Finance reserch report based on provided data

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McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Statements and Cash Flow

Chapter 2

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Key Concepts and Skills

  • Understand the information provided by financial statements
  • Differentiate between book and market values
  • Know the difference between average and marginal tax rates
  • Know the difference between accounting income and cash flow
  • Calculate a firm’s cash flow

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Chapter Outline

2.1 The Balance Sheet

2.2 The Income Statement

2.3 Taxes

2.4 Net Working Capital

2.5 Financial Cash Flow

2.6 The Accounting Statement of Cash Flows

2.7 Cash Flow Management

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Sources of Information

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This slide contains hyperlinks to the Wall Street Journal, the NYSE, NASDAQ, the publisher (McGraw), and the SEC.

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2.1 The Balance Sheet

  • An accountant’s snapshot of the firm’s accounting value at a specific point in time
  • The Balance Sheet Identity is:

Assets ≡ Liabilities + Stockholder’s Equity

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Note that Slides 4 through 7 from Chapter 1 could be reused here to emphasize the general structure of the balance sheet.

The left-hand side of the balance sheet lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are a direct result of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.)


Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm.

The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of management’s financing decisions.

Remember that shareholders’ equity consists of several components, and that total equity includes all of these components not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders.

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U.S. Composite Corporation Balance Sheet

2012

2011

2012

2011

Current assets:

Current Liabilities:

Cash and equivalents

$140

$107

Accounts payable

$213

$197

Accounts receivable

294

270

Notes payable

50

53

Inventories

269

280

Accrued expenses

223

205

Other

58

50

Total current liabilities

$486

$455

Total current assets

$761

$707

Long-term liabilities:

Fixed assets:

Deferred taxes

$117

$104

Property, plant, and equipment

$1,423

$1,274

Long-term debt

471

458

Less accumulated depreciation

(550)

(460)

Total long-term liabilities

$588

$562

Net property, plant, and equipment

873

814

Intangible assets and other

245

221

Stockholder's equity:

Total fixed assets

$1,118

$1,035

Preferred stock

$39

$39

Common stock ($1 par value)

55

32

Capital surplus

347

327

Accumulated retained earnings

390

347

Less treasury stock

(26)

(20)

Total equity

$805

$725

Total assets

$1,879

$1,742

Total liabilities and stockholder's equity

$1,879

$1,742

The assets are listed in order by the length of time it would normally take a firm with ongoing operations to convert them into cash.

Clearly, cash is much more liquid than property, plant, and equipment.

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Balance Sheet Analysis

  • When analyzing a balance sheet, the Finance Manager should be aware of three concerns:

Liquidity

Debt versus equity

Value versus cost

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Liquidity

  • Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value
  • Current assets are the most liquid.
  • Some fixed assets are intangible.
  • The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations.
  • Liquid assets frequently have lower rates of return than fixed assets.

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Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.

Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the IM for a more complete discussion of this issue.

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Debt versus Equity

  • Creditors generally receive the first claim on the firm’s cash flow.
  • Shareholder’s equity is the residual difference between assets and liabilities.

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Value versus Cost

  • Under Generally Accepted Accounting Principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost.
  • Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.

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2.2 The Income Statement

  • Measures financial performance over a specific period of time
  • The accounting definition of income is:

Revenue – Expenses ≡ Income

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U.S.C.C. Income Statement

Total operating revenues

Cost of goods sold

Selling, general, and administrative expenses

Depreciation

Operating income

Other income

Earnings before interest and taxes

Interest expense

Pretax income

Taxes

Current: $71

Deferred: $13

Net income

Addition to retained earnings $43

Dividends: $43

The operations section of the income statement reports the firm’s revenues and expenses from principal operations.

$2,262

1,655

327

90

$190

29

$219

49

$170

84

$86

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Total operating revenues

$2,262

Cost of goods sold

1,655

Selling, general, and administrative expenses

327

Depreciation

90

Operating income

$190

Other income

29

Earnings before interest and taxes

$219

Interest expense

49

Pretax income

$170

Taxes

84

Current: $71

Deferred: $13

Net income

$86

Addition to retained earnings: $43

Dividends: $43

The non-operating section of the income statement includes all financing costs, such as interest expense.

U.S.C.C. Income Statement

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Total operating revenues

Cost of goods sold

Selling, general, and administrative expenses

Depreciation

Operating income

Other income

Earnings before interest and taxes

Interest expense

Pretax income

Taxes

Current: $71

Deferred: $13

Net income

Addition to retained earnings: $43

Dividends: $43

Usually a separate section reports the amount of taxes levied on income.

$2,262

1,655

327

90

$190

29

$219

49

$170

84

$86

U.S.C.C. Income Statement

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Total operating revenues

Cost of goods sold

Selling, general, and administrative expenses

Depreciation

Operating income

Other income

Earnings before interest and taxes

Interest expense

Pretax income

Taxes

Current: $71

Deferred: $13

Net income

Retained earnings: $43

Dividends: $43

Net income is the “bottom line.”

$2,262

1,655

327

90

$190

29

$219

49

$170

84

$86

U.S.C.C. Income Statement

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Income Statement Analysis

  • There are three things to keep in mind when analyzing an income statement:

Generally Accepted Accounting Principles (GAAP)

Non-Cash Items

Time and Costs

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GAAP

The matching principle of GAAP dictates that revenues be matched with expenses.

Thus, income is reported when it is earned, even though no cash flow may have occurred.

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There is movement toward integration of GAAP with International standards.

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Non-Cash Items

Depreciation is the most apparent. No firm ever writes a check for “depreciation.”

Another non-cash item is deferred taxes, which does not represent a cash flow.

Thus, net income is not cash.

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Time and Costs

In the short-run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials.

In the long-run, all inputs of production (and hence costs) are variable.

Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.

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2.3 Taxes

  • The one thing we can rely on with taxes is that they are always changing
  • Marginal vs. average tax rates
  • Marginal – the percentage paid on the next dollar earned
  • Average = the tax bill / taxable income
  • Other taxes

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Point out that taxes can be a very important component of the decision making process, but that what they learn about tax specifics now could change tomorrow. Consequently, it is important to keep up with the changing tax laws and to utilize specialists in the tax area when making decisions where taxes are involved.

www: Click on the web surfer icon to go to the IRS web site for the most up-to-date tax information.

It is important to point out that we are concerned with the taxes that we will pay if a decision is made. Consequently, the marginal tax rate is what we should use in our analysis.

Point out that the tax rates discussed in the book are just federal taxes. Many states and cities have income taxes as well, and those taxes should figure into any analysis that we conduct.

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Marginal versus Average Rates

  • Suppose your firm earns $4 million in taxable income.
  • What is the firm’s tax liability?
  • What is the average tax rate?
  • What is the marginal tax rate?
  • If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

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Tax liability:

.15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,360,000

Average rate: 1,360,000 / 4,000,000 = .34 or 34%

Marginal rate comes from the table, and it is 34%

We should use the marginal rate with an expected additional $340,000 in taxes.

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2.4 Net Working Capital

Net Working Capital ≡

Current Assets – Current Liabilities

  • NWC usually grows with the firm

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U.S.C.C. Balance Sheet

2012

2011

2012

2011

Current assets:

Current Liabilities:

Cash and equivalents

$140

$107

Accounts payable

$213

$197

Accounts receivable

294

270

Notes payable

50

53

Inventories

269

280

Accrued expenses

223

205

Other

58

50

Total current liabilities

$486

$455

Total current assets

$761

$707

Long-term liabilities:

Fixed assets:

Deferred taxes

$117

$104

Property, plant, and equipment

$1,423

$1,274

Long-term debt

471

458

Less accumulated depreciation

(550)

(460

Total long-term liabilities

$588

$562

Net property, plant, and equipment

873

814

Intangible assets and other

245

221

Stockholder's equity:

Total fixed assets

$1,118

$1,035

Preferred stock

$39

$39

Common stock ($1 par value)

55

32

Capital surplus

347

327

Accumulated retained earnings

390

347

Less treasury stock

(26)

(20)

Total equity

$805

$725

Total assets

$1,879

$1,742

Total liabilities and stockholder's equity

$1,879

$1,742

Here we see NWC grow to $275 million in 2012 from $252 million in 2011.

This increase of $23 million is an investment of the firm.

$23 million

$275m = $761m- $486m

$252m = $707- $455

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2.5 Financial Cash Flow

  • In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.
  • Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.

CF(A)≡ CF(B) + CF(S)

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Remind students that this relation is just an application of the standard balance sheet identity.

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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow

$238

(Earnings before interest and taxes

plus depreciation minus taxes)

Capital spending

-173

(Acquisitions of fixed assets

minus sales of fixed assets)

Additions to net working capital

-23

Total

$42

Cash Flow of Investors in the Firm

Debt

$36

(Interest plus retirement of debt

minus long-term debt financing)

Equity

6

(Dividends plus repurchase of

equity minus new equity financing)

Total

$42

Operating Cash Flow:

EBIT $219

Depreciation $90

Current Taxes -$71

OCF $238

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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow

$238

(Earnings before interest and taxes

plus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assets

minus sales of fixed assets)

Additions to net working capital

Total

Cash Flow of Investors in the Firm

Debt

(Interest plus retirement of debt

minus long-term debt financing)

Equity

(Dividends plus repurchase of

equity minus new equity financing)

Total

Capital Spending

Purchase of fixed assets $198

Sales of fixed assets -$25

Capital Spending $173

-173

-23

$42

$36

6

$42

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Note that capital spending can also be calculated as:

End NFA – Beg NFA + Depr

= $1,118 - $1,035 + $90 = $173

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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow

$238

(Earnings before interest and taxes

plus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assets

minus sales of fixed assets)

Additions to net working capital

Total

Cash Flow of Investors in the Firm

Debt

(Interest plus retirement of debt

minus long-term debt financing)

Equity

(Dividends plus repurchase of

equity minus new equity financing)

Total

NWC grew from $275 million in 2010 from $252 million in 2009.

This increase of $23 million is the addition to NWC.

-173

-23

$42

$36

6

$42

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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow

$238

(Earnings before interest and taxes

plus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assets

minus sales of fixed assets)

Additions to net working capital

Total

Cash Flow of Investors in the Firm

Debt

(Interest plus retirement of debt

minus long-term debt financing)

Equity

(Dividends plus repurchase of

equity minus new equity financing)

Total

-173

-23

$42

$36

6

$42

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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow

$238

(Earnings before interest and taxes

plus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assets

minus sales of fixed assets)

Additions to net working capital

Total

Cash Flow of Investors in the Firm

Debt

(Interest plus retirement of debt

minus long-term debt financing)

Equity

(Dividends plus repurchase of

equity minus new equity financing)

Total

Cash Flow to Creditors

Interest $49

Retirement of debt 73

Debt service 122

Proceeds from new debt sales -86

Total $36

-173

-23

$42

$36

6

$42

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Cash flow to creditors can also be calculated as:

Interest paid – Net new borrowing = Interest paid – (End LT Debt – Beg LT Debt)

=$49 – ($471 - $458) = $36

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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow

$238

(Earnings before interest and taxes

plus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assets

minus sales of fixed assets)

Additions to net working capital

Total

Cash Flow of Investors in the Firm

Debt

(Interest plus retirement of debt

minus long-term debt financing)

Equity

(Dividends plus repurchase of

equity minus new equity financing)

Total

Cash Flow to Stockholders

Dividends $43

Repurchase of stock 6

Cash to Stockholders 49

Proceeds from new stock issue -43

Total $6

-173

-23

$42

$36

6

$42

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U.S.C.C. Financial Cash Flow

Cash Flow of the Firm

Operating cash flow

$238

(Earnings before interest and taxes

plus depreciation minus taxes)

Capital spending

(Acquisitions of fixed assets

minus sales of fixed assets)

Additions to net working capital

Total

Cash Flow of Investors in the Firm

Debt

(Interest plus retirement of debt

minus long-term debt financing)

Equity

(Dividends plus repurchase of

equity minus new equity financing)

Total

The cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders:

-173

-23

$42

$36

6

$42

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2.5 The Statement of Cash Flows

  • There is an official accounting statement called the statement of cash flows.
  • This helps explain the change in accounting cash, which for U.S. Composite is $33 million in 2010.
  • The three components of the statement of cash flows are:
  • Cash flow from operating activities
  • Cash flow from investing activities
  • Cash flow from financing activities

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It is extremely important to remind students that accounting cash flow and actual cash flow as calculated earlier are different values.

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U.S.C.C. Cash Flow from Operations

To calculate cash flow from operations, start with net income, add back non-cash items like depreciation and adjust for changes in current assets and liabilities (other than cash).

Operations

Net Income

Depreciation

Deferred Taxes

Changes in Assets and Liabilities

Accounts Receivable

Inventories

Accounts Payable

Accrued Expenses

Other

Total Cash Flow from Operations

$86

90

13

-24

11

16

18

-8

$202

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U.S.C.C. Cash Flow from Investing

Cash flow from investing activities involves changes in capital assets: acquisition of fixed assets and sales of fixed assets (i.e., net capital expenditures).

Acquisition of fixed assets

Sales of fixed assets

Total Cash Flow from Investing Activities

-$198

25

-$173

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U.S.C.C. Cash Flow from Financing

Cash flows to and from creditors and owners include changes in equity and debt.

Retirement of debt (includes notes)

Proceeds from long-term debt sales

-$73

86

Total Cash Flow from Financing

$4

Proceeds from new stock issue

43

Dividends

Repurchase of stock

-43

-6

Change in notes payable

-3

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U.S.C.C. Statement of Cash Flows

The statement of cash flows is the addition of cash flows from operations, investing, and financing.

Operations

Net Income

Depreciation

Deferred Taxes

Changes in Assets and Liabilities

Accounts Receivable

Inventories

Accounts Payable

Accrued Expenses

$86

90

13

-24

11

16

18

Other

Total Cash Flow from Operations

$202

-8

Acquisition of fixed assets

Sales of fixed assets

Total Cash Flow from Investing Activities

-$198

25

-$173

Investing Activities

Financing Activities

Retirement of debt (includes notes)

Proceeds from long-term debt sales

-$73

86

Dividends

Repurchase of stock

Proceeds from new stock issue

Total Cash Flow from Financing

-43

43

$4

-6

Change in Cash (on the balance sheet)

$33

Notes Payable

-3

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2.7 Cash Flow Management

  • Earnings can be manipulated using subjective decisions required under GAAP
  • Total cash flow is more objective, but the underlying components may also be “managed”
  • Moving cash flow from the investing section to the operating section may make the firm’s business appear more stable

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Quick Quiz

  • What is the difference between book value and market value? Which should we use for decision making purposes?
  • What is the difference between accounting income and cash flow? Which do we need to use when making decisions?
  • What is the difference between average and marginal tax rates? Which should we use when making financial decisions?
  • How do we determine a firm’s cash flows? What are the equations, and where do we find the information?

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McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Statements Analysis and Financial Models

Chapter 3

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Key Concepts and Skills

  • Know how to standardize financial statements for comparison purposes
  • Know how to compute and interpret important financial ratios
  • Be able to develop a financial plan using the percentage of sales approach
  • Understand 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

  • 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.

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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 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

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The ratios in the following slides will be computed using the 2012 information from the Balance Sheet (Table 3.1) and Income Statement (Table 3.4) given in the text.

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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

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The firm is able to cover current liabilities with it’s 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.

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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

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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 Du Pont Identity as a measure of the firm’s financial leverage.

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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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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.

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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

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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.

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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).

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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 Du Pont identity.

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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%
  • 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 Du Pont 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 Du Pont identity is used to identify factors that affect the ROE.

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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 = 3465
  • EV Multiple = EV / EBITDA
  • 3465 / 967 = 3.6 times

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See Table 3.6, as well as the instructor’s manual (chapter 3 appendix), for a summary list of financial ratios.

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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 firm’s performance is changing through time
  • Peer Group Analysis
  • Compare to similar companies or within industries
  • SIC and NAICS codes

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SIC codes have been used many years to identify industries and allow for comparison with industry average ratios. The SIC codes are limited, however, and have not kept pace with a rapidly changing environment. Consequently, the North American Industry Classification System was introduced in 1997 to alleviate some of the problems with SIC codes.

Click on the web surfer to go the NAICS home page. It provides information on the change to the NAICS and conversion between SIC and NAICS codes.

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3.3 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.

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Calculating the DuPont Identity

  • 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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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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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

  • 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)
  • Economic Assumptions – explicit assumptions about the coming economic environment

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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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Percent of Sales and EFN

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

*

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.

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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

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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.

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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
  • b = .667

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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.

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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.

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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

  • 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

  • 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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