Financial Goal Setting

By: Prachi Kulkarni

January, 2014

MCS- CH3 Financial Goal Setting

Financial Goal Setting includes estimating the

amount of capital to be raised by the firm and the proportionate amount of securities and laying down the policies as to the administration of the financial plan.

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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

MCS- CH3 Financial Goal Setting

Financial Forecasting

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Techniques of Financial Forecasting

i. ii. iii. iv.

Percentage of Sales Method Days Sales Method Simple Linear Regression Method Multiple Regression Method

v.
vi. vii. viii.

Projected Fund Flow Statement

Projected Cash Flow Statement Projected Income Statement Projected Balance Sheet

MCS- CH3 Financial Goal Setting

Techniques of Financial Forecasting

i. Percentage of Sales Method: Level of sales significantly impacts financial needs of a business. Hence, different items of expenses such as selling and distribution expenses, material cost, wages etc can be predicted with the help of sales forecast. Balance sheet items such as debtors, creditors can also be ascertained as a percentage to sales. Proper understanding of relationship between sales and balance sheet items is a prerequisite.

MCS- CH3 Financial Goal Setting

Techniques of Financial Forecasting

ii. Days Sales Method: It is a traditional technique used to forecast balance sheet 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 liabilities are estimated on the basis of values of independent variables (sales). Most of the balance sheet items are projected one by one based on regression line.

MCS- CH3 Financial Goal Setting

Techniques of Financial Forecasting

iv. Multiple Regression Method: It is used when behavior of one variable is dependent on more than one factor. Sales is a function of several variables such as ad-spend, competitors ad-spend, growth in 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, balance sheet, cash flow statement and funds flow statement can be projected.

MCS- CH3 Financial Goal Setting

Examples of Financial Forecasting

Income Statement
Y/E Mar, Rs mn FY05 FY06 200,915 17.1 5,764 206,679 180,778 25,901 19.3 12.5 5,209 20,691 20.2 10.3 671 2,935 2,264 607 19,035 5,245 13,790 11.5 15,289 15,959 1500 383 383 FY07 266,500 32.6 7,548 274,047 242,215 31,832 22.9 11.6 5,863 25,969 25.5 9.7 554 3,685 3,131 1,588 24,427 6,597 17,830 29.3 19,134 21,378 1305 385 385 FY08E FY09E Net sales 171,539 Growth, % 32.6 Op. Other income 2,652 Total income 174,191 Operating expenses 152,480 EBITDA 21,710 Growth, % 17.9 Margin, % 12.5 Depreciation 4,502 EBIT 17,209 Growth % 18.0 Margin, % 10.0 Interest received 637 Interest paid 2,178 Net interest 1,542 Other Non-operating Income 851 Pre-tax profit 16,519 Tax provided 4,150 MF Global PAT 12,369 Growth, % 60.8 Reported PAT 12,369 Equity Accounting PAT 13,758 EOI: Gains/(Losses) 0 Unadj. shares (m) Wtd avg shares (m) 362 362 298,175 341,649 11.9 14.6 5,266 5,793 303,441 347,441 270,411 308,689 33,030 38,752 3.8 17.3 10.9 11.2 6,895 8,783 26,134 29,969 0.6 14.7 8.8 8.8 1,000 750 4,308 4,294 3,308 3,544 2,027 2,149 24,853 28,574 6,089 7,001 18,764 21,573 5.2 15.0 20,823 21,573 22,595 25,997 2059 0 407 407 407 407

Balance Sheet
Y/E Mar, Rs mn FY05 FY06 11,194 4,647 7,158 20,122 58,077 61 85,418 15,504 79,716 44,015 9,512 45,212 54,633 155,893 59,003 12,150 71,154 29,368 100,522 FY07 8,268 3,351 7,822 25,010 60,260 59 93,151 21,420 87,758 48,945 25,133 63,946 77,598 182,367 59,935 13,643 73,578 40,091 113,669 3,854 64,843 68,698 182,367 FY08E FY09E Cash & bank 20,050 Marketable securities at cost13,473 Debtors 7,986 Inventory 16,014 Loans & advances 26,749 Other current assets 61 Total current assets 50,810 Investments 15,648 Gross fixed assets 66,120 Less: Depreciation 34,543 Add: Capital WIP 5,388 Net fixed assets 36,965 Non-current assets 47,142 Total assets 131,475 Current liabilities Provisions Total current liabilities Non-current liabilities Total liabilities 54,146 11,261 65,407 24,954 90,361 23,523 8,951 3,351 3,351 9,803 11,232 28,592 32,761 61,760 63,260 59 59 100,214 107,312 27,420 33,670 132,891 159,891 55,841 64,624 12,000 15,000 89,051 110,267 108,703 136,169 235,790 255,783 63,684 15,578 79,262 56,588 135,850 69,552 16,484 86,036 56,588 142,624

Paid-up capital 3,618 3,829 Reserves & surplus 37,496 51,542 Shareholders equity 41,114 55,371 Total equity & liabilities131,475 155,893

4,071 4,071 95,869 109,088 99,940 113,159 235,790 255,783

Source: Company, MF Global India Research Estimates

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Financials
Cash Flow
Y/E Mar, Rs mn PBT Depreciation, amortisation Chg in working capital Total taxes paid Other operating activities Other non-operating activities CF from operating activities Capital expenditure Chg in investments Chg in marketable securities Other investing activities CF from investing activities Free cash flow Equity raised/(repaid) Debt raised/(repaid) Dividend (incl tax) Other financial activities CF from financing activities Net chg in cash (a)+(b)+c FY05 16,519 4,502 -2,701 -4,150 244 0 14,414 -8,989 -2,768 4,215 177 -7,365 7,050 -2,025 12,357 -5,156 121 5,296 12,346 FY06 FY07 FY08E FY09E 19,035 24,427 24,853 28,574 5,209 5,863 6,895 8,783 -28,862 -5,308 -1,379 -324 -5,245 -6,597 -6,089 -7,001 700 512 0 0 -144 1,305 2,059 0 -9,307 20,201 26,339 30,033 -13,457 -24,596 -32,000 -30,000 144 -5,915 -6,000 -6,250 8,825 1,297 0 0 1,643 498 0 0 -2,845 -28,717 -38,000 -36,250 -12,151 -8,516 -11,661 -6,217 3,759 1,102 17,846 0 4,414 10,723 16,496 0 -5,678 -6,764 -7,426 -8,354 800 527 0 0 3,295 5,588 26,916 -8,354 -8,856 -2,928 15,255 -14,571

Ratios
Y/E Mar Return on assets (%) Return on equity (%) Return on Invested capital (%) RoIC/Cost of capital (x) RoIC - Cost of capital (%) Return on capital employed (%) Cost of capital (%) RoCE - Cost of capital (%) Operating cash flow/Total debt (x) Total debt/Equity (x) Asset turnover (x) Sales/Total assets (x) Sales/Net FA (x) Working capital/Sales (x) Receivable days Inventory days Payable days Current ratio (x) Quick ratio (x) Interest cover (x) Dividend cover (x) FY05 11.5 32.3 48.5 3.5 34.5 23.0 14.0 9.0 1.3 0.6 3.9 2.1 3.9 0.0 5 30 62 1.3 0.8 154.4 4.5 FY06 10.4 28.7 28.5 2.0 14.3 21.5 14.2 7.3 (0.3) 0.5 3.8 2.0 4.0 0.0 7 40 63 1.3 0.7 8.4 3.8 FY07 11.5 28.8 22.5 1.6 8.4 21.0 14.1 7.0 0.5 0.6 3.7 1.9 4.2 0.0 11 38 57 1.3 0.7 1.5 5.0 FY08E 9.9 22.3 17.7 1.2 3.5 16.9 14.3 2.6 0.7 0.6 3.1 1.7 3.5 0.0 11 38 60 1.2 0.7 0.8 4.9 FY09E 9.6 20.3 16.5 1.1 2.1 15.7 14.5 1.3 0.4 0.5 3.2 1.8 3.7 0.0 12 40 60 1.2 0.7 1.3 5.0

Per-share data
Y/E Mar, Rs mn FY05 FY06 36 41.7 9.6 144.3 36.0 49.6 -25.9 13.0 FY07 46 55.5 33.1 178.0 43.8 61.5 47.8 15.0 FY08E FY09E 46 55.5 0.1 245.2 46.1 63.0 54.7 16.0 53 63.9 15.1 277.7 53.0 74.6 68.5 18.0 MF Global EPS (INR) 34 Equity Account. MF Global EPS(INR) 38.0 Growth, % 48.3 Book NAV/share (INR) 113.1 FDEPS (INR) 34.2 CEPS (INR) 46.6 CFPS (INR) 38.2 DPS (INR) 12.5

PER (x) PEG (x) 2 yr CAGR PCE (x) PCF (x) Price/Book (x) Yield (%) EV/Net sales (x) EV/EBITDA (x) EV/EBIT (x) EV/NOPLAT (x) EV/CE EV/IC (x)

10.4
6.3 7.3 2.3 2.1 0.5 6.9 12.0 17.4 1.5 2.0

12.3
6.8 55.2 2.1 2.1 0.5 8.1 15.0 21.7 1.4 2.0

21.6 1.6 9.3 54.7 1.9 0.9 0.5 13.5 37.2 50.7 1.3 1.8

25.3
8.6 14.9 1.8 0.8 0.5 12.8 51.8 69.1 1.3 1.6

16.8
6.8 17.5 1.7 1.2 0.5 10.2 32.9 42.7 1.2 1.5

Source: Company, MF Global India Research Estimates

MCS- CH3 Financial Goal Setting

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

MCS- CH3 Financial Goal Setting

Financial gOAls

MCS- CH3 Financial Goal Setting

Financial Goals
i) EVA ii) Free Cash Flow iii) Return on Net Worth iv) Price Earning Ratio v) Earning Per Share vi) Return on Investment

MCS- CH3 Financial Goal Setting

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

MCS- CH3 Financial Goal Setting

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

MCS- CH3 Financial Goal Setting

The DuPont System

ROE ROA
Profit Margin

Equity Multiplier

Total Asset Turnover

MCS- CH3 Financial Goal Setting

The DuPont System

ROE ROA
Profit Margin

Equity Multiplier

Total Asset Turnover

ROE

ROA Equity M ultiplier Net Income Total Assets Total Assets Networth

MCS- CH3 Financial Goal Setting

The DuPont System

ROE ROA
Profit Margin

Equity Multiplier

Total Asset Turnover

ROA

Profit M argin Total Asset Turnover Net Income Sales Sales Total Assets

MCS- CH3 Financial Goal Setting

The DuPont System

ROE ROA
Profit Margin

Equity Multiplier

Total Asset Turnover

ROE Profit M argin Total Asset Turnover Equity M ultiplier Net Income Sales Total Assets Sales Total Assets Common Equity

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Du Pont Chart

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MCS- CH3 Financial Goal Setting

EVA

MCS- CH3 Financial Goal Setting

EVA (Economic Value Added)

EVA (Economic Value Added) was developed by a

New York Consulting firm, Stern Steward & Co in 1982 to promote value-maximizing behavior in corporate managers. management performance measure that compares net operating profit after tax to total cost of capital. evaluate business strategies, capital projects and to maximize long-term shareholders wealth.

Economic value added (EVA) is an internal

It is a single, value-based measure that was intended to

MCS- CH3 Financial Goal Setting

EVA sets managerial performance target and links

it to reward systems. The single goal of maximizing shareholder value helps to overcome the traditional measure problem, where different measures are used for different purposes with inconsistent standards and goal.

MCS- CH3 Financial Goal Setting

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 number indicates that the project did not make enough profit to cover the cost of doing business.

MCS- CH3 Financial Goal Setting

How Companies Have Used EVA

Name The CocaCola Co. Timeframe Use of EVA Early 1980s Focused business managers on increasing shareholder value Used EVA as the lead indicator of a performance measurement system that included "people value added" and "customer value added" 1999 Conducted a study with Stern Stewart that indicated that outsourcing IT often led to shortterm increases in EVA Late 1990s Tied EVA measure to senior managers' bonus and compensation system

AT&T Corp. 1994

IBM

Herman Miller Inc.

MCS- CH3 Financial Goal Setting

4 Ms of EVA

Measurement
EVA is the most accurate measure of corporate performance over any given period Management System EVA system covers the full range of managerial decisions Motivation bonuses and compensation can be decided on the basis of EVA Mindset EVA system also facilitates decentralized decision making

MCS- CH3 Financial Goal Setting

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

MCS- CH3 Financial Goal Setting

How to calculate WACC?

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Cost of Equity under CAPM

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Calculation of NOPAT
A.
PAT needs following adjustments to arrive at NOPAT Financial Anomaly: Interest is treated as expense whereas dividend is not. NOPAT is the profit of an unlevered company or firm. depreciation, COGS, lease, amortisations and deferred tax (flexibility to adopt policy by Generally Accepted Accounting Principles). The idea is that you are figuring out the income from continuing operations. Profits from R and D and strategic investments are theoretically realized over time. Useful Tutorial: http://www.youtube.com/watch?v=7fTUnZvDMKM

B. Accounting Anomaly: Arise due to accounting assumptions for:

MCS- CH3 Financial Goal Setting

Calculation of NOPAT
Balance Sheet As on 31 Mar, 2011 Equity (Rs. 5 each) 200,000 Reserves 300,000 10% Bonds 200,000 Creditors 50,000 8% Long Term Loans 150,000 900,000 Cash 450,000 Stock 100,000 Debtors 200,000 Fixed Assets 150,000 900,000 Income Statement for FY10-11 Sales 200000 Less: COGS 25000 Interest on CD 20000 Interest on LTD 12000 Expenses 20000 Depreciation 50000 127000 PBT 73000 Tax 21900 PAT 51100

MCS- CH3 Financial Goal Setting

Calculation of NOPAT
Balance Sheet As on 31 Mar, 2011 Equity (Rs. 5 each) 200,000 Reserves 300,000 10% Bonds 200,000 Creditors 50,000 8% Long Term Loans 150,000 900,000 Cash 450,000 Stock 100,000 Debtors 200,000 Fixed Assets 150,000 900,000 Ke 20% Capital Employed Equity 500,000 10% Bonds 200,000 8% Long Term Loans 150,000 Income Statement for FY10-11 Sales 200000 Less: COGS 25000 Interest on CD 20000 Interest on LTD 12000 Expenses 20000 Depreciation 50000 127000 PBT 73000 Tax 21900 PAT 51100 Cost of Capital 20% 10% 8% CoC (1-t) 20.0% 7.0% 5.6% PAT Add Interest * (1-t) NOPAT PAT Add Interest Less Tax Shield NOPAT EBIT Less Tax NOPAT 51100 22400 73500 51100 32000 9600 73500 105000 31500 73500

RoE (PAT / NW) EPS

10.2% 1.28

Charge on Capital Employed 100,000 14,000 8,400 122,400 EVA -48,900

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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 substandard operations where inadequate returns are being earned

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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 tradeoffs between 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

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Goal congruence of managerial and shareholder goals

achieved by tying compensation of managers and other 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 beyond traditional measures of EPS, ROA and ROE

MCS- CH3 Financial Goal Setting

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 market leader. EVA can be linked to valuation of goodwill and shares.

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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 which

diminishes innovation.

EVA provides information that is obvious but offers

no solutions in much the same way as historical financial statements do.

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ROCE, ROE, ROI

Return Ratios:

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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

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Uses of ROI
i)To measure operating performance of Firm. ii) To evaluate and control of Capital expenditure projects iii) To make Profit Planning iv) To analyse the profit by operating divisions v) To analyse the profit by product line vi) Pricing of new project vii) To analyse major cost areas viii) To determine the relative profiability of different projects

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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

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Limitation of ROI
i) Ii) Iv) V) Manipulation Different bases for computation Poor Measure Common Asset Allocation

Iii) Emphasis on Short Term Profits

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Other

Financial goals

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Free Cash Flow

Free cash flow (FCF) represents the cash that a

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

Free cash flow is important because it allows a

company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

MCS- CH3 Financial Goal Setting

Free Cash Flow

Net Income + Amortisation/ Depreciation - Changes in Working Capital - Capital Expenditure = Free Cash Flow

MCS- CH3 Financial Goal Setting

Return on Net Worth

= Net Profit (PAT) Net Worth

X 100

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Price Earning Ratio ( P/E Ratio)

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 Shares

EPS

MCS- CH3 Financial Goal Setting

Earning Per Share (EPS)

EPS is the Profit earned by each equity Share This is the most important ratio the investors EPS = PAT Pref Dividend No. of Equity Shares

MCS- CH3 Financial Goal Setting

Cash EPS

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

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Sensitivity Analysis

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 not coming true. E.g. in steel industry, input i.e metal prices play important role in projections. So one has to have multiple price assumptions while forecasting the financials.

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Sensitivity Analysis - Procedure

List the key factors or parameters. Attach the most likely values to each of the parameters

and 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 and make a subjective assessment of their likelihood. Draw conclusions for the purpose of deciding course of action.

MCS- CH3 Financial Goal Setting

Sensitivity Analysis - Example

From the following project details calculate the sensitivity of the

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 capital 14%. The annuity factor @ 14% for 4 years is 2.9137 and at 18% for 4 years is 2.6667.

- Project cost - Annual Cash Flow - Cost of capital

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Sensitivity Analysis - Example

(a) Calculation of NPV: PV of Annual Cash Flows (4,50,000 x 2.9137) Less: Project Cost NPV

13,11,165 12,00,000 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%

MCS- CH3 Financial Goal Setting

Sensitivity Analysis - Example

(d) Sensitivity for cost of capital: Assuming x the cumulative annuity factor which gives zero NPV So, 4,50,000x 12,00,000 = 0 x = 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 cash inflow will make the NPV of the project zero.

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THANK YOU

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