Session 3: Financial Statements Analysis

Student notes

September 26, 2023

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Please note

- Presentation slides are not a complete study aid.

- Students need to read the prescribed textbook.
- Try to do as many exercises as possible.
- Your own notes will remarkably support your study.
- Discussions are warmly welcome.
- Sometimes, the final answer is not very important. Instead, the problem solving process is!
Hence, please listen actively and attentively.

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Outline

1. Financial Statements Analysis

2. Ratio Analysis
3. The DuPont Identity
4. Financial models
5. External Financing and Growth
6. Tutorials

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What is next?

1. Financial Statements Analysis

2. Ratio Analysis
3. The DuPont Identity
4. Financial models
5. External Financing and Growth
6. Tutorials

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Financial Statements Analysis

• Financial statements: provide information about a company’s performance financial

position, and changes in financial position.
• Financial statement analysis + other information: to evaluate the past, current, and
potential performance and financial position of a company.
Managers: make operating, investing, and financing decisions;
Analysts: evaluate an equity investment for inclusion in a portfolio or merger/acquisition
candidate;
Banks: determine the creditworthiness of a company.
• Compare company A with company B in terms of financial health.
Tesla vs. GM
Acer vs. Lenovo

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Financial Statements Analysis (cont.)

Source: CFA (2022, p. 182)

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Financial Statements Analysis (cont.)

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Financial Statements Analysis (cont.)
Standardized statements make it easier to compare financial information.
- Common-Size Balance Sheets: Compute all accounts as a percent of total assets.

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Financial Statements Analysis (cont.)

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Financial Statements Analysis (cont.)

Standardized statements make it easier to compare financial information.

- Common-Size Income Statements: Compute all line items as a percent of sales.

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What is next?

1. Financial Statements Analysis

2. Ratio Analysis
3. The DuPont Identity
4. Financial models
5. External Financing and Growth
6. Tutorials

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Categories of Financial Ratios

- Short-term solvency, or liquidity, ratios: Indicate the firm’s ability to pay its bills over the
short run without undue stress.
- Long-term solvency, or financial leverage, ratios: Measure the firm’s long-run ability to meet
its obligations or, more generally, its financial leverage.
- Asset management, or turnover, ratios: Measure how efficiently, or intensively, a firm
uses/manages its assets.
- Profitability ratios: Measure how efficiently the firm uses its assets and how efficiently the
firm manages its operations.
- Market value ratios.

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Important notes

Note: For each ratio, pay attention to:

- 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 company’s ratio?

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Short-term solvency or liquidity measures (cont.)
- Will the firm be able to pay off its short-term debts as they come due?
- Short-term solvency or liquidity measures: Provide information about a firm‘s liquidity, which
attracts attention from lenders/creditors.

Current assets
Current ratio =
Current liabilities
- A higher ratio indicates a higher level of liquidity or a greater ability to meet short-term
obligations.

Example: Current ratio = 1.5 times.

The company has $1.5 in current assets for every $1 in current liabilities.
Example: Current ratio of 1.0.
The company would have just enough current assets to pay current liabilities.

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Short-term solvency or liquidity measures (cont.)

Example: Table 1 - Handout. Calculate Current ratio (2022) of Prufrock.

• Current assets (2022) = 708
• Current liabilities (2022) = 540
• Current ratio = 1.31 times

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Short-term solvency or liquidity measures (cont.)
Issue:
- Current assets include inventory, which is less liquid or may be damaged, obsolete, or lost.
- Inventory may not be converted to cash as quickly as expected.
Current assets − Inventory
Quick ratio =
Current liabilities
- The quick ratio is more conservative than the current ratio.
- A higher quick ratio indicates greater liquidity.

Example: Table 1 - Handout. Calculate Quick ratio (2022) of Prufrock.

• Current assets (2022) = 708
• Current liabilities (2022) = 540
• Inventory (2022) = 422
• Quick ratio = 0.53 times
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Short-term solvency or liquidity measures (cont.)

Cash
Cash ratio =
Current liabilities
- The cash ratio normally represents a reliable measure of an entity‘s liquidity in a crisis
situation.

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Long-term solvency measures (cont.)

Total Debt Ratio (debt-to-assets ratio)

Total assets − Total equity Total debt

Total debt ratio = =
Total assets Total assets
- Measures the percentage of total assets financed with debt.
- The total debt ratio takes into account all debts of all maturities to all creditors.
- Generally, higher debt means higher financial risk and weaker solvency.
E.g., Total debt ratio = 0.3
• 30% of company’s assets are financed with debt;
• The company has 0.3$ in debt for every $1 in assets.

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Long-term solvency measures (cont.)
Total debt
Debt − equity ratio =
Total equity
- Measures the amount of debt capital relative to equity capital.
- A higher ratio indicates weaker solvency.

Total assets Total debt

Equity multiplier = =1+
Total equity Total equity

Example: Table 1 - Handout.

Total debt ratio = ? ; Debt-equity ratio = ?; Equity multiplier = ?
• Total debt ratio = 0.28 times;
• Debt-equity ratio = 0.38 times;
• Equity multiplier = 1.38 times
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Long-term solvency measures (cont.)

Time Interest Earned: measures how well a company has its interest obligations covered.
EBIT
Time interest earned ratio =
Interest
Cash Coverage: a measure of cash flow available to meet financial obligations.

EBIT + (Depreciation and amortization)

Cash coverage ratio =
Interest

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Asset management or turnover measures
Inventory turnover: indicates how fast a company can sell products. It indicates how many
times inventory is turned over during the year.
Cost of goods sold
Inventory turnover =
Inventory

(Higher inventory turnover means higher efficiency in inventory management)

Example: Inventory turnover = 6.2.
* The company sold off (turned over) the entire inventory 6.2 times during the year.

365 days
Days‘ sales in inventory =
Inventory turnover
(The lower, the better)
Example: Days’ sales in inventory = 107 days.
* On average, Inventory sits 107 days before it is sold.
* It will take about 107 days to work off the current inventory.
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Asset management or turnover measures (cont.)

Receivables Turnover: indicates how fast a company can collect on their sales.
Sales
Receivables turnover =
Accounts receivable
Example: Receivables turnover = 15 times.
The company collected its outstanding credit accounts and lent the money again 15 times.

365 days
Days ′ sales in receivables =
Receivables turnover
Example: Days’ sales in receivables = 30 days.
On average, the company collects on its credit sales in 30 days.

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Asset management or turnover measures (cont.)

Total asset turnover: measures the company’s overall ability to generate revenues with a
given level of assets. It measures how effectively the firm uses its assets.
Sales
Total assets turnover =
Total assets

Example: Total assets turnover = 1.20.

The company is generating $1.20 of revenues for every $1 of assets.
Example: Total assets turnover = 0.5.
For every dollar in assets, the company generated $0.5 in sales.

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Profitability measures

Net income
Profit margin =
Sales
Example: Profit margin = 20% means the firm generates 20 cents in net income for 1$ in sales.

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Profitability measures (cont.)

Return on Assets (ROA): measures the return earned by a company on its assets. The higher
the ratio, the more income is generated by a given level of assets.
Net income
ROA =
Total assets
Return on Equity (ROE): measures the return earned by a company on its equity capital.

Net income
ROE =
Total equity

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Market value measures

Earnings per share (EPS): is the amount of earnings attributable to each share of common
stock.
Net income
Earnings per share (EPS) =
Shares outstanding
- Be careful: EPS does not provide adequate information for comparison of one company with
another.
Example:
Company A: Net income = $10 mil; Equity = $100 mil; ROE = 10%
Company B: Net income = $10 mil; Equity = $100 mil; ROE = 10%
Company A: 100 mil shares; EPS = $0.1/share
Company B: 10 mil shares; EPS = $1/share
The difference in EPS does not reflect a difference in profitability measured by ROE.

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Market value measures (cont.)

Price-Earnings Ratio: Measures how much investors are willing to pay per dollar of current
earnings.
Price per share per share
Price − Earning ratio =
EPS
- Higher PEs : the firm has significant prospects for future growth.
- Be careful: If the firm has almost no earnings (the denominator is quite small), the PE ratio is
large.

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Market value measures

Market value per share

Market − to − book (MTB) ratio =
Book value per share
where book value per share equals total equity divided by the number of shares outstanding.
(MTB < 1 means the firm has not been successful in creating value for its stockholders.)

Market Capitalization = Price per share ∗ Shares outstanding

Market cap is also an indicator for the size of public companies.

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Important notes
- Ratios need to be compared to "something".
* Time trend analysis: Used to see how the firm’s performance is changing through time.
* Peer Group Analysis: Compare to similar companies or within industries.

Source: Brigham & Houston (2021, p. 131)

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What is next?

1. Financial Statements Analysis

2. Ratio Analysis
3. The DuPont Identity
4. Financial models
5. External Financing and Growth
6. Tutorials

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The DuPont Identity

- Developed by E.I. DuPont de Nemours and Company in the early 20th century.
- Idea: decomposing ROE into its component parts.
- Purpose:
* Evaluate how different aspects of performance affected the company‘s profitability as
measured by ROE.
* Determine the reasons for changes in ROE over time for a given company.
* Determine the reasons for differences in ROE for different companies in a given time
period.
* Determine which areas firm managers should focus on to improve ROE.

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The DuPont Identity (cont.)
Net income
ROE =
Total equity
Net income Assets
ROE = ∗
Total equity Assets
Net income Assets
ROE = ∗
Assets Total equity

ROE = ROA ∗ Equity multiplier

ROE = ROA ∗ Financial leverage

• ROE is a function of a company’s ROA and its use of financial leverage.
• A company can improve its ROE by improving ROA or making more effective use of
leverage.
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The DuPont Identity (cont.)

Net income Assets

ROE = ∗
Assets Total equity
• If a company had no leverage (no liabilities)?
Assets/Total equity = 1 and ROE = ROA
• If that company takes on liabilities...
Assets/Total equity increases.
If that company can borrow at a rate < the marginal rate it can earn investing the
borrowed money in its business, the company is making an effective use of leverage. ROE
would increase as leverage increases.
If borrowing cost > the marginal rate it can earn on investing in the business, ROE would
decline as leverage increased because the effect of borrowing would be to depress ROA.

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The DuPont Identity (cont.)

Source: CFA (2022, p. 222)

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The DuPont Identity (cont.)

Net income
ROE =
Total equity
Sales Net income Assets
ROE = ∗ ∗
Sales Total equity Assets
Net income Sales Assets
ROE = ∗ ∗
Sales Assets Total Equity

ROE = Profit margin ∗ Total assets turnover ∗ Equity multiplier

ROE = Operating Efficiency ∗ Assets Use Efficiency ∗ Financial Leverage

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The DuPont Identity (cont.)
ROE = Operating Efficiency ∗ Assets Use Efficiency ∗ Financial Leverage
Example: Amazon vs. Alibaba

• Alibaba had a higher ROE than Amazon.

• Alibaba has an advantage in that its operating efficiency is much higher than that of Amazon.
• Amazon has an advantage in its asset utilization.
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Problem 3

Using the DuPont Identity.

Y3K, Inc., has sales of $5,987, total assets of $2,532, and a debt-equity ratio of .57. If its
return on equity is 11 percent, what is its net income?

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What is next?

1. Financial Statements Analysis

2. Ratio Analysis
3. The DuPont Identity
4. Financial models
5. External Financing and Growth
6. Tutorials

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A simple financial planning model

- All items will grow at exactly the same rate as sales.

Income statement Balance sheet

Sales $1,000 Assets $500 Debt $250
Costs $800 Equity $250
Net income $200 Total $500 Total $500

- If sales increase by 20% (from 1,000 to 1,200)

Costs will increase by 20%

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A simple financial planning model (cont.)

Income statement Balance sheet

Sales $1,200 [1000*1.2] Assets $ Debt $
Costs $960 [800*1.2] Equity $
Net income $240 Total $ Total $

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A simple financial planning model (cont.)

Income statement Balance sheet

Sales $1,200 [1000*1.2] Assets $600 [500*1.2] Debt $
Costs $960 [800*1.2] Equity $
Net income $240 Total $600 Total $

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A simple financial planning model (cont.)

Income statement Balance sheet

Sales $1,200 [1000*1.2] Assets $600 [500*1.2] Debt $300 [250*1.2]
Costs $960 [800*1.2] Equity $300 [250*1.2]
Net income $240 Total $600 Total $600

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A simple financial planning model (cont.)

Take a closer look:

Income statement Balance sheet

Sales $1,200 (+200) Assets $600 (+100) Debt $300 (+50)
Costs $960 (+160) Equity $300 (+50)
Net income $240 Total $600 Total $600

- Net income = 240 but equity increases by 50.

* Scenario 1: Company paid dividend (240-50 = 190)

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A simple financial planning model (cont.)
Take a closer look:

Income statement Balance sheet

Sales $1,200 (+200) Assets $600 (+100) Debt $300 (+50)
Costs $960 (+160) Equity $300 (+50)
Net income $240 Total $600 Total $600

- Net income = 240 but equity increases by 50.

* Scenario 2: Company did not pay dividend. $240 was the added to retained earnings.

Income statement Balance sheet

Sales $1,200 (+200) Assets $600 (+100) Debt $110 (-140)
Costs $960 (+160) Equity $490 (+240)
Net income $240 Total $600 Total $600

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A simple financial planning model (cont.)

Comments:
- Assets increase with sales since the firm needs to invest in net working capital and fixed assets
to promote sales.
- Assets grow, so do liabilities and equity.
- Changes in liabilities and equity depend on the firm’s financing and dividend policies.

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The percentage of sales approach

- Some items vary directly with sales, others do not.

Income statement:
• Costs may vary directly with sales—if this is the case, then the profit margin is constant.
• Depreciation and interest expense may not vary directly with sales—if this is the case, then
the profit margin is not constant.
• Dividends are a management decision and generally do not vary directly with sales—this
affects additions to retained earnings.

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The percentage of sales approach (cont.)

- Some items vary directly with sales, others do not.

Balance sheet:
• Initially assume all assets, including fixed, vary directly with sales.
• Accounts payable also normally vary directly with sales.
• Notes payable, long-term debt, and equity generally do not vary with sales because they
depend on management decisions about capital structure.
• The change in the retained earnings portion of equity will come from the dividend decision.
Idea:
To separate the income statement and balance sheet accounts into two groups: those that vary
directly with sales and those that do not.

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Problem 4

- Assets and costs are proportional to sales; debt and equity are not.
- A dividend of $1,400 was paid, and the company wishes to maintain a constant payout ratio.
- Next year‘s sales are projected to be $23,345.
What external financing is needed?

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Problem 4 (cont.)

Hint:
• The percentage of sales approach (i.e., some items increase at the same rate as sales,
others do not).
• Separate the income statement and balance sheet accounts into two groups: those that
vary directly with sales and those that do not.
• Growth rate of sales?
($23,345 - $20,300)/$20,300 = 15%

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Problem 4 (cont.)

Income statement Balance sheet

Sales $23,345.00 Assets Debt
Costs Equity
EBIT Total Total
Taxes
Net income

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Problem 4 (cont.)

Income statement Balance sheet

Sales $23,345.00 Assets Debt
Costs $19,665.00 Equity
EBIT Total Total
Taxes
Net income

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Problem 4 (cont.)

Income statement Balance sheet

Sales $23,345.00 Assets Debt
Costs $19,665.00 Equity
EBIT $3,680.00 Total Total
Taxes $772.80
Net income $2,907.20

Now, we move to the balance sheet!

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Problem 4 (cont.)

Income statement Balance sheet

Sales $23,345.00 Assets $54,050 [47,000 * 1.15] Debt
Costs $19,665.00 Equity
EBIT $3,680.00 Total $54,050 Total $54,050
Taxes $772.80
Net income $2,907.20

Calculate (i) new equity and (ii) how much financing the firm will need to support the predicted
sales level.

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Problem 4 (cont.)

(i) new equity

A dividend of $1,400 was paid, and the company wishes to maintain a constant payout ratio.
• New equity = Last year Equity + Addition to retained earnings
• Payout ratio?
Payout ratio = $1400/$2,528
• Dividend paid this year = ($1400/$2,528)*$2,907.2 = $1,610
• Addition to retained earnings = $2,907.2 - $1,610 = $1,297.2
• New equity = $20,100 + $1,297.2 = $21,397.20

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Problem 4 (cont.)

Income statement Balance sheet

Sales $23,345.00 Assets $54,050 Debt
Costs $19,665.00 Equity $21,397.20
EBIT $3,680.00 Total $54,050 Total $54,050
Taxes $772.80
Net income $2,907.20

Calculate (i) new equity and (ii) how much financing the firm will need to support the predicted
sales level.

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Problem 4 (cont.)

(ii) how much financing the firm will need

• Debt = Assets - Equity
• Debt = $54,050 - $21,397.2 = $32,652.8

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Problem 4 (cont.)

Income statement Balance sheet

Sales $23,345.00 Assets $54,050 Debt $32,652.8
Costs $19,665.00 Equity $21,397.2
EBIT $3,680.00 Total $54,050 Total $54,050
Taxes $772.80
Net income $2,907.20

External Financing Needed = ?

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Problem 4 (cont.)

Income statement Balance sheet

Sales $23,345.00 Assets $54,050 Debt $32,652.8
Costs $19,665.00 Equity $21,397.2
EBIT $3,680.00 Total $54,050 Total $54,050
Taxes $772.80
Net income $2,907.20

External Financing Needed = EFN = $54,050 - $21,397.2 - $26,900

External Financing Needed = EFN = $32,652.8 - $26,900 = $5752.8

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The percentage of sales approach
External Financing Needed
Assets Spontaneous liabilities
EFN = ∗∆Sales− ∗∆Sales−Profit margin∗Projected Sales∗(1−d)
Sales Sales
where:
Spontaneous liabilities: liabilities that naturally move up and down with sales (e.g., account
payable)
∆Sales = Salest+1 − Salest
Net income
Profit margin =
Sales
Cash dividends
d = Dividend payout ratio =
Net income
Addition to retained earning
1 − d = retention ratio or plowback ratio =
Net income
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The percentage of sales approach

External Financing Needed

Assets Spontaneous liabilities
EFN = ∗∆Sales− ∗∆Sales−Profit margin∗Projected Sales∗(1−d)
Sales Sales
Using Problem 4 as an example:
47, 000 2, 528 1, 400
EFN = ∗ (23, 345 − 20, 300) − 0 − ∗ 23, 345 ∗ (1 − )
20, 300 20, 300 2, 528

EFN = $5, 752.8

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Problem 8 (Textbook, p. 77)

The most recent financial statements for Hu, Inc., are shown here (assuming no income taxes):

Income statement Balance sheet

Sales $9,400 Assets $20,300 Debt $8,400
Costs $6,730 Equity $11,900
Net income $2,670 Total $20,300 Total $20,300

Assets and costs are proportional to sales; debt and equity are not. No dividends are paid. Next
year‘s sales are projected to be $11,092.
What is the external financing needed?

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Problem 9 (Textbook, p. 77)

Dahlia Colby, CFO of Charming Florist Ltd., has created the firm‘s pro forma balance sheet for the
next fiscal year.
- Sales are projected to grow by 16% to $320 million.
- Current assets, fixed assets, and accounts payable are 20%, 70%, and 15% of sales, respectively.
- Charming Florist pays out 30% of its net income in dividends.
- The company currently has $105 million of long-term debt and $45 million in common stock par value.
- The profit margin is 9%
a. Construct the current balance sheet for the firm using the projected sales figure.
b. Based on Ms. Colby‘s sales growth forecast, how much does Charming Florist need
in external funds for the upcoming fiscal year?

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What is next?

1. Financial Statements Analysis

2. Ratio Analysis
3. The DuPont Identity
4. Financial models
5. External Financing and Growth
6. Tutorials

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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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External Financing and Growth

The Internal Growth Rate tells us how much the firm can grow assets using retained
earnings as the only source of financing (i.e., with no external financing of any kind).

ROA ∗ b
Internal Growth Rate =
1 − ROA ∗ b
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 (i.e., no external equity
financing)
ROE ∗ b
Sustainable growth rate =
1 − ROE ∗ b
where: b is the plowback/retention ratio.

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Problem 5
Sales and Growth.
The most recent financial statements for Anderson Co.

Assets and costs are proportional to sales. Long-term debt and equity are not. The company maintains
a constant 40% dividend payout ratio and a constant debt-equity ratio.
What is the maximum increase in sales that can be sustained assuming no new equity
is issued?

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Problem 7

Sustainable Growth.
Assuming the following ratios are constant, what is the sustainable growth rate?
- Total asset turnover = 3.20
- Profit margin = 5.2%
- Equity multiplier = .95
- Payout ratio = 35%

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What is next?

1. Financial Statements Analysis

2. Ratio Analysis
3. The DuPont Identity
4. Financial models
5. External Financing and Growth
6. Tutorials

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Problem 13
External Funds Needed.
The Optical Scam Company has forecast a sales growth rate of 15% for next year.

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Problem 13 (cont.)

(a) Using the equation from the chapter, calculate the external funds needed for next
year.
(b) Construct the firm‘s pro forma balance sheet for next year and confirm the
external funds needed that you calculated in part (a).
(c) Calculate the sustainable growth rate for the company.
(d) Can the company eliminate the need for external funds by changing its dividend
policy? What other options are available to the company to meet its growth
objectives?

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Problem 19

Full-Capacity Sales.
Blue Sky Mfg., Inc., is currently operating at 90% of fixed asset capacity. Current sales are
$575,000.
How much can sales increase before any new fixed assets are needed?

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Problem 20

Fixed Assets and Capacity Usage.

For the company in the previous problem, suppose fixed assets are $720,000 and sales are
projected to grow to $665,000.
How much in new fixed assets are required to support this growth in sales?

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Thank you for your attention.
Q&A

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