Horizontal vs Vertical Financial Analysis

I was asked by a student to explain and give examples of the difference between horizontal and vertical financial analysis:

Horizontal Financial Analysis 
Looks at year over year trends.

Examples:

• Year over year sales growth
• Year over year trends (ie. debt to equity ratio, liquidity ratios, etc.)

Vertical Financial Analysis 
Profitability analysis is an example of a vertical financial analysis - Contribution margin, profit margin and gross profit rates. Here  we look at how a financial statement item relates to another within the same year.

Examples:

• Net income as a % of sales
• Gross Profit as a % of sales
• Expenses as a % of Net Income

The two types of analysis go hand in hand as we often look at how a company's various components are performing in relation to key financial figures like sales or net income, but we also look at how this has been trending throughout the years to get a complete picture.

Quantitative Analysis for Strategic Alternatives

There are various tools that should be applied in the CMA case exam as part of the quantitative analysis of strategic alternatives. It is important to calculate not only the NPV for the strategic alternatives but to apply a few other tools in addition to NPV for a complete analysis.  Below are some notes on my preferred quantitative analysis tools and when/how to use them:

NPV

Net Present Value (NPV) should be calculated for every strategic alternative if possible. See my post 'NPV Tips and Template' for a complete discussion of how to approach the NPV calculation.

Financing Required vs. Financing Available

It is important to calculate and demonstrate whether there is enough financing available for the strategic alternatives.

 

Constraints Met

You should calculate whether your strategic alternatives meet the constraints provided in the case. (ie. bank covenants, capacity constraints, etc.. If you do not have time to calculate this for every strategic alternative, be sure that you do the calculation at least for the strategic alternative that you end up recommending. 

Sensitivity Analysis

This is the easiest and quickest calculation and I always did this for at least one strategic alternative. What I do is calculate NPV for an alternative as usual, and then copy and paste this NPV two time. Then you end up with three sets of the same NPV - then, for the second and third NPV I would change my assumptions so that I would end up with the following set of three NPV calculations: conservative assumptions, optimistic assumptions and your normal/most likely assumptions. Make sure to tie this into the case via the analysis of the alternatives or in the recommendations.

Profitability Analysis

If there is no major investment for an alternative, I generally like to calculate profitability for 3-5 years. I show the after tax revenues vs expenses and identify whether the alternative generates a profit or loss through the years (don't forget to include any one time costs in the appropriate years).

Payback Period

This is my lease favorite quantitative tool but if you like, you may throw this one in as it doesnt usually take too much time to calculate. The payback period is calculated as follows:

Cost of the strategic alternative (cost of the investment) 

Annual incremental after-tax cash inflows

Keep in mind that payback period ignores the time value of money and generally assumes that annual cash inflows are the same each year. 

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NPV Tips and Template

~This template is now available for download in excel format so that you can see all the links and formulas: NPV Template ~

~This template is now available for download in excel format so that you can see all the links and formulas: NPV Template ~

This is the template that I used during the CMA Case Exam. I typed it in quickly for the first alternative and then copied and pasted it for all the other alternatives. This way, as I was approaching each alternative, I just had to fill in the data and all the calculations were already set up. This helped me streamline and speedup the (Net Present Value) NPV process and to not forget any of the NPV components. 

Below is a discussion of each of the above components as well as some general guidelines for NPV calculations:

General notes:

• Unless otherwise suggested, calculate a 5 year NPV with deemed disposition at year 5 (hence the salvage value at year 5). 
• Try not to calculate anything using the calculator. Use the securexam's mock excel so that if you need to change assumptions or fix errors all you have to do is change one number and everything gets recalculated for you.
• Remember to use incremental after tax cash flows.
• Financing costs are not relevant to NPV and should not be included (ie. the interest that will have to be paid for the line of credit that will fund the investment is not something that is relevant to the NPV calculation).
• Always state all of your assumptions clearly and show an audit trail.

Discussion of 'a' through 'f':
Note: In the above template and for the purpose of this example I assumed $40 million investment, $2 million salvage value, tax rate of 38% , a CCA rate of 15% and a discount rate of 8%.

a) This is the total of the one time/upfront investments that are required for the capital project. Remember to show this as a negative figure to ensure that the total sum of all the NPV components is correct. 

b) This is the tax shield that we get from the acquired capital. Use the correct CCA rate depending on the asset. If the investment consists of several assets, each with a different CCA rate, than you will need to calculate the tax shield for each asset separately. 

c) Here we calculate the present value of the salvage. We know that salvage value in 5 years (remember deemed disposition) is $2 million but for NPV we need to calculate the present value of this $2 million. 

d) There are two components to this part. 

• First, we calculate the tax shield that we will loose due to the deemed disposition in year 5. In 'b' we calculated the total tax shield for the investment assuming no disposition due to the nature of the CCA tax shield formula (it calculates tax shield for the life of the asset). However, since NPV assumes disposition in year 5, you have to take into account the tax shield that is being lost due to the deemed disposition of the capital. (ie. if we bought a machine that would yield a tax shield of $10 over 8 years, and then we decide to sell it in year 5, we will not get all the tax shield from it as we sold it before we had a chance to benefit from all the tax shield). 
• The tax shield lost calculated so far is a figure as at year 5 (its a Future Value for us) and therefore we now need to discount it and calculate its Present Value. The second component is where we take the FV of the tax shield lost and calculate the corresponding PV. 

e) This is the Present Value of the incremental cash flows. Remember to use the after tax figure. 

f) This is the sum of all the components that shows the NPV for the investment. Remember that an NPV of $0 is good - this means that the desired return rate has been achieved. 

~This template is now available for download in excel format so that you can see all the links and formulas: NPV Template ~

Key Elements of Convincing Strategic Recommendations

When putting together the Strategic recommendations for the May 2012 CMA Case Exam the key to remember is that it MUST be convincing. This is not an area to analyze rather an area to state, with authority and supporting backup, what the company should do and why.

Some students stumble in the recommendation section because they fail to convince the reader that their recommendations will in fact address the strategic issue. Students should not word the recommendations in a very weak and uncertain tone, in essence showing the reader that they are not sure of their recommendation. Some also forget to address any new risks that may arise due to the implementation of a strategic alternative (think cons that were listed under the strategic alternative that you are recommending). The following are elements that help create strategic recommendations that are strong, convincing and complete:

• Show that constraints are met
• Show that sufficient financing is available
• If appropriate, recommend only one alternative to avoid calculating the effect of one on the other (unless only one is not reasonable)
• Indicate how the recommended strategy takes advantage of strengths and opportunities while mitigating weaknesses and avoiding threats
• State how it will allow the company to address/resolve its overall strategic issue (ie. ‘I recommend that you buy the warehouse to expand into Canada as it will allow you to increase profits as well as market share).
• Rationalize based on pros and cons (re-worded into several overriding reasons) - Highlight the top pros for the recommended alternative as well as state how you will mitigate/address any cons associated with this alternative. For any cons that are not mitigated you should state two over-riding benefits that still keep this alternative as the right option. (ie. Even though expanding into outerwear may increase the threat from competitor A, the NPV which was calculated using conservative assumptions is positive and this alternative is in line with stakeholder preferences and capitalizes on the company’s strengths)
• Do NOT say ‘I recommend none’
• Do not be ambiguous. Use strong and convincing language.
• Cover all of the alternatives that are not recommended as well – state for each why they should not go with it. (Ie. Even though expanding into dog food is in line with the company’s strengths, this alternative has a negative NPV and is not in line with stakeholder preferences).
• Provide a brief Pro-Forma – if you do not have time for a detailed one, include very basic pro forma statements as appropriate to the situation (ie. Sales, expenses, Net Income – for 3 years, to show that your recommendations will have a positive impact on the company’s financials) – use ball park figures derived from your quantitative analysis, do not obsess about accuracy, it is better to have ball park #s than none at all
• State consistency with mission or provide a revised mission
• Propose a Balanced Scorecard

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