Chapter 3

FINANCIAL STATEMENTS ANALYSIS AND FINANCIAL MODELS

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3-1

KEY CONCEPTS AND SKILLS

Standardize financial statements for comparison
purposes
Compute and interpret important financial ratios
including the famous DuPont Identity
Develop a financial plan using the percentage of
sales approach
Discern how capital structure and dividend
policies affect a firms ability to grow

3-2

CHAPTER OUTLINE
3.1 Financial Statements Analysis
3.2 Ratio Analysis
3.3 The Du Pont Identity
3.4 Financial Models
3.5 External Financing and Growth
3.6 Some Caveats Regarding Financial Planning
Models

3-3

3.1 FINANCIAL STATEMENTS

ANALYSIS
Must develop a good working knowledge
of financial statements
Making financial statements useful for
users is one finance role
In order to make meaningful comparisons
of companies of different size financial
professionals use two key techniques:
Common-Size Statements
Financial Ratios
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COMMON-SIZE FINANCIAL
STATEMENTS

Common-Size Balance Sheets

Compute all accounts as a percent of total assets
Common-Size Income Statements
Compute all line items as a percent of sales
Standardized statements make it easier to compare
financial information, particularly as the company
grows.
They are also useful for comparing companies of
different sizes, particularly within the same industry.
Practice Hint: You may have round percentages in
Common-Size Statements
3-5

PRUFROCK CORPORATION
COMPARISON: FINANCIAL & COMMON SIZE
BALANCE SHEET

Balance Sheet

Common Size Balance

Sheet
3-6

Prufrock Corporation
Comparison: Financial & Common Size Income
Statement
Income Statement

Common Size Income

Statement

3-7

3.2 RATIO ANALYSIS

Ratios compliment common size analysis and
allow for deeper comparison through time or
between dissimilar companies
Not always computed precisely the same;
document your approach
As we look at each ratio, ask yourself:

How is the ratio computed?

What is the ratio trying to measure and why?
What is the unit of measurement?
What does the value indicate?
How can we improve the companys ratio?

3-8

CATEGORIES OF FINANCIAL RATIOS

Short-term solvency or liquidity ratios

Long-term solvency or financial leverage ratios
Asset management or turnover ratios
Profitability ratios
Market value ratios

Following examples all based on Tables 3.1 & 3.4

3-9

COMPUTING LIQUIDITY RATIOS

Current Ratio = CA / CL
708 / 540 = 1.31 times

Quick Ratio = (CA Inventory) / CL

(708 - 422) / 540 = .53 times

Cash Ratio = Cash / CL

98 / 540 = .18 times

3-10

COMPUTING LEVERAGE RATIOS

Total Debt Ratio = (TA TE) / TA
(3588 - 2591) / 3588 = 28%

Debt/Equity = TD / TE
(3588 2591) / 2591 = 38.5%

Equity Multiplier = TA / TE = 1 + D/E

1 + .385 = 1.385

3-11

COMPUTING COVERAGE RATIOS

Times Interest Earned = EBIT / Interest
691 / 141 = 4.9 times

Cash Coverage = (EBIT + Depreciation +

Amortization) / Interest
(691 + 276) / 141 = 6.9 times

3-12

COMPUTING INVENTORY RATIOS

Inventory Turnover = Cost of Goods Sold /
Inventory
1344 / 422 = 3.2 times

Days Sales in Inventory = 365 / Inventory

Turnover
365 / 3.2 = 114 days

3-13

COMPUTING RECEIVABLES RATIOS

Receivables Turnover = Sales / Accounts
Receivable
2311 / 188 = 12.3 times

Days Sales in Receivables = 365 / Receivables

Turnover
365 / 12.3 = 30 days

3-14

COMPUTING TOTAL ASSET TURNOVER

Total Asset Turnover = Sales / Total Assets
2311 / 3588 = .64 times
It is not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets.

3-15

COMPUTING PROFITABILITY
MEASURES
Profit Margin = Net Income / Sales
363 / 2311 = 15.7%

Return on Assets (ROA) = Net Income /

Total Assets
363 / 3588 = 10.12%

Return on Equity (ROE) = Net Income /

Total Equity
363 / 2591 = 14.01%

EBITDA Margin = EBITDA / Sales

967 / 2311 = 41.8%
3-16

COMPUTING MARKET VALUE

MEASURES
Market Capitalization = $88 per share x 33
million shares = 2904 million
PE Ratio = Price per share / Earnings per share
88 / 11 = 8 times

Market-to-book ratio = Market value per share /

Book value per share
88 / (2591 / 33) = 1.12 times

Enterprise Value (EV) = Market capitalization +

Market value of interest bearing debt Cash
2904 + (196 + 457) 98 = 3459 million

EV Multiple = EV / EBITDA
3459 / 967 = 3.6 times
3-17

SUMMARY OF RATIO FORMULAE

3-18

USING FINANCIAL RATIOS

Ratios are not very helpful by themselves:
they need to be compared to something
Time-Trend Analysis
Used to see how the firms performance is
changing through time
Peer Group Analysis
Compare to similar companies or within
industries
Go to www.reuters.com/finance/stocks
Use the Financials link to get comparative ratios for
many companies
3-19

3.3 THE DUPONT IDENTITY

Popularized by the DuPont Corporation
A more sophisticated method of evaluating
return
Illustrates the interaction between profit,
assets and leverage
Holds that ROE is actually a function of 3
measures:
Operating Efficiency (Profit Margin)
Asset Use Efficiency (Total Asset Turnover)
Financial Leverage (Equity Multiplier)
3-20

DERIVATION OF THE DU PONT

IDENTITY
ROE = NI / TE
Multiply by 1 and then rearrange:
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM

Multiply by 1 again and then rearrange:

ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM

3-21

USING THE DU PONT IDENTITY

ROE = PM * TAT * EM
Profit margin is a measure of the firms operating
efficiency how well it controls costs.
Total asset turnover is a measure of the firms asset use
efficiency how well it manages its assets.
Equity multiplier is a measure of the firms financial
leverage.

3-22

CALCULATING THE DU PONT IDENTITY

ROA = 10.12% and EM = 1.39
ROE = 10.12% * 1.39 = 14.01%

PM = 15.7% and TAT = 0.64

ROE = 15.7% * 0.64 * 1.39 = 14.0%

3-23

POTENTIAL PROBLEMS IN FINANCIAL

ANALYSIS
There is no underlying theory, so there is no
way to know which ratios are most relevant.
Benchmarking is difficult for diversified firms.
Globalization and international competition
makes comparison more difficult because of
differences in accounting regulations.
Firms use varying accounting procedures.
Firms have different fiscal years.
Extraordinary, or one-time, events

3-24

3.4 FINANCIAL MODELS

Projection of Future Plans
Short Term or Long Term
Results in Pro-Forma Statements

Influenced by:
Investment in new assets capital budgeting
decisions
Degree of financial leverage capital structure
decisions
Cash paid to shareholders dividend policy
decisions
Liquidity requirements net working capital
decisions

3-25

FINANCIAL PLANNING INGREDIENTS

Sales Forecast cash flows depend directly on the
level or estimated growth rate of sales
Pro Forma Statements Presenting the plan as
projected financial statements (pro forma) allows
for consistency and ease of interpretation
Asset Requirements additional assets required
to meet sales projections
Financial Requirements financing needed to pay
for the required assets
Plug Variable depends on type of financing to
be used (makes the balance sheet balance)
Economic Assumptions state of the economy,
anticipated changes in interest rates, inflation
3-26

PERCENT OF SALES APPROACH

Some items vary directly with sales,
others do not.
Income Statement
Costs may vary directly with sales - if this is
the case, then the profit margin is constant
Depreciation and interest expense may not
vary directly with sales if this is the case,
then the profit margin is not constant
Dividends are a management decision and
generally do not vary directly with sales this
affects additions to retained earnings
3-27

PERCENT OF SALES APPROACH

Balance Sheet

Initially assume all assets, including fixed, vary directly

with sales.
Accounts payable also normally vary directly with sales.
Notes payable, long-term debt, and equity generally do
not vary with sales because they depend on
management decisions about capital structure.
The change in the retained earnings portion of equity
will come from the dividend decision.

External Financing Needed (EFN)

The difference between the forecasted increase in

assets and the forecasted increase in liabilities and
equity.

3-28

PERCENT OF SALES APPROACH INCOME

STATEMENT

Indicate 25% Sales Growth Assumption

3-29

PERCENT OF SALES APPROACH BALANCE

SHEET

Indicate 25% Sales Growth Assumption

Highlight Plugs (Notes Payable $225 & LTD
$340)

3-30

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External Financing Needed (EFN) can also be

calculated as:

3-31

3.5 EXTERNAL FINANCING AND

GROWTH
At low growth levels, internal financing (retained
earnings) may exceed the required investment in
assets.
As the growth rate increases, the internal
financing will not be enough, and the firm will
have to go to the capital markets for financing.
Examining the relationship between growth and
external financing required is a useful tool in
financial planning.

3-32

R
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A

b
InteralG
ow
thR
ae19-.53%
26.7.0965

THE INTERNAL GROWTH RATE

The internal growth rate is the maximum growth

rate using retained earnings as the only source
of financing
In other words, the IGR is the maximum growth
rate with no EFN of any kind.
Using the information from the Hoffman Co.
ROA = 66 / 500 = .132
b = 44/ 66 = .667

3-33

R
O
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b
S
ustainbleG
row
thR
ae
1-
.2364%
7
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THE SUSTAINABLE GROWTH RATE

The sustainable growth rate tells us how much
the firm can grow by using internally generated
funds and issuing debt to maintain a constant
debt ratio.
Using the Hoffman Co.
ROE = 66 / 250 = .264
b = .667

3-34

DETERMINANTS OF GROWTH

Profit margin operating efficiency

Total asset turnover asset use efficiency
Financial leverage choice of optimal debt ratio
Dividend policy choice of how much to pay to
shareholders versus reinvesting in the firm

3-35

3.6 SOME CAVEATS

Financial planning models do not indicate which
financial polices are the best.
Models are simplifications of reality, and the world
can change in unexpected ways.
Without some sort of plan, the firm may find itself
adrift in a sea of change without a rudder for
guidance.

3-36

QUICK QUIZ
How do you standardize balance sheets
and income statements?
Why is standardization useful?
What are the major categories of
financial ratios?
How do you compute the ratios within
each category?
What are some of the problems
associated with financial statement
analysis?
3-37

QUICK QUIZ
What is the purpose of financial planning?
What are the major decision areas involved
in developing a plan?
What is the percentage of sales approach?
What is the internal growth rate?
What is the sustainable growth rate?
What are the major determinants of
growth?

3-38