Working With Financial
Statements
Chapter 3
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Prepare for Capital Budgeting
Part 2: Understand financial statement and cash flow
C2-Identify cash flow from financial statement
C3-Financial statement and comparison
Part 3: Valuation of future cash flow
C4-Basic concepts
C5-More exercise
Part 4: Valuing stocks and bonds
C6-Bond
C7-Stock
Part 5: Capital budgeting
3.1
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Chapter Outline
1.
2.
3.
4.
5.
Why Evaluate Financial Statements?
Categories of Financial Ratios
Du Pont Identity
Payout, Retention Ratios, and Growth Rate
Problems with Financial Statement
3.2
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1.Evaluate Financial Statements
evaluation – identifying problematic
operation and adjusting forecasting target
 Performance
Internal uses
 External uses



Creditors, Stockholders
Suppliers, Customers
 Planning
for the future – estimating future cash
flows
3.3
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Benchmarking
 Time-Trend Analysis

Used to see how the firm’s performance is changing
through time
 Peer
Group Analysis
Compare to similar companies or within industries
 SIC (Standard Industrial Classification) and NAICS
(North American Industry Classification System)
codes

3.4
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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
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

3.5
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Balance Sheets
3.6
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Common-Size Balance Sheets
3.7
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Income Statements
3.8
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Common-Size Income Statements
3.9
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2. Ratio Analysis
 Ratios
also 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 is that
information important
3.10
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Categories of Financial Ratios
 Short-term
solvency or liquidity ratios
 Long-term solvency or financial leverage ratios
 Asset management or turnover ratios
 Profitability ratios
 Market value ratios
3.11
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Sample Balance Sheet
Numbers in thousands
Cash
A/R
680,623 A/P
318,301
1,051,438 N/P
4,613
Inventory
300,459 Other CL
1,645,748
Other CA
415,310 Total CL
1,968,662
Total CA
2,447,830 LT Debt
909,814
Net FA
3,415,159 C/S
2,984,513
Total Assets
5,862,989 Total Liab. & Equity
5,862,989
3.12
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Sample Income Statement
Numbers in thousands, except EPS & DPS
Revenues
5,250,538
Cost of Goods Sold
2,046,645
Expenses
1,904,556
Depreciation & Amortization
124,647
EBIT
1,174,690
Interest Expense
5,785
Taxable Income
Taxes
1,168,905
412,495
Net Income
756,410
EPS
3.92
Dividends per share
1.20
3.13
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2.1 Short-term Solvency Measures:
Liquidity Ratios
Evaluate the firm’s ability to pay its bills over the
short run without undue stress.
 Current Ratio = CA / CL

2,447,830 / 1,968,662 = 1.24 times
 Quick

(2,447,830 – 300,459) / 1,968,662 = 1.09 times
 Cash

Ratio = (CA – Inventory) / CL
Ratio = Cash / CL
680,623 / 1,968,662 = .346 times
3.14
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2.2 Long-term Solvency Measures
Evaluate the firm’s ability to meet Long-term
obligations.
 Leverage ratios
 Coverage ratios
3.15
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Long-term Solvency Measures-1:
Leverage Ratios

Total Debt Ratio = TD/TA= (TA – TE) / TA



(5,862,989 – 2,984,513) / 5,862,989 = .491 times or
49.1%
The firm finances slightly over 49% of their assets with
debt.
Debt/Equity = TD / TE


(5,862,989 – 2,984,513) / 2,984,513 = .964 times
Equity Multiplier (EM) = TA / TE = 1 + D/E

1 + .964 = 1.964
3.16
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Long-term Solvency Measures-2:
Coverage Ratios
 Times

Interest Earned = EBIT / Interest
1,174,900 / 5,785 = 203 times
 Cash
Coverage = (EBIT + Depr. & Amort.) /
Interest

(1,174,900 + 124,647) / 5,785 = 225 times
3.17
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2.3 Asset Management Measures
Evaluate how efficiently the firm uses its asset to
generate sales.
 Inventory ratios
 Receivable ratios
 Total asset turnover
3.18
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Asset Management Measures-1:
Inventory Ratios
 Inventory
Turnover = Cost of Goods Sold /
Inventory

2,046,645 / 300,459 = 6.81 times
 Days’ Sales
in Inventory = 365 / Inventory
Turnover

365 / 6.81 = 54 days
3.19
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Asset Management Measures-2:
Receivables Ratios
 Receivables
Turnover = Sales / Accounts
Receivable

5,250,538 / 1,051,438 = 4.99 times
 Days’ Sales
in Receivables = 365 / Receivables
Turnover

365 / 4.99 = 73 days
3.20
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Asset Management Measures-3:
Total Asset Turnover
 Total Asset

Turnover = Sales / Total Assets
5,250,538 / 5,862,989 = .896 times
 Measure
of asset use efficiency
 Not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets
3.21
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2.4 Profitability Measures:
Profitability Ratios
Evaluate the operation efficiency (the ability to control
cost) of the firm.
 Profit Margin = Net Income / Sales


Return on Assets (ROA) = Net Income / Total Assets


756,410 / 5,250,538 = .1441 times or 14.41%
756,410 / 5,862,989 = .1290 times or 12.90%
Return on Equity (ROE) = Net Income / Total Equity

756,410 / 2,984,513 = .2534 times or 25.34%
3.22
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2.5 Market Value Measures:
Market Value Ratios
Illustrate the difference between market and book
value of the firm.
 Market Price (12/31/04) = $91.54 per share
 Shares outstanding = 189,813,459
 PE Ratio = Price per share / Earnings per share

91.54 / 3.92 = 23.35 times
 Market-to-book
ratio = market value per share /
book value per share

91.54 / (2,984,513,000 / 189,813,459) = 5.82 times
3.23
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Table 3.5
50%
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3.24
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Question

Short-term Solvency

Long-term Solvency

Asset Management

Profitability

Market Value
Profit
Total Asset
Equity
Margin
Turnover
Multiplier
3.25
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3.Du Pont Identity
PM  TAT  EM
Net Income
Total Assets
Sales



Sales
Total Assets
Equity
Net Income Total Assets


 ROA  EM
Total Assets
Equity
Net Income

E
O
R

Equity
PM  TAT  EM  ROA  EM  ROE
3.26
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Deriving the Du Pont Identity
 ROE
= NI / TE
 Multiply by 1 and then rearrange
ROE = (NI / TE) (TA / TA)
 ROE = (NI / TA) (TA / TE) = ROA * EM

 Multiply
by 1 again and then rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
 ROE = (NI / Sales) (Sales / TA) (TA / TE)
 ROE = PM * TAT * EM

3.27
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Using the Du Pont Identity
 ROE
= PM * TAT * EM
Profit margin is a measure of the firm’s operating
efficiency – how well does it control costs
 Total asset turnover is a measure of the firm’s
asset use efficiency – how well does it manage its
assets
 Equity multiplier is a measure of the firm’s
financial leverage

75%
3.28
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4. Payout and Retention Ratios
 Dividend
payout ratio
= Cash dividends / Net income

1.20 / 3.92 = .3061 or 30.61%
 Retention
ratio
= Additions to retained earnings / Net income
= 1 – payout ratio = b
(3.92 – 1.20) / 3.92 = .6939 = 69.39%
 Or 1 - .3061 = .6939 = 69.39%

3.29
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The Internal Growth Rate
 The
internal growth rate tells us how much the
firm can grow assets using retained earnings as
the only source of financing.
ROA  b
Internal Growth Rate 
1 - ROA  b
.1290  .6939

 .0983
1  .1290  .6939
 9.83%
3.30
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The Sustainable Growth Rate
 The
sustainable growth rate tells us how much
the firm can grow by using internally generated
funds and issuing debt to maintain a constant
debt ratio.
ROE  b
Sustainabl e Growth Rate 
1 - ROE  b
.2534  .6939

 .2133
1  .2534  .6939
 21.33%
3.31
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Determinants of Growth
ROA  b
1  ROA  b
ROE  b
1  ROE  b
margin – operating efficiency
 Total asset turnover – asset use efficiency
 Financial leverage – choice of optimal debt
ratio
 Dividend policy – choice of how much to pay
to shareholders versus reinvesting in the firm
 Profit
3.32
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Table 3.6
3.33
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5.Problems with Financial Statement
 Little
financial theory and economic logic exists
with financial statements
 Limits in comparability
1. Diversified business in conglomerates
2. Different accounting standards across nation
3. Different corporate structure
100%
3.34
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Review Questions
1. How do you standardize balance sheets and income statements
and why is standardization useful?
2. What are the major categories of ratios and what does each
category of ratios measure? How to interpret each ratio?
What are the relationships among three leverage ratios?
3. What is Du Pont Identity and what are the components of Du Pont
Identity?
4. What is retention ratio, internal/sustainable growth rate? What are
the major determinants of a firm’s internal and sustainable
growth potential?
5. What are some of the problems associated with financial
statement analysis?
3.35
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