Financial Statements

Analysis
And Financial Models
Chapter 3
 Key Concepts and Skills

PREPARE ANALYZE
Know how to standardize Know how to compute and
financial statements for interpret important
comparison purposes financial ratios

PROJECT SUMMARISE
Be able to develop a Understand how capital
financial plan using the structure and dividend
percentage of sales policies affect a firm’s
approach ability to grow
 TABLE OF CONTENTS

01 Financial Statements
Analysis 02 Ratio Analysis

03 The DuPont Identity

04 Financial Models

03 External Financing
and Growth 04 Some Caveats
Regarding Financial
Planning Models
01
Financial
Statements
Analysis
 Financial Statements Analysis

Ø Trend analysis vs Peer group analysis

Ø It is difficult to compare the financial statements
across firms due to various reasons:
Ø Size
Ø Currency
Ø Industry
Ø Accouting choices
Financial Statements Analysis
 Financial
Statements
Analysis
 Financial Statements Analysis

Ø Common-Size Balance Sheets

Ø Compute all accounts as a percent of total
assets
Ø Common-Size Income Statements
Ø Compute all line items as a percent of sales
Ø They are also useful for comparing companies of
different sizes, particularly within the same
industry.
02
Ratio
Analysis
 Categories of Financial Ratios
Financial
Liquidity Ratios Leverage Ratios
Related to short term Ralated to long term
solvency solvency

Profitability Market value

Turnover Ratios Ratios Ratios
Related to asset Related to return on Ralated to stock’s market
management invested capital price
 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 company’s ratio?

Liquidity Ratios
Liquidity Ratios
Leverage Ratios
Leverage Ratios
Leverage Ratios
Turnover Ratios
Turnover Ratios
 Turnover Ratios

• More Turnover:
• Can you calculate fixed asset turnover ratio or
payable turnover ratio of a company?
Profitabilty Ratios
Market Value Ratios
Financial Ratios
03
The DuPont
Identity
Using the
DuPont
Identity
 The Dupont Identity
𑁋 The DuPont identity tells us that ROE is affected by three
things:
○ Operating efficiency (as measured by profit margin)
○ Asset use efficiency (as measured by total asset turnover).
○ Financial leverage (as measured by the equity multiplier).

𑁋 Increasing debt also increases interest expense, which

reduces profit margins, which acts to reduce ROE.
𑁋 Increasing debt usually increase risk of a company.
 Potential Problems
v There is no underlying theory, so there is no way to know
which ratios are most relevant.
v Benchmarking is difficult for diversified firms.
v Globalization and international competition makes
comparison more difficult because of differences in
accounting regulations.
v Firms use varying accounting procedures.
v Firms have different fiscal years.
v Extraordinary, or one-time, events.
04
Financial
Models
 3.4 Financial Models
v Investment in new assets – determined by capital
budgeting decisions
v Degree of financial leverage – determined by capital
structure decisions
v Cash paid to shareholders – determined by dividend policy
decisions
v Liquidity requirements – determined by net working capital
decisions
 Financial Planning Ingredients
v Sales Forecast – many cash flows depend directly on the level of
sales (often estimate sales growth rate)
v Pro Forma Statements – setting up the plan as projected (pro
forma) financial statements allows for consistency and ease of
interpretation
v Asset Requirements – the additional assets that will be required to
meet sales projections
v Financial Requirements – the amount of financing needed to pay
for the required assets
v Plug Variable – determined by management decisions about what
type of financing will be used (makes the balance sheet balance)
 3.4 Financial Models
v A SIMPLE FINANCIAL PLANNING MODEL
v I

v Sales is supposed increase by 20% and all items will

increase by the same rate.
 3.4 Financial Models
v A SIMPLE FINANCIAL PLANNING MODEL

𑁋 Computerfield must have paid out $190 as a cash dividend

𑁋 Cash dividend is “plug” variable.
 3.4 Financial Models
v A MODEL THAT DEBT AS PLUG VARIABLE

𑁋 Computerfield must retire $140 in debt.

𑁋 There are an interaction between sales growth and financial
policies.
 3.4 Financial Models
v A more complex financial model

𑁋 Sales is projected to increase by 25%.

𑁋 The dividend policy is unchanged.
 3.4 Financial Models
v A more complex financial model

𑁋 Cash dividend for the next year is $55.

𑁋 Retained earning for the next year is $110.
3.4 Financial Models
3.4 Financial Models
 3.4 Financial Models

v Assets are projected to increase by $750, liabilities and

equity will increase by only $185. A shortfall $565 is called
External Financing Needed.
v It is a function of:
v The amount of asset will increase.
v The amount of operating liabilities will increase
v The amount of retained earnings.
 3.4 Financial Models
v A particular scenario
05
External
Financing
and Growth
3.5 External Financing and Growth
v At low growth levels, internal financing (retained earnings)
may exceed the required investment in assets.
v 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.
v Examining the relationship between growth and external
financing required is a useful tool in financial planning.
3.5 External Financing and Growth
𑁋 Growth and Projected EFN for the Hoffman Company
3.5 External Financing and Growth
 3.5 External Financing and Growth
v The Internal Growth Rate
v The internal growth rate tells us how much the firm can grow
assets using retained earnings as the only source of financing

v The Sustainable Growth Rate

v 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
3.5 External Financing and Growth
v Determinants of Growth
v Profit margin – operating efficiency
v Total asset turnover – asset use efficiency
v Financial leverage – choice of optimal debt ratio
v Dividend policy – choice of how much to pay to shareholders
versus reinvesting in the firm
06
Some
Caveats
3.6 Some Caveats
v Some caveats:
v Financial planning models do not indicate which financial
polices are the best.
v Models are simplifications of reality, and the world can
change in unexpected ways.
v Without some sort of plan, the firm may find itself adrift in a
sea of change without a rudder for guidance.
 Quick Quiz
v How do you standardize balance sheets and
income statements?
v Why is standardization useful?
v What are the major categories of financial
ratios?
v How do you compute the ratios within each
category?
v What are some of the problems associated
with financial statement analysis?
 Quick Quiz
v What is the purpose of financial planning?

v What are the major decision areas involved

in developing a plan?
v What is the percentage of sales approach?

v What is the internal growth rate?

v What is the sustainable growth rate?

v What are the major determinants of growth?

THANK YOU!!!

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