Foundations of Financial Management: An Analysis (part 12)

Money is a terrible master but an excellent servant.

P.T. Barnum

Operating and Financial Leverage

by

Charles Lamson

 Leverage in a Business

Assume you are approached with an opportunity to start your own business. You are to manufacture and market industrial parts, such as ball bearings, wheels, and casters. you are faced with two primary decisions.

First, you must determine the amount of fixed cost planned and equipment you wish to use in the production process. By installing modern, sophisticated equipment, you can virtually eliminate labor in the production of inventory. At high volume, you will do quite well, as most of your costs are fixed. At low volume, however, you could face difficulty in making your fixed payments for plant and equipment. If you decide to use expensive labor rather than machinery, you will lessen your opportunity for profit, but at the same time you will lower your exposure to risk (you can lay off part of the workforce).

Second, you must determine how you will finance the business. If you rely on debt financing and the business is successful, you will generate substantial profits as an owner, paying only the fixed costs of debt. Of course, if the business starts off poorly, the contractual obligations related to debt could mean bankruptcy. As an alternative, you might decide to sell equity rather than borrow, a step that will lower your own profit potential (you must share with others) but minimize your risk exposure.

In both decisions, you are making very explicit decisions about the use of leverage. To the extent that you go with a heavy commitment to fixed costs in the operation of the firm, you are employing operating leverage. To the extent that you utilize debt in the financing of the firm, you are engaging in financial leverage. We shall carefully examine each type of leverage and then show the combined effect of both.

Operating Leverage

Operating leverage reflects the extent to which fixed assets and associated fixed costs are utilized in the business. As indicated in Table 1, a firm's operational costs may be classified as fixed, variable, or semi variable.

Table 1   Classification of costs

For purposes of analysis, variable and semivariable costs will be combined. In order to evaluate the implications of heavy fixed asset use, we employ the technique of break-even analysis.

Break-Even Analysis

How much will changes in volume affect cost and profit? At what point does the firm break even? What is the most efficient level of fixed assets to employ in the firm? A break-even chart is presented in Figure 1 to answer some of these questions. The number of units produced and sold as shown along the horizontal axis, and revenue and costs are shown along the vertical axis.

Figure 1

Note, first of all, that our fixed costs are $60,000, regardless of volume, and that our variable costs at $0.80 per unit are added to fixed costs to determine total cost at any point. The total revenue line is determined by multiplying price ($2) times volume.

Of particular interest is the break-even be point at 50,000 units, where the total cost and total revenue lines intersect. The numbers are as follows:

The break-even point for the company may also be determined by use of a simple formula---in which we divide fixed costs by the contribution margin on each unit sold, with the contribution margin defined as price minus variable cost per unit. The formula is shown below.

Formula 1

Since we are getting a $1.20 contribution toward covering fixed costs from each unit sold, minimum sales of 50,000 units will allow us to cover our fixed costs (50,000 units X $1.20 equals $60,000 fixed costs). Beyond this point, we move into a highly profitable range in which each unit of sales brings a profit of $1.20 to the company. As sales increase from 50,000 to 60,000 units, operating profits increase by $12,000 as indicated in Table 2; as sales increase from 60,000 to 80,000 units, profits increase by another $24,000; and so on. As further indicated in Table 2, at low volumes such as 40,000 or 20,000 units our losses are substantial ($12,000 and $36,000 in the red).

Table 2 Volume-cost-profit analysis: Leveraged firm

It is assumed that the firm depicted in Figure 1, as previously presented, is operating with a high degree of leverage. The situation is analogous to that of an airline that must carry a certain number of people to break even, but beyond that point is in a very profitable range.

A More Conservative Approach

Not all firms would choose to operate at the high degree of operating leverage exhibited in Figure 1. Fear of not reaching the 50,000 unit break-even level might discourage some companies from heavy utilization of fixed assets. More expensive variable costs might be substituted for automated plant and equipment. Assume fixed costs for a more conservative firm can be reduced to $12,000 but variable costs will go from $0.80 to $1.60 if the same price assumption of $2 per unit is employed, the break-even level is 30,000 units.

Figure 2

Even at high levels of operation, the potential profit in Figure 2 is rather small. Located in Table 3 (below), at a 100,000 unit volume, operating income is only $28,000 some $32,000 less than that for the leveraged firm previously analyzed in Table 2.

Table 3 Volume-cost-profit analysis: Conservative firm

The Risk Factor

Whether management follows the path of the leveraged firm or of the more conservative firm depends on its perceptions about the future. If the vice president of finance is apprehensive about economic conditions, the conservative plan may be undertaken. For a growing business in times of relative prosperity, management might maintain a more aggressive, leveraged position. The firm's competitive position within its industry will also be a factor. Does the firm desire to merely maintain stability or to become a market leader? To a certain extent, management should tailor the use of leverage to meet its own risk-taking desires. Those who are risk-averse (prefer less risk to more risk) should anticipate particularly high return before contracting for heavy fixed costs. Others, less averse to risk, may be willing to leverage under more normal conditions. Simply taking risk is not a virtue---our prisons are full of risk takers. The important idea, which is stressed throughout this analysis, is to match an acceptable return with the desired level of risk. 

Cash Break-Even Analysis

Our discussion to this point has dealt with break-even analysis in terms of accounting flows rather than cash flows. For example, depreciation has been implicitly included in fixed expenses, but it represents a non-cash accounting entry rather than an explicit expenditure of funds. To the extent that we were doing break-even analysis on a strictly cash basis, depreciation would be excluded from fixed expenses. In the previous example of the leveraged firm in Formula 1, if we eliminate $20,000 of "assumed" depreciation from fixed costs, the break-even level is reduced to 33,333 units.

Other adjustments could also be made for non-cash items. For example, sales may initially take the form of accounts receivable rather than cash, and the same can be said for the purchase of materials and accounts payable. An actual weekly or monthly cash budget would be necessary to isolate these items.

While cash break-even analysis is helpful in analyzing the short-term outlook of the firm, particularly when it may be in trouble, break-even analysis is normally conducted on the basis of accounting flows rather than strictly cash flows. Most of the assumptions throughout this and the next few posts are based on concepts broader than pure cash flows.

Degree of Operating Leverage

Degree of operating leverage (DOL) may be defined as the percentage change in operating income that occurs as a result of a percentage change in the units sold.

Formula 2

Highly leveraged firms, such as Ford Motor Company or Dow Chemical, are likely to enjoy a rather substantial increase in income as volume expands, while more conservative firms will participate in an increase to a lesser extent. Degree of operating leverage should be computed only over a profitable range of operations. However, the closer DOL is computed to the company break-even point, the higher the number will be due to a large percentage increase in operating income.

Let us apply the formula to the leveraged and a conservative firms previously discussed. Their income or losses at various levels of operations are summarized in Table 4.

Table 4

We will now consider what happens to operating income as volume moves from 80,000 to 100,000 units for each firm. We will compute the degree of operating leverage (DOL) using formula 2 (see above).

Leveraged Firm 

Conservative Firm 

We see above that the DOL is much greater for the leveraged firm, indicating at 80,000 units a 1% increase in volume will produce a 2.7 percent change in operating income, versus a 1.6 percent increase for the conservative firm.

The formula for degree of operating leverage may be algebraically manipulated to read:

We once again derive an answer of 2.7. The same type of calculation could also be performed for the conservative firm.

Limitations of Analysis

Throughout our analysis of operating leverage, we have assumed that a constant or linear function exists for revenues and costs as volume changes. For example, we have used $2 as the hypothetical sales price at all levels of operation. In the real world, however, we may face price weakness as we attempt to capture an increasing market for our product, or we may face cost overruns as we move beyond an optimum-size operation. Relationships are not so fixed as we have assumed.

Nevertheless, the basic patterns we have studied are reasonably valid for most firms over an extended operating range (in our example that might be between 20,000 and 100,000 units). It is only at the extreme levels that linear assumptions fully breakdown, as indicated in Figure 3. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 114-121*

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Foundations of Financial Management: An Analysis (part 11)

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Friedrich August von Hayek

Financial Forecasting (Part C)

by

Charles Lamson

Pro Forma Balance Sheet

Now that we have developed a pro forma income statement and a cash budget (see last post), it is relatively simple to integrate all of these items into a pro forma balance sheet. Because the balance sheet represents cumulative changes in the corporation over time, we first examine the prior period's balance sheet and then translate these items through time to represent June 30th, 2021. The last balance sheet, dated December 31st 2020, is shown in Table 16.

Table 16

In constructing our pro forma balance sheet for June 30th, 2021, some of the accounts from the old balance sheet will remain unchanged, while others will take on new values, as indicated by the pro forma income statement and cash budget. The process is depicted in Figure 1.

 Figure 1 Development of a pro forma balance sheet

We present the new pro forma balance sheet as of June 30th, 2021, in Table 17.

Table 17

Explanation of Pro Forma Balance Sheet

Each item in Table 17 can be explained on the basis of a prior calculation or assumption. The explanations are presented below in Figure 2.  

Figure 2

Analysis of Pro Forma Statement

In comparing the pro forma balance sheet (Table 17) to the prior balance sheet (Table 16), we note that assets are up by $25,640.

The growth was financed by accounts payable, notes payable, and profit (as reflected by the increase in retained earnings). Though the company will enjoy a high degree of profitability, it must still look to bank financing of $5,884 (shown as notes payable in Table 17) to support the increase in assets. This represents the difference between the $25,640 buildup and assets, and the $1,232 increase in accounts payable as well as the $18,524 buildup in retained earnings.

Percent of Sales Method

An alternative to tracing cash and accounting flows to determine financial needs is to assume that accounts on the balance sheet will maintain a given percentage relationship to sales. We then indicate a change in the sales level and ascertain our related financing needs. This is known as the percent-of-sales method. For example, for the Thomas Corporation, introduced in Table 18, we show the following balance sheet accounts in dollars and their percent of sales, based on a sales volume of $200,000. 

Table 18

Cash of $5,000 represents 2.5% of sales of $200,000; receivables of $40,000 are 20% of sales; and so on. No percentages are computed for notes payable, common stock, and retained earnings because they are not assumed to maintain a direct relationship with sales volume. Note that any dollar increase in sales will necessitate a 60% increase in assets, As shown at the bottom Of Table 18. Of this 60%, 25% will be spontaneously or automatically finance through accounts payable and accrued expenses, leaving 35% to be financed by profit or additional outside sources of financing. We will assume the Thomas Corporation has an after-tax return of 6% on the sales dollar and 50% of profits are paid out as dividends.

If sales increase from $200,000 to $300,000, the $100,000 increase in sales will necessitate $35,000 (35 percent) in additional financing. Since we will earn 6 percent on total sales of $300,000, we will show a profit of $18,000. With a 50 percent dividend payout, $9,000 will remain for internal financing. This means $26,000 out of the $35,000 must be financed from outside sources. Our formula to determine the need for funds is:

Presumably the $26,000 can be financed at the bank or through some other appropriate source.

Using the percent-of-sales method is much easier than tracing through the various cash flows to arrive at the pro forma statements. Nevertheless, the output is much less meaningful and we do not get a month-to-month breakdown of the data. The percen-of-sales method is a broad-brush approach, while the development of pro forma statements is more exacting. Of course, whatever method we use, the results are only as meaningful or reliable as the assumptions about sales and production that went into the numbers. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., 96-99*

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Foundations of Financial Management: An Analysis (part 10)

Under capitalism, man exploits man. Under communism, it's just the opposite.

John Kenneth Galbraith

 Financial Forecasting (Part B)

by

Charles Lamson 

Cash budget

As previously indicated in the last post, the generation of sales and profits does not necessarily ensure there will be adequate cash on hand to meet financial obligations as they come due. A profitable sale may generate accounts receivable in the short run but no immediate cash to meet maturing obligations. For this reason, we must translate the pro forma income statement from the last post into cash flows. In this process we divide the longer-term pro forma income statement into smaller and more precise time frames to anticipate the seasonal and monthly patterns of cash inflows and outflows. Some months may represent particularly high or low sales volume or may require dividends, taxes, or capital expenditures.

Cash Receipts

In the case of the Lamson Corporation, we break down the pro forma income statement from the last post for the first half of the Year 2021 into a series of monthly cash budgets. In Table 1 from the last post, we showed anticipated sales of $100,000 over this time. We shall now assume these sales can be divided into monthly projections, as indicated in Table 9.

Table 9 Monthly sales pattern (for first half of 2021)

A careful analysis of past sales and collection records indicates 20 percent of sales is collected in the month of sales and 80 percent in the following month. The cash receipt pattern related to monthly sales is shown in table 10. It is assumed that sales for December 2020 will be $12,000.

Table 10 Monthly cash receipts

The cash inflow will vary between $11,000 and $23,000 with the high point in receipts coming in May.

We now examine the monthly outflows.

Cash Payments

The primary considerations for cash payments are monthly costs associated with inventory manufactured during the period (material, labor, and overhead) and disbursements for general and administrative expenses, interest payments, taxes, and dividends. We must also consider cash payments for any new plant and equipment, an item that does not show up on our pro forma income statement. Costs associated with units manufactured during the period may be taken from the data provided in Table 5 from last post. In Table 11, we simply recast these data in terms of material, labor, and overhead.

Table 11 Component costs of manufactured goods

We see that the total costs for components in the two products in Table 11 are materials, $34,390; labor, $17,195; and overhead, $11,125. We shall assume all these costs are incurred on an equal monthly basis over the six-month period. Even though the sales volume varies from month to month, we assume we are employing level monthly production to ensure maximum efficiency in the use of various productive resources. Average monthly costs for materials, labor, and overhead are as shown in Table 12.

Table 12 Average monthly manufacturing costs

We hall pay for materials one month after the purchase has been made. Labor and overhead represent direct monthly cash outlays, as is true of interest, taxes, dividends, and the purchases of $8,000 in new equipment in February and $10,000 in June. We summarize all of our cash payments in Table 13. Past records indicate that $4,500 in materials was purchased in December.

Table 13 Summary of all monthly cash payments

Actual Budget

We are now in a position to bring together our monthly cash receipts and payments into a cash flow statement, illustrated in Table 14. The difference between monthly receipts and payments is net cash flow for the month.

Table 14 Monthly cash flow

The primary purpose of the cash budget is to allow the firm to anticipate the need for outstanding funding at the end of each month. In the present case, we shall assume the Lamson Corporation wishes to have a minimum cash balance of $5,000 at all times. If it goes below this amount, the firm will borrow funds from the bank. If it goes above $5,000 and the firm has a loan outstanding, it will use the excess funds to reduce the loan. This pattern of financing is demonstrated in Table 15---a fully developed cash budget with borrowing and repayment provisions.

Table 15 Cash budget with borrowing and repayment provisions

The first line in table 15 shows net cash flow from table 14, which is added to the beginning balance to arrive at the cumulative cash balance. The fourth entry in the additional monthly loan or loan repayment, if any, required to maintain a minimum cash balance of $5,000. To keep track of our loan balance, the fifth entry represents cumulative loans outstanding for all months. Finally, we show the cash balance at the end of the month, which becomes the beginning cash balance for the next month.

At the end of January the firm has $6,380 in cash, but by the end of February the cumulative cash position of the firm is negative, necessitating a loan of $5,072 to maintain a $5,000 cash balance. The firm has a loan on the books until May, at which time there is an ending cash balance of $11,069. During the month of April and May the cumulative cash balance is greater than the required minimum cash balance of $5,000, so loan repayments of $4,548 and $4,479 are made to retire the loans completely in May. In June the firm is once again required to borrow $5,884 to maintain a $5,000 cash balance. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 92-96*

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Foundations of Financial Management: An Analysis (part 9)

Your net worth to the world is usually determined by what remains after your bad habits are subtracted from your good ones.

Benjamin Franklin

Financial Forecasting

 by

Charles Lamson

While we may assume that no growth or a decline in volume is the primary cause for a shortage of funds; this is not necessarily the case. A rapidly growing firm may witness a significant increase in accounts receivable, inventory, and plant and equipment that cannot be financed in the normal course of business. Assume sales go from $100,000 to $200,000 in one year for a firm that has a 5 percent profit margin (see last post about calculating profit margin) on sales. At the same time, assume assets represent 50% of sales and go up from $50,000 to $100,000 as sales double. The $10,000 of profit (5 percent X $200,000) will hardly be adequate to finance the $50,000 asset growth. The remaining $40,000 must come from suppliers, the bank, and perhaps stockholders. You should recognize that profit alone is generally inadequate to finance some significant growth and a comprehensive financing plan must be developed. Too often, the small business person (and sometimes the big one as well) is mystified by an increase in sales and profits but less cash in the till.

Constructing Pro Forma Statements

The most comprehensive means of financial forecasting is to develop a series of pro forma, or projected, financial statements. We will give particular attention to the pro forma income statement, the cash budget, and the pro forma balance sheet. Based on the projected statements, the firm is able to estimate its future level of receivables, inventory, payables, and other corporate accounts as well as its anticipated profits and borrowing requirements. The financial officer can then carefully track actual events against the plan and make necessary adjustments. Furthermore, the statements are often required by bankers and other lenders as a guide for the future.

A systems approach is necessary to develop pro forma statements. We first construct a pro forma income statement based on sales projections and the production plan, then translate this material into a cash budget, and finally assimilate all previously developed material into a pro forma balance sheet. the process of developing pro forma financial statements is depicted in Figure 1. We will use a six-month time frame to facilitate the analysis, though the same procedures could be extended to one year or longer.

Figure 1 Development of pro forma statements

Pro Forma Income Statement

Assume the Lamson Corporation has been asked by its bank to provide pro forma financial statements for midyear 2021. The pro forma income statement will provide a projection of how much profit the firm anticipates making over the ensuing time period. In developing the pro forma income statement, we will follow four important steps.

1. Establish a sales projection. 

2. Determine a production schedule and the associated use of new material, direct labor, and overhead to arrive at gross profit. 

3. Compute other expenses. 

4. Determine profit by completing the actual pro forma statement.

Establish a Sales Projection

For purposes of analysis, we shall assume the Lamson Corporation has two primary products: wheels and casters. Our sales projection calls for the sale of 1000 wheels and 2,000 casters at a price of $30 and $35, respectively. As indicated in Table 1, we anticipate total sales of $100,000.

 

Table 1 Projected wheel and caster sales (first six months, 2021)

Determine a Production Schedule and the Gross Profit

Based on anticipated sales, we determine the necessary production plan for the six-month period. The number of units produced will depend on the beginning inventory of wheels and casters, our sales projection, and the desired level of ending inventory. Assume that on January 1st, 2021, the Lamson Corporation has in stock the items shown in Table 2.

Table 2 Stock of beginning inventory

We will add the projected quantity of unit sales for the next 6 months to our desired ending inventory and subtract our stock of beginning inventory and units to determine our production requirements. This process is Illustrated below.

Following this process, in Table 3 we see a required production level of 1,015 wheels and 2,020 casters.

Table 3 Production requirements for six months

We must now determine the cost to produce these units. In previously mentioned table 2 we see that the cost of units in stock was $16 for wheels and $20 for casters. However, we shall assume the price of materials, labor, and overhead going into the new products is now $18 for wheels and $22 for casters, as indicated in Table 4.

Table 4 Unit costs

The total cost to produce the required new items for the next six months is shown in Table 5.

Table 5 Total production costs

Cost of Goods Sold The main consideration in constructing a pro forma income statement is the costs specifically associated with units sold during the time (the cost of goods sold). Note that in the case of wheels we anticipate sales of 1,000 units, as indicated in Table 1, but are producing 1,015, as indicated in Table 3, to increase our inventory level by 15 units. For profit measurement purposes, we will not charge these extra 15 units against current sales. Furthermore, in determining the cost of the 1,000 units sold during the current time period, we will not assume that all of the items sold represent inventory manufactured in this period. We shall assume the Lamson Corporation uses FIFO (first-in, first-out) accounting and it will first allocate the cost of current sales to beginning inventory and then to goods manufactured during the period. 

In Table 6 we look at the revenue, associated cost of goods sold, and gross profit for both products. For example, 1,000 units of wheels are to be sold at a total revenue of $30,000. Of the 1,000 units, 85 units are from beginning inventory at a $16 cost, and the balance of 915 units is from current production at an $18 cost. The total cost of goods sold for wheels is $17,830, yielding a gross profit of $12,170. The pattern is the same for casters, with sales of $70,000, cost of goods sold of $43,640, and gross profit of $26,360. The combined sales for the two products are $100,000 with cost of goods sold of $61,470 and gross profit of $38,530.

Table 6 Allocation of manufacturing cost and determination of gross profits

At this point, we also compute the value of ending inventory for later use in constructing financial statements. As indicated in Table 7, the value of ending inventory will be $6,200. 

Table 7 Value of ending inventory

Other Expense Items

Having computed total revenue, cost of goods sold, and gross profit, we must now subtract other expense items to arrive at a net profit figure. We deduct general and administrative expenses as well as interest expenses from gross profit to arrive at earnings before taxes, then subtract taxes to determine after-tax income, and finally deduct dividends to ascertain the contribution to retained earnings. For the Lamson Corporation, we shall assume general and administrative expenses are $12,000, interest expense is $1,500, and dividends are $1,500.

Actual Pro Forma Income Statement

Combining the gross profit in Table 6 with our assumptions on other expense items, we arrive at the pro forma income statement presented in Table 8. as shown toward the bottom of the table, we anticipate earnings after taxes of $20,024. Dividends of $1,500, and an increase in retained earnings of $18,524.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 87-92*

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