CH 04

Introduction to Corporate
Finance
Fifth Canadian Edition
Booth, Cleary, Rakita
Chapter 4
Financial Statement Analysis and Forecasting
Copyright ©2020 John Wiley & Sons, Inc.

Learning Objectives
4.1 Identify the issues that need to consider in applying consistent financial analysis.
4.2 Explain why return on equity is one of the key financial ratios to assess a firm’s performance.
4.3 Calculate, interpret and evaluate the key ratios relating to financial leverage.
4.4 Calculate, interpret and evaluate the key ratios relating to financial efficiency.
4.5 Calculate, interpret and evaluate the key ratios relating to financial productivity.
4.6 Calculate, interpret and evaluate the key ratios relating to financial liquidity.
4.7 Calculate, interpret and evaluate the key ratios relating to the valuation of a company.
4.8 Explain how to prepare financial forecasts using the percentage of sales method.
4.9 Explain how external financing requirements are related to sales growth, profitability, dividend
payouts, and sustainable growth rates.
4.10 Apply financial forecasting to a real company.
Copyright ©2020 John Wiley & Sons, Inc. 2

4.1 CONSISTENT FINANCIAL ANALYSIS
• Consistent financial analysis across companies, industries and countries is important

• Analysts must understand the challenges to comparability and attempt to ascertain
the financial health of the organizations they study, understanding the limitations
inherent in financial accounting practice
• Intra-Company Comparisons
o GAAP provides considerable latitude for the company
o Once a firm chooses an acceptable accounting treatment for revenue recognition,
capitalization of expenses, inventory valuation, etc., then the firm must use these same
provisions year after year
o Any change in accounting principles must be noted in the notes to the financial statements
and prior years restated to ensure there is a common basis of comparison to the present
o Therefore, internal comparisons, year-over-year, are possible and supported by GAAP

CONSISTENT FINANCIAL ANALYSIS
• Inter-Company Comparisons
o Making comparisons between companies, even in the same
industry, is much more difficult than comparing the same
company to itself over time because:
o There is a potentially wide divergence in accounting treatment
results under GAAP
• Historical, cost-based accounting can seriously affect efficiency,
leverage and profitability ratios

4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
• Financial statement analysis studies, absolute numbers, comparative

statements and ratios to:
o Ascertain trends in the financial statements
o Identify areas of strength and concern
• The DuPont System gives a framework for the analysis of financial statements
through the decomposition of the return on equity (ROE) ratio as shown in
Figure 4.1:

A FRAMEWORK FOR FINANCIAL ANALYSIS (1 of 4)
• ROE is a function of:

o Leverage, or the use of debt
o Efficiency, the ability of a firm to control costs in relationship to sales
o Productivity, the degree to which a firm can generate sales in relationship to the assets
employed
• ROE is not a pure ratio because it involves dividing an income statement item (a flow)
by a balance sheet (or stock) item, as in Equations 4.1 and
4.7:
Net Income NI  NI Sales  TA
ROE     
Shareholders' Equity SE  Sales TA  SE
• Instead of using ending shareholders’ equity, many argue that average
shareholders’ equity over the period should be used because shareholders’ equity
changes over the year as income is earned and retained earnings grow
• Return on assets (ROA) shows the ratio of income to assets used to produce the
income, and it can be further decomposed as the product of the net profit margin and
sales to total assets ratio:
NI NI Sales
ROA   
TA Sales TA
• Multiplying ROA by leverage (total assets divided by shareholders’ equity), we obtain
ROE
• The DuPont system provides a good starting point for any financial analysis because:
o It shows that financial strength comes from many sources: profitability, asset utilization
and leverage
o It reinforces the concept that good financial analysis requires looking at each ratio in the
context of the others
o It shows that it is important to look at a sample of ratios from each major category to
identify areas of strength and weakness

TABLE 4.1 Canadian Pacific’s DuPont Ratios

2018 2017 2016
ROE 0.2940 0.3736 0.3457
ROA 0.0918 0.1194 0.0832
Net profit margin 0.2667 0.3670 0.2566
Turnover 0.3442 0.3255 0.3242
Leverage 3.2028 3.1280 4.1550
TABLE 4.2 Canadian National and U.S. Industry Average DuPont Ratios
Canadian Canadian Canadian U.S. Industry U.S. Industry U.S. Industry
National: 2018 National: 2017 National: 2016 Average: 2018 Average: 2017 Average: 2016
ROE 0.2453 0.3293 0.2453 0.2430 0.3778 0.1645
ROA 0.1050 0.1457 0.0982 0.0882 0.1663 0.0574
Net profit margin 0.3022 0.4205 0.3024 0.2547 0.4987 0.1786
Turnover 0.3475 0.3466 0.3248 0.3453 0.3274 0.3180
Leverage 2.3363 2.2592 2.4969 2.7258 2.3126 2.8794

• Table 4.3 shows a ROE analysis for Canadian National Railway and for the U.S.
Industry
• A ratio, by itself, is just a number; to judge if a ratio is “good” or “bad,” we must
compare it for the same company over time (trend analysis), or to other companies
in the same industry (industry analysis):
TABLE 4.3 Canadian Pacific, Canadian National, and U.S. Industry Average Leverage
Ratios Canadian Canadian Canadian Canadian Canadian Canadian U.S. U.S. U.S.
Pacific: Pacific: Pacific: National: National: National: Industry Industry Industry
2018 2017 2016 2018 2017 2016 Average: Average: Average:
2018 2017 2016
Leverage 3.2028 3.1280 4.1550 2.3363 2.2592 2.4969 2.7258 2.3126 2.8794
Debt ratio 0.6878 0.6803 0.7593 0.5720 0.5574 0.5995 0.6295 0.5668 0.6522
D/E ratio 1.3104 1.2675 1.8772 0.7125 0.6501 0.7369 0.9988 0.6953 0.8476
TIE 6.7130 6.2812 5.5690 12.6196 11.5800 11.2646 8.2871 8.2954 7.3217

4.3 LEVERAGE RATIOS
• Financial leverage occurs when a firm uses sources of financing that carry a fixed cost,
such as long-term debt, and uses this to generate greater returns to shareholders
• Leverage means magnification of both profits and losses
• Leverage ratios include:
o Debt ratio
o Debt-equity ratio
o Times interest earned
o Cash flow to debt
• The debt ratio is a stock ratio that indicates the proportion of total assets financed by
debt as at the balance sheet date; as in Equation 4.8:
Total Liabilities TL
Debt Ratio  
Total Assets TA
LEVERAGE RATIOS (1 of 3)
• The debt-equity (D/E) ratio is a stock ratio that indicates the proportion
that total debt represents in relationship to the shareholders’ equity
(both common stock and retained earnings) at the balance sheet date;
as in Equation 4.9:
Total Debt D
Debt-Equity Ratio  
Shareholders' Equity SE
• The times interest earned (TIE) ratio is an income statement (flow)
ratio that indicates the number of times the firm’s pre-tax income
(EBIT, earnings before interest and taxes) exceeds its fixed financial
obligations to its lenders; as in Equation 4.1:
EBIT
Times Interest Earned  TIE  
Interest Expense

• The cash flow to debt ratio measures how long it would take
to pay off a firm’s debt using cash flow from operations; as in
Equation 4.11:
Cash Flow from Operations
Cash Flow to Debt Ratio 
Total Debt

• Table 4.3 shows Canadian Pacific’s leverage ratios
• CP’s leverage ratios show that the amount of debt as a percentage of total financing has
decreased since 2016; the coverage ratio has increased.
• Comparing CP with CN and the U.S. industry average, we can see CP has more debt and lower
coverage ratio. Overall CP’s debt level and coverage have improved since 2016, but it still
possess more than average debt with less than average coverage.
• Overall, good position relative to leverage.
TABLE 4.3 Canadian Pacific, Canadian National, and U.S. Industry Average Leverage Ratios
Canadian Canadian Canadian Canadian Canadian Canadian U.S. Industry U.S. Industry U.S. Industry
Pacific: Pacific: Pacific: National: National: National: Average: Average: Average:
2018 2017 2016 2018 2017 2016 2018 2017 2016
Leverage 3.2028 3.1280 4.1550 2.3363 2.2592 2.4969 2.7258 2.3126 2.8794
Debt ratio 0.6878 0.6803 0.7593 0.5720 0.5574 0.5995 0.6295 0.5668 0.6522
D/E ratio 1.3104 1.2675 1.8772 0.7125 0.6501 0.7369 0.9988 0.6953 0.8476
TIE 6.7130 6.2812 5.5690 12.6196 11.5800 11.2646 8.2871 8.2954 7.3217

4.4 EFFICIENCY RATIOS
• Efficiency ratios measure how efficiently a dollar of sales is turned

into profits; these include:
o Degree of total leverage
o Break-even point
o Gross profit margin
o Operating margin
• Efficiency ratios give insight into a firm’s cost structure and can
help analysts determine if problems exist with either variable or
fixed costs, or both

EFFICIENCY RATIOS (1 of 3)
• Degree of total leverage (DTL) is an income statement ratio that measures the
exposure of profits to changes in sales, as in Equation 4.12:
Contribution Margin CM
Degree of Total Leverage  
Earnings Before Taxes EBT
• The greater the DTL, the greater the leverage effect
• The break-even point estimates the unit volume that must be produced and
sold in order for the firm to cover all costs, both fixed and variable, as in
Equation 4.13:
Fixed Costs FC
Break Even Point  
Contribution Margin CM
• The break-even point tends to increase as the use of fixed costs increases

• Gross profit margin demonstrates the proportion of sales that are

available to cover fixed (period) costs and financing expenses after
variable costs have been paid, as in Equation 4.14:
Sales - Cost of Goods Sold S  CGS
Gross Profit Margin  
Sales S
• A declining gross profit margin raises concerns about the firm’s ability
to control variable costs, such as direct materials and labour
• The operating margin measures the cumulative effect of both variable
and period costs on the ability of the firm to turn sales into operating
profits to cover interest, taxes, depreciation and amortization
(EBITDA), as in Equation 4.15:
Net Operating Income NOI
Operating Margin  
Sales S

• Table 4.5 shows Canadian Pacific’s efficiency ratios
• CP’s profitability, like CN’s and U.S. railways’, improved during 2017,
then declined but remained healthy
• CP was slightly less profitable than CN in 2018, and slightly more
profitable than the U.S. railways
TABLE 4.5 Canadian Pacific, Canadian National, and U.S. Industry Average Efficiency
Ratios
Canadian Canadian Canadian Canadian Canadian Canadian U.S. U.S. U.S.
2018 2017 2016
Net profit margin 0.2667 0.3670 0.2566 0.3022 0.4205 0.3024 0.2547 0.4987 0.1786
Operating profit margin 0.3870 0.3843 0.3869 0.3836 0.4020 0.4180 0.3694 0.3506 0.3267
Gross profit margin 0.6286 0.6463 0.6348 N/A N/A N/A 0.3944 0.4006 0.3848

4.5 PRODUCTIVITY RATIOS
• Productivity ratios measure the firm’s ability to generate sales from its
assets; these include:
o Receivables turnover
o Average collection period (ACP)
o Inventory turnover
o Average days revenue in inventory (ADRI)
o Fixed asset turnover
• Excessive investment in assets with little or no increase in sales reduces
the rate of return on both assets (ROA) and equity (ROE)

PRODUCTIVITY RATIOS (1 of 4)
• Receivables turnover measures the sales generated by every dollar of

receivables, as in Equation 4.16:
Sales S
Receivables Turnover  
Accounts Receivable AR
• Average collection period (ACP) estimates the number of days it takes for a
firm to collect on its accounts receivable, as in Equation 4-17:
Accounts Receivable 365
Average Collection Period  
Average Daily Credit Sales Receivable Turnover
• Example: If ACP is 40 days, and the firm’s credit policy is net 30, clearly
customers are not paying according the to firm’s policies and there may be
concerns about the quality of customer’s credit and what might happen if
economic conditions deteriorate
• Inventory turnover measures the number of times ending inventory was “turned over” or sold
during the year, as in Equations 4.18 and 4.19:
Cost of Goods Sold Revenues
Inventory Turnover  OR
Inventory Inventory
• When cost of goods sold is not publicly available, the inventory turnover ratio can be
estimated using revenue instead, as in Equation 4.19
• Using sales instead of cost of good sold is not ideal, because while cost of goods sold is based
on inventoried cost, sales includes a profit margin that may not be comparable to other firms
• This is a ratio that involves both stock and flow values and is strongly a function of ending
inventory
• Managers often try to improve this ratio as they approach year end through inventory
reduction strategies (e.g., cash and carry sales, inventory clearance, etc.)
• year end through inventory reduction strategies (e.g., cash and carry sales, inventory
clearance, etc.)

• Average Days Sales in Inventory (ADSI) estimates the number of days of sales
tied up in inventory, based on ending inventory values, as in Equation 4.20:
Inventory 365
Average Days Sales in Inventory (ADSI)  
Average Daily Sales Inventory Turnover
• Fixed asset turnover estimates the number of dollars of sales produced by

each dollar of net fixed assets, as in Equation 4.21:
Revenues
Fixed Asset Turnover 
Net Fixed Assets

• Table 4.6 shows CP’s productivity ratios:

TABLE 4.6 Canadian Pacific, Canadian National, and U.S. Industry Average Productivity
Ratios
2018 2017 2016
TA turnover 0.3442 0.3255 0.3242 0.3475 0.3466 0.3024 0.3453 0.3274 0.3180
Receivables turnover 8.9767 9.5400 10.5448 12.2506 13.2530 13.7566 12.1647 12.3451 12.7052
ACP 40.6609 38.2600 34.6142 29.7945 27.5409 26.5329 30.0974 29.9096 29.6134
Inventory (materials and 42.2890 43.1184 33.8696 25.7110 30.7571 33.1600 44.2338 35.5172 31.1610
supplies) turnover (using sales)
ADRI 8.6311 8.4651 10.7766 14.1963 11.8672 11.0072 8.7641 10.8177 12.0105
FA turnover 0.3972 0.3852 0.3734 0.3791 0.3814 0.3566 0.3949 0.3729 0.3611

4.6 LIQUIDITY RATIOS
• Liquidity ratios measure the ability of the firm to meet its financial obligations as they
mature using liquid (i.e., cash and near cash) resources; these include:
o Working capital
o Current
o Quick (acid test)
• The working capital ratio measures the proportion of total assets invested in current
assets, as in Equation 4.22
Current Assets CA
Working Capital  
Total Assets TA
• The working capital ratio demonstrates a firm’s capital intensity and corporate
liquidity

LIQUIDITY RATIOS (1 of 3)
• The current ratio measures the number of dollars of current assets for each dollar of
current liabilities, as in Equation 4.23:
Current Assets CA
Current ratio  
Current Liabilities CL
• The current ratio estimates the capacity of the firm to meet its financial obligations
as they mature
• The quick ratio or acid test ratio recognizes that inventories and other current
assets may be less liquid and, in some cases, when liquidated quickly, can result in
cash flows that are less than book value
• Therefore, the quick ratio gives a clearer indication of the firm’s ability to meet its
maturing financial obligations out of very liquid current assets, as in Equation 4.24:
Cash Marketable Securites  Accounts Receivable C  MS  AR

Quick ratio  
Current Liabilities CL

• Table 4.7 shows CP’s liquidity ratios
• The quick ratio is less than 1, which indicates the company could not pay off all its
current liabilities
• The current ratios increased over the period, reaching a level similar to CNR, but still
well below U.S.Ind.Avg.
TABLE 4.7 Canadian Pacific, Canadian National, and U.S. Industry Average Liquidity Ratios

2018 2017 2016
Current ratio 0.5714 0.6421 0.7491 0.7794 0.5498 0.7003 0.9860 0.9575 1.0622
Quick ratio 0.4481 0.5166 0.5605 0.5509 0.3859 0.5143 0.7676 0.7018 0.8285

• Estimating Net Realizable Values

o When firms are financially strained and no longer a going concern, book
(accounting) values become less valid
o Instead, net liquidation values can be estimated by discounting asset
values based on their degree of liquidity
o Liquid assts are valued at close to or the same as book value
o Illiquid assets are discounted from book value based on their degree of
liquidity
o Liabilities are stated in nominal terms, because it takes those dollars to
satisfy debt obligations
o Preferred stock value is based on residual values, if any residual remains
after liquidation
4.7 VALUATION RATIOS
• Valuation ratios are used to assess how the market is valuing the firm
(i.e., its share price) in relation to its assets, earnings, profits and
dividends; these include:
o Equity book value per share (BVPS)
o Dividend yield
o Dividend payout
o Trailing Price-earnings (P/E)
o Forward P/E
o Market-to-book
o Earnings before interest, taxes, depreciation and amortization (EBITDA)
multiple
VALUATION RATIOS (1 of 4)
• Book value per share (BVPS) expresses shareholders’ equity on a per share
basis, as in Equation 4.25:
Shareholders' Equity
Book Value Per Share 
Number of Shares
• Dividend yield expresses the dividend payout as a proportion of the current
share price, as in Equation 4.26:
Dividend Per Share DPS
Dividend Yield  
Price Per Share P
• The dividend yield can be compared to the yield on other investment
instruments, such as bonds or the stocks of other dividend-paying
companies
• The P/E ratio (also called Trailing P/E) is an earnings multiple based on the most recent earnings,
as in Equation 4.28:
Share Price P
P/E  
Earnings Per Share EPS
• The price-earnings (P/E) ratio is often used to estimate the value of a stock
• Example: A stock trading at a P/E multiple of 10 will take 10 years at current earnings to
recover its price
• The forward P/E ratio is an earnings multiple based on forecast earnings per share and is
often used to estimate the value of a stock for companies with rapid growth in EPS, as in
Equation 4.29:
Share Price P
Forward P/E  
Estimated Earnings Per Share EEPS
• Low P/E shares are regarded as value stocks

• High P/E shares are regarded as growth stocks

• The market-to-book ratio estimates the dollars of share price per dollar of book value per share,
as in Equation 4.30:
Share Price P
Market-to-book  
Book Value Per Share BVPS
• Given historical cost accounting as the basis for BVPS, the degree to which market value per
share exceeds BVPS indicates the value that has been added to the company by management
• The EBITDA multiple expresses total enterprise value (TEV) for each dollar of operating
income, or earnings before interest, taxes, depreciation and amortization (EBITDA), as in
Equation 4.31:
TEV
EBITDA Multiple 
EBITDA
• Total enterprise value is an estimate of the market value of the firm, i.e., the market value of
both its equity and its debt

• Table 4.8 shows valuation ratio for CP, CNR and U.S. Industry Average
• CP’s dividend yield, though slightly increasing, is only 60% of CN’s yield, and further below U.S.
industry average. This is reflected in the payout as well.
• Overall, based on these ratios, CP is valued higher than both CN and comparable U.S. railways.
TABLE 4.8 Canadian Pacific, Canadian National, and U.S. Industry Average Valuation Ratios

2018 2017 2016
Dividend yield 0.0104 0.0088 0.0093 0.0175 0.0156 0.0156 0.0180 0.0162 0.0210
Dividend payout 0.1841 0.1730 0.1680 0.2280 0.3160 0.3170 0.1500 0.4003 0.4257
P/E 17.75 18.70 19.00 13.00 20.30 20.00 8.30 24.97 20.27
M/B 5.13 6.00 6.00 4.20 5.10 4.60 3.57 4.40 3.20

4.8 FINANCIAL FORECASTING
• Financial managers must produce forecasts of the results of business plans in order to:
o Determine if the plans will require additional external financing
o Determine if the plans will produce surplus cash resources that could be distributed to
shareholders as dividends
o Assess financial forecasts to determine if plans are feasible; if poor results are forecast,
management has the opportunity to amend plans in an attempt to produce better results
before resources and committed
• The basis for all financial forecasts is the sales forecast and the most recent balance
sheet values are the starting point
• Pro forma (forecast) balance sheets are projected, assuming some relationship with
projected sales as a constant percentage of sales
• Current liabilities are usually assumed to rise and fall in a constant percentage with
sales, and are called spontaneous liabilities because they change without negotiation
with creditors
THE PERCENTAGE OF SALES METHOD (1 of 11)
The percentage of sales method involves the following steps:

1. Determine the financial policy variables in which you are interested
2. Set all the non-financial policy variables as a percentage of sales
3. Extrapolate the balance sheet based on a percentage of sales
4. Estimate future retained earnings
5. Modify and re-iterate until the forecast makes sense
This process most often results in a balance sheet that does not balance, so a “plug” (or balancing) amount is the external funds
required, or the surplus funds forecast
TABLE 4.9 Balance Sheet ($)
Cash 5 Accruals 5
Securities 10 Payables 5
Receivables 10 Bank debt 20
Inventory 25 Current liabilities 30
Current assets 50 Long‐term debt 40
Net fixed assets 100 Common equity 80
Total assets 150 Total liabilities and equity 150

TABLE 4.10 Initial Forecast
10% Sales 10% Sales 10% Sales
Increase in Increase in Increase in Year
Base Case % of Total Sales Year 1 Year 2 3
Sales $120 $132 $145 $160
PERCENTAGES OF SALES: Cash 5 4.2 5.5 6.1 6.7
PERCENTAGES OF SALES: Marketable securities 10 8.3 11 12.1 13.3
PERCENTAGES OF SALES: Accounts receivable 10 8.3 11 12.1 13.3
PERCENTAGES OF SALES: Inventory 25 20.8 27.5 30.3 33.3
PERCENTAGES OF SALES: Net fixed assets 100 83.3 110 121 133
PERCENTAGES OF SALES: Total assets 150 125 165 181.6 199.6
PERCENTAGES OF SALES: Accrual 5 4.2 5.5 6.1 6.7
PERCENTAGES OF SALES: Accounts payable 5 4.2 5.5 6.1 6.7
Short‐term debt 20 16.7 20 20 20
Long‐term debt 40 33.3 40 40 40
Equity 80 66.7 80 80 80
Total liabilities and equity 150 125 151 152.2 153.4
Cumulative EFR 14 29.4 46.2

• The prior pro forma balance sheet was developed

TABLE 4.11 Income Statement ($)
using very naïve assumptions:
• Policy variables held constant
Sales 120
• Asset growth in all accounts held at the same
percentage of sales Gross operating profit 48
• Spontaneous liabilities increased at a constant Fixed costs 31
percentage of sales
EBIT 17
• One improvement is to realize that the firm’s
Interest 5
equity will grow by the amount of retained
earnings Taxes (50%) 6
• Note that in Table 4.12 retained earnings is net Net income 6
income (6) less dividends (3). Assuming the firm Dividends 3
holds this percentage constant, we can project an
increase in equity on the balance sheet as 50% of
the 5% profit margin or 2.5% of sales.

TABLE 4.12 First Revision of Forecast
Base Case % of Total Sales 10% Sales Increase in Year 1 10% Sales Increase in Year 2 10% Sales Increase in Year 3
Sales $120 $132 $145 $160
Cash 5 4.2 5.5 6.1 6.7
Marketable securities 10 8.3 11 12.1 13.3
Accounts receivable 10 8.3 11 12.1 13.3
Inventory 25 20.8 27.5 30.3 33.3
Net fixed assets 100 83.3 110 121 133
Total assets 150 125 165 181.6 199.6
Accrual 5 4.2 5.5 6.1 6.7
Accounts payable 5 4.2 5.5 6.1 6.7
Long‐term debt 40 33.3 40 40 40
Equity 80 66.7 83.3 86.9 90.9
Total liabilities and equity 150 125 154.3 159.1 164.3
Cumulative EFR 10.7 22.5 35.3

• Further improvements to the pro forma balance sheet include:

o Recognizing that cash balances may not have to rise as a constant
percentage of sales
o Cash balances are required for a variety of reasons: to support
transactions, as a safety cushion against unforeseen cash needs, and
as a speculative balance to take advantage of unforeseen
opportunities
o Even at low levels of sales, cash balances are required
o As sales increase, additional cash on hand may be required, but at a
decreasing percentage of sales

• Figure 4.2 illustrates the difference between a simple

percentage of sales forecast, and perhaps a more realistic
forecast that includes a base amount (constant) and a
decreasing percentage of sales

• Further improvements to the pro forma balance sheet include re-examining asset
growth assumptions:
o Refinement of the cash forecast
o Realization that EFR can be offset by marketable securities that can be easily liquidated to
finance growth needs
o Re-examination of assumptions of accounts receivable growth and whether we want to
change credit policies in the context of the forecast macroeconomic and competitive
environment
o Re-examination of inventory management policies taking into account the macroeconomic
and competitive environment
o Realization that increases in net fixed assets is “lumpy” and not continuously incremental; if
the firm has excess capacity, it may not need to invest any further in fixed assets until it is
forecast to exceed that capacity
• Additional improvements also include re-examining assumptions about growth in
spontaneous liabilities
TABLE 4.13 Second Revision of Forecast
Base Case % of Total Sales 10% Sales Increase in Year 1 10% Sales Increase in Year 2 10% Sales Increase in Year 3
Sales $120 $132 $145 $160
Cash 5 4.2 5 5 5
Marketable securities 10 8.3 0 0 0
Accounts receivable 10 8.3 11 12.1 13.3
Inventory 25 20.8 27.5 30.3 33.3
Net fixed assets 100 83.3 110 90 80
Total assets 150 125 143.5 137.4 131.6
Accruals 5 4.2 5.5 6.1 6.7
Accounts payable 5 4.2 5.5 6.1 6.7
Long‐term debt 40 33.3 40 40 40
Equity 80 66.7 83.3 86.9 90.9
Total liabilities and equity 150 125 154.3 159.1 164.3
Cumulative EFR −10.8 −21.7 −32.7

• Given assumptions about capacity, and there being no need for further
expansion in plant and equipment to support anticipated sales growth, we can
re-examine our assumptions about the cost structure of the firm
• Figure 4.15 shows the effects of these changes on the pro forma income
statement
• Variable costs (direct materials and direct labour) will likely grow in proportion
to sales
• Fixed costs, however, should remain fixed; by modifying the income statement
for this change in assumptions, we see the net result of this is an increase in
forecast net income
• Most firms do not follow a constant dividend payout ratio, but hold dividends
constant over multiple years; we will assume $3 dividends will be paid for the
next three years
TABLE 4.14 Profit Margin and Sales

Sales $120 $132 $145 $160
Gross margin (40%) 48 53 58 64
Fixed costs 31 31 31 31
Interest 5 5 5 5
Tax 6 8.5 11 14
Net income 6 8.5 11 14
Net profit margin 5% 6.4% 7.6% 8.8%

• Given our modified income TABLE 4.13 Second Revision of Forecast

statement and assumptions Base
Case
% of Total Sales 10% Sales
Increase in
10% Sales
Increase in
10% Sales
Increase in
Year 1 Year 2 Year 3
regarding net profit and cash Sales $120 $132 $145 $160
dividends, we can prepare a Cash 5 4.2 5 5 5

Marketable securities 10 8.3 0 0 0
final revised balance sheet Accounts receivable 10 8.3 11 12.1 13.3
• The balance sheet now shows Inventory

Net fixed assets
25
100
20.8
83.3
27.5
100
30.3
90
33.3
80
we forecast significant surplus Total assets 150 125 143.5 137.4 131.6
cash resources and must make Accrual

Accounts payable
5
5
4.2
4.2
5.5
5.5
6.1
6.1
6.7
6.7
some decisions about their Short‐term debt 20 16.7 20 20 20
management: should they be Long‐term debt

Equity
40
80
33.3
66.7
40
85.5
40
93.5
40
104.5
invested in marketable Total liabilities and equity 150 125 156.5 165.1 177.9
Cumulative EFR −13 −28.3 −46.3
securities or paid as dividends?

4.9 FORMULA FORECASTING
• We can express the foregoing percentage of sales method of forecasting using equations rather
than spreadsheets
• Equation 4.32 shows the external financing requirements (EFR):
EFR = a × S × g – b × PM × (1 + g) × S
• where:
o a = the treasurer’s financial policy variable, the total invested capital or net assets of the firm as a
percentage of its sales
o g = sales growth rate
o S = current period sales
o S × g = next period sales
o a × S × g = incremental capital required
o PM = profit margin on sales
o b= payout ratio
o 1 – b = retention or plowback ratio

FORMULA FORECASTING (1 of 2)
• External financing requirements can also be expressed as a linear function of the sales
growth rate (g) by dividing both sides of Equation 4.32 by the current sales level to
obtain Equation 4-33:
EFR
 b  PM  a  b  PM  g
S
• Equation 4.33 is plotted in Figure 4.4; the sustainable growth rate (g*) occurs where
the blue line intersects the horizontal axis

FORMULA FORECASTING (2 of 2)
• The sustainable growth rate (g*) is the sales growth rate at which the
firm neither generates nor needs external financing; it can sustain its
own rate of growth through the reinvestment of its own profits.
Equation 4.34 gives the sustainable growth rate:
b  PM
g* 
a  b  PM
• When g > g*, EFR > 0 (external financing will be required)

• When g = g*, EFR = 0 (the firm can finance its own growth with retained earnings)
• When g < g*, EFR < 0 (the firm will have surplus funds available after financing its
planned growth)

4.10 CP’S Financial Forecast (1 of 2)
TABLE 4.16 Canadian Pacific’s Balance Sheet Accounts as a Percentage of Sales
Assets % of Sales % of Sales % of Sales Average (2016 – Use
(2016) (2017) (2018) 2018)
Current assets
Cash and cash equivalents 0.0263 0.0516 0.0083 0.0287 average
Accounts receivable, net 0.0943 0.1048 0.1114 0.1037 average
Materials and supplies 0.0295 0.0232 0.0236 0.0255 average
Deferred income taxes 0.0000 0.0000 0.0000 0.0000 average
Other current assets 0.0112 0.0148 0.0093 0.0118 average
Total current assets 0.1619 0.1944 0.1527 0.1697 sum
Investments 0.0311 0.0278 0.0277 0.0289 average
Properties 2.6780 2.5963 2.5175 2.5972 average
Goodwill and intangible assets 0.0324 0.0285 0.0276 0.0295 2018 figure
Pension assets 0.1717 0.2147 0.1699 0.1854 2018 figure
Other assets 0.0091 0.0105 0.0097 0.0098 2018 figure
Total assets 3.0842 3.0722 2.9051 3.0205 sum

4.10 CP’S Financial Forecast (2 of 2)
TABLE 4.16 Canadian Pacific’s Balance Sheet Accounts as a Percentage of Sales
Assets % of Sales (2016) % of Sales (2017) % of Sales (2018) Average (2016 –2018) Use
Liabilities
Accounts payable and accrued liabilities 0.2121 0.1889 0.1981 0.1997 average
Long-term debt maturing within one year 0.0040 0.1138 0.0692 0.0623 2018 figure
Total current liabilities 0.2161 0.3027 0.2672 0.2620 sum
Pension and other benefit liabilities 0.1178 0.1143 0.0981 0.1101 2018 figure
Other long-term liabilities 0.0456 0.0352 0.0324 0.0377 2018 figure
Long-term debt 1.3894 1.1311 1.1195 1.2133 2018 figure
Deferred income taxes 0.5730 0.5067 0.4809 0.5202 2018 figure
Total liabilities 2.3419 2.0900 1.9981 2.1434 sum
Shareholders’ equity
Share capital 0.3212 0.3100 0.2736 0.3016 2018 figure
Additional paid-in capital 0.0083 0.0066 0.0057 0.0069 2018 figure
Accumulated other comprehensive loss −0.2887 −0.2656 −0.2793 −0.2779 2018 figure
Retained earnings 0.7014 0.9312 0.9069 0.8465 2018 figure + (NI − Div)
Total shareholders’ equity 0.7423 0.9821 0.9071 0.8772 sum
Total liabilities and shareholders’ equity 3.0842 3.0722 2.9051 3.0205 sum

CP’S Financial Forecast (1 of 2)
• The percentage seems quite similar for 2016, 2017, 2018, thus
using the percentage of sales method is reasonable in this case
• Some items do not have a close relationship with sales, and for
these will just use the 2018 figures (e.g. long-term debt, goodwill)
• Note that for Retained Earnings we use a different growth
equation:
2018 figure + NI − Div
• 2016-2018 average growth rate is 3.21%, which we will use to
construct the forecast

CP’S EXTERNAL FINANCING REQUIREMENTS (1 of 2)
TABLE 4.17 Canadian Pacific Inc. Forecast ($Million)

2019 ProForma 2020 ProForma 2021 ProForma
Assets
Current assets
Cash and cash equivalents 217 224 231
Accounts receivable, net 783 808 834
Materials and supplies 192 198 205
Deferred income taxes 0 0 0
Other current assets 89 92 95
Total current assets 1,281 1,322 1,365
Investments 218 225 232
Properties 19,612 20,242 20,893
Goodwill and intangible assets 202 202 202
Pension assets 1,243 1,243 1,243
Other assets 71 71 71
Total assets 22,627 23,305 24,006

CP’S EXTERNAL FINANCING REQUIREMENTS (2 of 2)
2019 ProForma 2020 ProForma 2021 ProForma
Liabilities
Accounts payable and accrued liabilities 1,508 1,556 1,606
Long-term debt maturing within one year 506 506 506
Total current liabilities 2,014 2,062 2,112
Pension and other benefit liabilities 718 718 718
Other long-term liabilities 237 237 237
Long-term debt 8,190 8,190 8,190
Deferred income taxes 3,518 3,518 3,518
Total liabilities 14,677 14,725 14,775
Shareholders’ equity
Share capital 2,002 2,002 2,002
Additional paid-in capital 42 42 42
Accumulated other comprehensive loss −2,043 −2,043 −2,043
Retained earnings 8,528 10,492 12,531
Total shareholders’ equity 8,529 10,493 12,532
Total liabilities and shareholders’ equity 23,206 25,218 27,307
Cumulative EFR −579 −1,913 −3,301
Common shares outstanding (assumed) 140.5 140.5 140.5

CP’S Financial Forecast (2 of 2)
• As seen in table 4.17, CP’s EFR is -$579m for 2019 and further
declines to -$1,913m and -$3,301m in 2020 and 2021
• This means CP could pay down a large part of its outstanding debt
• It could also:
o Increase capital spending
o Increase dividend payout
o Repurchase shares

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Introduction to Corporate

Financial Statement Analysis and Forecasting

Copyright ©2020 John Wiley & Sons, Inc.

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• Consistent financial analysis across companies, industries and countries is important

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• Financial statement analysis studies, absolute numbers, comparative

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• ROE is a function of:

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TABLE 4.1 Canadian Pacific’s DuPont Ratios

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• Efficiency ratios measure how efficiently a dollar of sales is turned

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• Gross profit margin demonstrates the proportion of sales that are

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• Receivables turnover measures the sales generated by every dollar of

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• Fixed asset turnover estimates the number of dollars of sales produced by

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• Table 4.6 shows CP’s productivity ratios:

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Cash Marketable Securites  Accounts Receivable C  MS  AR

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Canadian Canadian Canadian Canadian Canadian Canadian U.S. U.S. U.S.

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• Estimating Net Realizable Values

• Low P/E shares are regarded as value stocks

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Canadian Canadian Canadian Canadian Canadian Canadian U.S. U.S. U.S.

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The percentage of sales method involves the following steps:

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• The prior pro forma balance sheet was developed

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• Further improvements to the pro forma balance sheet include:

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• Figure 4.2 illustrates the difference between a simple

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TABLE 4.14 Profit Margin and Sales

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• Given our modified income TABLE 4.13 Second Revision of Forecast

dividends, we can prepare a Cash 5 4.2 5 5 5

• The balance sheet now shows Inventory

cash resources and must make Accrual

management: should they be Long‐term debt

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• When g > g*, EFR > 0 (external financing will be required)