unit 7 | balance sheet analysis & planning

Question 1

What determine a company’s need for capital?

Answer 1

A company’s growth & growth-prospect determine its need for capital (debt or equity)

Question 2

What method do we use when analyzing the BS?

Answer 2

Examine dependencies to analyze BS
- Consider link between BS & IS
- Possible difference in financial performance displayed

Question 3

Loan Covenants

Answer 3

Terms & conditions of a loan that require the borrower to meet certain requirements established by the lender

Question 4

Example of Loan Covenants

Answer 4

Ex. maintain certain ratio → profit margin > 5% or debt-to-equity < 60%

Question 5

What happens if a company violates a loan covenant?

Answer 5

The lender can legally enforce specific actions

E.g., require the lender to improve a ratio by the end of the quarter, or demand the loan be repaid immediately

Question 6

Return on Assets (ROA) formula

Answer 6

ROA = (net income + interest expense) / average total assets

Question 7

Return on Assets (ROA) definition

Answer 7

How effective a company is in utilizing its assets to generate returns for debt & equity investors
- Net income cannot tell if a company is efficiently profitable
- Observe ROA performance over time
- Interest expense → returns to investors (cost of borrowing)

Question 8

Return on Equity (ROE) formula

Answer 8

ROE = net income / average shareholders’ equity

Question 9

Return on Equity (ROE) definition

Answer 9

How effectively a company uses equity holders’ investments to generate income (cash > profit)
- Higher the better
- Compared over time or benchmarked

Question 10

Asset Turnover formula

Answer 10

Asset turnover = total revenue / average total assets

Question 11

Asset Turnover definition

Answer 11

Indicates how well a company is managing its assets to generate sales
- Amount of sales generated for each dollar invested in assets
- Useful when benchmarking
- Higher is better, but consider asset infrastructure requirements

Question 12

Budgets - Planning for the Future (BS)

Answer 12

1. Do not obsess over precision
   - “A/R has a close relationship with sales”
2. Focus on FS relationship & trends, & known expectations
   - “A/R & A/P relationships, inventory trends, loan repayment schedules
   - Ratios +/- 1% generally considered “within expectations”
3. Factor in known/highly probable events
   - “IPO at $125M in Jan → cash to be conserved in Q1”
   - If big asset purchases are expected, factor them in
4. More focused on ratios
5. Rely heavily on expectations, particularly around purchases & financing