Session 3

Financial Statements Analysis and Financial Models

Ng Eng Wan
FCPA CIA ACMA CGMA
Key Concepts and Skills
 Know how to standardize financial statements for
comparison purposes (vertical analysis)
 Know how to compute and interpret important
financial ratios (ratio analysis)
 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

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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

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3.1 Financial Statements Analysis
 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.

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Common Size Balance Sheet

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Common Size Income Statement

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3.2 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

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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

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Case

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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

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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

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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

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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

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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.

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Computing Profitability Measures
 Profit Margin = Net Income / Sales
◦ 363 / 2311 = 15.7%
 Return on Assets (ROA) = Net Income / Total Assets
◦ 363 / 3588 = 10.1%
 Return on Equity (ROE) = Net Income / Total Equity
◦ 363 / 2591 = 14.0%
 EBITDA Margin = EBITDA / Sales
◦ 967 / 2311 = 41.8%

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Computing Market Value Measures
 Market Capitalization = $88 per share x 33 million shares =
$2,904 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 = $3,459
 EV Multiple = EV / EBITDA
◦ 3459 / 967 = 3.6 times

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Overview of Financial Ratios

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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 (Standard Industrial Classification) and NAICS (North
American Industry Classification System) codes

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Limitations of Ratio 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

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3.3 Calculating the DuPont Identity
 ROA = 10.1% and EM = 1.39
◦ ROE = ROA * EM
= 10.1% * 1.385 = 14.0%
 PM = 15.7% and TAT = 0.64
◦ ROE = PM * TAT * EM
= 15.7% * 0.64 * 1.385 = 14.0%

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DuPont Identity - comparison

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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

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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

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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

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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.

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Percent of Sales and EFN
 External Financing Needed (EFN) can also be
calculated as:

 Refer to pages 63-66 in the reference book.

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Exercise

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Exercise
An increase of sales to $45,426 is an increase of:

Sales increase = ($45,426 – 40,200) / $40,200

Sales increase = .1300, or 13.00%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like
this:

Pro forma income statement Pro forma balance sheet

Sales $45,426.00 Assets $ 163,850.00 Debt $ 39,000.00
Costs 30,849.00 Equity 111,665.82
EBIT 14,577.00 Total $ 163,850.00 Total $150,665.82
Taxes (34%) 4,956.18
Net income $ 9,620.82

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Exercise
The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net
income, or:

Dividends = ($3,500 / $8,514)($9,620.82)

Dividends = $3,955

The addition to retained earnings is:

Addition to retained earnings = $9,620.82 – 3,955

Addition to retained earnings = $5,665.82

And the new equity balance is:

Equity = $106,000 + 5,665.82

Equity = $111,665.82

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $163,850 – 150,665.82
EFN = $13,184.18

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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.

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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 = 44/ 66 = .667

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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 or overall
financial leverage.
 Using the Hoffman Co.
◦ ROE = 66 / 250 = .264
◦ b = .667

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Exercise

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Exercise

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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

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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.

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Summary

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Quick Quiz
 How do you standardize balance sheets and income
statements?
 Why is standardization useful?
 What are the major categories of financial ratios?
 What are the ratios within each category?
 What are the limitations associated with financial
statement analysis?

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Quick Quiz
 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?

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