Corporate Finance

Twelfth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan / Joe Smolira (digital co-author)

Chapter 3
Financial Statements Analysis and
Financial Models

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction
or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Key Concepts and Skills

Know how to standardize financial statements for

comparison purposes
Know how to compute and interpret important financial
ratios
Be able to develop a financial plan using the
percentage of sales approach
Understand how capital structure and dividend policies
affect a firm’s ability to grow

© 2019 McGraw-Hill Education. 3-2

 Chapter Outline

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

© 2019 McGraw-Hill Education. 3-3

 3.1 Financial Statements Analysis

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.
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

© 2019 McGraw-Hill Education. 3-4

 3.2 Ratio Analysis

Ratios also allow for better comparison through time or

between companies.
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 company’s ratio?

© 2019 McGraw-Hill Education. 3-5

 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

© 2019 McGraw-Hill Education. 3-6

Balance Sheet
Income Statement
 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

© 2019 McGraw-Hill Education. 3-9

 Computing Leverage Ratios

Total Debt Ratio   TA – TE  TA

 $3,588 – 2591 $3588  .28 times
Debt-Equity Ratio  TD TE
$.28 $.72  .38 times
Equity Multiplier  TA TE  1  D-E
1  .385  1.385 times

© 2019 McGraw-Hill Education. 3-10

 Computing Coverage Ratios

Times Interest Earned  EBIT Interest

$600 $141  4.26 times
Cash Coverage   EBIT  Depreciation and Amortization  Interest

 $600  276  $141  6.22 times

© 2019 McGraw-Hill Education. 3-11

 Computing Inventory Ratios

Inventory Turnover  Cost of Goods Sold Inventory

$1, 435 $422  3.40 times
Days’ Sales in Inventory  365 Inventory Turnover
365 3.40  107.37 days

© 2019 McGraw-Hill Education. 3-12

 Computing Receivables Ratios
Receivables Turnover  Sales Accounts Receivable
$2,311 $188  12.29 times
Days’ Sales in Receivables  365 Receivables
Turnover
365 12.29  29.69 days

© 2019 McGraw-Hill Education. 3-13

 Computing Total Asset Turnover
Total Asset Turnover  Sales Total Assets
$2,311 $3,588  .64 times
It is not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets.

© 2019 McGraw-Hill Education. 3-14

 Computing Profitability Measures
Profit Margin  Net Income Sales
$363 $2,311  15.7%
EBITDA Margin  EBITDA Sales
$876 $2,311  37.91%
Return on Assets  ROA   Net Income Total Assets
$363 $3,588  10.1%
Return on Equity  ROE   Net Income Total Equity
$363 $2,591  13.99%

© 2019 McGraw-Hill Education. 3-15

 Computing Market Value Measures
Price-Earnings Ratio  Price per share Earnings per share
$88 $11  8.01 times
Market-to-Book Ratio  market value per share book value per share
$88  $2,591 33  1.12 times
Market Capitalization  Price per share  Shares outstanding
$88  33 million  $2,904 million
Enterprise Value  EV   Market capitalization  Market value of interest-bearing debt – Cash

 In millions  $2,904   196  457   98  $3, 459 million

EV Multiple  EV EBITDA

$3, 459 $876  3.95 times

© 2019 McGraw-Hill Education. 3-16

 Using Financial Statements

Ratios are not very helpful by themselves: they need to

be compared to something
Time Trend Analysis
• Used to see how the firm’s performance is changing
through time
Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes

© 2019 McGraw-Hill Education. 3-17

 3.3 The DuPont Identity

Return on Equity  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

© 2019 McGraw-Hill Education. 3-18

 Using the DuPont Identity

ROE = PM × TAT × EM
• Profit margin is a measure of the firm’s operating
efficiency—how well it controls costs.
• Total asset turnover is a measure of the firm’s asset
use efficiency—how well it manages its assets.
• Equity multiplier is a measure of the firm’s financial
leverage.

© 2019 McGraw-Hill Education. 3-19

 Calculating the DuPont Identity

ROA = 10.11% and EM = 1.38

ROE = 10.11% × 1.385 = 13.99%
PM = .1569 and TAT = .64
• ROE = .1569 × .64 × 1.38 = 13.99%

© 2019 McGraw-Hill Education. 3-20

 Potential Problems

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 make
comparison more difficult because of differences in
accounting regulations.
Firms use varying accounting procedures.
Firms have different fiscal years.
Extraordinary, or one-time, events

© 2019 McGraw-Hill Education. 3-21

 3.4 Financial Models

Investment in new assets—determined by capital

budgeting decisions
Degree of financial leverage—determined by capital
structure decisions
Cash paid to shareholders—determined by dividend
policy decisions
Liquidity requirements—determined by net working
capital decisions

© 2019 McGraw-Hill Education. 3-22

 Financial Planning Ingredients

Sales Forecast—many cash flows depend directly on the level of

sales (often estimate sales growth rate)
Pro Forma Statements—setting up the plan as projected (pro
forma) financial statements allows for consistency and ease of
interpretation
Asset Requirements—the additional assets that will be required
to meet sales projections
Financial Requirements—the amount of financing needed to pay
for the required assets
Plug Variable—determined by management decisions about what
type of financing will be used (makes the balance sheet balance)
Economic Assumptions—explicit assumptions about the coming
economic environment
© 2019 McGraw-Hill Education. 3-23
 Percentage of Sales Approach - I

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

© 2019 McGraw-Hill Education. 3-24

 Percentage of Sales Approach – II

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.

© 2019 McGraw-Hill Education. 3-25

 Percentage of Sales and EFN

External Financing Needed (EFN) can also be calculated as:

EFN
= ($3,000/$1,000) × ($250) – ($300/$1,000) × ($250) – (.132 × $1,250 × (1 – .3333)

= $565

© 2019 McGraw-Hill Education. 3-26

 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.

© 2019 McGraw-Hill Education. 3-27

 The Internal Growth Rate

The internal growth rate tells us how much the firm can grow
assets using retained earnings as the only source of financing.
Using the information from the Hoffman Co.

ROA  $66 $500  .132

b  plowback ratio   $44 $66  .6667

ROA  b
Internal Growth Rate 
1 – ROA  b
.132  .6667
  .0965
1  .132  .6667
 9.65%
© 2019 McGraw-Hill Education. 3-28
 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
ROE  b
Sustainable Growth Rate 
1– ROE  b
.264  .6667

1  .264  .6667
 21.36%
© 2019 McGraw-Hill Education. 3-29
 Determinants of Growth

Profit margin—operating efficiency

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

© 2019 McGraw-Hill Education. 3-30

 3.6 Some Caveats Regarding Financial
Planning Models
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.

© 2019 McGraw-Hill Education. 3-31

 Quick Quiz – I

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?

© 2019 McGraw-Hill Education. 3-32

 Quick Quiz - II

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?

© 2019 McGraw-Hill Education. 3-33

 End of Main Content

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
further distribution permitted without the prior written consent of McGraw-Hill Education. 3-34