T3.1 Chapter Outline
Chapter 3
Working With Financial Statements
Chapter Organization
 3.1 Cash Flow and Financial Statements: A Closer Look
 3.2 Standardized Financial Statements
 3.3 Ratio Analysis
 3.4 The Du Pont Identity
 3.5 Using Financial Statement Information
 3.6 Summary and Conclusions
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copyright © 2002 McGraw-Hill Ryerson, Ltd.
Working With Financial Statements - Introduction
 Chapter 2 - looked at the basic financial statement
components; the balance sheet and income statement and the
concept of cash flow

Cash Flow • cash flow identity - cash flow from assets = to cash flow paid
to the suppliers of capital to the firm - creditors and
shareholders
• how to calculate cash flow from assets



operating cash flow
net capital spending
changes in net working capital
 Chapter 3 - expands on the use of financial statements from a
corporate finance perspective
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Slide 2
Financial Statements
 Financial Statements and the role of Corporate Finance
 capital budgeting - where and how much should we invest
 long term financing - capital structure
 short term financing - working capital management
 risk management - derivative securities and hedging
 A good working knowledge of financial statements is important
as F/S are the primary means of communicating financial
information both internally and externally.


many different ways of using F/S - or components
many different users
 The connection between accounting information contained in
financial statements and shareholder value is tenuous
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Slide 3
Financial Statements and Shareholder Value
 Shareholder Value
 share price as established by the market
 dividends paid from internally generated cash flow
 Relationship or ‘line of sight’ between business decision and
the creation of shareholder value is usually not that clear


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analysis ->understanding of financial statements is a starting point
- understand the impact of business/financial decisions in terms of
the balance sheet, income and cash flow
the next step in establishing the connection between the business
decision and the creation of shareholder value is complex and not
well understood
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Slide 4
Financial Statements and Cash Flow
 Financial statements present cash flow with a focus on the
sources and uses of cash (vs. the cash flow identity)
 Statement of Changes in Financial Position - sources and uses
of cash
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Slide 5
T3.2 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
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Slide 6
T3.2 Hermetic, Inc. Balance Sheet (concluded)
Liabilities and equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
1999
2000
$ 210
110
$ 320
$ 260
175
$ 435
205
225
290
795
1085
290
895
1185
$1610
$1845
Stockholders’ equity
Common stock and
paid-in surplus
Retained earnings
Total
Total liabilities and equity
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Slide 7
T3.3 Hermetic, Inc., Income Statement
($ in thousands)
Net sales
Cost of goods sold
Depreciation
Earnings before
interest and taxes
Interest
480.00
30.00
$200.00
20.00
Taxable income
Taxes
180.00
53.45
Net income
Dividends
Addition to retained earnings
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$710.00
2005
$126.55
$ 26.55
100.00
Slide 8
T3.4 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



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+ Ending fixed assets
– Beginning fixed assets
+ Depreciation
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Slide 9
T3.4 Statement of Cash Flows (concluded)
 Financing activities
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
– Decrease in notes payable

+ Increase in notes payable

– Decrease in long-term debt

+ Increase in long-term debt

+ Increase in common stock

– Dividends paid
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Slide 10
T3.5
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)
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Slide 11
T3.5 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, the net addition to
cash for the period is:
$91.55 – 145.00 + 58.45 = $5.00
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Slide 12
Standardized Financial Statements
 A standardized financial statement presenting all items in
percentage terms.


Balance sheets are shown as a % of assets
Income statements are shown as a % of sales
 An attempt to make comparisons of companies, who may be
vastly different in terms of size, more effective.
 There are two general approaches to standardized financial
statements:


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common size
common base year
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Slide 13
Financial Statement Analysis
 Common - Size Statements
 a standardized financial statement expressing all items in
percentage terms
• the balance sheet as a % of assets and
• the income statement as a % of sales
 Common-Base Year Financial Statement - Trend Analysis
 A standardized financial statement presenting all items relative to a
certain base year amount
• useful in trend analysis
• lends itself to plotting the trends graphically
.
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Slide 14
T3.6 Hermetic, Inc. Common-Size Balance Sheet
Assets
1999
2000
Current Assets
Cash
Accounts receivable
Inventory
Total
2.8%
16.1
19.9
38.8%
2.7%
16.8
20.9
40.4%
61.2%
59.6%
100%
100%
Fixed assets
Net plant and equipment
Total assets
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Slide 15
T3.6 Hermetic, Inc., Common-Size Balance Sheet (continued)
Liabilities and equity
1999
Current liabilities
Accounts payable
Notes payable
Total
13.0%
6.8
19.9%
14.1%
9.5
23.6%
Long-term debt
12.7%
12.2%
Stockholders’ equity
Common stock and
paid-in surplus
Retained earnings
Total
18.0%
49.4
67.4
15.7%
48.5
64.2
Total liabilities and equity
100%
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2000
100%
Slide 16
T3.6 Hermetic, Inc., Common-Size Balance Sheet
More on Standardized Statements
Suppose we ask: “What happened to Hermetic’s net plant and
equipment (NP&E) over the period?”
1. Based on the 1999 and 2000 B/S, NP&E rose from $985 to
$1100, so NP&E rose by $115 (a use of cash).
2. If we standardized the 2000 numbers by dividing each by
the 1999 number, we get a common base year statement. In
this case, $1100/$985 = 1.117, so NP&E rose by 11.7% over
this period.
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Slide 17
T3.6 Hermetic, Inc., Common-Size Balance Sheet (concluded)
More on Standardized Statements
3. Did the firm’s NP&E go up or down? Obviously, it went up,
but so did total assets. In fact, looking at the standardized
statements,
NP&E went from
61.2% of total assets to 59.6% of total assets.
4. If we standardized the 2000 common size numbers by
dividing each by the 1999 common size number, we get a
combined common size, common base year statement. In this
case, 59.6%/61.2% = 97.4%, so NP&E fell by 2.6% as a
percentage of assets.
(. *.)In absolute terms, NP&E is up by $115, or 11.7%, but
relative to total assets, NP&E fell by 2.6%.
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Slide 18
T3.7 Hermetic, Inc. Common-Size Income Statement
Net sales
Cost of goods sold
Depreciation
Earnings before interest
and taxes
Interest
28.2
2.8
Taxable income
Taxes
Net income
25.4
7.5
17.8 %
Dividends
4.2
3.7 %
Addition to retained earnings
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100.0 %
67.6
2005
14.1 %
Slide 19
Ratio Analysis
 Ratio Analysis
 relationships determined from a firm’s financial information and
used for comparison purposes
 Similar to Common Size and Base Year Financial Statements,
the use of financial ratios is an attempt to make comparisons of
different sized companies more effective.

We eliminate the size problem in ratios by focusing only on
percentages, or multiples or time periods
 Wide range of users of financial ratios:
 Investment:
• financial analysts with major brokerage firms
• pension fund managers & money management firms
 Bond Rating Firms
 Lenders
 Table 3.8 in the text is a good summary
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Slide 20
T3.8 Things to Consider When Using Financial Ratios
 What aspect of the firm or its operations are we attempting to
analyze?

Firm performance can be measured along “dimensions”
-liquidity, capital structure, performance
 What goes into a particular ratio?
 Historical cost? Market values?
 What is the unit of measurement?
 Dollars? Days? Turns?
 What would a desirable ratio value be? What is the
benchmark? Is there an industry standard?

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Time-series analysis? Peer Group Analysis
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Slide 21
T3.9 Categories of Financial Ratios
 Short-Term Solvency, or Liquidity
 Ability to pay bills in the short-run
 Long-Term Solvency, or Financial Leverage

Ability to meet long-term obligations
 Asset Management, or Turnover

Intensity and efficiency of asset use
 Profitability

The ability to control expenses
 Market Value

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focusing on share market price
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Slide 22
T3.10 Common Financial Ratios (Table 3.8)
I. Short-Term Solvency, or Liquidity, Ratios
Current assets
Current ratio
=
Current liabilities
Quick ratio = (Current assets - inventory) / Current liabilities
Cash ratio = Cash / Current liabilities
Current assets
Interval measure
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=
2005
Average daily operating costs
Slide 23
T3.10 Common Financial Ratios (Table 3.8) (continued)
II. Long-Term Solvency, or Financial Leverage Ratios
Total assets - Total equity
Total debt ratio =
Total assets
Debt/equity ratio = Total debt/Total equity
Equity multiplier = Total assets/Total equity
Long-term debt
Long-term debt ratio =
Long-term debt + Total equity
EBIT
Times interest earned ratio =
Interest
EBIT + depreciation
Cash coverage ratio =
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Interest
Slide 24
T3.10 Common Financial Ratios (Table 3.8) (continued)
III. Asset Utilization, or Turnover, Ratios
Cost of goods sold
Inventory turnover =
Inventory
365 days
Days’ sales in inventory =
Inventory turnover
Sales
Receivables turnover =
Accounts receivable
Days’ sales in receivables =
365 days
Receivables turnover
Sales
NWC turnover =
NWC
Sales
Fixed asset turnover =
Net fixed assets
Sales
Total asset turnover =
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Total assets
Slide 25
T3.10 Common Financial Ratios (Table 3.8) (continued)
IV. Profitability Ratios
Net income
Profit margin =
Sales
Net income
Return on assets (ROA) =
Total assets
Net income
Return on equity (ROE) =
Operating Margin
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Total equity
Op. Income
o
Sales
Slide 26
T3.10 Common Financial Ratios (Table 3.8) (concluded)
V. Market Value Ratios
Price per share
Price-earnings ratio =
Earnings per share
Market value per share
Market-to-book ratio =
Dividend yield
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Book value per share
Dividend per share/
current market price
Slide 27
Financial Ratios - Oil & Gas Industry
 There exists a unique set of ratios which are utilized in the oil &
gas industry and with some variation in other resource based
industries e.g.

Reserve Life Index
looks at how long the current reserve base will support a given
level of production
• calculated as - year end proven producing reserves/year end
production

Operating Costs per BOE - annual operating costs divided by
yearly production on a BOE basis
General and Administrative Costs per BOE
Finding and Onstream Cost per BOE
• important efficiency ratio measuring costs to add new reserves
over a specified period of time


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Slide 28
Financial Ratios - Oil & Gas
 Price to cash flow multiple
 share price / cash from operations per share
• as opposed to the traditional P/E ratio
• emphasizes cash flow instead of earnings
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Slide 29
T3.11 The Du Pont Identity
1. Return on equity (ROE) can be decomposed as follows:
ROE
= Net income/Total equity
= Net income/Total equity Total assets/Total assets
= Net income/Total assets Total assets/Total equity
= _____________
Equity multiplier
2. Return on assets (ROA) can be decomposed as follows:
ROA
= Net income/Total assets Sales/Sales
= Net income/Sales Sales/Total assets
= ______________
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_______________
Slide 30
T3.11 The Du Pont Identity
1. Return on equity (ROE) can be decomposed as follows:
ROE
= Net income/Total equity
= Net income/Total equity Total assets/Total assets
= Net income/Total assets Total assets/Total equity
=
ROA
Equity multiplier
2. Return on assets (ROA) can be decomposed as follows:
ROA
= Net income/Total assets Sales/Sales
= Net income/Sales Sales/Total assets
=
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Profit margin
2005
Total asset turnover
Slide 31
T3.11 The Du Pont Identity
3. Putting it all together gives the Du Pont identity:
ROE
= ROA
Equity multiplier
= Profit margin
Total asset turnover
Equity multiplier
4. Profitability (or the lack thereof!) thus has three parts:
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
Operating efficiency

Asset use efficiency

Financial leverage
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Slide 32
T3.11 The Du Pont Identity (concluded)
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Slide 33
T3.12
Using Financial Statement Information
Why evaluate Financial Statements?
 Internal Uses
 Allocate capital by division
 Measure and reward performance
 Corporate/ Financial Planning
 External Uses
 Extend trade credit to customers
 Investor Community Ratio Analysis
 Banks requiring loan covenants
 Competitor Analysis
 Valuing a target in an acquisition
 Benchmarks
 Year on year
 Peer group
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Slide 34
T3.12
Using Financial Statement Information
Problems with Financial Statement Analysis
 The need for theory
 what is the connection between financial statements and a firm’s
true value and the associated risk ?
 Which ratios matter most?
 What is the “right” value for the ratio
 The difficulty in establishing appropriate benchmarks


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Conglomerates or diversified firms
Not identified in a single industry or sector
Hard to find comparables
Global reach
Comparability of financial statements between countries with
differences in accounting regulations
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Slide 35
Quick Quiz

What is the Statement of Cash Flows and how do you determine
sources and uses of cash?

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 some of the problems associated with financial statement
analysis?
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Slide 36
Summary
 You should be able to:
 Identify sources and uses of cash
 Understand the Statement of Cash Flows
 Understand how to make standardized financial statements and
why they are useful
 Calculate and evaluate common ratios
 Understand the Du Pont identity
 Describe how to establish benchmarks for comparison purposes
and understand some key problems that can arise
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Slide 37