Using Financial

Statements
Developed and Presented by
Dr Angelo Aspris
Discipline of Finance

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 Plan of attack

Using financial statements

– The purpose of financial statements in financial valuation analysis.
– The role of the income, balance sheet, and cash flow financial statements.

– The elements that make up these financial statements.

– The links between financial statements.

I want you to know these things so as to be able to construct your own statements
which will form the basis of your valuation.
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 Financial Statements
– Accounting plays an important role in valuation analysis:
– It is the language for describing financial position and performance
– Provides the framework that valuation takes place in.

– We use the language of accounting to…

– Understand historical financial performance.
– Forecast financial performance.

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 Financial Statements

– Specifically we can use financial statements for:

– Establishing company profiles

– Cash flow analysis

– Budget planning and financial statement forecasting

– Comparable companies analysis

– M&A and due diligence analysis

– Pitch book presentations

– DCF valuation

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 Financial Statements
– This can be done because these statements allow us to assess:
– Operating performance
– Liquidity and solvency
– Asset efficiency
– Capital structure
– Future funding requirements
– Current and future capital expenditure needs
– Debt servicing capacity
– Cash flow generation capacity
– Dividend paying capacity
– Credit Risk
– …and so much more!!!

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 Complete and Internally Consistent
– The accounting framework helps in the creation of a complete and
internally consistent set of projected events for the firm.

– The focus here is on financial analysis not accounting in its own right.

– Accounting techniques are useful in describing the operating aspects of the

firm. For example, sales, costs, assets employed.

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 Complete Set of Financial Statements
– Under Australian Accounting Standards and the Corporations Act (2001),
companies must provide a complete set of financial statements. This
comprises of:

a) A statement of financial position

b) A statement of comprehensive income
c) A statement of cash flows
d) A statement of changes in equity
e) Notes to the accounts (changes to accounting policy plus other
explanatory information)

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 Underpinnings of accounting
– The building blocks of accounting are Assets and Liabilities. Assets represent future
benefits and liabilities represent future obligations. The difference between asset
and liability value is the equity in the firm that belongs to the owners:

Equity = Assets – Liabilities

– Equity is also known as net assets or book value. If all assets are and liabilities
were recorded at market values then

Book Value of Equity = Market Value of Equity

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 Underpinnings of accounting
– Due to difficulties in determining market values accountants
do not attempt this task!!!
– Accountants seek to supply reliable (read historical cost) information,
leaving users to make the subjective adjustments required for a
valuation.
– Other: Current Cost, Realisable Value (Settlement), Present Value

– Financial analysis involves finding benefits and obligations

that have been ignored in the preparation of financial
statements and determining those that have been incorrectly
valued.
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 Balance Sheet
– The two main accounting outputs are the Balance Sheet and
the Income Statement.

– The Balance Sheet is a double-sided listing of the assets of the

business (LHS) and the financing of these assets (RHS) at a
point in time.

– The Balance Sheet is a cumulative statement showing the

effect of the firm’s actions up to a point in time.

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 Balance Sheet
– Items in the balance sheet are organised in order of liquidity, from most
liquid (easier to convert to cash) to least liquid (harder to convert to cash).

– Current items are expected to be converted to cash within a year.

– Note that in the context of financial analysis we may depart from the
traditional accounting groupings for balance sheet items.

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 The Traditional Balance Sheet
Assets Liabilities
Current Assets – includes all the firms Current Liabilities – all the firms short
short-term assets: term obligations:
Cash – money the firm has in the Accounts payable – unpaid bills to
bank suppliers
Marketable Securities – securities Accrued Tax – unpaid tax
held, at market value Current portion of long term debt –
Accounts Receivable – customers the part of the long term debt
unpaid bills to the firm principal to be paid in the next year.
Inventory Short-term borrowing – all
borrowing that (in principal) has to
Fixed Assets be repaid within the year.
Leased property and equipment – if
the firm has leases the value of the Long Term Liabilities
items leased may appear on the Obligation under leases – the debt
balance sheet equivalent of long term leases
Plant, Property & Equipment – Long term debt – borrowing by the
these items are listed at historical firm to be repaid over a number of
cost minus the loss of value due to years
aging (depreciation)
Preferred Stock
Goodwill – if assets have been purchased Equity – investments in the firm by its
at more than their market value the owners plus undistributed accumulated
difference is listed earnings.
Stock Value – the value of the stock
at issue
Retained Earnings – that part of
profit after tax not paid as dividends
Total Assets – sum of items in this column Total Liabilities - sum of items in this
column

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 …and some basic calculations
Assets Reference Liabilities Reference
Cash and Cash Equivalents (1) Accounts Payable (11)
Accounts receivable (2) Accrued Expenses (12)
Inventories (3) Short term Debt (13)
Deferred Income Taxes (4) Total Current Liabilities (14=11+12+13)
Total Current Assets (5=1+2+3+4) Long Term Debt (15)
Plant Property and (6) Other Long Term (16)
Equipment (PPE) Liabilities
Accumulated Depreciation (7) Total Liabilities (17=14+15+16)
Net PPE (8=6-7) Shareholders’ Equity
Other assets (9) Common Stock (18)
Total Assets (10=5+8+9) Retained Earnings (19)
Total Liabilities and (20=18+19)
Equity

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 Balance Sheet (Example: Telstra)

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 Accountants v Analysts

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 Assets
– Assets are defined as probable future economic benefits obtained or controlled by
a firm as that is the result of past transactions or events.

– What makes a benefit probable?

– This is generally defined in the accounting standards. Some things that are not considered
as assets are, Research and Development and Marketing, as they generate potential
benefits of unknown magnitude.

– The future benefit must have resulted from past events.

– This requirement leads to the “realisation principle”, sales cannot be recognised until the
sale has been completed. This stops future sales from being recognised.

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 Assets
– Accountants recognise:
– Cash
– Amounts owed from previous events, and
– Benefits acquired in past transactions (inventory, property, acquired
intangibles) as assets.

– If the asset is marketable it is recorded at observed market value.

– If the assets are not traded they are valued at historical cost. They are then
adjusted downwards by the amount that future benefit has been consumed or
impaired in each accounting period.

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 Liabilities
– Liabilities are the opposite of assets.
– They are probable future sacrifices of economic benefit that result from past
events. The conditions that govern liabilities are the same as those for assets.
They must be probable and they must result from past events.

– An example of an obligation not recognised is the potential cost of a loan

guarantee. Future costs that arise from contracts to purchase goods and
services are not recorded as liabilities.

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 Changes in Equity
There are two reasons for changes in equity:
– Transactions with equity holders, distributions or receiving funds from them.
– Transfers of the operating surplus to the equity account.

– As equity is equal to assets less liabilities, periodic net income is related to equity
as:

Ending Equity = Beginning Equity + Net Profit After Tax –

Distributions to Equity Holders

Net Profit After Tax = Change in Equity + Net Distributions to Equity

– This equation is known as the clean surplus relation.

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 Income Statement
– The Income Statement measures the net economic benefits generated over
a period of time.
– It uses the principles of recognition developed for assets and liabilities.

– Given the clean surplus relation, what information does the income
statement add?
– The information comes from the classification of changes in assets and liabilities into the
components of income.

– This statement does not give full information about the amount of cash
that the firm generates.
– It aims to provide a measure of the economic performance of the firm.

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 Income Statement
Cost of making the Revenue/Sales (1)
product Other Income (2)
Total Revenues (3=1+2)
Cost of Goods Sold (COGS/OPEX/Cost of Sales) (4)
Selling, General and Administrative Expenses (SG&A) (5)
Earnings before Interest, Taxes, Depreciation and Amortisation (6=3-4-5)
Supporting the
business
(EBITDA)
(product/service) Depreciation (7)
EBIT (Earnings before Interest and Taxes /Operating Profit) (8=6-7)
Interest (11=9+10)
Interest Expense (9)
Cost of financing Interest Income (10)
EBT (Earnings Before Tax/ Income Before Taxes) (12=8-11)
Taxes (13)
Taking care of the tax-
Net Income (14=12-13)
man

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 Income Statement (Example: Telstra)

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 Revenue
– Revenue is defined to be an increase in assets or reduction in liabilities that is caused by the
sale of goods and services as part of the firm’s normal operations.

– The general rule is that revenue is recognised when:

– The earnings process is substantially complete; and
– Collection is reasonably assured.

– This is straightforward for most cases, but can require subjective judgments in certain cases
such as long-term contracts.

– Revenue is the key driver of the firm’s activities, once revenue is recognised accounting rules
attempt to match asset consumption necessary to produce the revenue.

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 Getting the Basics Right – Revenue Recognition

– Revenue recognition criteria is even more important than you may first appreciate –
why?
– Companies are valued on multiples of revenue (Therefore, higher revenue  higher
value)
– Pro-formas are typically prepared in a top-down fashion – hence revenues are a key
driver of profits.
– Revenue quality – and the ability to turn it into cash – will tell you a lot about the
financial viability of a firm.

– Remember, that an income statement does not necessarily tell you about cash!
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 Drivers of Revenue

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 Expenses
– Expenses are the opposite of revenues; they are the decrease in assets or
increase in liabilities that arise from the normal operating activities of the
firm.
– The objective is to match consumption of assets to the revenue produced.
– Making/Buying the Product = COGS/Gross Profit

– Supporting the Business = SGA / Operating Profit

– Financing the Business = Interest & Finance Costs / Profit Before Tax

– Paying the Government = Tax Cost / Profit After Tax (NPAT)

– Frequently there is an arbitrary allocation of costs over the useful life of an

asset such as straight line depreciation.
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 Profit
– There are many “profit” or “earnings” numbers analysed.

– Operating profit or EBIT is the difference between revenue and expenses associated
with the firm’s recurring or ongoing operations. This is seen as the primary driver
of firm value (also note the use of EBITDA).
Operating Profit (EBIT) =Revenue – Expenses

– Profit Before Taxes (PBT) or EBT accounts for the firm’s net interest expense

– Tax is applied to EBT to arrive at Net Profit After Tax (NPAT) or Net Income

– Historical profit numbers are usually analysed excluding or “normalising” for non-
recurring items but are often disclosed in financial reports.

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 Normalised Profit
– Normalised profit removes one-off charges that affect current
earnings.
– These one-off’s are charges not expected to occur in the future.
– They can include: restructuring charges, large gains and losses on the
sale of businesses or assets, impairments of non-current assets, large
one-time tax charges.

– Normalised profits tell us about the profitability of the core

business
– By normalised, they should be core, continuing, and controlled.

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 A note on Depreciation
– In financial statements, the depreciation expense may be included in
COGS or SG&A.

– When analysing a business it is better to separate the depreciation

expenses. Why?

– Depreciation is not a cash expense.

– However, it does generate a tax saving (tax shield) because it is tax deductible
so we need to track it separately in order to accurately calculate cash taxes for
our FCF calculation.

– Best place to get D&A is CFS

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 Cash Flow Statement
– In Australia companies have been required to publish a Cash Flow Statement (CFS) since
1992.

– The CFS outlines the firm’s sources and uses of cash and shows the net cash provided or used
by the firm

– As you will see demonstrated in tutorials:

– The CFS is the closing link between the firm’s financial statements and provides the balancing item
in the balance sheet;
– The CFS is derived from the Income Statement and the opening and closing Balance Sheets (and
should be modelled as such).

– The Free Cash Flow (FCF) that we are interested in for the purpose of valuation is not
provided by the CFS. We need to derive it.
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 Why is cash flow information so important?
– It allows us to:
– Assess the solvency of companies
– Assess the financial flexibility and capacity to adapt

– And is useful for:

– Predicting future cash flows
– Corporate valuation models
– Financial distress models

– Not as easy to manipulate as earnings.

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 Cash flow statement
– The cash flow statement reports cash flows during the period classified by
operating, investing, and financing activities.

– Operating Activities: are the principal revenue producing activity of the

entity

– Investing Activities: are activities that result in changes in the size and
composition of the contributed equity and borrowing of the entity

– Financing Activities: are the acquisition and disposal of long-term assets

and other investments not included in cash equivalents.

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 Cash Flow Statement

OPERATING ACTIVITIES Reference

Cash to and
Net Income (1)
from the Depreciation (2)
main Change in Inventory (3)
business Change in Accounts Receivable (4)
operations Change in Accounts Payable (5)
Change in accruals (6)
Net Cash from Operating Activities (7=1+2+3+4+5+6)
Cash to INVESTING ACTIVITIES -
support Investment in Plant, Property and Equipment (PPE) (9)
future Net Cash from Investing Activities (10=9)
FINANCING ACTIVITIES -
business
Change in Short term Debt (11)
activities Change in Long term Debt (12)
Change in Common Stock (13)
Common Dividends (14)
Cash to the
Net Cash from Financing Activities (15=11+12+13+14)
principle Net Change in Cash -
providers of Start Cash (16)
the firm End Cash (17=7+10+15+16)

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 Cash Flow Statement (Example: Telstra)

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 Financial Analysis
– We are analysing the past in order to understand the nature of
the business.
– Financial analysis allows us to form a view of the future.

– By breaking down each of the individual accounts we can see:

– What made an account go up or down
– What drives the levels/changes in that account

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 Financial Statements
– The 3 financial statements are connected....
– The job of an analyst is to ensure that statements not only comply with
accounting conventions, but more importantly, that they make
economic sense!
– Examples of links:
• Revenue is linked to Cash, AR, Deferred Revenues
• Net Income is related to Retained Earnings
• Depreciation, CAPEX, and PPE are all related

– This will be discussed further in future classes.

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 Limitations of Financial Reports
There are many, including:
1) Timeliness and frequency of disclosure;
2) Basis of measurement (e.g. HCA vs current value)
3) Inconsistencies between Accounting standards and Accounting concepts
4) Complexity of financial statements
5) Quality of accounting arising from too many accounting policy
alternatives…

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 Earnings Management
– Even though all firms are governed by the same accounting standards, the application of those standards in
practice can vary from firm to firm.
– More aggressive firms will try and show higher earnings than more conservative firms.

– While catching outright fraud is quite difficult, warning bells should go off when you see the following:
– Income from unspecified sources – holdings in other businesses that are not revealed or from special purpose entities.

– Income from asset sales or financial transactions.

– Sudden changes in standard expense items – a big drop in SG&A or R&D expense as a % of revenues.

– Frequent accounting restatements.

– Accrual earnings that run ahead of cash earnings consistently.

– Big differences between tax income and reported income.

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 The Fudge – NZ Farming Systems Uruguay

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Part 2: Financial
Statements
Building Pro-formas

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 Outline
– This part of the lecture is designed to help you with the
construction of a pro-forma statement. I will:
– Discuss what a pro-forma is and why they are required in valuation
analysis
– Examine the sales-driven approach to forecasting.
– Examine how FSA (or forensic accounting) can help us with
assembling a pro-forma.
– Learn about the plug and circularity problems driven by the sales
driven approach.
– Discuss problems encountered in ratio analysis.
– Develop a pro-forma out of a mini-case study.

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 Pro-forma statements
– A pro-forma statement is a prediction of how a firm’s financial statements
will look in succeeding years.
› These statements are typically prepared by analysts.
› Are constructed as an integrated model of the firm’s financial statements based
on a view of the firm’s efficiency in the production and marketing of its products
and/or services.

– By constructing pro-forma statements the financing needed under various

assumptions of growth, operating ratios, financing ratios, and the
sensitivity of the firm to changes in the business environment can be
evaluated.

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 Pro-forma statement
– A reliable valuation analysis requires a set of economically plausible and rational
assumptions gathered from an understanding of the firm but also its operating
environment. The projections that form the basis of the pro-forma statement are
likely to be based on:
– historical information
– analyst expectations
– macro-economic announcements,
– industry analysis
– and most importantly subjective business judgement.

– Understanding the interaction of these factors will allow an analyst (or investor) to
make informed and rational choices regarding the assumptions that will form the
pro-forma model.
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 Ratio Analysis
– This is primarily done using ratio analysis.
– The first step is to study the firm’s past performance using financial ratios.
– Then proceed to predict future financial ratios. Often this is based on the
assumption that past relationships will continue into the future.

– Remember that past performance is no guarantee of future performance.

– By using ratios we construct a “sales driven model”. Why?

– Sales projections allow us to determine FCF.

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 Sales Driven Approach to Forecasting
– The sales-driven approach
– Wherever possible (and reasonable) one should assume that the items in the
balance sheet and income statement depend directly on the sales of the firm.

– While not all accounts in financial statements will be related to sales, this
approach is based on the assumption that in the long run all a firm’s
productive assets will be related to sales.
– Think about a firm that has recently seen an increase in sales. When a firm’s
sales increases, its expenses will also increase as a function of the production
process; its assets will increase to support the increase in sales; and its
liabilities will also increase to finance the expansion.

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 Free Cash Flow
– In a financial valuation context the goal is ultimately to relate sales to free cash flow.

– Hence the analysis we need to perform is to use ratios to relate the variables used to derive
free cash flow to sales.
– How are components of the income statement related to sales?
– How are working capital requirements related to sales?
– How is capital expenditure related to sales?

– There are a large number of ratios that can be calculated. In this analysis ratios that have an
economic interpretation will be used whenever they exist.
– Essentially the focus will be on efficiency and profitability ratios.

– Depending on the context, different ratios may be used (e.g., an equity investor vs. a lender).

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 Financial Ratios

I have included an appendix

in this lecture pack with
further ratio descriptions.

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 Financial Ratios

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 Common Approaches to Ratio Analysis
– Cross sectional analysis
– Where does the firm’s multiple lie relative to comparable companies?
– What should the firm’s multiple be if it is to be in line with comparable companies?
– Trade-off between number of comparable firms and the level of comparability.
– Do not be alarmed by abnormal ratios as long as you can explain them.

– Time series analysis

– One way around the issue of comparability.
– Note that the production, marketing and financial policies of the firm can and do change
over time.
– Historical cost accounting may induce spurious trends in financial ratios.
– If a firm under or over performs to begin with then time series analysis may not reveal
this.

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 Common Approaches to Valuation Analysis
– It is therefore important to use both cross sectional and time series
analyses.

– Economic interpretation of ratio changes is important

– Understanding the business of the firm is key to interpreting differences and
changes in ratios

– Comparing ratios on a scale free basis

– Restate all income statement items as a percentage of sales.
– Restate all balance sheet items as a percentage of total assets.
– This facilitates comparisons across firms and time but obviously can be
misleading when scale matters (e.g., when there is a degree of ‘operating
leverage’)
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 Ratio Analysis
– Further issues to think on:
– Use of commercial database services
• Where are you getting your data from? (Bloomberg, Reuters,
Worldscope, Morningstar???)
– Calculation of industry average
– What is the distribution of a financial ratio for a given industry?
– How has the ratio been defined?

– An inquisitive analyst/researcher will make their own ratios

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 Questions
– It is very important to rise above the pure mechanics of the forecasting task and to
interpret the economics of the firm’s future.

– What creates the growing financing need?

– Need to identify the self-sustainable growth rate

– Is the firm retaining enough earnings to finance its growth in assets?

– Sensitivity analysis of the key drivers

– How does one find the key drivers and assess their effects?

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 Common Sense
– One must move past the mechanics and accounting into an arena of
corporate financial reasoning

– View the model as:

– part of a process of analysis, rather than as an end in itself;
– a financial system in which human managers must decide among competing
policies, rather than as an opaque box from which policy choices just emerge

– The ultimate aim of the modelling process is to increase investors’ returns

and/or reduce their risks

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 Characteristics of a good forecast
– Economic plausibility
– The statements must reflect how the firm might realistically operate in
the future.

– Accounting consistency
– Do the financial statements balance?
– Do they “articulate?”
– Are they a good model of the firm’s finances?

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A simple worked example:

The CorpVal company Ltd

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 CorpVal’s P&L Statement

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 Balance Sheet
Actual Actual Actual
Balance sheet 2001 2002 2003
Cash 42.0 47.0 50.0
Short term investments 10.0 15.0 25.0
Inventory 75.0 85.0 100.0
Accounts receivable 65.0 70.0 75.0
Total current assets 192.0 217.0 250.0
Net PP&E 275.0 280.0 300.0
Total assets 467.0 497.0 550.0

Accounts payable 80.0 70.0 75.0

Accrued expenses 8.0 10.0 10.0
Short-term debt 50.0 30.0 25.0
Total current liabilities 138.0 110.0 110.0
Long-term debt 54.0 84.0 99.0
Total liabilities 192.0 194.0 209.0
Common stock 125.0 125.0 125.0
Retained earnings 150.0 178.0 216.0
Total common equity 275.0 303.0 341.0
Total liabilities and equity 467.0 497.0 550.0
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 Modelling Financial Statements
– The reason we create a model of the financial statements is to reduce the work
needed to construct projections.
– It would be a great deal of work to project each of the items on the income statement and
balance sheet separately and independently.

– We want to reduce our projections to a limited number of “drivers” and use

projections of these drivers to fill in the financial statements.

– We will assume that COGS, SGA, Cash, Inventory, Accounts Receivable, Net PPE,
Accounts Payable, and accrued expenses vary with sales.
– In the short run SGA and Net PPE may not directly vary with sales.

– Depreciation charges are set by the depreciation schedule and depend on Net PPE.
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 Choosing Inputs for the Model

– Projecting the sales growth rate

– Projecting operating profit

– Projecting operating capital

– Projecting taxes

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 Historical Ratios
Calculation of Historical Ratios Actual Actual Actual
2001 2002 2003 3-year Average
Ratios to calculate operating profit
Sales growth rate 12.38% 5.93% 9.16%
COGS / Sales 61.90% 66.21% 64.00% 64.04%
SGA / Sales 23.81% 21.72% 21.50% 22.34%
Depreciation / Net PPE 14.91% 15.00% 15.00% 14.97%
Ratios to calculate operating capital
Cash / Sales 5.00% 4.98% 5.00% 4.99%
Inventory/ Sales 8.93% 9.00% 10.00% 9.31%
Accts. Rec. / Sales 7.74% 7.42% 7.50% 7.55%
Net PPE / Sales 32.74% 29.66% 30.00% 30.80%
Accts. Pay./ Sales 9.52% 7.42% 7.50% 8.15%
Accruals / Sales 0.95% 1.06% 1.00% 1.00%
Ratios to calculate operating taxes
Tax Rate (Taxes/EBT) 40.00% 39.06% 40.00% 39.69%

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 Projected Growth Rate
– Look at the history:
– 9.2% average growth rate over the past two years

– Look at the internal / external environment:

– Economy is predicted to recover substantially by 2004, so the analyst predicts more rapid
growth than in 2003, and more rapid than the average.

– After speaking with marketing and operations, the analyst predicts that CorpVals’s sales
will increase by 9% next year due to increased unit sales, and by 2% due to anticipated
inflation.

– Dollar sales therefore are projected to increase by a total of 11% from $1,000 to
$1,110.
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 COGS / SGA
– COGS
– Higher COGS comes from higher production costs or lower sales price, or
both.
– Lower COGS comes from cost containment with stable prices, or higher prices
with stable costs, or both.
– Marketing predicts COGS will decrease from last year’s 64% to 62.5% of
sales.

– Some further things to think about...

– COGS are either fixed or variable. We can’t observe that from looking at the
numbers directly but we can try to estimate.
– Fixed costs tend to make up a bigger part of smaller firm costs so should be
taken into account for when forecasting margins.
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 COGS / SGA
– SGA
– CorpVal’s has minimal advertising
– Sales commission rate will increase next year and a half from 9% to
12%.
– Staffing will remain constant, salaries will increase with inflation.
– Net impact is SGA will increase from 21.5% to 22.5% of sales.

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 Tax
– Tax expenses also form a component of the firm’s free cash flow.

– We need to project the effective tax rate.

Tax expense
Effective tax rate 
Income before taxes
– Then compare this to the statutory rate. The differences in the rates need to be explored for an effective
projection of this item to be made.

– The differences come from timing differences (using two different depreciation schemes) and permanent
differences (expenses not allowed under tax law that are included in income calculation).

– Remember: Net operating losses can be carried backward and forward. Additionally, be mindful that tax
rates may not persist at current levels.

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 Tax - Corporate

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 Tax - Effective

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 Differences between Statutory and Effective
– Many firms follow different accounting standards for tax and reporting
purposes.
– e.g. some firms use straight line depreciation for reporting purposes and
accelerated depreciation for tax purposes.
– Firms can use tax credit to reduce the taxes they pay.
– Firms can sometimes defer taxes on income to future periods.
– Layered tax system.

– So which should we use in valuation?

– If the same tax rate has to be applied to earnings every period then which is a
better rate?

The University of Sydney Page 68

 Depreciation / Cash
– Depreciation schedule is set by the cost of the assets purchased and accounting
rules.
– Overall this will change dramatically only if a company changes the type (long-term or
short-term) of assets it is purchasing.
– CorpVal’s will continue using the same type of assets it has been using, so depreciation
will remain at 15% of net PPE.
– Not all assets are depreciated.....

– Some useful ratios:

– Average expected life = Cost of fixed assets / Annual depreciation charges
– Fraction of expected life exhausted = Accum. depreciation / Cost of fixed assets
– Remaining years = (1-fraction of life exhausted)*average expected life

The University of Sydney Page 69

 Depreciation / Cash

– Cash: This is the minimum cash balance required for the

business to function.
– Has been 5% historically.
– Expects to drop to 3% with better information technology.

– Will the cash balance be similar across all industries?

The University of Sydney Page 70

 How to think about Operating Items
– Accounts Receivable
– Credit sales generate accounts receivable.
– Tighter policy means less accounts receivable, but also fewer sales.
– Looser policy means more sales, but more accounts receivable and more bad debt write-
offs.
– Averaged 7.6% over last 3 years. Plans to maintain same credit policy, so the percent
should remain the same.
– May want to focus on average collection period (AR/Sales/365).

– Inventories
– Higher inventory means more investment, but lower chance of a stock out. Lower
inventory may increase chance of missed sales.
– Averaged 9% of sales. Expects to stock up in 2004 to support the projected summer
recovery, so will be 11% of sales.

The University of Sydney Page 71

 How to think about Operating Items
– Net PPE as a % of sales
– This ratio will decrease as the firm uses up capacity, and will be large just after
building a plant and operating at under-full capacity.
– Also changes as the firm alters its technology.
– CorpVal’s must invest in another plant in 2004, so PPE will increase to 34% of
sales. PPE as % of sales will decrease as it grows into its new facilities.

– Accounts payable
– Increasing AP means paying later, decreasing means paying earlier.
– Payables deferral period = AP/(COGS/365)
– Has been 45.6 days. This corresponds to accounts payable of 8.1% of sales.
– CorpVal’s will maintain this policy.

The University of Sydney Page 72

 Projections Summary
Actual Projected
Income Statement 2003 2004
Net Sales 1,000.0 1,110.0
Cost Of Goods Sold 640.0 693.8
Selling, general & administrative 215.0 249.8
Depreciation 45.0 56.6
Operating profit 100.0 109.9

Balance sheet
Cash 50.0 33.3
Inventory 100.0 122.1
Accounts receivable 75.0 84.4
Total operating current assets 225.0 239.8
Net PP&E 300.0 377.4
Total net operating assets 525.0 617.2

Accounts payable 75.0 89.9

Accrued expenses 10.0 11.1
Total operating current liabilities 85.0 101.0

The University of Sydney Page 73

 Warnings
– The calculated ratios are no more valid than the financial statements from which they are
derived.
– The benchmarks are no more relevant than the group of firms that form part.

– The quality of the financial statements should be assessed, and appropriate adjustments made
before ratios are calculated.

– Assess the reasonableness of the accounting choices and assumptions embedded in the
statements.

– Deviations from industry averages are not necessarily good or bad and must be interpreted in
the context of the operating and financial policies and overall performance.

– FSA is a skill, an analytical technique; not a theory.

The University of Sydney Page 74

 Computational Issues
– Negative denominators:
– Can result in nonsensical results. E.g. in profitability or ROE ratios. Ways of
dealing with negative numbers:
– Delete the observation
– Examine underlying reasons and make adjustments accordingly
– Use an alternative ratio with similar interpretations

– Outliers:
– Are the observations outliers or extreme states of the underlying
characteristics? Is it inconsistent with the remainder of the data set.
– Recording error, low denominator, accounting classification or method,
economic, structural change.

The University of Sydney Page 75

 Completing Pro-forma projections
– The remaining financial statement items reflect managerial
decisions about how to finance the assets required for
operations. They reflect financial policies rather than
operations.

– 3 Categories of Policies
– Cash management
– Capital structure
– Dividends

The University of Sydney Page 76

 Financial Policy Decisions
– How much debt?
– Short-term? Long-term?

– How much equity?

– Dividends? Repurchases?

– How much marketable securities?

The University of Sydney Page 77

 Financial Policy Decisions
– Long Term Debt
– Usually decided by senior managers or board of directors
– Many companies maintain debt at a relatively constant proportion of total assets.
– This will be modelled as a percentage of operating assets (other?).

– Common Stock
– Issuing common stock is expensive, so companies do it infrequently.
– The assumption is that CorpVal’s will not issue common stock. Instead, it will fund its equity needs
by retaining its profits rather than paying them out as dividends.

– Dividends
– Board of directors sets dividend payments.
– Within bounds, dividends can be just about any level at all.
– Dividends are assumed to grow at their historical rate (other?).

The University of Sydney Page 78

 The Plug
– Based on the assumed financial policies, there are only two items left to
make the balance sheet balance.
– Short-term investments
– Short-term debt

– Making the Balance Sheet Balance:

– Change financial policy (i.e., issue more debt or equity, or pay less dividends).
– Buy fewer operating assets.
– Liquidate short-term investments.

The University of Sydney Page 79

 The Plug
– Following the forecast of particular accounts, modelled within the template of the
primary accounting statements, analysts must ensure that the two sides of the
balance sheet remain in equilibrium.

– Following the projections of specific accounts in the income statement and balance
sheet, an analyst will often find that the cumulative asset position either exceeds
or is less than the cumulative financing position.

– While the assumptions made for long-term debt financing should ensure that there
is not an overwhelming large financing gap, not correcting for the difference will
mean that a firm may not have enough financing in place to purchase operating
assets needed to support is sales.

The University of Sydney Page 80

 The Plug
– To correct for this difference, (depending on the direction of the inequality) analysts will solve
for what is referred to as the “plug”.

– The plug is normally expressed in the balance sheet as short term debt if the cumulative asset
position is greater than the cumulative financing position or short-term investments if the
cumulative asset position is less than the cumulative financing position .

– In other words, where:

– The plug is causing the balance sheet to move into an equilibrium position consistent with general
accounting conventions.
The University of Sydney Page 81
 Completing the Income Statement
– Project interest income/expense

– Project dividends

– Project long-term debt level

– Plug short-term debt or short-term investments to make

balance sheet balance

The University of Sydney Page 82

 Interest Income and Expense
– Interest expense depends on debt, but debt changes throughout the year.
– Base it on beginning of year debt. Alternatives?
– Interest income depends on short-term investments, but this changes throughout the year too.

Other Assumptions:
– Interest rates:
– 3% on short-term investments
– 9% on all debt

– Dividends were $16 million in 2003. They will grow by 10% to $17.6 million in 2004.
– Long-term debt will decline from 18.9% of operating assets to 15% of operating assets.
– Projected operating assets = cash + accounts receivable + inventories + net PPE
= $33.3 + $84.4 + $122.1 + $377.4 = $617.2 million.
– Projected long-term debt = 0.15($617.2) = $92.6 million.

The University of Sydney Page 83

 Summary of Assumptions

Actual Actual Actual

Dividend and debt ratios 2001 2002 2003 3 Year Average

Dividend policy: growth rate - -8.33% 45.45% 18.56%

Long-term Debt / operating assets 11.82% 17.43% 18.86% 16.03%

Interest Rates

Interest rate on short-term invest. - 10.00% 0.00% 5.00%

Interest rate on debt  - 8.70% 8.80% 8.75%

The University of Sydney Page 84

 Projected Balance Sheet
– Using the projected income statement (see earlier slide) the balance sheet will look
like:
Actual Actual Actual Proj.
Balance sheet 2001 2002 2003 2004
Cash 42.0 47.0 50.0 33.3
Short term investments 10.0 15.0 25.0 -
Inventory 75.0 85.0 100.0 122.1
Accounts receivable 65.0 70.0 75.0 84.4
Total current assets 192.0 217.0 250.0 239.8
Net PP&E 275.0 280.0 300.0 377.4
Total assets 467.0 497.0 550.0 617.2
The University of Sydney Page 85
 Projected Balance Sheet

The University of Sydney Page 86

 Balancing Issues
– Total assets (excluding short-term investments) = $617.2

– Total liabilities and equity (excluding short-term debt) = $577.0

– CorpVal’s financing plan is $40.2 million short.

– Add short-term debt = $40.2 million.

– Don’t have any short-term investments.
– In reality, the problem will be more complex because of circularity.

The University of Sydney Page 87

 Circularity
– Circularity in the model
– The pro-forma statement needs to be iterated through to solve for debt

– Why?
– The income statement drives the balance sheet
– The balance sheet affects the income statement through interest expense
– No solution can be found except by iteration

The University of Sydney Page 88

 Balance

The University of Sydney Page 89

 Multi-Year Projections
– As we project further ahead, our information set becomes less complete.

– As a result we need to think of three types of time periods in these projections:

– The short-term, in which there is plenty of specific information on which to base
projections
– The steady state, in which the firm is assumed to be at constant growth and some form of
competitive equilibrium. It starts with the last year of projections.
– The long-term is between the short term and the steady state--general firm and industry
information is used to base projections.

– Although the process is similar, extra care must be taken in multi-year projections.

The University of Sydney Page 90

 Check for reasonableness after the fact
– Are asset and liability changes from year to year smooth? If not, is that
expected?
– For example, PPE increases $77.4 million in 2004, but that was predicted
because a new plant is coming online.
– Cash falls in 2004. But that is also predicted due to changes in information
technology.
– Short-term investments decrease to zero—this is because we projected that
CorpVal’s wouldn’t simultaneously borrow short-term and invest short-term.
– Short-term borrowing increases substantially. If this happens in subsequent
years, the long-term debt policy (or dividend policy) may need to be revisited.

The University of Sydney Page 91

Appendix: Ratio Analysis

The University of Sydney Page 92

 Ratio Analysis
– The value of a firm is determined by its profitability and growth.
– Firm and growth are a function of the firm’s product market and financial
market strategies that it adopts.

– Product market strategies are implemented through the firm’s competitive

strategy, operating policies and investment decisions.

– Financial market strategies are implemented through financing a dividend

policies.

The University of Sydney Page 93

 Value Creation
– Managers have certain levers they can use to unlock firm value. They
include:
– Operating management
– Investment management
– Financial strategy
– Dividend policies

– The objective of ratio analysis is to evaluate the effectiveness of the firm’s

policies in each of these areas.
– While it may not give you all the answers, it will help you frame the questions for further
probing.

The University of Sydney Page 94

 Drivers of Profitability and Growth
Growth and
Profitability

Product Market Financial market

Strategies policies

Operating Investment Financing Dividend Policy

Management Management Decisions

Managing Managing Managing Managing

Revenue working Liabilities Payout
and capital and and Equity
Expenses fixed assets

The University of Sydney Page 95

 Profitability Ratios

Profitability Ratios Calculation

𝑁𝑃𝐴𝑇 𝑏𝑒𝑓𝑜𝑟𝑒 𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙𝑠 /𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Net Profit Margin  
EBIT Margin 𝐸𝐵𝐼𝑇 /𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
 
𝑁𝑂𝑃𝐿𝐴𝑇 /𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
NOPLAT margin
 
𝐸𝐵𝐼𝑇 / ( 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 −𝑂𝑢𝑡𝑠𝑖𝑑𝑒 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 )
ROA
  ′
𝑁𝑃𝐴𝑇 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑂𝑢𝑡𝑠𝑖𝑑𝑒 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 ¿ ¿
ROE  
𝑁𝑂𝑃𝐿𝐴𝑇 /𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥 .𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙
ROIC  

The University of Sydney Page 96

 Profitability Ratios
– Profitability measures focus on a firm’s earnings.
– ROE and ROA allow us to compare on a per-dollar invested basis.

– ROE measures profitability for contributors of equity capital

– Similarly ROA measures profitability for all contributors of capital

– These two measures are linked and the relationship is affected by firm financial
policies.

The University of Sydney Page 97

 Leverage and ROE (Example)
– Company 1 is all equity financed.
– It has assets of 100m and a tax rate of 40%
– Company 2 has a debt to asset ratio of 40%
– It also has assets of 100m and a tax rate of 40%.
– It has an interest rate of 8% and pays annual interest of $3.2m
– The two firms have similar business risks

Company 1 Company 2

Scenario EBIT ($) Net Profit ROE (%) Net Profit ROE (%)
($) ($)
Bad Year 5 3 3 1.08 1.8

Normal Year 10 6 6 4.08 6.8

Good Year 15 9 9 7.08 11.8

The University of Sydney Page 98

 Leverage and ROE
– The
  previous figure can be mathematically summarised in the
following way:

- If ROA > Borrowing rate then ROE increases

- If ROA < Borrowing rate then ROE decreases by an amount that depends on the
D/E ratio

The University of Sydney Page 99

 DuPont Method
– DuPont analysis is a structured method for analysing a firm
– It involves using an interrelated series of financial ratios.

– Performance measured as return on equity (ROE) is a product of various

component ratios.
– DuPont shows how each aspect of the firm’s performance can be broken down
into the component ratios.

– Decomposing ROE is useful in determining the reasons for changes in

ROE over time for a given company.
– Information gleaned from it can help management focus on areas to improve
ROE
The University of Sydney Page 100
 DuPont Method
– The ROE decomposition shows that a company’s profitability
(ROE) is a function of its:
1) Efficiency
2) Operating Profitability
3) Taxes
4) Financial Leverage

– There are a number of ways to decompose ROE

– We will focus on the most common method

The University of Sydney Page 101

 Return on Equity
–– Return
  on Equity (ROE) is calculated in the following way:

- Which can be interpreted as:

* Note: SE and Total Assets are normally measured as an average (over the year)

The University of Sydney Page 102

 Return on Equity
– Leverage is measured as average total assets over shareholders’ equity
– If a company had no leverage, its leverage ratio would equal 1.0 and ROE
would exactly equal ROA.

– As liabilities increase, so does leverage. Is this a bad thing?

– If a company can borrow at a rate lower than the marginal rate it can earn
investing the borrowed money then leverage will contribute to a higher ROE
ROE (%) ROA (%) Leverage
Coy 1 8.18 5.45 1.5
Coy 2 5 5 1
Coy 3 -3.9 -3 1.3
The University of Sydney Page 103
 Return on Equity
–– Just
  as ROE can be decomposed, the individual components such as ROA can be decomposed.

– Which can be summarised as:

– The three terms to the right of the equation explain:

1) How much income a company derives from every dollar of sales (NPM)
2) How much revenue a company gets from every unit of assets (TAT)
3) How much leverage the company has (LEV)

Remember:

The University of Sydney Page 104

 Return on Equity
ROE Net Profit Total Asset Leverage
Margin Turnover
Coy 1 8.18 4.96 1.1 1.5
Coy 2 5 5.26 0.95 1
Coy 3 -3.9 -3.0 1.0 1.3

– The following example reveals:

– Profitability (NPM) is an important contributor to ROE
– Higher asset turnover (efficiency)  higher ROA/ROE

The University of Sydney Page 105

 Return on Equity
– To
  further isolate the effects of taxes and interest, we can
further decompose the net profit margin:

– which can be restated as:

The University of Sydney Page 106

 Return on Equity
– The five terms on the right hand side of the previous equation explain:
1) The effect of taxes on ROE (how much of pre-tax profit is kept)
2) The effect of interest on ROE (higher borrowing costs reduce ROE)
3) The effect of operating margin on ROE
4) The effect of total asset turnover (efficiency) on ROE
5) The effect of financial leverage (solvency) on ROE

The University of Sydney Page 107

 Return on Equity (Example – ASX:FLT)
Return on
Equity
=21.60%

Return on Assets Leverage

=9.86% =2.20

Net Profit Total Asset

Margin Turnover
=10.84% =0.91

Tax Burden Interest EBIT Margin

= 70.04% Burden =15.16%
= 102.09
The University of Sydney Page 108
 ROE: Flight Centre Decomposed

The University of Sydney Page 109

 Other Ratio Categories
– Having discussed profitability ratios, there are several other
categories of ratios, such as:
– Asset management / utilisation

The University of Sydney Page 110

 Asset Management / Utilisation Ratios

Asset Management / Utilisation Ratios

Total Asset Turnover 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 /𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

 
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 / 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑜𝑛 −𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Fixed Asset Turnover
 
PPE Turnover 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 / 𝑃𝑃𝐸 − 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
 
Depreciation / PPE (%) 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛/ 𝑃𝑃𝐸
 
Inventory Turnover 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 /𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
 
Working Capital Turnover 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑛𝑢𝑒 / 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
 

The University of Sydney Page 111

 Asset Management Ratios
– Various aspects of the efficiency with which assets are utilised can be learned from
turnover ratios as well as from several of the previous examined ratios. One such
ratio is the total asset turnover ratio

– This ratio indicates how many times annual sales cover total assets. In examining
this ratio, it is important also to examine the related net income to sales ratio.
– Firms may trade off an increase in the total asset turnover ratio for a decrease in the
net income to sales ratio.

The University of Sydney Page 112

 Asset Management Ratios
– A second turnover ratio is the accounts receivable (A/R) turnover ratio

– As accounts receivable pertain only to credit sales, it is recommended that the

numerator only include credit sales.
– In many cases, however, total sales are used due to a breakdown financial reports
don’t provide a breakdown of cash and credit.
– By dividing A/R by 365 we obtain an estimate of the average collection period of
credit sales.

The University of Sydney Page 113

 Asset Management Ratios
– Inventory turnover ratio is:

– Like many other ratios, the magnitude of this ratio can be affected
markedly by inventory valuation rules.
– For example, for firms experiencing increasing raw material prices and
increasing inventory levels, the use of LIFO typically will result in higher
inventory turnover ratios vis-à-vis the ratios computed with the FIFO valuation
method.
– This is because LIFO assumes that the oldest inventories (and hence lowest
priced inventories in times of inflation) will be included in closing inventory.

The University of Sydney Page 114

 Liquidity (Debt/Safety) Ratios

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 /𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Current Ratio
 
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 /𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Quick Ratio ('acid test')  
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Financial Leverage  
𝑆𝑇 𝐷𝑒𝑏𝑡 + 𝐿𝑇 𝐷𝑒𝑏𝑡 / 𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Gross Debt / Equity (%)  
𝑆𝑇𝐷𝑒𝑏𝑡 + 𝐿𝑇 𝐷𝑒𝑏𝑡 −𝐶𝑎𝑠h / 𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Net Gearing (%)  
𝐸𝐵𝐼𝑇 / 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
Net Interest Cover  
𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 ( 𝑆𝑇 + 𝐿𝑇 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠h )/ 𝐺𝑟𝑜𝑠𝑠 𝐶𝑎𝑠h 𝐹𝑙𝑜𝑤 ¿ ¿
Net Debt to Cash Flow
 
𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 − 𝑂𝑡h𝑒𝑟 𝐼𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒𝑠 / 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆h𝑎𝑟𝑒𝑠
NTA per share  

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Liquidity and Solvency Ratios
– Cash Position Ratios
– Cash and ST investments form an important reservoir that the firm can use to
meet its operating expenditures and other cash obligations as they fall due.
– Key ratios include:

– The higher each of these ratios, the higher the cash resources available to the
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Sydney Is this a good thing? Page 116
 Liquidity and Solvency Ratios
– As with all ratios, care needs to be taken ascertaining the
accounting policy adopted in the measurement and
presentation of elements of the financial statement.

– Different measurement techniques can be used for inventory

(FIFO, LIFO, standard costing)
– classification of current assets and liabilities usually depends on
management intent.

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 Debt Servicing Coverage
– Debt service coverage refers to the ability of an entity to service from its
operations interest payments that are due to non-equity suppliers of capital.

– Two ratios useful in making inferences about interest coverage are:

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 Interest Cover
– Operating income typically is calculated as revenue less cost of goods sold
(COGS) and marketing and general administrative expenses (SGA)

– Annual interest payments in financial ratios refer to the interest payments

made to the non-equity suppliers of capital
– The higher these ratios, the greater the ability to service interest payments to
external parties.

– Debt service coverage ratios can be based on interest payments to external

loan capital providers, or they can be extended to include payments to
other providers of capital
– For example, by including payments on leasing contracts in the denominator of the two
coverage ratios.
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 Capital Structure Ratios
– Capital structure ratios provide insight into the extent to which
non-equity capital is used to finance the assets of the firm.
– Some representative ratios include:

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 Capital Structure Ratios
– The higher each of these ratios, the higher the proportion of assets financed
by non-shareholder parties.

– Which components are included in the numerator or denominator depend

on how one defines liabilities and shareholders’ equity.

– The growing complexity of hybrid securities has increased they grey areas
that arise when computing debt-to-equity ratios.

The University of Sydney Page 121

 Cash Flow Ratios

Cash Flow Ratios

Days Receivables
(
 
Days Payable
  ¿ ¿
Days Inventory ¿ ¿
 
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 /𝐶h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑃𝐸
Depreciation / CAPEX  

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 Cash Flow Ratios
– Two important ratios indicate cash-generating ability are:

– The average total assets figure in the ratios is typically calculated as the weighted
average of the opening and closing total asset figure for the fiscal period.

– The higher each of the ratios, the larger the cash flow generated by the firm in its
operations

The University of Sydney Page 123

 Capital Structure Ratios
– Capital structure ratios provide insight into the extent to which
non-equity capital is used to finance the assets of the firm.
– Some representative ratios include:

The University of Sydney Page 124

 Capital Structure Ratios
– The higher each of these ratios, the higher the proportion of assets financed
by non-shareholder parties.

– Which components are included in the numerator or denominator depend

on how one defines liabilities and shareholders’ equity.

– The growing complexity of hybrid securities has increased they grey areas
that arise when computing debt-to-equity ratios.

The University of Sydney Page 125

 Valuation Ratios

Valuation Multiples

Enterprise Value 𝐸𝑉 / 𝐸𝐵𝐼𝑇𝐷𝐴

 
𝐸𝑉 / 𝐸𝐵𝐼𝑇
Enterprise Value
 
Market to Book Ratio 𝑃𝑟𝑖𝑐𝑒 /𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒
 
Price-to-Earnings Ratio 𝑃𝑟𝑖𝑐𝑒/ 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆h𝑎𝑟𝑒
 
𝐸𝑃𝑆/ 𝑃𝑟𝑖𝑐𝑒
Earnings Yield
 

The University of Sydney Page 126