Financial Statements Analysis and Financial

Model
By Dr. Chin, Phaik Nie

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} 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

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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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} 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

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} 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?

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} 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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} 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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} 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

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} Times Interest Earned = EBIT / Interest
◦ $600 / $141 = 4.26 times
} Cash Coverage = (EBIT + Depreciation and
Amortization) / Interest
◦ ($600 + 276) / $141 = 6.22 times

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} 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

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} Receivables Turnover = Sales / Accounts Receivable
◦ $2,311 / $188 = 12.29 times
} Days’ Sales in Receivables = 365 / Receivables
Turnover
◦ 365 / 12.29 = 29.69 days

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} 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.

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} 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%

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} 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

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} 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

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} 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

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} 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.

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} 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%

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} 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

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

Proj. Sales (1 – d))

= ($3000 / $1,000) × ($250) – ($300 / $1,000) × ($250) – (.132 × $1,250 × (1 – .3333)

= $565

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} 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 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%

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} 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
= = .2136
1−.264 ×.6667
= 21.36%

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} 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

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} 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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