3
Working With
Financial
Statements
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
 Financial Statements: A Closer Look
 Ratio Analysis
 The DuPont Identity
 Using Financial Statement Information
3-2
Balance Sheet
Assets = Liabilities + Owner’s Equity
Current Assets
Cash
Inventory
A/R
Current Liabilities
A/P
Accruals
S-T Debt
Fixed Assets
L-T Liabilities
Land
Bonds
Plant
L-T Bank Debt
Equipment
Mortgages
Less:Depreciation
Preferred Stock
Common Stock
Par Value
Paid-In Capital
Retained Earnings
3-3
Sample Balance Sheet
Numbers in millions
2007
2006
2007
2006
Cash
696
58 A/P
307
303
A/R
956
992 N/P
26
119
Inventory
301
361 Other CL
1,662
1,353
Other CA
303
264 Total CL
1,995
1,775
Total CA
2,256
1,675 LT Debt
843
1,091
Net FA
3,138
3,358 C/S
2,556
2,167
Total
Assets
5,394
5,033 Total Liab.
& Equity
5,394
5,033
3-4
Sample Balance Sheet
Balance Sheet
Simsboro Computer Company
Assets
Liabilities
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
$2,530
Total Assets
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Bonds
$600
Owner’s Equity
Common Stock (par) $300
Paid-in Capital
600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
$2,530
Owners Equity
3-5
Income Statement
Revenues - Expenses = Net Income
Sales
Investment Income
Gains
Interest Received
Dividend Received
COGS
Salaries
Depreciation
Dividends
Taxes
Other Expenses
Interest Paid
Addition to
Retained
Earnings
3-6
Sample Income Statement
Numbers in millions $
Revenues
5,000
Cost of Goods Sold
(2,006)
Expenses
(1,740)
Depreciation
(116)
EBIT
1,138
Interest Expense
(7)
Taxable Income
Taxes
1,131
Net Income
$689
(442)
Dividends Paid
$500
Addition to Retained Earnings
$189
3-7
Sample Income Statement
Income Statement
Simsboro Computer Company
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Net Operating Income
$330
Interest Expense
60
Net Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Dividends Paid
100
Addition to Retained Earnings $62
3-8
Why Evaluating Financial
Performance?
 Evaluate the success of an ongoing business
 Determine weaknesses of an ongoing business
 Compare current performance with past performance
 Compare current performance with industry
standards.
3-9
Categories of Financial Ratios
 Liquidity ratios
 Leverage ratios (Debt)
 Activity / Efficiency Ratios:
 Profitability ratios
 Market value ratios
3-10
Common Financial Ratios
Summary
3-11
Financial Analysis
 Liquidity Ratios: The ability to pay bills in the short-run.
 Leverage Ratios: The ability to meet long-term
obligations.
 Activity / Efficiency Ratios: how efficiently or intensively a
firm uses its assets to generate sales.
 Profitability Ratios: measure how efficiently a firm uses
its assets and manages its operations.
 Market value ratios: how the market values the firm
relative to the book values.
3-12
1. Liquidity Ratios
Current ratio =
Current Assets (CA)
Current Liabilities (CL)
 Measures ability to meet current liabilities with current assets (eg. = 1.31 times)
Quick ratio =
CA – Inventory
Current Liabilities (CL)
 Measures the ability to meet current liabilities with liquid current assets (0.53 times)
Cash + (~ Cash)
Current Liabilities (CL)
 It is an extreme liquidity ratio. It measures the ability of a business to repay its current
liabilities by only using its cash and cash equivalents and nothing else (0.18 times)
Cash ratio =
NWC to TA =
Current Assets (CA) – Current Liabilities (CL)
Total Assets (TA)
 Measures the degree that working capital should meet daily obligations in relation to
business volume (0.047)
3-13
2. Debt / Leverage Ratios
Total Debt (D)
Total Assets (TA)
 Indicates the extent of debt financing relative to total assets (0.28 times)
Debt ratio =
Total Debt (D)
Equity (E)
 Indicates the extent of debt financing relative to equity financing (0.39 times)
Debt-equity ratio =
Total Assets (TA)
Equity (E)
 Shows how much leverage a company is using to fund its assets (1.39 times)
Equity multiplier =
Long-term Debt (LTD)
LTD + Equity (E)
 Indicates the extent of debt financing relative to capitalization (permanent financing)
(0.15 times)
EBIT
Time interest earned ratio =
Interest I)
 Indicates the ability to cover interest expenses with the given level of earnings (4.9 t)
Long-term debt ratio =
EBIT + Depriciation
Interest (I)
 Indicates the ability to cover interest expenses with the given level of cash available
3-14
(6.9 times)
Cash coverage ratio =
3. Activity / Efficiency Ratios:
Inventory Turnover =
Cost of goods sold (COGS)
Inventory
 Measures number of times the inventory has been turned over into sales (3.2 times)
Inventory Turnover in Days =
365 days
Inventory Turnover
 Measures number of days the inventory is held before turned into sales (114 days)
Receivables Turnover =
Revenue
Accounts receivable (A/R)
 Measures the number of times on average, receivables are collected during the period(12.3)
Average Collection Period =
365 days
receivables turnover
 Measures the number of days taken to collect the receivables (30 days)
NWC Turnover =
Revenue
NWC (or CA – CL)
 Shows how efficiently the firm is using the working capital to generate sales (13.8 times)
Revenue
Fixed Asset Turnover =
Net Fixed Asset
 Measures of how efficiently a company uses its fixed assets to generate sales (0.8 times)
Total Asset Turnover =
Revenue
Total Assets (TA)
3-15
 Measure of how efficiently and effectively a company uses its assets to generate sales
(0.64)
4. Profitability Ratios:
Net Income (NI)
Revenue
 Measures overall profitability with respect to sales; the amount of profits
available to shareholders after interest and taxes (15.7%)
Profit Margin =
Net Income (NI)
Total Assets
 Measures the overall effectiveness in generating profits with the given
investment in assets (ROA = 10.12%)
Return on Assets (ROA) =
Net Income (NI)
Equity
 Measures the overall effectiveness in generating profits with the given equity
(ROE = 14%)
Return on Equity (ROE) =
The Dupont Analysis
ROE = Profit Margin X Total Assets Turnover
X Equity multiplier
 Measures relationship of other important ratios with the ROE
3-16
5. Market Value Ratios:
Earnings Per Share (EPS) =
Net Income (NI)
Shares outstanding
 Measures earnings capability of an ordinary share (EPS = 11$)
Price per share
Price Earnings Ratio (PE) =
EPS
 Measures the amount the investors are willing to pay for each dollar of
earnings (PE = 8 times)
Market-to-Book ratio (M/B)
Market value per share
Book value per share
 Measures market price of share relative to book value (1.12 times)
3-17
DuPont Analysis
 The DuPont Identity provides analysts with a way
to break down ROE and investigate what areas
of the firm need improvement.
 ROE = Net Income / Total Equity = NI / TE
 ROE = (NI / TA) (TA / TE) = ROA * EM
 ROE = (NI / TA) (TA / TE) (Sales / Sales)
 ROE = (NI / Sales) (Sales / TA) (TA / TE)
 ROE = PM * TAT * EM
3-18
DuPont Analysis
 ROE = ROA * EM
= (PM * TAT) * EM
 Strategies to raise ROE?
 Increase PM?
 Increase TAT?
 Increase EM?
3-19
DuPont Analysis
 ROE = ROA * EM
= (PM * TAT) * EM
3-20
Extended DuPont Chart
3-21
3-22
Union Pacific: Railroad industry
3-23
PRACTICE
Expanded DuPont Analysis
 Bal. Sheet Data
(millions, $U.S.)




 Inc. Statement Data
(millions, $U.S.)





Cash = 225.27
Inventory = 91.91
Other CA = 22.16
Fixed Assets = 164.62
Sales = 1,204.35
COGS = 841.87
SG&A = 227.04
Interest = (3.67)
Taxes = 55.15
 Computations
 Computations
 TA = 503.96
 TAT = 2.39
 EM = 1.77
 NI = 83.96
 PM = 6.97%
 ROA = 16.66%
ROE = ROA*EM = NI*TAT*EM = 29.49%
SG&A: Selling, general and administrative expense
3-24
Extended DuPont Chart
ROE = 29.49%
ROA = 16.66%
Total Costs = - 1,120.39
EM = 1.77
x
PM = 6.97%

NI = 83.96
x
+
Sales = 1,204.35
Sales = 1,204.35
TAT = 2.39
Sales = 1,204.35

TA = 503.96
Fixed Assets = 164.62
COGS = - 841.87
SG&A = - 227.04
Cash = 225.27
Interest = - (3.67)
Taxes = - 55.15
Other CA = 22.16
+
Current Assets = 339.34
Inventory = 91.91
3-25
Benchmarking
 Ratios are not very helpful by themselves; they
need to be compared to something
 Trend or Time-Series Analysis:
 Used to see how the firm’s performance is changing
through time.
 Cross-Sectional Analysis:
 Compare to similar companies or within industries.
3-26
Benchmarking
3-27
EXAMPLE
3-28
3-29
3-30
Who uses ratio analysis?
 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
3-31
Potential Problems
 There is no underlying theory for financial analysis
 no way to know which ratios are most relevant
 Benchmarking is difficult for diversified firms
 lobalization 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
3-32
3
End of Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.