Chapter 3
Working with Financial Statements
Sample Balance Sheet
2000
1999
Change
Cash &
3,171
Equivalents
6,489
-3,318
2000
1999
Change
A/P
313,286
340,220
-26,934
227,848
86,631
+141,217
A/R
1,095,118 1,048,991 +46,127
N/P
Inventory
388,947
295,255 +93,692
Other CL 1,239,651 1,098,602 +141,049
Other CA
314,454
232,304 +82,150
Total CL 1,780,785 1,525,453
Total CA
1,801,690 1,583,039
LT Debt 1,389,615 871,851
Net FA
3,129,754 2,535,072 +594,682
C/S
1,761,044 1,648,490
Total
Liab. &
Equity
4,931,444 4,118,111
Total Assets 4,931,444 4,118,111
Sample Income Statement
Revenues
4,335,491
Cost of Goods Sold
1,762,721
Expenses
1,390,262
Depreciation
362,325
EBIT
820,183
Interest Expense
52,841
Taxable Income
767,342
Taxes
295,426
Net Income
471,916
EPS
2.41
Dividends per share
0.93
+517,764
Numbers are in thousands, except EPS & DPS
Sources and Uses of Cash
Sources
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Sources of cash are transactions that create cash inflows for the firm
Cash inflow occurs when we “sell” something
Decrease in asset account
Increase in liability or equity account
Uses
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Uses of cash are transactions that create cash outflows for the firm
Cash outflow occurs when we “buy” something
Increase in asset account (i.e., we acquired new assets)
Decrease in liability or equity account (i.e., we paid off debt or gave out
dividends)
Statement of Cash Flows
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Statement that summarizes the sources and uses of cash
Changes divided into three major categories
– Operating Activity – includes net income and changes in most current
accounts
– Investment Activity – includes changes in fixed assets
– Financing Activity – includes changes in notes payable, long-term debt
and equity accounts as well as dividends
Sample Statement of Cash Flows
Cash, beginning of year
6,489
Operating Activity
Financing Activity
Increase in Notes Payable 141,217
Net Income
471,916
Increase in LT Debt
517,764
Plus: Depreciation
362,325
Decrease in C/S
-36,159
Increase in Other CL
141,049
Dividends Paid
-395,521
Less: Increase in A/R
-46,127
Net Cash from Financing
227,301
Increase in Inventory
-93,692
Net Decrease in Cash
-3,319
Increase in Other CA
-82,150
Cash End of Year
3,170*
Decrease in A/P
-26,934
Net Cash from Operations 726,387
Investment Activity
Fixed Asset Acquisition -957,007
Net Cash from Investments -957,007 *Difference due to rounding of dividends
Notes:
Fixed Asset Acquisition = Change in Net Fixed Assets + Depreciation
= $594,682 + $362,325 = $957,007
Depreciation is deducted as an expense in computing net income. It is not a cash expense
though, so it is added to net income as a source of cash on the statement of cash flows.
Standardized Financial Statements
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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
Ratio Analysis
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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
Short-term Solvency or Liquidity Ratios
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Look at the short-term solvency of a firm.
Show the relation of a firm’s cash and other current assets to its current liabilities.
Measures the firm’s ability to meet short-term obligations with short-term assets
as they come due.
Current Ratio = CA / CL
1,801,690 / 1,780,785 = 1.01 times
Quick (Acid-Test) Ratio = (CA – Inventory) / CL
(1,801,690 – 388,947) / 1,780,785 = .793 times
Cash Ratio = Cash / CL
3,171 / 1,780,785 = .002 times
Long-term Solvency or Debt Management Ratios
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Look at the long-term solvency of a firm.
Measures the extent to which borrowed or debt funds are used to finance assets.
Measures the firm’s indebtedness.
Total Debt Ratio (Debt Ratio) = (TA – TE) / TA
4,931,444 – 1,761,044) / 4,931,444 = .6429 times or 64.29%
The firm finances a little over 64% of its assets with debt.
Debt to Equity Ratio = TD / TE
(4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times
Equity Multiplier = TA / TE = 1 + D/E
1 + 1.800 = 2.800
Coverage Ratios
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Coverage Ratios indicate how much operating income is available to pay interest.
Times Interest Earned = EBIT / Interest
820,183 / 52,841 = 15.5 times
Cash Coverage = (EBIT + Depreciation) / Interest
(820,183 + 362,325) / 52,841 = 22.38 times
Asset Management (Turnover) Ratios
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Measure how effectively a firm manages its assets.
Indicate the extent to which individual working capital or fixed asset accounts are
turned over or used to support sales.
A- Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
1,762,721 / 388,947 = 4.53 times
Days’ Sales in Inventory = 365 / Inventory Turnover = 365 (Inventory) / CGS
365 / 4.53 = 81 days
B- Receivables Ratios
A/R Turnover Ratio = Sales / Accounts Receivable
4,335,491 / 1,095,118 = 3.96 times
Days’ Sales in Receivables [Average Collection Period] = 365 / A/R Turnover
= (A/R) / (Sales / 365)
365 / 3.96 = 92 days
A/P Turnover = Cost of Goods Sold / Accounts Payable
1,762,721 / 313,286 = 5.63 times
Total Asset Turnover
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Measure of asset use efficiency.
Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets.
NWC Turnover = Sales / NWC
4,335,491 / (1,801,690 - 1,780,785) = 207.390 times
Fixed Asset Turnover = Sales / Net Fixed Assets
4,335,491 / 3,129,754 = 1.385 times
Total Asset Turnover = Sales / Total Assets
4,335,491 / 4,931,444 = .88 times
Capital Intensity Ratio = Total Assets / Sales = 1 / TAT
1 / 0.88 = 1.14 times
Profitability Ratios
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Measure how efficiently the firm uses its assets and manages its operations.
Show combined effects of liquidity, asset management, and debt on operating
results.
Measures the firm’s effectiveness in terms of profit margins and rates of return on
investments.
Profit Margin = Net Income / Sales
471,916 / 4,335,491 = .1088 times or 10.88%
Return on Assets (ROA) = Net Income / Total Assets
471,916 / 4,931,444 = .0957 times or 9.57%
Return on Equity (ROE) = Net Income / Total Equity
471,916 / 1,761,044 = .2680 times or 26.8%
Market Value Measures
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Relates the firm’s stock price to its earnings and book value per share.
Show what investors feel about the firm’s past performance and future prospects.
Market Price = $60.98 per share
# of shares outstanding = 205,838,910
PE Ratio = Price per share / Earnings per share
60.98 / 2.41 = 25.3 times
Earnings per share = Net Income / # of shares outstanding
Market-to-book ratio = market value per share / book value per share
60.98 / (1,761,044,000 / 205,838,910) = 7.1 times
Book value per share = Common Equity / # of shares outstanding
1,761,044,000 / 205,838,910 = $8.56 per share
Deriving the Du Pont Identity
ROE = NI / TE
Multiply by 1 and then rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM
Using the Du Pont Identity
ROE = PM * TAT * EM
- 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
Using Financial Statement Information
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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
Benchmarking
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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 (Cross-Sectional Analysis)
– Compare to similar companies or within industries
– NAICS codes, Financial Post Datagroup, and Dun & Bradstreet Canada
Potential Problems
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There is no underlying theory, so there is no way to know which ratios are most
relevant
Benchmarking is difficult for diversified firms
Globalization and international competition makes comparison more difficult
because of differences in accounting regulations
Varying accounting procedures, i.e. FIFO vs. LIFO
Different fiscal years
Extraordinary events