Chapter 3
Working with Financial Statements
3-0
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
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Statement of Cash Flow
Standardized Financial Statements
Ratio Analysis
The Du Pont Identity
Why Evaluate Financial Statements?
Benchmarking
Potential Problems
1
Statement of Cash Flow
• Sources of Cash = cash inflow
• Uses of Cash = cash outflow
Source
Use
Assets
Equity &
Liabilities
2
Standardized Financial
Statements
• 1. Common-Size Statements:
- Common-Size Balance Sheet: reports ever item
as % of total assets
- Common-Size Income Statement:
reports every item as % of sales
• 2. Common-Base Year Statements:
reports every item as % of the same item in
another year
• 3. Combined Common-Size and
Common-Base Year Statements:
reports every item as a % of the % of the same
item in another year
3
Standardized Financial
Statements
4
Ratio Analysis:
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
• 5. Market value ratios
Du Pont Identity
5
1. Short-Term Solvency Ratios
current assets
2429
1. current ratio 

 1.94
current liabilitie s 1255
current assets - inventory 2429  1300
2. quick ratio 

 .8996
current liabilitie s
1255
6
2. Long-Term Solvency or Leverage Ratios
debt
3340
1. debt ratio 

 .3314
assets 10079
equity 6739
equity ratio 

 1  .3314  .67
assets 10079
debt/equit y ratio 
debt
3340

 .4956
equity 6739
assets equity  debt
debt 10079
equity multiplier 

 1

 1.4956
equity
equity
equity 6739
2. long term debt ratio 
long term debt
2085

 .2363
long term debt  equity 2085  6739
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2. Long-Term Solvency or
Leverage Ratios
EBIT
922
3. times interest earned ratio (TIE) 

 4.7
interest
196
EBIT  depreciati on 922  952
4. cash coverage ratio 

 9.56
interest
196
8
3. Asset Management Ratios
1a) inventory turnover 
costs of goods sold 2633

 2.03
inventory
1300
1 b) days' sales in inventory 
365 days
365

 180
inventory turnover 2.03
9
3. Asset Management Ratios
sales
4507
2 a) receivable s turnover 

 6.39
accounts receivable
705
365 days
365
2 b) average collection period 

 57
receivable s turnover 6.38
sales
4507
3. total asset turn over 

 .4472
total assets 10079
10
4. Profitability Ratios
net income
472
1. profit margin  PM 

 .1047
sales
4507
2. return on assets  ROA 
net income
472

 .0468
assets
10079
3. return on equity  ROE 
net income
472

 .07
equity
6739
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5. Market Value Ratios
Assume: there are 30 mil shares outstanding selling at $350/share
price per share
350
350
1. price/earn ings ratio  PE 


 22.25
472
earnings per share
15.73
30
PE
22.25
2. PEG 

 4
g%
5%
Assume : g=5%.
3. market - to - book ratio 
market val ue per share
350
350


 1.56
6739
book value per share
224.63
30
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DuPont Identity
• ROE = NI/equity
• ROE = NI/equity x sales/sales x assets/assets
• ROE= NI/sales x sales/assets x assets/equity
profit margin
x asset turnover x equity multiplier
ROE  0.1047 x 0.4472 x 1.4956
ROE  0.07
The DuPont Identity decomposes the ROE into an operating
efficiency ratio (day-to-day activities) x asset use efficiency
(investment s) x financial leverage (financing)
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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
14
Benchmarking
• Statements and ratios are not very
helpful by themselves; they need to be
compared to something.
• Use:
- Time and Trend Analysis
- Peer Group Analysis
15
Potential Problems
• Which ratios are most relevant?
• Diversified firms are hard to compare
• Differences in international accounting
regulations
• Varying accounting procedures, i.e. FIFO
vs. LIFO
• Different fiscal years
• Extraordinary events
16