Chapter 3: Financial Statement

Analysis and Financial Models

Corporate Finance

By
Abdullah Al Masud
Lecturer, Southeast University
Using Financial Ratios:
Interested Parties

• Ratio analysis involves methods of calculating and interpreting

financial ratios to analyze and monitor the firm’s performance.
Interested Parties in Ratio Analysis
• Current and prospective shareholders are interested in the firm’s
current and future level of risk and return, which directly affect share
price.
• Creditors are interested in the short-term liquidity of the company and
its ability to make interest and principal payments.
• Management is concerned with all aspects of the firm’s financial
situation, and it attempts to produce financial ratios that will be
considered favorable by both owners and creditors.
Using Financial Ratios:
Types of Ratio Comparisons

• Cross-sectional analysis is the comparison of different

firms’ financial ratios at the same point in time; involves
comparing the firm’s ratios to those of other firms in its
industry or to industry averages
• Benchmarking is a type of cross-sectional analysis in
which the firm’s ratio values are compared to those of a
key competitor or group of competitors that it wishes to
emulate.
• Comparison to industry averages is also popular, as in the
following example.
Using Financial Ratios:
Types of Ratio Comparisons (cont.)

Caldwell Manufacturing’s calculated inventory

turnover for 2019 and the average inventory turnover
were as follows:

Inventory turnover 2019

Caldwell Manufacturing 14.8
Industry average 9.7
Example: Financial Ratios for Select Firms
and Their Industry Median Values

3-5
Using Financial Ratios: Types
of Ratio Comparisons (cont.)

• Time-series analysis is the evaluation of the firm’s

financial performance over time using financial ratio
analysis
• Comparison of current to past performance, using ratios,
enables analysts to assess the firm’s progress.
• Developing trends can be seen by using multiyear
comparisons.
• The most informative approach to ratio analysis combines
cross-sectional and time-series analyses.
Ratio Analysis

 Short Term Solvency or Liquidity Ratios:

 The liquidity of a firm is measured by its ability to
satisfy its short-term obligations as they come
due. Liquidity refers to the ease with which firm can
pay its bills.
Current ratio = Current assets ÷ Current liabilities

Cash Ratio= Cash ÷ Current liabilities

Matter of Fact

 The importance of inventories:

– From Table 3.5:
Company Current ratio Quick ratio
Dell 1.3 1.2
Home Depot 1.3 0.4
Lowes 1.3 0.2
– All three firms have current ratios of 1.3. However, the
quick ratios for Home Depot and Lowes are
dramatically lower than their current ratios, but for
Dell the two ratios are nearly the same. Why?
 Ratio Analysis (cont.)

 Long Term Solvency or Financial Leverage or Debt

Ratios
Debt ratio = Total liabilities ÷ Total assets
Debt-to-equity ratio=Total Liabilities ÷ Shareholders’ Equity
Equity Multiplier=Total Assets ÷Total Shareholders’ Equity
Times interest earned ratio = EBIT ÷ Interest Expense
Cash Coverage Ratio= (EBIT+ Depreciation+ Amortization) ÷ Interest
Expense

N.B The figure for earnings before interest and taxes (EBIT) is the same as
that for operating profits shown in the income statement.
Ratio Analysis (cont.)

 Asset Management or Turnover or Activity Ratios:

Activity ratios measure the speed with which various accounts are
converted into sales or cash—inflows or outflows. For measuring the
activity of most important current accounts, which include inventory,
accounts receivable, and accounts payable. The efficiency with which
total assets are used can also be assessed.

Inventoryturnover = Cost of goods sold ÷ Inventory

Days’ Sales in Inventory or Average Age of Inventory =
365 ÷ Inventory turnover = (365*Inventory)/Cost of Goods Sold
Ratio Analysis (cont.)

 Asset Management or Turnover or Activity Ratios

(cont’d):

 Days’ Sales in Receivables or Average Collection Period=

(365 * Accounts Receivables)/ Sales

 Total Asset Turnover = Sales/ Assets

- Average Payment Period= (365* Accounts Payables)/ Cost of Goods Sold

Ratio Analysis (cont.)

 Profitability Measures:
These ratios show how efficiently the firm uses its
assets and how efficiently the firm manages its
operations. These ratios are expressed in
percentages.
 Net Profit Margin= Net Income/Sales
 EBITDA Margin= EBITDA/Sales
 Return on Assets= Net Income/Assets
 Return on Equity= Net Income/Total Equity
- Gross Profit Margin = Gross Profit/ Sales
Ratio Analysis (cont.)

 Market Ratios or Market Value Measures:

These ratios can be calculated only for public limited
companies. These measures are based on market
price per share of stock. These measures are useful
measures for making investment in assets or shares
of a particular company
 Price- Earnings Ratio (P/E Ratio)= Market Price Per Share/EPS
 Market-to-Book Ratio (P/B Ratio)= Market Price per share/ Book
value per share
 Enterprise value multiple = Enterprise Value/EBITDA
The Du Pont Identity

 Among all the financial ratios, return on equity (ROE

= net income / equity) is probably the most
scrutinized one among practitioners.
 Some practitioners view ROE as the bottom-line
ratio.
 Thus, it is important to understand the sources
(determinants) of ROE.
 The Du Pont Identity is popular among practitioners
because it shows the determinants of ROE.
The Du Pont Identity (cont’d)

 ROE = (NI / sales) × (sales / total assets) × (total assets / equity)

= profit margin × total asset turnover × equity multiplier.
 The Du Pont Identity is the decomposition of ROE.
 ROE is a function of profitability, as measured by
profit margin.
 ROE is a function of asset use efficiency, as
measured by total asset turnover.
 ROE is a function of financial leverage.
An example (Intel)

ROE Profit margin Turnover Multiplier

1993 30.60% 26.13% 0.77 1.51
1994 22.86% 19.86% 0.83 1.38
1995 27.72% 22.01% 0.93 1.36
1996 30.08% 24.73% 0.88 1.38
1997 32.55% 27.70% 0.87 1.35
1998 25.74% 23.10% 0.83 1.33
1999 22.39% 24.89% 0.67 1.34
2000 28.23% 31.24% 0.7 1.28
2001 3.60% 4.86% 0.6 1.24
2002 8.79% 11.65% 0.61 1.25
2003 14.91% 18.72% 0.64 1.25
2004 19.48% 21.97% 0.71 1.25
An example (Intel) (Cont’d)

 Intel’s ROEs seem to trend downward.

 Can you say something about what might
have happen based on the ROE
decomposition?
 It is also sometimes useful to compare the
financial ratios (profit margin, total asset
turnover, equity multiplier, etc.) of Intel with
those of its peers.
Pro Forma Analysis

 It is important for corporate insiders, and outside

investors as well, to project future financial
conditions of a firm.
 The process of projecting future financial conditions
is call pro forma analysis.
 Pro forma analysis is used to generate after-tax cash
flows estimates. This is the reason why we are
studying Chapter 3 after we talked about those
capital budgeting decision rules in Chapter 6.
 The default method that we use in this course is the
percentage of sales approach.
The percentage of sales approach

 The logic of the percentage of sales method

is to assume that many items on the income
statement and balance sheet increase
(decrease) proportionally with sales.
 You should not be afraid to refine the
estimates from this method if you have better
information.
Starting with sales forecasts

 Pro forma analysis starts with a sales forecast.

 For outside investors, there are at least 2 methods
for obtaining sales forecasts:
– Use analysts’ forecasts: Institutional Brokers' Estimate
System (I/B/E/S) regularly surveys analysts about their
expectations on publicly held companies. See
finance.yahoo.com.
– Use companies’ forecasts. Many companies provide sales
estimates in their 10-Ks (Annual Reports). Usually, better
(worse) companies provide conservative (aggressive)
estimates.
 These forecasts serve as starting points.
Pro forma income statement, I

 For income statement, except for depreciation,

interest expense, other income, and special items,
all accounts are assumed to increase (decrease)
proportionally with sales.
 That is, if sales will grow at 10% next year, costs
(expenses) estimate except depreciation will also
increase by 10% next year. This assumption is
based on the observation that when a firm has sales
increase, the firm needs to purchase more raw
materials and needs more labor hours, etc.
Pro forma income statement, II

 Depreciation is usually based on the asset base. It

seems more reasonable to forecast depreciation as
a percent of net plant and equipment. In addition,
many firms provide depreciation estimates; these
numbers are usually of high quality.
 Interest expense is a function of a firm’s financing
decisions which may be independent of the firm’s
operations and sales.
 If an item, e.g., other income and special items, is
one-time in nature, its projected value is zero; unless
you have more information about it.
Pro forma balance sheet, I

 For balance sheet, cash, accounts receivable,

inventories, net plant and equipment, accounts
payable, and accruals are usually assumed to
increase (decrease) proportionally with sales.
 There may be economies of scale in inventories. As
a result, inventories may grow less rapidly than
sales.
 There may be unused capacity in the exiting fixed
assets. Thus, there may be no new fixed assets
needed when sales increase moderately.
Pro forma balance sheet, II

 Adding the additions to retained earnings (=

NI available to common shareholders –
dividends) in year T (income statement) to
the retaining earnings in year T-1, you have
the retained earnings in year T.
 Short-term investments, notes payable, long-
term bonds, preferred stocks, and common
stocks are “plug variables.”
Pro forma balance sheet, III

 Plug variable(s): the source(s) of external

financing (or dividends) needed to deal with
any shortfall (or surplus) in financing and
thereby bring the pro forma balance sheet
into balance.
 At first we usually do not make any change to
the value of a plug variable.
 Of course, this often will not lead to a
balance for the pro forma balance sheet.
External Funds Needed (EFN)

 The difference between the right-hand-side and the

left-hand-side of the statement at this stage is called
“additional funds needed” (AFN) or external funds
needed (EFN).
 If this number is positive, this means that the firm
needs to raise money externally to support the firm’s
growth.

 This amount can be financed by an increase in

notes payable, long-term bonds, preferred stock,
common stock, or a combination of the above.
A reiterative process

 Preparing pro forma statements is a reiterative

process.
 The main reason for this is that the interest expense
in income statement is a function of the financing
policy in balance sheet, while the retained earnings
in balance sheet is a function of the addition to
retained earnings in income statement.
 You will see this clearer when we actually work on
the following mini-case.
Growth and EFN

 When a company experiences sales growth, it needs to

expand and this requires External Financing .
 Rule of thumb: the higher the rate of growth in sales, the
greater will be the need for external financing. Growth in
internal financing, via the increase in Retained Earnings, is
rather slow.
 But, this causality is not purely one way. Financing policy
also affects growth in real life. For example, a company may
expect higher sales, but choose not to borrow or to issue
shares. If the company imposes constraints on financing, it
may raise the prices of its beers to increases profit and slow
down sales growth.
The internal growth rate

 Internal growth rate: the maximum growth

rate that can be achieved with no external
financing of any kind (neither debt nor new
equity).
 Only internally retained earnings are used to
fund growth.
 Internal growth rate = (ROA × b) / ( 1 – ROA × b),
where ROA = NI / total assets, and
b is the retention ratio = addition to retained earnings / NI.
The sustainable growth rate

 Sustainable growth rate (SGR): the maximum growth rate

a firm can achieve with no external equity financing (no
new shares) while it maintains a constant debt-equity
ratio.
 SGR > IGR.
 This is a popular target for growth among many firms.
This is the growth concept that most of Fortune 500
would use.
 Firms do not like to issue new shares because when they
announce new issues, the prices of their old shares fall.
 Firms tend to have a comfort zone for their debt-equity
ratios.
The sustainable growth rate
(cont’d)

 SGR = (ROE × b) / ( 1 – ROE × b), where b is the

retention ratio.
 The higher the retention ratio, the higher the SGR.
 The higher the ROE, the higher the SGR.
 From the Du Pont Identity, we know that ROE is
positively related to (1) profit margin, (2) total asset
turnover, and (3) equity multiplier.
 Thus, SGR is positively related to 4 variables: (1)
retention ratio, (2) profit margin, (3) total asset
turnover, and (4) equity multiplier.
Sustainable Growth Rate (SGR)-
implications

 If a firm wants to pursue a growth rate that is higher

than its SGR, the firm must do at least one of the
following:
(1) retain more earnings within the firm (pay less
dividends),
(2) increase profit margin,
(3) increase total asset turnover,
(4) increase financial leverage (borrow more), or
(5) sell new shares.
End-of-chapter questions

 Concept questions: 3-5.

 Questions and problems: 1-13.