CHAP 3: FINANCIAL STATEMENT ANALYSIS AND FINANCIAL MODELS
Financial Statement Analysis
STANDARDIZING STATEMENTS
The difference in size can affect the comparison between
two or more companies
the same company in different period.
need to standardize the financial statements
working with percentages
common-size statements
COMMON-SIZE BALANCE SHEETS
Percentage of Cash in 2022 = 98/3, 588 * 100 = 2.7 % ⇐ Cash / Total Assets * 100.
accounts as a percent of Total Assets
COMMON-SIZE INCOME STATEMENTS
Common-size income statement tells us what happens to each dollar in sales
eg. Interest expense eats up $0.061 out of every sales dollar.
These percentages are useful in comparisons.
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Compute all
Net income: reflects the differences in capital structure and taxes, as well as operating income.
EPS:
expresses net income on a per share basis.
EPS = Net income / Number of shares outstanding
eg. Prufrock has 33 million shares of stock outstanding.
EPS = 363/33 = 11
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EBIT:
often called “operating income” on the income statement ⇐ earnings before interest and tax.
EBIT = Operation revenues - Operating expenses
it removes the impact of differences in earnings from capital structure (interest expense) and
taxes.
EBITDA:
measure ability to generate cash from operations, or, cash flow available to meet financial
obligations
earnings before interest expense, taxes, depreciation, and amortization
EBITDA = EBIT + Depreciation + Amortization
Amortization is the same as depreciation, but it applies to intangible assets.
eg. EBITDA = 600 + 276 = 876
Ratio Analysis
Financial ratios are used to compare and investigate the relationships between pieces of financial
information.
SHORT-TIME SOLVENCY OR LIQUIDITY MEASURES
Primary concern is the ability to pay its bills over the short run without undue stress
current assets and current liabilities.
focus on
It is essential for short-term creditors.
Advantage: book value and market value of current assets and liabilities are likely to be similar.
Disadvantage: not a reliable guide to the future.
Current Ratio
eg. For Prufrock, Current ration in 2022 is:
Current ratio =708/540 = 1.31 times
The unit is either dollars or times.
Prufrock has $1.31 in current assets for every $1 in current liabilities.
Prufrock has its current liabilities covered 1.31 times over
We expect current ratio to be at least 1.
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Current ratio < 1
current assets < current liabilities
net working capital is negative.
Current ratio is affected by types of transactions
The firm borrows long-term to raise money
long-tern debt Current ratio would rise.
Short run effect would be an increase in cash and
Quick (or Acid-Test) Ratio
Inventory is the least liquid.
Large inventories are often a sign of short-term trouble.
Quick (or Acid-Test) Ratio is used to evaluate liquidity, and inventory is omitted.
Using cash to buy inventory doesn’t affect current ratio, but quick ration.
eg. For Prufrock, this ratio in 2022 is
Quick ratio = (788 − 422)/540 = 0.53 times
Cash Ratio
LONG-TERM SOLVENCY MEASURES
Address long-run ability to meet its obligations, or, financial leverage.
These ratios are called financial leverage ratios or leverage ratios.
Total Debt Ratio
Take into account all debt of all maturities to all creditors.
eg. Prufrock uses 28% debt
$.28 in debt for every $1 in assets
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There is $.72 in equity (= $1 - .28)
Times Interest Earned (TIE)
It measures how well a company has its interest obligations covered
interest coverage ratio
Cash Coverage
ASSET MANAGEMENT OR TURNOVER MEASURES
Describe how efficiently a firm uses the assets we are measuring. ( inventory and receivables)
The measures are called asset management or utilization ratios.
Inventory Turnover and Days’ Sales in Inventory
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It says that we sold off, or turned over, the entire inventory 3.40 times during the year
The higher this ratio is, the more efficiently we are managing inventory (as long as not running out of
stock)
To know how long it took us to turn it over,
Receivables Turnover and Days' Sales in Receivables/ Average Collection period
(ACP)
Notice: Payables Turnover
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Payables Turnover = Cost of Goods sold / Accounts Payable
Total Asset Turnover
In other words, for every dollar in assets, we generated $.64 in sales.
PROFITABILITY MEASURES
Profit Margin
EBITDA Margin
It looks more directly at operating cash flows.
Return on Assets (ROA)
a measure of profit per dollar of assets.
It is also called Return on book assets
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Return on Equity (ROE)
a measure of how the stockholders fared during the year.
It is also called return on book equity or return on net worth.
MARKET VALUE MEASURES
Earning per share
eg. Prufrock has 33 million shares outstanding.
Price-Earnings Ratio
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Market-to-Book Ratio
Book value per share reflects historical costs.
Market Capitalization
Enterprise Value
It will estimate how much it would take to buy all of the outstanding stock of a firm and also to pay off
the debt.
Enterprise Value Multiples
It will estimate the value of total business.
Allow comparisons between companies.
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The DuPont Identity
The DuPont identity tells us that ROE is affected by three things:
Operating efficiency (measured by profit margin)
Asset use efficiency (measured by total asset turnover)
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Financial leverage (measured by the equity multiplier)
Weakness in operating or asset use efficiency (or both) will diminish ROA
lower ROE
PROBLEMS WITH FINANCIAL STATEMENT ANALYSIS
No underlying theory to identify which quantities to look at and to guide us in establishing
benchmarks.
Many firms are conglomerates (đa dạng lĩnh vực), owing more or less unrelated lines of business.
the analysis only works when the firms are on the same line of business, the industry is competitive,
and there is only one way of operating
Major competitors and natural peer group members in an industry may be scattered around the
globe. different countries will have different standards
difficult to compare financial statements
Profitability is affected by the regulatory environment.
Different accounting procedures
Seasonal businesses
fluctuations in accounts
Unusual or transient event may affect financial performance.
Financial Models
Financial statements are the form we use to summarize the projected future financial status of a
company.
PRO FORMA FINANCIAL STATEMENTS
A SIMPLE FINANCIAL PLANNING MODEL
Suppose sales increase by 20%, planners also forecast a 20% increase in cost
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To reconcile two pro forma statements
Can net income = 240 and equity increase 50?
→ Company must have paid out the difference of 240 - 50 = 190 → possibly a cash dividends
Dividends are the “plug" variable”.
If the company does not pay out 190
Addition to retained earnings = 240
→ Equity = 250 + 240 = 490
→ Debt must be retired to keep assets = 600 → Debt = 600 − 490 = 110
→ The amount of retire = 250 − 110 = 140
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Debt is the plug variable
The way the liabilities and owners’ equity change depends on the firm’s financing and dividend
policies
THE PERCENTAGE OF SALES APPROACH
Goal: develop a quick and practical way of generating pro forma statements.
The Income Statement
Project dividend payment
Assume constant fraction of net income in the form of a cash dividend
Dividend pay out ratio
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Retention Ratio/ Plowback Ratio = 1 - Dividend payout ratio
Payout ratio is constant
The Balance Sheet
Assume that some items vary directly with sales
some are not
express each as a percentage of sales
write “n/a" for “not applicable"
Account Payable varies with sales: sales increase
expect A.Payable change “spontaneously"
Capital intensity ratio = Total assets / Sales
It tells the amount of assets needed to generate $1 in sales
The higher the ratio, the more capital intensive is the firm.
The reciprocal of Total Asset Turnover
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If the ratio is constant, $3 in total assets will generate $1 in sales
assets will increase by $300.
Assets increase by 750
Liabilities and equity increase 185
→ Shortfall of 750 - 185 = 565
External financing needed (EPN)
In this case
NOTICE
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sales increase by $100, total
A Particular Scenario
To get $565 in new financing, there are 3 possible sources: short-term and long-term borrowing, and
new equity.
External Financing and Growth
The higher the rate of growth in sales or assets, the greater will be the need for external financing.
Growth is a convenient means of examining the interactions between investment and financing
decisions.
THE RELATIONSHIP BETWEEN EFN AND GROWTH
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Suppose the projected sales are $600 → $100 increase
20% increase
projected addition to retained earnings = New net income * Retention Ratio/ Plowback Ratio = 1 Dividend payout ratio = 79.2 * 44/66 = 52.8
EFN = (600 − 500) − 52.8 = 47.2
Debt-equity ratio was originally 1.0 = 250 / 250. → Assume that company does not wish to sell new
equity.
→ $47.2 in EFN must be borrowed.
→ New Total Debt = 250 + 47.2 = 297.2
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→ New Debt-equity ratio = 297.2/302.8 = 0.98
The need for new assets grows at a much faster rate than the addition to retained earnings →
internal financing provided by the addition to retained earnings rapidly disappears.
FINANCIAL POLICY AND GROWTH
The Internal Growth Rate
The rate the firm can maintain with internal financing only.
At this rate, Increase in sales = Addition to retained earnings
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EFN = 0
The company can expand at a maximum rate of 9.64% per year without external financing.
The Sustainable Growth Rate
The maximum growth rate a firm can achieve with no external equity financing while it maintains a
constant debt-equity ratio.
not increasing its overall financial leverage.
Company can expand at a maximum rate of 21.34 percent per year without external equity financing
Determinants of Growth
ROE is also an important determinant of growth.
Some factors
Profit margin
Dividend policy
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Financial policy
Total asset turnover.
If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy, and
total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate.
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