FIN 460: M & A

Dr. Murat Binay

Financial Statement Analysis

 COMMON-SIZE ANALYSIS

Common-size analysis is the restatement of financial statement information in

a standardized form.
- Horizontal common-size analysis uses the amounts in accounts in a
specified year as the base, and subsequent years’ amounts are stated as a
percentage of the base value.
- Useful when comparing growth of different accounts over time.
- Vertical common-size analysis uses the aggregate value in a financial
statement for a given year as the base, and each account’s amount is
restated as a percentage of the aggregate.
- Balance sheet: Aggregate amount is total assets.
- Income statement: Aggregate amount is revenues or sales.

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 EXAMPLE: COMMON-SIZE ANALYSIS

Consider the CS Company, which reports the following financial information:

Year 2008 2009 2010 2011 2012 2013
Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40
Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65
Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29
Intangibles 400.00 402.00 404.01 406.03 408.06 410.10
Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54

1. Create the vertical common-size analysis for the CS Company’s assets.

2. Create the horizontal common-size analysis for CS Company’s assets, using
2008 as the base year.

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 EXAMPLE: COMMON-SIZE ANALYSIS

Vertical Common-Size Analysis:

Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%
Graphically:
100%
80%
Proportion 60%
of Assets 40%
20%
0%
2008 2009 2010 2011 2012 2013
Fiscal Year

Cash Inventory Accounts receivable Net plant and equipment Intangibles

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 EXAMPLE: COMMON-SIZE ANALYSIS

Horizontal Common-Size Analysis (base year is 2008):

Year 2008 2009 2010 2011 2012 2013
Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

Graphically:
130%
Percentage 120%
of Base
110%
Year
Amount 100%
90%
2008 2009 2010 2011 2012 2013
Fiscal Year

Cash Inventory Accounts receivable Net plant and equipment Intangibles Total assets

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 FINANCIAL RATIO ANALYSIS

• Financial ratio analysis is the use of relationships among financial statement

accounts to gauge the financial condition and performance of a company.
• We can classify ratios based on the type of information the ratio provides:

Solvency Profitability
Activity Ratios Liquidity Ratios
Ratios Ratios

Effectiveness Ability to
Ability to meet
in putting its Ability to manage
asset short-term, expenses to
immediate satisfy debt
investment to obligations. produce profits
use. obligations. from sales.

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 ACTIVITY RATIOS
• Turnover ratios reflect the number of times assets flow into and out of the
company during the period.
• A turnover is a gauge of the efficiency of putting assets to work.
• Ratios:
Cost of goods sold How many times inventory is
Inventory turnover =
Average inventory created and sold during the
period.
Total revenue How many times accounts
Receivables turnover =
Average receivables receivable are created and
collected during the period.
Total revenue The extent to which total
Total asset turnover =
Average total assets assets create revenues during
the period.
Total revenue The efficiency of putting
Working capital turnover =
Average working capital working capital to work

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 OPERATING CYCLE COMPONENTS
• The operating cycle is the length of time from when a company makes an
investment in goods and services to the time it collects cash from its accounts
receivable.
• The net operating cycle is the length of time from when a company makes an
investment in goods and services, considering the company makes some of its
purchases on credit, to the time it collects cash from its accounts receivable.
• The length of the operating cycle and net operating cycle provides information
on the company’s need for liquidity: The longer the operating cycle, the greater
the need for liquidity.

Number of Days of Inventory Number of Days of Receivables

| | |

Buy Inventory on Pay Accounts Sell Inventory on Collect Accounts

Credit Payable Credit Receivable

Number of Days of Payables Net Operating Cycle

Operating Cycle
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 OPERATING CYCLE FORMULAS

Inventory 365 Average time it

Number of days of inventory = =
Average day′s Inventory turnover
takes to create
cost of goods sold
and sell
inventory.
Receivables 365 Average time it
Number of days of receivables = =
Average day′s Receivables turnover takes to collect
revenues on accounts
receivable.
Accounts payable 365 Average time it
Number of days of payables = =
Average day′s Accounts payable turnover takes to pay
purchases suppliers.

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 OPERATING CYCLE FORMULAS

Number of days Number of days Time from investment in

Operating cycle = +
of inventory of receivables inventory to collection of
accounts.

Net operating Number of days Number of days Number of days Time from investment in
= + −
cycle of inventory of receivables of payables inventory to collection of
accounts, considering
the use of trade credit in
purchases.

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 LIQUIDITY

• Liquidity is the ability to satisfy the company’s short-term obligations using

assets that can be most readily converted into cash.
• Liquidity ratios:
Current assets Ability to satisfy current
Current ratio =
Current liabilities liabilities using current assets.
Short−term Ability to satisfy current
Cash + + Receivables
Quick ratio = investments liabilities using the most liquid
Current liabilities of current assets.

Short−term Ability to satisfy current

Cash +
Cash ratio = investments liabilities using only cash and
Current liabilities cash equivalents.

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 SOLVENCY ANALYSIS

• A company’s business risk is

determined, in large part, from the
company’s line of business. Risk
• Financial risk is the risk resulting from
a company’s choice of how to finance
the business using debt or equity.
Business Financial
• We use solvency ratios to assess a Risk Risk
company’s financial risk.
• There are two types of solvency ratios:
component percentages and coverage
ratios. Sales Risk
- Component percentages involve
comparing the elements in the
capital structure. Operating
- Coverage ratios measure the ability Risk
to meet interest and other fixed
financing costs.

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 SOLVENCY RATIOS
Total debt Proportion of assets financed with debt.
Debt−to−assets ratio =
Component-Percentage

Total assets
Long−term debt Proportion of assets financed with long-
Long−term debt−to−assets ratio =
Total assets term debt.
Solvency Ratios

Total debt Debt financing relative to equity financing.

Debt−to−equity ratio =
Total shareholders′ equity

Total assets Reliance on debt financing.

Financial leverage =
Total shareholders′ equity

EBIT Ability to satisfy interest obligations.

Interest coverage ratio =
Interest payments
Coverage Ratios

Fixed charge EBIT + Lease payments Ability to satisfy interest and lease
=
coverage ratio Interest payments + Lease payments obligations.
Cash flow CFO + Interest payments + Tax payments Ability to satisfy interest obligations with
=
coverage ratio Interest payments cash flows.

Cash−flow−to− CFO Length of time needed to pay off debt

=
debt ratio Total debt with cash flows.

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 PROFITABILITY

• Margins and return ratios provide information on the profitability of a company

and the efficiency of the company.
• A margin is a portion of revenues that is a profit.
• A return is a comparison of a profit with the investment necessary to generate
the profit.

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 PROFITABILITY RATIOS: MARGINS

Each margin ratio compares a measure of income with total revenues:

Gross profit
Gross profit margin =
Total revenue

Operating profit
Operating profit margin =
Total revenue

Net profit
Net profit margin =
Total revenue

Earnings before taxes

Pretax profit margin =
Total revenue

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 PROFITABILITY RATIOS: RETURNS

Return ratios compare a measure of profit with the investment that produces the profit:

Operating income
Operating return on assets =
Average total assets

Net income
Return on assets =
Average total assets

Net income
Return on total capital =
Average interest−bearing debt + Average total equity

Net income
Return on equity =
Average shareholders′ equity

Operating income
Operating return on assets =
Average total assets

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THE DUPONT FORMULAS
Return on Equity

• The DuPont formula uses the Return on Assets

relationship among financial statement
accounts to decompose a return into Total Asset Financial
components. Net Profit
Margin Turnover Leverage
• Three-factor DuPont for the return on
equity:
- Net profit margin
- Total asset turnover ROA Operating Profit
(EBIT) Margin
- Financial leverage
• Five-factor DuPont for the return on
equity:
- Total asset turnover Interest
- Financial leverage Burden
- Operating profit margin
- Interest burden
- Tax burden Tax
Burden

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 FIVE-COMPONENT DUPONT MODEL

Return on Total assets Return on

= ×
equity Shareholders′ assets
equity

Return on Total assets Net income

= ×
equity Shareholders′ Total assets
equity

Return on Total assets Revenues Net income

= × ×
equity Shareholders′ Total assets Revenues
equity
Income
Operating before
Return on Total assets Revenues Taxes
= × × income × taxes × 1 −
equity Shareholders′ Total assets Revenues Operating Income
equity income before
taxes

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 EXAMPLE: THE DUPONT FORMULA

Suppose that an analyst has noticed that the return on equity of the D
Company has declined from FY2012 to FY2013. Using the DuPont
formula, explain the source of this decline.

(millions) 2013 2012

Revenues $1,000 $900
Earnings before interest and taxes $400 $380
Interest expense $30 $30
Taxes $100 $90

Total assets $2,000 $2,000

Shareholders’ equity $1,250 $1,000

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 EXAMPLE: THE DUPONT FORMULA

2013 2012
Return on equity 0.20 0.22
Return on assets 0.13 0.11

Financial leverage 1.60 2.00

Total asset turnover 0.50 0.45
Net profit margin 0.25 0.24
Operating profit margin 0.40 0.42

Interest burden 0.83 0.82

Tax burden 0.76 0.71

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 OTHER RATIOS

• Earnings per share is net income, restated on a per share basis:

Net income available to common shareholders

Earnings per share =
Number of common shares outstanding

• Basic earnings per share is net income after preferred dividends, divided by
the average number of common shares outstanding.
• Diluted earnings per share is net income minus preferred dividends, divided
by the number of shares outstanding considering all dilutive securities.
• Book value per share is book value of equity divided by number of shares.
• Price-to-earnings ratio (PE or P/E) is the ratio of the price per share of equity
to the earnings per share.
- If earnings are the last four quarters, it is the trailing P/E.

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 OTHER RATIOS

Measures of Dividend Payment:

Dividends per Dividends paid to shareholders

=
share (DPS) Weighted average number of ordinary shares outstanding

Dividends paid to common shareholders

Dividend payout ratio =
Net income attributable to common shares
Plowback ratio = 1 – Dividend payout ratio
- The proportion of earnings retained by the company.

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 EXAMPLE: SHAREHOLDER RATIOS
Calculate the book value per share, P/E, dividends per share, dividend payout, and
plowback ratio based on the following financial information:

Book value of equity $100 million

Market value of equity $500 million
Net income $30 million
Dividends $12 million
Number of shares 100 million

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 EXAMPLE: SHAREHOLDER RATIOS

Book value per share $1.00 There is $1 of equity, per the books, for
every share of stock.
P/E 16.67 The market price of the stock is 16.67
times earnings per share.
Dividends per share $0.12 The dividends paid per share of stock.

Dividend payout ratio 40% The proportion of earnings paid out in the
form of dividends.
Plowback ratio 60% The proportion of earnings retained by the
company.

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 EFFECTIVE USE OF RATIO ANALYSIS
• In addition to ratios, an analyst should describe the company (e.g., line of
business, major products, major suppliers), industry information, and major
factors or influences.
• Effective use of ratios requires looking at ratios
- Over time.
- Compared with other companies in the same line of business.
- In the context of major events in the company (for example, mergers or
divestitures), accounting changes, and changes in the company’s product
mix.

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 PRO FORMA ANALYSIS

Estimate
typical Estimate Estimate Construct
relation fixed sales-driven future period
Estimate
between burdens, Forecast accounts income
revenues fixed
such as revenues. based on burdens. statement
and sales- interest and forecasted and balance
driven taxes. revenues. sheet.
accounts.

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 PRO FORMA INCOME STATEMENT
Imaginaire Company Income Statement (in millions)
One Year
Year 0 Ahead
Sales revenues 1,000.0 1,050.0 ï Growth at 5%
Cost of goods sold 600.0 630.0 ï 60% of revenues
Gross profit 400.0 420.0 ï Revenues less COGS
SG&A 100.0 105.0 ï 10% of revenues
Operating income 300.0 315.0 ï Gross profit less operating exp.
Interest expense 32.0 33.6 ï 8% of long-term debt
Earnings before taxes 268.0 281.4 ï Operating income less interest exp.
Taxes 93.8 98.5 ï 35% of earnings before taxes
Net income 174.2 182.9 ï Earnings before taxes less taxes
Dividends 87.1 91.5 ï Dividend payout ratio of 50%

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 PRO FORMA BALANCE SHEET

Imaginaire Company Balance Sheet, End of Year (in millions)

One Year
Year 0 Ahead
Current assets 600.0 630.0 ï 60% of revenues
Net plant and equipment 1,000.0 1,050.0 ï 100% of revenues
Total assets 1,600.0 1,680.0

Current liabilities 250.0 262.5 ï 25% of revenues

Long-term debt 400.0 420.0 ï Debt increased by 20 million
to maintain the same capital
structure
Common stock and paid-in capital 25.0 25.0 ï Assume no change
Treasury stock (44.0) ï Repurchased shares
Retained earnings 925.0 1,016.5 ï Retained earnings in Year 0,
plus net income, less
dividends
Total liabilities and equity 1,600.0 1,680.0

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 SUMMARY
• Financial ratio analysis and common-size analysis help gauge the financial
performance and condition of a company through an examination of
relationships among these many financial items.
• A thorough financial analysis of a company requires examining its efficiency in
putting its assets to work, its liquidity position, its solvency, and its profitability.
• We can use the tools of common-size analysis and financial ratio analysis,
including the DuPont model, to help understand where a company has been.
• We then use relationships among financial statement accounts in pro forma
analysis, forecasting the company’s income statements and balance sheets for
future periods, to see how the company’s performance is likely to evolve.

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