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McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

CHAPTER

3 Financial StatementsAnalysis and Long-Term Planning

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw-Hill/Irwin

Key Concepts and Skills

Know how to standardize financialstatements for comparison purposes

Know how to compute and interpretimportant financial ratios

Be able to develop a financial plan usingthe percentage of sales approach

Understand how capital structure anddividend policies affect a firms ability to

grow

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Chapter Outline

3.1 Financial Statements Analysis

3.2 Ratio Analysis

3.3 The Du Pont Identity3.4 Using Financial Statement Information

3.5 Long-Term Financial Planning

3.6 External Financing and Growth3.7 Some Caveats Regarding Financial Planning

Models

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3.1 Financial StatementsAnalysis

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 tocompare financial information, particularly as the

company grows. They are also useful for comparing companies

of different sizes, particularly within the sameindustry.

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3.2 Ratio Analysis

Ratios also allow for better comparisonthrough 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

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Computing Liquidity Ratios

Current Ratio = CA / CL

708 / 540 = 1.31 times

Quick Ratio = (CAInventory) / CL (708 - 422) / 540 = .53 times

Cash Ratio = Cash / CL

98 / 540 = .18 times

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Computing Leverage Ratios

Total Debt Ratio = (TATE) / TA

(3588 - 2591) / 3588 = 28%

Debt/Equity = TD / TE (35882591) / 2591 = 38.5%

Equity Multiplier = TA / TE = 1 + D/E

1 + .385 = 1.385

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Computing Coverage Ratios

Times Interest Earned = EBIT / Interest

691 / 141 = 4.9 times

Cash Coverage = (EBIT + Depreciation) /Interest

(691 + 276) / 141 = 6.9 times

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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

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Computing Receivables Ratios

Receivables Turnover = Sales / AccountsReceivable

2311 / 188 = 12.3 times

Days Sales in Receivables = 365 /

Receivables Turnover

365 / 12.3 = 30 days

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Computing Total AssetTurnover

Total Asset Turnover = Sales / TotalAssets 2311 / 3588 = .64 times

It is not unusual for TAT < 1, especially if afirm has a large amount of fixed assets.

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Computing ProfitabilityMeasures

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%

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Computing Market ValueMeasures

Market Price = $88 per share

Shares outstanding = 33 million

PE Ratio = Price per share / Earnings pershare

88 / 11 = 8 times

Market-to-book ratio = market value pershare / book value per share

88 / (2591 / 33) = 1.12 times

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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

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Using the Du Pont Identity

ROE = PM * TAT * EM

Profit margin is a measure of the firms

operating efficiencyhow well it controls

costs. Total asset turnover is a measure of the firms

asset use efficiencyhow 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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3.4 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 withinindustries

SIC and NAICS codes

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Potential Problems

There is no underlying theory, so there is no wayto know which ratios are most relevant.

Benchmarking is difficult for diversified firms.

Globalization and international competitionmakes comparison more difficult because ofdifferences in accounting regulations.

Firms use varying accounting procedures. Firms have different fiscal years.

Extraordinary, or one-time, events

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3.5 Long-Term FinancialPlanning

Investment in new assetsdetermined bycapital budgeting decisions

Degree of financial leveragedeterminedby capital structure decisions

Cash paid to shareholdersdeterminedby dividend policy decisions

Liquidity requirementsdetermined by networking capital decisions

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Financial Planning Ingredients

Sales Forecastmany cash flows depend directly onthe level of sales (often estimate sales growth rate)

Pro Forma Statementssetting up the plan as projected(pro forma) financial statements allows for consistencyand ease of interpretation

Asset Requirementsthe additional assets that will berequired to meet sales projections

Financial Requirementsthe amount of financingneeded to pay for the required assets

Plug Variabledetermined by management decisionsabout what type of financing will be used (makes thebalance sheet balance)

Economic Assumptionsexplicit assumptions about thecoming economic environment

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Percent of Sales Approach

Some items vary directly with sales, others donot.

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 varydirectly with salesif this is the case, then the profitmargin is not constant

Dividends are a management decision and generallydo not vary directly with salesthis affects additionsto retained earnings

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Percent of Sales Approach Balance Sheet

Initially assume all assets, including fixed, varydirectly with sales.

Accounts payable also normally vary directly withsales.

Notes payable, long-term debt, and equity generallydo not vary with sales because they depend onmanagement decisions about capital structure.

The change in the retained earnings portion of equity

will come from the dividend decision. External Financing Needed (EFN)

The difference between the forecasted increase inassets and the forecasted increase in liabilities andequity.

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Percent of Sales and EFN

External Financing Needed (EFN) can also becalculated as:

565$

)667.0125013.0()2503.0()2503(

)1(Sales)Projected(SalesSales

LiabSponSalesSales

Assets

dPM

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3.6 External Financing andGrowth

At low growth levels, internal financing(retained earnings) may exceed the requiredinvestment in assets.

As the growth rate increases, the internalfinancing will not be enough, and the firm willhave to go to the capital markets for

financing. Examining the relationship between growth

and external financing required is a usefultool in long-range planning.

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The Internal Growth Rate

The internal growth rate tells us how muchthe firm can grow assets using retainedearnings as the only source of financing.

Using the information from the Hoffman Co.ROA = 66 / 500 = .132

b = 44/ 66 = .66700

%65.9

0965.667.132.1

667.132.

bROA-1bROARateGrowthInternal

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The Sustainable Growth Rate

The sustainable growth rate tells us howmuch the firm can grow by using internallygenerated 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.

bROE-1bROERateGrowtheSustainabl

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Determinants of Growth

Profit marginoperating efficiency

Total asset turnoverasset useefficiency

Financial leveragechoice of optimaldebt ratio

Dividend policychoice of how much topay to shareholders versus reinvesting inthe firm

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3.7 Some Caveats

Financial planning models do not indicatewhich financial polices are the best.

Models are simplifications of reality, andthe world can change in unexpected ways.

Without some sort of plan, the firm mayfind itself adrift in a sea of change without

a rudder for guidance.

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Quick Quiz How do you standardize balance sheets and

income statements?

Why is standardization useful?

What are the major categories of financialratios?

How do you compute the ratios within eachcategory?

What are some of the problems associatedwith financial statement analysis?

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Quick Quiz

What is the purpose of long-range 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?

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