Chapter Three
Working with Financial
Statements
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-1
Chapter Organisation
3.1 Cash Flow and Financial Statements: A Closer
Look
3.2 Financial Statements of Publicly Listed Firms
3.3 The Du Pont Identity
3.4 Using Financial Statement Information
3.5 Summary and Conclusions
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-2
Chapter Objectives
• Identify the ways that firms obtain and use cash as
•
•
•
•
reported in the Statement of Cash Flows.
Calculate and interpret key financial ratios.
Discuss the Du Pont identity as a method of
financial analysis.
Understand the use of financial information for
comparative purposes.
Outline the problems associated with using
financial ratios.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-3
Cash
• Cash is generated by selling a product or service,
asset or security.
• Cash is spent by paying for materials and labour to
produce a product or service and by purchasing
assets.
• Recall:
Cash flow from assets = Cash flow to debtholders
+ Cash flow to shareholders
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-4
Cash Flow
• Sources of cash are those activities that bring in
cash.
• Uses of cash are those activities that involve
spending cash.
• The firm’s statement of cash flows is the firm’s
financial statement that summarises its sources
and uses of cash over a specified period.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-5
Statement of Financial Position
('000s)
Assets (‘000s)
Current assets
Cash
Accounts receivable
Inventory
Total
Fixed assets
Net plant and equipment
TOTAL ASSETS
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
2003
2004
$
45
260
320
$ 625
$
50
310
385
$ 745
985
1 100
$1 610
$1 845
3-6
Statement of Financial Position
('000s)
Liabilities and equity (‘000s)
2003
2004
$
210
110
$ 320
$
Long-term debt
$ 205
$ 225
Shareholders’ equity
Ordinary shares
Retained earnings
Total
TOTAL LIABILITIES AND EQUITY
290
795
$1 085
$1 610
290
895
$1 185
$1 845
Current liabilities
Accounts payable
Notes payable
Total
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
260
175
$ 435
3-7
Statement of Financial Performance
('000s)
Net sales
Cost of goods sold
Depreciation
EBIT
Interest
Taxable income
Tax
Net profit
Dividends
Addition to retained earnings
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
$710.00
480.00
30.00
$200.00
20.00
180.00
53.45
$126.55
26.55
$100.00
3-8
Statement of Cash Flows
• A statement that summarises the sources and uses
of cash.
• Changes are divided into three main categories:
–
–
–
Operating activities—includes net profit and changes in
most current accounts
Investment activities—includes changes in fixed assets
Financing activities—includes changes in notes payable,
long-term debt and equity accounts as well as dividends.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-9
Statement of Cash Flows
• Operating activities
+ Net profit
+ 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
+ Ending fixed assets
– Beginning fixed assets
+ Depreciation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-10
Statement of Cash Flows
• Financing activities
– Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
– Dividends paid
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-11
Statement of Cash Flows
• Operating activities
+ Net profit
+ Depreciation
+ Increase in payables
– Increase in receivables
– Increase in inventory
+ $ 126.55
+
30.00
+
50.00
–
50.00
–
65.00
$ 91.55
• Investment activities
+ Ending fixed assets
– Beginning fixed assets
+ Depreciation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
+$1 100.00
– 985.00
+
30.00
( $ 145.00)
3-12
Statement of Cash Flows
• Financing activities
–
–
–
+ Increase in notes payable
+ Increase in long-term debt
– Dividends
+ $ 65.00
+ 20.00
– 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
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-13
‘Players’ in Accounting Standards
• Accountants
• Government
• Regulators
• Other users
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-14
Ratio Analysis
• Financial ratios are relationships determined from
a firm’s financial information.
• Used to compare and investigate relationships
between different pieces of financial information,
either over time or between companies.
• Ratios eliminate the size problem.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-15
Categories of Financial Ratios
• Liquidity—measures the firm’s short-term solvency.
• Capital structure—measures the firm’s ability to
meet long-run obligations (financial leverage).
• Asset management (turnover)—measures the
efficiency of asset usage to generate sales.
• Profitability—measures the firm’s ability to control
expenses.
• Market value—per-share ratios.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-16
Liquidity Ratios
Current asset s
Current rat io
Current liabilit ies
Current asset s  Invent ory
Quick rat io
Current liabilit ies  Bank overdraft
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-17
Capital Structure Ratios
T otalfinancialdebt  Cash
T otalequity  Intangibles
T otaldebt
Debt/equity ratio 
T otalequity
T otalassets
Equity multiplier 
T otalequity
EBIT
Net interestcover 
Interest financecharges
Interest- bearing debt
Debt togross cash flow 
Net profitafter tax depreciation  amortisation
Net debt/equity ratio 
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-18
Turnover Ratios
Cost of goods sold
Inventoryturnover
Inventory
365days
Days'sales in inventory
Inventoryturnover
Sales
Receivables turnover
Accountsreceivable
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-19
Turnover Ratios (continued)
365days
Days'sales in receivables 
Receivables t urnover
Sales
Fixed asset t urnover 
Non - currentasset s
Sales
T ot alasset t urnover 
T ot alasset s
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-20
Profitability Ratios
P rofit margin 
Net profit
Sales
Net profit
Return on assets (ROA) 
 100%
T otal assets
EBIT
Return on investment
100%
T otalassets
Return on equity (ROE) 
Net profit
100%
T otalequity
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-21
Market Value Ratios
Priceper share
Price/earning ratio
Earningsper share
Market val
ue per share
Market- to - book ratio
Book valueper share
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-22
The Du Pont Identity
• Breaks ROE into three parts:
–
–
–
operating efficiency
asset use efficiency
financial leverage
Net profit Sales Assets
ROE 


Sales
Assets Equity
 Profitmargin T otalasset turnover Equity multiplier
 ROA  Equity multiplier
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-23
Uses for Financial Statement
Information
• Internal uses:
–
–
performance evaluation
planning for the future
• External uses:
–
–
–
evaluation by outside parties
evaluation of main competitors
identifying potential takeover targets
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-24
Benchmarks for Comparison
• Ratios are most useful when compared to a
benchmark.
• Time-trend analysis—examine how a particular
ratio(s) has performed historically.
• Peer group analysis—using similar firms
(competitors) for comparison of results.
• Global Industry Classification Standard (GICS)
used by ASX is a useful way to find a peer
company.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-25
Problems with Ratio Analysis
• No underlying theory to identify correct ratios to
•
•
•
•
use or appropriate benchmarks.
Benchmarking is difficult for diversified firms.
Firms may use different accounting procedures.
Firms may have different recording periods.
One-off events can severely affect financial
performance.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
3-26