Chapter 3 Working with Financial Statements 3-1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • Cash Flows and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The DuPont Identity • Using Financial Statement Information 3-2 Chapter Outline • Cash Flows and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The DuPont Identity • Using Financial Statement Information 3-3 Sample Balance Sheet XYZ Corporation December 31, 201X (Figures in millions of dollars) 2011 3-4 2010 2011 2010 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 Sample Income Statement XYZ Corporation January 1 – December 31, 201X ( Figures in millions of dollars) Revenues $5,000 Cost of Goods Sold (2,006) Expenses (1,740) Depreciation (116) EBIT 1,138 Interest Expense 3-5 (7) Taxable Income 1,131 Taxes (442) Net Income $689 EPS $3.61 Dividends per share $1.08 Sources and Uses of Cash Sources • Cash inflow – occurs when we “sell” something and we add to the cash account • Decrease in asset account • Accounts receivable, inventory, and net fixed assets • Increase in liability or equity account • Accounts payable, other current liabilities, and common stock 3-6 Sources and Uses of Cash Uses • Cash outflow – occurs when we “buy” something • Increase in asset account • Cash and other current assets • Decrease in liability or equity account • Notes payable and long-term debt 3-7 Statement of Cash Flows Statement that summarizes the sources and uses of cash 3-8 Statement of Cash Flows Changes divided into three major categories: 1. Operating Activity – includes net income and changes in most current accounts 2. Investment Activity – includes changes in fixed assets 3. Financing Activity – includes changes in notes payable, long-term debt, and equity accounts, as well as dividends 3-9 Sample Statement of Cash Flows (Numbers in millions of dollars) Cash, beginning of year 58 Operating Activity Decrease in Notes Payable Net Income 689 Decrease in LT Debt Plus: Depreciation 116 Decrease in C/S (minus RE) Decrease in A/R 36 Decrease in Inventory 60 Increase in A/P Increase in Other CL Dividends Paid Net Cash from Financing -93 -248 -94 -206 -641 4 309 Less: Increase in other CA -39 Net Cash from Operations 1,175 Investment Activity 3-10 Financing Activity Sale of Fixed Assets 104 Net Cash from Investments 104 Net Increase in Cash 638 Cash End of Year 696 Chapter Outline • Cash Flows and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The DuPont Identity • Using Financial Statement Information 3-11 Standardized Financial Statements • 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 3-12 Standardized Financial Statements 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 3-13 Chapter Outline • Cash Flows and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The DuPont Identity • Using Financial Statement Information 3-14 Ratio Analysis The goal of ratio analysis is to take the numerous lines from both the income statement and balance sheet and to interpret this information in a meaningful way. There is simply too much information to grasp at one time. 3-15 3-16 Ratio Analysis Ratios are simply the construction of a numerator and a denominator using data from a balance sheet and/or an income statement. 3-17 Numerator ____________ Denominator Ratio Analysis • 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 that information is important? 3-18 Categories of Financial Ratios 1. Short-term solvency or liquidity ratios 2. Long-term solvency or financial leverage ratios 3. Asset management or turnover ratios 4. Profitability ratios 3-19 5. Market value ratios Categories of Financial Ratios 1. Short-term solvency or liquidity ratios 2. Long-term solvency or financial leverage ratios 3. Asset management or turnover ratios 4. Profitability ratios 3-20 5. Market value ratios Sample Balance Sheet XYZ Corporation December 31, 201X (Figures in millions of dollars) 2011 Cash A/R Inventory Other CA Total CA 3-21 2010 2011 2010 696 58 A/P 307 303 956 992 N/P 26 119 1,662 1,353 1,995 1,775 843 1,091 301 303 2,256 361 Other CL 264 Total CL 1,675 LT Debt 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 Computing Liquidity Ratios Current Ratio = CA / CL 2,256 / 1,995 = 1.13 times Quick Ratio = (CA – Inventory) / CL (2,256 – 301) / 1,995 = .98 times 3-22 Sample Income Statement XYZ Corporation January 1 – December 31, 201X ( Figures in millions of dollars) Revenues $5,000 Cost of Goods Sold (2,006) (1,740) Expenses Depreciation (116) EBIT 1,138 Interest Expense 3-23 (7) Taxable Income 1,131 Taxes (442) Net Income $689 EPS $3.61 Dividends per share $1.08 Categories of Financial Ratios 1. Short-term solvency or liquidity ratios 2. Long-term solvency or financial leverage ratios 3. Asset management or turnover ratios 4. Profitability ratios 3-24 5. Market value ratios Sample Balance Sheet XYZ Corporation December 31, 201X (Figures in millions of dollars) 2011 3-25 2010 2011 2010 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 2,556 2,167 5,394 5,033 Total Assets 5,394 C/S 5,033 Total Liab. & Equity Computing Long-term Solvency Ratios Total Debt Ratio = (TA – TE) / TA (5,394 – 2,556) / 5,394 = 52.61% Debt/Equity = TD / TE (5,394 – 2,556) / 2,556 = 1.11 times 3-26 Sample Balance Sheet XYZ Corporation December 31, 201X (Figures in millions of dollars) 2011 2011 2010 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 1,775 843 2,556 1,091 5,394 5,033 Total CA 2,256 1,675 Net FA 3,138 3,358 Total Assets 3-27 2010 5,394 LT Debt C/S 5,033 Total Liab. & Equity 2,167 Computing Long-term Solvency Ratios Equity Multiplier = EM = TA / TE = 1 + D/E 1 + 1.11 = 2.11 3-28 Categories of Financial Ratios 1. Short-term solvency or liquidity ratios 2. Long-term solvency or financial leverage ratios 3. Asset management or turnover ratios 4. Profitability ratios 3-29 5. Market value ratios Sample Income Statement XYZ Corporation January 1 – December 31, 201X ( Figures in millions of dollars) Revenues $5,000 Cost of Goods Sold (2,006) Expenses (1,740) Depreciation EBIT Interest Expense 3-30 (116) 1,138 (7) Taxable Income 1,131 Taxes (442) Net Income $689 Categories of Financial Ratios 1. Short-term solvency or liquidity ratios 2. Long-term solvency or financial leverage ratios 3. Asset management or turnover ratios 4. Profitability ratios 3-31 5. Market value ratios Computing Profitability Measures Profit Margin = PM = Net Income / Sales 689 / 5,000 = 13.78% Return on Assets (ROA) = Net Income / Total Assets 689 / 5,394 = 12.77% Return on Equity (ROE) = Net Income / Total Equity 3-32 689 / 2,556 = 26.96% Categories of Financial Ratios 1. Short-term solvency or liquidity ratios 2. Long-term solvency or financial leverage ratios 3. Asset management or turnover ratios 4. Profitability ratios 3-33 5. Market value ratios Computing Market Value Measures If the Market Price = $87.65 per share and if the number of shares of common stock outstanding is: 190.9 million, Then the PE Ratio = Price per share / Earnings per share 87.65 / 3.61 = 24.28 times 3-34 Computing Market Value Measures If the Market Price = $87.65 per share and If the number of shares of common stock outstanding is: 190.9 million, and the book value of the equity is $2,556, Then the Market-to-book ratio = Market value per share / book value per share 87.65 / 3.61 = 24.28 times 3-35 Computing Market Value Measures The Price/Earnings (P/E) ratio focuses on the market price of a share of stock and compares it to the Net Earnings of a company. 3-36 Work the Web • The Internet makes ratio analysis much easier than it has been in the past • Click on the web surfer to go to www.reuters.com • Click on Stocks, then choose a company and enter its ticker symbol • Click on Ratios to see what information is available 3-37