Interpreting Financial
Statements
Objective
1
Contrast Economic and
Accounting Models
<=>
Value of Accounting
Information
Contents
• Functions of Financial
Statements
• Review of Financial
Statements
• Analysis Using Financial
Ratios
• Working Capital
• Constructing a Financial
Planning Model
2
Functions of Financial
Statements
• Financial Statements:
– Provide information to the owners & creditors of a firm
about the current status and past performance
– Provide a convenient way for owners & creditors to set
performance targets & to impose restrictions of the
managers of the firm
– Provide a convenient templates for financial planning
3
Review of Financial
Statements
•Balance Sheet
•Income Statement
•Statement of Cash Flow
4
The Balance Sheet
• Summarizes a firms assets, liabilities, and owner’s
equity at a moment in time
• Prepared according to GAAP, Generally Accepted
Accounting Principles
– GAAP modified occasionally by the Financial Accounting
Standards Board
5
The Balance Sheet
• Major Divisions:
– Assets
• Current assets (less than a year)
• Long-term assets (longer than a year
– Depreciation
– Liabilities and Stockholder’s Equity
• Liabilities
– Current Liabilities
– Long-term debt
• Equity
6
GPC Balance Sheet at Dec 31, 2xx1
2xx0
Assets
Cash & mkt'ble secs
Receivables
Inventories
*Current assets
2xx1
Change
100.0
50.0
150.0
300.0
120.0
60.0
180.0
360.0
20.0
10.0
30.0
60.0
400.0
(100.0)
300.0
490.0
(130.0)
360.0
90.0
(30.0)
60.0
**Total Assets
600.0
720.0
120.0
Liabilities & Equity
Accounts payable
Short-term debt
*Current liabilities
60.0
90.0
150.0
72.0
184.6
256.6
12.0
94.6
106.6
Long-term debt
**Total liabilities
150.0
300.0
150.0
406.6
106.6
Paid-in capital
Retained earnings
*Shareholders equ
200.0
100.0
300.0
200.0
113.4
313.4
13.4
13.4
Liab + Shareholder
600.0
720.0
120.0
Pp&e
Acc depreciation
*Net pp&e
7
The Income Statement
• Summarizes the profitability of a
company during a time period
• Major Divisions:
– Revenue & cost of goods sold
» Gross margin
– General administrative and selling expenses (GS&A)
» Operating income
– Debt service
» Taxable income
– Corporate Taxes
» Net income
8
GPC Income Statement
for Year Ending 2xx1
Sales revenues
Cost of goods sold
*Gross margin
200.0
(110.0)
90.0
Gen sell, & admin exp
*Operating income
(30.0)
60.0
Interest expense
*Taxable income
(21.0)
39.0
Income tax
*Net income
(15.6)
23.4
Allocation to divs
*Chg retained earn
(10.0)
13.4
9
The Cash-Flow Statement
• Show the cash that flowed into and from
a firm in during a time period
– Focuses attention on a firm’s cash situation
• A firm may be profitable and short of cash
– Unlike the balance sheet and income
statement, cash flow statements are
independent of accounting methods
• The IRS uses accounting income to compute
tax, so accounting rules have a second order
effect on cash flows through taxes
10
GPC Cash Flow Statement, for
the Year ending Dec 31, 2xx0
Net income
+ Depreciation
- Increase in acc rec
- Increase in invent
+ Increase in acc rec
*Total cash from operations
23.4
30.0
(10.0)
(30.0)
12.0
25.4
- Invest in new ppe
*Cash flow invest' activities
(90.0)
(90.0)
-Div paid
+ Inc short-term debt
*Cash flow from financing
(10.0)
94.6
84.6
**Chng cash & mkt securities
20.0
11
GPC Income Statement
for Year Ending 2xx1
Sales revenues
Cost of goods sold
*Gross margin
GPC Balance Sheet at Dec 31, 2xx1
2xx0
Assets
Cash & mkt'ble secs
Receivables
Inventories
*Current assets
Pp&e
Acc depreciation
*Net pp&e
**Total Assets
2xx1
Change
100.0
50.0
150.0
300.0
120.0
60.0
180.0
360.0
20.0
10.0
30.0
60.0
400.0
(100.0)
300.0
490.0
(130.0)
360.0
90.0
(30.0)
60.0
600.0
720.0
120.0
Liabilities & Equity
Accounts payable
Short-term debt
*Current liabilities
60.0
90.0
150.0
72.0
184.6
256.6
12.0
94.6
106.6
Long-term debt
**Total liabilities
150.0
300.0
150.0
406.6
106.6
Paid-in capital
Retained earnings
*Shareholders equ
200.0
100.0
300.0
200.0
113.4
313.4
13.4
13.4
Liab + Shareholder
600.0
720.0
120.0
200.0
(110.0)
90.0
Gen sell, & admin exp
*Operating income
(30.0)
60.0
Interest expense
*Taxable income
(21.0)
39.0
Income tax
*Net income
(15.6)
23.4
Allocation to divs
*Chg retained earn
(10.0)
13.4
GPC Cash Flow Statement, for
the Year ending Dec 31, 2xx0
12
Net income
+ Depreciation
- Increase in acc rec
- Increase in invent
+ Increase in acc pay
*Total cash from operations
23.4
30.0
(10.0)
(30.0)
12.0
25.4
- Invest in new ppe
*Cash flow invest' activities
(90.0)
(90.0)
-Div paid
+ Inc short-term debt
*Cash flow from financing
(10.0)
94.6
84.6
**Chng cash & mkt securities
20.0
Financial Ratios
• Return Ratios
• Profitability Ratios
• Liquidity Ratios
• Shareholder Ratios
• Leverage Ratios
• Activity Ratios
13
Examples: Return Ratios
EBIT
Sales
60
 30%

200
EBIT
Return on Assets (RoA) 
AverageTot alAssets
60
 9.1%

600  720 / 2
NetIncome
Return on Equity (RoE) 
StockHolder' sEquity
23.4
 7.6%

300  313.4 / 2
Return on Sales (RoS) 
14
Examples: Activity Ratios
Sales
Average Receivables
200

 3.6 Times
50  60  / 2
Cost of Goods Sold
Inventory Turnover 
Average Inventory
110

 0.7 Times
150  180  / 2
Sales
Asset Turnover 
Average Total Assets
200

 0.3 Times
600  720  / 2
Receivables Turnover 
15
Example: Financial Leverage
Debt to Assets 

Debt to Equity 

Total Debt
Total Assets
406.6
 57%
720
Total Debt
Equity
406.6
 1.3 Times
313.4
16
Examples: Liquidity Ratios
Current Assets
Current Ratio 
Current Liabilitie s
360

 1.4 Times
256.6
Current Assets - Inventory
Quick Ratio 
Current Liabilitie s
360  180

 0.7 Times
256.6
17
Examples: Shareholder Ratios
Market Capitaliza tion
Price to Earnings 
Earnings (net income)
187.2

 8.0
23.4
Market Capitalization = Share Price x Shares Outstanding
See Yahoo Finance for Additional Shareholder Ratios
18
Ratio Comparisons
• Establish Your Perspective
• Shareholder
• employee, Management, or Union
• Creditor
• Predator, Customer, Supplier, Competitor, Trade Association
• Establish Benchmarks
• Other companies ratios
• The firm’s historical ratios
• Data extracted from financial markets
19
Working Capital
• Represents the amount of day-by-day operating
liquidity available to a business
• Working Capital = Current Assets – Current Liabilities
• Example: Working Capital = 360 – 256.6 = 103.4
20
GPC Financial Statements, Years xxx1 - xxx3
(Nearest $ Million)
Year xxx0 xxx1 xxx2 xxx3
(Percent of Year's Sales)
xxx1
xxx2
xxx3
Income Statement
Sales
Cost of goods sold
Gross margin
Selling, general & admin. expenses
EBIT
Interest expences
Taxes
Net income
Dividends
Change in shareholder's equity
200
110
90
30
60
30
12
18
5
13
240
132
108
36
72
45
11
16
5
11
288
158
130
43
86
64
9
13
4
9
100.0% 100.0% 100.0%
55.0% 55.0% 55.0%
45.0% 45.0% 45.0%
15.0% 15.0% 15.0%
30.0% 30.0% 30.0%
15.0% 18.8% 22.2%
6.0%
4.5%
3.1%
9.0%
6.7%
4.7%
2.7%
2.0%
1.4%
6.3%
4.7%
3.3%
10
40
50
500
600
12
48
60
600
720
14
58
72
720
864
17
69
86
864
1037
6.0%
6.0%
6.0%
24.0% 24.0% 24.0%
30.0% 30.0% 30.0%
300.0% 300.0% 300.0%
360.0% 360.0% 360.0%
30
120
150
300
300
36
221
150
407
313
43
347
150
540
324
52
502
150
704
333
18.0% 18.0% 18.0%
110.7% 144.6% 174.2%
75.0% 62.5% 52.1%
203.7% 225.1% 244.3%
156.3% 134.9% 115.7%
Balance Sheet
Assets:
Cash & equivalents
Receivables
Inventories
Property, Plant & equipment
Total Assets
Liabilities:
Payables
Short-term debt
Long-term debt
Total Liabilities
Shareholder's equity
21
(Nearest $ Million)
Year xxx0 xxx1 xxx2 xxx3
Income Statement
Sales
Cost of goods sold
Gross margin
Selling, general & admin. expenses
EBIT
Interest expences
Taxes
Net income
Dividends
Change in shareholder's equity
200
110
90
30
60
30
12
18
5
13
22
240
132
108
36
72
45
11
16
5
11
288
158
130
43
86
64
9
13
4
9
Balance Sheet
Assets:
Cash & equivalents
Receivables
Inventories
Property, Plant & equipment
Total Assets
Liabilities:
Payables
Short-term debt
Long-term debt
Total Liabilities
Shareholder's equity
10
40
50
500
600
12
48
60
600
720
14
58
72
720
864
17
69
86
864
1037
30
120
150
300
300
36
221
150
407
313
43
347
150
540
324
52
502
150
704
333
23
(Percent of Year's Sales)
Year xxx1
xxx2
xxx3
Income Statement
Sales
100.0% 100.0% 100.0%
Cost of goods sold
55.0% 55.0% 55.0%
Gross margin
45.0% 45.0% 45.0%
Selling, general & admin. expenses
15.0% 15.0% 15.0%
EBIT
30.0% 30.0% 30.0%
Interest expences
15.0% 18.8% 22.2%
Taxes
6.0%
4.5%
3.1%
Net income
9.0%
6.7%
4.7%
Dividends
2.7%
2.0%
1.4%
Change in shareholder's equity 6.3%
4.7%
3.3%
24
Balance Sheet
Assets:
Cash & equivalents
Receivables
Inventories
Property, Plant & equipment
Total Assets
Liabilities:
Payables
Short-term debt
Long-term debt
Total Liabilities
Shareholder's equity
6.0%
6.0%
6.0%
24.0% 24.0% 24.0%
30.0% 30.0% 30.0%
300.0% 300.0% 300.0%
360.0% 360.0% 360.0%
18.0% 18.0% 18.0%
110.7% 144.6% 174.2%
75.0% 62.5% 52.1%
203.7% 225.1% 244.3%
156.3% 134.9% 115.7%
25
GPC Financial Statements, Years xxx1 - xxx3
(Nearest $ Million)
Year xxx0 xxx1 xxx2 xxx3 xxx4
Income Statement
Sales
Cost of goods sold
Gross margin
Selling, general & admin. expenses
EBIT
Interest expences
Taxes
Net income
Dividends
Change in shareholder's equity
200
110
90
30
60
30
12
18
5
13
26
240
132
108
36
72
45
11
16
5
11
288
158
130
43
86
64
9
13
4
9
346
190
156
52
104
87
7
10
3
7
GPC Financial Statements, Years xxx1 - xxx3
(Nearest $ Million)
Year xxx0 xxx1 xxx2 xxx3 xxx4
Balance Sheet
Assets:
Cash & equivalents
Receivables
Inventories
Property, Plant & equipment
Total Assets
Liabilities:
Payables
Short-term debt
Long-term debt
Total Liabilities
Shareholder's equity
10
40
50
500
600
12
48
60
600
720
14
58
72
720
864
17
69
86
864
1037
21
83
104
1037
1244
30
120
150
300
300
36
221
150
407
313
43
347
150
540
324
52
502
150
704
333
62
692
150
904
340
27