Financial Statements Analysis and Financial Models Please go through the attached presentations of Chapters 3 and 4, read the Corporate Finance textbook to
Financial Statements Analysis and Financial Models Please go through the attached presentations of Chapters 3 and 4, read the Corporate Finance textbook to write a summary of the assigned chapters in no less than three pages.Let me know if you have any questions. Chapter 3
Financial Statements Analysis and Financial
Models
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
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3-1
Financial Statements Analysis
Ratio Analysis
Financial Models
External Financing and Growth
Some Caveats Regarding Financial Planning
Models
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3-2
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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3-3
Net Income (the bottom line) Revenues minus
expenses.
EPS – Earnings per share (net income/number
of common stock shares outstanding)
EBIT – Earnings before interest and taxes
(income from operations). It is income before
unusual items, discontinued operations, or
extraordinary items.
EBITDA – Earnings before interest, taxes,
depreciation and amortization. It is a better
measure of before tax cash flow.
3-4
Financial Ratios also allow for better comparison
through time or between companies.
These ratios are ways of comparing and investigation
the relationships between different pieces of
information
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?
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3-5
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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3-6
Current Ratio = CA / CL (best known and widely used
for short term liquidity) (what if it is less than 1) (How
strong is the ratio)
◦ 708 / 540 = 1.31 times
Quick Ratio = (CA – Inventory) / CL (also called acid –
test) uses the most liquid of assets
◦ (708 – 422) / 540 = .53 times
Cash Ratio = Cash / CL
◦ 98 / 540 = .18 times
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3-7
Can the company meets its long run ability to meet its
obligation
Total Debt Ratio = (TA – TE) / TA (TA =Total Assets,
TE = Total Equity)
◦ (3588 – 2591) / 3588 = 28%
Debt/Equity = TD / TE (TD = Total Debt)
◦ (3588 – 2591) / 2591 = 38.5%
Equity Multiplier = TA / TE = 1 + D/E
◦ 1 + .385 = 1.385
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3-8
Times Interest Earned = EBIT / Interest
◦ 691 / 141 = 4.9 times (Interest coverage ratio)
Cash Coverage = (EBIT + Depreciation +
Amortization) / Interest
◦ (691 + 276) / 141 = 6.9 times
◦ This is a basic measure of the firms ability to
generate cash from operations and is frequently
used as a measure of cash flow to meet financial
obligations.
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3-9
These are asset management ratios or utilization ratios
to check and see how efficent the firms uses it assets
Inventory Turnover = Cost of Goods Sold / Inventory
◦ 1344 / 422 = 3.2 times ( we turned over the entire
inventory 3.2 times in a year)
Days’ Sales in Inventory = 365 / Inventory Turnover
◦ 365 / 3.2 = 114 days ( we have 114 days of
inventory on hand to sell).
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3-10
How fast do we collect our Receivables
Receivables Turnover = Sales / Accounts Receivable
◦ 2311 / 188 = 12.3 times ( we collected our outstanding
credit and lent the money our again 12.3 times during the
year)
Days’ Sales in Receivables = 365 / Receivables
Turnover
◦ 365 / 12.3 = 30 days (On average we collect our credit sales
In 30 days, called the average collection period)
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3-11
Total Asset Turnover = Sales / Total Assets
◦ 2311 / 3588 = .64 times (For every dollar in assets, the firm
generated $.64 in sales)
◦ It is not unusual for TAT < 1, especially if a firm has a large
amount of fixed assets.
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3-12
They are intended to measure how efficiently the
firm uses its assets and how efficiently the firm
manages its operations.
Profit Margin = Net Income / Sales
◦ 363 / 2311 = 15.7% (for every $1 in sales the firm gets
$.157 in net income
Return on Assets (ROA) = Net Income / Total Assets
◦ 363 / 3588 = 10.1% (profit per $1 of assets)
Return on Equity (ROE) = Net Income / Total Equity
◦ 363 / 2591 = 14.0% (true bottom line of performance)
EBITDA Margin = EBITDA / Sales
◦ 967 / 2311 = 41.8% (operating cash flow per $1 of sales
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3-13
Market Capitalization = $88 per share x 33 million shares =
$2,904 million (market price times shares outstanding)
PE Ratio = Price per share / Earnings per share
◦ 88 / 11 = 8 times (investors willing to pay 8 time earnings for stock)
Market-to-book ratio = market value per share / book value per
share
◦ 88 / (2591 / 33) = 1.12 times (Value has been created)
Enterprise Value (EV) = Market capitalization + Market value
of interest bearing debt – cash
◦ 2904 + (196 + 457) – 98 = $3,459( this is a better estimate on how
much it would take to buy all of the outstanding stock and pay off the
debt)
EV Multiple = EV / EBITDA
◦ 3459 / 967 = 3.6 times (how many time is EV of total cash flow)
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3-14
Ratios are not very helpful by themselves: they 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
◦ SIC and NAICS codes
◦ A good summary of the ratios are on page 57.
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3-15
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 can affect some of the
ratios. Be careful and use caution in ratio analysis and
make sure you understand the numbers being used.
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3-16
Financial planner models use Pro Forma statements –
“as a matter of form” or “what if statements”
Investment in new assets – determined by capital
budgeting decisions
Degree of financial leverage – determined by capital
structure decisions
Cash paid to shareholders – determined by dividend
policy decisions
Liquidity requirements – determined by net working
capital decisions
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3-17
Sales Forecast – many cash flows depend directly on the level
of sales (often estimate sales growth rate)
Pro Forma Statements – setting up the plan as projected (pro
forma) financial statements allows for consistency and ease of
interpretation
Asset Requirements – the additional assets that will be
required to meet sales projections
Financial Requirements – the amount of financing needed to
pay for the required assets
Plug Variable – determined by management decisions about
what type of financing will be used (makes the balance sheet
balance)
Economic Assumptions – explicit assumptions about the
coming economic environment
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3-18
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
◦ The Estimate of Sales is very important to the use of a sales
model.
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3-19
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.
External Financing Needed (EFN)
◦ The difference between the forecasted increase in assets
and the forecasted increase in liabilities and equity.
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3-20
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.
The higher the rate of growth is sales or assets, the
greater will be the need for external financing. It
takes cash to grow.
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3-21
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 (b is plowback ratio)
Internal Growth Rate
ROA b
1 - ROA b
.132 .667
=
= .0965
1 − .132 .667
= 9.65%
=
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3-22
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
Sustainable Growth Rate
ROE b
1- ROE b
.264 .667
=
= .214
1 − .264 .667
= 21.4%
=
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3-23
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
If a firm does not wish to sell new equity and its
profit margin, dividend policy, financial policy
and the total asset turnover are all fixed, then
there is only one possible growth rate. The
sustainable growth rate.
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3-24
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.
The models rely upon historical accounting relationships
Financial planning is an iterative process that are created,
examined, modified over and over. The process is never
over.
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3-25
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?
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3-26
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?
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3-27
Chapter 4
Discounted Cash Flow Valuation
Be able to compute the future value and/or present
value of a single cash flow or series of cash flows
Be able to compute the return on an investment
Be able to use a financial calculator and/or
spreadsheet to solve time value problems
Understand perpetuities and annuities
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4-1
4.1 Valuation: The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 Loan Amortization
4.6 What Is a Firm Worth?
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4-2
If you were to invest $10,000 at 5-percent interest for one
year, your investment would grow to $10,500.
$500 would be interest ($10,000 × .05)
$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:
$10,500 = $10,000×(1.05)
The total amount due at the end of the investment is called the
Future Value (FV) or Compound Value.
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4-3
In the one-period case, the formula for FV can be
written as:
FV = PV×(1 + r)
Where PV is present value (i.e., the value today), and
r is the appropriate interest rate (referred to as the
compound rate)
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4-4
If you were to be promised $10,000 due in one year
when interest rates are 5-percent, your investment
would be worth $9,523.81 in today’s dollars.
$10,000
$9,523.81 =
1.05
The amount that a borrower would need to set aside
today to be able to meet the promised payment of
$10,000 in one year is the Present Value (PV).
that $10,000 = $9,523.81×(1.05).
Note
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4-5
In the one-period case, the formula for PV can be
written as:
C1
PV =
1+ r
Where C1 is cash flow at date 1, and r is the
appropriate interest rate or the discount rate. We
could
also write the formula as:
PV =
1
1+
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4-6
The Net Present Value (NPV) of an investment is the
present value of the expected cash flows, less the cost
of the investment. (A cost benefit analysis)
Suppose an investment that promises to pay $10,000
in one year is offered for sale for $9,500. Your
interest rate is 5%. Should you buy the investment?
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4-7
$10,000
NPV = −$9,500 +
1.05
NPV = −$9,500 + $9,523.81
NPV = $23.81
The present value of the cash inflow is greater than
the cost. In other words, the Net Present Value is
positive, so the investment should be purchased.
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4-8
In the one-period case, the formula for NPV can be
written as:
NPV = –Cost + PV
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less
than the $10,000 the investment promised, and we
would be worse off in FV terms :
$9,500×(1.05) = $9,975 < $10,000
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4-9
The correct discount rate for an expected
cash flow is the expected return available in
the market on another investment of similar
risk.
This is an appropriate discount rate to use
because it represents an economic
opportunity cost to investors.
It is the expected return the investor will
require before committing and cash.
4-10
The general formula for the future value of an
investment over many periods can be written as:
FV = PV×(1 + r)t
Where
PV is present value,
r is the appropriate interest rate, and
t is the number of periods over which the cash is
invested.
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