standpoint, but bad from a ROE standpoint because lower profitability means lower ROE). The ROE check is performed in the spreadsheet by computing ROE directly as NP/E, rather than multiplying the three components together, to verify the calculation in row 121. The trend column is the rate of change from 2009 to 2010, showing the relative change for each component. The 216% change in profitability is the key driver of the 212% change in ROE. Conclusions from the financial ratio analysis of Universal Industries are: The large 212% increase in ROE, as discussed above, caused by very large 212% increase in profitability, helped by a smaller but still impressive 21% change in efficiency, hurt a little by a 19% decline in leverage is impressive but not likely to be sustainable. Profitability increase is powered by operating cost decreases shown in rows 114-15 and reduction of interest expense because of lower debt, confirmed. Unless sustainable, which is unlikely, profit growth may normalize in the future. Growth in revenue in row 128 is lower than growth in profits in rows 129-130, confirming the suspicion that profitability gains are driven by cost reduction rather than either unit volume or unit price increases. Big improvements in times interest earned and full burden coverage ratios may lead to a higher credit-quality rating and a reduction in interest expense. The liquidity situation is mixed; both days in receivables and inventory have improved (fewer days), but days in payables are higher. Collection of receivables may be more efficient and inventory control may be better, but, finance managers may view these metrics differently than production, marketing, and sales managers. More days in payables may mean that Universal is taking better advantage of vendor financing, but, it may be missing discounts for quick payment. 28 Summary You probably expect these financial ratios to give you answers about financial performance of businesses, but they may pose more questions than answers. It takes lots of practice and seasoning to work comfortably with them. A quick ratio analysis can be performed by with the DuPont Formula, then adding in the Coverage ratio. The question always comes up, do I need to memorize these ratios? Can I use a cheat sheet? Sure you can use a cheat sheet. But the more you rely on a cheat sheet, the less you know, the more you're going to struggle. You'll see that these ratios come up over and over again. So knowledge of what the terms mean, where the ratio comes from (income statement or balance sheet), if the ratio is made up of numerator or denominator only from the income statement or only from the balance sheet, or one from income statement and one from balance sheet, you should be getting used to all of that. Your color-coded IS/BS Model always guides you in seeing the source of each numerator and each denominator. Notice the three categories for decision-making listed in the IS/BS Model, upperright corner: WORKING CAPITAL changes spontaneously with revenue ?what levels of ca, cl, s-t loans? CAPITAL BUDGETING ?which projects to accept? FINANCING ?how much debt capacity? Your study of financial ratios should have given you insights into the following questions: What about WORKING CAPITAL POLICY? Is each account trending up or down over time? Is each account tracking with the industry benchmark, or is it higher or lower? What about Fixed Assets (the result of CAPITAL BUDGETING POLICY)? Is turnover rising or falling over time? Is turnover tracking with the industry benchmark, or is it higher or lower? Is there an indication about full or partial use of plant capacity, i.e., efficiency? Can a measure of high or low operating leverage (risk) be discerned? What about FINANCING POLICY? Is interest coverage rising or falling over time? Is interest coverage tracking with the industry benchmark, or it is higher or lower? Is debt capacity being used lightly or heavily? Can a measure of high or low financial leverage be discerned? 29 Operating Leverage and Breakeven Levels Breakeven Analysis and Operating Leverage Published financial statements do not help us very much if we want to distinguish between fixed and variable costs. Nevertheless, such knowledge, if we had it, would be important. You do have fixed and variable cost breakdowns for your own business, so this lesson tells you how important it is and what you need to know about it. Learning Objectives 1. Understand behavior of variable costs and fixed costs 2. Understand the double-edged sword of operating leverage 3. Understand difference between operating leverage and financial leverage Breakeven Analysis You may want to know, for each year of a business plan, what minimum level of revenue is needed to cover the costs of doing business. In other words, the break-even level of revenue is where you have zero before tax profit, but where all operating and financial expenses are covered. A complete discussion of break-even levels requires understanding of the behavior of fixed costs and variable costs. Some of the expense items listed on the income statement are fixed, that is, they stay at the same level no matter what the revenue is. An example of a fixed cost is rent. When the doors are open for business, rent does not rise or fall as revenue rises or falls. In contrast, other expense items on the income statement are variable costs, that is, they vary up and down as revenue volume varies up and down. An example of that is electricity used to power production machines. Be aware that even fixed costs are variable over the long run, such as an increase in rent when you move to a larger building. Breakeven Chart Below is the classic breakeven chart, plotting revenue against fixed cost, variable cost, and total cost. Where the revenue line intersects with the total cost line, profit is zero, defining the breakeven level of revenue. 30 Breakeven Point Revenue Cost Profit Total Cost Loss Variable Cost Fixed Cost Volume (Units) Notice that the fixed cost line steps up, indicating that growth in the business leads to increased overhead the variable cost line starts at zero the total costs line sums variable and fixed cost, and starts at the minimum level of fixed cost the revenue line starts at zero and is steeper than the cost lines breakeven is defined as zero profit, where revenue equals total cost 31 Fixed vs. variable costs Look at the income statement. Think about the nature of each of these categories. Ask yourself: To what extent are these costs fixed? In the long run, all costs are variable because even salaried employees can be fired, leases can be broken, buildings can be sold, and factories can be expanded. Legacy companies such as airlines use bankruptcy law to reduce fixed cost by rescheduling debt service payments, revising contractual terms of leases, rewriting collective bargaining agreements covering wages, health care, and pensions. For cost of goods sold, part of it is fixed and part variable. Only knowledge of the specifics behind a particular business will provide an estimate of the breakdown. Foremen's salaries, a portion of assembly-line laborers' salaries, a portion of plant maintenance cost, and a portion of the heat and light bill can all be considered fixed costs. No matter what fluctuations occur in revenue, the business will continue to operate, and expenses will be incurred. The portion of cost of goods sold that is not fixed is variable. That means the materials used in the production process, the electricity used by the machines, and the workers' salaries that are directly related to the volume of production are variable. General overhead is partly fixed and partly variable. Any personnel subject to layoff constitute variable costs, but there are limits to laying off experienced personnel who may not be available for rehiring when business picks up. It may be short-sighted to attempt to convert fixed costs into variable costs during temporary periods of slow business, because gearing back to full production may cost more than was saved, or may be hampered by not being able to rehire qualified personnel. For example, firing people will cost you in terms of reputation (people will be less willing to work for you and may demand greater compensation to do so), retraining costs and overall morale. Fixed cost, variable cost, and risk It can be said that high fixed-cost businesses are more risky than low fixed cost businesses. With high fixed costs, it is easier for a decline in revenue to result in a loss, because fixed costs must be paid even when revenue drops. A business with low fixed costs, however, can suffer a much larger drop in revenue before a loss occurs, because as its revenue fall, most of the costs of operating fall along with them. Therefore, keep in mind the magnification effect behind the relationship of fixed costs to total costs. 32 The box below demonstrates operating leverage. Company A has $200 of fixed costs. As its revenue doubles from one year to the next, its operating profit triples. Company B has no fixed costs, only variable costs. As its revenue doubles from one year to the next, its operating profit doubles - the same proportion as the revenue increase. In contrast, Company A had a magnified increase in its operating profit, tripling when revenue doubled. This is how operating leverage works. The presence of fixed costs causes a magnified change in operating profit when revenues change. Don't forget that it works both ways - the change in operating profit is magnified on the downside as well as the upside. That is why it involves risk. Revenue Fixed cost Variable cost Operating profit Operating Leverage Company A Company B YEAR 1 YEAR 2 YEAR 1 YEAR 2 1000 2000 1000 2000 200 200 0 0 600 1200 800 1600 200 600 200 400 Summary Operating leverage is an under-appreciated aspect of financial management. Much more attention is paid to financial leverage, which is a big oversight. The significance of operating leverage is, the greater the proportion of fixed operating costs to operating total costs, the greater will be the change in EBIT when sales change. With General Motors having very heavy fixed costs because of its labor contracts, a given percentage of falling sales creates a magnified fall in EBIT. If 100% of costs were variable, they would rise and fall in proportion to rises and falls in sales. Leverage is a double-edged sword. When it cuts with you, it's good because a given percentage ch