Chapter 2 & 3
Working with
Financial Statements
Konan Chan
Financial Management, Spring 2016
Topics Covered
 Balance sheet & working capital
 Income vs. cash flow
 Cash flow from assets
 Statement of cash flow
 Du Pont identity
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Konan Chan
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Key Concepts and Skills
 Review the basic formats of B/S, I/S
 Know the difference between accounting
income and cash flow
 Determine a firm’s cash flow from its
financial statements
 Understand sources and uses of cash
 Compute and interpret the DuPont Identity
Financial Management
Konan Chan
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Balance Sheet &
Working Capital
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Konan Chan
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Cash inflows and outflows
 B/S right-hand side: source of cash
 B/S left-hand side: uses of cash
 Cash inflow: increase of right-hand side
accounts
 Cash outflow: increase of left-hand side
accounts
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Konan Chan
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The Income Statement
Net Sales
COGS
Other Expenses
Selling, G&A expenses
Depreciation expense
EBIT (Earnings Before Interests & Taxes)
Net interest expense
Taxable Income
Income Taxes
Net Income
Financial Management
Konan Chan
26,935
10,754
392
10,526
1,082
4,181
152
4,029
1,367
2,662
6
Profits (Income) vs. Cash
Flows
 “Profits” record income and expenses at the
time of sales, not when the cash exchanges
actually occur
 Accounting income



subtract depreciation (a non-cash expense)
ignore cash expenditures on new capital (the expense
is capitalized)
do not consider changes in working capital
Financial Management
Konan Chan
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Cash Flow from Assets
 Cash flow from assets =
Cash flow to creditors +
 Cash flow to stockholders
 Also called “free cash flow”

 Cash flow from assets =
Operating cash flow –
 Net capital spending –
 Changes in net working capital

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Konan Chan
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Free Cash Flow
 Operating cash flow

EBIT + Depreciation - Taxes
 Net capital spending

Ending FA – Beginning FA + Depreciation
 Changes in net working capital (NWC)

Ending NWC – Beginning NWC
 Cash flow to creditors

Interest paid – Net new borrowing
 Cash flow to stockholders

Dividend paid – Net new equity raised
Financial Management
Konan Chan
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The Statement of Cash Flows
 Reconciles the income statement with
changes in the balance sheet from the
beginning to the end of the year
 Inflows: net income, depreciation, decrease in
asset item, or increase in liability item
 Outflows: increase in asset item, or decrease
in liability item, dividend paid
Financial Management
Konan Chan
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Parts of Statement of Cash
Flows
 Cash flows from operations


net income, depreciation
change in working capital
 Cash flows from investments

purchases and sales of long-term real assets and
investments (marketable securities)
 Cash flows from financing



issuances and payments of debt
issue and repurchase stock
dividend paid
Financial Management
Konan Chan
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The DuPont Identity

ROE 
Net Income
Equity
 NI   Sales   TA 
ROE  
 

 Sales   TA   E 
Profit Margin Asset Use Leverage

Equity multiplier
Measures the firm’s financial leverage
EM = TA/E = (E + D)/E = 1+D/E
Financial Management
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Du Pont Identity
 ROE = Profit margin * Asset turnover * Leverage
 Du Pont system: breaks up ROE into components



ROE 
Net Income Assets
 ROA * Leverage ratio
*
Assets
Equity
Operating performance + Financing decision
Leverage can increase ROE
 Further break ROA into components


Net Income Sales
*
Assets
Sales
Operating efficiency + Asset use efficiency
ROA 
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Financial Management
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Du Pont Analysis (Example)
Profit margin
Asset turnover
Debt/Asset
•
Coca - 2004
22.07%
70.11%
49.13%
Coca - 2005
21.09%
78.51%
44.42%
Pepsi-2004
14.39%
104.55%
51.68%
Pepsi-2005
12.52%
102.63%
55.08%
What are the ROEs?
Leverage 
–
Leverage
ROE
Financial Management
Assets
1
1


Equity Equity / Assets 1  debt ratio
Coca - 2004
1.97
30.42%
Coca - 2005 Pepsi-2004
1.80
2.07
29.79%
31.15%
Konan Chan
Pepsi-2005
2.23
28.62%
15
Google vs. Yahoo
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Ethics Issues
 Why is manipulation of financial statements
not only unethical and illegal, but also bad for
stockholders?
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Quick Quiz
 What is the difference between accounting
income and cash flow?
 How do we determine a firm’s cash flows?
What are the equations and where do we find
the information?
 How do you determine sources and uses of
cash?
 What is Du Pont Identity and how to use this
equation?
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