+
Working With Financial
Statements
ch 3
+
Using Financial Statement

Our goal in this chapter is to expand our understanding of the
uses of financial statement information.

Keep in mind we have different users of financial statement.

Although market value information is more important to
financial managers, they rely more on accounting numbers
because they are unable to obtain all the market information
they want.

Accounting numbers are just pale reflection of economic reality
but they are the best available information.
+
3.1 Cash Flow and Financial
Statements
Cash flow from the assets= Cash flow to creditors +Cash flow to shareholders

The previous formula simply means that firms do two things:
Generate cash ( Source of cash)
 Spend cash
( Use of cash )

 Source


of Cash: A firm’s activity that generate cash.
Examples: selling a product, selling an asset, selling a security
(by selling bonds to borrow money or by selling a share of
stock)
Uses of Cash: A firm’s activity in which cash is spent.

Examples: paying for materials and labor to produce a product,
purchasing assets, payment for creditors and owners.
+
Sources and Uses of Cash
^
Assets
v
Liabilities
v MONEY
Use of Cash
v Assets
^ Liabilities
^ MONEY
Source of Cash
2008
cash.
+
2009
change
Assets
Current Assets
Cash
$84
$94
+$14
Account Receivable
$165
$188
+$23 USE
Inventory
$393
$422
+ $29 USE
Total
$642
$708
+$66
Net plant and
Equipment
$2,731
$2,880
+$149 USE
Total Assets
$3,373
$3,588
+$215
Fixed Assets
Liabilities and Owner’s Equity
Current liabilities
Account payable
$312
$344
+ $32 Source
Notes Payable
$231
$196
- $35
Total
$543
$540
-$3
Long term debt
$531
$457
-$74
Common stock
$500
$550
+$50
Source
Retained earning
$1,799
$2,041
+242
Source
Total
$2,299
$2,591
+$292
Total liabilities and
owner’s equity
$3,373
$3,588
+$215
Use
Use
Owner’s Equity
+
Analyzing the Results

You might ask, how did we get the +$14 increase in cash in the
previous balance sheet

The answer is : All sources of cash – All uses of cash

In Our example: sources of cash (increase 32 in account
payable + +$50 increase in common stock + $242 increase
retained earnings = $324)

uses of cash ( $23 increase in account receivable + $29
increase in inventory + $35 decrease in note payable + $74
decrease in long term debt + $149 increase in fixed assets
acquisition = $310)

$324 - $310 = $14 in cash.
+ The Statement of Cash Flow
Statement of Cash flow:
A firm’s financial statement that summarizes its sources and uses of cash flow over a specified
period
Steps to prepare the statement of cash flow:
1. To prepare the statement of cash flow, we need to use both the income statement and the
balance sheet.
2. Find the difference (changes) between the end of the year and the beginning of the year in the
balance sheet.
↑Assets or ↓ Liabilities or owner’s equity = use of cash
↓Assets or ↑ Liabilities or Owner’s equity = Source of cash
3. Start the cash flow statement by (cash at the beginning of the year ), then, Divide the
statement of cash flow to three categories:

Operating Activity: includes net income + depreciation, and changes in current accounts
(current assets or account payable, add them if they are sources and subtract them if they are
uses).

Investment Activity: includes changes in fixed assets+ depreciation.

Financing Activity: includes changes in notes payable, long-term debt, equity accounts, and
dividend.
4. To find (cash at the end of the year), add all (sources of cash) together and subtract them from
all (uses of cash)
+
Statement of Cash Flow

The following is the income statement since we will use it in making the
statement of cash flow.
2009 Income Statement of Prufrock Corporation
Sales
$2,311
Cost of Good Sold
$1,344
Depreciation
$ 276
Earning before Interest and taxes
$691
Interest paid
$141
Taxable Income
$550
Taxes (34%)
$187
Net Income
$363
Dividends
$121
Addition to retained earnings
$242
+ Building a Statement of Cash Flow
2009 statement of cash flow
$84
Cash, beginning of the year
• Operating Activity
Net income
$363
+Depreciation
$276
Increase in account payable
(source)
Increase in account receivable
Increase in inventory
(use)
(use)
Net cash from operating activity
$32
- $23
- $29
$619
Investment Activity
Fixed asset acquisition
+ Depreciation
assets)
(use)
(added because it was subtracted from the fixed
Net cash from investment activity
- $149
- $276
- $425
Financing Activity
Decrease in note payable
(use)
-$35
Decrease in long term debt
(use )
-$74
Dividend Paid
(use)
- $121
Increase in common stock
(source)
$50
Net cash from financing activity
-$180
Net increase in cash
$14
Cash end of the year
(84+14)
$98
+ 3.2
Standardized Financial Statements

It will be impossible to compare financial statement of one company to
other financial statements of similar companies who do the same
business. WHY? Because they have different sizes so we can not
compare dollar amounts.

It is also hard to compare the financial statements of the same
company but in different periods of time because the size has
changed.

To start making comparisons, we need to standardized the financial
statements by using percentages instead of total dollars.

Three ways to standardize financial statements:
①
②
③
Common Size statements
Common Base year financial statements (Trend Analysis)
Combined Common Size and Base year Analysis
+ Standardized Financial Statements
1.Common



Size Statements:
Is a standardized financial statement presenting all items in
percentage terms.
Balance sheet items are shown as a percentage of assets
and income statement items as a percentage of sales and
cash flow items as a percentage of total sources or total
uses of cash.
Next slides is a common size balance sheet and common
size income statement.
cash.
2008
+
2009
2008 ratio
2009 ratio
Assets
Current Assets
Cash
$84
$94
84/3373 = 2.5%
2.7%
Account Receivable
$165
$188
165/3373=
4.9%
5.2%
Inventory
$393
$422
11.7%
11.8%
Total
$642
$708
19.1%
19.7%
Net plant and Equip.
$2,731
$2,880
Total Assets
$3,373
$3,588
Fixed Assets
80.9%
80.3%
100%
100%
Liabilities and Owner’s Equity
Current liabilities
Account payable
$312
$344
9.2%
9.6%
Notes Payable
$231
$196
6.8%
5.5%
Total
$543
$540
16%
15.1%
Long term debt
$531
$457
15.7%
12.7%
Common stock
$500
`550
14.8
15.3%
Retained earning
$1,799
$2,041
53.3%
56.9%
Total
$2,299
$2,591
68.1%
72.2%
Total liabilities and
owner’s equity
$3,373
$3,588
100%
100%
Owner’s Equity
+
Common size income statement
2009 Income Statement of Prufrock Corporation
Ratios%
Sales
$2,311
100%
Cost of Good Sold
$1,344
58.2%
Depreciation
$ 276
11.9%
Earning before Interest
and taxes
$691
29.9%
Interest paid
$141
6.1%
Taxable Income
$550
23.8%
Taxes (34%)
$187
8.1%
Net Income
$363
15.7%
Dividends
$121
5.2%
Addition to retained
earnings
$242
10.5%
+ Standardized Financial Statements
2. Common Base year Financial Statement
Is a standardized financial statement presenting all items relative to a certain
base year amount.

Choosing a base year and then express each item relative to the base amount.

Used to compare the performance of the company during the years to see the
pattern of the firm operations:


Ex. Does the firm use more or less debt? Has the firm grown more or less
liquid?
The following slide is a common base year balance sheet.
Common Base Year Financial Statement .
+
2008
2009
Common base
year
Assets
Current assets
Cash
$84
$94
98/84 = 1.17%
Account Receivable
$165
$188
1.14%
Inventory
$393
$422
1.07%
Total
$642
$708
1.10%
Net plant and Equip.
$2,731
$2,880
Total Assets
$3,373
$3,588
Fixed Assets
1.05%
1.06%
Liabilities and Owner’s Equity
Current liabilities
Account payable
$312
$344
1.10%
Notes Payable
$231
$196
0.84%
Total
$543
$540
0.99%
Long term debt
$531
$457
0.86%
Common stock
$500
550
1.1%
Retained earning
$1,799
$2,041
1.13%
Total
$2,299
$2,591
1.13%
Total liabilities and
owner’s equity
$3,373
$3,588
1.06%
Owner’s Equity
+ Standardized Financial Statements
3. Combined common size and base year analysis:
(see table in the following slide)
2008
cash.
+
2009
2008 common
size ratio
2009commo
n size ratio
combin
ed
Assets
Current Assets
Cash
$84
$94
84/3373 = 2.5%
2.7%
Account Receivable
$165
$188
165/3373=
4.9%
5.2%
2.7/2.5=
1.08%
1.06%
Inventory
$393
$422
11.7%
11.8%
1.01%
Total
$642
$708
19.1%
19.7%
1.03%
Net plant and
Equip.
$2,731
$2,880
80.3%
0.99%
Total Assets
$3,373
$3,588
100%
100%
1.00%
Fixed Assets
80.9%
Liabilities and Owner’s Equity
Current liabilities
Account payable
$312
$344
9.2%
9.6%
1.04%
Notes Payable
$231
$196
6.8%
5.5%
0.80%
Total
$543
$540
16%
15.1%
0.94%
Long term debt
$531
$457
15.7%
12.7%
0.80%
Common stock
$500
`550
14.8
15.3%
1.03%
Retained earning
$1,799
$2,041
53.3%
56.9%
1.06%
Total
$2,299
$2,591
68.1%
72.2%
1.06%
Total liabilities and
owner’s equity
$3,373
$3,588
100%
100%
1.00%
Owner’s Equity
+
3.3 Ratio Analysis

Financial Ratios: Relationships determined from a firm’s
financial information and used for comparison purposes.

We will learn the most important ratios and we consider several
questions when finding them:

How is it computed?

What is it intended to measure?

What is the unit of measurement?

What might a high or low value tell us?

How could this measure be improved?
+
3.3 Ratio Analysis

Financial ratios are grouped into four categories:
1)
Short term solvency, or liquidity ratios.
2)
Long term solvency, or financial leverage ratios.
3)
Asset management or turnover measures.
4)
Profitability ratios
5)
Market value ratios.
+ 1. Short Time Solvency OR

1. Short Term Solvency Ratios, or Liquidity Measures
A.
Current ratio
B.
Quick ratio (Acid test)
C.
Cash ratio
D.
Net working capital to total assets
E.
Inventory measure

Liquidity Ratios
The primary concern of these ratios is
To measure the firm’s ability to pay its bills over the short run. Or,
a measure of a short term liquidity.

Who is interested in knowing these ratios the most?
Creditors (banks, suppliers).
+ 1. Short Time Solvency OR
Liquidity Ratios
1.A. Current ratio
Current ratio = Current Assets /Current Liabilities
(From the previous table) Current assets = $708/540 = 1.31 times. Or we
can say, the company has $1.31 in current assets for every $1 in current
liabilities.

What does this number mean to the firm’s creditors?
The higher the current ratio, the better.

What does this number mean to the firm itself?
A higher current ratio indicates liquidity, but it also means inefficient use of
cash and other short term assets. (it shouldn’t be less than 1 )

See example 3.1 in the textbook
+
1.Short Time Solvency OR Liquidity Ratios

1.B The Quick Ratio or (Acid test):
The Quick Ratio=( Current assets-inventory)/Current liabilities

Because inventory is the least liquid current assets item and some of it get
damaged or lost, we want to find the current ratio excluding the inventory.

Quick ratio = ($708- $422)/$540 = 0.53 times.

NOTE that using cash to buy inventory does not affect the current ratio, but it
reduces the quick ratio

1.C Cash Ratio:
Cash Ratio = Cash / Current Liabilities

Some short term creditors might be just interested in cash ratio.
+ 1.Short Time Solvency OR

Liquidity Ratios
1. D. Net working capital to total assets
Net working capital = NWC/Total Assets
= (708-540)/3588 = 4.7%

1.E Interval measure
Interval measure= Current𝑡 assets/Average daily operating costs

This ratio is used when the firm is facing a strike and cash inflows start to
dry up, how long could the business be running (cover the operating
costs)?

Average daily operating cost = cost of good sold (from the income
statement) / 365

708/3.68= 192 days.
+ 2. Long Term Solvency Measures

it measures the firm’s financial leverage or the firm’s ability to pay its debt or
meet its obligations.

2.A Total Debt Ratio
Total Debt Ratio =( total assets-total equity)/total assets
From the balance sheet in page55:
= ($3,588 – 2,591)/$3,588 = 0.28 times

which means that the firm uses 28% debt. Or we say the company has $0.28 in
debt for every $1 in assets.

Assets = Liability + Owners Equity
$1
= $0.28 +
$0.72
+ 2. Long Term Solvency Measures

from this ratio we can come up with two related ratios:

2.B Debt Equity Ratio
debt-equity ratio = total debt/total equity
=
0.28/ 0.72 = 0.39 times
2.C Equity multiplier
Equity multiplier = total assets/total equity
= $1/$0.72 = 1.39

OR
1 + debt-equity
ratio
OR
1+0.3
NOTE If we have any one of the previous three ratios, we can find the other two
ratios.
+ 2. Long Term Solvency Measures

2.D Long term debt ratio:
Long term debt ratio = Long term debt(/Long term debt+ total equity)

Financial analyst are more concerned with the firm long term debt
more than its short term debt because they want to know the firms
debt management policy and the short term debt is constantly
changing.

Long-term debt and equity are called firm’s total capitalization.
+ 2. Long Term Solvency Measures

2.E. Times interest earned (TIE)
Times interest earned (TIE) =EBIT/ Interest
= $691/141 = 4.9 times

Means how well the company has its interest obligation covered.

The problem with TIE is that its based o EBIT that has a non cash item
(depreciation), which is not a measure of cash available to pay interest.

2.F. Cash coverage Ratio
Cash coverage ratio =( EBIT+ Depreciation)/ Interest
= (691+267)/141 = 6.9 times.
+ 3. Asset Management or Turnover, Measures

These ratios are also called utilization ratios.

They describe how efficiently a firm uses its assets to generate sales.
A. Inventory Turnover:
A.1 Inventory turnover
Inventory Turnover= cost of good sold / Inventory

This ratio means how fast we can sell our inventory.
= $1,344/$422 = 3.2 times

The higher the ratio, the more efficiently we are managing inventory.
A.2. Days’ sales in inventory
Days’ sales in inventory= 365 days/Inventory turnover

This ratio shows how long or (how many days) does it take to turn it over on average.
= 365/3.2 = 114 days

Inventory sits 114 days on average before it is sold.
+
3. Asset Management or Turnover, Measures
B. Receivables Turnover
B.1 Receivables Turnover
= $2,311/$188
= 12.3
times receivable
Receivables Turnover
= Sales/
Account
= $2,311/$188 = 12.3 Times

It means that the firm collected credit accounts and reloaned the money 12.3 times during
the year.

We are assuming here that all sales are credit sales.
B.2 Days’ sales in Receivables
Days’ sales in Receivables = 365 days/Receivable turnover
= 365/12.3 = 30 days

When the firm increases the days it gives the firm a competitive advantage and when the
days are reduced, the company is reducing its financing cost significantly.

Its is also called average collected period.
B.3 Payable turnover

Payable turnover= Cost of good sold/Account payable
Assuming the firm purchase everything on credit, how often the firm pays the money it
owes to the creditors (suppliers).
+ 3. Asset Management or Turnover, Measures
C. Asset Turnover Ratios
NWC Ratio = Sales/ NWC
C.1 NWC Ratio
=$2311/(708-540) = 13.8 times

This provides some useful information as to how effectively a company is using its working
capital to generate sales.

The higher the better.
C.2 Fixed Assets Turnover
Fixed assets turnover= Sales/Net Fixed Assets
= $2,311/$2880 = 0.80 times

it means that for every dollar in fixed assets, the company got $0.80 in sales.
C.3 Total asset turnover
Turn asset turnover = sales /total assets
= $2,311/$3588 = 0.64 times

for every dollar in assets, the firm generated $0.64 in sales.
+ 4. Profitability Ratios
Profitability Ratios

It measures how the efficiently the firm uses its assets and manages
its operations.

A.1 Profit Margin
Profit Margin = Net Income / Sales
= 363/2311 = 15.7%

it means for every dollar in sales the firm generates 0.157 in profit.

A.2 Return on Assets
Return on Assets = Net income / total Assets
= $363/3,588 = 10.12%

How efficient the company is in using its assets to get earnings.

Measure of profit per dollar of assets.
+ 4. Profitability Ratios
A.3 Return on Equity
Return on Equity (ROE)= Net Income Total
Equity
= 363/ 2591 = 14%

How much profit a company generates with the money shareholders
have invested.

Sometimes its called return on net worth.

Looking at ROA = 10% AND ROE 14%, the difference shows the
amount of financial leverage.

we usually take the average when we calculate ROA,ROE. (ex 3.4).
+ 5. Market Value Ratios

for publicly traded companies

These types of ratios are not included in the financial statements like the (market price per
share of stock) is not in the financial statement.

EX. If the company has 33 million shares and from the financial statement the net income
was $363 million
A. Earning per Share
= $363/33 =$11
EPS= Net Income/ # of shares outstanding
B. Price earning ratio
= $88/$11 = 8 times
PE = Price per share/Earning per share

Which means that the company’s shares sell for 8 times earnings.

It measures how much investors are willing to pay per dollar of current earnings.

Higher PE s means that the firm has a significant prospects for future growth.

Dividing the PE/ future earning growth rate
weather PE ratio is high or low depending
100 , results in PEG ratio that shows
+ 5. Market Value Ratios
C. Price sales ratio
Price sales ratio= price per share/sales per share
= $88/ ($2,311/33) = 1.26

This ratio was created because some starts up companies have negative earnings for some
period of time so we replace the net income by sales
D. Market to Book Ratio
Market value per share/Book value per share
= $88/ (2,591/33) = 1.12 times
E. book value per share
Book value per share= total equity / number of shares outstanding


This ratio compares the market value of the firm’s investments to their cost.
Book value is a historical cost.
+
THE DU PONT IDENTITY

ROE = Net Income/ Total Equity

ROE = Net Income/ Total Equity × Assets /Assets
ROE
= Net Income/ Assets
× Assets /Total Equity
ROE
×
ROE
=
=
ROA
ROA
Equity Multiplier
× (1 + Debt-Equity ratio)
ROE = Sales Sales × Net Income/ Assets × Assets /Total Equity
ROE = (Net Income/ Sales)×( Sales / Assets) ×( Assets Total Equity)
ROE = Profit margin × Total assets turnover × Equity multiplier
+
THE DU PONT IDENTITY

Du Pont identity tells us that ROE is effected by three
things:
1.
Operating activity and its measured by the profit margin.
2.
Asset use efficiency as measured by the total assets
turnover.
3.
Financial leverage as measured by the equity multiplier.

If ROE is unsatisfactory , then Du point tells you where to start
looking for the reasons.
+ 3.5 Using Financial Statement Information

The primary reason for looking at accounting information is that we don’t have
and cant expect to get market information.

Internal Uses

Performance evaluation

Financial manager insures the financial safety of the company.

Are we liquid enough to cover our current liabilities with our current assets

Can we pay our supplier on time?

Is our level of debt good to minimize our cost of capital?

Do we generate enough income? ..etc

Financial ratios documents a company’s operational and financial strengths
and weaknesses and highlight areas that require reaction by the financial
management.

Planning for the future.
+ 3.5 Using Financial Statement Information
External Uses

financial statements are useful for parties outside the firm,
including, short term and long term creditors, and potential
investors.

Large customers use this information as well.

Credit rating agencies rely on financial statements in assessing
a firm creditworthiness.
+
Choosing a Benchmark
Time trend Analysis
By looking at the company’s history and compare the result.
Peer Group Analysis
The second way of establishing a benchmark is by identifying firms similar to our
firm (compete in the same market, have similar assets, and operate in similar
way). In other words, we need to identify a peer group.

Potential peers is based on Standard Industrial Classification SIC:

Which is a U.S four digit code used to classify a firm by its type of business
operation.
+
Review

1. Which one of the following is a source of cash?
A. Increase in accounts receivable
B. decrease in notes payable
C. decrease in common stock
D. increase in accounts payable
E. increase in inventory

2. Which one of the following is a source of cash?
A. increase in accounts receivable
B. decrease in common stock
C. decrease in long-term debt
D. decrease in accounts payable
E. decrease in inventory

3. On a common-size balance sheet all accounts are expressed as a percentage of:
A. sales for the period.
B. the base year sales.
C. total equity for the base year.
D. total assets for the current year.
E. total assets for the base year.
+
Review

6. A firm has sales of $2,190, net income of $174, net fixed assets of $1,600,
and current assets of $720. The firm has $310 in inventory. What is the
common-size statement value of inventory?
A. 13.36 percent
B. 14.16 percent
C. 19.38 percent
D. 30.42 percent
E. 43.06 percent

5. Over the past year, the quick ratio for a firm increased while the current ratio
remained constant. Given this information, which one of the following must
have occurred? Assume all ratios have positive values.
A. current assets increased
B. current assets decreased
C. inventory increased
D. inventory decreased
E. accounts payable increased

7. Russell's Deli has cash of $136, accounts receivable of $87, accounts
payable of $215, and inventory of $409. What is the value of the quick ratio?