Lecture 5

McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
3.2 Ratio Analysis
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 companys ratio?

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Categories of Financial Ratios
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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Computing Liquidity Ratios
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
What does having high short-term solvency
ratios imply? Good or bad?
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Computing Leverage Ratios
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
What does having high long-term solvency
ratios imply? Good or bad?
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Computing Coverage Ratios
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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Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold /
Inventory
1344 / 422 = 3.2 times
Days Sales in Inventory = 365 / Inventory
Turnover
365 / 3.2 = 114 days
What would make you under or overestimate
these values?
Remedy?
3-7
Computing Receivables Ratios
Receivables Turnover = Sales / Accounts
Receivable
2311 / 188 = 12.3 times
Days Sales in Receivables = 365 /
Receivables Turnover
365 / 12.3 = 30 days
What would make you under or overestimate
these values?
Remedy?
3-8
Computing Total Asset Turnover
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.
What can be good and bad about a high TAT?

3-9
Computing Profitability Measures
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%

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Computing Market Value Measures
Earning Per Share = NI / Shares Outstanding

PE Ratio = Price per share / Earnings per share

Market to Book Ratio = Market Value per Share/Book Value

per Share

Market Capitalization = $88 per share x 33 million shares =

2904 million

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Using Financial Statements
Ratios are not very helpful by themselves: they
need to be compared to something
Time-Trend Analysis
Used to see how the firms performance is
changing through time
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes
Cross price elasticities
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3.3 The Du Pont Identity
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

3-13
Using the Du Pont Identity
ROE = PM * TAT * EM
Profit margin is a measure of the firms operating
efficiency how well it controls costs.
Total asset turnover is a measure of the firms asset
use efficiency how well it manages its assets.
Equity multiplier is a measure of the firms financial
leverage.
By decomposing the ROE, we can investigate the
reasons behind a low or high ROE.
How can you improve ROE? What happens if EM
goes up? 3-14
 DuPont Example:

Suppose you are comparing the DuPont decomposition of two companies,

Company I and Company II, operating in the same industry.

ROEI = PMI * TATI * EMI

ROEII = PMI I* TATI I* EMII

Suppose that I has a lower ROE compared to II even though they have similar PM
and TAT. Therefore, we can deduce that I has a lower Equity Multiplier
(remember that EM = Assets/Equity).
I uses less debt compared to II as a percentage of its assets.
II can maintain similar PM even with financing costs.
We can deduce that everything else being equal, company I is doing a better
job managing its finances and offering a higher ROE to its investors.

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Potential Problems
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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Quick Quiz
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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3.4 Financial Models
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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Financial Planning Ingredients
Economic Assumptions explicit assumptions about the
coming economic environment
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) 3-19
Percent of Sales Approach
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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Percent of Sales Approach
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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A Simple Financial Planning Example

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Another Financial Planning Example

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Another Financial Planning Example - continued

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Another Financial Planning Example
continued
1st step in balancing the Balance Sheet

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Another Financial Planning Example
continued
Bal. Sheet balanced assumption: NWC stays the same

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 Percent of Sales and EFN

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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3.5 External Financing and Growth
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
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
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
ROE b
b = .667 Sustainabl e Growth Rate
1 - ROE b
.264 .667
.214
1 .264 .667
21.4%
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 Relationship between growth rate and EFN
in (Assets-
in (Assets- SponLiab)
SponLiab)
and in RE in RE

g
Two things to note: EFN<0 surplus EFN>0 deficit
1. Note that in (Assets-SponLiab) starts at the origin. If the company does not grow (g=0%) there is no need to increase assets or change
spontaneous liabilities. (Per year, sales will take place as before, existing assets will be used and depreciation amount, which is taken
off as cost, can be used to replace the depreciating asset. in RE starts at a positive value. Note that if the company does not grow, it
will still have revenue, albeit as before. Hence, if company had positive profit and kept some of it as RE, without anygrowth, the same
amount of revenue and in RE will be obtained.
2. There is a differential in the slopes of two lines which allows a unique intersection and the existence of IGR. The Slope of the white
line is equal to in Assets-SponLiab per percentage growth rate. The slope of the yellow line is equal to in RE per percentage growth
rate. Since assets are expected to be used over time, it is reasonable to expect the sales to be smaller and profit and addition to RE even
smaller than assets. 3-31
Determinants of Growth
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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3.6 Some Caveats
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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Quick Quiz
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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