CHAPTER 3
Working With Financial
Statements
Key Concepts and Skills
 Know how to standardize financial statements for
comparison purposes
 Know how to compute and interpret important
financial ratios
 Know the determinants of a firm’s profitability and
growth
 Understand the problems and pitfalls in financial
statement analysis
Cash Flow and Financial Statement
 Sources and Uses of Cash
The statement of cash flow or sources and uses of cash
reflects an enterprise’s major sources of cash receipts
and cash payment.
-Activities that bring cash in are sources. Firms raise
cash by selling assets, borrowing money or selling
securities.
-Activities that involve cash outflows are uses. Firms use
cash to buy assets, pay off debt, repurchase stock or
pay dividends.
Mechanical Rules for Determining Sources
and Uses
 Sources:
Decrease in asset account
Increase in liabilities or equity account
 Uses:
Increase in asset account
Decrease in liabilities or equity account
Sources of cash:
Increase in accounts payable
Increase in common stock
Increase in retained earnings
Total sources
Uses of cash:
Increase in accounts receivable
Increase in inventory
Decrease in notes payable
Decrease in long term debt
Net fixed assets acquisitions
Total uses
Net additional cash
$32
50
242
$324
$23
29
35
74
149
$310
14
The Statement of Cash Flows
Provides a summary of cash flows over the period
concerned, typically the year just ended. Sometimes
call sources and uses statement. The idea is to group
cash flows into one of three categories: operating
activities, investing activities, and financing activities.
Prufrock Corporation
2008 Statement of Cash Flows
($ in millions)
Cash, beginning of year
Operating activities:
Net Income
Plus: Depreciation
Increase in A/P
Less: Increase in A/R
Increase in inventory
Net cash flow from operating activities
Investing activities:
Fixed assets acquisitions
Net cash flow from investing activities
Financing activities:
Decrease in N/P
Decrease in long-term debt
Dividend paid
Increase in common stock
Net cash flow from financing activities
Net increase in cash
Cash, end of year
84
363
276
32
-23
-29
619
-425
-425
-35
-74
-121
50
-180
14
98
Prufrock Corporation
2008 Statement of Cash Flows ($ in millions)
Cash, beginning of year
Sources of cash
Operations:
Net income
363
Depreciation
276
639
Working capital:
Increase in accounts payable
32
Long term financing:
Increase in common stock
50
Total sources of cash
Uses of cash
Working capital:
Increase in A/R
23
Increase in inventory
29
Decrease in N/P
35
Long-term financing:
Decrease in long-term debt
74
Fixed asset acquisitions
425
Dividends paid
121
Total uses of cash
Net addition to cash
Cash, end of year
84
721
707
14
98
Standardized Financial Statement
 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.
Common-size statements
Useful in comparison of unequal size:
Common-size balance sheet: express each account as a
percentage of total assets.
Common-size income statement: express each item as
a percentage of sales.
Ratio Analysis
Financial ratios are traditionally grouped into the
following categories:
1. Short-term solvency or liquidity ratios.
2. Long-term solvency or financial leverage ratios.
3. Asset management or turnover, ratios.
4. Profitability ratios.
5. Market value ratios.
Short-Term Solvency or Liquidity Ratios
 Current Ratio
Measures short-term liquidity, the ability of a firm to
meet need for cash they arise.
To a creditor, particularly a short-term creditor such
as a supplier, the higher the current ratio, the better.
To the firm, a high current ratio indicates liquidity,
but it also may indicate an inefficient use of cash
and other short-term assets.
• Quick Ratio
Measures short-term liquidity more rigorously than
current ratio by eliminating inventory, generally the
least liquid current asset.
The quick ratio here tells a somewhat different story than
the current ratio, because inventory accounts for more than
half of Prufrock's current assets. To exaggerate the point, if
this inventory consisted of, say, unsold nuclear power
plants, then this would be a cause for concern.
Long-Term Solvency Measures
 Total Debt Ratio
Measures the prudence of the firm’s debt management
policies.
Prufrock has $.28 in debt for every $1 in assets. Therefore,
there is $.72 in equity ($1 - .28) for every $.28 in debt. With
this in mind, we can define two useful variations on the
total debt ratio, the debt-equity ratio and the equity
multiplier:
 Time Interest Earned Ratio
Measures how many times interest expense is covered
by operating earnings.
•Cash Coverage Ratio
Measures how many times interest expense is covered
by cash available.
Asset Management, or Turnover, Measures
 Inventory Turnover
Measures efficiency of the firm in managing and
selling inventory.
In a sense, we sold off, or turned over, the entire
inventory 3.2 times. As long as we are not running out
of stock and thereby forgoing sales, the higher this
ratio is, the more efficiently we are managing
inventory.
If we know that we turned our inventory over 3.2 times
during the year, then we can immediately figure out
how long it took us to turn it over on average. The
result is the average days' sales in inventory:
 Day’s Sales in Inventory
Measures how long the inventory sells in the average
term.
This tells us that, roughly speaking, inventory sits 114 days
on average before it is sold. Alternatively, assuming we
used the most recent inventory and cost figures, it will take
about 114 days to work off our current inventory.
 Receivables Turnover
Indicates how many times receivables are collected
during a year on average.
Loosely speaking, we collected our outstanding credit
accounts and reloaned the money 12.3 times during the
year.
This ratio makes more sense if we convert it to days, so the
days' sales in receivables is:
 Days’ Sales in Receivable or Average Collection
Period
Indicates how many day receivables are collected on
average.
Therefore, on average, we collect on our credit sales
in 30 days. For obvious reasons, this ratio is very
frequently called the average collection period
(ACP).
Asset Turnover Ratios
 NWC Turnover
This ratio measures how much work we get out of our
working capital.
NWC Turnover = Sales / NWC
= 2,311/ (708 -540)
= 13.8 times
 Fixed Asset Turnover
Measures efficiency of the firm in managing fixed
assets.
Fixed Asset Turnover = Sales / Fixed Assets
= 2,311 / 2,880
= 0.80 times
 Total Asset Turnover
Measures efficiency of the firm in managing all assets.
Profitability Measures
These measures are based on book values, so they are
not comparable with returns that you see on publicly
traded assets:
 Profit Margin
Measures profit generated after consideration of all
expenses and revenues.
This tells us that Prufrock, in an accounting sense, generates
a little less than 16 cents in profit for every dollar in sales.
 Return on Assets
Measures overall efficiency firm in managing assets
and generate profits.
•Return on Equity
Measures rate of return on common stockholders’ (owners)
investment.
Market Value Measures
Earning per share shows about net income for one share.
We assume that Prufrock has 33 million shares
outstanding and the stock sold for $88 per share at the
end of the year.
•Price-earning Ratio
Price earning ratio measures the price of the share in
market to net income per share.
Market-to-Book Ratio
 It shows about the stock price in the market to stock
price in the book.
The Du Pont Identity
 The Du Pont Identity provides a way to breakdown
ROE and it is popular expression breaking ROE into
three parts:
1. Operating efficiency (as measured by profit margin)
2. Asset use efficiency ( as measured by total asset
turnover)
3. Financial leverage ( as measured by the equity
multiplier) efficiency, and financial leverage.
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.
Common Financial Ratios
End of Chapter 3
1-The Hooya Company has a long-term debt ratio (i.e.
the ratio of long-term debt to long-term debt plus equity)
of 0.60 and a current ratio of 1.3. Current liabilities are
$900, sales are $6,590, profit margin is 9 percent, and
ROE is 16 percent. What is the amount of the firm's net
fixed assets?
2-Kaleb's Karate Supply had a profit margin of 9
percent, sales of $17 million, and total assets of $7
million. What was t0tal asset turnover? If
management set a goal of increasing total asset
turnover to 2.75 times, what would the new sales
figure need to be, assuming no increase in total
assets?