Financial Statements Analysis and Long-Term

Planning
Chapter 3
Copyright 2010 by the McGraw-Hill Companies, I nc. All rights reserved.
McGraw-Hill/I rwin
3-1
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 firms ability to grow
3-2
Chapter Outline
3.1 Financial Statements Analysis
3.2 Ratio Analysis
3.3 The Du Pont 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 companys 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
3-6
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
3-7
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
3-8
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
3-9
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
3-10
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

3-11
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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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%
3-13
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
3-14
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 firms performance is
changing through time
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes
3-15
3.3 The Du Pont 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
3-16
Using the Du Pont Identity
ROE = PM * TAT * EM
Profit margin is a measure of the firms operating
efficiency how well it controls costs.
Total asset turnover is a measure of the firms
asset use efficiency how well it manages its
assets.
Equity multiplier is a measure of the firms
financial leverage.
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Calculating the Du Pont 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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3.5 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
% 65 . 9
0965 .
667 . 132 . 1
667 . 132 .
b ROA - 1
b ROA
Rate Growth Internal

3-26
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
% 4 . 21
214 .
667 . 264 . 1
667 . 264 .
b ROE - 1
b ROE
Rate Growth e Sustainabl

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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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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.
3-29
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?
3-30
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?
3-31
Review
1. A firm has sales of $1,200, net income of
$200, net fixed assets of $500, and current
assets of $300. The firm has $100 in
inventory. What is the common-size statement
value of inventory?
A. 8.3%
B. 12.5%
C. 20.0%
D. 33.3%
E. 50.0%
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2. Jessica's Boutique has cash of $50,
accounts receivable of $60, accounts payable
of $200, and inventory of $150. What is the
value of the quick ratio?
A. .30
B. .55
C. .77
D. 1.30
E. 1.82


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3. A firm has a debt-equity ratio of .40. What
is the total debt ratio?
A. .29
B. .33
C. .67
D. 1.40
E. 1.50
The debt-equity ratio is .40. Thus, if total debt
is $40, total equity is $100 and total assets are
$140. Total debt ratio = $40 $140 = .29

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4. Syed's Industries has accounts receivable of
$700, inventory of $1,200, sales of $4,200,
and cost of goods sold of $3,400. How long
does it take Syed's to both sell its inventory
and then collect the payment on the sale?
A. 128 days
B. 146 days
C. 163 days
D. 190 days
E. 211 days
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5. A firm has net working capital of $400, net
fixed assets of $2,400, sales of $6,000, and
current liabilities of $800. How many dollars
worth of sales are generated from every $1 in
total assets?
A. $1.33
B. $1.67
C. $1.88
D. $2.33
E. $2.50

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6. Lee Sun's has sales of $3,000, total assets
of $2,500, and a profit margin of 5%. The
firm has a total debt ratio of 40%. What is the
return on equity?
A. 6%
B. 8%
C. 10%
D. 12%
E. 15%

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7. Patti's has net income of $1,800, a price-
earnings ratio of 12, and earnings per share of
$1.20. How many shares of stock are
outstanding?
A. 1,200
B. 1,400
C. 1,500
D. 1,600
E. 1,800
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8. Samuelson's has a debt-equity ratio of 40%,
sales of $8,000, net income of $600, and total
debt of $2,400. What is the return on equity?
A. 6.25%
B. 7.50%
C. 9.75%
D. 10.00%
E. 11.25%

3-39
9. A firm has a return on equity of 15%. The
debt-equity ratio is 50%. The total asset
turnover is 1.25 and the profit margin is 8%.
The total equity is $3,200. What is the amount
of the net income?
A. $480
B. $500
C. $540
D. $600
E. $620

3-40
10. Neal's Nails has an 11% return on assets
and a 30% dividend payout ratio. What is the
internal growth rate?
A. 7.11%
B. 7.70%
C. 8.34%
D. 8.46%
E. 11.99%


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11. The Green Giant has a 5% profit margin
and a 40% dividend payout ratio. The total
asset turnover is 1.40 and the equity multiplier
is 1.50. What is the sustainable rate of
growth?
A. 6.30%
B. 6.53%
C. 6.72%
D. 6.80%
E. 6.83%
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12. A firm has a market capitalization of $2
million, market value of interest bearing debt
of $1 million, book value of interest bearing
debt of $500,000 and cash of $100,000. What
is the enterprise value?
A. $2.5 million
B. $2.9 million
C. $3.0 million
D. $3.5 million
E. $3.6 million