Chapter 3
Financial Statements Analysis and Financial
Models
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
3.1 Financial Statements Analysis
3.2 Ratio Analysis
3.3 The DuPont Identity
3.4 Financial Models
3.5 External Financing and Growth
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3-2
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.
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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
◦ (3588 - 2591) / 3588 = 28%
Debt/Equity = TD / TE
◦ (3588 – 2591) / 2591 = 38.5%
Equity Multiplier = TA / TE = 1 + D/E
◦ 1 + .385 = 1.385
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Times Interest Earned = EBIT / Interest
◦ 691 / 141 = 4.9 times
Cash Coverage = (EBIT + Depreciation +
Amortization) / Interest
◦ (691 + 276) / 141 = 6.9 times
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3-8
Inventory Turnover = Cost of Goods Sold / Inventory
◦ 1344 / 422 = 3.2 times
Days’ Sales in Inventory = 365 / Inventory Turnover
◦ 365 / 3.2 = 114 days
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Receivables Turnover = Sales / Accounts Receivable
◦ 2311 / 188 = 12.3 times
Days’ Sales in Receivables = 365 / Receivables
Turnover
◦ 365 / 12.3 = 30 days
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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.
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3-11
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%
EBITDA Margin = EBITDA / Sales
◦ 967 / 2311 = 41.8%
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3-12
Market Capitalization = $88 per share x 33 million shares =
$2,904 million
PE Ratio = Price per share / Earnings per share
◦ 88 / 11 = 8 times
Market-to-book ratio = market value per share / book value per
share
◦ 88 / (2591 / 33) = 1.12 times
Enterprise Value (EV) = Market capitalization + Market value
of interest bearing debt – cash
◦ 2904 + (196 + 457) – 98 = $3,459
EV Multiple = EV / EBITDA
◦ 3459 / 967 = 3.6 times
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3-13
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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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
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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 = 10.1% 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.
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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3-19
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:
Assets Spon Liab
Sales ?Sales (PM Projected Sales) (1 d)
Sales Sales
(3 250) (0.3 250) (0.13 1250 0.667)
$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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3-24
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 = 44/ 66 = .667
ROA b
Internal Growth Rate
1 - ROA b
.132 .667
.0965
1 .132 .667
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 .667
.214
1 .264 .667
21.4%
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Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt ratio
Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
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