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Chapter3.FinancialStatementsAnalysisandFinancialModels1.pptx

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Financial Statements Analysis and Financial Models

Chapter 3

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Key Concepts and Skills

Standardize financial statements for comparison purposes

Compute and interpret important financial ratios including the famous DuPont Identity

Develop a financial plan using the percentage of sales approach

Discern how capital structure and dividend policies affect a firm’s ability to grow

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Chapter Outline

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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3.1 Financial Statements Analysis

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

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Common-Size Financial Statements

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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Prufrock Corporation Comparison: Financial & Common Size Balance Sheet

Balance Sheet

Common Size Balance Sheet

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You may wish to point out that all captions on the common size sheet are expressed as a percentage of total assets.

Income Statement

Common Size Income Statement

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Insert Table 3.4 Here

Insert Table 3.5 Here

PRUFROCK CORPORATION COMPARISON: FINANCIAL & COMMON SIZE INCOME STATEMENTS

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3.2 Ratio Analysis

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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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

Following examples all based on Tables 3.1 & 3.4 (on previous slides)

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The ratios in the following slides will be computed using the 2017 information from the Balance Sheet (Table 3.1) and Income Statement (Table 3.4) given in the text.

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

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The firm is able to cover current liabilities with its current assets by a factor of 1.3 to 1. The ratio should be compared to the industry – it’s possible that this industry has a substantial amount of cash flow and that they can meet their current liabilities out of cash flow instead of relying solely on the liquidation of current assets that are on the books.

The quick ratio is quite a bit lower than the current ratio, so inventory seems to be an important component of current assets.

This company carries a low cash balance. This may be an indication that they are aggressively investing in assets that will provide higher returns. We need to make sure that we have enough cash to meet our obligations, but too much cash reduces the return earned by the company.

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

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Note that these are often called solvency ratios.

TE = total equity, and TA = total assets. The numerator in the total debt ratio could also be found by adding all of the current and long-term liabilities.

The firm finances approximately 28% of its assets with debt.

Another way to compute the D/E ratio if you already have the total debt ratio:

D/E = Total debt ratio / (1 – total debt ratio) = .28 / .72 = .39

Note the rounding error as compared to the direct method applied in the slide.

The EM is one of the ratios that is used in the DuPont Identity as a measure of the firm’s financial leverage.

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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Remember that depreciation (and amortization) is a non-cash deduction. A better indication of a firm’s ability to meet interest payments may be to add back the depreciation and amortization to get an estimate of cash flow before taxes.

You can also calculate a type of inverse value as follows:

Interest Bearing Debt / EBITDA = (196 + 457) / 967 = .68

Values less than one are indicative of a stable position.

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

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Inventory turnover can be computed using either ending inventory or average inventory when you have both beginning and ending figures. It is important to be consistent with whatever benchmark you are using to analyze the company’s strengths or weaknesses.

It is also important to consider seasonality in sales. If the balance sheet is prepared at a time when there is a large inventory build-up to meet seasonal demand, then the inventory turnover will be understated and you might believe that the company is not performing as well as it is. On the other hand, if the balance sheet is prepared when inventory has been drawn down due to seasonal sales, then the inventory turnover would be overstated and the company may appear to be doing better than it really is. Averages using annual data may not fix this problem. If a company has seasonal sales, you may want to look at quarterly averages to get a better indication of turnover.

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

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Technically, the sales figure should be credit sales. This is often difficult to determine from the income statements provided in annual reports. If you use total sales instead of credit sales, you will overstate your turnover level. You need to recognize this bias when credit sales are unavailable, particularly if a large portion of the sales are cash sales.

As with inventory turnover, you can use either ending receivables or an average of beginning and ending.

You also run into the same seasonal issues as discussed with inventory.

Probably the best benchmark for days’ sales in receivables is the company’s credit terms. If the company offers a discount (1/10 net 30), then you would like to see days’ sales in receivables less than 30. If the company does not offer a discount (net 30), then you would like to see days’ sales in receivables close to the net terms. If days’ sales in receivables is substantially larger than the net terms, then you first need to look for biases, such as seasonality in sales. If this does not provide an explanation for the difference, then the company may need to take another look at its credit policy (who it grants credit to and its collection procedures).

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.

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Having a TAT of less than one is not a problem for most firms. Fixed assets are expensive and are meant to provide sales over a long period of time. This is why the matching principle indicates that they should be depreciated instead of immediately expensed.

This is one of the ratios that will be used in the DuPont identity.

Computing Profitability Measures

Profit Margin = Net Income / Sales

363 / 2311 = 15.7%

Return on Assets (ROA) = Net Income / Total Assets

363 / 3588 = 10.12%

Return on Equity (ROE) = Net Income / Total Equity

363 / 2591 = 14.01%

EBITDA Margin = EBITDA / Sales

967 / 2311 = 41.8%

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You can also compute the gross profit margin and the operating profit margin.

GPM = (Sales – COGS) / Sales

OPM = EBIT / Sales

Profit margin is one of the components of the DuPont identity and is a measure of operating efficiency. It measures how well the firm controls the costs required to generate the revenues. It tells how much the firm earns for every dollar in sales. In the example, the firm earns almost $0.16 for each dollar in sales.

Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return on investment). As with many of the ratios, there are variations in how they can be computed. The most important thing is to make sure that you are computing them the same way as the benchmark you are using.

ROE will always be higher than ROA as long as the firm has debt (and ROA is positive). The greater the leverage, the larger the difference will be. ROE is often used as a measure of how well management is attaining the goal of owner wealth maximization. The DuPont identity is used to identify factors that affect the ROE.

Computing Market Value Measures

Market Capitalization = $88 per share x 33 million shares = 2904 million

PE Ratio = Price per share / Earnings per share

88 / 11 = 8 times

Market-to-book ratio = Market value per share / Book value per share

88 / (2591 / 33) = 1.12 times

Enterprise Value (EV) = Market capitalization + Market value of interest bearing debt – Cash

2904 + (196 + 457) – 98 = 3459 million

EV Multiple = EV / EBITDA

3459 / 967 = 3.6 times

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Summary of Ratio Formulae

Insert Table 3.6 Here

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Using Financial Ratios

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 Reuters

Use the Financials link to get comparative ratios for many companies

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3.3 The DuPont Identity

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)

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Interaction between profit, assets and leverage is discussed in the following excerpt from the text:

“Weakness in either operating or asset use efficiency (or both) will show up in a diminished return on assets, which will translate into a lower ROE. Considering the DuPont Identity, it appears that ROE could be leveraged up by increasing the amount of debt in the firm. However, notice that increasing debt also increases interest expense, which reduces profit margins, which acts to reduce ROE.”

Derivation of The DuPont 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

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Using the DuPont Identity

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

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Improving our operating efficiency or our asset use efficiency will improve our return on equity. If the TAT is low compared to our benchmark, then we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong, then we can look at fixed asset turnover and cash management.

We can also improve our ROE by increasing our leverage – up to a point. Debt affects a lot of other factors, including profit margin, so we have to be a little careful here. We want to make sure we have enough debt to utilize our interest tax credit effectively, but we don’t want to overdo it.

Calculating the DuPont Identity

ROA = 10.12% and EM = 1.39

ROE = 10.12% * 1.39 = 14.01%

PM = 15.7% and TAT = 0.64

ROE = 15.7% * 0.64 * 1.39 = 14.0%

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Potential Problems in Financial Analysis

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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3.4 Financial Models

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

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Financial Planning Ingredients

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

Plug Variable – depends on type of financing to be used (makes the balance sheet balance)

Economic Assumptions – state of the economy, anticipated changes in interest rates, inflation

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Percent of Sales Approach: Income Statement

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

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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Percent of Sales Approach: Example of Income Statement

Indicate 25% Sales Growth Assumption

Insert Table 3.8 Here

Insert Table 3.9 Here

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Indicate 25% Sales Growth Assumption

Highlight Plugs (Notes Payable $225 & LTD $340)

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Insert Table 3.10 Here

Insert Table 3.11 Here

PERCENT OF SALES APPROACH: EXAMPLE OF BALANCE SHEET

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Plug is derived as follows:

Need for additional assets is $750

Spontaneous increase in AP (75) and Retained Earnings (110) account for 185 of the amount required, leaving 565 of EFN

Company will not sell new equity, so EFN can come from notes payable and LTD

In this case, the company will assume $225 in new notes payable which results in a constant Current Ratio

The company also assumes 340 of new LTD

Net, the EFN plug is 225 of new notes payable; and 340 of new LTD

Percent of Sales and EFN

External Financing Needed (EFN) can also be calculated as:

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The first term measures the increase in assets, which is based on the capital intensity ratio. The second and third terms capture the increase in liabilities and equity, respectively.

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 is the maximum growth rate using retained earnings as the only source of financing

In other words, the IGR is the maximum growth rate with no EFN of any kind

Using the information from the Hoffman Co.

ROA = 66 / 500 = .132

b = 44/ 66 = .667

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The information for these calculations is given in Table 3.13. This firm could grow assets at 9.65% without raising additional external capital.

Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in later chapters, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.

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

b = .667

Sustainable Growth Rate

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Note that no new equity is issued.

The sustainable growth rate is substantially higher than the internal growth rate. This is because we are allowing the company to issue debt as well as use internal funds.

Commonly, sustainable growth is calculated as only the numerator of our formula (ROE * b), but this assumes we calculate ROE based on beginning, rather than ending, equity.

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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The first three components come from the ROE and the Du Pont identity.

It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important so long as it continues to maximize shareholder value.

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

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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Quick Quiz (continued)

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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