Chapter 3
Working with financial statements
Financial Principles
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1
Chapter Outline
3-1 Standardized Financial Statements.
3-2 Ratio Analysis.
3-3 The DuPont Identity.
3-4 Internal and Sustainable Growth.
3-5 Using Financial Statement Information.
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Standardized Financial Statements
Common-Size Balance Sheets.
• All accounts = percent of total assets (%TA).
Common-Size Income Statements.
• All line items = percent of sales or revenue (%SLS).
Standardized statements are useful for:
• Comparing financial information year-to-year.
• Comparing companies of different sizes, particularly within
the same industry.
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3
Prufrock Corporation Balance Sheets: Table 3.1
PRUFROCK CORPORATION
Balance Sheets as of December 31, 2021 and 2022
(in millions)
2021
Assets
Current assets
Cash
Accounts receivable
Inventory
Total
Fixed assets
Net plant and equipment
Total assets
Liabilities and Owners’ Equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Owners’ equity
Common stock and paid-in surplus
Retained earnings
Total
Total liabilities and owners’ equity
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2022
$
84
165
393
$ 642
$
98
188
422
$ 708
$2,731
$3,373
$2,922
$3,620
$ 312
231
$ 543
$ 531
$ 344
204
$ 548
$ 457
$ 500
1,799
$2,299
$3,373
$ 510
2,115
$2,625
$3,630
4
Prufrock Corporation Common-Size Balance
Sheets: Table 3.2
PRUFROCK CORPORATION
Common-Size Balance Sheets
December 31, 2021 and 2022
2021
Assets
Current assets
Cash
Accounts receivable
Inventory
Total
Fixed assets
Net plant and equipment
Total assets
Liabilities and Owners’ Equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Owners’ equity
Common stock and paid-in surplus
Retained earnings
Total
Total liabilities and owners’ equity
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2022
Change
2.5%
4.9
11.7
19.0%
2.7%
5.2
11.6
19.5%
+ .2%
+ .3
+ .0
+ .5%
81.0%
100.0%
80.5%
100.0%
− .5%
0%
9.2%
6.8
16.1%
15.7%
9.5%
5.6
15.1%
12.6%
+ .2%
−1.2
−1.0%
−3.2%
14.8%
53.3
68.2%
100.0%
14.0%
58.3
72.3%
100.0%
− .8%
+4.9
+4.2%
0%
5
Prufrock Corporation Income Statement: Table 3.3
PRUFROCK CORPORATION
2022 Income Statement
(in millions)
Sales
$2,361
Cost of goods sold
1,344
Depreciation
276
Earnings before interest and taxes
$ 741
Interest paid
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141
Taxable income
$ 600
Taxes (21%)
126
Net income
$ 474
Dividends
$158
Addition to retained earnings
316
6
Prufrock Corporation Common-Size Income
Statement: Table 3.4
PRUFROCK CORPORATION
Common-Size Income Statement
2022
Sales
100.0%
Cost of goods sold
56.9
Depreciation
11.7
Earnings before interest and taxes
31.4%
Interest paid
6.0
Taxable income
25.4%
Taxes (21%)
5.3
Net income
20.1%
Dividends
6.7%
Addition to retained earnings
13.4
Tells us what happened to each dollar of sales
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Ratio Analysis
Allow for better comparison through time or between
companies.
Used both internally and externally.
For each ratio, ask yourself:
• What the ratio is trying to measure.
• Why that information is important.
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Categories of Financial Ratios
Liquidity ratios or Short-term solvency.
Financial leverage ratios or Long-term solvency ratios.
Asset management or Turnover ratios.
Profitability ratios.
Market value ratios.
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Table 3.5
1
Common financial ratios
I. Short-term solvency,
or liquidity, ratios
Current ratio 
Current assets
Current liabilities
Current assets  Inventory
Quick ratio 
Current liabilities
Cash ratio 
Cash
Current liabilities
II. Long-term solvency, or
financial leverage, ratios
Total debt ratio 
Total assets  Total equity
Total assets
Debt-equity ratio  Total debt Total equity
Equity multiplier  Total assets Total equity
Times interest earned ratio 
Cash coverage ratio 
EBIT
Interest
EBIT+Depreciation
Interest
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Table 3.5
2
Common financial ratios
III. Asset utilization, or turnover,
ratios (how efficient at using assets
Cost of goods sold
Inventory turnover 
Inventory
Days' costs in payables 
365 days
Payables turnover
Days' sales in inventory 
365 days
Inventory turnover
Total asset turnover 
Receivables turnover =
Sales
Accounts receivable
Capital intensity 
Payables turnover 
Sales
Total assets
Total assets
Sales
Cost of goods sold
Accounts payable
Days' sales in receivables 
365 days
Receivables turnover
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Table 3.5
3
Common financial ratios
IV. Profitability ratios
V. Market value ratios
Net income
Profit margin 
Sales
Price-earnings ratio 
Net income
Return on assets (ROA) 
Total assets
Price-sales ratio 
Return on equity (ROE) 
ROE 
Net income
Total equity
Net income Sales Assets


Sales
Assets Equity
Price per share
Sales per share
Market-to-book ratio 
EBITDA ratio 
Price per share
Earnings per share
Market value per share
Book value per share
Enterprise value
EBITDA
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Liquidity Ratios
PRUFROCK
Balance Sheet - 2022
PRUFROCK
Income Statement - 2022
ASSETS
Liabilities & Owners’ Equity
Sales
$ 2,361
Current Assets
Current Liabilities
COGS
1,344
Cash
98
Accounts Payable
Accounts Receivable
188
Notes Payable
204
Inventory
422
Total
$ 548
708
Long-term debt
$ 457
Total
$
$
$ 344
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Assets
EBIT
276
$
Interest
Taxable Income
741
141
$
Taxes (21%)
600
126
Common Stock and paid-in surplus
$ 510
Retained Earnings
2,115
Net Income
$
474
$2,625
Dividends
$
158
$3,630
Addition to RE
$2,922
$3,630
Depreciation
Total
Total Liabilities & Owners' Equity
316
Current Ratio = CA CL.
•
$708 $548  1.29 times.
Quick Ratio = (CA  Inventory) CL.
• “Acid Test.”
• ($708  422) $548  .52 times
Cash Ratio = Cash CL.
•
$98 $548  .18 times.
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Financial Leverage Ratios
1
PRUFROCK
Balance Sheet - 2022
PRUFROCK
Income Statement - 2022
ASSETS
Liabilities & Owners’ Equity
Sales
$ 2,361
Current Assets
Current Liabilities
COGS
1,344
Cash
98
Accounts Payable
Accounts Receivable
188
Notes Payable
204
Inventory
422
Total
$ 548
708
Long-term debt
$ 457
Total
$
$
$ 344
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Assets
$2,922
$3,630
Depreciation
EBIT
276
$
Interest
Taxable Income
741
141
$
Taxes (21%)
600
126
Common Stock and paid-in surplus
$ 510
Retained Earnings
2,115
Net Income
$
474
$2,625
Dividends
$
158
$3,630
Addition to RE
Total
Total Liabilities & Owners' Equity
316
Total Debt Ratio =  TA  TE  TA.
•
 $3, 630  2, 625  $3, 630  .28 times.
Uses 28% debt 72% equity
Debt/Equity = TD TE.
•  $.28 $.72   .38 times.
Equity Multiplier = TA TE  1  D E.
•  $1 $.72   1  .38   1.38.
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Simply 1 + D/E
14
Financial Leverage Ratios
2
PRUFROCK
Income Statement - 2022
Sales
$ 2,361
COGS
1,344
Depreciation
EBIT
276
$
Interest
Taxable Income
741
141
$
Taxes (21%)
600
126
Net Income
$
474
Dividends
$
158
Addition to RE
316
Times Interest Earned = EBIT Interest.
• $741 $141  5.26 times.
Cash Coverage =  EBIT  Depreciation  Interest.
•  $741  276  $141  7.21 times.
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Asset Management: Inventory Ratios
Prufrock Ratios
Liquidity Ratios
Current Ratio
Quick Ratio
Cash Ratio
Financial Leverage Ratios
Total Debt Ratio
Debt to Equity
Equity Multiplier
Times Interest Earned
Cash Coverage
1.29
.52
.18
.28
.38
1.38
5.26
7.21
Asset Management Ratios
Inventory Turnover
Days' Sales in Inventory
Receivables Turnover
Days' Sales in Receivables
Total Asset Turnover
Profitability Measures
Profit Margin
ROA
ROE
Market Value Measures
Market Price
Shares Outstanding
EPS
PE Ratio
Market-to-book ratio
3.18
114.61
12.56
29.06
.65
days
days
20.08%
13.06%
18.06%
$ 115
33
14.36
8.01
1.45
million
Inventory Turnover = COGS Inventory.
• $1,344 $422  3.18 times.
Sold off/turned over inventory 3.18 times : higher the better
Days’ Sales in Inventory = 365 Inventory Turnover.
•
365 3.2  114.61 days.
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Asset Management: Receivables Ratios
PRUFROCK
Balance Sheet - 2022
PRUFROCK
Income Statement - 2022
ASSETS
Liabilities & Owners’ Equity
Sales
$ 2,361
Current Assets
Current Liabilities
COGS
1,344
Cash
98
Accounts Payable
Accounts Receivable
188
Notes Payable
204
Inventory
422
Total
$ 548
708
Long-term debt
$ 457
Total
$
$
$ 344
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Assets
$2,922
$3,630
Depreciation
EBIT
276
$
Interest
Taxable Income
741
141
$
Taxes (21%)
600
126
Common Stock and paid-in surplus
$ 510
Retained Earnings
2,115
Net Income
$
474
$2,625
Dividends
$
158
$3,630
Addition to RE
Total
Total Liabilities & Owners' Equity
316
Receivables Turnover = Sales AR.
•
$2,361 $188  12.56 times.
Days’ Sales in Receivables = 365 Receivables Turnover.
•
365 12.56  29.06 days.
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Asset Management: Payables Ratios
PRUFROCK
Balance Sheet - 2022
PRUFROCK
Income Statement - 2022
ASSETS
Liabilities & Owners’ Equity
Sales
$ 2,361
Current Assets
Current Liabilities
COGS
1,344
Cash
98
Accounts Payable
Accounts Receivable
188
Notes Payable
204
Inventory
422
Total
$ 548
708
Long-term debt
$ 457
Total
$
$
$ 344
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Assets
EBIT
276
$
Interest
Taxable Income
741
141
$
Taxes (21%)
600
126
Common Stock and paid-in surplus
$ 510
Retained Earnings
2,115
Net Income
$
474
$2,625
Dividends
$
158
$3,630
Addition to RE
$2,922
$3,630
Depreciation
Total
Total Liabilities & Owners' Equity
316
Payables Turnover = COGS AP.
•
$1,344 $344  3.91 times.
Days’ Costs in Payables = 365 Payables Turnover.
•
365 3.91  93.42 days.
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Asset Management: Asset Turnover Ratios
PRUFROCK
Balance Sheet - 2022
PRUFROCK
Income Statement - 2022
ASSETS
Liabilities & Owners’ Equity
Sales
$ 2,361
Current Assets
Current Liabilities
COGS
1,344
Cash
98
Accounts Payable
Accounts Receivable
188
Notes Payable
204
Inventory
422
Total
$ 548
708
Long-term debt
$ 457
Total
$
$
$ 344
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Assets
$2,922
$3,630
Depreciation
EBIT
276
$
Interest
Taxable Income
741
141
$
Taxes (21%)
600
126
Common Stock and paid-in surplus
$ 510
Retained Earnings
2,115
Net Income
$
474
$2,625
Dividends
$
158
$3,630
Addition to RE
Total
Total Liabilities & Owners' Equity
316
Total Asset Turnover = Sales Total Assets.
• $2,361 $3, 630  .66 times.
Capital Intensity Ratio = 1 TAT.
• 1 .65  1.54.
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Profitability Ratios
PRUFROCK
Balance Sheet - 2022
PRUFROCK
Income Statement - 2022
ASSETS
Liabilities & Owners’ Equity
Sales
$ 2,361
Current Assets
Current Liabilities
COGS
1,344
Cash
98
Accounts Payable
Accounts Receivable
188
Notes Payable
204
Inventory
422
Total
$ 548
708
Long-term debt
$ 457
Total
$
$
$ 344
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Assets
EBIT
276
$
Interest
Taxable Income
741
141
$
Taxes (21%)
600
126
Common Stock and paid-in surplus
$ 510
Retained Earnings
2,115
Net Income
$
474
$2,625
Dividends
$
158
$3,630
Addition to RE
$2,922
$3,630
Depreciation
Total
Total Liabilities & Owners' Equity
316
Profit Margin = NI Sales.
• $474 $2,361  .2008, or 20.08%.
Return on Assets ( ROA) = NI TA.
• $474 $3,630  .1306, or 13.06%.
Return on Equity (ROE) = NI TE.
• $474 $2, 625  .1806, or 18.06%.
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Market Value Ratios
Market Price = $115 per share = PPS.
Shares outstanding = 33 million.
Earnings per Share = EPS = $474 33  $14.36.
PE ratio = PPS EPS.
•
$115 / $14.36  8.01 times.
Price/Sales ratio = PPS/Sales per share.
• $115  $2,361 33   1.61 times.
Market-to-book ratio = PPS/Book value per share.
• Book value per share = Total Equity/shares outstanding
 $2, 625 33  $79.55.
• Market-to-Book = $115 $79.55  1.45 times.
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Market Value Ratios EBITDA Ratio
Enterprise value = Total market value of the stock + Book
value of all liabilities − Cash.
• ($115 × 33) + ($3,630 − 2,625) − $98 = $4,702.
EBITDA ratio = Enterprise value/EBITDA.
• EBITDA = EBIT + Depreciation and Amortization
= $741 + 276 = $1,017.
• EBITDA ratio = $4, 702 $1, 017  4.62 times.
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Prufrock Ratios
Prufrock Ratios
Liquidity Ratios
Current Ratio
Quick Ratio
Cash Ratio
Financial Leverage
Ratios
Total Debt Ratio
Debt to Equity
Equity Multiplier
Times Interest
Earned
Cash Coverage
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Asset Management Ratios
1.29
Inventory Turnover
.52
Days' Sales in Inventory
.18
Receivables Turnover
Days' Sales in Receivables
3.18
114.61 days
12.56
29.06 days
.28
Total Asset Turnover
.38 Profitability Measures
1.38
Profit Margin
ROA
5.26
ROE
.65
20.08%
13.06%
18.06%
7.21 Market Value Measures
Market Price
Shares Outstanding
EPS
PE Ratio
Market-to-book ratio
$ 115
33 million
$14.36
8.01
1.45
23
Table 3.7: Lowe’s versus Home Depot
Financial information from 2021 for Lowe’s and The Home Depot
(numbers in millions except for per-share data)
Sales
Net income
Current assets
Current liabilities
Total assets
Total debt
Total equity
Price per share
Book value per share
Earnings per share
Current ratio
Debt-equity ratio
Total asset turnover
Profit margin
ROE
ROA
Market-to-book ratio
Price-earnings ratio
Lowe’s
$68,819
3,447
12,772
12,096
35,291
29,418
5,873
100.50
7.12
4.18
1.06
5.01
1.95
5.01%
58.69%
9.77%
14.11
24.04
The Home Depot
$100,904
8,630
18,933
16,194
44,529
43,075
1,454
199.64
1.25
7.44
1.17
29.63
2.27
8.55%
593.54%
19.38%
159.27
26.83
Source: Lowe’s; Home Depot.
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The DuPont Identity
ROE = NI/TE = Basic formula.
ROE = PM * TAT * EM = DuPont identity.
• PM = Net income/Sales.
• TAT = Sales/Total assets.
• EM = Total Assets/Total Equity.
NI
 NI   Sales   TA 
ROE  
 
 
 
TE
 Sales   TA   TE 
Profit margin
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Asset use
Leverage ROE
25
Using the DuPont Identity
ROE = PM * TAT * EM.
Profit margin.
• Measures firm’s operating efficiency.
• How well does it control costs.
Total asset turnover.
• Measures the firm’s asset use efficiency.
• How well does it manage its assets.
Equity multiplier.
• Measures the firm’s financial leverage.
• EM = TA TE  1  D E ratio.
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Prufrock’s DuPont Identity
Prufrock Ratios
Liquidity Ratios
Current Ratio
Quick Ratio
Cash Ratio
Financial Leverage Ratios
Total Debt Ratio
Debt to Equity
Equity Multiplier
Times Interest Earned
Cash Coverage
1.29
.52
.18
.28
.38
1.38
5.26
7.21
Asset Management Ratios
Inventory Turnover
Days' Sales in Inventory
Receivables Turnover
Days' Sales in Receivables
Total Asset Turnover
Profitability Measures
Profit Margin
ROA
ROE
Market Value Measures
Market Price
Shares Outstanding
EPS
PE Ratio
Market-to-book ratio
3.18
114.61
12.56
29.06
.65
days
days
20.08%
13.06%
18.06%
$ 115
33
14.36
8.01
1.12
million
ROE = PM * TAT * EM.
•
PM = 20.08%.
•
TAT = .65.
• EM = 1.38.
ROE = .2008 × .65 × 1.38 = .1806, or 18.06%.
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27
The Internal Growth Rate
How much the firm can grow assets using retained earnings
as the only source of financing.
ROA  b
Internal growth rate 
1  ROA  b
.1306  .6667

1  .1306  .6667
 .0954, or 9.54%
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Determinants of Growth
Profit margin – operating efficiency.
Total asset turnover – asset use efficiency.
Financial leverage – choice of optimal debt ratio.
Dividend policy – choice of how much to pay to shareholders
versus reinvesting in the firm.
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29
Table 3.8: Amazon versus Alibaba
DuPont analysis for Amazon and Alibaba
Amazon
Profit margin ×
Total asset turnover
× Equity multiplier
Year
ROE
=
2017
15.0%
=
2.3%
×
1.355
×
4.74
2016
21.7%
=
3.1%
×
1.631
×
4.32
2015
16.7%
=
2.1%
×
1.653
×
4.84
Alibaba
Profit margin ×
ROE
=
2017
15.7%
=
27.6%
×
.312
×
1.82
2016
32.9%
=
70.7%
×
.278
×
1.68
2015
16.7%
=
31.8%
×
.298
×
1.76
© McGraw Hill, LLC
Total asset turnover
× Equity multiplier
Year
30
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.
• Stockholders.
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Benchmarking
Ratios need to be compared to something.
Time-Trend Analysis.
• How the firm’s performance is changing through time.
• Internal and external uses.
Peer Group Analysis.
• Compare to similar companies or within industries.
• SIC and NAICS codes (NAICS codes can be found at this
link).
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32
Problems with Financial Analysis
Conglomerates.
• No readily available comparables.
Global competitors.
Different accounting procedures.
Different fiscal year ends.
Differences in capital structure.
Seasonal variations and one-time events.
Return to Quiz
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33
Quick Quiz
How do you standardize balance sheets and income
statements?
• Why is standardization useful?
What are the major categories of ratios and provide name of
two ratios within each category?
Profitability ratios all have the same figure in numerator.
What is it and what does this category measure?
What is the purpose of the DuPont equation/how can it be
useful? What does the equation give us?
ROE can be expressed 2 ways. What are those ways and
when written in 3 parts, what does each part represent?
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