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
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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
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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
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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
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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:
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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
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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
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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
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Quick Ratio = (CA – Inventory) / CL (also called acid –
test) uses the most liquid of assets
◦ (708 – 422) / 540 = .53 times
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Cash Ratio = Cash / CL
◦ 98 / 540 = .18 times
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3-7
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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%
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Debt/Equity = TD / TE (TD = Total Debt)
◦ (3588 – 2591) / 2591 = 38.5%
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Equity Multiplier = TA / TE = 1 + D/E
◦ 1 + .385 = 1.385
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3-8
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Times Interest Earned = EBIT / Interest
◦ 691 / 141 = 4.9 times (Interest coverage ratio)
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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
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These are asset management ratios or utilization ratios
to check and see how efficent the firms uses it assets
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Inventory Turnover = Cost of Goods Sold / Inventory
◦ 1344 / 422 = 3.2 times ( we turned over the entire
inventory 3.2 times in a year)
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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
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How fast do we collect our Receivables
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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)
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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
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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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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% =  Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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% =  Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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? Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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? Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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? Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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) Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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+ Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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? Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 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. Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent o... Purchase answer to see full attachment