Working With Financial
Statements
P.V. Viswanath
For use with
Fundamentals of Corporate Finance
Brealey, Myers and Marcus, 4th ed.
Key Concepts and Skills
 Know how to standardize financial statements for
comparison purposes
 Know how to compute and interpret important
financial ratios
 Know the determinants of a firm’s profitability and
growth
 Understand the problems and pitfalls in financial
statement analysis
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Chapter Outline





Standardized Financial Statements
Ratio Analysis
The Du Pont Identity
Internal and Sustainable Growth
Using Financial Statement Information
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Standardized Financial Statements
 Common-Size Balance Sheets

Compute all accounts as a percent of total assets
 Common-Size Income Statements

Compute all line items as a percent of sales
 Standardized statements make it easier to compare financial
information, particularly as the company grows
 They are also useful for comparing companies of different
sizes, particularly within the same industry
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Ratio Analysis
 Ratios also allow for better comparison through
time or between companies
 As we look at each ratio, ask yourself what the ratio
is trying to measure and why is that information
important
 Ratios are used both internally and externally
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Categories of Financial Ratios
 Liquidity ratios

Short-term solvency or how easily the firm can lay its hands on cash.
 Financial leverage ratios

Show long-term solvency; how heavily the firm is in debt.
 Efficiency or turnover ratios

Indicate how productively the firm is using its assets
 Profitability ratios

Used to measure the firm’s return on its investments
 Market value ratios
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Sample Balance Sheet
Numbers in thousands
Cash
Acc Receiv
6,489 Acc Payable
1,052,606 Notes Pay
340,220
86,631
Inventory
295,255 Other Curr Li
1,098,602
Other Curr A
199,375 Total CL
1,525,453
Total CA
1,553,725 LT Debt
871,851
Net Fixed A
2,535,072 Comm Stock
1,691,493
Total Assets
4,088,797 Tot Liab & Eq
4,088,797
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Sample Income Statement
Numbers in thousands, except EPS & DPS
Revenues
3,991,997
Cost of Goods Sold
1,738,125
Expenses
1,269,479
Depreciation
308,355
EBIT
739,987
Interest Expense
42,013
Taxable Income
Taxes
697,974
Net Income
425,764
272,210
EPS
2.17
Dividends per share (DPS)
0.86
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Computing Leverage Ratios
 Total Debt Ratio = (Tot Assets – Tot Eq) / TA


(4,088,797 – 1,691,493) / 4,088,797 = .5863 times or 58.63%
The firm finances almost 59% of their assets with debt.
 Debt/Equity = Tot Debt / Tot Eq

(4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times
 These numbers can also be computed for long-term debt:
 Long Term Debt Ratio = LT Debt/ (LT Debt + Eq) =
871,851/(871851+ 1, 691,493) = 0.34
 Long Term Debt/Equity = 871851/ 1, 691,493 = 0.515
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Data from last year



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Inventory = 280,044
Accounts Receivable = 940,044
Total Assets = 3,998,256
Total Equity = 1,480,493
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Computing Coverage Ratios
 Times Interest Earned = EBIT / Interest

739,987 / 42,013 = 17.6 times
 Cash Coverage = (EBIT + Depreciation) / Interest

(739,987 + 308,355) / 42,013 = 24.95 times
 Determinant of the riskiness of a firm’s debt
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Computing Liquidity Ratios
 Current Ratio = CA / CL

1,553,725 / 1,525,453 = 1.02 times
 Quick Ratio = (CA – Inventory) / CL

(1,553,725 – 295,225) / 1,525,453 = 0.825 times
 Cash Ratio = Cash / CL

6,489 / 1,525,453 = .004 times
 Net Working Capital to TA Ratio = NWC/TA

(1,553,725 - 1,525,453)/ 4,088,797 = 0.007
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Computing Inventory Ratios
 Inventory Turnover = Cost of Goods Sold / Average
Inventory

1,738,125 / [(295,255 + 280,044)/2] = 6.04 times
 Days’ Sales in Inventory = 365 / Inventory Turnover = Av
Inv/(COGS/365)
365 / 6.04 = 60.41 days
 When you have ratios with I/S numbers in the numerator and B/S
numbers in the denominator, use average of year beginning and year end
quantities.

 Last year’s Inventory = 280,044.
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Computing Receivables Ratios
 Receivables Turnover = Sales / Av Accounts
Receivable

3,991,997 / [(1,052,606 + 940,044)/2] = 4.01 times
 Average Collection Period = Days’ Sales in
Receivables = 365 / Receivables Turnover = Av
Receiv/ (Av Sales)

365 / 4.01 = 91.1 days
 Ac Rec last year = 940,044
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Computing Total Asset Turnover
 Total Asset Turnover = Sales / Av Total Assets

3,991,997 / [(4,088,797 + 3,998,256)/2] = 0.99 times
 Measure of asset use efficiency
 Not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets
 Total Assets last year = 3,998,256
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Computing Profitability Measures
 Profit Margin = Net Income / Sales

425,764 / 3,991,997 = 0.1067 times or 10.67%
 Operating Profit Margin = (NI + Int) / Sales

(425,764 + 42013) / 3,991,997 = 0.1172 times or 11.72%
 Return on Assets (ROA) = (Net Income + Interest) / Av TA

(425,764 + 42013) / [(4,088,797 + 3,998,256)/2] = 0.11.57 times or
11.57%
 Return on Equity (ROE) = Net Income / Average Equity

425,764 / [(1,691,493 +1,480,493)/2] = 0.2685 times or 26.85%
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Computing Market Value Measures
 Market Price = $61.625 per share
 Shares outstanding = 205,838,594
 P/E Ratio = Price per share / Earnings per share

61.625 / 2.17 = 28.4 times
 Market-to-book ratio = market value per share /
book value per share

61.625 / (1,691,493,000 / 205,838,594) = 7.5 times
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Payout and Retention Ratios
 Dividend payout ratio = Cash dividends / Net
income

0.86 / 2.17 = .3963 or 39.63%
 Plowback ratio = Retention ratio = Additions to
retained earnings / Net income = 1 – payout ratio


1.31 / 2.17 = 0.6037 = 60.37%
Or 1 - .3963 = 0.6037 = 60.37%
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Sustainable Growth
 The sustainable growth rate tells us how fast the firm can grow,
without increasing financial leverage.
 Sustainable growth rate = Growth in equity from plowback =
plowback ratio x ROE


0.6037 x 0.2685 = 0.1621 or 16.21%
If the firm can continue to earn 26.85% on its equity and can plow back
60% of earnings into operations, its earnings and equity should both
grow at 16.21% p.a.
 Growth at this rate requires external financing to grow at the
existing rate. Without any additional external financing, the
firm can only grow at what is called the Internal Growth Rate.
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Internal Growth
Internal
retained earnings

growth rate
total assets
retained earnings net income
equity

x
x
net income
equity
total assets
Internal
Sustainabl e
equity

x
growth rate Growth Rate total assets

0.1621 x (1,691,493 +1,480,493) /(4,088,797 +
3,998,256) = 0.1621 x 0.3922 = 0.0636 or 6.36%
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Determinants of Growth

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Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt ratio
Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
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Deriving the Du Pont Identity
 ROE = NI / TE
 Multiply by 1 and then rearrange

ROE = (NI / TA) * (TA / TE) = ROA * Equity Multiplier
 Multiply by 1 again and then rearrange


ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = Profit Margin * Total Asset Turnover * Equity
Multiplier
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Deriving the Du Pont Identity
 ROA = (NI + Interest)/ TA



Multiply by 1 and rearrange
ROA = [(NI + Int)/ TA]*(Sales / TA)
ROA = (Operating Profit Margin)*(Asset Turnover)
 ROE = NI / TE





ROE = (NI/Sales]*(Sales/TA)*(TA/TE)
= Net Profit Margin*Asset Turnover*Equity Multiplier
ROE = [NI/(NI+Int)]*[(NI +Int)/ Sales]*(Sales/TA)*(TA/TE)
= Debt Burden * Op Profit Margin * Asset Turnover*Eq Multiplier
= Debt Burden * ROA*Equity Multiplier
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Using the Du Pont Identity
ROE = Net Profit Margin * Total Asset Turnover *
Equity Multiplier



Net Profit margin is a measure of the firm’s operating
efficiency – how well does it control costs
Total asset turnover is a measure of the firm’s asset use
efficiency – how well does it manage its assets
Equity multiplier is a measure of the firm’s financial
leverage
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Table 3.6
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Why Evaluate Financial Statements?
 Internal uses


Performance evaluation – compensation and comparison between
divisions
Planning for the future – guide in estimating future cash flows
 External uses




Creditors
Suppliers
Customers
Stockholders
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Benchmarking
 Ratios are not very helpful by themselves; they need
to be compared to something
 Time-Trend Analysis


Used to see how the firm’s performance is changing
through time
Internal and external uses
 Peer Group Analysis


Compare to similar companies or within industries
SIC and NAICS codes
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Work the Web Example
 The Internet makes ratio analysis much easier than
it has been in the past
 Go to Multex Investor (yahoo.multexinvestor.com)
 Choose a company and enter its ticker symbol

Click on Ratios and see what comparative information is
available
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Quick Quiz
 How do you standardize balance sheets and income
statements and why is standardization useful?
 What are the major categories of ratios and how do
you compute specific ratios within each category?
 What are the major determinants of a firm’s growth
potential?
 What are some of the problems associated with
financial statement analysis?
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