Journal of Finance and Accountancy The melding of financial and valuation analysis: an application Harold D. Fletcher Loyola University Maryland Thomas Ulrich Loyola University Maryland Abstract The purpose of this paper is to explicitly show how changes in cash flows from operating and financing decisions made as a result of financial ratio analysis can impact the value of the firm. The paper by applying firm-valuation analysis to the resulting cash flows illustrates the impact on firm value of specific management strategies through the melding of financial and valuation analysis. Keywords: Financial analysis, valuation analysis, adjusted present value The melding of financial, Page 1 Journal of Finance and Accountancy Introduction While managers frequently perform or are presented with financial ratio analysis that compares their firm's results to industry averages or other suitable benchmarks, many managers fail to grasp the significance of carrying out such an analysis and the potential benefits that may accrue from such an endeavor. The purpose of this paper is to illustrate the value of performing financial ratio analysis by melding standard financial ratio analysis with firm-valuation analysis. In this manner, not only does the significance of performing financial ratio analysis become ab- undantly clear, but the potential benefits accruing from various management actions can be ex- plicitly illustrated. As important as financial-analysis skills are to investors and creditors, these skills are even more important to general managers who in the aggregate decide how society's limited re- sources are allocated within the economy. The former perform their analyses from the outside looking in and are passive observers with respect to a firm's operations. The latter, on the other hand, are active participants in the firm's operations. It is their choice of actions and their effec- tiveness in carrying out those decisions that determine not only the value of the firm to the shareholders, but also the efficiency with which the nation's limited capital resources are em- ployed. Thus, regardless of the general manager's functional specialty or the size of the general manager's company, general managers need to possess financial-analysis skills so as to be able to diagnose their firm's ills, prescribe useful remedies, and anticipate fully the financial conse- quences and benefits of their actions. Unfortunately, many general managers do not fully understand accounting and finance and, thus, are working under a handicap. "You can't manage what you can't measure." And, you cannot evaluate alternative courses of action if you are unable to assess fully the consequences and benefits of these actions. Financial ratio analysis is more than simply a printout of a listing of financial ratios. Financial ratio analysis need to go further by indicating the potential changes in a firm's cash flows from undertaking policies to remedy unfavorable financial ratios. To any oth- er than the finance professional, the total significance of this action and the resulting change in cash flows is often missed or misunderstood. Sadly, many general managers fail to grasp the significance of doing such an analysis and the potential benefits that may accrue from undertaking such an endeavor. Seldom do they look beyond the immediate numbers to see the potential resulting impact on the firm's cash flows by instituting differing operating and financing strategies. Yet, by tracing financial ratio analysis from company performance evaluation, through potential corrective actions to cash-flow im- pacts, and ultimately firm value, general managers will be better able to appreciate the signific- ance of financial analysis and how their managerial actions and decisions can impact the value of the firm. Thus, by melding standard financial ratio analysis with firm-valuation analysis, the general manager can better understand and determine how much of the firm's value depends on his or her actions, and how much impact on firm value will result from instituting differing ma- nagerial alternatives. It is important that the executives responsible for operations realize how much impact they have on the firm's value and more specifically on what that value depends. The purpose of this paper is to explicitly show how changes in cash flows from operating and financing decisions made as a result of financial ratio analysis can impact the value of the firm by applying firm-valuation analysis to the resulting cash flows. The melding of financial, Page 2 Journal of Finance and Accountancy Adjusted Present Value The valuation technique employed in this paper is adjusted present value (APV) (Myers 1974, Ruback 1986, Shapiro 1978 & 1983). APV's signature characteristic is that no discount rate contains anything other than time value (the risk-free rate of interest) and a risk premium (according to the riskiness of the cash flows being discounted). This allows the impact of indi- vidual decisions to be determined by unbundling the base-case cash-flow projections into sepa- rate cash flows associated with each value-creating decision. Baseline cash flows are derived from recent operating results and represent the business in its current underperforming configura- tion. Then, the values of the incremental cash flows for each of the proposed operating initia- tives, for example, margin improvements, networking-capital improvements, asset liquidations, and higher steady-state growth are separately determined. Any value created by financial ma- neuvers -- tax savings, risk management, subsidized debt, credit-enhanced debt -- has its own cash-flow consequences. You can treat each of those consequences by laying out the cash flows in a spreadsheet and discounting them at a rate that reflects time value and their riskiness, but nothing else. In other words, APV is exceptionally transparent; you get to see all the components of value in the analysis; none are buried in adjustments to the discount rate as in the more tradi- tional-valuation analysis. The adjusted present value is based on the concept of value additivity. This concept holds that in well-functioning capital markets the market value of a firm is the sum of the present value of all the assets held by the firm. Here, all assets mean intangible as well as tangible assets. Thus, while the present value of all the firm's tangible assets may very well fall short of the firm's mar- ket value, the difference is explained by the present value of intangible assets, such as going- concern value, experienced-management team value, value of potential-growth opportunities, and stable- and dependable-workforce value. It is this value additivity concept that permits the adjusted present value to be broken down into its component parts, thus, providing more mana- gerially relevant information than traditional-valuation analysis. This unbundling of component values can help managers analyze not only how much a decision alternative is worth in terms of value it adds to the firm but also what is causing that value increment. To portray the value of financial analysis, the case example of D/A Instruments, Inc. will be used to trace financial ratio analysis from the analysis of the firm's current situation through decision making to the impact of differing alternative decisions on a firm's cash flows, and then through the use of adjusted present value analysis to changes in the value of the firm. This is ac- complished by first performing financial ratio analysis on the case situation to evaluate the past performance of the company and suggest alternative courses of actions. The impact of these al- ternative courses is then traced to their effects on cash flows and then ultimately to their impact on the value of the firm to its shareholders. Hence, in this manner the general manager learns to appreciate financial ratio analysis. D/A Instrument, Inc. Roger Diamond had just been named the new president of D/A Instruments, Inc. He took over from his father who was forced to retire due to health problems. As a teenager Roger worked on the company's production line, and he continued to work in the production area dur- ing the summers while he attended the University of Maryland. After graduating with a degree in electrical engineering, Roger worked full-time in the company's production department while he The melding of financial, Page 3 Journal of Finance and Accountancy pursued his MBA degree at night. For the last five years to increase his knowledge and his expe- rience with differing aspects of the company, Roger has been based in California as sales manag- er for West Coast sales. D/A Instruments, headquartered in Cambridge, Maryland, was a relatively small manu- facturer of electromedical and electrotherapeutic instruments for hospitals. While it made a num- ber of devices, its primary products were cardiographs, respiratory analysis equipment, and ultra- sonic equipment. It sold the equipment through a direct sales force on the east and west coasts and covered the rest of the country through manufacturers' representatives. James Diamond, Roger's father, and a partner William Anderson had founded the company thirty years ago. Bill Anderson had been bought out approximately fifteen years ago. While the company's stock was traded over-the-counter, the Diamond family held a controlling interest in the company. The company's stock was followed by the regional investment management firm of Alexander & Sons. Recently, Roger received a copy of an investment report prepared by a financial analyst at Alexander & Sons which showed an intrinsic value for D/A Instruments of $16.25 million which accorded the stock a price-to-earnings ratio of only about five times earnings (See Table 3.). Therefore, one of the first things Roger did was to undertake a complete financial analysis of the firm with the help of Jennifer Meyer, a CPA and financial consultant.