Laurence Booth
Sean Cleary
4
Financial Statement Analysis and
Forecasting
LEARNING OBJECTIVES
4.1
4.2
4.3
4.4
4.5
Identify the issues that need to be considered in applying
consistent financial analysis.
Explain why return on equity is one of the key financial
ratios used for assessing a firm’s performance, and how it
can be used to provide information about three areas of a
firm’s operations.
Describe, calculate and evaluate the key ratios relating to
financial leverage.
Describe, calculate and evaluate the key ratios relating to
financial efficiency.
Describe, calculate and evaluate the key ratios relating to
financial productivity. (continued)
4
Financial Statement Analysis and
Forecasting
LEARNING OBJECTIVES
4.6
Describe, calculate and evaluate the key ratios relating to
financial liquidity.
4.7 Describe, calculate and evaluate the key ratios relating to
the valuation of a company.
4.8 Explain why financial forecasting is critical for both
management and external parties, and explain how to
prepare financial forecasts using the percentage of sales
method.
4.9 Explain how external financing requirements are related to
sales growth, profitability, dividend payouts, and
sustainable growth rates.
4.10 Apply financial forecasting to a real company.
4.1 CONSISTENT FINANCIAL ANALYSIS
• Consistent financial analysis across companies,
industries and countries is important
• Analysts must understand the challenges to
comparability and attempt to ascertain the financial
health of the organizations they study, understanding
the limitations inherent in financial accounting
practice
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4
4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
• Financial statement analysis studies, absolute numbers,
comparative statements and ratios to:
– Ascertain trends in the financial statements
– Identify areas of strength and concern
• The DuPont System gives a framework for the analysis of financial
statements through the decomposition of the return on equity
(ROE) ratio as shown in Figure 4-1:
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4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
• ROE is a function of:
– Leverage, or the use of debt
– Efficiency, the ability of a firm to control costs in relationship to
sales
– Productivity, the degree to which a firm can generate sales in
relationship to the assets employed
• ROE is not a pure ratio because it involves dividing an income
statement item (a flow) by a balance sheet (or stock) item, as in
equations 4-1 and 4-7:
ROE 
Net Income
NI  NI
Sales  TA





Shareholde rs' Equity
SE  Sales
TA  SE
• Instead of using ending shareholders’ equity, many argue that
average shareholders’ equity over the period should be used because
shareholders’ equity changes over the year as income is earned and
retained earnings grow
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4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
• Return on assets (ROA) shows the ratio of income to assets used to
produce the income, and it can be further decomposed as the
product of the net profit margin and sales to total assets ratio:
NI
NI
Sales
ROA 


TA Sales
TA
• Multiplying ROA by leverage (total assets divided by shareholders’
equity), we obtain ROE
• The DuPont system provides a good starting point for any financial
analysis because:
– It shows that financial strength comes from many sources:
profitability, asset utilization and leverage
– It reinforces the concept that good financial analysis requires looking
at each ratio in the context of the others
– It shows that it is important to look at a sample of ratios from each
major category to identify areas of strength and weakness
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4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
• Tables 4-1 and 4-2 show an ROE analysis for Tim Hortons:
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4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
• Table 4-3 shows an ROE analysis for two of Tim Hortons’
competitors: McDonald’s and Starbucks
• A ratio, by itself, is just a number; to judge if a ratio is “good”
or “bad,” we must compare it for the same company over
time (trend analysis), or to other companies in the same
industry (industry analysis):
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4.2 A FRAMEWORK FOR FINANCIAL ANALYSIS
• Financial leverage occurs when a firm uses sources
of financing that carry a fixed cost, such as long-term
debt, and uses this to generate greater returns to
shareholders
• Leverage means magnification of both profits and
losses
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4.3 LEVERAGE RATIOS
• Stock ratios indicate the amount of debt outstanding
at a particular time
– Leverage ratio
– Debt ratio
– Debt-equity ratio
• The debt ratio is a stock ratio that indicates the
proportion of total assets financed by debt as at the
balance sheet date; as in Equation 4-8:
Debt Ratio 
Booth • Cleary – 3rd Edition
Total Liabilitie s TL

Total Assets
TA
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4.3 LEVERAGE RATIOS
• The debt-equity (D/E) ratio is a stock ratio that
indicates the proportion that total debt represents in
relationship to the shareholders’ equity (both
common stock and retained earnings) at the balance
sheet date; as in Equation 4-9:
Total Debt
D
Debt - Equity Ratio 

Shareholde rs' Equity SE
• The times interest earned (TIE) ratio is an income
statement (flow) ratio that indicates the number of times
the firm’s pre-tax income (EBIT, earnings before interest
and taxes) exceeds its fixed financial obligations to its
lenders; as in Equation 4-10:
Times Interest Earned (TIE) 
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EBIT
Interest Expense
12
4.3 LEVERAGE RATIOS
• The cash flow to debt ratio measures how long it
would take to pay off a firm’s debt using cash flow
from operations; as in Equation 4-11:
Cash Flow from Operations
Cash Flow to Debt Ratio 
Total Debt
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4.3 LEVERAGE RATIOS
• Table 4-4 shows Tim Hortons’ leverage ratios
• Tim Hortons’ leverage ratios show that the amount of debt as a
percentage of total financing increased slightly during 2011, and the
coverage ratio declined very slightly
• Comparing Tim Hortons with McDonald’s and Starbucks, we can see
that Tim Hortons had a much lower percentage of debt financing
than McDonald’s, and its coverage ratios were much better
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4.4 EFFICIENCY RATIOS
• Efficiency ratios measure how efficiently a dollar of
sales is turned into profits; these include:
–
–
–
–
Degree of total leverage
Break-even point
Gross profit margin
Operating margin
• Efficiency ratios give insight into a firm’s cost
structure and can help analysts determine if
problems exist with either variable or fixed costs, or
both
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4.4 EFFICIENCY RATIOS
• Degree of total leverage (DTL) is an income statement ratio that
measures the exposure of profits to changes in sales, as in Equation
4-12:
Contributi on Margin
CM
Degree of Total Leverage 

Earnings Before Taxes EBT
• The greater the DTL, the greater the leverage effect
• The break-even point estimates the unit volume that must be
produced and sold in order for the firm to cover all costs, both fixed
and variable, as in Equation 4-13:
Fixed Costs
FC
Break Even Point 

Contributi on Margin CM
• The break-even point tends to increase as the use of fixed costs
increases
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4.4 EFFICIENCY RATIOS
• Gross profit margin demonstrates the proportion of sales that are
available to cover fixed (period) costs and financing expenses after
variable costs have been paid, as in Equation 4-14:
Revenue - Cost of Sales Re v  COS
Gross Profit Margin 

Revenue
Re v
• A declining gross profit margin raises concerns about the firm’s
ability to control variable costs, such as direct materials and labour
• The operating margin measures the cumulative effect of both
variable and period costs on the ability of the firm to turn sales into
operating profits to cover interest, taxes, depreciation and
amortization (EBITDA), as in Equation 4-15:
Operating Margin 
Booth • Cleary – 3rd Edition
Operating Income
OI

Revenue
Re v
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4.4 EFFICIENCY RATIOS
• Table 4-6 shows Tim Hortons’ efficiency ratios
• Tim Hortons maintained steady profitability, but lower gross
profit margins than McDonald’s and Starbucks
• However, Tim Hortons maintained operating profit margins
and net profit margins that were higher than Starbucks’, but
lower than McDonald’s.
• Table 4-6 shows that Tim Hortons has displayed consistent,
strong profitability over the 2008–11 period
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4.5 PRODUCTIVITY RATIOS
• Productivity ratios measure the firm’s ability to generate
sales from its assets; these include:
–
–
–
–
–
Receivables turnover
Average collection period (ACP)
Inventory turnover
Average days sales in inventory (ADSI)
Fixed asset turnover
• Excessive investment in assets with little or no increase in
sales reduces the rate of return on both assets (ROA) and
equity (ROE)
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4.5 PRODUCTIVITY RATIOS
• Receivables turnover measures the sales generated by every dollar
of receivables, as in Equation 4-16:
Revenue
Re v
Receivable s Turnover 

Accounts Receivable
AR
• Average collection period (ACP) estimates the number of days it
takes for a firm to collect on its accounts receivable, as in Equation
4-17:
Average Collection Period 
Accounts Receivable
365

Average Daily Credit Sales Receivable Turnover
• Example: If ACP is 40 days, and the firm’s credit policy is net 30,
clearly customers are not paying according the to firm’s policies and
there may be concerns about the quality of customer’s credit and
what might happen if economic conditions deteriorate
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4.5 PRODUCTIVITY RATIOS
• Inventory turnover measures the number of times
ending inventory was “turned over” or sold during the
year, as in equations 4-18 and 4-19:
Cost of Goods Sold
Rev
Inventory Turnover 
OR
Inventory
Inventory
• When cost of goods sold is not publicly available, the
inventory turnover ratio can be estimated using sales
instead, as in Equation 4-19
• Using sales instead of cost of good sold is not ideal,
because while cost of goods sold is based on inventoried
cost, sales includes a profit margin that may not be
comparable to other firms
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4.5 PRODUCTIVITY RATIOS
Inventory turnover (continued)
• This is a ratio that involves both stock and flow values and is
strongly a function of ending inventory
• Managers often try to improve this ratio as they approach
year end through inventory reduction strategies (e.g., cash
and carry sales, inventory clearance, etc.)
• year end through inventory reduction strategies (e.g., cash
and carry sales, inventory clearance, etc.)
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4.5 PRODUCTIVITY RATIOS
• Average Days Sales in Inventory (ADSI) estimates the number
of days of sales tied up in inventory, based on ending
inventory values, as in Equation 4-20:
Average Days Sales in Inventory (ADSI) 
Inventory
365

Average Daily Sales Inventory Turnover
• Fixed asset turnover estimates the number of dollars of sales
produced by each dollar of net fixed assets, as in Equation 421:
Sales
Fixed Asset Turnover 
Net Fixed Assets
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4.5 PRODUCTIVITY RATIOS
• Table 4-7 shows Tim Hortons’ productivity ratios:
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4.6 LIQUIDITY RATIOS
• Liquidity ratios measure the ability of the firm to meet its financial
obligations as they mature using liquid (i.e., cash and near cash)
resources; these include:
– Working capital
– Current
– Quick (acid test)
• The working capital ratio measures the proportion of total assets
invested in current assets, as in Equation 4-22
Working Capital 
Current Assets CA

Total Assets
TA
• The working capital ratio demonstrates a firm’s capital intensity
and corporate liquidity
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4.6 LIQUIDITY RATIOS
• The current ratio measures the number of dollars of current assets
for each dollar of current liabilities, as in Equation 4-23:
Current ratio 
Current Assets
CA

Current Liabilitie s CL
• The current ratio estimates the capacity of the firm to meet its
financial obligations as they mature
• The quick ratio or acid test ratio recognizes that inventories and
other current assets may be less liquid and, in some cases, when
liquidated quickly, can result in cash flows that are less than book
value
• Therefore, the quick ratio gives a clearer indication of the firm’s
ability to meet its maturing financial obligations out of very liquid
current assets, as in Equation 4-24:
Quick ratio 
Cash Marketable Securites  Accounts Receivable C  MS  AR

Current Liabilitie s
CL
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4.6 LIQUIDITY RATIOS
• Table 4-8 shows Tim Hortons’ liquidity ratios
• For 2011 Tim Hortons’ quick ratio is less than 1, which indicates that
the company could not pay off all of its current liabilities from its
“quick” (i.e., most liquid) assets
• Tim Hortons’ current ratios were higher than McDonald’s and
Starbucks’ over the entire period, except for 2008 when McDonalds
had a higher ratio, and in 2011 when Starbucks’ was higher.
• However, Tim Hortons’ quick ratios were generally below those for
McDonald’s, but above those for Starbucks with the exception of
2011
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4.6 LIQUIDITY RATIOS
• Estimating Net Realizable Values
– When firms are financially strained and no longer a going
concern, book (accounting) values become less valid
– Instead, net liquidation values can be estimated by
discounting asset values based on their degree of liquidity
– Liquid assts are valued at close to or the same as book
value
– Illiquid assets are discounted from book value based on
their degree of liquidity
– Liabilities are stated in nominal terms, because it takes
those dollars to satisfy debt obligations
– Preferred stock value is based on residual values, if any
residual remains after liquidation
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4.7 VALUATION RATIOS
• Valuation ratios are used to assess how the market is
valuing the firm (i.e., its share price) in relation to its
assets, earnings, profits and dividends; these include:
– Equity book value per share (BVPS)
– Dividend yield
– Dividend payout
– Trailing Price-earnings (P/E)
– Forward P/E
– Market-to-book
– Earnings before interest, taxes, depreciation and
amortization (EBITDA) multiple
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4.7 VALUATION RATIOS
• Book value per share (BVPS) expresses shareholders’ equity on a
per share basis, as in Equation 4-25:
Shareholde rs' Equity
Book Value Per Share 
Number of Shares
• Dividend yield expresses the dividend payout as a proportion of the
current share price, as in Equation 4-26:
Dividend Per Share DPS
Dividend Yield 

Price Per Share
P
• The dividend yield can be compared to the yield on other
investment instruments, such as bonds or the stocks of other
dividend-paying companies
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4.7 VALUATION RATIOS
• The price-earnings (P/E) ratio is an earnings multiple based on the most
recent earnings, as in Equation 4-28:
Share Price
P
P/E 

Earnings Per Share EPS
• The price-earnings (P/E) ratio is often used to estimate the value of a stock
• Example: A stock trading at a P/E multiple of 10 will take 10 years at
current earnings to recover its price
• The forward P/E ratio is an earnings multiple based on forecast earnings
per share and is often used to estimate the value of a stock for companies
with rapid growth in EPS, as in Equation 4-29:
Share Price
P
Forward P/E 

Estimated Earnings Per Share EEPS
• Low P/E shares are regarded as value stocks
• High P/E shares are regarded as growth stocks
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4.7 VALUATION RATIOS
• The market-to-book ratio estimates the dollars of share price per dollar of
book value per share, as in Equation 4-30:
Share Price
P
Market - to - book 

Book Value Per Share BVPS
• Given historical cost accounting as the basis for BVPS, the degree to which
market value per share exceeds BVPS indicates the value that has been
added to the company by management
• The EBITDA multiple expresses total enterprise value (TEV) for each dollar
of operating income, or earnings before interest, taxes, depreciation and
amortization (EBITDA), as in Equation 4-31:
TEV
EBITDA Multiple 
EBITDA
• Total enterprise value is an estimate of the market value of the firm, i.e.,
the market value of both its equity and its debt
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4.7 VALUATION RATIOS
• Table 4-10 shows valuation ratios for Tim Hortons
• Tim Hortons’ 2011 dividend yield of 1.38 percent is slightly
higher than its 2010 value, but is lower than McDonald’s yield
of 2.7 percent, but above Starbucks’ ratio of 1.01 percent.
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4.8 FINANCIAL FORECASTING
• Financial managers must produce forecasts of the results of business plans
in order to:
– Determine if the plans will require additional external financing
– Determine if the plans will produce surplus cash resources that could
be distributed to shareholders as dividends
– Assess financial forecasts to determine if plans are feasible; if poor
results are forecast, management has the opportunity to amend plans
in an attempt to produce better results before resources and
committed
• The basis for all financial forecasts is the sales forecast and the most
recent balance sheet values are the starting point
• Pro forma (forecast) balance sheets are projected, assuming some
relationship with projected sales as a constant percentage of sales
• Current liabilities are usually assumed to rise and fall in a constant
percentage with sales, and are called spontaneous liabilities because they
change without negotiation with creditors
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
• The percentage of sales method involves the following steps:
1. Determine the financial policy variables in which you are interested
2. Set all the non-financial policy variables as a percentage of sales
3. Extrapolate the balance sheet based on a percentage of sales
4. Estimate future retained earnings
5. Modify and re-iterate until the forecast makes sense
• This process most often results in a balance sheet that does not balance,
so a “plug” (or balancing) amount is the external funds required, or the
surplus funds forecast
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
•
•
•
The prior pro forma balance sheet was
developed using very naïve assumptions:
– Policy variables held constant
– Asset growth in all accounts held at
the same percentage of sales
– Spontaneous liabilities increased at a
constant percentage of sales
One improvement is to realize that the
firm’s equity will grow by the amount of
retained earnings
Note that in Table 4-13 retained earnings
is net income (6) less dividends (3).
Assuming the firm holds this percentage
constant, we can project an increase in
equity on the balance sheet as 50% of the
5% profit margin or 2.5% of sales.
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
• Further improvements to the pro forma balance
sheet include:
– Recognizing that cash balances may not have to rise as
a constant percentage of sales
– Cash balances are required for a variety of reasons: to
support transactions, as a safety cushion against
unforeseen cash needs, and as a speculative balance
to take advantage of unforeseen opportunities
– Even at low levels of sales, cash balances are required
– As sales increase, additional cash on hand may be
required, but at a decreasing percentage of sales
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
• Figure 4-3 illustrates the difference between a simple
percentage of sales forecast, and perhaps a more realistic
forecast that includes a base amount (constant) and a
decreasing percentage of sales
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
• Further improvements to the pro forma balance sheet include reexamining asset growth assumptions:
– Refinement of the cash forecast
– Realization that EFR can be offset by marketable securities that can be
easily liquidated to finance growth needs
– Re-examination of assumptions of accounts receivable growth and
whether we want to change credit policies in the context of the
forecast macroeconomic and competitive environment
– Re-examination of inventory management policies taking into account
the macroeconomic and competitive environment
– Realization that increases in net fixed assets is “lumpy” and not
continuously incremental; if the firm has excess capacity, it may not
need to invest any further in fixed assets until it is forecast to exceed
that capacity
• Additional improvements also include re-examining assumptions about
growth in spontaneous liabilities
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
• Given assumptions about capacity, and there being no need for
further expansion in plant and equipment to support anticipated
sales growth, we can re-examine our assumptions about the cost
structure of the firm
• Figure 4-16 (next slide) shows the effects of these changes on the
pro forma income statement
• Variable costs (direct materials and direct labour) will likely grow in
proportion to sales
• Fixed costs, however, should remain fixed; by modifying the income
statement for this change in assumptions, we see the net result of
this is an increase in forecast net income
• Most firms do not follow a constant dividend payout ratio, but hold
dividends constant over multiple years; we will assume $3
dividends will be paid for the next three years
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
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4.8 FINANCIAL FORECASTING
The Percentage of Sales Method
• Given our modified income
statement and
assumptions regarding net
profit and cash dividends,
we can prepare a final
revised balance sheet
• The balance sheet now
shows we forecast
significant surplus cash
resources and must make
some decisions about their
management: should they
be invested in marketable
securities or paid as
dividends?
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4.9 FORMULA FORECASTING
• We can express the foregoing percentage of sales method of
forecasting using equations rather than spreadsheets
• Equation 4-32 shows the external financing requirements
(EFR): EFR = a × S × g – b × PM × (1 + g) × S
• where:
a = the treasurer’s financial policy variable, the total invested
capital or net assets of the firm as a percentage of its sales
g = sales growth rate
S = current period sales
S × g = next period sales
a × S × g = incremental capital required
PM = profit margin on sales
B = payout ratio
1 – b = retention or plowback ratio
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4.9 FORMULA FORECASTING
• External financing requirements can also be expressed as a linear function
of the sales growth rate (g) by dividing both sides of Equation 4-32 by the
current sales level to obtain Equation 4-33:
EFR
 b  PM  (a  b  PM ) g
S
• Equation 4-33 is plotted in Figure 4-4; the sustainable growth rate (g*)
occurs where the blue line intersects the horizontal axis
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4.9 FORMULA FORECASTING
• The sustainable growth rate (g*) is the sales growth rate at
which the firm neither generates nor needs external
financing; it can sustain its own rate of growth through the
reinvestment of its own profits. Equation 4-34 gives the
sustainable growth rate:
b  PM
g* 
a  b  PM
• When g > g*, EFR > 0 (external financing will be required)
• When g = g*, EFR = 0 (the firm can finance its own growth
with retained earnings)
• When g < g*, EFR < 0 (the firm will have surplus funds
available after financing its planned growth)
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