Chapter 3 CF Notes

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Chap003
Corporate Finance (Trường Đại học Kinh tế Thành phố Hồ Chí Minh)
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Chapter 03 - Financial Statements Analysis and Financial Models
Chapter 3
FINANCIAL STATEMENTS ANALYSIS AND FINANCIAL
MODELS
SLIDES
3.1 Key Concepts and Skills

3.2 Chapter Outline
3.3 Financial Statements Analysis
3.4 Ratio Analysis
3.5 Categories of Financial Ratios
3.6 Computing Liquidity Ratios
3.7 Computing Leverage Ratios
3.8 Computing Coverage Ratios
3.9 Computing Inventory Ratios
3.10 Computing Receivables Ratios
3.11 Computing Total Asset Turnover
3.12 Computing Profitability Measures
3.13 Computing Market Value Measures
3.14 Using Financial Statements
3.15 The Du Pont Identity
3.16 Using the Du Pont Identity
3.17 Calculating the Du Pont Identity
3.18 Potential Problems
3.19 Financial Models
3.20 Financial Planning Ingredients
3.21 Percent of Sales Approach
3.22 Percent of Sales Approach
3.23 Percent of Sales and EFN
3.24 External Financing and Growth
3.25 The Internal Growth Rate
3.26 The Sustainable Growth Rate
3.27 Determinants of Growth
3.28 Some Caveats
3.29 Quick Quiz
3.30 Quick Quiz
3-1
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale
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CHAPTER WEB SITES
Section Web Address

3.2 www.reuters.com/finance/stocks
www.sba.gov
3.4 www.planware.org
CHAPTER ORGANIZATION
3.1 Financial Statements Analysis

Standardizing Statements
Common-Size Balance Sheets
Common-Size Income Statements
3.2 Ratio Analysis

Short-Term Solvency or Liquidity Measures
Long-Term Solvency Measures
Asset Management or Turnover Measures
Profitability Measures
Market Value Measures
3.3 The DuPont Identity

A Closer Look at ROE
Problems with Financial Statement Analysis

A Simple Financial Planning Model
The Percentage of Sales Approach

EFN and Growth
Financial Policy and Growth
A Note about Sustainable Growth Rate Calculations
3.6 Some Caveats Regarding Financial Planning Models
ANNOTATED CHAPTER OUTLINE
Slide 3.0 Chapter 3 Title Slide

Slide 3.1 Key Concepts and Skills
Slide 3.2 Chapter Outline
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Lecture Tip: Students sometimes get the impression that

accounting data is useless because care must be used when
some of the results are interpreted. They sometimes ask
why we bother with financial statement analysis at all.
Robert Higgins provides a good answer to this question:
“Objectively determinable current values of many

assets do not exist. Faced with a trade-off between
relevant, but subjective current values, and
irrelevant, but objective historical costs,
accountants have opted for irrelevant, but objective
historical costs. This means that it is the user’s
responsibility to make adjustments”
Financial statement information is often our ONLY source of

information. Consequently, we use the information we have and
make adjustments where appropriate.
A possible extension to this discussion involves the movement to
market value accounting and its impact on the credit crisis (and
associated writedowns) and recession which begun in 2008.
3.1. Financial Statements Analysis
A. Standardizing Financial Statements
Standardized statements allow users to compare companies of

different sizes (particularly within the same industry) or to better
compare an individual company as it grows through time.
Slide 3.3 Financial Statements Analysis
B. Common-Size Balance Sheets

Express each account as a percent of total assets.
C. Common-Size Income Statement

Express each item as a percent of sales.
3.2. Ratio Analysis
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Lecture Tip: Unfortunately, students often make it through an

entire business program without ever having to interpret the
consolidated financial statements in an annual report. Yet, they
need to grasp the differences between the simplified statements
that are presented in textbooks and the statements they will see in
the business world. There are several things you can do to increase
their awareness of the differences. One idea is to go to a
company’s web site and pull up their annual report. Go through
the balance sheet and income statement and point out some of the
differences. For example, EBIT is often referred to as “operating
income” or “income from operations,” and not all companies list
“cost of goods sold” on the income statement. An excellent
homework assignment is to have them download the financial
statements for a company of your (or their) choice, and then have
them compute the ratios and discuss the results in class.
Slide 3.4 Ratio Analysis
Questions to answer when interpreting financial ratios:
-How is the ratio computed?
-What aspects of the firm are we attempting to analyze?
-What is the unit of measurement (times, days, percent)?
-What does the value indicate? (What are the benchmarks used for
comparison? What makes a ratio “good” or “bad”?)
-What actions could the company take to improve the ratio? (How
will this affect other ratios?)
Slide 3.5 Categories of Financial Ratios
-Short-term solvency, or liquidity, ratios: The ability to pay bills in the short-
run
-Long-term solvency, or financial leverage, ratios: The ability to meet long-

term obligations
-Asset management, or turnover, ratios: Efficiency of asset use
-Profitability ratios: Efficiency of operations and how this translates to the

“bottom line”
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-Market value ratios: How the market values the firm relative to the book
values
Lecture Tip: Students often fail to see the “forest” for all the “trees”
(equations) when they are first learning financial statement
analysis. It is important to remind them that we are not just
computing ratios; we are computing ratios to help us make better
decisions. Teaching the ratios by category and showing how each
category can answer different questions related to the financial
strength of the firm may help students see the overall picture
painted by financial statement analysis, as well as how ratios
relate to each other.
A. Short-term Solvency or Liquidity Ratios
Slide 3.6 Computing Liquidity Ratios: Note that the ratios on Slides 3.6
through 3.13 are computed using financial data from Tables 3.1 and 3.4.
Current Ratio = current assets / current liabilities
Quick Ratio = (current assets – inventory) / current liabilities
Cash Ratio = cash / current liabilities
Lecture Tip: When asked to define liquidity, students invariably state that it is
the “ability to convert assets to cash quickly.” Wrong! You should
stress the inadequacy of this definition by pointing out that you can
convert anything to cash quickly if you lower the price enough. A
good example is to ask the students how long it would take to sell a
house if the seller only asked for $1. Then ask them if this means
that the house is a liquid asset. Most of them recognize that it is
not, and then it is easier for them to remember the second part of
the definition – “without a significant loss in value.”
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Lecture Tip: Students often think that a high current ratio is, in and of itself, a
good thing. This may be true if you are a short-term creditor and
you are evaluating whether or not to grant trade credit or make a
short-term loan, but liquid assets are generally less profitable for
the company. Consequently, too large an investment in current
assets may reduce the earnings power of the firm and actually
reduce the stock price. Remind the students that the goal of the
firm is to maximize owner wealth.
Kirk Kerkorian’s takeover bid for Chrysler in April 1995 is a
perfect example of investor dissatisfaction with excess liquidity. At
the time, Chrysler’s management had accumulated $7.3 billion in
cash and marketable securities as a cushion against an economic
down-turn. Mr. Kerkorian instigated a takeover bid because
Chrysler’s management refused to pay this cash to stockholders. A
Wall Street Journal article noted that some analysts considered
several other firms with large cash holdings relative to firm value
vulnerable to takeover bids as well.
Lecture Tip: You may want students to consider the interaction of ratios.
Suggest a scenario in which the current ratio exhibits no change
over a two- or three-year period, while the quick ratio experiences
a steady decline. How could this occur? Is it a desirable strategy?
Have the students consider the following:
1. The company is operating with lower levels of the most
liquid assets, and this situation should be monitored. A problem
could arise should a large amount of current liabilities come due
for payment. However, this may not be a major concern if the
company has access to a line of credit at a bank.
2. This situation also indicates that larger levels of inventory,
relative to current liabilities, have accumulated in the firm. Point
out that an examination of other ratios is required to explore this
situation further. For example, it would be useful to know how
inventory relative to sales or cost of goods sold has changed
through time. This provides a nice lead-in to the asset management
section.
A. Long-Term Solvency Measures
These are also known as leverage ratios.
Slide 3.7 Computing Leverage Ratios
Total debt ratio = (total assets – total equity) / total assets
Variations:
debt/equity ratio = (total assets – total equity) / total equity
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Using the balance sheet identity, the debt/equity ratio can

also be calculated as: debt ratio / (1 – debt ratio)
equity multiplier = total assets / total equity

= 1 + debt/equity ratio
The equity multiplier captures the leverage effect in the

DuPont identity.
Slide 3.8 Computing Coverage Ratios
Times interest earned ratio = EBIT / interest
Cash coverage ratio = (EBIT + depreciation + amortization) /

interest
= EBITDA / interest
You can also calculate a type of inverse value as follows:

Interest Bearing Debt / EBITDA = (196 + 457) / 967 = .68
Values less than one are indicative of a stable position.
Lecture Tip: This group of ratios (i.e., long-term solvency) really measures
two different aspects of leverage – the level of indebtedness and
the ability to service debt. The former is indicative of the firm’s
debt capacity, while the latter more closely relates to the likelihood
of default.
Further, it is sometimes helpful to alert students to some of the
nuances of the ratios within these subgroups. For example, the
total debt ratio measures what proportion of the firm’s assets are
financed with borrowed money, while the debt/equity ratio
compares the amount of funds supplied by creditors and owners.
The long-term debt ratio looks at the percent of long-term
financing that is raised using debt.
Lecture Tip: The importance of coverage ratios is sometimes overlooked,

particularly when one considers their importance to all types of
creditors. There are several types of coverage ratios that may
include interest expense, sinking fund payments, and lease
payments in the denominator. The format of the ratios depends
largely on the reason that the analyst is looking at them, so it is
always important to pay attention to exactly how the ratio is being
computed, not just what it is called.
B. Asset Management or Turnover Measures
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Slide 3.9 Computing Inventory Ratios
Inventory turnover = cost of goods sold / inventory
Days’ sales in inventory = 365 days / inventory turnover
Lecture Tip: You may wish to mention that there may be

significant inconsistencies in the methods used to compute ratios
by financial advisory firms. When using ratios supplied by others,
it is important to be aware of the exact financial items used. A
manufacturer would typically consider inventory at cost, and thus,
relate inventory to cost of goods sold. However, a retailer might
maintain its inventory level based on retail price. In the latter
case, inventory should be related to sales to compute inventory
turnover. The markup would cancel in the numerator and
denominator and give a more accurate indication of turnover
based on cost. You also have some analysts use average inventory
over some period instead of ending inventory. The same is true for
the other assets used in the various turnover ratios.
Slide 3.10 Computing Receivables Ratios
Receivables turnover = sales / accounts receivable
Days’ sales in receivables = 365 days / receivables turnover

(Also called “average collection period” or “days’ sales outstanding.”)
Lecture Tip: In discussing the nature of financial statement

analysis, you may wish to emphasize frequently that it is a means
to an end, rather than an end in itself. That is, financial ratios are
“red flags” that a good analyst will use to determine what needs to
be investigated further. For example, suppose a firm’s average
collection period (days’ sales in receivables) is significantly higher
than the industry norm. What questions might you ask?
-What are the firm’s credit terms? What are the industry’s terms on
average?
-Has the average collection period been trending upward, or is
this an aberration?
-Which consumers are contributing to the relatively high average
collection period?
-Is this an industry or economy wide phenomenon?
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Clearly, these questions are not all easily answered. Nonetheless, it should be
emphasized that a thorough analyst will consider numerous
questions like these in making a final determination about the
firm’s ability to manage its assets.
Slide 3.11 Computing Total Asset Turnover
Total Asset Turnover (TAT) = sales / total assets
Lecture Tip: In addition to TAT, it may be helpful to calculate

components of TAT such as Fixed Asset Turnover or Net Working
Capital Turnover. This highlights that the firm may be doing better
or worse in total, but it is possible for segments to be doing the
opposite.
Lecture Tip: Students should be warned that, just as one must take care in
making generalizations across industries, so intra-industry
generalizations should also be made with great caution. For
example, a fixed asset turnover ratio that is high relative to that of
the industry can be the result of efficient asset utilization, or it can
indicate that the firm is utilizing old (and perhaps inefficient)
equipment, while others in the industry have invested in modern
equipment. This example also provides you with the opportunity to
illustrate the underlying linkages inherent in financial statement
analysis. In this case, the firm using inefficient equipment would
display a favorable fixed asset turnover ratio, but would be likely
to display a higher level of expenses, and unless offset by other
factors, lower profitability.
C. Profitability Measures
Slide 3.12 Computing Profitability Measures
These measures are based on book values, so they are not comparable with
returns that you see on publicly traded assets.
Profit margin = net income / sales
EBITDA Margin = EBITDA / Sales
Return on Assets (ROA) = net income / total assets
Return on Equity (ROE) = net income / total equity
For ROA, we could use EBIT rather than Net Income to get a
measure that is neutral with respect to capital structure.
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Slide 3.13 Using Financial Statements
Lecture Tip: Economic Value Added (EVA®) and Market Value Added (MVA)
are relatively recent additions to the analyst’s toolbox. EVA® was
developed by Stern Stewart & Company and is the difference
between the firm’s after-tax net operating profit and its cost of
funds. The roots of EVA® can be traced to Modigliani and Miller
(1958). More recently, EVA® has become a buzz-word among
consultants and writers in the business press. The degree to which
EVA has entered the mainstream can be seen in a November 1997
Fortune magazine article entitled “America’s Greatest Wealth
Creators” in which the authors ranked 200 firms on the basis of
their EVAs and MVAs. Interestingly, the article characterizes
increasing EVA® as “a good sign that a stock will soar.” Stern
Stewart & Company’s internal research shows that the stock of
companies that have used EVA® for at least five years have
substantially outperformed comparable firms. The stock
performance is even more impressive if the companies also use
compensation plans based on EVA®. This is ongoing research that
is being conducted by Stern Stewart & Company.
D. Market Value Measures
Slide 3.14 Computing Market Value Measures
Earnings Per Share (EPS) = net income / shares outstanding
Price-earnings ratio = price per share / earnings per share
Market-to-book ratio = market value per share / book value per share
Market capitalization = Price per share x Shares Outstanding
Enterprise Value (EV) = Market capitalization + Market value of

interest bearing debt – Cash
EV multiple = EV / EBITDA
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Lecture Tip: What is “EEBS”? Under the heading “A Wire Story We’d Like
to See,” those people at Fortune magazine have proposed a new
earnings metric: EEBS, or “Earnings Excluding Bad Stuff.” The
tongue-in-cheek article implies that, since Wall Street does not like
things that negatively impact earnings, firms should just report
earnings they would have made “if all this bad stuff hadn’t
happened” during the quarter. At first glance it sounds silly; on
the other hand, it may be the next logical step for those firms that
practice “income smoothing” and “earnings management.”
Lecture Tip: Here’s a tip for teaching about the interpretations of the P-E
ratio, either in your discussion of ratios, or in your discussion of
stock market history. Consider the table of year-end P-E ratios for
the S&P 500 (courtesy of the S&P web site computed as Index / as
reported EPS):
Year P-E Year P-E
1988 11.69 1996 19.13
1989 15.45 1997 24.43
1990 15.47 1998 32.60
1991 26.12 1999 30.50
1992 22.82 2000 26.41
1993 21.31 2001 46.50
1994 15.01 2002 31.89
1995 18.14 2003 22.81
The average P-E ratio over the 16-year period is 23.77. But what is the
average over a subset through time?
Period Average P-E

1988 – 92 18.31
1993 – 97 19.60
1998 – 2003 31.79
Is the increase in market P-E a secular trend or a fluke? What does this imply
for traditional measures of “overvaluation” such as the market P-
E? And if the benchmark market P-E is higher than it used to be,
what does that suggest for the interpretation of company P-Es?
Obviously, the high PE in the latest period was a fluke, as subsequent years
(particularly given the credit crisis of the late 2000s) have seen a
drop to lower levels, even below the other time period averages
reported in the table above.
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Lecture Tip: A Wall Street Journal article suggested that accounting methods
and ratio analysis may require some rethinking in the “new era”
in which we seem to be living. Specifically, an article entitled
“Bulls Use Convoluted Measures to Justify View” from the April
20, 1998, issue notes that “By almost any standard measure of
stock value, Friday’s record closes leave large stocks trading at or
beyond history’s most extreme limits of valuation.” [Note to the
cautious reader: when the WSJ article was written, the DJIA was
at 9167.50; it went as high as 11,500 in early 2000, dropped to
about 7900 after the terrorist attacks on September 11, 2001, was
back to almost 10,400 following the election in early November
2004, and closed around 8,000 at the end of 2008. ]
In any event, the article notes that the bull market of the 1990s
was attributable in large part to nearly divine macroeconomic
conditions – low inflation, low interest rates, and increasing
productivity. Put another way, the traditional valuation
benchmarks – historical price-earnings ratios, market-to-book
ratios, and dividend yields, as well as the underlying accounting
data - require careful consideration.
Lecture Tip: There are the “official” earnings estimates, compiled by First
Call, and then there are the “unofficial” estimates or “whisper
numbers.” Money Daily, in November 1998 called whisper
numbers “unofficial, unsubstantiated and unattributed forecast[s]
derived from rumors, hints and often, innuendo.” Academic
studies suggest that whisper numbers (which are often
disseminated via the Internet) “are a better proxy for market
expectations and are more accurate than consensus numbers.”
(Purdue University professor Susan Watts, quoted in the same
Money Daily article.) Another common term on Wall Street is
“visibility.” This term refers to the ability of management and
analysts to forecast earnings for future quarters. The more
confident they are about their estimates, the more “visibility” that
exists. Of course, visibility was much better when the economy was
good. When the economy began to slow down, visibility vanished.
It ties back to “EEBS.” In a down economy, companies do not
want to predict bad earnings very far into the future, but they are
more than willing to project good earnings for an extended
number of quarters during a good economy.
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Lecture Tip: Ask the students to consider how the market-to-book

ratio could be interpreted if you are considering the purchase of a
company’s stock. Some feel a ratio of less than one would be
preferred since the stock is selling below its book value. You can
point out that the market is evaluating the company’s future
earnings power, while the book value reflects the price at which
stock had previously been issued and the earnings that had been
retained in the firm. Valuation techniques concerning a company’s
future earnings will be explored in later chapters (as will capital
market efficiency and security valuation).
3.3 The DuPont Identity
A. A Closer Look at ROE
The DuPont Identity provides analysts with a way to break down ROE and
investigate what areas of the firm need improvement.
Slide 3.15 The DuPont Identity
ROE = (NI / total equity)
multiply by one (assets / assets) and rearrange

ROE = (NI / assets) (assets / total equity) = ROA*EM
multiply by one (sales / sales) and rearrange

ROE = (NI / sales) (sales / assets) (assets / total equity)
ROE = PM*TAT*EM
Slide 3.16 Using the DuPont Identity
These three ratios indicate that a firm’s return on equity depends

on its operating efficiency (profit margin), asset use efficiency
(total asset turnover) and financial leverage (equity multiplier).
Slide 3.17 Calculating the DuPont Identity
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Lecture Tip: The development of financial statement analysis is rooted in a

manufacturing tradition, with the large industrial corporation at
its center. Many notions about financial statement analysis grew
out of a view of business in which specialized plant and equipment
are used to turn raw materials into finished goods that are then
sold on credit. This view was modified by the advent of the large
retail corporation, but the emphasis on balance sheet assets
(receivables, inventories, plant and equipment) and the measures
associated with them remain.
Because of this manufacturer/retailer tradition, much of the
conventional wisdom about statement analysis is inappropriate to
many of today’s business situations. This is even more true when
we consider the advent of the “dot.com’s.” Good examples of firms
that do not fit the traditional mold are the professional
organizations formed by doctors, consultants, attorneys, etc., or
other service companies such as television and radio stations and
colleges and universities. The most important assets for these firms
are the people, and they do not show up on the balance sheet.
Their liquidity does not come from current assets but from the
services provided. Financial statements will eventually evolve, but
it is important to understand where we are starting from.
B. Problems with Financial Statement Analysis
Slide 3.18 Potential Problems
-no underlying financial theory

-finding comparable firms
-what to do with conglomerates, multidivisional firms
-differences in accounting practices
-differences in capital structure
-seasonal variations, one-time events
Lecture Tip: While some investors use PE ratios as if they are universally
comparable, differences in generally accepted accounting
practices used to compute EPS make international comparisons
risky. For example, the conventional wisdom for many years was
that the high PE ratios of Japanese stocks was due in part to the
more conservative nature of Japanese accounting practices which
depressed reported earnings and increased PEs.
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An interesting discussion of this issue appeared in the November 14, 1988,

Pensions and Investment Age. Gary Schieneman, Vice President –
International Equity Research with Prudential-Bache applied US
accounting standards to 25 Japanese firms in 17 industries and
found little evidence of a systematic downward bias in reported
earnings. But, Paul Aron, Vice-Chairman emeritus of Daiwa
Securities countered by suggesting that, after adjusting for
methodological problems, 75% of the firms in Mr. Schieneman’s
sample did underreport earnings. Regardless of who is correct, the
most telling aspect of the discussion is Mr. Schieneman’s comment
in summing up: “I don’t think earnings mean a whole lot in
Japan.”
Ethics Note: An interesting example of an additional problem faced by

professional analysts is demonstrated by the Trump-Roffman case.
In 1990, Marvin Roffman, an analyst at Janney Montgomery Scott,
Inc. stated in a Wall Street Journal article that, on the basis of his
examination of the financial data, he had “severe reservations
about the future” of the Trump Taj Mahal in Atlantic City. In
response, Donald Trump threatened to sue Janney Montgomery
Scott. Roffman wrote, and then retracted, a
public apology to Trump and was dismissed. He successfully sued and
received a large settlement. Nonetheless, his case illustrates the
dangers one faces as a practicing analyst. (For further details, see
the New York Times, June 6, 1991.)
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Lecture Tip: The explosion of the Internet has placed financial information in
the hands of millions of individuals and has increased the speed
with which information is obtained by professionals. Many
companies now webcast their earnings conference calls. This
information used to only be directly available to analysts, who
then passed selected information on to their clients. There is also
more opportunity for false information to be spread quickly. An
excellent example is the case of Emulex and a phony press release.
On Friday, August 25, 2000, someone issued a press release
indicating that the CEO of Emulex was quitting and that quarterly
earnings would be restated from a profit to a loss. The stock price
immediately plunged 62 percent. Mark Jakob has been arrested for
releasing the phony press release. His motive was apparently to
cover substantial losses from a short position in Emulex. The
Internet and other financial news sources disseminated the
information from the press release much faster than would have
been possible in the past. This is an excellent opportunity to
introduce the subject of efficient markets. If information is more
readily available, it should be incorporated into the price more
quickly, thereby increasing market efficiency. There is a trade-off,
however. False information can also be incorporated very quickly,
so investors need to remember the old adage “you can’t believe
everything you read.”
Slide 3.19 Financial Models
Financial planning is based on the three areas of corporate finance that were
discussed in chapter one: capital budgeting decisions, capital structure
decisions, and working capital management.
A. A Simple Financial Planning Model
Slide 3.20 Financial Planning Ingredients
Sales Forecast – most other considerations depend upon the sales forecast, so
it is said to “drive” the model
Pro Forma Statements – the output summarizing different projections
Asset Requirements – investment needed to support sales growth
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Financial Requirements – debt and dividend policies
The “Plug” – designated source(s) of external financing
Economic Assumptions – state of the economy, anticipated changes in interest

rates, inflation, etc.
B. The Percentage of Sales Approach
Slide 3.21 –
Slide 3.22 Percent of Sales Approach
Sales generate retained earnings (unless all income is paid out in dividends).
Retained earnings, plus external funds raised, support an increase
in assets. More assets lead to more sales, and the cycle starts again.
This simplified approach assumes that certain items are fixed and
other vary proportionally with sales. Once forecasted, you must
select a plug account that will be used to make the balance sheet
balance. This number generally reflects External Financing Needed
(EFN).
Lecture Tip: An interesting discussion can be started by asking the

question, “Does a company’s capacity level affect the percentage
of sales approach?”
Lecture Tip: In the first two chapters of the text, we have described “the
financing decision” in one of two ways: either in broad terms,
referring simply to the means by which funding is acquired to
accomplish our investment objectives, or specific terms, i.e.,
capital structure. At this point, the financing decision is
characterized in another way: as one aspect of the day-to-day
operations of the business. You may wish to take this opportunity
to set the stage for the material on working capital management to
be covered in subsequent chapters. Specifically, it can be helpful to
introduce the concept of “spontaneous” financing (financing that
arises in the normal course of business, requires little face-to-face
negotiation with the lender and is less likely to result in
bankruptcy proceedings in case of default). Students should be
reminded that while long-term financing decisions may have
greater potential impacts on firm value, they are made relatively
infrequently. Short-term investment and financing decisions are
made continuously and affect the daily cash flows of the business.
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Slide 3.23 Percent of Sales and EFN
An alternative method for calculating EFN is to use a formula

approach, where we subtract expected increases in (spontaneous)
liabilities and equity from the expected increase in assets.
 Assets  Spon Liab

  Sales  ΔSales  ( PM Projected Sales) (1  d )
EFN =  Sales  Sales
Slide 3.24 External Financing and Growth
All else equal, more growth means more external financing will be
needed.
Lecture Tip: You might point out that the relationship between firm
growth and external financing needs is of utmost importance to firms in
the early stages of their lives. Typically, these are firms that have
developed a new product or technology, are experiencing rapid sales
growth, have continuing capital needs, and must be extremely careful in
forecasting cash flows. Since many of these firms are relatively small
and/or new, their financing problems are often exacerbated by a lack of
access to the capital markets. As such, the “internal growth rate” and
“sustainable growth rate” concepts are of particular importance to
financial decision-makers.
A. EFN and Growth
Lecture Tip: For new firms, internal financing is often virtually zero,
particularly if the product or service being developed has not yet
been marketed to the public. External financing is, therefore, the
only significant source of funds and may come from venture
capitalists, banks, “angels,” or family and friends. Should you
wish to digress a bit and discuss the concept of “angel investors,”
who often provide capital to start-ups before venture capitalists
become involved, you will find a good hands-on article in the April
1996 issue of Worth magazine. There are also plenty of online
resources that can shed light on this issue.
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Assuming no spontaneous sources of funds, EFN equals the increase in total

assets less the addition to retained earnings.
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Low growth firms will run a surplus that causes a decline in the debt-to-equity
ratio. As the growth rate increases, the surplus becomes a deficit,
and the firm will need external financing.
B. Financial Policy and Growth
Slide 3.25 The Internal Growth Rate
The Internal Growth Rate (IGR) is the growth rate the firm can maintain with
internal financing only.
IGR = (ROA*b) / [1 – ROA*b]
Slide 3.26 The Sustainable Growth Rate
The Sustainable Growth Rate (SGR) is the maximum growth rate a firm can
achieve without external equity financing, while maintaining a
constant debt-to-equity ratio.
SGR = (ROE*b) / [1 – ROE*b]
Lecture Tip: Some students will wonder why managers would wish to avoid
issuing equity to meet anticipated financing needs. This is a good
opportunity to bring in concepts from previous chapters
(stockholder/bondholder conflicts of interest and agency costs), as
well as to introduce topics to be covered in future chapters
(information asymmetry and signaling, flotation costs, high cost of
equity and corporate governance).
Slide 3.27 Determinants of Growth

Determinants of growth – From the DuPont identity, ROE can be viewed as
the product of profit margin, total asset turnover, and the equity
multiplier. Anything that increases ROE will increase the
sustainable growth rate as well. Therefore, the sustainable growth
rate depends on the following four factors:
Operating efficiency – profit margin

Asset use efficiency – total asset turnover
Financial leverage – equity multiplier
Dividend policy – retention ratio
Lecture Tip: Wanting sales or revenues to grow by X% per year as a goal of

the firm is properly understood as meaning: “All else equal, we
want sales to grow.” Here are some things to consider:
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-Cutting margins might make sales grow – but is it good for the firm?
-Using more assets may make sales grow, but is this truly
increasing efficiency?
-Increasing financial leverage might pay for growth – but can
the firm survive?
-Cutting the dividend might pay for growth – but is it what stockholders
want?
C. A Note about Sustainable Growth Rate Calculations
The sustainable growth rate that we commonly see in other texts or

applications is ROE*b – why is it different? The formula that is
used throughout the text is based on an ROE that is computed
using ending balance sheet numbers for equity. The “simpler”
formula is appropriate only when the ROE is computed using
beginning equity balance sheet numbers.
3.7 Some Caveats Regarding Financial Planning Models
Slide 3.28 Some Caveats
The main problem is that the models are really accounting statement
generators rather than determinants of value. As we will see, value is
determined by cash flows, timing and risk; and these financial planning
models do not address any of these issues.
Slide 3.29 –
Slide 3.30 Quick Quiz
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Appendix: Useful Financial Ratios
SHORT-TERM SOLVENCY RATIOS

Current ratio = Current assets ÷ Current liabilities
Quick ratio = (Current assets – Inventory) ÷ Current liabilities
Cash ratio = Cash ÷ Current liabilities
FINANCIAL LEVERAGE RATIOS
Total debt ratio = Total debt ÷ Total assets = (Total assets – Total equity) ÷ Total assets
Debt-equity ratio = Total debt ÷ Total equity
Equity multiplier = Total assets ÷ Total equity = 1 + debt-equity ratio
Times interest earned = Earnings before interest and taxes ÷ Interest
Cash coverage = (Earnings before interest and taxes + depreciation + amortization) ÷
Interest
TURNOVER RATIOS
Inventory turnover = Cost of goods sold ÷ Inventory
Days sales in inventory = 365 ÷ Inventory turnover
Receivables turnover = Sales ÷ Receivables
Days’ sales in receivables= 365 ÷ Receivables turnover
Total asset turnover = Sales ÷ Total assets
Days in inventory = Days in period ÷ Inventory turnover
PROFITABILITY MEASURES
Profit margin = Net income ÷ Sales
Return on assets = Net income ÷ Total assets
Return on equity = Net income ÷ Total equity
EBITDA margin = EBITDA ÷ Sales
MARKET VALUE RATIOS
Price-to-earnings ratio = Market price per share ÷ Earnings per share
Market-to-book ratio = Market price per share ÷ Book value per share
Market capitalization = Market price per share x Shares Outstanding
Enterprise Value (EV) = Market capitalization + Market value of interest bearing debt –
cash
EV Multiple = EV ÷ EBITDA
3-22

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Chapter 03 - Financial Statements Analysis and Financial Models

3.1 Key Concepts and Skills

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Chapter 03 - Financial Statements Analysis and Financial Models

CHAPTER WEB SITES

Section Web Address

3.1 Financial Statements Analysis

3.2 Ratio Analysis

3.3 The DuPont Identity

3.4 Financial Models

3.5 External Financing and Growth

3.6 Some Caveats Regarding Financial Planning Models

ANNOTATED CHAPTER OUTLINE

Slide 3.0 Chapter 3 Title Slide

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Chapter 03 - Financial Statements Analysis and Financial Models

Lecture Tip: Students sometimes get the impression that

“Objectively determinable current values of many

Financial statement information is often our ONLY source of

3.1. Financial Statements Analysis

A. Standardizing Financial Statements

Standardized statements allow users to compare companies of

Slide 3.3 Financial Statements Analysis

B. Common-Size Balance Sheets

C. Common-Size Income Statement

3.2. Ratio Analysis

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Chapter 03 - Financial Statements Analysis and Financial Models

Lecture Tip: Unfortunately, students often make it through an

Slide 3.4 Ratio Analysis

Questions to answer when interpreting financial ratios:

-How is the ratio computed?

-What aspects of the firm are we attempting to analyze?

-What is the unit of measurement (times, days, percent)?

Slide 3.5 Categories of Financial Ratios

-Long-term solvency, or financial leverage, ratios: The ability to meet long-

-Asset management, or turnover, ratios: Efficiency of asset use

-Profitability ratios: Efficiency of operations and how this translates to the

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Chapter 03 - Financial Statements Analysis and Financial Models

A. Short-term Solvency or Liquidity Ratios

Current Ratio = current assets / current liabilities

Quick Ratio = (current assets – inventory) / current liabilities

Cash Ratio = cash / current liabilities

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Chapter 03 - Financial Statements Analysis and Financial Models

A. Long-Term Solvency Measures

These are also known as leverage ratios.

Slide 3.7 Computing Leverage Ratios

Total debt ratio = (total assets – total equity) / total assets

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Chapter 03 - Financial Statements Analysis and Financial Models

Using the balance sheet identity, the debt/equity ratio can

equity multiplier = total assets / total equity

The equity multiplier captures the leverage effect in the

Slide 3.8 Computing Coverage Ratios

Times interest earned ratio = EBIT / interest

Cash coverage ratio = (EBIT + depreciation + amortization) /

You can also calculate a type of inverse value as follows: