Chapter 3

Financial Statements Analysis and Financial

Models

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
3.1 Financial Statements Analysis
3.2 Ratio Analysis
3.3 The Du Pont Identity
3.4 Financial Models
3.5 Some Caveats Regarding Financial Planning
Models

3-2
 Must develop a good working knowledge of
financial statements
 Making financial statements useful for users
is one finance role
 In order to make meaningful comparisons
of companies of different size financial
professionals use two key techniques:
◦ Common-Size Statements
◦ Financial Ratios

3-3
 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.
 Practice Hint: You may have round percentages in
Common-Size Statements

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 Common Size Balance
Balance Sheet Sheet

3-5
Prufrock Corporation
Comparison: Financial & Common Size Income
Statement
Income Statement Common Size Income
Statement

3-6
 Ratios compliment common size analysis and
allow for deeper comparison through time or
between dissimilar companies
 Not always computed precisely the same;
document your approach
 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

 Following Examples all Based on Tables 3.1 & 3.4

3-8
 Current Ratio = CA / CL
◦ 708 / 540 = 1.31 times

3-9
 Debt/Equity = TD / TE
◦ (3588 – 2591) / 2591 = 38.5%
 Equity Multiplier = TA / TE = 1 + D/E
◦ 1 + .385 = 1.385

3-10
 Times Interest Earned = EBIT / Interest
◦ 691 / 141 = 4.9 times

3-11
 Inventory Turnover = Cost of Goods Sold /
Inventory
◦ 1344 / 422 = 3.2 times

3-12
 Receivables Turnover = Sales / Accounts
Receivable
◦ 2311 / 188 = 12.3 times

3-13
 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.

3-14
 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%

3-15
 Market-to-book ratio = market value per share /
book value per share
 Market value per share is the same as the price per
share
 Book value per share is the same as total equity per
share
 88 / (2591 / 33) = 1.12 times

3-16
 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
◦ Go to www.reuters.com/finance/stocks
 Use the ratios link to get comparative ratios for many
companies

3-17
 Popularized by the DuPont Corporation
 A more sophisticated method of evaluating

return
 Illustrates the interaction between profit,

assets and leverage

 Holds that ROE is actually a function of 3

measures:
◦ Operating Efficiency (Profit Margin)
◦ Asset Use Efficiency (Total Asset Turnover)
◦ Financial Leverage (Equity Multiplier)

3-18
 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

3-19
 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.

3-20
 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.
 Extraordinary, or one-time, events

3-22
 Projection of Future Plans
◦ Short Term or Long Term
◦ Results in Pro-Forma Statements
 Influenced by:
◦ Investment in new assets – capital budgeting
decisions
◦ Degree of financial leverage – capital structure
decisions
◦ Cash paid to shareholders – dividend policy
decisions
◦ Liquidity requirements – net working capital
decisions

3-23
 Sales Forecast –cash flows depend directly on the
level or estimated growth rate of sales
 Pro Forma Statements –Presenting the plan as
projected financial statements (pro forma) allows
for consistency and ease of interpretation
 Asset Requirements – additional assets required to
meet sales projections
 Financial Requirements – financing needed to pay
for the required assets

3-24
 Indicate 25% Sales Growth Assumption

3-25
Percent of Sales Approach – Balance
Sheet

 Indicate 25% Sales Growth Assumption

 In the previous year the firm retained 88/132=2/3 of net
income. Assume the same this year (165*2/3=110). Assume
accounts payable grow at the same rate as sales. This means
that for the pro forma change in liabilities and owner’s equity to
equal the change in assets we require an increase in funds of
565 (565=750-75-110). Which we distributed between notes
payables (225) and LTD (340).

3-26
 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.

3-27