Chapter
Three
Working With
Financial Statements
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
3.1
Key Concepts and Skills
• Understand sources and uses of cash and the
Statement of Cash Flows
• Know how to standardize financial statements
for comparison purposes
• Know how to compute and interpret important
financial ratios
• Be able to compute and interpret the Du Pont
Identity
• Understand the problems and pitfalls in
financial statement analysis
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
3.2
Chapter Outline
• Cash Flow and Financial Statements: A Closer
Look
• Standardized Financial Statements
• Ratio Analysis
• The Du Pont Identity
• Using Financial Statement Information
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
3.3
Sample Balance Sheet
Numbers are in thousands
Year
2000
1999
Cash &
Equivalent
3,171
1,095,118
A/R
2000
1999
6,489 A/P
313,286
340,220
1,048,991 N/P
227,848
86,631
Inventory
388,947
295,255 Other CL
1,239,651
1,098,602
Other CA
314,454
232,304 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 C/S
1,761,044
1,648,490
Total
Assets
4,931,444
4,118,111 Total
L& E
4,931,444
4,118,111
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
3.4
Sample Income Statement
Numbers are in thousands, except EPS & DPS
Sales
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 (EBT)
Taxes
767,342
-295,426
Net Income
471,916
EPS
2.29
Dividends per share
0.93
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3.5
Sources and Uses of Cash 3.1
• Sources
– Sources of cash are transactions that create cash inflows
for the firm
– Cash inflows – occur when we “sell” something
– Decrease in asset account
– Increase in liability or equity account
• Uses
– Uses of cash are transactions that create cash outflows
for the firm
– Cash outflows – occur when we “buy” something
– Increase in asset account (e.g., acquire new assets)
– Decrease in liability (e.g., pay off debt) or equity account
(e.g., pay out dividends)
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3.6
Statement of Cash Flows
• 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
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
3.7
Standardized Financial Statements 3.2
• 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
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3.8
Ratio Analysis 3.3
• Ratios 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
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3.9
Categories of Financial Ratios
• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage
ratios
• Coverage Ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
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3.10
Common Financial Ratios
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3.11
Common Financial Ratios
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3.12
Liquidity Ratios
• 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.
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3.13
Computing Liquidity Ratios
• Current Ratio = CA / CL
• Quick Ratio = (CA – Inventory) / CL
• Cash Ratio = Cash / CL
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3.14
Long-term Solvency Ratios
• 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.
• Also known as “Debt Management Ratios”
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3.15
Computing Long-term Solvency Ratios
• Total Debt Ratio = (TA – TE) / TA
• Debt/Equity = TD / TE = (CL + LTD)/TE
• Equity Multiplier = TA / TE = 1 + D/E
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3.16
Computing Coverage Ratios
• Coverage Ratios indicate how much operating
income is available to pay interest
• Times Interest Earned = EBIT / Interest
• Cash Coverage = (EBIT + Depreciation) /
Interest
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3.17
Asset Management (Turnover) Ratios
• 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.
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3.18
Computing Asset Management Ratios
A- Inventory Ratios
• Inventory Turnover = Cost of Goods Sold /
Inventory
• Days’ Sales in Inventory = 365 / Inventory
Turnover
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3.19
Computing Asset Management Ratios
B- Receivables Ratios
• Receivables Turnover = Sales / Accounts
Receivable
• Days’ Sales in Receivables [ACP]= 365 /
(Receivables Turnover)
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3.20
Total Asset Turnover
• Measure of asset use efficiency.
• Not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets.
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3.21
Computing Total Asset Turnover
• NWC Turnover = Sales / NWC
• Fixed Asset Turnover = Sales / Net Fixed
Assets
• Total Asset Turnover = Sales / Total Assets
• Capital Intensity Ratio = TA / Sales = 1/TAT
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3.22
Profitability Measures
• 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.
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3.23
Computing Profitability Measures
• Profit Margin = Net Income / Sales
• Return on Assets (ROA) = Net Income / Total
Assets
• Return on Equity (ROE) = Net Income / Total
Equity
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3.24
Market Value Measures
• 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.
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3.25
Computing Market Value Measures
• Market Price = $60.98 per share
• # of shares outstanding = 205,838,910
• PE Ratio = Price per share / Earnings per share
• Earnings per share = Net Income / # of shares
outstanding
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3.26
Computing Market Value Measures
• Book value per share = Common Equity / # of
shares outstanding
Market-to-book ratio = market value per share
/ book value per share
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3.27
Deriving the Du Pont Identity 3.4
• 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
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3.28
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
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3.29
Using Financial Statement Information 3.5
• 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
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3.30
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
– Internal and external uses
• Peer Group Analysis
– Compare to similar companies or within industries
– NAICS codes, Financial Post Datagroup, and Dun
& Bradstreet Canada
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3.31
Potential Problems
• 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
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3.32
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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3.33
Summary 3.6
• 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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