FIN 468: Intermediate
Corporate Finance
Topic 2–Financial Statements
Larry Schrenk, Instructor
1 (of 22)
Topics

The Statements

Ratio Analysis and Types of Ratios

DuPont Equation

Forecasting Pro Forma Statements
2 (of 22)
The Statements
3 (of 22)
Stock versus Flow
1.
Income Statement
Flow
2.
Balance Sheet
Stock
3.
Statement of Cash Flows Flow
4 (of 22)
Balance Sheet Organization
Assets (LHS)




Firm Value
Organized by
‘Receivable’ Liquidity
Allocation of Firm’s
Investable Funds
Assets Portfolio
Liabilities (RHS)




Claims on Firm Value
Organized by
‘Payable’ Liquidity
Allocation of Return
and Risk to Investors
Claims Portfolio
Income Statement Organization
Sales
– Variable Costs
Gross Costs
– Fixed Costs
EBIT
– Interest
EBT
– Taxes
Net Income
– Dividends
Additions to Retained Earnings
Earnings…▪
From Unit Production
From Total Production
After Financing Included
After Taxes Included
Retained by the Firm ▪
Ratio Analysis and Types
of Ratios
7 (of 22)
Principles
1.
2.
3.
4.
5.
6.
7.
Consider the Perspective
Toolbox Approach
Check Annualization
Beware of Anomalies
Ratios as Red Flags
Use Customized Ratios
No Official Rules
Classification
1.
2.
3.
4.
5.
Short-Term Solvency (Liquidity)
Long-Term Solvency
(Leverage)
Efficiency
Profitability
Market Value
Use

Comparisons

Time-Trend Analysis


Firm’s Performance over Time
Peer Group Analysis

Similar Companies or Industry Analysis
Short-Term Solvency

Form

Purpose



Measure of Short-Term Cash Inflow
Measure of Short-Term Cash Outflow
Short-Term Liquidity
Can the Firm Meet Current Obligations?
Examples

Cash Ratio, Current Ratio, Quick Ratio
Long-Term Solvency:
Degree of Leverage Analysis

Form

Purpose



Measure of Debt
Measure Asset Base
Long-Term Liquidity
Can the Firm Remain Solvent?
Examples

Total Debt Ratio, Debt/Equity Ratio
Long-Term Solvency:
Coverage Analysis
Measure of Short-Term Cash Inflow
Interest Payment

Form

Purpose



Firm Service its Long-Term Obligations?
Is Bankruptcy a Concern?
Examples

Times Interest Earned (TIE), Cash Coverage
Efficiency: Analysis
Sales (or other Benchmark)
Balance Sheet Asset

Form

Purpose

How Efficiently does the Firm Use the Value
Invested in each Asset?



Balance Sheet Assets as Portfolio
Liquidity-Return Trade-Off
Examples

Turnover Analysis
Profitability: Analysis

Form

Purpose



Earnings Cash Flow
Asset Benchmark
Is the Firm Generating Reasonable Earnings
Relative to Total Assets or Equity
NOTE: Accounting Measures
Examples

Return on Assets (ROA), Return on Equity
(ROE)
Market Value: Analysis

No Common Form or Purpose

Use of Market Data

Examples

PE Ratio, Market-to-Book Ratio
Some Cautions





No Underlying Theory
Diversified Firms
Globalization
Varying Accounting Procedures
Different Fiscal Years
DuPont Equation
18 (of 22)
DuPont Equations: Analysis

Decomposition

Analysis, Not Calculation
The DuPont Equation
Net Income
ROE =
Total Equity
Net Income
Sales
Total Assets
=


Sales
Total Assets Total Equity
Profit
Total Assets
Equity
=


Margin
Turnover
Multiplier


Profitability Effeciency

Leverage
Extending the DuPont Equation
Forecasting Pro Forma
Statements
22 (of 22)
Percent of Sales Approach


Some items vary directly (at least
approximately) with sales.
‘Driver’
Percent of Sales Approach

Some items may not vary with sales



Items whose value cannot be easily
changed
Items whose value is determined by other
variables, and
Items under the policy control of the firm:


Financing policy: long-term debt and equity
Payout policy: dividends
Income Statement



Costs may vary directly with sales. Why?
Depreciation and interest expense may not
vary directly with sales. Why?
Dividends generally do not vary directly with
sales. Why?
Balance Sheet–Assets


Generally current assets vary
directly with sales. Why?
Generally long-term assets do not
vary directly with sales. Why?
Balance Sheet–Liabilities



Many current liabilities vary directly with
sales. Why?
But notes payable do not vary with sales.
Why?
Long term debt does not vary with sales.
Why?
Balance Sheet–Equity


How does retained earnings
change?
Changes on equity (and all the
various sub-groups)do not vary
with sales. Why?
External Financing Needed
(EFN)


After applying the percentage of sales
method, the balance sheet will most likely
not balance.
External Financing/Funds Needed (EFN)

difference between


forecasted increase in assets and
the forecasted increase in liabilities and equity.
External Financing Needed
(EFN)

EFN is the new capital that must be raised.



This is often called the ‘plug’
EFN can be negative.
Financing policy determines the type of
instruments to be used, i.e., whether new
funds are raised through debt, equity or
some combination of the two.
Pro Forma Example

Exogenous Parameters

Annual Sales Increase: 10%

Firm Policies:


Payout ratio: 75%
Financing: EFN will be raised through equity.
Pro Forma Example

Color Codes




Red Numbers are those which change with sales,
e.g., accounts receivable.
Blue numbers are those that do not change with
sales, e.g., fixed assets.
Purple numbers are those whose value is
determined by firm policies, e.g., dividends.
Black numbers are values which are entirely a
function of other variables, e.g. retained earnings.
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
COGS
$1,644
Depreciation
$276
EBIT
$391
Interest Paid
$141
EBT
$250
Taxes
Net Income
$85
$165
Dividends
$121
Addition to Ret. Earn.
$44
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
COGS
$1,644
Depreciation
$276
EBIT
$391
Interest Paid
$141
EBT
$250
Taxes
Net Income
Changes with Sales
No Change
Pre-Determined
$85
$165
Dividends
$121
Addition to Ret. Earn.
$44
Follows Policy
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
COGS
$1,644
Depreciation
$276
EBIT
$391
Interest Paid
$141
EBT
$250
Taxes
Net Income
$85
$165
Dividends
$121
Addition to Ret. Earn.
$44
$2,542
Increases by 10%
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
COGS
$1,644 $1,808
Depreciation
$276
EBIT
$391
Interest Paid
$141
EBT
$250
Taxes
Net Income
$85
$165
Dividends
$121
Addition to Ret. Earn.
$44
$2,542
Increases with Sales
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
COGS
$1,644 $1,808
Depreciation
$276
EBIT
$391
Interest Paid
$141
EBT
$250
Taxes
Net Income
$85
$165
Dividends
$121
Addition to Ret. Earn.
$44
$2,542
$276
No Change: No Capital Invest.
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
$2,542
COGS
$1,644 $1,808
Depreciation
$276
$276
EBIT
$391
$458
Interest Paid
$141
$141
EBT
$250
Taxes
Net Income
$85
$165
Dividends
$121
Addition to Ret. Earn.
$44
No Change (Debt Not Changed)
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
$2,542
COGS
$1,644 $1,808
Depreciation
$276
$276
EBIT
$391
$458
Interest Paid
$141
$141
EBT
$250
$317
$85
$108
Taxes
Net Income
$165
Dividends
$121
Addition to Ret. Earn.
$44
Tax Rate is 34%
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
$2,542
COGS
$1,644 $1,808
Depreciation
$276
$276
EBIT
$391
$458
Interest Paid
$141
$141
EBT
$250
$317
$85
$108
$165
$209
Taxes
Net Income
Dividends
$121
Addition to Ret. Earn.
$44
$157
Dividends are 75% of Net Income
Pro Forma Income Statement
Income Statement
2006 pro forma
Sales
$2,311
$2,542
COGS
$1,644 $1,808
Depreciation
$276
$276
EBIT
$391
$458
Interest Paid
$141
$141
EBT
$250
$317
$85
$108
$165
$209
Taxes
Net Income
Dividends
$121
$157
Addition to Ret. Earn.
$44
$52
Add to Retained Earning
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
Accounts Receivable $688
Inventory
$922
Total
$1,908
Fixed Assets
Accounts Payable
$344
Notes Payable
$196
Total
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
CS and Surplus
Goodwill
Retained Earnings $2,041
$600
Total Fixed Asst $1,680
Total Assets
$3,588
Total
$550
$2,591
Total Liabilities/Equity $3,588
pro forma
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
Accounts Receivable $688
Inventory
$922
Total
$1,908
Fixed Assets
$328
Accounts Payable
$344
Notes Payable
$196
Total
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
CS and Surplus
Goodwill
Retained Earnings $2,041
$600
Total Fixed Asst $1,680
Total Assets
$3,588
Total
$550
$2,591
Total Liabilities/Equity $3,588
Increases with Sales
pro forma
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
$328
Accounts Payable
$344
Accounts Receivable $688
$757
Notes Payable
$196
Inventory
$922
Total
$1,908
Fixed Assets
Total
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
CS and Surplus
Goodwill
Retained Earnings $2,041
$600
Total Fixed Asst $1,680
Total Assets
$3,588
Total
$550
$2,591
Total Liabilities/Equity $3,588
Increases with Sales
pro forma
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
$328
Accounts Payable
$344
Accounts Receivable $688
$757
Notes Payable
$196
Inventory
$922
Total
$1,908
Fixed Assets
$1,014
Total
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
CS and Surplus
Goodwill
Retained Earnings $2,041
$600
Total Fixed Asst $1,680
Total Assets
$3,588
Total
$550
$2,591
Total Liabilities/Equity $3,588
Increases with Sales
pro forma
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
$328
Accounts Payable
$344
Accounts Receivable $688
$757
Notes Payable
$196
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$600
Total Fixed Asst $1,680
Total Assets
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$1,080
CS and Surplus
$550
Retained Earnings $2,041
Total
$2,591
Total Liabilities/Equity $3,588
No Change (Fixed Assets)
pro forma
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
$328
Accounts Payable
$344
Accounts Receivable $688
$757
Notes Payable
$196
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$600
Total Fixed Asst $1,680
Total Assets
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$1,080
$600
CS and Surplus
$550
Retained Earnings $2,041
Total
$2,591
Total Liabilities/Equity $3,588
No Change (Fixed Assets)
pro forma
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
$328
Accounts Payable
$344
Accounts Receivable $688
$757
Notes Payable
$196
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
$550
Retained Earnings $2,041
Total
$2,591
Total Liabilities/Equity $3,588
New Total Assets
pro forma
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
$298
$328
Accounts Payable
$344
Accounts Receivable $688
$757
Notes Payable
$196
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
$550
Retained Earnings $2,041
Total
$2,591
Total Liabilities/Equity $3,588
Increase with Sales
pro forma
$378
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
pro forma
$298
$328
Accounts Payable
$344
$378
Accounts Receivable $688
$757
Notes Payable
$196
$196
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
$540
$457
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
$550
Retained Earnings $2,041
Total
$2,591
Total Liabilities/Equity $3,588
No Change (Financing Policy)
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
pro forma
$298
$328
Accounts Payable
$344
$378
Accounts Receivable $688
$757
Notes Payable
$196
$196
$540
$574
$457
$457
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
$550
Retained Earnings $2,041
Total
$2,591
Total Liabilities/Equity $3,588
No Change (Financing Policy)
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
pro forma
$298
$328
Accounts Payable
$344
$378
Accounts Receivable $688
$757
Notes Payable
$196
$196
$540
$574
$457
$457
$550
$550
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
Retained Earnings $2,041
Total
$2,591
Total Liabilities/Equity $3,588
This is will increased once we have determined EFN.
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
pro forma
$298
$328
Accounts Payable
$344
$378
Accounts Receivable $688
$757
Notes Payable
$196
$196
$540
$574
$457
$457
$550
$550
Retained Earnings $2,041
$2,093
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
Total
$2,591
Total Liabilities/Equity $3,588
Retained Earnings = 2,041 + 52 (from the Income Statement) = 2,093
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
pro forma
$298
$328
Accounts Payable
$344
$378
Accounts Receivable $688
$757
Notes Payable
$196
$196
$540
$574
$457
$457
$550
$550
Retained Earnings $2,041
$2,093
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
Total
$2,591
$2,643
Total Liabilities/Equity $3,588
$3,675
EFN = Total Assets – Total Liabilities = 3,588 – 3,675 = 104
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
pro forma
$298
$328
Accounts Payable
$344
$378
Accounts Receivable $688
$757
Notes Payable
$196
$196
$540
$574
$457
$457
$550
$654
Retained Earnings $2,041
$2,093
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
Total
$2,591
$2,747
Total Liabilities/Equity $3,588
$3,779
Increase Stock by EFN = 550 + 104 = 654
Pro Forma Balance Sheet
Balance Sheet
2006
pro forma
2006
Assets
Liabilities and Owner's Equity
Current Assets
Current Liabilities
Cash
pro forma
$298
$328
Accounts Payable
$344
$378
Accounts Receivable $688
$757
Notes Payable
$196
$196
$540
$574
$457
$457
$550
$654
Retained Earnings $2,041
$2,093
Inventory
$922
$1,014
Total
$1,908
$2,099
Fixed Assets
$1,080
$600
$600
Total Fixed Asst $1,680
$1,680
Total Assets
Long-Term Debt
Owner's Equity
Net Plant & Equip. $1,080
Goodwill
Total
$3,588
$3,779
CS and Surplus
Total
$2,591
$2,747
Total Liabilities/Equity $3,588
$3,779
Balanced!
Pro Forma Ratios
Ratio
Current
Pro forma
Change
ROE
6.37%
7.61%
19.47%
Times Interest Earned
2.77 times
3.25 times
17.06%
Total Asset Turnover
0.64 times
0.67 times
4.45%
Current Ratio
3.53 times
3.65 times
3.41%
Other Firm Policies


Dividend Policy
Financing Policy

Fund EFN through long-term debt.


Using the Excel Goal Seek function
Fund EFN while maintaining the same debt to
equity ratio.

Using the Excel Solver function