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MSBC 5060Chapter 3

Financial Statement Analysis and Financial Models

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Chapter Outline

1. Financial Statements Analysis2. Ratio Analysis3. The Du Pont Identity4. Financial Models5. External Financing and Growth6. Some CaveatsExtra: Personal Finance Applications

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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• Relate corporate loan criteria to personal loan

criteria

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Common-Size Financial StatementsThe basic idea: Divide Everything on the page by

the main number on the page• Balance Sheet: – The main number is Total Assets • which equals Liabilities plus Equity

– So all values are reported as a percentage of Total Assets

• Income Statement– The largest number is Sales– So all values are reported as a percentage of Sales

(also called Total Revenue)

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Common-Size Balance Sheet(Tables 3.1 and 3.2) Prufrock corporation

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Common-Size Income Statement(Tables 3.4 and 3.5)

Some other stuff we will need later for the Ratio Analyses:• EBIT = NI + Int Exp + Tax Exp = 363 + 141 + 187 = $691• EBITDA = NI + Int Exp + Tax Exp + Dep Exp = 691 + 276 = $967

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Review of Earnings numbers (Table 3.3 page 47)

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Ratio AnalysisInstead of values, show as fractions of other values (ratios)

Ratio Categories:1. Short-Term Solvency– Firm’s ability to pay current bills

2. Long-Term Solvency – Firm’s ability to meet LT debt obligations

3. Asset Management – aka Turnover Ratios (Efficiency measures)

4. Profitability Ratios5. Market Value Ratios

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Some things to think about as we look at ratios:1. Definition of the Ratio– How is it computed? Is it always the same?

(It will be for us)– Use the Beginning, Ending or Average B-S value?

2. What is the unit of Measure? – dollars, years, dollars per dollars of assets…

3. What are HIGH values? What are LOW values?– High or low for the company over time– for the industry– for the sector– for all companies…

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Category 1: Short-Term SolvencyFirst Some Notation:• Current Assets = CA,• Current Liabilities = CL• Total Assets = TA = A• Total Liabilities = TL = L = Total Debt = TD = Debt =D• Total Equity = TE = E

[3.1] Current Ratio = CA/CL = 708/540 = 1.31[3.2] Quick Ratio = (CA – Inv)/CL = (708 – 442)/540 = 0.53

• Inventory is the least liquid current asset[3.3] Cash Ratio = Cash/CL = 98/540 = 0.18

• Cash is the most liquid current asset

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Review Question

Did the firm’s short-term solvency improve or deteriorate?

Current Assets 2013 2014 Current Liabilities 2013 2014

Cash $84 $98 A/P $312 $344

A/R $165 $188 Notes Payable $231 $196

Inventory $393 $422 Total $543 $540

Total $642 $708

Ratio 2013 2014

Current Ratio = CA/CL 642/543 = 1.18 708/540 = 1.31

Quick Ratio = (CA – Inv)/CL (642-393)/543 = 0.46 (708-442)/540 = 0.53

Cash ratio = Cash/CL 84/543 = 0.15 98/540 = 0.18

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Category 2: Long-Term Solvency and LeverageBalance Sheet:[3.4] Total Debt Ratio = Debt to Assets = D/A = 997/3,588 = 0.28 Equity to Assets = E/A = 2,591/3,588 = 0.72

[3.5] Debt to Equity = D/E = 997/2,591 = 0.38 = 0.28/0.72 = 0.39 ≈ 0.38

[3.6] Equity Multiplier (EM) = A/E = 3,588/2,591 = 1.38 = 1/(E/A) = 1/0.72 = 1.38 = 1 + D/E = 1 + 0.38 = 1.38

Note: EM = A/E = (D + E)/E = E/E + D/E = 1 + D/E• All these are also called Financial Leverage Measures• In general, the more levered, the less likely a firm is to repay its debt

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Category 2: Long-Term Solvency (Continued)Coverage Ratios:

Income Statement:[3.7] Times Interest Earned (TIE) = EBIT/In Exp = 691/141 = 4.9 times

[3.8] Cash Coverage = EBITDA/In Exp = 967/141 = 6.9 times

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Review Question

Did the firm’s Long-term solvency improve or deteriorate?

• The firm borrowed $200 and bought new assets• LT solvency deteriorated since Leverage increased

Current Assets 2013 2014 Liab. and Equity 2013 2014

ST Assets $100 $150 ST Liabilities $300 $300

LT Assets $900 $1,050 LT Liabilities $500 $700

Equity $200 $200

Ratio 2013 2014

Debt to Assets $800/$1,000 = 0.80 $1,000/$1,200 = 0.83

Debt to Equity $800/$200 = 4 $1,000/$200 = 5

Equity Multiplier = A/E $1,000/200 = 5 $1,200/200 = 6

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Category 3: Asset Management or Efficiency

[3.9] Inventory Turnover = COGS/Inventory = 1,344/422 = 3.2 times• This is the value of inventory sold during the year (COGS) divided by

the amount of inventory on hand at the end of the year• So during the year, the firm sold 3.2 times amount of inventory on

hand at year’s end

[3.10] Days’ Sales in Inventory = 365/Inventory Turnover = 365/3.2 = 114 days

• Since the firm sold the current amount of inventory 3.2 times over the last year, the current inventory will be sold in 1/3.2 years or 114 days

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Cat 3: Asset Management or Efficiency (Continued)

[3.11] Receivables Turnover = Sales/(A/R) = 2,311/188 = 12.3 times• Really should be “Credit Sales” not total Sales. We don’t have that.• Would be number of times in the year credit was extended and then

collected• Often Average A/R is used as opposed to Ending A/R

[3.12] Days’ Sales in Receivables = 365/Receivables Turnover = 365/12.3 = 30 days

• Credit was extended and collected 12.3 times over the last year or 1/12.3 years or 30 days

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Cat 3: Asset Management or Efficiency (Continued)

[3.13] Asset Turnover = Sales/Assets = 2,311/3,588 = 0.64• For each dollar of assets, the firm generated $0.64 in sales• This is the amount of sales the firm was able to generate

from asset in place

Capital Intensity = Assets/Sales = 3,588/2,311 = 1.56• It takes $1.56 in Assets to generate $1 in Sales• A way to think about this ratio:

• If Sales are going to increase by 25%• Then assets must also increase by 25% • Unless the firm can somehow generate more sales from each unit of

assets • Which means increase Asset Turnover or lower Capital Intensity • Which means an increase in operating efficiency

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Review Question

Calculate: (1) Inventory Turnover (IT) (2) Days’ Sales in Inventory (DSI) (3) Asset Turnover (AT)

• IT = Inv sold/Inv on hand IT = COGS/Inv = $5,000/$1,000 = 5

• DSI = Days per year/ # of times Inv turned in per yearDSI = 365/IT = 365/5 = 73

• AT = Amount sold/Amount “employed” to generate salesAT = Sales/Assets = $10,000/$25,000 = 0.4

Account

Sales $10,000

COGS $5,000

Inventory $1,000

A/R $500

Assets $25,000

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Category 4: Profitability (Really Efficiency)[3.14] Profit Margin (PM)

PM = NI/Sales = 363/2,311 = 15.7%• Income Statement “Bottom Line” divided “Top Line”• Accounting Profit per Dollar of Sales• Think of PM as a measure of Efficiency not Profitability• Measures the expenses needed to generate sales (Sales – Expenses = NI)

[3.15] Return on Asset (ROA) ROA= NI/Assets = 363/3,588 = 10%

• This is the (accounting) profit per unit of Assets• Compare with Asset Turnover Ratio (AT) = Sales/Assets = 2,311/3,588 = 0.64• Sales are 64% of Assets and Profits are 10% of Assets• PM = ROA/AT = 0.10/0.64 = 15.7%• Think of ROA as a measure of Efficiency not Profitability• Think of assets as some number of trucks. How much profit is generated from

these trucks? The more you generate, the more efficient the business.• It is a function of sales (more is better) and expenses (less is better)

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Category 4: Profitability[3.16] Return on Equity (ROE)

ROE = NI/Equity = 363/2,591 = 14%• This measures the (accounting) profit per unit of Equity• ROE = ROA x EM = NI/Assets x Assets/Equity• So Profit (ROE) is a function of Efficiency (ROA) and Leverage (EM)• So increase profit by increasing efficiency or increasing leverage• Remember Efficiency has two components:

Increasing Sales and Decreasing Expenses• So Increase Efficiency by Increasing Sales or Decreasing Expenses

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Important Relationship:ROE = NI/Equity (Profitability)ROA = NI/Assets (Efficiency)EM = Assets/Equity (Leverage)

Profitability = Efficiency X LeverageROE = ROA X EM

NI/Equity = NI/Assets X Assets/Equity

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Category 5: Market Value MeasuresBut First: # of Shares Outstanding is 33m and Price is $88 per share

[3.17] Earnings per Share (EPS) = NI/Shares = $363/33 = $11/Share• So each owners’ share earned $11

[3.18] Price-Earnings Ratio (PE or P/E) = Price/EPS = $88/$11 = 8 times• So pay $8 for $1 of earnings• PE (and EPS) can be compared across different stocks• Why pay more for a dollar of earnings?

[3.19] Market-to-Book = Price per Share/Book Val of Equity per Share• Book Value of Equity per Share = $2,591/33 = $78.52• Market-to-Book = $88/$78.52 = 1.12• Sometimes called Price-to-Book • Some contexts use Book-to-Market (BM), the inverse

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Category 5: Market Value Measures

[3.20] Enterprise Value (EV) = Mkt Cap + Mkt Val Debt – Cash = Shares x Price + Notes + LTD – Cash = 33 m x $88 + $196 + $457 – $98 = $3,465• Note the use of book value of debt instead if market value of debt. This is

common since they are often very close.• This is cost to acquire all claims on the firm’s assets

Enterprise Value Multiple = EV/EBITDA = $3,465/$967 = 3.6 times

• The EV Multiple is especially useful because it allows comparison across firms even if there are differences in capital structure.

• Since EBITDA is before interest expense, taxes, or capital spending (depreciation)

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Review Question

• NKE has a greater PE and Market-to-Book. • So “the market” is paying more for a dollar of NKE’s earnings

and more for a dollar of its equity.• Why?

StockPrice Share(6/22 Close)

EPS(ttm)

Book Val ofEquity (mrq)

# of Shares(mrq)

Nike (NKE) $106.79 $3.50 $12,368 m 860 mWal-Mart (WMT) $72.79 $4.98 $76,574 m 3,227 m

Stock PE RatioBook Val of

Equity Per share Market-to-BookNKE $106.79/$3.50 = 30.51 $12,368/860 = $14.38 $106.79/$14.38 = 7.43

WMT $72.79/$4.98 = 14.62 $76,574/3,227 = $23.73 $72.79/$23.73 = 4.50

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One More Efficiency Measure…

EBITDA Margin = EBITDA/Sales = $967/$2,311 = 41.8%

Compare EBITDA Margin to Profit Margin:

Profit Margin (PM) = NI/Sales = $363/$2,311 = 15.7%

• What is the difference in the numerators?

EDITDA – Dep – Amort – Int Exp – Taxes = NI

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Recap: Table 3.6 page 56

Remember: Think of ROA and PM as Efficiency Ratios, not Profitability Ratios

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Problems with Ratio Analysis• No good way to know which ratios are most

important• 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 can confuse

the results

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DuPont Identity• A method of calculating the contribution of different parts

to overall profitability• Also called Profitability decomposition

or ROE Decomposition• Profitability is measured by ROE = NI/E

The Du Pont Identity:[3.21] ROE = AT x PM x EM NI/E = Sales/A x NI/Sales x A/E Profit = Sales Efficiency x Expense Efficiency x Leverage

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DuPont Analysis (Continued)

First: Decompose Profitability (ROE) into broad measures of Efficiency (ROA) and Leverage (EM)• Efficiency ROA = NI/A• Leverage EM = A/E• ROE = ROA x EM NI/E = NI/A x A/E

Profit = Efficiency X Leverage

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DuPont Analysis (continued)

Second: Decompose Efficiency into Sales generated from Assets (AT) and Expenses needed to generate the sales (PM)• Sales Generated from Assets (Asset Turnover)

AT = Sales/A• Earnings kept from each dollar of sales

PM = NI/Sales

NI/A = Sales/A x NI/SalesROA = AT x PM

Total Efficiency is a function of Sales and Expenses

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DuPont Analysis (continued)

Third: Decompose AT (Sales/A) into different types of Sales• Manufactured Products, Servicing, Consulting…• AT Product Sales/A, Servicing/A, Consulting/A, • What break-down categories are appropriate? Depends on

the company and its business

Fourth:Decompose PM (NI/Sales) into different expenses• COGS/Sales, SG&A/Sales, Int Exp/Sales, Tax Exp/Sales, Dep

Exp/Sales• PM = NI/Sales = (Sales – Expenses)/Sales

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DuPont Analysis (continued)

ROE = NI/E(Profit)

EM = A/E(Leverage)

ROA = NI/A(Efficiency)

AT = Sales/A(Revenues)

Equip Sales/A

Servicing/A

Consulting/A

PM = NI/Sales(Expenses)

COGS/Sales

SG&A/Sales

Int Exp/Sales

Tax Exp/Sales

Dep Exp/Sales

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Review QuestionFor both firms calculate:(1) ROE = NI/E (2) ROA = NI/A(3) EM = A/E(4) AT = Sales/A(5) PM = NI/Sales

Why is Firm 2 more profitable?

• ROE greater for Firm 2 because EM is bigger. • EM measures leverage

Account Firm 1 Firm 2

Assets $10,000 $20,000

Equity $5,000 $5,000

NI $1,000 $2,000

Sales $5,000 $8,000

Ratio Firm 1 Firm 2

ROE = NI/E 0.2 0.4

ROA = NI/A 0.1 0.1

EM = A/E 2.0 4.0

AT = Sales/A 0.5 0.5

PM = NI/Sales 0.2 0.2

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Financing Growth• For a firm to Grow, Assets must grow (almost by definition)

1. External Growth: Sell stocks or bonds (talk about this later)2. Internal Growth: Retain Earnings (talk about this now)

• Internally Financed Growth is a function of:1. The Earnings (aka NI) as a percentage of Assets2. The Earnings Retained by the business as a percentage of NI

• So: How much did you make and how much did you keep?

First some definitions:[3.22] Dividend Payout Ratio = Div/NI = 121/363 = 33% = 1/3

• Payout 1/3 of Accounting Profits

Retention Ratio (aka Plowback Ratio) = RE/NI = 242/363 = 2/3• Also equal to 1 - Div/NI• Often denoted as “b”

• Note: The text Switches from Prufrock to Hoffman Company for these ratios. • I’ll stay with Prufrock

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External Financing and Growth• Let b = RE/NI (Plowback Ratio)• ROA = NI/A (Accounting profits per unit of assets)

[3.24] Internal Growth = (ROA x b)/(1 – ROA x b)

For the example company• ROA = 363/3,588 = 10.12% and b = 242/262 = 0.6667

– (How many digits after the decimal point? It depends.)

• Internal Growth = (0.1012 x 0.6667)/(1 – 0.1012 x 0.6667) = 0.0724 = 7.24%• If the company plows back 2/3 of NI (which increases assets) and

ROA is 10.12%, then the firm grows at 7.24% (without external financing).– Note that growth can be improved if ROA is improved– How can ROA be improved? Increase Sales or Decrease Expenses– Which parts of sales or expenses are best suited for improvement?

How do you breakdown sales and expenses into different categories?

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Internal and Sustainable Growth (continued)• Note that retaining earnings increases… • Retained Earnings (the Equity account on the B-S)

– But this does not increase Debt (liabilities)– So over time, the D/E ratio decreases

• So to maintain the same D/E ratio, the firm must sell some debtThis leads to the Sustainable Growth Rate:

[3.25] Sustainable Growth = (ROE x b)/(1 – ROE x b)

• ROE = 14.01%• Sustainable Growth = (0.1401 x 0.6667)/(1 – 0.1401 x 0.6667) = 0.1030 = 10.30%

• Internal Growth Rate = 7.24%• Sustainable Growth = 10.30%

– Sustainable growth implies borrowing to maintain the same D/E ration– Borrowing means increasing leverage

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Internal and Sustainable Growth (continued)• So Growth is determined by four things:1. Sales generated from Assets in place

– Assets Use Efficiency: AT = Sales/Assets

2. NI (aka Earnings) kept from those sales– Operating Efficiency: PM = NI/Sales = (Sales – Expenses)/Sales

3. Portion of NI Retained– Plowback Ratio: b = RE/NI

4. Financing Policy– How much more is borrowed (relative to earnings retained)– Leverage: Equity Multiplier (EM) = A/E

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Recap: Table 3.16

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A note about SGR and IGR

If we use Ending Equity or Assets (at Time 1):• SGR = (ROE1 x b)/(1 – ROE1 x b)

• IGR = (ROA1 x b)/(1 – ROA1 x b)

If we use Beginning Equity or Assets (at Time 0):• SGR = ROE0 x b

• IGR = ROA0 x b

See “SGR and IGR Begin or End Values.xlsx”

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How to use Ratio Analysis:• Compare to same firm over time• Compare to firms within industry– SIC codes– North American Industry Classification System – NAICS or “Nakes”

• But use your own common sense and knowledge about the company or industry

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Financing Growth• Given a Sales Growth Forecast• How much new money will the firm need to raise to finance

the forecast growth? • The text uses the Rosengarten example to develop the

formula to calculate External Financing Needed (EFN)

EFN is:• The money that needs to be raised (through new equity or

new borrowing) if sales increase by a certain percent• Assuming no other relationships or ratios change– A simplifying assumption– So no change in EM, or ROA

• Which means no change in AT (or its inverse CIR) or PM

– No change in asset or liability “mix”

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Financing Growth• For a given change in sales (sales growth)• With other relationships fixed…– Capital Intensity Ratio (Assets/Sales) is fixed• This is “assets as a percentage of sales”• So if sales increase, assets must increase

proportionately• Also the mix of assets does not change

– A/P as a percentage of sales is fixed• This is the only liability ratio we assume fixed• We’ll see why in a minute• This is why we consider A/P a “Spontaneous Liability”

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Financing Growth• How much more in assets are needed to

generate this forecast sales increase?• How much more in liabilities will

automatically result from the increase in sales?

• How much more earnings will the firm retain from the increase in sales?

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The EFN formula:

Where:• Spontaneous Liabilities = liabilities that automatically result

from increased sales (in this case it is only A/P)• d = the div payout ratio = Divs/NI• (1 – d) = the Retention Ratio

But we will look at the formula slightly differently

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EFNEFN = ΔSales x Capital Intensity Ratio - ΔSales x Spontaneous Liabilities/Sales - Retention Ratio x Profit Margin x Projected Sales• Can rewrite it this way: EFN = ΔSales x Assets/Sales

- ΔSales x Accts Payable/Sales- Retention Ratio x NI/Sales x Projected Sales

• Or in words:EFN = Assets Needed to Generate New Sales

- Liabilities Automatically Created by New Sales - Increase Retained Earnings from New Sales

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EFN Example from Text (Page 63)Text Example:Sales = $1,000, Sales Growth = 25% ΔSales = $250Assets = $3,000 Cap Intensity Ratio = $3,000/$1,000 = 3.00A/P = $300 (A/P)/Sales = $300/$1,000 = 0.30NI = $132 PM = NI/Sales = $132/$1,000 = 0.132Divs = $44 Retention Ratio = 1 - $44/$132 = 0.6667

EFN = ΔSales x Capital Intensity Ratio - ΔSales x Spontaneous Liabilities/Sales - Retention Ratio x Profit Margin x Projected Sales

• ΔSales x Capital Intensity Ratio = $250 x 3.00 = $750 (in new assets)• ΔSales x Spontaneous Liabilities/Sales = $250 x 0.30 = $75 (in new A/P)• Retention Ratio x PM x Proj Sales = 0.67 x 0.132 x $1,250 = $110 (in new RE)

EFN = $750 - $75 - $110 = $565• The firm needs to $565 in External Financing to pay for the $750 in

new assets needed to finance 25% sales growth

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Recap:• Increase Sales by 25% or $250? Need $750 in new Assets

– Why? Because Cap Intensity Ratio = Assets/Sales = 3.00– $250 in new sales requires 3.00 x $250 = $750 in assets

• If Sales increases by $250 A/P will increase by $75– Why? Because (A/P)/Sales is fixed at = 30% – So $250 in new sales requires 0.30 x $250 = $75 in new A/P

• If Sales increases to $1,250 RE will be $110– Why? Because PM = NI/Sales = 13.20% so NI will be $165– And the firm keeps 66.66% of NI so RE = 0.6667 x $165 = $110

So the firm needs to finance $750 in new Assets• $75 will be finance though new A/P• $110 will be financed though RE• $565 will be finance externally (EFN)

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So the firm will need to raise $565 to finance forecast growth– It can’t do it without External Financing – How do we know? Because EFN > 0– But just to be sure, check the IGR for Rosengarten:

Internal Growth Rate = (ROA x b)/(1 – ROA x b) • ROA = NI/Assets = $132/$3,000 = 0.044 • b = Retention Ratio = 1 - $44/$132 = 0.6667• Internal Growth = (ROA x b)/(1 – ROA x b)

= (0.044 x 0.6667)/(1 – 0.044 x 0.6667) = 0.0302 = 3.02%• Rosengarten can only grow at 3.02% if it only uses internal financing (RE).

• So it must sell $565 of stocks and bonds in order to finance 25% sales growth

• But how much of the $565 should be stock and how much should be bonds?

• Easy if we assume constant EM (leverage)• We’ll get to that when we cover capital structure in chapter 14

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Some Other Return Measures

ROI = Return on Investment = Gain / Cost = (Value – Cost)/Cost = (P1 – P0)/P0 = P1/P0 - 1• So an “investment measure”, not really a corporate profitability measure

ROC = Return on Capital = EBIT( 1 – T)/(Book Value of Debt + Book Value of Equity – Cash)

ROIC = Return on Invested Capital = EBIT( 1 – T)/(Book Value of Debt + Book Value of Equity)

Some Notation: • NOPAT = Net Operating Profit After Taxes = EBIT(1 – T)• K = Invested Capital = Book Value of Debt + Book Value of EquityROC = NOPAT/(K – Cash)ROIC = NOPAT/K

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One More We’ll Revisit Later…

EVA = (Return Earned on Invested Capital) - (Cost of Invested Capital) = (r x K) – (c x K) = (r – c) x K = (NOPAT/K – c) x K = NOPAT – c x K

Where:r = NOPAT/K = ROIC = EBIT( 1 – T)/(Book Value of Debt + Book Value of Equity)c = WACC = Weighted Average Cost of Capital

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What’s Next?• Time Value of Money (TVM)– Present Value– Future Value

• Interest Rate Conventions– APR– EAR

• Payment (and Repayment) Conventions – Annuities– Perpetuates – Amortization…