Financial Statements

Analysis

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 Key Concepts and Skills
• 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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 Financial Statements Analysis
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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 Ratio Analysis
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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 Categories of Financial Ratios
• Short-term solvency, or liquidity, ratios: The ability to pay
bills in the short-run
• Long-term solvency, or financial leverage, ratios: The
ability to meet long-term obligations
• Profitability ratios: Efficiency of operations and how this
translates to the “bottom line”
• Market value ratios: How the market values the firm
relative to the book values
• Asset management, or turnover, ratios: Efficiency of asset
use

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 Liquidity Ratios
• Liquidity is the “ability to convert assets to cash quickly without
a significant loss in value.”

Current Ratio = current assets / current liabilities

Quick Ratio = (current assets – inventory) / current liabilities

Cash Ratio = cash / current liabilities

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 Liquidity Ratios (Contd…)

CA $708
Current Ratio = = 1.31 times
CL $540

(CA − Inventory) ($708 − $422)

Quick Ratio = = .53 times
CL $540

Cash $98
Cash Ratio = = .18 times
CL $540

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 Liquidity Ratios (Contd…)
• Is a high current ratio a good thing?
• This may be true if you are a short-term creditor and you are
evaluating whether or not to grant trade credit or make a short-
term loan
• But liquid assets are generally less profitable for the company
• Consequently, too large an investment in current assets may
reduce the earnings power of the firm and actually reduce the
stock price
• Remember that the goal of the firm is to maximize owner
wealth.

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 Liquidity Ratios (Contd…)
• Kirk Kerkorian’s takeover bid for Chrysler in April 1995 is a
perfect example of investor dissatisfaction with excess liquidity.
• At the time, Chrysler’s management had accumulated $7.3
billion in cash and marketable securities as a cushion against
an economic down-turn.
• Mr. Kerkorian instigated a takeover bid because Chrysler’s
management refused to pay this cash to stockholders.
• A Wall Street Journal article noted that some analysts
considered several other firms with large cash holdings relative
to firm value vulnerable to takeover bids as well.

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 Leverage Ratios
• Total debt ratio = (total assets – total equity) / total assets

• Variations:
debt/equity ratio = (total assets – total equity) / total equity

Using the balance sheet identity, the debt/equity ratio can also be
calculated as: debt ratio / (1 – debt ratio)

equity multiplier = total assets / total equity

= 1 + debt/equity ratio

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 Leverage Ratios (Contd…)

(TA − TE ) ($3,588 − 2,591)

Total Debt Ratio = = .28 times
TA $3,588

TD $.28
Debt − Equity Ratio = = .38 times
TE $.72

TA
Equity Multiplier = = 1+ D − E 1 + .38 = 1.38 times
TE

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 Leverage Ratios (Contd…)
• The key financial ratios for the credit rating agencies are the two
leverage ratios: debt-to-EBITDA and funds from operations
(FFO)-to-debt.
• Funds from operations/Debt = (EBITDA – Interest expenses –
Taxes)/ (Existing debtt + New debtt)
• Debt/EBITDA= (Existing debtt + New debtt)/EBITDA
• Example: If debt-to-EBITDA were to persistently remain above
4.5% and if FFO-to-debt were to persistently fall below 13%,
S&P would change Dominion’s financial risk to “aggressive,”
which would result in a credit downgrade to BBB+ from A–.

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 Coverage Ratios

EBIT $600
Times Interest Earned = = 4.26 times
Interest $141

( EBIT + Depreciation and Amortization)

Cash Coverage =
Interest
($600 + 276)
= 6.22 times
$141

Remember that depreciation (and amortization) is a noncash

deduction. A better indication of a firm’s ability to meet interest
payments may be to add back the depreciation and
amortization to get an estimate of cash flow before taxes.
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 Coverage Ratios (Contd…)
• This group of ratios (i.e., long-term solvency) really
measures two different aspects of leverage – the level of
indebtedness and the ability to service debt
• The former is indicative of the firm’s debt capacity, while the
latter more closely relates to the likelihood of default
• Further, it is sometimes helpful to observe some of the
nuances of the ratios within these subgroups
• For example, the total debt ratio measures what proportion
of the firm’s assets are financed with borrowed money, while
the debt/equity ratio compares the amount of funds supplied
by creditors and owners
• The long-term debt ratio looks at the percent of long-term
financing that is raised using debt
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 Profitability Measures
• These measures are based on book values, so they are not
comparable with returns that you see on publicly traded assets.

• Profit margin = net income / sales

• EBITDA Margin = EBITDA / Sales

• Return on Assets (ROA) = net income / total assets

• Return on Equity (ROE) = net income / total equity

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 Profitability Measures (Contd…)
Net Income $363
Profit Margin = = .1569, or15.69%
Sales $2,311

EBITDA $876
EBITDA Margin = = .3791, or 37.91%
Sales $2,311

Net Income $363

Return on Assets (ROA) = = .1011, or10.11%
Total Assets $3,588

Net Income $363

Return on Equity (ROE) = = .1399, or13.99%
Total Equity $2,591

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 Market Value Measures
• Earnings Per Share (EPS) = net income / shares outstanding

• Price-earnings ratio = price per share / earnings per share

• Market-to-book ratio = market value per share / book value per

share

• Market capitalization = Price per share x Shares Outstanding

• Enterprise Value (EV) = Market capitalization + Market value of

interest bearing debt – Cash

• EV multiple = EV / EBITDA
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 Market Value Measures (Contd…)
Price per share $88
Price–Earnings Ratio = = 8.01times
Earnings per share $10.99

Market value per share $88

Market–to–Book Ratio = = 1.12 times
Book value per share  $2,591 
 
 33 

Market Capitalization = Price per share  Shares outstanding $88  33million = $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 $3,459
EV Multiple = = 3.95 times
EBITDA $876

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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.

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 The DuPont Identity

The DuPont Identity provides analysts with a way to break down

ROE and investigate what areas of the firm need improvement.

ROE = (NI / total equity)

multiply by one (assets / assets) and rearrange

ROE = (NI / assets) (assets / total equity) = ROA*EM

multiply by one (sales / sales) and rearrange

ROE = (NI / sales) (sales / assets) (assets / total equity)
ROE = PM*TAT*EM

These three ratios indicate that a firm’s return on equity depends on its
operating efficiency (profit margin), asset use efficiency (total asset
turnover) and financial leverage (equity multiplier).

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 Using the DuPont Identity
RO E = PM × T AT × 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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 Asset Management or Turnover Ratios

• Total asset turnover

• Inventory ratios
• Receivables ratios

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 Total Asset Turnover
Sales $2,311
Total Asset Turnover = = .64 times
Total Assets $3,588

• It is not unusual for T A T < 1, especially if a firm has a large

amount of fixed assets
• Having a TAT of less than one is not a problem for most firms
• Fixed assets are expensive and are meant to provide sales over
a long period of time
• This is why the matching principle indicates that they should be
depreciated instead of immediately expensed
• In addition to TAT, it may be helpful to calculate components of
TAT such as Fixed Asset Turnover or Net Working Capital
Turnover
• This highlights that the firm may be doing better or worse in
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 Inventory Ratios

Cost of GoodsSold $1, 435

Inventory Turnover = = 3.40 times
Inventory $422

365 365
Day'sSales in Inventory = = 107.37 days
Inventory Turnover 3.40

• Inventory turnover can be computed using either ending

inventory or average inventory when you have both beginning
and ending figures
• It is important to be consistent with whatever benchmark you
are using to analyze the company’s strengths or weaknesses
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 Receivables Ratios

Sales $2,311
Receivables Turnover = = 12.29 times
Accounts Receivable $188

365 365
Day'sSales in Receivables = = 29.69 days
Receivables 12.29

(Also called “average collection period” or “days’ sales outstanding.”)

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 Potential Problems with Financial
Statement Analysis
• No underlying financial theory
• Finding comparable firms
• What to do with conglomerates, multidivisional firms
• Differences in accounting practices
• Differences in capital structure
• Seasonal variations, one-time events

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 Financial Models
• Financial planning is based on the three areas of corporate
finance
- Capital budgeting decisions,
- Capital structure decisions, and
- Working capital management.

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 Financial Planning Ingredients
• Sales Forecast – most other considerations depend upon the
sales forecast, so it is said to “drive” the model

• Pro Statements – the output summarizing different projections

• Asset Requirements – investment needed to support sales

growth

• Financial Requirements – debt and dividend policies

• The “Plug” – designated source(s) of external financing

• Economic Assumptions – state of the economy, anticipated

changes in interest rates, inflation, etc.
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 Percentage of Sales Approach - I
• Sales generate retained earnings (unless all income is paid out
in dividends).
• Retained earnings, plus external funds raised, support an
increase in assets.
• More assets lead to more sales, and the cycle starts again.
• This simplified approach assumes that certain items are fixed
and other vary proportionally with sales.
• Once forecasted, you must select a plug account that will be
used to make the balance sheet balance.
• This number generally reflects External Financing Needed
(EFN).

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 Percentage of Sales Approach - I
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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 Percentage of Sales Approach – II
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 and Growth
• At low growth levels, internal financing (retained earnings) may
exceed the required investment in assets.
• All else equal, more growth means more external financing will
be needed.
• 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 (i.e., internal financing) as the
only source of financing.
• IGR = (ROA*b) / [1 – ROA*b]

$66 $44
ROA = = .132 b ( plowback ratio ) = = .6667
$500 $66

ROA  b .132  .6667

Internal Growth Rate = = = .0964, or 9.64%
1 − ROA  b 1 − .132  .6667

• This firm could grow assets at 9.64 percent without raising

additional external capital.

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 The Sustainable Growth Rate
• The Sustainable Growth Rate (SGR) is the maximum growth
rate a firm can achieve without external equity financing, while
maintaining a constant debt-to-equity ratio.
• 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.

SGR = (ROE*b) / [1 – ROE*b]

$66 b = .667
ROE = = .264
$250
ROE  b .264  .6667
Sustainable Growth Rate = = = .2134, or 21.34%
1 − ROE  b 1 − .264  .6667

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 Determinants of Growth
• From the DuPont identity, ROE can be viewed as the product of
profit margin, total asset turnover, and the equity multiplier.
• Anything that increases ROE will increase the sustainable
growth rate as well. Therefore, the sustainable growth rate
depends on the following four factors:

i. Operating efficiency – profit margin

ii. Asset use efficiency – total asset turnover
iii. Financial leverage – equity multiplier
iv. Dividend policy – retention ratio

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 Determinants of Growth (Contd…)
Self-sustainable growth model:
gss = (NI/S × S/A × A/E) × (1 − DPO)
where:

• gss is the self-sustainable growth rate, NI is net income, S is sales, A

is assets, E is equity, DPO is the dividend-payout ratio

• The model describes the rate at which a firm can grow if it

issues no new shares of common stock, which describes
the behavior of circumstances of the vast majority of firms.
• The model illustrates that the financial policies of a firm are
a closed system: Growth rate, dividend payout, and debt
targets are interdependent.
• The model offers the key insight that no financial policy can
be set without reference to the others.
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 Some Caveats Regarding Financial
Planning Models
• 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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