Chapter 3

Financial Statements Analysis and Financial

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
3.1 Financial Statements Analysis
3.2 Ratio Analysis
3.3 The Du Pont Identity
3.4 Financial Models
3.5 Some Caveats Regarding Financial Planning
Models

3-2
 Must develop a good working knowledge of
financial statements
 Making financial statements useful for users
is one finance role
 In order to make meaningful comparisons
of companies of different size financial
professionals use two key techniques:
◦ Common-Size Statements
◦ Financial Ratios

3-3
 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.
 Practice Hint: You may have round percentages in
Common-Size Statements

3-4
 Common Size Balance
Balance Sheet Sheet

3-5
Prufrock Corporation
Comparison: Financial & Common Size Income
Statement
Income Statement Common Size Income
Statement

3-6
 Ratios compliment common size analysis and
allow for deeper comparison through time or
between dissimilar companies
 Not always computed precisely the same;
document your approach
 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

 Following Examples all Based on Tables 3.1 & 3.4

3-8
 Current Ratio = CA / CL
◦ 708 / 540 = 1.31 times

3-9
 Debt/Equity = TD / TE
◦ (3588 – 2591) / 2591 = 38.5%
 Equity Multiplier = TA / TE = 1 + D/E
◦ 1 + .385 = 1.385

3-10
 Times Interest Earned = EBIT / Interest
◦ 691 / 141 = 4.9 times

3-11
 Inventory Turnover = Cost of Goods Sold /
Inventory
◦ 1344 / 422 = 3.2 times

3-12
 Receivables Turnover = Sales / Accounts
Receivable
◦ 2311 / 188 = 12.3 times

3-13
 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.

3-14
 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%

3-15
 Market-to-book ratio = market value per share /
book value per share
 Market value per share is the same as the price per
share
 Book value per share is the same as total equity per
share
 88 / (2591 / 33) = 1.12 times

3-16
 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
◦ Go to www.reuters.com/finance/stocks
 Use the ratios link to get comparative ratios for many
companies

3-17
 Popularized by the DuPont Corporation
 A more sophisticated method of evaluating

return
 Illustrates the interaction between profit,

assets and leverage

measures:
◦ Operating Efficiency (Profit Margin)
◦ Asset Use Efficiency (Total Asset Turnover)
◦ Financial Leverage (Equity Multiplier)

3-18
 ROE = 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

3-19
 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.

3-20
 ROA = 10.1% and EM = 1.39
◦ ROE = 10.1% * 1.385 = 14.0%
 PM = 15.7% and TAT = 0.64
◦ ROE = 15.7% * 0.64 * 1.385 = 14.0%

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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
makes comparison more difficult because of
differences in accounting regulations.
 Firms use varying accounting procedures.
 Extraordinary, or one-time, events

3-22
 Projection of Future Plans
◦ Short Term or Long Term
◦ Results in Pro-Forma Statements
 Influenced by:
◦ Investment in new assets – capital budgeting
decisions
◦ Degree of financial leverage – capital structure
decisions
◦ Cash paid to shareholders – dividend policy
decisions
◦ Liquidity requirements – net working capital
decisions

3-23
 Sales Forecast –cash flows depend directly on the
level or estimated growth rate of sales
 Pro Forma Statements –Presenting the plan as
projected financial statements (pro forma) allows
for consistency and ease of interpretation
 Asset Requirements – additional assets required to
meet sales projections
 Financial Requirements – financing needed to pay
for the required assets

3-24
 Indicate 25% Sales Growth Assumption

3-25
Percent of Sales Approach – Balance
Sheet

 Indicate 25% Sales Growth Assumption

3-26
 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.

3-27