Module3 Lecture Transcript

Introduction to Finance: The Basics
Professor Xi Yang
Module 3: Financial Statements and Cash Flow
Table of Contents
Module 3: Financial Statements and Cash Flow ...................................................................... 1
Lesson 3-1: Module 3 Overview........................................................................................................ 2
Lesson 3-1.1. Module 3 Overview........................................................................................................................ 2
Lesson 3-2: Standardized Statements ............................................................................................... 5

Lesson 3-2.1. Standardized Statements ............................................................................................................... 5
Lesson 3-3: Financial Ratios ............................................................................................................ 13

Lesson 3-3.1. Financial Ratios: Introduction ...................................................................................................... 13
Lesson 3-3.2. Financial Ratios: Liquidity Ratios.................................................................................................. 17
Lesson 3-3.2. Financial Ratios: Leverage Rations ............................................................................................... 25
Lesson 3-3.4. Financial Ratios: Turnover Ratios................................................................................................. 33
Lesson 3-3.5. Financial Ratios: Profitability Ratios............................................................................................. 40
Lesson 3-3.6. Financial Ratios: Market Value Ratios.......................................................................................... 50
Lesson 3-4: Financial Planning ........................................................................................................ 56

Lesson 3-4.1. Financial Forecasting ................................................................................................................... 56
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Lesson 3-1: Module 3 Overview
Lesson 3-1.1. Module 3 Overview
In this module, we'll learn financial statements analysis and financial models. First, I
want you to think about some familiar things in your daily life. Supposed you make an
appointment with a doctor to get an annual checkup. Your doctor will check your
important vital signs, such as your body temperature, pulse rate, rate of breathing, blood
pressure, body mass index and others. Based on these vitals, your doctor will have a
general idea of whether you are healthy or not. For each vital, there's a healthy range.
For example, if your body temperature is in the range of 97 to 99 degrees Fahrenheit,
you are considered normal. For some vitals, only the range information is not enough.
For example, the healthy range of BMI, body mass index for adults is between 18.5 and
24.9. But you cannot use this range to evaluate a two-year-old child. You need to know
the age of a person and compare the vital with the same age group. Here, you may
think these are common sense, but is there anything to do with finance? Yes, what we
are learning today is just the vitals of a company. If we want to know whether a
company is healthy or not, we also need some metrics to help us make the decision.
For each metric, you also need to know what it measures and how to compare it with
similar companies or companies in the same industry. This is just like how you compare
the BMI of a two-year-old with the same age group.
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In the first part of the module, we'll introduce the common size financial statements.
We'll cover topics such as how to derive common size balance sheet and common size
income statement. How to compare the financial performance of a company over years
and compare one company with another.
There are some commonly used financial ratios, each group of the ratios tell us different
aspects of a company. Some financial ratios tell us whether a company can pay its debt
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or not, and others show us whether a company is profitable or not. We'll explore these
ratios in this model. In addition to that, we want to forecast what will happen in the
future. We want to use financial statements to make predictions so that we can make
better management decisions.
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Lesson 3-2: Standardized Statements
Lesson 3-2.1. Standardized Statements
We have learned the basics of financial statements in Module 2. They contain important
information for us to understand the financial situation. However, we cannot use them
directly when we want to compare a company's financial performances.
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Sometimes we want to compare financial statements over time for the same company.
For example, Target is growing, and the size is larger over years. The total assets
increase, and the total revenues increase as well. Only based on absolute dollar values
of financial statements is hard for us to tell whether the performance of Target improves
or not.
The same logic applies when we want to compare a company with its competitors.
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Suppose we want to compare the financial performance of Target and Walmart. It is not
appropriate to say Walmart is better than Target because it has more assets and
produce more net income. We should also take their sizes into consideration.
In order to make comparisons, one way is to convert dollar values to percentages to

create common size statements. Common size balance sheets are derived by dividing
each item by total assets.
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Common size income statements are calculated by dividing each line item by total
revenue. Working with percentages instead of total dollars. Standardized statement
makes it much easier to compare financial information as the company grows. There
are also useful tools for comparing companies of different sizes within the same
industry.
Let's use Target as an example. If we look at the standard dollar version of balance
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sheet as of February 1, 2020, and February 2, 2019, we can tell the current assets,
fixed assets, and total assets all increase. However, we are not sure about the structural
change of each item. Total liabilities and the shareholders equity also rise. But we don't
know which one increases more proportionally. When we use each line item divided by
the total assets of that year, we get the common size balance sheet for Target.
We can see that there's a small decrease in total current assets in terms of proportion.
Current assets represent 30.16 percent of total assets in 2020, compared with 30.32
percent a year earlier. The fraction of fixed assets increased from 69.84 percent in 2019
to 69.68 percent in 2020. Because Target invested heavily in its property, plant and
equipment.
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There is a 2.5 percent drop in the fraction of current liabilities, which is bigger than the
drop in current assets. From this comparison, we can tell Target is in a better position to
pay its current liabilities. Target also increases its fraction of long-term liabilities by 2.2
percent, meaning liabilities are shifting from short-term to long-term.
The fraction of total shareholders' equity increased by 0.3 percent. One advantage of
common size balance sheet is that it is easy to spot any insignificant changes in a firm's
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balance sheet. Now, we want to introduce the common size income statement.
Common size income statements include an additional column of data. We should
express each line item as a percentage of total revenue.
Here is the common size income statement for Target. All percentages are calculated
using total net revenue as the base. For example, the percentage of cost of sales is
70.24 percent, which is calculated using $54.86 billion dollars of cost of sales divided by
total net revenue, $78.11 billion dollars. It represents that the direct cost of sales
accounts for about 70.24% of total net revenue. In addition, the selling general and
administrative expenses account for 20.78 percent of total net revenue. About 0.6
percent of sales are used to pay interest, and 1.16 percent are used to pay taxes. The
net income is 4.2 percent of total revenue. Common size income statements enable us
to compare trends and changes in a business.
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Common size financial statements are also used to compare companies within the
same industry. We put the common size income statement of Target and Walmart side-
by-side and study the difference between these two companies. Walmart's total
revenue, $523.96 billion dollars, is much larger than Target's, $78.11 billion dollars total
revenue. When we compare the common size income statement, we noticed that
Target's cost of sales as a percentage of total revenue is 5 percent lower than Walmart,
generating a higher gross margin percentage. Target's selling general and
administrative expenses is slightly higher than Walmart. Target's interest expenses and
taxes percentages are also a bit higher than Walmart. Target's net income percentage
is 1.36 percent higher than Walmart which means for each dollar of sales, Target
generates more net income than Walmart.
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Lesson 3-3: Financial Ratios
Lesson 3-3.1. Financial Ratios: Introduction
In addition to the common-size financial statements, there's another way to evaluate the
performance of a company, which is called financial ratio analysis. When you first hear
about financial ratios, you may feel it's hard. Actually, you use ratios a lot in your daily
life but you may not realize you are making mathematical calculations. For example,
when we want to buy a car, we care about its fuel efficiency. Using the miles traveled
divided by how many gallons of gasoline used, we got a ratio called miles per gallon. If
the car has a high miles per gallon number, it means we can save a lot of money on
gasoline and produce less pollution. Just like the miles per gallon example, when we
use financial ratio analysis, we need to know how the ratio is calculated, what it
measures, a high value is better, or a low value is better, and how to improve the value
through financial management. In order to evaluate the performance of the company,
we need to compare them with something. There are two major ways of comparison.
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One way is to perform time-trend analysis, which means we compare the performance
of a company with its past to see whether there's any improvement or not.
Another way is to perform peer group analysis. We compare the financial ratios of a
company with its major competitors and industry average.
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In this module, we want to compare the financial performance of Target to Walmart in

2020 because both are large retailers, and they can be considered as competitors.
Financial ratios can be divided into several categories. Short-term liquidity ratios, which
measures the liquidity of a company, long-term solvency ratios, which evaluates
financial leverage of a company, asset turnover ratios, which tells us the efficiency of
asset management, profitability ratios, and market value ratios.
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Lesson 3-3.2. Financial Ratios: Liquidity Ratios
We want to start our ratio analysis from liquidity ratios. Liquidity ratios evaluate a
company's ability to pay its short-term liabilities. Several common liquidity ratios include
the current ratio, quick ratio, cash ratio and the operating cash flow ratio.
The current ratio is a ratio of a company's current assets to its current liabilities. The
ratio measures a company's ability to pay its short-term liabilities using cash accounts
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receivable, and inventory. We calculate the current ratio using the balance sheet
information of Target and Walmart for the physical year 2020.
Target's current ratio is 0.89, which means for each dollar in current liabilities, Target
has 89 cents to pay off his debt. Walmart has 79 cents in current assets for each dollar
of current liabilities. When we compare the current ratio of Target and Walmart, we find
that Target's current ratio is higher than Walmart, which means its liquidity is better.
When we use current ratio to make comparisons, there's one problem we need to be
aware of. Current assets are made of three major parts and their liquidities are quite
different.
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Cash and cash equivalents are the most liquid asset within the current assets' family.
Then followed by accounts receivable, inventory is the least liquid current asset.
Suppose there are two companies and they have exactly the same current ratio, but
one with more inventory and another one maintains large accounts receivable. Of
course, the liquidities of these two companies should not be the same. This is why we
want to introduce another liquidity ratio in addition to current ratio.
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The second liquidity ratio we want to introduce is the quick ratio, which is also called
acid test ratio. It can be calculated as the sum of cash, marketable securities and
accounts receivable divided by current liabilities. The numerator can also be considered
as current assets without inventory and prepaid expenses, since their liquidity is not as
good as cash and accounts receivable.
We calculate the quick ratio for Target and Walmart, and we find that targets quick ratio
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0.24 is higher than Walmart's 0.2, indicating Target is in a better position to pay its
current liabilities using the more liquid portion of its current assets. Another observation
is that the quick ratios of these two companies are much lower than their current ratios
because inventory and prepaid expenses are more than half of their current assets.
Quick ratio is a more conservative measure of liquidity than current ratio and it is more
useful when inventory percentage is high.
A company's cash ratio is the ratio of cash and cash equivalents to its current liabilities.
It is considered as the most conservative liquidity ratio because it only considers cash
and near cash financial securities. This ratio is used more often to evaluate a company
in financial distress. Because at that time, the company is very hard to convert its
accounts receivables and inventory into cash in a short period of time.
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We compute the cash ratio for Target and Walmart. Target's cash ratio 0.18 is higher
than Walmart 0.12, which means Target's, proportional cash balance is more adequate
than Walmart. When we study the cash ratio of a company, we also need to realize that
there is a tradeoff of holding too much cash. Although creditors are happy to see the
company holding a lot of cash because they can be paid off cash and near cash
securities have low returns compared with other assets Financial managers need to
keep appropriate level of cash balance based on the nature of the industry and
company characteristics.
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Operating cash flow ratio evaluates the capacity a company's cash generated from
operating activities to pay its current liabilities.
It is calculated by dividing the cash flow from operations by the company's total current
liabilities. You can get the cash flow from operations from a company's statement of
cash flows and the current liabilities from the balance sheet.
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Target's operating cash flow ratio 0.49 is higher than Walmart's 0.32, which indicates a
higher capacity to pay its current liabilities out of its operating cash flow. Combining the
current ratio, the quick ratio, the cash ratio, and the firm's operating cash flow ratio, you
can generate a solid view of a company's ability to pay its short-term bills. These are
commonly used metrics that lenders often look at in the long approval process.
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Lesson 3-3.2. Financial Ratios: Leverage Rations
We have learned that liquidity ratios are used to measure a company's short-term
obligations. Now, we want to talk about how to value a company's ability to pay the total
financial obligations. The ratios to help us do the job is called solvency ratios or
leverage ratios. We will introduce three widely used solvency ratios: total debt ratio,
equity multiplier, and the interest coverage ratio.
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The total debt ratio is a ratio of total liabilities to total assets. Here we use a very broad
version of debt, which includes all current liabilities and long-term liabilities. But in some
other versions, the total debt doesn't include items such as accounts payable and
accrued expenses. When you use these ratios, you'll also need to investigate whether
they use the broad version of debt or the narrow version.
Target's debt ratio is computed as 72.34 percent, which means it finances about 72.34
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percent of its assets with debt and the remaining 27.66 percent with equity. Walmart's
debt ratio is lower than that. It has 65.52 percent of debt and 34.38 percent of equity.
Target uses more debt than Walmart, but these ratios are in line with the industry
average. For retail industry, the average total debt ratio is about 60-65 percent.
The equity multiplier is defined as total assets divided by total shareholders' equity. The
equity multiplier indicates how much equity financing a company uses. If we know the
total debt ratio, we can also calculate the equity multiplier based on that value.
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The equity multiplier measures the capital structure of a company. Target's equity
multiplier is higher than Walmart, which means Target relies more on that. Here, you
may have a question.
Is it good to have a high leverage ratio? Our answer is, the leverage ratio should be
within the appropriate range. This range varies by industry and company.
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In order to understand how much leverage is appropriate, we need to know the benefits
and the costs of using that. Using that helps a company to lower its taxes because the
interest payments are tax deductible. However, dividends paid to shareholders are not
tax deductible and come from after-tax net income. Therefore, the cost of debt financing
is usually lower than equity financing. Using that also benefit existing shareholders
because of the financial leverage. When a company finances its operations using debt,
shareholders keep any remaining profits after paying interests. Given the same amount
of equity investments, using more debt will help shareholders to boost their investment
returns.
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On the other hand, debt represents an obligation. If a company fails to pay its interest
expenses, creditors will sue the company and drive the company to file for bankruptcy.
If the company uses too much debt, the business will become too risky for creditors and
investors. In order to protect themselves, they may charge a higher interest rate or
demand a higher return as a compensation. Another long-term solvency measure we
want to introduce is the interest coverage ratio. Sometimes it is also called times
interest earned. There are several versions of this ratio. We adopted the most
commonly used version.
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It is calculated by dividing a company's earnings before interests and taxes, EBIT, by

the company's interest expenses within the physical year. The interest coverage ratio
tells us how easily a company can pay its interest expenses with its earnings.
Target's interest coverage ratio is 9.95, which means the interest expense is covered
9.95 times over. Walmart's interest coverage ratio, 8.9 times, is lower than Target but
still higher than the industry average. We can argue that both companies have no
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problem paying their debt out of their earnings. Normally, the interest coverage ratio is
used by creditors to determine the riskiness of a company's debt. A common view is
that the interest coverage ratio should be at least 1.5. If a company's earnings is less
than 1.5 times the interest payments, the company might be struggling paying its debt.
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Lesson 3-3.4. Financial Ratios: Turnover Ratios
In this part, we want to talk about asset turnover ratios. With the help of these ratios, we
can tell whether a company uses its assets efficiently or not. There are three commonly
used asset turnover ratios: the inventory turnover ratio, days' sales in inventory, and
total asset turnover.
Inventory turnover ratio is the ratio of cost of goods sold to inventory. Cost of goods sold
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comes from the income statement, and it is measured during the fiscal year. Well,
inventory is from the balance sheet, and it is measured at a specific time. So, here
comes a question.
Which inventory should we use? The beginning inventory, the ending inventory, or the
average inventory? To get the answer to this question, you must look for the industry
norm. See how other people compute the inventory turnover, and you just need to
follow their method so that your number is comparable with others.
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For both Target and Walmart, they use the average inventory to compute the inventory
turnover because any extreme values will be smooth. From the table, you can see that
Target sold off or turned over the entire inventory 5.93 times during the year. Now, I
want you to use the information on Walmart to calculate its inventory turnover by
yourself.
Ok! Here's the answer. Walmart sold its inventory 8.9 times during the year. This means
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Walmart sells its new inventory at a faster speed than Target. Normally, retailers favor a
high inventory turnover because holding inventory incurs high holding costs, such as
storage costs, insurance, and the opportunity cost of the money tied up in inventory. A
low inventory turnover may indicate either the company has weak sales or it is holding
too much inventory.
Days' sales in inventory is the inverse of inventory turnover times 365 days. It measures
the average time a company can turn its inventory into sales.
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Based on our calculation, Target's inventory is 62 days on average before it is sold.

Well, Walmart only takes 41 days to sell its inventory on hand. Walmart outperforms
Target according to this metric. We also want to show you some days' in inventory data
for the auto industry.
This table presents the days in inventory for big automakers in the world and the
industry median value. You can see that there's a lot of variations among the
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automakers. For example, Ford has a 33-day supply, which is pretty good compared to
other automakers. If the day in inventory is short, it means the automaker converts the
inventory into cash easily and the inventory is more liquid. Well, Volkswagen's days in
inventory is 89 days. Each company's data can be compared to the industry data, 74
days, to decide whether it is better than the industry average or not.
Total asset turnover is defined as the ratio of total revenues to total assets. Total
revenues come from the income statement while total assets from the balance sheet.
Just like the inventory turnover case, we need to decide which asset value to use. The
beginning value, ending value, or average value. The practice used by Target and
Walmart is to use average assets. But in other industries, this may not be the case.
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Target's total asset turnover is 1.86, which means for every dollar in assets, Target
generates $1.86 dollars in total revenues. Walmart's total asset turnover is higher than
that of Target's, which indicates it's more efficient at generating revenues from its
assets. Both values are higher than their industry average level.
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Lesson 3-3.5. Financial Ratios: Profitability Ratios
In this part, we want to introduce you to several profitability ratios. Gross profit margin,
net profit margin, ROA and ROE. In addition to that, we also want to explore the
relationship between ROA and ROE and learn the DuPont Identity. When investors
decide which company to invest, the profitability ratios are key variables to consider.
The formula for gross profit margin is gross profit divided by total revenues. Gross profit
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is expressed as a company's total revenues minus the cost of goods sold, also called
COGS.
Target's gross profit margin is 29.76%, which is higher than Walmart's gross profit
margin 24.69%. The industry average gross profit margin is about 24% for retail
industry. Gross profit margin is good at evaluating how a company control is direct cost
of operations because the cost of goods sold is a measure of direct costs required to
produce goods or services, not including overhead costs such as utilities, management,
wages and rent. However, gross profit margin cannot capture the whole picture of a
company's profitability. We need other indicators to help us. Net profit margin is the
most widely used metric of profitability. Sometimes people just call it profit margin.
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Net profit margin is calculated by dividing net income by total revenues. Target has a
net profit margin of 4.2%.
A net profit margin of 4.2% means Target generates 4.2 cents in net income for each
dollar in sales. Walmart's net profit margin is lower than that, mainly because its
business model is quite different from Target. The average net profit margin of retail
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industry is 2.5%, which means both companies have a higher net profit margin than the
industry average.
These ratios may look familiar to you. If you still recall when we have learned in the
common-size financial statements, you will find that we calculated the ratios in the
common-size income statement implicitly. Net profit margin is a very important indicator
of a company's financial performance. If a company's net profit margin is in line with the
industry or rising compared to its peers, we know the company is good at generating
profits from its sales and controlling its costs.
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Return on assets is defined as net income divided by total assets. When we use the
ROA numbers, it's important for us to remember that the ROA value is accounting rate
of return.
Both Target and Walmart use average total assets as denominator to calculate their
ROA. Now, why don't you try it out for yourself and see what the ROA for Walmart is.
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Based on the comparison between Target and Walmart, we can argue that Target is
more successful at generating earnings from its total assets.
Return on equity is calculated as net income divided by total equity. In Module 1 we

mentioned that the goal of a corporation is shareholder wealth maximization. ROE is
often used to measure how well management is attaining the goal of shareholder wealth
maximization. Investors are happy to invest a company with high ROE.
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Overall, within the Target is doing a better job than Walmart based on the ROE value.
But at the same time, we are curious, what causes the difference in their performance?
We want to explore the story behind the ROE numbers.
We also want to talk about the relationship between ROE and ROA. If we multiply the
ROE numerator and the denominator by total assets at the same time and then
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manipulate the equation. We derive the relationship that ROE = ROA x Equity Multiplier.
In other words, ROE is different from ROA because of the financial leverage. As long as
a firm has debt, ROE will always be higher than ROA. If the company uses a lot of debt,
ROE will be higher than ROA. Otherwise, these two metrics will be close to each other.
We can further multiply the right-hand side of the equation with total revenues in the
numerator and denominator. After some manipulation, we decompose the ROE into the
product of three components. Net profit margin, total asset turnover and equity
multiplier. This formula is called DuPont identity because it was first adopted by the
DuPont corporation to evaluate the performance of its corporate divisions.
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The DuPont Identity shows us that the ROE is determined by three factors. The first one
is the net profit margin. It evaluates the operation efficiency of a company. The second
one is total asset turnover, which measures the asset use efficiency. The last one,
equity multiplier. It measures the financial leverage of a company.
In this table, we present the result of DuPont Identity for both Target and Walmart. One
small thing is the ROE number is a little bit off because we use the ending values to
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calculate the equity multiplier while we use the average values in total asset turnover.
When we compare Target and Walmart using the DuPont Identity, we find that Target
achieved a higher ROE mainly because it has a higher net profit margin and it uses
more debt than Walmart. Although Walmart manages its assets more efficiently, the
earnings from each sale are low. Here comes the question, how can we improve the net
profit margin? There are two ways you can think of, increase prices and reduce costs.
Increasing prices seems easy, but your customers may switch to your competitors if
they can buy the same product with a lower price. Unless a company has pricing power
and has a lot of loyal customers, increasing prices will harm the business instead of
increasing revenues. Another way is to reduce costs, but you have to make sure that
you can do so without sacrificing the quality of goods and services. Some common
practices, including using the latest technologies to automate the production process
and checking for unnecessary expenses. Another question I want you to think about is,
can we improve a company's ROE by increasing leverage? If you take a look at DuPont
Identity, it seems that we can improve the ROE by increasing equity multiplier. If a
company issues more debt instead of equity, the equity multiplier will increase. At the
same time, the interest payments will also go up. The net profit margin will go down as a
result. Overall, we don't know the ROE will increase or decrease because of these two
opposite effects. Here you may also notice that a lot of financial ratios are linked with
each other. You need to pay attention to their relationship when we use them.
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Lesson 3-3.6. Financial Ratios: Market Value Ratios
In this lesson, I want to show you two market value ratios, P/E ratio and market
capitalization. In order to get these ratios, we also need a current information from the
stock market. The values may have already changed when you learn this part. But I'll
show you where to get the information and how to interpret them. For investors, P/E
ratio is a key variable that they want to look at.
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The P/E ratio is calculated by dividing our company's current share price by earnings
per share. It measures how much investors are willing to pay for each dollar in current
earnings. Here comes a question. Where can we get real-time stock price information?
One place is Yahoo Finance.
Click the link here, and then search for Target Corporation using stock ticker "TGT".
You will get directed to this webpage.
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The current price is listed in red at the very top, $122.33 dollars as of May 29th, 2020.
The earnings per share is $6.36 dollars per share. When you use P/E ratio, there's one
thing you need to pay attention to. When the firm's earning is negative, you can no
longer use the P/E ratio because it doesn't make any sense. Sometimes P/E ratio is
high, not because its share's price is high, but its earnings is close to zero. You need to
interpret the P/E numbers carefully and dig a little bit deeper to investigate its earnings.
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Here is an exercise for you to practice. Please visit Yahoo Finance and check the most
recent information about the P/E ratio for both Target and Walmart and compare which
one achieves a higher P/E ratio. As an investor, which one would you rather pay a
higher price for based on its current earnings?
The market cap is calculated as the current price per share multiplied by the number of
shares outstanding. Market cap measures how much a company is worth in the stock
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market and the investor's perception of its future prospects. For Target, this is $122.33
per share times 499.92 million shares outstanding, which equals to $61.155 billion.
We can divide the companies into three groups based on their market cap. We call a
company large cap when its market value is $10 billion or more. Large-cap firms often
an established company within an industry with high reputation. A steady growth, and
constant dividend payments. Investing in these companies will generate a pretty safe
return for investors. Mid-cap companies have a market value between $2 billion and
$10 billion. These companies are still growing and expanding. Its risks and return are
considered as moderate.
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Small-cap companies are businesses with a market value of $300 million to $ 2 billion.
These are young companies or companies in emerging industries. They are very
vulnerable to business cycles, especially economic downturn. Meanwhile, they deliver
the highest return among these three groups because of their growth potential. This
represents a wonderful choice for those risk-loving investors.
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Lesson 3-4: Financial Planning
Lesson 3-4.1. Financial Forecasting
In this lesson, we want to talk about financial planning. We can also use financial
statements to calculate the financial ratios. Another application of financial statements is
to use them to forecast what is going to happen in the future. We want to introduce you
a commonly used method to do that. It is called percentage of sales approach. The
underlying assumption of this approach is that many items in the income statement and
balance sheet will experience a proportional increase as sales increase.
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We start our analysis from income statement. First, we calculate each item as a
percentage of sales. This step is very similar to what we have done in the common size
income statement analysis. There's one thing I want to mention. The income tax
expense, 21.69 percent is calculated as a percentage of EBT earnings before income
taxes, not a percentage of sales. This number represents the effective tax rate of
Target. Next, we assume that the sales growth is 7 percent next year. This information
is derived from analysts' forecast. You can also check the information through Yahoo
finance. The new total net revenue will grow to $83.58 billion. It is the total net revenue
of 2020, $78.112 billion times 1 plus 7 percent increase. The new cost of sales is
calculated as 70.24 percent times the new sales number. This makes sense because
when sales increase, the associated costs should also increase to support the sales
growth. The growth profit is the total net revenue minus the gross sales. The selling
general and administrative expenses. Depreciation and amortization will also be a
proportion of the new sales value. We use gross profit minus these two cost items to
derive the operating income. EBIT is the same as operating income because there's no
other income. Here, we assume the interest expense is the same as before because
without issuing new debt, the interest expense won't increase. EBT is calculated as
EBIT minus the interest expense. And taxes are derived by EBT times the effective tax
rate, 21.69 percent. The taxes for the next year will increase from $909 million to $980
million because of the increase in pre-tax income. The new net income will increase
from $3.281 billion to $3.536 billion. Now, we have finished the pro forma income
statement.
57
Professor Xi Yang
We are also interested in how the net income is distributed based on the retention ratio
of 2020, 59.2 percent are kept in the company for future investments. We assume the
retention ratio will be the same for next year. The retained earnings will be 59.2 percent
times the new net income, $3.536 billion, which is $2.094 billion. This number will also
be used in the pro forma balance sheet. We start to work with the balance sheet now.
For the left-hand side of the balance sheet, we express all items as a percentage of
sales of 2020. We assume that current assets and fixed assets need to keep pace with
the sales so that the sales increase can be achieved. This is a very strong assumption.
If the company still has some extra capacity, they may not need to invest that much in
fixed assets, and they can still increase their sales. When you collect more information
about the production capacity of the company, you can make further adjustments. But
here we just use this assumption to simplify our analysis. The projected assets are
calculated using the percentage times the new sales level. For the right-hand side of the
balance sheet, only two accounts increase accordingly with sales, accounts payable
and accrued expenses. Because you will have more orders with your suppliers. Other
items won't change automatically with sales. Unless the company issues more debt or
equity, the other items will be the same as before. One thing we also need to take care
of is the retained earnings. From the pro forma income statement, Target generates
more retained earnings and this needs to be added to the current retained earnings.
The retained earnings will be increased by $2.094 billion. All the other items in the
liabilities and equity's part will be the same as before. We take a look at the newly
generated pro forma balance sheet and notice that total assets is $45.774 billion. Well,
total liabilities and equities is $45.875 billion. The projected total liabilities and equity is
58
Professor Xi Yang
higher than the projected assets, meaning Target will generate a surplus of $102 million
with a 7 percent increase in sales. There's no need to obtain upside financing to support
the growth level. For some other companies, if the projected total assets exceed total
liabilities and equity, it means the company needs to seek external financing. The profit
generated by the sales growth itself is not enough to support its growth.
59

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Introduction to Finance: The Basics

Module 3: Financial Statements and Cash Flow

Lesson 3-2: Standardized Statements ............................................................................................... 5

Lesson 3-3: Financial Ratios ............................................................................................................ 13

Lesson 3-4: Financial Planning ........................................................................................................ 56

Lesson 3-1: Module 3 Overview

Lesson 3-1.1. Module 3 Overview

Lesson 3-2: Standardized Statements

Lesson 3-2.1. Standardized Statements

In order to make comparisons, one way is to convert dollar values to percentages to

Lesson 3-3: Financial Ratios

Lesson 3-3.1. Financial Ratios: Introduction

In this module, we want to compare the financial performance of Target to Walmart in

It is calculated by dividing a company's earnings before interests and taxes, EBIT, by

Based on our calculation, Target's inventory is 62 days on average before it is sold.

Return on equity is calculated as net income divided by total equity. In Module 1 we

Lesson 3-4: Financial Planning

Lesson 3-4.1. Financial Forecasting

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