Ross Chap03

Chapter 3: Financial Statements Analysis and Financial
Models
BUI Duy Tung, PhD.1
1 Slides for Coporate Finance 2 at UFM
Ngày 13 tháng 11 năm 2023
BUI Duy Tung (UFM) Coporate Finance 12e - Ross Ngày 13 tháng 11 năm 2023 1 / 82
Disclaimer
These slides are preliminary and incomplete. So, they are only used in this class. We follow
linearly ? and their slides. There are also other materials from various sources. Some references
are missing, but not on purpose. Hence, it is strictly prohibited to use these slides outside of the
class, or to re-distribute. Any typos and errors should be reported to tungbuiduy@ gmail .com
Table of Contents
1 Financial Statements Analysis
2 Ratio Analysis
Short-Term Solvency or Liquidity Measures
Long-Term Solvency Measures
Asset Management or Turnover Measures
Profitability Measures
Market Value Measures
3 The DuPont Identity
4 Financial Models
Table of Contents
2 Ratio Analysis
4 Financial Models
Introduction
Financial statements are essential for evaluating a company’s fiscal standing.

Comparative analysis is fraught with complexities.
This lecture aims to demystify these complexities and introduce standardization
techniques.
Challenges in Comparative Analysis
Size Disparity: Comparing companies of different sizes can be misleading.

Example: Comparing VinGroup and a local Vietnamese startup.
Temporal Variability: Year-to-year changes can distort comparisons.
Example: The expansion of Viettel over the years.
Currency Differences: Currency variations can affect international comparisons.
Example: Comparing a Vietnamese company’s VND statements with a U.S. company’s USD
statements.
Standardization Techniques
Standardization allows for more equitable comparisons.

Common-size statements express each item as a percentage of a base item.
This technique is particularly useful for balance sheets and income statements.
Example: Balance Sheets
Original Common-Size
Item 2018 (VND) 2019 (VND) 2018 (%) 2019 (%)
Cash 5M 4M 5 4
Inventory 10M 12M 10 12
Total Assets 100M 100M 100 100
Bảng 1: Original and Common-Size Balance Sheets for a Vietnamese Corporation
Example: Detailed Income Statement and Common-Size
Item Original Common-Size (%)
2018 (VND) 2019 (VND) 2018 2019
Sales 200M 250M 100 100
COGS 100M 130M 50 52
Gross Profit 100M 120M 50 48
Operating Expenses 40M 50M 20 20
EBIT 60M 70M 30 28
Interest Expense 10M 12M 5 4.8
EBT 50M 58M 25 23.2
Taxes 10M 11.6M 5 4.64
Net Income 40M 46.4M 20 18.56
Bảng 2: Detailed and Common-Size Income Statements for a Vietnamese Corporation
Note: COGS stands for Cost of Goods Sold, EBIT for Earnings Before Interest and Taxes,
and EBT for Earnings Before Taxes.
Table of Contents
2 Ratio Analysis
4 Financial Models
Table of Contents
2 Ratio Analysis
Introduction
Financial ratios offer a way to compare companies of different sizes.

They provide insights into various aspects of a company’s financial health.
However, they come with their own set of challenges.
Challenges in Using Ratios
Different sources may compute ratios differently.

This inconsistency can lead to confusion.
Documentation of calculation methods is crucial.
Key Questions for Ratios
1 How is the ratio computed?

2 What does it measure, and why is it important?
3 What is the unit of measurement?
4 What do high or low values indicate? How can they be misleading?
5 How can the measure be improved?
Categories of Financial Ratios
1 Short-term solvency, or liquidity, ratios.

2 Long-term solvency, or financial leverage, ratios.
3 Asset management, or turnover, ratios.
4 Profitability ratios.
5 Market value ratios.
PRUFROCK CORPORATION Balance Sheets
2018 2019
2018 2019 Liabilities and Owners’ Equity
Assets Current Liabilities
Current Assets Accounts Payable 312 344
Cash 84 98 Notes Payable 231 196
Accounts Receivable 165 188 Total 543 540
Inventory 393 422 Long-term Debt 531 457
Total 642 708 Owners’ Equity
Fixed Assets Common Stock and Paid-in Surplus 1,799 2,041
Net Plant and Equipment 2,731 2,880 Retained Earnings 500 550
Total Assets 3,373 3,588 Total 2,299 2,591
Total Liabilities and Owners’ Equity 3,373 3,588
Prufrock Corporation: 2019 Income Statement
Item Amount ($ in millions)

Sales $2,311
Cost of Goods Sold $1,435
Depreciation $276
Earnings Before Interest and Taxes (EBIT) $600
Interest Paid $141
Taxable Income $459
Taxes (21%) $96
Net Income $363
Dividends 121
Addition to Retained Earnings 242
Table of Contents
2 Ratio Analysis
4 Financial Models
Short-term solvency ratios provide information about a firm’s liquidity.

Focuses on current assets and current liabilities.
Particularly interesting to short-term creditors.
Book values and market values are likely to be similar.
Amounts may change rapidly, affecting future reliability.
Current Ratio
Defined as:
Current assets
Current ratio =
Current liabilities
Measures short-term liquidity.
Unit of measurement: dollars or times.
A current ratio of less than 1 indicates negative net working capital.
Effects on Current Ratio
Affected by various types of transactions.

E.g., borrowing over the long term increases cash and long-term debt.
Current liabilities remain unaffected, thus current ratio rises.
Quick (or Acid-Test) Ratio
Inventory is often the least liquid current asset.

Large inventories may indicate short-term trouble due to overestimation of sales.
The Quick Ratio omits inventory to provide a more accurate measure of liquidity.
Formula:
Current assets − Inventory
Quick ratio =
Current liabilities
Indicates liquidity without the influence of potentially slow-moving inventory.
Comparing Quick and Current Ratios
Walmart: Current Ratio = .85, Quick Ratio = .22

ManpowerGroup: Current Ratio = 1.39, Quick Ratio = 1.39
Shows the impact of inventory on liquidity measures.
Cash Ratio
Focuses solely on cash for extreme short-term liquidity.

Formula:
Cash
Cash ratio =
Current liabilities
Useful for very short-term creditors.
Table of Contents
2 Ratio Analysis
4 Financial Models
Focus on the firm’s long-run ability to meet its obligations.

Also known as financial leverage ratios.
Address the firm’s financial leverage in the long term.
Total Debt Ratio
Considers all debts to all creditors.

Formula:
Total assets − Total equity
Total debt ratio =
Total assets
Indicates that 28% of assets are financed by debt.
$.28 in debt for every $1 in assets.
Debt-Equity Ratio and Equity Multiplier
Debt-Equity Ratio:
Total debt .28
= = .38 times
Total equity .72
Equity Multiplier:
Total assets 1
= = 1.38 times
Total equity .72
These ratios are interrelated and can be derived from each other.
Times Interest Earned (TIE) Ratio
Measures how well interest obligations are covered.

Formula:
Earnings Before Interest and Taxes (EBIT)
TIE ratio =
Interest paid
Indicates that interest obligations are covered 4.26 times over.
Cash Coverage Ratio
Addresses the limitation of the TIE ratio, which is based on EBIT.

EBIT may not accurately represent cash available to pay interest.
Formula:
EBIT + (Depreciation and amortization)
Cash coverage ratio =
Interest
EBITDA is a measure of cash flow available to meet financial obligations.
Interest-Bearing Debt to EBITDA Ratio
Another measure of long-term solvency.

Formula:
Interest-bearing debt
EBITDA
Values below 1 are strong; above 5 are weak.
Requires comparison with similar firms for proper interpretation.
Table of Contents
2 Ratio Analysis
4 Financial Models
Focus on the efficiency with which a firm uses its assets.

Also known as asset management or utilization ratios.
Intended to describe how intensively a firm uses specific assets.
We examine two key current assets: inventory and receivables.
Inventory Turnover
Measures how many times the inventory is sold and replaced over a period.
Formula:
Cost of goods sold
Inventory turnover =
Inventory
Indicates efficiency in managing inventory.
A high ratio could mean paying for too many shipments.
Days’ Sales in Inventory
Measures the average number of days inventory is held before being sold.
Formula:
365 days
Days’ sales in inventory =
Inventory turnover
Inventory sits for about 107 days on average before being sold.
Example: U.S. automobile industry had a 74-day supply, BMW had 40 days, Mitsubishi
had 125 days.
Receivables Turnover and Days’ Sales in Receivables
Measures how quickly a firm collects on its credit sales.

Formula:
Sales
Receivables turnover =
Accounts receivable
Collected and lent money 12.29 times during the year.
Days’ sales in receivables:
365
Receivables turnover
Payables Turnover
Measures how long it takes for a firm to pay its bills.

Formula:
Cost of goods sold
Payables turnover =
Accounts payable
Days’ sales in payables:

365
Payables turnover
Takes about 88 days to pay bills.
Total Asset Turnover
Measures the efficiency of asset utilization.

Formula:
Sales
Total asset turnover =
Total assets
Generated $.64 in sales for every dollar in assets.
Table of Contents
2 Ratio Analysis
4 Financial Models
Measures the efficiency of asset utilization and operational management.

Widely used in financial analysis.
Profit Margin
Measures the net income generated per dollar of sales.

Formula:
Net Income
Profit Margin =
Sales
Prufrock generates approximately 16 cents in net income for every dollar in sales.
EBITDA Margin
Measures profitability from operating cash flows.

Formula:
EBITDA
EBITDA Margin =
Sales
Indicates the efficiency of generating operating cash flows.
Industry Variations
Margins vary significantly across industries.

Grocery stores: Around 2% profit margin.
Pharmaceutical industry: Around 15% profit margin.
Example: Kroger at 1.5%, Abbott Laboratories at 11.8%.
Return on Assets (ROA) and Return on Equity (ROE)
Key measures of profitability.

Indicate how well a company is utilizing its assets and equity.
Important to note: These are accounting rates of return.
Return on Assets (ROA)
Measures the profit generated per dollar of assets.

Formula:
Net Income
ROA =
Total Assets
Indicates that Prufrock earns 10.11 cents for each dollar of assets.
Return on Equity (ROE)
Measures the profit generated per dollar of equity.

Formula:
Net Income
ROE =
Total Equity
Indicates that Prufrock earns 13.99 cents for each dollar of equity.
Important Considerations
ROA and ROE are accounting measures, not market rates.

ROE exceeding ROA indicates the use of financial leverage.
Inappropriate to compare these to market interest rates.
Table of Contents
2 Ratio Analysis
4 Financial Models
Based on market price per share of stock.

Applicable only for publicly traded companies.
Measures include Earnings Per Share (EPS), Price-Earnings (PE) Ratio, Market-to-Book
Ratio, and Market Capitalization.
Earnings Per Share (EPS)
Formula:
Net Income
EPS =
Shares Outstanding
Indicates earnings generated per share of stock.
Price-Earnings (PE) Ratio
Formula:
Price per Share
PE Ratio =
EPS
Measures how much investors are willing to pay per dollar of current earnings.
Higher PE often suggests significant prospects for future growth.
Market-to-Book Ratio
Formula:
Market Value per Share
Market-to-Book Ratio =
Book Value per Share
Compares market value to historical cost.
A value less than 1 could indicate lack of value creation for stockholders.
Market Capitalization
Formula:
Market Capitalization = Price per Share × Shares Outstanding
Indicates the total market value of the company.
Useful for potential buyers in mergers or acquisitions.
Table of Contents
2 Ratio Analysis
4 Financial Models
Understanding ROA and ROE
ROA and ROE are key profitability measures.

Difference between ROA and ROE reflects financial leverage.
ROE can be decomposed into its component parts.
Decomposing ROE
Basic Formula:
Net Income
ROE =
Total Equity
Extended Formula:
Net Income Assets
ROE = ×
Total Equity Assets
Result:
ROE = ROA × Equity Multiplier
For Prufrock:
ROE = 0.1011 × 1.38 = 0.1399 or 13.99%
Further Decomposing ROE
Formula:
Net Income Sales Assets

ROE = × ×
Sales Assets Total Equity
Simplified:
ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
DuPont Identity
DuPont Identity:
ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
DuPont Identity reveals three key factors affecting ROE:

1 Operating Efficiency (Profit Margin)
2 Asset Use Efficiency (Total Asset Turnover)
3 Financial Leverage (Equity Multiplier)
DuPont Identity and ROE
DuPont Identity helps in understanding ROE.

Increasing debt can both increase or decrease ROE.
Capital structure policy governs the amount of leverage.
DuPont Identity is useful for systematic financial statement analysis.
If ROE is unsatisfactory, DuPont helps identify the areas to investigate.
The DuPont Breakdown for Yahoo! and Alphabet
Company Year ROE Profit Margin Total Asset Turnover Equity Multiplier
12/15 -15.0% -87.5% .110 1.56
Yahoo! 12/14 .4% 3.1% .075 1.59
12/13 10.4% 29.2% .279 1.29
12/15 13.6% 21.8% .509 1.23
Alphabet 12/14 13.6% 21.4% .511 1.24
12/13 14.8% 21.6% .539 1.27
DuPont Analysis: Yahoo! vs. Alphabet
Introduction
Analysis framework for financial Profit Margin
performance. Yahoo!: -87.5%
Focus on Yahoo! and Alphabet. Alphabet: 21.8%
ROE in 2015 Asset Utilization
Yahoo!: -15.0% Alphabet has higher asset utilization.
Alphabet: 13.6%
Key Takeaways
Alphabet outperforms Yahoo! in ROE and profit margin.
Similar levels of financial leverage.
Asset utilization is a differentiator.
Table of Contents
2 Ratio Analysis
4 Financial Models
Financial Planning
Financial planning is another important use of financial statements.

Most financial planning models use pro forma financial statements, where pro forma
means “as a matter of form.”
Financial statements are the form we use to summarize the projected future financial
status of a company.
Introduction to Financial Planning Models
Financial planning models help in forecasting a company’s financial performance.

They are based on assumptions about sales, costs, and other financial variables.
The Computerfield Corporation example demonstrates a simple financial planning model.
A Simple Financial Planning Model I
Suppose sales increase by 20 percent
A Simple Financial Planning Model II
A Simple Financial Planning Model III
Suppose Computerfield does not pay out the $190. Then, the addition to retained earnings would
be the full $240.
In this case, debt is the plug variable used to balance projected total assets and liabilities.
This example shows the interaction between sales growth and financial policy. As sales
increase, so do total assets.
A Simple Financial Planning Model IV
This occurs because the firm must invest in net working capital and fixed assets to
support higher sales levels.
Because assets are growing, total liabilities and equity, the right side of the balance sheet,
will grow as well.
The Percentage of Sales Approach I
an extended version of our simple model.

The basic idea is to separate the income statement and balance sheet accounts into two
groups: those that vary directly with sales and those that do not.
percentage of sales approach: a quick and practical way of generating pro forma
statements.
The Percentage of Sales Approach II
Rosengarten has projected a 25 percent increase in sales for the coming year
Assume that total costs will continue to run at 83.3 percent of sales.
The Percentage of Sales Approach III
We will assume Rosengarten has a policy of paying out a constant fraction of net income in the
form of a cash dividend.
The projected dividends and addition to retained earnings will be:
The Percentage of Sales Approach IV
The Balance Sheet

On our balance sheet, we assume that some items vary directly with sales and others do
not.
For those items that vary with sales, we express each as a percentage of sales for the year
just completed.
When an item does not vary directly with sales, we write “n/a” for “not applicable.”
The Percentage of Sales Approach V
The Percentage of Sales Approach VI
The Percentage of Sales Approach VII
Assets Spontaneous liabilities

EFN = × ∆Sales − × ∆Sales − PM × Projected sales × (1 − d)
Sales Sales
EFN = External Financing Need

By “Spontaneous liabilities,” we mean liabilities that naturally move up and down with
sales.
PM and d are the profit margin and dividend payout ratios
The Percentage of Sales Approach VIII
A Particular Scenario
Rosengarten has three possible sources: short-term borrowing, long-term borrowing, and
new equity.
Suppose Rosengarten decides to borrow the needed funds. In this case, the firm might
choose to borrow some over the short term and some over the long term.
How much the firm should borrow to keep net working capital unchanged?
How much the firm should borrow as long-term debt?
The Percentage of Sales Approach IX
The Internal Growth Rate
The first growth rate of interest is the maximum growth rate that can be achieved with no
external financing of any kind. We call this the internal growth rate because this is the
rate the firm can maintain with internal financing only.
ROA × b
Internal growth rate =
1 − ROA × b
The Sustainable Growth Rate
The second growth rate of interest is the maximum growth rate a firm can achieve with
no external equity financing while it maintains a constant debt-equity ratio.
This rate is commonly called the sustainable growth rate because it is the maximum rate
of growth a firm can maintain without increasing its overall financial leverage.
If a firm does not wish to sell new equity and its profit margin, dividend policy, financial
policy, and total asset turnover (or capital intensity) are all fixed, then there is only one
possible growth rate.
ROE × b
Sustainable growth rate =
1 − ROE × b

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Chapter 3: Financial Statements Analysis and Financial

BUI Duy Tung, PhD.1

1 Slides for Coporate Finance 2 at UFM

Ngày 13 tháng 11 năm 2023

1 Financial Statements Analysis

3 The DuPont Identity

1 Financial Statements Analysis

3 The DuPont Identity

Financial statements are essential for evaluating a company’s fiscal standing.

Size Disparity: Comparing companies of different sizes can be misleading.

Standardization allows for more equitable comparisons.

1 Financial Statements Analysis

3 The DuPont Identity

Financial ratios offer a way to compare companies of different sizes.

Different sources may compute ratios differently.

1 How is the ratio computed?

1 Short-term solvency, or liquidity, ratios.

Item Amount ($ in millions)

1 Financial Statements Analysis

3 The DuPont Identity

Short-term solvency ratios provide information about a firm’s liquidity.

Affected by various types of transactions.

Inventory is often the least liquid current asset.

Walmart: Current Ratio = .85, Quick Ratio = .22

Focuses solely on cash for extreme short-term liquidity.

1 Financial Statements Analysis

3 The DuPont Identity

Focus on the firm’s long-run ability to meet its obligations.

Considers all debts to all creditors.

Measures how well interest obligations are covered.

Addresses the limitation of the TIE ratio, which is based on EBIT.

Another measure of long-term solvency.

1 Financial Statements Analysis

3 The DuPont Identity

Focus on the efficiency with which a firm uses its assets.

Measures how quickly a firm collects on its credit sales.

Measures how long it takes for a firm to pay its bills.

Days’ sales in payables:

Measures the efficiency of asset utilization.

1 Financial Statements Analysis

3 The DuPont Identity

Measures the efficiency of asset utilization and operational management.

Measures the net income generated per dollar of sales.

Measures profitability from operating cash flows.

Margins vary significantly across industries.

Key measures of profitability.

Measures the profit generated per dollar of assets.

Measures the profit generated per dollar of equity.

ROA and ROE are accounting measures, not market rates.

1 Financial Statements Analysis

3 The DuPont Identity

Based on market price per share of stock.

1 Financial Statements Analysis

3 The DuPont Identity

ROA and ROE are key profitability measures.

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier

DuPont Identity reveals three key factors affecting ROE:

DuPont Identity helps in understanding ROE.

1 Financial Statements Analysis

3 The DuPont Identity

Financial planning is another important use of financial statements.

Financial planning models help in forecasting a company’s financial performance.