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Overview People should understand the impact of different types of risk on financial health, whether they’re dealing with personal or corporate finances. The risks involved with personal finance often only impact individuals and families—for example, when determining if you can afford to buy a house or deciding whether to invest in stocks. Financial risks for businesses often affect multiple people throughout the entire company, including individuals who do not work in the finance department. When businesses make finance-related decisions, it is essential that they know how their decisions will impact different aspects of their company. Prompt Read the Assessing a Company’s Future Financial Health case study, then write a response. Specifically, you must address the following rubric criteria: · Systematic and Unsystematic Risk: Explain the differences between systematic and unsystematic risk. · Financial Risks: Describe the potential impacts of the following types of financial risk on the company featured in the case study: · Interest rate risk · Economic risk · Credit risk · Operational risk · Lower Growth Impact: Explain the impact a lower growth in sales could have on the dividend policy and retained earnings for the company featured in the case study. · Higher Growth Impact: Explain the impact a higher growth in sales could have on the dividend policy and retained earnings for the company featured in the case study. 9-911-412 R E V : M A Y 2 8 , 2 0 1 2 ________________________________________________________________________________________________________________ Professor Thomas Piper prepared the original version of this note, “Assessing a Firm’s Future Financial Health,” HBS No. 201-077, which is being replaced by this version prepared by the same author. This note was prepared as the basis for class discussion. Copyright © 2010, 2011, 2012 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1- 800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. Assessing a Company’s Future Financial Health Assessing the long-term financial health of a company is an important task for management as it formulates goals and strategies and for outsiders as they consider the extension of credit, long-term supplier agreements, or an investment in a company’s equity. History abounds with examples of companies that embarked on overly ambitious programs and subsequently discovered that their portfolios of programs could not be financed on acceptable terms. The outcome was frequently the abandonment of programs mid-stream at considerable financial, organizational, and human cost. It is the responsibility of management to anticipate a future imbalance in the corporate financial system before its severity is reflected in the financials, and to consider corrective action before both time and money are exhausted. The avoidance of bankruptcy is an insufficient standard. Management must ensure the continuity of the flow of funds to all of its strategically important programs, even in periods of adversity. Figure A provides a conceptualization of the corporate financial system, with a suggested step-by- step process to assess whether it will remain in balance over the ensuing 3 to 5 years. The remainder of this note discusses each of the steps in the process and then provides an exercise on the various financial measures that are useful as part of the analysis. The final section of the note demonstrates the relationship between a firm’s strategy and operating characteristics; and its financial characteristics. This document is authorized for use only by Melany Carvalho in FIN-320-X3178 Principles of Finance 22EW3 at Southern New Hampshire University, 2022. 911-412 Assessing a Company’s Future Financial Health 2 Figure A The Corporate Financial System Analyze Goals Step 1 Strategy Market, Competitive Technology Regulatory and Operating Characteristics Step 2 Analyze Revenue Outlook growth rate volatility, predictability Step 3 Step 4 Analyze Investment in Assets Assess Economic Performance to support growth profitability improvement/deterioration in asset management cash flow volatility, predictability Step 5 Step 6 Assess External Financing Need Ensure Access to Target Sources of Finance $ amount lending/investing criteria timing, duration deferability attractiveness of firm to each target source Step 7 Assess Viability of 3 to 5-year Plan consistency with goals achievable operating plan achievable financing plan Step 8 Perform Stress Test for Viability Under Various scenarios Step 9 Formulate Financing and Operating Plan for Current Year This document is authorized for use only by Melany Carvalho in FIN-320-X3178 Principles of Finance 22EW3 at Southern New Hampshire University, 2022. Assessing a Company’s Future Financial Health 911-412 3 Steps 1, 2: Analyze Fundamentals The corporate financial system is driven by a firm’s goals, business unit choices and strategies, market conditions, and operating characteristics. The firm’s strategy and sales growth in each of its business units will determine the investment in assets needed to support these strategies; and the effectiveness of the strategies, combined with the response of competitors and regulators, will strongly influence the firm’s competitive and profit performance, its need for external finance, and access to debt and equity markets. Clearly, many of these questions require information beyond that contained in a company’s published financial reports. Step 3: Analyze Investments to Support the Business Unit(s) Strategy(ies) The business unit strategies inevitably require investments in accounts receivable, inventories, plant & equipment, and possibly, acquisitions. Step 3 of the process is an attempt to estimate the amount that will be tied up in each of the asset types by virtue of sales growth and the improvement/deterioration in asset management. An analyst can make a rough estimate by studying the past pattern of the collection period, the days of inventory, and plant & equipment as a percentage of cost of goods sold; and then applying a “reasonable value” for each category to the sales forecast or the forecast of cost of goods sold. Extrapolation of past performance assumes, of course, that the future underlying market, competitive, and regulatory “conditions” will be unchanged from those that influenced the historical performance. Step 4: Assess Future Profitability and Competitive Performance Strong sustained profitability is an important determinant of (1) a firm’s access to debt and/or equity finance on acceptable terms; (2) its ability to self-finance growth through the retention of earnings; (3) its capacity to place major bets on risky new technologies, markets, and/or products; and (4) the valuation of the company. A reasonable starting point for assessing firm’s future profitability is to analyze its past pattern of profitability. 1. What has been the average level, trend, and volatility of profitability? 2. Is the level of profitability sustainable, given the outlook for the market and for competitive and regulatory pressures? 3. Is the current level of profitability at the expense of future growth and/or profitability? 4. Has management initiated major profit improvement programs? Are they unique to the firm or are they industrywide and may be reflected in lower prices rather than higher profitability? 5. Are there any “hidden” problems, such as suspiciously high levels or buildups of accounts receivable or inventory relative to sales, or a series of unusual transactions and/or accounting changes? Step 5: Assess Future External Financing Needs Whether a company has a future external financing need depends on (1) its future sales growth; (2) the length of its cash cycle; and (3) the future level of profitability and profit retention. Rapid sales growth by a company with a long cash cycle (a long collection period + high inventories + high plant & equipment relative to sales) and low profitability/low profit retention is a recipe for an ever- This document is authorized for use only by Melany Carvalho in FIN-320-X3178 Principles of Finance 22EW3 at Southern New Hampshire University, 2022. 911-412 Assessing a Company’s Future Financial Health 4 increasing appetite for external finance, raised in the form of loans, debt issues, and/or sales of shares. Why? Because the rapid sales growth results in rapid growth of an already large level of total assets. The increase in total assets is offset partially by an increase in accounts payable and accrued expenses, and by a small increase in owners’ equity. However, the financing gap is substantial. For example, the company portrayed in Table A requires $126 million of additional external finance by the end of year 2010 to finance the increase in total assets required to support 25% per year sales growth in a business that is fairly asset intensive. Table A Company Financials Assuming a 25% Increase in Sales ($ in millions) 2009 2010 Assets Cash $ 12 ↑ 25% $ 15 Accounts receivable 240 ↑ 25% 300 Inventories 200 ↑ 25% 250 Plant & equipment 400 ↑ 25% 500 Total $852 $1,065 Liabilities and Equity Accounts payable $100 ↑ 25% $ 125 Accrued expenses 80 ↑ 25% 100 Long-term debt 272 Unchanged 272 Owners’ equity 400 footnotea 442 Total $852 $ 939 External financing need 0 126 Total $852 $1,065 a It is assumed (1) that the firm earns $60 million (a 15% return on beginning of year equity) and pays out $18 million as a cash dividend; and (2) that there is no required debt repayment in 2010. If, however, the company reduced its sales growth to 5% (and total assets, accounts payable and accrued expenses increased accordingly by 5%), the need for additional external finance would drop from $126 million to $0. High sales growth does not always result in a need for additional external finance. For example, a food retailer that extends no