Financial statement analysis

2. Working with Financial Statements
• A firm’s financial statements contain a wealth of important information which can inform the
astute analyst regarding its overall health, how well operational or strategic adjustments are
impacting returns, and provides an opportunity to benchmark performance to other similar
entities.
• Although the IFRS standard provides for 5 separate statements, here we are focused on the two we rely
upon the most: the income statement and balance sheet.
• All accounting standards attempt to capture much of the same information so learning how ideas are
represented, rather than memorizing definitions, is what leads to mastery in this area.
• To reinforce the basics and prepare you to estimate the financial implications of decisions for firms
facing complex situations, we will review some of analytical tools which can be derived from them, and
consider how to construct forecast financial statements in a way that helps us approximate the firm’s
funding needs (or capacity to pay out to investors).

3. A Very Basic Business
• Imagine a lemonade stand selling 20 glasses of juice for $0.25 each
• Direct juice costs are $0.10 a glass and there is “overhead” of $1.00 for their signage. It pays no wages to
the owner, just profit (also no taxes).
• Profit for a period is calculated by subtracting total costs from total revenues.
• For the day, profit is: [(20 x $0.25) – (20 x $0.10) - $1.00 = $2.00]
• Alternately: [20 x ($0.25 - $0.10) - $1.00 = $2.00]
• What happens if relevant inflows or outflows occur outside the period?
• In terms of daily profits, if signage was created the day before sales are made, the enterprise will appear to
lose money on day 1 but make money on day 2.
• Putting those two days together however shows the firm as profitable.

4. The Matching Principle
• To get around this timing issue (which complicates management), accountants developed a
practice which matches revenues to their relevant costs.
• If a sale is booked in some period its costs are “matched” to it, even if they were incurred before the sale
and after the actual cash was received.
• This allows us to consider what the incremental flows (profits) would be if all the
transactions had happened at the same time.
• In this way, we can analyze the profitability of an activity cycle rather than an arbitrary period
• This means that the profits for a given period may not actually line up with cash flowing into
or out of the business.
• While accounting profits are a useful consideration in planning, they fail to capture some potentially
important information, like timing. (more on this later)

5. Financial Statements: Income Statement
• The I/S reports revenue earned over
some period, as well as the expenses
incurred to earn that income.
• Cost are organized from the most to
least attributable.
• The “margin” earned after various kinds of
costs are removed can be informative for
benchmarking
• Gross margin is the % flow through after
“direct costs”
• EBIT margin after operational costs
• Profit margin after all costs (NI/Rev)
Income Statement for ABC Corp.
for the year ended Dec 31, 2020
Revenues $ 6,700,000
Cost of Goods Sold $ 4,020,000
Gross Profit $ 2,680,000
Selling and Administrative expenses $ 1,500,000
Earnings before Interest and Taxes (EBIT) $ 1,180,000
Interest Expense $ 450,000
Earnings before tax (EBT) $ 730,000
Income Taxes (32%) $ 233,600
Net Income $ 496,400
Dividends $ 100,000
Retained Earnings $ 396,400

6. Balancing Assets and Financing
• Its one thing to know that a firm or project is profitable but an important consideration is the
amount of money tied up to make those profits.
• What assets are needed to support the enterprise and how were they financed?
• Assets can be financed with the firm’s money (equity) or another’s (debt)
• A balance sheet shows both of these things:
• One side lists assets, the other lists liabilities and owners equity.
• Top to bottom items are listed from most liquid, to least liquid
• Unlike an income statement (which covers a period of time), a balance sheet is a financial
‘snapshot’ at one point in time which may or may not be representative of average (or
current) conditions.

7. Financial Statements: Balance Sheet
• Just like operational leverage, financial leverage increases the range of outcomes for equity
investors. Debt amplifies the return on equity (ROE), for good or bad.
Balance Sheet for DEF Corp
as at Dec 31, 2020
ASSETS FINANCING (Liabs & SH’s Equity)
Cash 5 Accrued wages and taxes 5
Marketable Securities 10 Accounts payable 5
Accounts Receivable 10 Long-term debt 20
Inventory 25 Paid-in capital 40
Net Fixed Assets 100 Retained earnings 80
TOTAL 150 150

8. Analysing Financials
• Now that you know how they are built, let’s talk about what they can tell us
• Historical analysis: benchmarking levels and stability
• Analysing forecasts: sources of cash flow variation
• What metrics should we care about?
• Prices: P/E, P/BV, EV/S, EV/EBITDA, EV/CFFA
• Returns and leverage: ROA, ROE, D/E
• Liquidity: current and quick ratios, TIE, cash coverage
• Working Capital Analysis: cash conversion cycle
• On their own, most ratios won’t “tell you” anything - you need to benchmark and then try to
understand what motivates changes or differences.

9. Benchmarking to Comparable Firms
• Select 6-10 comparable firms to calculate a composite based on the types of assets they
use to generate the key metric.
• Seek out comparable firms first by industry, then geography, then size. The objective is to select firms
expected to use similar assets and thus face similar business risk (KeU).
• When comparing to an industry group, recall that industries can have skewed prices during
bubbles or crashes (all tech stocks had high prices in 1999)
• Be mindful of accounting differences when benchmarking to a specific competitor or across borders
(revenue recognition, inventory valuation, pension and benefit liabilities)
• Benchmarking against industry groups removes a lot of “unique” firm risks.
• Be careful about being too specific as it can lead to a small sample which can be
dominated by outliers or common problems.
• Pre-2008 crisis GM, Ford & Chrysler all benchmarked their results to one another…

10. Benchmarking with Accounting Ratios
• Over the past 5-10 years, a company will have displayed a range of values according to
different price ratios, as will its family of comparable firms.
• Comparing the current value of a firm to its own history informs us about the relative
valuation of the business
• Comparing to an industry mean or median provides us with relative measures of
effectiveness and risk.
• They lead us to identify “cheapest of a group” but that isn’t necessarily “cheap” on an
absolute or historical basis.
• A company trading at a P/E of 40 that has been at 50 for the last 2 years while its industry
averages 60, is NOT undervalued

11. Prices and Enterprise Values
• Price ratios generally use “per share” metrics but whole-company measures provide the
same values (X/50) / (Y/50) = (X/Y).
• Price/Earnings: Earnings can be re-stated and are subject to accrual manipulation. Affected by the
Rf rate.
• Price/Book Value: A good metric for industrial firms with machines and inventory but a poor metric
for services, tech, or firms with intangible assets.
• Ratios based on stock prices are affected by differences in capital structure more than
those based on enterprise value so EV ratios are favoured by some analysts.
• Enterprise Value/Sales: Good for industry comparison.
• Enterprise Value/EBITDA: Like P/E but less affected by leverage.
• Enterprise Value/CFFA: (cash flow from assets, aka free cash flow). Focuses on cash rather than
earnings.

12. Returns and Leverage
• Combining data from the I/S and B/S, we can calculate the rates of return:
• On assets (ROA = net income / assets), and on equity (ROE = net income / shareholder’s equity).
• By expanding the ROE formula, we can see how astute managers can increase the returns earned
by shareholders:
• ROE = net income / equity
• ROE = (net income / sales) * (sales / assets) * (assets / equity) = [ROA * (assets / equity)]
• ROE = (profit margin) * (asset turnover) * (equity multiplier)
• Asset turnover measures how effectively assets are used to generate sales.
• A common measure of a firm’s financial leverage is its debt/equity ratio (D/E).
• This is different from the “equity multiplier” in the Dupont equation above, but related.
• A = D + E; therefore A/E = (D+E)/E = D/E + 1
• There are no hard rules for what constitutes too much leverage but it IS important to remember that a leveraged
investment that goes bad can lead to bankruptcy.

13. Liquidity
• Current and Quick ratios: Prudence suggests these be higher than their industry
averages but very high numbers may indicate an excess amount of idle cash.
• The quick ratio drops inventory from the current ratio. Best used when inventories can’t be sold off for full
price in a hurry.
• A current ratio of 1 or more is held to indicate safety (liquidity) but firms with superior working capital
management will have lower ratios relative to those carrying excess inventories.
• Times-Interest-Earned: (EBIT/I). High values indicate safety but also a lost opportunity to
capture tax shields.
• Cash coverage: [(EBIT+Depr)/I]. Firms with high depreciation expenses will show poorly
on TIE but have good cash coverage. Safety thresholds vary by industry but cash
coverage benchmarks are higher than TIE ones.

14. Working Capital
• Although there are several working capital ratios, the most powerful is a composite
diagnostic however, the Cash Conversion Cycle.
• It estimates the average time between when a firm pays its bills and when it gets paid.
• The shorter it is (negative even!), the faster a firm turns over its working capital and the more rapidly it can
grow without recourse to outside funding.
Cash Conversion Cycle = avg. age of Inv. + avg. age of A/R – avg. age of A/P
• Be careful and don’t blindly optimize around this number!
• Minimizing working capital investments can be counter-productive where A/R and inventory policies
are part of a firm’s strategy but having a faster CCC is usually a good indicator of efficiency.

16. Forecasting Financials
• Our second block today considers how to estimate what financial statements might look like
going forward based on assumptions about revenue growth, cost structure, financing needs,
etc
• This is an important aspect of financial management as it allows us to project what our financing needs or
what excess flows might be available to investors
• They also enable us to forecast financial ratios, approximate the impact of shifts in strategy or operations,
and make estimates of the economic value of the firm.
• These forecasts are only as good as their inputs and it is important to recognize the limits of
our ability to predict future tax rates, expenses, sales growth, and other important inputs.
Garbage in, garbage out.

17. Forecasting Income Statements
• The first step requires a sales forecast up until the horizon.
• This can come from industry estimates of market size and firm estimates of market share.
• Be careful when relying on managerial estimates that may be more aspirational than realistic
• Variable costs (direct materials and labour) per unit may change as the firm grows but
mature firms tend to have stable gross margins (costs grow as a % to sales).
• You may wish to average this over a few recent years if the most recent is not representative.
• Fixed costs depend on the need for overhead and usually looks like a staircase.
• If there is slack capacity in the system a firm may increase sales without adding fixed assets.
• A best practice in long-term forecasting is to average capex over the asset life cycle but is not be
appropriate for start-ups which are building their asset base.

18. Pro-Forma Income Statement
Year 1 Year 2 Year 3
(40% of sales)
(assumed not to change)
(gross profit less fixed costs)
(of EBT = EBIT less interest)

19. Improving the I/S Forecast
• The proceeding example was very simplified in that we assumed sales could increase
without an increase in overhead (or debt, same interest expense).
• While that may be possible in some cases, the expansion of sales often requires an expansion in fixed
assets which necessitates capex but also increases depreciation expenses.
• We consider this in the next example.
• Depreciation expenses in Canada are dealt with through the Capital Cost Allowance
(CCA) system which allows firms to write of a % of the remaining value of assets. Its
complicated (call accounting for details).
• Conversely, “straight line” depreciation, which writes of a % of price annually, may be used internally but
it does not reflect the actual cash flows resulting from taxation (CCA rules).

20. Forecasting the Balance Sheet
• Depending on the nature of the output, projects (or firms) which expand over time need to
maintain sufficient assets to sustain additional sales.
• As a result, a rapid expansion of sales can sometimes lead to a firm’s need for new assets outstripping its
available cash resources.
• This may involve the purchase of long-lived assets (plant, property, equipment) from time to time but rising
sales tends to require the expansion of “current” assets (cash, inventory, receivables, etc) on a more
granular scale.
• The technique shown here constructs the balance sheet in three steps:
1. A basic % of sales forecast (will not balance)
2. Tweaking the assumptions of the model (will not balance)
3. Meeting needs or disbursing funds via policy variables (balances)

21. The Balance Sheet (baseline)
Cash 5 Accruals 5
Securities 10 Payables 5
Receivables 10 Short-term debt 20
Inventory 25
Current assets 50 Long-term debt 40
Net fixed assets 100 Common equity 80
Total assets 150 Total Liabilities 150
The historical balance sheet.
Spontaneous
liabilities also
likely to grow
as a % of sales
Policy
variables
requiring
decision.
If sales rise, assets
used to produce
sales must grow.

22. Forecasting a Balance Sheet (first pass)
• Start by setting assets and non-financial liabilities as a % of sales and extrapolate
• THIS WILL NOT BALANCE but shows the required funds necessary for it to do so.

23. Second-Pass Balance Sheet – External Funds Required
• Our first improvement is to account for the increase in equity from retained earnings (the
portion of net income not paid as dividends).
• Another is to recognize that cash and securities balances do not have to rise as a fraction of
sales (marketable securities can be sold off too).
• Marketable securities are where “excess” cash is usually parked as they earn some return while the
purchasing power of cash degrades with inflation.
• Similarly, accruals and pre-paid expenses usually vary throughout the year but should not necessarily rise
as a % of sales.
• I kept cash and accruals flat and liquidated marketable securities in year 1.
• Once again, the forecast will NOT balance as is and instead it shows what is need for
balance (in this case, more external funds).

24. Pro Forma Balance Sheet (second pass)
%
Sales 120 100.0% 132 145 160
Cash 5 4.2% 5.00 5.00 5.00
Securities 10 8.3% 0.00 0.00 0.00
Receivables 10 8.3% 11.00 12.08 13.33
Inventory 25 20.8% 27.50 30.21 33.33
Net fixed assets 100 83.3% 110.00 121.00 133.10
Total assets 150 125.0% 153.50 168.29 184.77
Accruals 5 4.2% 5.00 5.00 5.00
Payables 5 4.2% 5.50 6.04 6.67
Short-term debt 20 16.7% 20.00 20.00 20.00
Long-term debt 40 33.3% 40.00 40.00 40.00
Equity 80 66.7% 85.50 93.50 104.50
Total liabilities and equity 150 125.0% 156.00 164.54 176.17
External Funds Required -2.50 3.75 8.60
• Assuming cash remains
constant, we liquidate
marketable securities and we
include retained earnings from
each year, the forecast
required funds changes
dramatically.
• The firm is still projected to
need external funds but not
until year 2 and the estimated
amount is substantially
reduced.
Year 1 Year 2 Year 3

25. Final Pass Balance Sheet
• Based on our forecast of external funds required, the next step is to consider where that
money will come from (or where it will go).
• We can either reduce assets or increase funding (or grow slower?)
• If external funds required is negative, it implies you have extra resources available which you can use to
increase assets, or return funding to source (dividends or debt repayment).
• In practice, positive external funds required is usually met by increasing debt and negative
funds required means a build up of cash.
• A savvy manager will seek to raise funds from the lowest cost source while deploying excess funds to debt
repayment, stock repurchases, or increased dividends (if it looks sustainable).
• Increasing the use of debt will affect the interest expense of future years.

26. Linked Statements
• A good way to ensure your model works is to
construct a cash flow statement.
• Its not required (CFSs can be built from I/S and B/S data)
but can sometimes be helpful.
• All three statements should flow into each other if
properly prepared.
• Net income (I/S) feeds into the operating cash (CFS)
• Changes in asset and liability accounts (B/S) feed into
cash flows (CFS)
• The net change in cash (CFS) should be the difference
between cash at the time the B/S is prepared (t=1) and
the last time it was (t=0) so as to reconcile it with reality.
Cash Flow Statement for XYZ Corp
for the year ended Dec 31, 2020
Cash flow from Operations
Net Income 4500
Depreciation (+) 175
increase in A/R (-) -750
increase in prepaids (-) -42
increase in Inv (-) -600
increase in accruals (+) 25
increase in A/P (+) 1200
TOTAL 4508
Cash flow from Financing
increase in short-term debt (+) 100
increase in long-term debt (+) -300
repurchase of shares (-) -200
sale of new shares (+) 0
dividends paid (-) -500
TOTAL -900
Cash flow from Investing
new capital expenditures (-) -2200
proceeds from sale of LT assets (+) 85
TOTAL -2115
TOTAL CHANGE IN CASH 1493

28. What the Jones Electric Case Teaches You
• In this case you, the core lesson is about working capital management.
• As a fast growing firm with a physical product, Jones Electric an ongoing need to invest in the assets
needed to sustain those sales.
• With a healthy gross margin and reasonable overhead costs, the owners feel their creditors
should to continue funding its expansion.
• The financiers feel a little different – Jones Electric has borrowed A LOT of money in the past few years
and they are concerned about its financial health.
• Can both of these be true? Can a company be fast-growing and profitable, and still run into financial
trouble?

29. What is Jones Electric?
• Jones Electric is in the electrical parts business. They supply many contractors with parts
from multiple manufacturers.
• The overall market is cyclical and currently expanding, enabling sales growth from both increasing
aggregate demand and competitive interaction.
• How fast should they want to grow? Can you “blitz-scale” a parts business?
• The company has good relations with both customers and suppliers, enabling trade credit
to “oil the wheels of commerce”.
• Note the increase in accounts receivable and payable over the past few years.
• As sales have increased, so too has the firm’s need for inventory (to smooth the timing gaps between
demand and production and shipping time)

30. The Main Question
• What options does Jones Electric have and what should they do?
• You will need to produce a set of recommendations for the firm’s owners which could go beyond tinkering
with financial variables – think about the broader implications for the firm’s strategy of changing its financial
policies.
• To better understand the company’s situation, you will need to create a pro forma Income
Statement and Balance Sheet for 2007 and assess the firm’s situation based on projections
provided in the case.
• A second year might prove useful to check as surviving the year only to fail the following January isn’t
exactly what the owners are hoping for.
• A cash flow statement might prove useful but is not strictly required.

31. Important Questions to Think About
1) Why are Jones’ lenders concerned about the firm’s financial health?
2) What consequences could there be for Jones Electric if its lenders refused to provide
more capital?
3) How competitive is the electric parts industry and what does this imply about the
company’s changing policies?
4) What source of funding did Jones primarily rely on during the first quarter of 2007 (where
did the money come from)?
5) What line items from the financials should NOT be increased as a percentage of sales in
the pro forma statements?

32. What to do With The Projections
• Once you have built the pro forma statements, you can use them to forecast the impact of
various policy adjustments.
• The “external funds required” model from the slides and videos will be helpful
• ALWAYS try to think about the impact on other areas of the business which tweaking a
financial input could have (strategy, marketing, etc)
• Its usually impossible to change things in isolation from one another so give some thought to how any
adjustments you are proposing might ripple out.
• It is quite possible that the company’s “needs” cannot be met.
• Don’t neglect the constraints they face when crafting your action plan.

33. What You Need to do Next
• Meet with your group to discuss Jones Electric’s industry and what the company has to do
to succeed.
• This will ground you in terms of what remedies are actionable vs aspirational
• Build pro forma financials for 2007 (possibly 2008) for Jones Electric
• Percentage of Sales, and External Funds Required methods will be useful here.
• Consider non-financial risks; implementation is rarely frictionless.
• Make a pro looking report. 3000-4000 words plus appendices is about right.