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 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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 An internal financial analysis might be done:
 to evaluate the performance of employees to determine pay
raises and bonuses.
 to compare the performance of different divisions.
 to prepare financial projections (e.g. for the launch of a new
product).
 to evaluate the firm’s financial performance in light of its
competitors’ performance and determine how to improve the
firm’s own operations.

 External financial analysis is done by:

 banks and other lenders deciding to lend money.
 suppliers deciding to grant credit.
 credit-rating agencies determining credit worthiness.
 professional analysts who work for investment companies
deciding to invest in the company.
 individual investors deciding to invest in the company.
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 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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 How to prepare a common-size financial
statement.
 For a common-size income statement, divide each
entry in the income statement by sales.
 For a common-size balance sheet, divide each
entry in the balance sheet by total assets.

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6
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Cost of goods sold
are 75% of the
firm’s sales
resulting in a
gross profit of
25%

Operating
expenses are only
10.8% of sales.
Income taxes are
4.1% of the firm’s
sales.

After all expenses,

the firm generates
net income of 7.6%
of firm’s sales.
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3-8
Total current assets increased
are 32.6% of all assets in
2015, increasing from 27% in
2014.
However, total current
liabilities are 14.6% of total
assets in 2015, which is a
decline from the 16.6% in
2014.

Total non-current liabilities

(long term debt) are 39.2% of
total assets in 2015, which is
a slight decrease from the
40.8% in 2014.
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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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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%

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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 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 PPE 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%

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 ratios provide a second method for
standardising the financial information on the
income statement and balance sheet.

 A ratio by itself may have no meaning.

 Hence, a given ratio is generally compared to:
(1) ratios from previous years; or
(2) ratios of other firms in the same industry.

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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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Liquidity ratios address a basic question: How liquid is the firm?
A firm is liquid if it is able to pay its bills on time.

 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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Capital structure refers to the way a firm finances its
assets, using a combination of debt and equity.
Capital structure ratios address the important question:
How did the firm finance the purchase of its assets?

 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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 Coverage Ratios: measures the ability of the firm to
service its debt or repay the interest on debt.

 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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Asset management efficiency ratios measure a firm’s
effectiveness in utilising its assets to generate sales.
They are commonly referred to as turnover ratios as they
reflect the number of times a particular asset account
balance turns over during a year

 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 = 0.64 times

Total asset turnover ratio represents the amount of sales

generated per dollar invested in firm’s assets

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Profitability ratios address a very fundamental
question: Has the firm earned adequate returns on
its investments?

To answer this question, the analyst turns to two

measures:
1. The firm’s profit margins to predict the ability to
control expenses
2. The firm’s rate of return on investments.

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 Net Profit Margin = Net Income / Sales
◦ 363 / 2311 = 15.7%
 EBITDA Margin = EBITDA / Sales
◦ 967 / 2311 = 41.8%
You can also compute the gross profit margin and the operating profit
margin.
 Gross Profit Margin = (Sales – COGS) / Sales
 Operating Profit Margin = EBIT / Sales
 Gross profit margin - measuring how well the firm’s management
controls its expenses to generate profits.
 Operating profit margin – measuring how much profit is
generated from each dollar of sales after accounting for both
costs of goods sold and operating expenses.
 Net profit margin measures how much income is generated from
each dollar of sales after adjusting for all expenses (including
income taxes).

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 Return on Assets (ROA) = Net Income / Total Assets
◦ 363 / 3588 = 10.1%
ROA is a measure of profit per dollar of assets.
 Return on Equity (ROE) = Net Income / Total Equity
◦ 363 / 2591 = 14.0%
ROE is a measure of profit per dollar of equity.

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 PE Ratio = Price per share / Earnings per share
◦ 88 / 11 = 8 times
 PE indicates how much investors are currently willing to pay for $1 of
reported earnings. Higher PEs are often taken to mean that the firm has
significant prospects for future growth.

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

share
◦ 88 / (2591 / 33) = 1.12 times
 Market Capitalization = $88 per share x 33 million shares = $2,904
million
 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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 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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 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 = Profit Margin * Total Asset Turnover * Equity Multiplier

◦ 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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 But both total asset
Net profit margin is
turnover and equity
lower
multiplier are higher

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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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 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 –assumptions about the coming
economic environment

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Sales increase by 20%

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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.

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Sales increase by 25%

Dividend payout ratio = Cash dividends/Net income = $44/132 = 33.3%

The retention ratio or plowback ratio = 88/132= 66.7%

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Sales increase by 25%

Projected dividends paid to shareholders = $165 × 1/3 = $ 55

Projected addition to retained earnings = $165 × 2/3 = 110

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  External Financing Needed (EFN) can also be
calculated as:
 Assets  Spontenious Liabilities
   Sales   Sales  ( PM  Projected Sales)  (1  d )
 Sales  Sales
 (3  250)  (0.3  250)  (0.13  1250  0.667)
 $565

External Financing Needed (EFN): The difference

between the forecasted increase in assets and the forecasted
increase in liabilities and equity.

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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 = 44/ 66 = .667 Internal Growth Rate  ROA  b
1 - ROA  b
.132  .667
  .0965
1  .132  .667
 9.65%

This company can expand at a maximum rate of 9.65 percent per

year without external financing.

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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%

Thus, the Hoffman Company can expand at a maximum rate of 21.36

percent per year without external equity financing
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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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 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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 How do you standardize balance sheets and income
statements?
 Why is standardization useful?
 What are the major categories of financial ratios?
 How do you compute the ratios within each category?
 What are some of the problems associated with
financial statement analysis?

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 What is the purpose of financial planning?
 What are the major decision areas involved in
developing a plan?
 What is the percentage of sales approach?
 What is the internal growth rate?
 What is the sustainable growth rate?
 What are the major determinants of growth?

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 3,4,5,7,8,19,20

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