Slide 1Common-Size StatementsAnnual Income StatementCommon-size Annual Income StatementRatio AnalysisShort Term Solvency RatiosLong Term Solvency RatiosAsset Management RatiosAsset Management Ratios IIProfitability RatiosMore Profitability RatiosMarket Value MeasuresMore Market Value MeasuresDu Pont IdentityDu Pont IdentityDu Pont IdentityDu Pont Identity IIISummary of RatiosPotential Problems in Financial AnalysisFinancial ModelsPercentage of Sales ApproachPercentage of Sales Approach ExampleDividend PayoutExternal Financing NeededEFN FormulaSales CapacitySales Capacity ExampleProjecting GrowthInternal Growth RateSustainable Growth RateDeterminants of Growth© J. David Miller 2017Financial Statement AnalysisChapter 3 Finance 357Common-Size StatementsCommon-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 sales2Annual Income StatementSafeway Inc. (SWY) Kroger Co. (KR)Annual Income Statement 12/29/2007 2/2/2008Total Revenue 42,286,000 70,235,000Direct Costs 30,133,100 53,779,000Gross Profit 12,152,900 16,456,000Selling General & Admin 10,380,800 12,799,000Total Indirect Operating Costs 10,380,800 14,155,000Operating Income 1,772,100 2,301,000Interest Income -388,900 -474,000Other Non-Operating Income 20,400 0Total Non-Operating Income -368,500 -474,000Earnings Before Tax 1,403,600 1,827,000Taxation 515,200 646,000Net Income 888,400 1,181,0003Common-size Annual Income StatementSafeway Inc. (SWY) Kroger Co. (KR)Common-size Annual Income Statement 12/29/2007 2/2/2008Total 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%4Ratio AnalysisRatios allow analysis of different pieces of financial informationTraditional grouping of ratiosShort-term solvency or liquidityLong-term solvencyAsset management or turnoverProfitabilityMarket value5Short Term Solvency RatiosShort Term Solvency ratios focus on firms ability to pay its bills in the short term.Current RatioQuick Ratio (acid-test)Cash Ratio6Long Term Solvency RatiosLong Term Solvency ratios focus on the firm’s ability to cover long term obligationsTotal Debt RatioTimes Interest EarnedCash Coverage Ratio7Asset Management RatiosAsset Management or Turnover Ratios focus on the efficiency with which a firm manages parts of its operationsInventory TurnoverDays Sales in InventoryReceivables Turnover8Asset Management Ratios IIDays Sales in ReceivablesTotal Asset Turnover9Profitability RatiosProfitability ratios focus on the efficiency with which a firm uses its assets Profit MarginEBITDA MarginEBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization. 10More Profitability RatiosReturn on AssetsReturn on Equity11Market Value MeasuresThese measures help investors determine the value of the equity of public companiesEarnings per SharePrice – Earnings RatioMarket to Book Ratio12More Market Value MeasuresMarket Capitalization (Market Cap)Enterprise ValueEnterprise Value Multiple13Du Pont IdentityBasic Return on Equity FormulaMultiply by 1Replace 1 with Assets divided by Assets which = 114Du Pont IdentityMultiply (Net Income / Total) Equity times (Assets / Assets)Multiply by 115Du Pont IdentityReplace 1 with Sales divided by Sales which = 1Multiply (Sales / Sales) times (Net Income / Assets)16Du Pont Identity IIIThe 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.17Summary of Ratios 18Potential Problems in Financial Analysis•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, events19Financial ModelsFinancial 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.20Percentage of Sales ApproachFor 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 Income21Percentage of Sales Approach ExampleWith a 25% sales growth assumption:Costs as a percentage of sales are 80%22Dividend PayoutThe Payout ratio = Cash Dividends/Net IncomeUsing 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. orb = 1 – Payout RatioIf all earnings are either retained or paid out, then the Payout Ratio + Retention Ratio = 1. 23External Financing NeededWhen 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=Spontaneous Liabilities are