Chapter 3
Working With Financial
Statements
Prepared by Anne Inglis
McGraw-Hill Ryerson
© 2013 McGraw-Hill Ryerson Limited
Key Concepts and Skills
• Know the sources and uses of a firm’s
cash flows.
• Understand how to standardize financial
statements for comparison purposes
• Know how to compute and interpret
common financial ratios
• Be able to understand the determinants of
a firm’s profitability
• Understand some of the problems and
pitfalls in financial statement analysis
© 2013 McGraw-Hill Ryerson Limited
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Chapter Outline
• Cash Flow and Financial Statements: A
Closer Look
• Standardized Financial Statements
• Ratio Analysis
• The Du Pont Identity
• Using Financial Statement Information
• Summary and Conclusions
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Sample Statement of Financial
Position
Numbers are in thousands
Cash &
Equivalents
A/R
2010
2009
2010
2009
3,171
6,489 A/P
313,286
340,220
1,095,118
1,048,991 N/P
227,848
86,631
Inventory
388,947
295,255 Other CL
1,239,651
1,098,602
Other CA
314,454
232,304 Total CL
1,780,785
1,525,453
Total CA
1,801,690
1,583,039 LT Debt
Retained
Earnings
1,389,615
76,395
871,851
0
Net FA
3,129,754
2,535,072 C/S
1,684,649
1,720,807
Total Assets
4,931,444
4,931,444
4,118,111
4,118,111 Total Liab.
& Equity
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Sample Statement of
Comprehensive Income
Numbers are in thousands, except EPS & DPS
Revenues
4,335,491
Cost of Goods Sold
1,762,721
Expenses
1,390,262
Depreciation
362,325
EBIT
820,183
Interest Expense
52,841
Taxable Income
Taxes
767,342
Net Income
471,916
295,426
Additions to retained earnings
?
Dividends Paid
395,521
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LO1
Sources and Uses of Cash 3.1
• Sources
• Cash inflow – occurs when we “sell”
something
• Decrease in asset account
• Increase in liability or equity account
• Uses
• Cash outflow – occurs when we “buy”
something
• Increase in asset account
• Decrease in liability or equity account
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LO1
Statement of Cash Flows
• Statement that summarizes the sources
and uses of cash
• Changes divided into three major
categories
• Operating Activity – includes net income and
changes in most current accounts
• Investment Activity – includes changes in fixed
assets
• Financing Activity – includes changes in notes
payable, long-term debt and equity accounts
as well as dividends
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LO1
Sample Statement of Cash
Flows
Numbers are in thousands
Cash, beginning of year
6,489 Financing Activity
Operating Activity
Increase in Notes Payable
141,217
Net Income
471,916
Increase in LT Debt
517,764
Plus: Depreciation
362,325
Decrease in C/S
-36,158
141,049
Dividends Paid
Increase in Other CL
Less: Increase in A/R
-46,127
Net Cash from Financing
-395,521
227,302
Increase in Inventory
-93,692 Net Decrease in Cash
-3,318
Increase in Other CA
-82,150 Cash End of Year
3,170*
Decrease in A/P
-26,934
Net Cash from Operations
726,387
Investment Activity
Fixed Asset Acquisition
Net Cash from
Investments
957,007
- *Difference due to rounding of dividends
957,007
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LO2
Standardized Financial
Statements 3.2
• Common-Size Statements of Financial
Position
• Compute all accounts as a percent of total
assets
• Common-Size Statements of
Comprehensive Income
• Compute all line items as a percent of sales
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LO2
Why do we use 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
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LO3
Ratio Analysis 3.3
• 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
• Ratios are used both internally and
externally
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LO3
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
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LO3
Computing Liquidity Ratios
• Current Ratio = CA / CL
• 1,801,690 / 1,780,785 = 1.01 times
• Quick Ratio = (CA – Inventory) / CL
• (1,801,690 – 388,947) / 1,780,785 = .793
times
• Cash Ratio = Cash / CL
• 3,171 / 1,780,785 = .002 times
• Cash means cash + cash equivalents
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LO3
Computing Long-term Solvency
Ratios
• Total Debt Ratio = (TA – TE) / TA
• (4,931,444 – 1,761,044) / 4,931,444 = .6429
times or 64.29%
• The firm finances a little over 64% of its assets
with debt.
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LO3
Long-Term Solvency Ratios
continued
• Debt/Equity = TD / TE
• (4,931,444 – 1,761,044) / 1, 761,044 = 1.800
times
• Equity Multiplier = TA / TE = 1 + D/E
• 1 + 1.800 = 2.800
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LO3
Computing Coverage Ratios
• Times Interest Earned = EBIT / Interest
• 820,183 / 52,841 = 15.5 times
• Cash Coverage =
(EBIT + Depreciation) / Interest
• (820,183 + 362,325) / 52,841 = 22.38 times
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LO3
Computing Inventory Ratios
• Inventory Turnover =
Cost of Goods Sold / Inventory
• 1,762,721 / 388,947 = 4.53 times
• Days’ Sales in Inventory =
365 / Inventory Turnover
• 365 / 4.53 = 81 days
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LO3
Computing Receivables Ratios
• Receivables Turnover =
Sales / Accounts Receivable
• 4,335,491 / 1,095,118 = 3.96 times
• Days’ Sales in Receivables =
365 / Receivables Turnover
• 365 / 3.96 = 92 days
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LO3
Computing Total Asset Turnover
• NWC Turnover = Sales / NWC
• 4,335,491 / (1,801,690 - 1,780,785) = 207.390
times
• Fixed Asset Turnover = Sales / Net Fixed
Assets
• 4,335,491 / 3,129,754 = 1.385 times
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LO3
Asset Turnover Ratios continued
• Total Asset Turnover =
Sales / Total Assets
• 4,335,491 / 4,931,444 = .88 times
• Measure of asset use efficiency
• Not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets
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LO3
Computing Profitability
Measures
• Profit Margin = Net Income / Sales
• 471,916 / 4,335,491 = .1088 times or 10.88%
• Return on Assets (ROA) =
Net Income / Total Assets
• 471,916 / 4,931,444 = .0957 times or 9.57%
• Return on Equity (ROE) =
Net Income / Total Equity
• 471,916 / 1,761,044 = .2680 times or 26.8%
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Computing Market Value
Measures
LO3
•
•
•
•
Market Price of Stock = $60.98 per share
Shares outstanding = 205,838,910
Market Value of LTD = $1,461,874,980
EPS = Net Income / Shares Outstanding
• 471,916,000 / 205,838,910 = 2.29
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LO3
Market Value Measures Continued
• PE Ratio = Price per share / Earnings per
share
• 60.98 / 2.29 = 26.6 times
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LO3
Market Value Ratios continued
• Market-to-book ratio = Market Value Per
Share / Book Value Per Share
• 60.98 / (1,761,044,000 / 205,838,910) = 7.1
times
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LO3
Table 3.8 – Common Financial
Ratios
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LO3
Table 3.8 – Common Financial
Ratios
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LO4
Deriving the Du Pont Identity 3.4
• ROE = NI / TE
• Multiply by 1 and then rearrange
NI TA NI TA
ROE 



 ROA  EM
TE TA TA TE
• Multiply by 1 again and then rearrange
NI TA Sales
NI Sales TA
ROE 





TA TE Sales Sales TA TE
ROE  PM  TAT  EM
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LO4
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
© 2013 McGraw-Hill Ryerson Limited
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Using Financial Statement
Information 3.5
LO5
• 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
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LO5
Benchmarking
• Ratios are not very helpful by themselves; they
need to be compared to something
• Time-Trend Analysis
• Used to see how the firm’s performance is changing
through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within industries
• NAICS codes, Financial Post Datagroup, Dominion
Bond Rating Service (DBRS) and Dun & Bradstreet
Canada
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LO5
Potential Problems
• There is no underlying theory, so there is no way
to know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition
makes comparison more difficult because of
differences in accounting regulations
• Varying accounting procedures, i.e. FIFO vs.
LIFO
• Different fiscal years
• Extraordinary events
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Summary 3.6
• You should be able to:
• Identify sources and uses of cash
• Understand the Statement of Cash Flows
• Understand how to make standardized
financial statements and why they are useful
• Calculate and evaluate common ratios
• Understand the Du Pont identity
• Describe how to establish benchmarks for
comparison purposes and understand some
key problems that can arise
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Homework
• 1, 2, 5, 18, 21
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