FA : Planning

​Financial Analysis : DuPont, Financial Planning - Overview and Walkthrough
                                 written  by : William F Bryant
 
ROE = Net Income/Common Equity
 
               = Net Income/Revenue * Revenue/Total Assets * Total Assets/Common Equity
 
               = (Profit Margin) * (Total Asset Turnover) * (Equity Multiplier)
 
‘2019’   =         8.01%          *                  1.19                *             1.43           = 13.64%
 
‘2017’   =         9.06%          *                  1.52                *             1.34           = 18.45%
 
When a company has streamlined their operations and are running at a consistent, optimal efficiency you begin to see it in the ratios.  This is one of the reasons that ratios and trending is analyzed and compared to the industry, as a whole, and ideal benchmarks.  If a company gets to this point, which only happens to the “survivors” of the competitive markets, then strategic decisions to produce optimal returns for invested capital extend outside of the wall-to-wall operations and into acquisitions. 
 
The alcoholic beverage industry is a great example of the acquisition scenario.  A beer brewer can create the gambit of product lines per beer category and seasonal selections.  If you are a brewer that has found success in many categories and the product line success has allowed for growth, then then next obvious choices are to develop the market in other lines or to jump into a completely different alcoholic beverage market segment.  The trending over the past few years with the millennial generations has been ‘hard’ teas, lemonades and now seltzers.  Because the market is continually anticipating consumer demands, there are brands that have already entered into these product lines.  These companies may not have the capital to compete in other markets and may not have the managerial efficiency or economies of scale of a larger operation.  This creates the ideal strategic situation for a beer focused firm.  The beer focused firm could fork over funds and sacrifice time (perhaps more important) to build the necessary supporting assets to venture into new product lines, because the odds are that their current operations are running at a satisfactory capacity, or they could seek to purchase operations that are already up and running and have developed a market share.
 
Examining these scenarios and other options are the basis of financial planning and analysis.  Each option that can be put on the table can be projected into the future and valued in the present.  These are called ‘real options’ suitably enough.  Perhaps, from my description in the previous paragraph, you gathered the importance of time in decisions and business cycles.  Every moment of time you aren’t selling products is a moment of time that you do not have incoming cash flows from that decision.  If you decided to build as opposed to purchase readily available assets, those years of building may drastically impact the NPV, IRR of your decision.  In finance, everything is interest rates and interest rates are monetary representations of time and all the corresponding risks that are compiled in a period of time.  Much the same as an investment, the less you leave to the risks of future time periods, the better.  I would lay out the strong linked of portfolio planning theory and applications to financial planning and analysis, but I will get to more of that later.  For now, the firm and its acquisition.
 
The ROE is what the investor supplied equity capital is returning in terms of the net income.  The Dupont derivation of the ROE gives insight into how the relations of efficiencies, leverage and decisions make up that return.  When we look to return our firm to its former ROE level after its acquisition, the corresponding ROE, common size financial statements and future projections will give us a strategic path and necessary financial planning basis to get to that point.  As an example, looking above at the ROE-DuPont equation, it is easy to see that the acquisition has had an impact on the sales generated from total assets.  This could mean there are some assets that are not yet online, there is less efficiency or large recent purchases of assets.  If accelerated depreciation produces a large expense that it would be enough to impact the margin.  The equity multiplier displays that there was a large bump in total assets to equity and so when the assets are running smoothly in operations then the ROE should fall back in line with historical ROE.  Industry average on ROE at this time was 10.32% so the drop in ROE is still above the industry average and the biggest concern is how quickly the managers can get the assets producing.
 
Operating Planning:
 
The firm made its acquisition.  The firm and M&A team would have made projections and valued future operations after the acquisition, but during the integration period the expected free cash flows may be reevaluated with any new information that may come from the current or future economic environment, operational transition and updated sales projections.  If strategic decisions had been planned but not yet implemented, then these are times that those ‘real options’ would be revalued with the new information and new strategies developed. 
 
The process can be as complicated as the firm needs it to be to make an assessment.  Given that our current economic environment is uncertain, depending on who you ask, the firm may commence with a detailed bottom-up approach for anticipated sales for each product line.  This may be costly, however, if
inflation is anticipated to affect commodities, not the least of which is energy, then the benefits may out weigh the costs of a detailed analysis.
 
 The forecast always begins with sales.  Sales will determine capacity requirements or excess, which in turn will give a basis for variable costs of labor and material, distribution requirements and perhaps even marketing budget if your marketing plan works in coordination as percent of sales.  This is, of course, the basis for the free cash flows that can be used to fund expanded operations or managerial decisions on inventory changes (as in this firm’s case) or if perhaps the free cash flows will fall short of necessary capital and additional funding will be needed.  The financial planning is the plan to finance the operational needs and forecasts for the operational strategies. 
 
Forecasted Financial Statements:
 
The forecasting of statements should be organized in such a way that it is fairly easy to make necessary changes after the preliminary percentages are laid out.  You will make changes.  Just start by getting the historic relationships correct and the models can be changed from this point.  If doing a bottom up forecasting at each level, variance of forecasting will become an issue.  It is for this reason that top-down assessments are used and the simultaneous relationships of the bottom-up are often avoided.  I still tend to prefer bottom-up if you have access to the data.  The reason is that experienced managers and executives will, hopefully, be able to put together the workings of the simultaneous operations with a level-to-level sensitivity analysis.
 
 Not having managerial accounting data for the product lines for this firm, the forecasting will be a top-down projection.
 
Revenues in the alcoholic beverage industry suffers multiple levels of government interference.  This interference is in taxation, permits, distribution and is at every level, municipal, county, state and federal.  I mention this for the reason that, these become relevant for operational costs and sales, were it to change.  Recall from economics the affects that taxation has on costs and the portion of taxation costs that can be shared between the producer and the consumer.
 
In order to evaluate strategic options, a ‘status quo’ scenario must be constructed to value the strategies against.  The following tables are the ‘status quo’ scenarios after the acquisition.  The sales are gross sales*(1-t) such that ‘t’ will represent the excise tax.  The excise tax for this company is steady around 6%.  For particular industries you will see seasonal patterns in the revenues.  If quarterly data is available, paired with geographic market share, the paired-pattern will assist in the projections.  Some publicly available data can be found in basic searches, for example TD Bank offers basic coverage on industry and firm ratios that could be used for rough estimation.
 
Of interest is that while 2017-2018 and 2018-2019 where large bumps in sales, the previous three years saw consecutive declines YoY to sales of -5%.  It is also important to keep in mind that growth is not linear, nor does is it by percentage (elasticities) representation.  The percentage representation is a method to simplify relationships amongst the operational accounts.  Sales grow by units.  If your percentages do not seem feasible when in units, then the percentage should not be used.  Accurate and realistic projections are necessary to get the most out of your models.  As the saying goes, Garbage-In, Garbage-Out for any model.  That said, the following is a roughed-out model and not any semblance of a final product.

​Before the pandemic, the 2020 forecast most likely would have had to compensate for the amount of total expenditures needed to bring the acquisition up to par.  The resources expended in these areas probably would have had an affect on expanding revenues.  In addition, there were assets under construction, not yet completed, that would add to capacity in the following years.  We should also take into consideration the behavioral changes toward hard seltzer consumption and this product lines’ increased sales.  Once revenues are well understood, the corresponding relations of needed assets and liabilities to support said sales are much easier to forecast.  Without the addition of significant technological changes or strategic decisions, optimal support assets and expenses will stay at relative levels. 
 
The HV, horizon value, is a “long-run” growth.  This is a mathematical need for computations of perpetuities.  This simply suggests that the firm has long term value from its cash flows in the future.  I generally tend to be very conservative in this when assessing growth rates.  As markets become saturated with competitors, the fluctuations in sales can vary from large changes, if acquisitions are made (as is seen with this firm), to almost no changes or even slightly negative if products fall out-of-favor with the consumer base.  It should be obvious that the further out you attempt to project the more uncertain the estimates. 
 
One final note on this status quo forecasting model, Inflation is here.  This inflation is not transitory no matter how many times the Fed says it is transitory.  The interest rates will have to outpace inflation in order to keep the inflation from taking off, but when this will be realized is for a separate paper.  This circumstance will have multiple behavioral and market forces play out together.  As a currency loses purchasing power, the general investor will ‘lose’ relative discretionary income.  Any investments will need to be, not only, “risk-free” but also affordable and of more perceived value than usage elsewhere.  The return on equity would, therefore have to be more than the inflation rate, but can a company keep growing income in real, not nominal, terms while its cost are increasing and fewer customer may be purchasing their products?  Another corresponding issue is the dividend, or lack thereof.  Will companies be forced to go back to dividends as real productivity and real assets are purchased with real labor and real value currency; dollars in the hand are worth more as dividends?  These are some thoughts for companies going forward.
 
What do the projections reflect in real terms at the status quo:

​Once again, in any business, sales support the operations and in-turn more operations are needed to support increasing sales.  Accurate forecasting of sales is then a terribly important piece of planning; the rub being, once again, that the further out the predictions are carried, the more risks that impact the accuracy of the forecasts.  There is a particular balance of assets and liabilities needed to continue growth of sales and if forecasts are too much or too little then there may be solvency issues or supply constraints and, again, customer opinion and sales may suffer.
 
The previous tables give a place to start as a top-down view for strategic decisions for a growing business.  The tables make assumptions that the needs to support sales will continue proportionally to the growth of sales.  Even if the operations were as streamlined and optimized as ‘no frill’ as managers could make them, there would still be a base proportion that you couldn’t get under.  But, between the ratios for the business and these tables, there is an understanding of both the areas that could be addressed for optimization and for future growth planning.
 
Since the ratios and components of the tables above each have their own considerations for optimization, a business really needs to monitor and set up bottom-up assessments for each of these areas in order to get the most out of operational and planning strategies.  For example, cash on-hand is affected by your cash conversion cycle, credit terms offered through your receivables and operational needs.  Your NOPAT will change dependent upon CAPEX, depreciation schedules and capital structure decisions.  It follows that every incremental piece of your operations and decisions affecting these operations will have influences from the bottom-up.  Armed with a complete understanding of your business, you can then implement ratio sensitivities to visualize how much changes in areas will affect the value of your operations.
 
While it should be obvious that improvements in every area would result in the top value of operations, there are things to consider.  Cost. Cost. Cost.  Benefit. Benefit. Benefit.  In other words, every benefit comes with a cost and the real-world examples of the economic concept of diminishing marginal returns is always present.  This means that for additional incremental costs, they will produce decreasing incremental benefits.  Cost-Benefit analysis is not a linear function!  

​The OP ratio, CR ratio and ROIC are the one year forecast that correspond to a 1% change in the scenarios.  The value of operations and intrinsic stock price reflect a 1% change throughout the forecast in the given scenarios.  The OP ratio was simplified to a 1% decline in (operational expenses/sales) each year.  The CR ratio was a 1% change down in the operational asset ratios with a corresponding 1% increased change in the AP/sales ratio, holding the accruals the same.  Given these scenarios, it is obvious that, holding all else constant in the scenarios, the company gets the most distance from addressing operational expenses.
 
This is fairly simplified and it does not go into the details of operations, but it does give an idea of the sensitivity of semi-elastic changes that the value of operations has to value drivers.   The next step would be to implement strategic planning options and continue to model perceived changes and value additions that these changes would have on the value of the firm.