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
To determine how much current assets are available to
pay off current liabilities
The higher the liquidity ratio, the higher the ability of
firm to pay off current L using current assets
 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

The higher the leverage, the higher finance risk

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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
The higher the ratio, the higher the ability to service interest

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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 =
Inventory/ COGS *365
◦ 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
or AR/Sales *365
◦ 365 / 12.3 = 30 days
 -How long it takes to sell inventory on average
(from date of manufactured/ purchased to the
date it is sold/delivered to customer)
 The shorter the Dso, the more efficient in the
firm managing receivables

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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.
◦ For every dollar of asset, how much sales is generated
◦ The higher the ratio, the more efficient in managing the 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%

The higher the ratio, the more profitable the firm is

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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:
Assets  Spon Liab
  Sales   ?Sales  (PM  Projected Sales)  (1  d)
 Sales  Sales
 (3  250)  (0.3  250)  (0.13  1250  0.667)
 $565

 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
ROA  b
Internal Growth Rate 
1 - ROA  b
.132  .667
  .0965
1  .132  .667
 9.65%


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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
ROE  b
Sustainable Growth Rate 
1 - ROE  b
.264  .667
  .214
1  .264  .667
 21.4%


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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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