Chapter 3
Working with Financial
Statements
•Homework: 13-17
Topics
•Sources and Uses of Cash
•Financial Ratio Analysis
•The Du Pont Identity
•Using Financial Statement Information
Sources and Uses of Cash
 Sources of cash include:




Decrease in assets
Increase in liabilities
Increase in common stock
Increase in retained earnings
 Uses of cash include:




Increase in assets
Decrease in liabilities
Decrease in common stock
Decrease in retained earnings
Organizes cash flows into 3 main categories
Operating Activities
•Revenues from sales of goods and services
•Costs associated with productions
Investment Activities
•Acquisition of a new production plan
•Proceeds from selling equipment
Financing Activities
•Issuing long-term debt
•Payments associated with retiring long-term debt
•Proceeds from issuing equity
•Cash Dividends paid to shareholders
Statement of Cash Flows
 Operating activities
 + Net income
 + Depreciation
 + Any decrease in current assets (except cash)
 + Increase in accounts payable
 – Any increase in current assets (except cash)
 – Decrease in accounts payable
 Investment activities



+ Ending fixed assets
– Beginning fixed assets
+ Depreciation
Statement of Cash Flows (concluded)
 Financing activities

– Decrease in notes payable

+ Increase in notes payable

– Decrease in long-term debt

+ Increase in long-term debt

+ Increase in common stock

– Dividends paid
Example: Hermetic, Inc., Balance Sheet
Hermetic, Inc.
Balance Sheet as of December 31
($ in thousands)
Assets
1999
2000
Current Assets
Cash
$
45
$
50
Accounts receivable
260
310
Inventory
320
385
$ 625
$ 745
985
1100
$1610
$1845
Total
Fixed assets
Net plant and equipment
Total assets
Hermetic, Inc., Balance Sheet (concluded)
Liabilities and equity
1999
2000
Current liabilities
Accounts payable
Notes payable
Total
$ 210
110
$ 320
$ 260
175
$ 435
205
225
290
795
1085
290
895
1185
$1610
$1845
Long-term debt
Stockholders’ equity
Common stock and
paid-in surplus
Retained earnings
Total
Total liabilities and equity
Hermetic, Inc., Income Statement
($ in thousands)
Net sales
Cost of goods sold
$710.00
480.00
Depreciation
Earnings before
interest and taxes
30.00
$200.00
Interest
Taxable income
20.00
180.00
Taxes
Net income
Retained earnings
Dividends
53.45
$126.55
$100.00
26.55
Hermetic, Inc., Statement of Cash Flows
 Operating activities

+ Net income
+ 126.55

+ Depreciation
+
30.00

+ Increase in payables
+
50.00

– Increase in receivables
–
50.00

– Increase in inventory
–
65.00
91.55
 Investment activities

+ Ending fixed assets
+1,100.00

– Beginning fixed assets
– 985.00

+ Depreciation
+
30.00
(145.00)
Hermetic, Inc., Statement of Cash Flows (concluded)
 Financing activities

+ Increase in notes payable
+
65.00

+ Increase in long-term debt
+
20.00

– Dividends
–
26.55
58.45
Putting it all together
91.55 – 145.00 + 58.45 = 5.00
Financial Ratios
 Short-Term Solvency or Liquidity
 Ability to pay bills in the short-run
 Long-Term Solvency

Ability to meet long-term obligations
 Asset Management

Intensity and efficiency of asset use
 Profitability
 Market Value

Going beyond financial statements
Short-Term Liquidity Ratios
The Current Ratio
Current Ratio =
Current Assets
Current Liabilities
•Indicates a firm's ability to meet its short-term obligations
•What Does This Number Mean?
•Question: If you are a short-term creditor, the higher the current ratio the
better?
Current Ratio
Notes of Caution
•Changes in the trend are difficult to interpret
•Equal increases and decreases in current assets and current liabilities
have different effects on the current ratio.
•Depends on whether the current ratio is greater or less than one.
Quick Ratio
Includes only current assets that can be converted quickly to cash.
Current Assets - Inventory
Quick Ratio
=
Current Liabilities
Short-term Solvency Ratios:
The Bottom Line
•Use both measures when assessing a firm's short-term liquidity
•Using only the current ratio will overstate a firm's liquidity in the
short-term.
•By using both measures, we can see why the firm's current assets are
increasing over time.
Long-Term Solvency Ratios
The Total Debt Ratio
Takes into account all debt of all maturities of all creditors
Total Assets - Total Equity
Total Debt Ratio
=
Total Assets
Long-Term Solvency Ratios
Debt/Equity Ratio
•Variation of the total debt ratio.
•Measures total debt as a multiple of total equity.
Total Debt
Debt/Equity Ratio
=
Total Equity
Long-Term Solvency Ratios
Long-Term Debt Ratio
•Most popular leverage ratio
•Omits short-term liabilities which are changing often.
•Account payables: more a reflection of trade practices than of debt
management
Tot. Long-term Debt
Long-Term Debt Ratio =
Tot. L.T. Debt + Tot. Equity
Long-Term Solvency Ratios
Times Interest Earned Ratio
•Also called interest coverage ratio.
•Measures the multiple of interest expense that a firm could support
given its current level of earnings.
EBIT
Times Interest Earned Ratio
=
Interest expense
The Lower this ratio, the more levered the firm.
Long-Term Solvency Ratios
Cash Coverage Ratio
•EBIT includes depreciation
•Measures the multiple of interest expense that a firm could support
given its level of cash.
EBIT + depreciation
Cash Coverage Ratio
=
Interest Expense
The Lower this ratio, the more levered the firm.
Long-term Solvency Ratios
•Measure a firm's ability to meet its long-term financial obligations.
•Three Debt Ratios: The higher the ratios the more levered the firm.
•Times Interest Earned and Cash Coverage Ratios: The lower the ratio
the more levered the firm.
•What is a good ratio?
•Analysts vary the standard in direct relation to the stability of the
firm's earnings and cash flows.
•Different standards for different industries.
Asset Management Ratios
Inventory Turnover Ratio
Measures how many times a firm sold off its inventory
Cost of Goods Sold
Inventory Turnover Ratio
=
Inventory
Asset Management Ratios
Days' Sale in Inventory Ratio
Measures how long it took a firm to sell inventory
365
Days' Sales in Inventory
=
Inventory Turnover
Inventory Management Ratios
•Measure how quickly a firm can convert inventory into cash.
•Important in industries where inventory becomes obsolete relatively
quickly.
Fashion industry
•Inventory becomes obsolete and can't be converted into cash.
liquidate below costs => losses for the firm
Asset Management Ratios
Receivables Turnover Ratio
Measures how fast a firm collects on the credit sales of
inventory
Sales
Receivables Turnover Ratio
=
Accounts Receivable
Asset Management Ratios
Days' Sale in Receivables Ratio
Measures how long it took a firm to collect on its credit sales
365
Days' Sales in Receivables
=
Receivables Turnover
Receivables Management Ratios
•Measure how quickly a firm can convert receivables into cash.
•If we observe an increase in days' sales in receivables, what does it
indicate?
•Loan officers will ask for a list of top customers and percentage of
sales accounted by these customers.
•Assess credit quality of the firm's main sources of revenues
Asset Management Ratios
NWC Turnover Ratio
Measures the efficiency of a firm's NWC
Sales
NWC Turnover Ratio
=
NWC
Asset Management Ratios
Total Asset Turnover Ratio
Measures the efficiency of a firm's Total Assets
Sales
Total Asset Turnover Ratio
=
Total Assets
Profitability Ratios
Profit Margin
Measures how well a firm is managing its costs relative to its sales
Net Income
Profit Margin =
Sales
Profitability Ratios
Return of Assets (ROA)
Measures how hard a firm's assets are working
Net Income
ROA =
Total Assets
Profitability Ratios
Return of Equity (ROE)
Measures how efficient a firm's equity is being employed to
generate profit
ROE =
Net Income
Total Equity
Market Value Measures
Price/Earnings (P/E) Ratio
Measures what investors are willing to pay per $1 of current
earnings
Price Per Share
P/E Ratio =
Earnings Per Share
Market Value Measures
Market-to-Book Ratio
Measures the market value of the firm's
investments to their historical costs.
Market Value Per Share
Mkt-to-Book =
Book Value Per Share
Example
The Cross Companies
45 Million Shares Outstanding
Stock sells for $80 per share at fiscal year-end
Net Income = $675 million
Total Equity = $3,375 million
The Du Pont Identity
ROE Can be Decomposed into 3 Components:
ROE = Net income/Sales x Sales/Assets x Assets/Equity
ROE = Profit Margin x Asset Turnover x Equity Multiplier
Operating Efficiency
Financial Leverage
Asset Use Efficiency
Standardized Financial Statements
Common Size Balance Sheet
All items are presented as a percentage of total assets
=> Divided all items by total assets
Common Size Income Statement:
All items are presented as percentage of total sales
=> Divide all items by total sales
Common-Base Year Financial Statement
=> Present relative to a certain base year.
Things to Consider When Using Financial Ratios
 What goes into a particular ratio?

Historical cost? Market values? Accounting conventions?
 What is the unit of measurement?

Dollars? Days? Turns?
 What would a desirable ratio value be? What is the benchmark?

Time-series analysis? Cross-sectional analysis?
Problems with Financial Analysis
•Very little underlying financial theory
•Differences in accounting practices
•Finding comparable firms is difficult
•Differences in fiscal-year ends
•One-time events
•Seasonal variations
•Conglomerates
•Choosing Benchmark: Which industry?