FIN 468: Intermediate Corporate Finance Topic 2–Financial Statements Larry Schrenk, Instructor

Topics The Statements Ratio Analysis and Types of Ratios DuPont Equation Forecasting Pro Forma Statements

The Statements

Stock versus Flow Income Statement Flow Balance Sheet Stock Statement of Cash Flows Flow

Balance Sheet Organization Assets (LHS) Firm Value Organized by ‘Receivable’ Liquidity Allocation of Firm’s Investable Funds Assets Portfolio Liabilities (RHS) Claims on Firm Value Organized by ‘Payable’ Liquidity Allocation of Return and Risk to Investors Claims Portfolio

Income Statement Organization Sales – Variable Costs Gross Costs – Fixed Costs EBIT – Interest EBT – Taxes Net Income – Dividends Additions to Retained Earnings Earnings…▪ From Unit Production From Total Production After Financing Included After Taxes Included Retained by the Firm ▪

Ratio Analysis and Types of Ratios

Principles Consider the Perspective Toolbox Approach Check Annualization Beware of Anomalies Ratios as Red Flags Use Customized Ratios No Official Rules

Classification Short-Term Solvency (Liquidity) Long-Term Solvency (Leverage) Efficiency Profitability Market Value

Use Comparisons Time-Trend Analysis Peer Group Analysis Firm’s Performance over Time Peer Group Analysis Similar Companies or Industry Analysis

Short-Term Solvency Examples Form Purpose Short-Term Liquidity Can the Firm Meet Current Obligations? Examples Cash Ratio, Current Ratio, Quick Ratio

Long-Term Solvency: Degree of Leverage Analysis Form Purpose Long-Term Liquidity Can the Firm Remain Solvent? Examples Total Debt Ratio, Debt/Equity Ratio

Long-Term Solvency: Coverage Analysis Form Purpose Firm Service its Long-Term Obligations? Is Bankruptcy a Concern? Examples Times Interest Earned (TIE), Cash Coverage

Efficiency: Analysis Examples Form Purpose How Efficiently does the Firm Use the Value Invested in each Asset? Balance Sheet Assets as Portfolio Liquidity-Return Trade-Off Examples Turnover Analysis

Profitability: Analysis Form Purpose Is the Firm Generating Reasonable Earnings Relative to Total Assets or Equity NOTE: Accounting Measures Examples Return on Assets (ROA), Return on Equity (ROE)

Market Value: Analysis No Common Form or Purpose Use of Market Data Examples PE Ratio, Market-to-Book Ratio

Some Cautions No Underlying Theory Diversified Firms Globalization Varying Accounting Procedures Different Fiscal Years

DuPont Equation

DuPont Equations: Analysis Decomposition Analysis, Not Calculation

The DuPont Equation

Extending the DuPont Equation

Forecasting Pro Forma Statements

Percent of Sales Approach Some items vary directly (at least approximately) with sales. ‘Driver’

Percent of Sales Approach Some items may not vary with sales Items whose value cannot be easily changed Items whose value is determined by other variables, and Items under the policy control of the firm: Financing policy: long-term debt and equity Payout policy: dividends

Income Statement Costs may vary directly with sales. Why? Depreciation and interest expense may not vary directly with sales. Why? Dividends generally do not vary directly with sales. Why?

Balance Sheet–Assets Generally current assets vary directly with sales. Why? Generally long-term assets do not vary directly with sales. Why?

Balance Sheet–Liabilities Many current liabilities vary directly with sales. Why? But notes payable do not vary with sales. Why? Long term debt does not vary with sales. Why?

Balance Sheet–Equity How does retained earnings change? Changes on equity (and all the various sub-groups)do not vary with sales. Why?

External Financing Needed (EFN) After applying the percentage of sales method, the balance sheet will most likely not balance. External Financing/Funds Needed (EFN) difference between forecasted increase in assets and the forecasted increase in liabilities and equity.

External Financing Needed (EFN) EFN is the new capital that must be raised. This is often called the ‘plug’ EFN can be negative. Financing policy determines the type of instruments to be used, i.e., whether new funds are raised through debt, equity or some combination of the two.

Pro Forma Example Exogenous Parameters Annual Sales Increase: 10% Firm Policies: Payout ratio: 75% Financing: EFN will be raised through equity.

Pro Forma Example Color Codes Red Numbers are those which change with sales, e.g., accounts receivable. Blue numbers are those that do not change with sales, e.g., fixed assets. Purple numbers are those whose value is determined by firm policies, e.g., dividends. Black numbers are values which are entirely a function of other variables, e.g. retained earnings.

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 COGS $1,644 Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 COGS $1,644 Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44 Changes with Sales No Change Pre-Determined Follows Policy

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 Increases by 10% COGS $1,644 Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Increases with Sales Depreciation $276 EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276 $276 No Change: No Capital Invest. EBIT $391 Interest Paid $141 EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276 $276 EBIT $391 $458 Interest Paid $141 $141 No Change (Debt Not Changed) EBT $250 Taxes $85 Net Income $165 Dividends $121 Addition to Ret. Earn. $44

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276 $276 EBIT $391 $458 Interest Paid $141 $141 EBT $250 $317 Taxes $85 $108 Tax Rate is 34% Net Income $165 Dividends $121 Addition to Ret. Earn. $44

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276 $276 EBIT $391 $458 Interest Paid $141 $141 EBT $250 $317 Taxes $85 $108 Net Income $165 $209 Dividends $121 $157 Dividends are 75% of Net Income Addition to Ret. Earn. $44

Pro Forma Income Statement Income Statement 2006 pro forma Sales $2,311 $2,542 COGS $1,644 $1,808 Depreciation $276 $276 EBIT $391 $458 Interest Paid $141 $141 EBT $250 $317 Taxes $85 $108 Net Income $165 $209 Dividends $121 $157 Addition to Ret. Earn. $44 $52 Add to Retained Earning

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 Accounts Receivable $688 Inventory $922 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 Inventory $922 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increases with Sales

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increases with Sales

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 Fixed Assets Net Plant & Equip. $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increases with Sales

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 No Change (Fixed Assets)

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 Total Assets $3,588 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 No Change (Fixed Assets)

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 New Total Assets

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 Increase with Sales

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 $196 Total $540 Long-Term Debt $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 No Change (Financing Policy)

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 $196 Total $540 $574 Long-Term Debt $457 $457 Owner's Equity CS and Surplus $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 No Change (Financing Policy)

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 $196 Total $540 $574 Long-Term Debt $457 $457 Owner's Equity CS and Surplus $550 $550 Retained Earnings $2,041 Total $2,591 Total Liabilities/Equity $3,588 This is will increased once we have determined EFN.

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 $196 Total $540 $574 Long-Term Debt $457 $457 Owner's Equity CS and Surplus $550 $550 Retained Earnings $2,041 $2,093 Total $2,591 Total Liabilities/Equity $3,588 Retained Earnings = 2,041 + 52 (from the Income Statement) = 2,093

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 $196 Total $540 $574 Long-Term Debt $457 $457 Owner's Equity CS and Surplus $550 $550 Retained Earnings $2,041 $2,093 Total $2,591 $2,643 Total Liabilities/Equity $3,588 $3,675 EFN = Total Assets – Total Liabilities = 3,588 – 3,675 = 104

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 $196 Total $540 $574 Long-Term Debt $457 $457 Owner's Equity CS and Surplus $550 $654 Retained Earnings $2,041 $2,093 Total $2,591 $2,747 Total Liabilities/Equity $3,588 $3,779 Increase Stock by EFN = 550 + 104 = 654

Pro Forma Balance Sheet Balance Sheet 2006 pro forma Assets Current Assets Cash $298 $328 Accounts Receivable $688 $757 Inventory $922 $1,014 Total $1,908 $2,099 Fixed Assets Net Plant & Equip. $1,080 $1,080 Goodwill $600 $600 Total Fixed Asst $1,680 $1,680 Total Assets $3,588 $3,779 2006 pro forma Liabilities and Owner's Equity Current Liabilities Accounts Payable $344 $378 Notes Payable $196 $196 Total $540 $574 Long-Term Debt $457 $457 Owner's Equity CS and Surplus $550 $654 Retained Earnings $2,041 $2,093 Total $2,591 $2,747 Total Liabilities/Equity $3,588 $3,779 Balanced!

Pro Forma Ratios Ratio Current Pro forma Change ROE 6.37% 7.61% 19.47% Times Interest Earned 2.77 times 3.25 times 17.06% Total Asset Turnover 0.64 times 0.67 times 4.45% Current Ratio 3.53 times 3.65 times 3.41%

Other Firm Policies Dividend Policy Financing Policy Fund EFN through long-term debt. Using the Excel Goal Seek function Fund EFN while maintaining the same debt to equity ratio. Using the Excel Solver function