# UT FIN 357 - Chapter 3. Financial Statement Analysis v4 (31 pages)

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**View the full content.**## Chapter 3. Financial Statement Analysis v4

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## Chapter 3. Financial Statement Analysis v4

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- Pages:
- 31
- School:
- University of Texas at Austin
- Course:
- Fin 357 - Business Finance

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Financial Statement Analysis Chapter 3 Finance 357 J David Miller 2017 Common Size Statements Common size are standardized statements that state value in percentages rather than in Dollars Yen or Euros For Balance Sheets state all values as a percentage of total assets For Income Statements state all values as a percentage of total sales 2 Annual Income Statement Safeway Inc SWY Annual Income Statement 12 29 2007 2 2 2008 Total Revenue 42 286 000 70 235 000 Direct Costs 30 133 100 53 779 000 Gross Profit 12 152 900 16 456 000 Selling General Admin 10 380 800 12 799 000 Total Indirect Operating Costs 10 380 800 14 155 000 1 772 100 2 301 000 388 900 474 000 20 400 0 368 500 474 000 1 403 600 1 827 000 Taxation 515 200 646 000 Net Income 888 400 1 181 000 Operating Income Interest Income Other Non Operating Income Total Non Operating Income Earnings Before Tax 3 Kroger Co KR Common size Annual Income Statement Safeway Inc SWY Kroger Co KR 12 29 2007 2 2 2008 Total Revenue 100 00 100 00 Direct Costs 71 26 76 57 Gross Profit 28 74 23 43 Selling General Admin 24 55 18 22 Total Indirect Operating Costs 24 55 20 15 Operating Income 4 19 3 28 Interest Income 0 92 0 67 Other Non Operating Income 0 05 0 00 Total Non Operating Income 0 87 0 67 Earnings Before Tax 3 32 2 60 Taxation 1 22 0 92 Net Income 2 10 1 68 Common size Annual Income Statement 4 Ratio Analysis Ratios allow analysis of different pieces of financial information Traditional grouping of ratios 5 Short term solvency or liquidity Long term solvency Asset management or turnover Profitability Market value Short Term Solvency Ratios Short Term Solvency ratios focus on firms ability to pay its bills in the short term Current Ratio Quick Ratio acid test Cash Ratio 6 Long Term Solvency Ratios Long Term Solvency ratios focus on the firm s ability to cover long term obligations Total Debt Ratio Times Interest Earned Cash Coverage Ratio 7 Asset Management Ratios Asset Management or Turnover Ratios focus on the efficiency with which a firm manages parts of its operations Inventory Turnover Days Sales in Inventory Receivables Turnover 8 Asset Management Ratios II Days Sales in Receivables Total Asset Turnover 9 Profitability Ratios Profitability ratios focus on the efficiency with which a firm uses its assets Profit Margin EBITDA Margin EBITDA is Earnings Before Interest Taxes Depreciation and Amortization 10 More Profitability Ratios Return on Assets Return on Equity 11 Market Value Measures These measures help investors determine the value of the equity of public companies Earnings per Share Price Earnings Ratio Market to Book Ratio 12 More Market Value Measures Market Capitalization Market Cap Enterprise Value Enterprise Value Multiple 13 Du Pont Identity Basic Return on Equity Formula Multiply by 1 Replace 1 with Assets divided by Assets which 1 14 Du Pont Identity Multiply Net Income Total Equity times Assets Assets Multiply by 1 15 Du Pont Identity Replace 1 with Sales divided by Sales which 1 Multiply Sales Sales times Net Income Assets 16 Du Pont Identity III The Du Pont identity allows analysts to take a closer look at which relationships drive ROE and can help determine which areas of operations are especially strong or need improvement Note The total debt ratio is equal to 1 1 Equity Multiplier This is important because it means that equity multiplier is a measure of financial leverage 17 Summary of Ratios 18 Potential Problems in Financial Analysis 19 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 Financial Models Financial planning is another use of financial statements We normally use pro forma financial statements which are basically projected financial statements There are many different ways to project future financial information for companies One simple method is the Percentage of Sales Approach 20 Percentage of Sales Approach For projecting the income statement we will assume that costs vary directly with sales We first make a projection about how much sales will grow over the next year We then grow each cost by the same percentage that we believe that sales will grow by Profit margins will stay the same with this approach After we have projected the income statement we can determine the projected dividend payment We can look at previous years to determine the Payout Ratio The Payout ratio Cash Dividends Net Income 21 Percentage of Sales Approach Example With a 25 sales growth assumption Costs as a percentage of sales are 80 22 Dividend Payout The Payout ratio Cash Dividends Net Income Using the payout ratio from previous years with the pro forma income statement we developed we can estimate the amount of the next dividend We can also estimate the amount of earnings that will be retained This is known as the Retention Ratio or Plowback Ratio The plowback ratio is often written as b The Retention Ratio 1 Payout Ratio or b 1 Payout Ratio If all earnings are either retained or paid out then the Payout Ratio Retention Ratio 1 23 External Financing Needed When we project the balance sheet using the percentage of sales method we will often discover that the increase in assets is greater than the increase in liabilities and equity This amount is called External Financing Needed EFN Sometimes rather than creating a pro forma statement we just calculate external financing needed directly EFN Spon Liab Assets Sales PM Projected Sales 1 d Sales Sales Sales Spontaneous Liabilities are liabilities that vary directly with sales PM is profit margin and d is dividend payout ratio 24 EFN Formula EFN can be broken down in three parts Spon Liab Assets Sales PM Projected Sales 1 d Sales Sales Sales Projected Increase in Assets 25 Projected Increase in Liabilities Projected addition to retained earnings Sales Capacity Most companies normally do not need new assets to support every increase in sales This is because they are not at full sales capacity Different assumptions can be made about how much sales could increase before new assets would be needed To determine the sales of a firm that could be supported at its full capacity divide the current sales by the percentage capacity the firm is operating at currently 26

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