3.0
Chapter
3
McGraw-Hill/Irwin
Working With
Financial
Statements
©2001 The McGraw-Hill Companies All Rights Reserved
3.1
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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3.2
Chapter Outline
 Standardized
Financial Statements
 Ratio Analysis
 The Du Pont Identity
 Internal and Sustainable Growth
 Using Financial Statement Information
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3.3
3.1 Standardized Financial
Statements
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3.4
Standardized Financial Statements
 In
order to make comparisons we must
standardize the financial statements
We convert dollars to percentages
 The resulting financial statements are called:


Common-Size Statements: 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.
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3.5
Standardized Financial Statements
PRUFROCK CORPORATION
FINANCIAL STATEMENTS
Page 31 - Table 3.1: Balance Sheet
 Page 32 - Table 3.2: Common-Size Balance Sheet

Page 33 – Table 3.3: Income Statement
 Page 33 – Table 3.4: Common-Size Income
Statement

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3.6
Standardized Financial Statements

Standardized statements make it easier to compare:




Companies of “Different Sizes”, particularly within the
same industry
Organizations with “Currency Differences”
Financial information over time “as a company grows”
Once we standardize the financial statements (i.e.
convert dollars to percentages, resulting in commonsized statements), we can make comparisons: perform
“Ratio Analysis” .
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3.7
3.2 Ratio Analysis
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3.8
Ratio Analysis
 Another
way of avoiding the problems
involved in comparing companies of different
sizes is to calculate and compare financial
ratios.
 Financial Ratios: Relationships determined
from a firm’s financial information and used
for comparison purposes.
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3.9
Ratio Analysis
 A few
problems to consider:
Different people and different sources frequently
don’t compute ratios in exactly the same way, which
leads to confusion.
 If comparing your numbers to those of another
source, be sure you know how their numbers are
computed.
 Be careful to document your calculations when
using ratios as a tool for analysis.

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3.10
Ratio Analysis
Financial ratios are traditionally grouped into the
following categories:
 1. Short-Term Solvency: Liquidity Ratios
 2. Long-Term Solvency: Financial Leverage Ratios
 3. Asset Management (Utilization): Turnover Ratios
 4. Profitability Ratios
 5. Market Value Ratios


Table 3.5, Page 61: Common Financial Ratios
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3.11
Short-Term Solvency:
Liquidity Ratios
 Short-term
solvency ratios are intended to
provide information about a firm’s liquidity
Liquidity measures
 Focus on the firm’s ability to pay its bills over the
short run without undue stress.
 Focus on current assets and current liabilities



Book values and market values are likely to be similar for
current assets and liabilities
Of particular interest to short-term creditors of the
firm
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Short-Term Solvency:
Liquidity Ratios

3.12
Current Ratio = Current Assets / Current Liabilities






708 / 540 = 1.31 times
Measure of short-term liquidity
The unit of measure is either dollars or times
$1.31 in current assets for every $1 in current liabilities or
Current liabilities are covered 1.31 times over
The higher the current ratio the better – indicates liquidity


(however, may indicate an inefficient use of short term
assets)
Should expect to see a current ratio of at least 1
 Less than 1 indicates negative working capital
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3.13
Short-Term Solvency:
Liquidity Ratios

Quick (Acid Test) Ratio =



(Current Assets – Inventory) / Current Liabilities
(708 – 422) / 540 = .53 times
Computed just like the current ratio, except inventory is omitted



Inventory is the least liquid current asset with the least reliable measures
of market value – may be damaged, obsolete, lost, etc.
Relatively large inventories may be a sign of short-term trouble:
overestimated sales, overbought, overproduced – liquidity tied up in
slow-moving inventory
Note: using cash to buy inventory does not affect the current ratio,
but it reduces the quick ratio

Inventory is relatively illiquid compared to cash
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3.14
Short-Term Solvency:
Liquidity Ratios

Cash Ratio = Cash / Current Liabilities


98 / 540 = .18
A very short term creditor might have interest in the Cash
Ratio
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3.15
Long-Term Solvency:
Financial Leverage Ratios
 Intended
to address the firm’s long-run ability
to meet its obligations – its financial leverage
 Sometimes called financial leverage ratios or
leverage ratios
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3.16
Long-Term Solvency:
Financial Leverage Ratios

Total Debt Ratio =




(Total Assets – Total Equity) / Total Assets
(3588 – 2591) / 3588 = 28% debt
The firm has 28 cents in debt for every $1 of assets
Therefore, the firm has 72 cents in equity ($1 - .28) for every
28 cents in debt:

Two variations on the Total Debt Ratio
 Debt-Equity ratio = Total Debt / Total Equity
 Equity Multiplier = Total Assets / Total Equity
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3.17
Long-Term Solvency:
Financial Leverage Ratios

Two variations of the Total Debt Ratio:

Debt-Equity Ratio = Total Debt / Total Equity



.28/.72 = .39 or 39%
(540 + 457) / 2591 = .39
Equity Multiplier = Total Assets / Total Equity


1 /.72 = 1.39
3,588 / 2,591 = 1.39
 Note: If you know one of these you can calculate the other
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3.18
Long-Term Solvency:
Financial Leverage Ratios

Times Interest Earned = EBIT / Interest




691 / 141 = 4.9 times
Measures how well a company has its interest obligations
covered
Often called the interest coverage ratio
Here the interest bill is covered 4.9 times over


Problem: depreciation, a non-cash expense, has been deducted
from EBIT
Resolved with the Cash Coverage Ratio 
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3.19
Long-Term Solvency:
Financial Leverage Ratios

Cash Coverage = (EBIT + Depreciation) / Interest




(691 + 276) / 141 = 967/141 = 6.9 times
Note: (this formula adds back depreciation - EBDIT)
A basic measure of the firm’s ability to generate cash
from operations
Frequently used as a measure of cash flow available to
meet financial obligations
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3.20
Asset Management:
Turnover Ratios
 Measure
the efficiency with which the firm
uses its assets
 Sometimes called: Asset Utilization Ratios
 Can be interpreted as measures of turnover
 Intended to describe how efficiently, or
intensively, a firm uses its assets to generate
sales
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3.21
Asset Management:
Turnover Ratios
 Inventory
Turnover =
Cost of Goods Sold / Inventory
 1344 / 422 = 3.2 times
 The entire inventory was sold off, or turned over 3.2
times
 As long as we-re not running out of stock and
forgoing sales, the higher this ratio, the more
efficiently we are managing inventory.

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3.22
Asset Management:
Turnover Ratios
If we know we turned our inventory over 3.2 times
during the year (previous Inventory Turnover
Calculation) then we can figure out how long it took
us to turn it over on average
 Days’ Sales in Inventory =




365 days / Inventory Turnover
365 / 3.2 = 114 days
Inventory sits 114 days on average before sold:



We have 114 days of inventory on hand
We have 114 days of sales in inventory
It will take 114 days to deplete the available inventory
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3.23
Asset Management:
Turnover Ratios
 Receivables
Turnover =
Sales / Accounts Receivable
 2311 / 188 = 12.3 times
 Measures how fast accounts receivables are collected
 Here we collected our outstanding credit accounts
and reloaned the money 12.3 times during the year
 This ratio makes more sense if we convert it to days


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3.24
Asset Management:
Turnover Ratios
 Days’ Sales
in Receivables =
365 days / Receivables Turnover
 365 / 12.3 = 30 days
 On average, credit sales are collected in 30 days
 Frequently called the average collection period
(ACP)
 We have 30 days’ worth of sales currently
uncollected.

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3.25
Asset Management:
Turnover Ratios

Total Asset Turnover = Sales / Total Assets




2311 / 3588 = .64
For every dollar in assets, we generate $.64 in sales.
Big Picture Ratio
Measure of “total” asset use efficiency


For every dollar in assets, we generate .64 in sales
Not unusual for Total Asset Turnover to be < 1, especially
if a firm has a large amount of fixed assets
Closely related ratio of the Total Asset Ratio is the
reciprocal of the Total Asset Turnover: Capital Intensity
Ratio 
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
3.26
Asset Management:
Turnover Ratios
 Capital
Intensity Ratio =
1 / Total Asset turnover (previously calculated)
 1 / .64 = $1.56
 It takes $1.56 in assets to create $1 in sales
 Its the dollar investment in assets needed to generate
$1 in sales
 High values correspond to capital intensive industries

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3.27
Profitability Ratios
 Probably
the best known and most widely used
of all financial ratios
 Intended to measure how efficiently the firm
uses its assets and how efficiently the firm
manages its operations.
 The focus in this group is on the bottom line,
“Net Income”.
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3.28
Profitability Ratios
 Profit



363 / 2311 = 15.7%
Generates a little less than 16 cents in profit for every
dollar in sales
A high profit margin is desirable


Margin = Net Income / Sales
Corresponds to low expense ratios
Note: lowering the sales price will “usually “ increase
unit volume, but will normally cause profit margins to
shrink.


“Total” $ profit may go up (or down)
The fact that margins are smaller isn’t necessarily bad “if” the
bottom line increases.
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3.29
Profitability Ratios
 Return
on Assets (ROA) =

Net Income / Total Assets

A measure of profit per dollar of assets
363 / 3588 = 10.12%
A measure of profit per dollar of assets
However: this is return on “Book” Assets






Not “Market” Value
Inappropriate to compare this result to, for example , an interest
rate observed in the financial markets
Should properly be called: Return on “Book” Assets
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3.30
Profitability Ratios

Return on Equity (ROE) =







Net Income / Total Equity
363 / 2591 = 14%
For every $ in equity, the firm generated 14 cents in profit
A measure of how the stockholders fared during the year
Sometimes called: Return on Net Worth
Since benefiting shareholders is our goal, ROE is, in
an accounting sense, the true bottom-line measure of
performance
However: this is return on “Book” Equity


Not “Market” Value
Inappropriate to compare this result to, for example, an
interest rate observed in the financial markets
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
©2001 The McGraw-Hill Companies All Rights Reserved
Should properly be called: Return on “Book” Equity
3.31
Market Value Ratios
 This
group of measure is based, in part, on
information not necessarily contained in
financial statements: The “market” price per
share of the stock
 These measures can only be calculated directly
for publicly traded companies.
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3.32
Market Value Ratios

Assume:




Prufrock has 33 million shares outstanding
The stock sold for $88 per share at the end of the year
Recall that Prufrock’s net income was $363 million
Earnings Per Share (EPS) =


Net Income / Shares O/S
363 / 33 = $11
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3.33
Market Value Ratios

Price-Earnings or PE Ratio =


Price per share / Earnings per share
88 / 11 = 8 times

(info assumed or calculated on previous slide)

Shares sell for 8 times earnings or you could say
Prufrock shares have or “carry” a PE multiple of 8
Measures how much investors are willing to pay “per dollar of
current earnings”
Higher PE’s indicate significant prospects for future growth
Note: if a firm had no or almost no earnings, its PE ratio would
probably be quite large, so care is needed in interpreting this
ratio




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3.34
Market Value Ratios

Market-to-Book Ratio =

Market Value Per Share / Book Value Per Share





Book Value per Share = (Balance Sheet “Total” Equity / # O/S)
88 / (2,591/ 33) = 1.12 times
Since book value per share is an accounting number, it
reflects historical costs
The Market-to-Book Ratio compares the “market value”
of the firm’s investments ($88 per share) to their cost (book
historical value)
A value less than 1 could mean that the firm has not been
successful overall in creating value for its stockholders.
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3.35
Ratio Analysis
 TABLE

3.5, Page 61
Recaps the previous Common Financial Ratios
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3.36
3.3 The Du Pont Identity
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3.37
The Du Pont Identity
 Du
Pont Identity: Popular expression breaking
ROE into three parts:
Operating Efficiency
 Asset Use Efficiency
 Financial Leverage

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3.38
The Du Pont Identity

Remember:

Return on Equity (ROE) = Net Income / Total Equity
363 / 2591 = 14%
We can decompose ROE as follows:
 ROE = Profit Margin x Total Asset Turnover x Equity
Multiplier (all previously calculated)
 15.7 x .64 x 1.39 = 14%
 The Du Pont Identity: says that ROE is affected by
three things:


1. Operating efficiency (as measured by Profit Margin)
 2. Asset use efficiency (as measured by total Asset
Turnover)
 3. Financial leverage (as measured by the Equity
Multiplier)
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
3.39
3.4 Internal and Sustainable
Growth
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3.40
Internal and Sustainable Growth
 A firm’s
“return on assets” and “return on
equity” are frequently used to calculate two
additional numbers, both of which have to do
with the firm’s “ability to grow”.
The Internal Growth Rate
 The Sustainable Growth Rate

 First
we’ll look at two basic ratios:
Dividend Payout Ratio
 Retention Ratio

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3.41
Dividend Payout and Earnings Retention

Net Income gets divided into two pieces






Cash dividends paid to stockholders (Dividend P/O Ratio)
Addition to retained earnings (Retention Ratio)
Payout Ratio + Retention Ratio = 1
Prufrock’s net income was $363 of which $121 was paid out in
dividends
If we express dividends paid as a percentage of net income, the
result is the:
Dividend Payout Ratio = Cash dividends / Net income


121 / 363 = 33 1/3%
Prufrock pays out 1/3 of its net income in dividends
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3.42
Dividend Payout and Earnings Retention


Anything Prufrock does “not” pay out in the form of
dividends must be retained in the firm:
Retention Ratio = Additions to Retained Earnings / Net
income
 Note: Additions to Retained Earnings = Net Income –
Dividends
 363 – 121 = 242




242 / 363 = 66 2/3%
Prufrock retains two-thirds of its net income.
The Retention Ratio is also known as the Plow Back Ratio
 the portion of net income that’s plowed back into the business
Since net Income must be either paid out or plowed back, the
dividend payout and plowback ratios have to add up to 1.
 (1 – Payout
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Ratio) =
1 - 33 1/3% = 66 2/3%
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3.43
ROA, ROE, and Growth
 How
rapidly can a firm’s sales grow?
If Sales are to grow: assets have to grow as well, at
least over the long run.
 If Assets are to grow: the firm must obtain the
money to pay for the needed acquisitions

 Growth
has to be financed!
Therefore, a firms ability to grow depends on its
financing policies
 Properly managing growth is vital!

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3.44
ROA, ROE, and Growth
 Two
broad sources of financing:
Internal – what the firm earns and plows back into
the business
 External – funds raised by borrowing money or
selling stock

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3.45
The Internal Growth Rate

Internal Growth Rate: The maximum possible growth
rate for a firm that relies only on internal financing



Internal Growth Rate = ROA x b / 1 – ROA x b



No borrowing
No selling stock
Where ROA = Return on Assets
b = Retention or plowback ratio just discussed
.1012 x (2/3) / 1 - .1012 x (2/3) = 7.23%

If Prufrock relies solely o internally generated financing, it can
grow at a maximum rate of 7.23% per year
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3.46
The Sustainable Growth Rate

The Sustainable Growth Rate: The maximum possible
growth rate for a firm that maintains a constant debt
ratio and doesn’t sell new stock.
Same as the internal growth rate formula, except that
ROE is used instead of ROA
 Sustainable Growth Rate = ROE x b / 1 – ROE x b




Where ROE = Return on Equity
b = Retention or plowback ratio just discussed
.14 x (2/3) / 1 - .14 x (2/3) = 10.29%

The firm can expand more rapidly due to new borrowing.
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3.47
Determinants of Growth
The firm’s ability to sustain growth depends explicitly
on the following four factors:
 1. Profit Margin




Operating efficiency
Generates funds internally
2. Total Asset Turnover:

Increases sales generated for each dollar in assets



Decreased capital intensity
Asset use efficiency decreases the need for new assets
3. Financial Policy:
Additional debt financing ncreases sustainable growth
rate
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 Note these were the 3©2001
components
of Companies
the Du All
Pont

3.48
Determinants of Growth
 Dividend
Policy:
Choice of how much to pay to shareholders versus
reinvesting in the firm
 A decrease in the dividend pay-out will increase the
retention ratio


Increases internally generated equity and thus increases
internal and sustainable growth
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3.49
3.5 Using Financial Statement
Information
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3.50
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
Acquisitions
Stockholders
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3.51
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
Peer Group Analysis


Compare to similar companies or within industries
Standard Industrial Classification (SIC) code: U.S.
government code used to classify a firm by its type of
business operations

(TABLE 3.7, Page 68)
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3.52
Problems with Financial Statement
Analysis
Industry categories are not neat
 Foreign Organizations may not comply to US GAAP
 Companies in the same line of business may not be
comparable
 Different YE’s and accounting procedures


(i.e. inventory)
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3.53
Quick Quiz


How do you standardize balance sheets and income statements
and why is standardization useful?
 With Percentages instead of Dollars (Common-size stmts)
 To compare with other similar companies of different sizes and
currencies
 To Analyze performance
What are the major categories of ratios and how do you compute
specific ratios within each category?





Short-term solvency, or liquidity ratios
2. Long-term solvency, or financial leverage, ratios
3. Asset management, or turnover ratios
4. Profitability ratios
5. Market value ratios
1.
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3.54
Quick Quiz

What are the major determinants of a firm’s growth
potential?




Profit Margin
Total Asset Turnover
Financial Policy
Dividend Policy



Internal growth rate
Sustainable growth rate
What are some of the problems associated with
financial statement analysis?




Industry categories are not neat
Foreign Organizations may not comply to US GAAP
Companies in the same line of business may not be comparable (i.e.
electric utilities)
Different YE’s and accounting procedures (i.e. inventory)
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3.55
Chapter 3:
Suggested Homework

Know chapter theories, concepts, and definitions



Re-read the chapter
Review the Power Point Presentation Slides
Suggested Homework:

The Chapter Review and Self-Test Problem:
 3.1, Page 73
 (Answers are provided in book)

Critical Thinking and Concepts Review:
 Review Questions: 1 through 7, Page 75 & 76
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Questions and Problems:
 Review Question 1 through 14, Page 77 & 78
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