Finance
School of Management
Chapter 3: Interpreting
Financial Statements
Objective
Contrast Economic and
Accounting Models
Value of Accounting
Information
1
School of Management
Finance
Chapter 3 Contents





Review of Financial
Statements
Market Values v. Book
Values
Accounting v. Economic
Measures of Income
Return on Shareholders v.
Return on Equity
Analysis Using Financial
Ratios




The Relation Among
Ratios
Limitations of Ratio
Analysis
Purpose and Process of
Financial Planning
Managing Working
Capital
2
School of Management
Finance
Review of Financial Statements

Financial Statements
– Provide information (clues) 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 on
the managers of the firm.
– Provide a convenient templates for financial
planning.
3
School of Management
Finance
The Balance Sheet

Summarizing a firm’s assets (what it owns),
liabilities (what it owes), and net worth (owners’
equity) at a moment in time.
– Amounts measured at historical values (acquisition
cost) and historical exchange rates.
– Prepared according to GAAP (Generally Accepted
Accounting Principles).
– Exchange-listed companies must comply with SEC
(Securities and Exchange Commission) rules.
4
School of Management
Finance
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
Net Working Capital = Current Assets - Liabilities
– Long-term debt

Equity
5
Finance
GPC Balance Sheet at Dec 31, 2xx1
2xx0
Assets
Cash & mkt'ble secs
Receivables
Inventories
*Current assets
Pp&e
Acc depreciation
*Net pp&e
2xx1
School of Management
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
Market Price
Per Share
6
2xx0
2xx1
200.0
187.2
Finance
School of Management
The Income Statement

Summarizing the profitability of a company
during a time period.
– the difference of revenues and expenses
– also to be called the statement of the earnings or
the statement of profit and loss
7
School of Management
Finance
The Income Statement

Major Divisions
– Revenue & cost of goods sold
 Gross margin
– General selling and administrative expenses
(GS&A)
 Operating income
– Interest expense
 Taxable income
– Corporate Taxes
 Net income
8
School of Management
Finance
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
School of Management
Finance
The Income Statement
 It
is important to remember
– Retained earnings are not added to the cash
balance of the firm, but are added to
shareholder’s equity.
– Accounts show historical values, not market
values.
10
School of Management
Finance
The Cash-Flow Statement

Shows the cash that flowed into and from a firm
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.
 Net income is based on accrual accounting methods,
and affected by many judgments about issues such as
how to value the inventory, depreciate the tangible
assets, and amortize the intangible assets.
11
School of Management
Finance
GPC Cash Flow Statement, for
the Year ending Dec 31, 2xx1
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
12
School of Management
Finance
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, 2xx1
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
13
20.0
School of Management
Finance
Notes on Financial Statements
 More
information relevant to understanding the
true financial condition of the company in the
notes to the financial statements.
– An explanation of accounting methods used
– Greater details regarding certain assets or liabilities
– Information regarding the equity structure of the
firm
– Documentation of changes in operations
– Off-balance-sheet items
14
Finance
School of Management
Market Values v. Book Values
 Book
value: the official accounting values of assets
and shareholders’ equity
 Two reasons why the market price of a company’s
stock does not equal its book value
– The book value does not include all of a firm’s assets
and liabilities.
– The assets and liabilities included on a firm’s official
balance sheet are valued at original acquisition cost
less depreciation, rather than at current market value.
15
School of Management
Finance
Market Values v. Book Values

The accounting balance sheet often omits some
economically significant assets.
– Intangible assets: a good reputation, a knowledge base
– Goodwill: the difference between the acquisition price
and the book value when a firm is acquired

The accounting balance sheet also omits some
economically significant liabilities.
– Contingent liabilities: costly lawsuits
16
Finance
School of Management
Which is Relevant for Financial Decision-Making

IBM’s equipment for shell molding
– Purchased for $3.9 million 3 years ago
– The book value at $2.6 million after 3 years depreciation
– The market value has fallen to $1.2 million because of technological
change in the manufacture of computer shells.

Inventory of copper to be used in the manufacturing
process of heating furnaces
– You paid $29,000 at the beginning of the year.
– The market value has risen to $60,000.

For decision-making purposes, the correct value to use is
the market value, whenever available.
– Marking to market
17
School of Management
Finance
Accounting v. Economic Measures of Income

Accounting measure of net income
Revenue - Expenses - Taxes

Economic measure of net income
Net cash flow to shareholders + Change in value of existing
shareholders’ equity
– The accounting net income of GPC Corp. in 20x1 was $23.4
million.
– Net cash flow to GPC shareholders was $10 million, and the price
of GPC stock fell from $200 to $187.2. Thus, its economic income
in 20x1 was
$10 million - $12.8 million = -$2.8 million
18
School of Management
Finance
Returns to Shareholders v. Return on Equity
 Recall:
Capital gain
or loss
Re turn =
Interest
payments
(EndPrice - StartPrice )+ CashDividends
StartPrice
EconomicIncome $ - 2.8Million
=
=
= -1.4%
StartPrice
$200Million

This is the total shareholder return.
19
School of Management
Finance
Returns to Shareholders v. Return on Equity

Traditionally, corporate performance has been
measured by Return on Equity, ROE
Accounting Income
Shareholders Equity
Net Income
=
Shareholders Equity
$ 23 .4 Million
=
= 7 .8 %
$ 300 Million
ROE =
20
Finance
School of Management
Analysis Using Financial Ratios

Despite the differences between accounting and
economic financial principle, a firm’s published
statements can often offer some clues about its
financial condition and provide insights into its
past performance that may be relevant for the
future.
21
School of Management
Finance
Profitability
EBIT
Sales
60
=
= 30%
200
EBIT
Return on Assets (RoA) =
AverageTotalAssets
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) =
22
School of Management
Finance
Asset Turnover
Sales
AverageReceivables
200
=
= 3.6 Times
(50 + 60)/ 2
Cost of Goods Sold
InventoryTurnover=
AverageInventory
110
=
=
(150 + 180)/ 2 0.7 Times
Sales
Asset Turnover=
AverageTotal Assets
200
=
= 0.3 Times
(600 + 720)/ 2
Receivables Turnover=
23
School of Management
Finance
Financial Leverage
Total Debt
=
Debt
Total Assets
= 406.6 = 57%
720
EBIT
=
Times Interest Earned
Interest Expense
60
=
= 2.9 Times
21
24
School of Management
Finance
Liquidity
Current Assets
Current Liabilities
360
=
= 1.4 Times
256.6
Cash + Receivables
Quick, or acid test =
Current Liabilities
180
=
= 0.7 Times
256.6
Current =
25
School of Management
Finance
Market Value
Price Per Share
Price to Earnings =
Earnings per Share
187.2
=
= 8.0
23.4
Price per Share
Market to Book =
Book Value per Share
187.20
=
= 0.6
313.4
26
School of Management
Finance
Ratio Comparisons

Establish Your Perspective
–
–
–
–

Shareholder
Employee, Management, or Union
Creditor
Predator, Customer, Supplier, Competitor, Trade
Association
Benchmarks
– Other companies’ ratios
– The firm’s historical ratios
– Data extracted from financial markets
27
Finance
School of Management
Relationships Amongst Ratios

It is sometimes valuable to decompose ratios into
sums, differences, products and quotients of
other ratios. Many such schemes start with:
EBIT
EBIT Sales
RoA =
=
*
Assets Sales Assets
= Return on Sales * Asset Turnover
28
School of Management
Finance
Differences between ROS and ATO
across Industries

A “low” ROS or ATO ratio need not be a sign of a
trouble firm.
ROS
*
ATO
=
ROA
Supermarket chain
0.02
5.0
0.10
Public utility
0.20
0.5
0.10
29
Finance
School of Management
The Effect of Financial Leverage

An increase in a firm’s financial leverage will increase its
ROE if and only if its ROA exceeds the interest rate on
the borrowed funds.
ROE＝ (1－Tax Rate) ×[ROA＋Debt/Equity×(ROA－Interest Rate)]


Increased financial leverage magnifies the variability that
firms experience in their ROE over the business cycle
and increases the likelihood of bankruptcy.
From the perspective of a creditor, an increase in a firm’s
debt ratio is generally a negative sign.
30
Finance
School of Management
Limitations of Ratio Analysis



A firm’s profitability as reflected in its financial
statements may sometimes seem awful but may just be
inevitable result of a long-run strategy of restructuring
or repositioning which will ultimately make the firm
much more profitable.
It is difficult to define a set of comparable firms to serve
as a benchmark for judging a company’s performance.
Financial statements reflect the conventions of the
accounting profession, which may not reflect what is
most relevant from a financial decision-maker’s
perspective.
31
School of Management
Finance
The Financial Planning Process

Financial Planning is a dynamic process following
a cycle of
– making plans,
– implementing them, and
– revising them in the light of actual results.


Strategic plans
Planning horizon
32
Finance
School of Management
Steps of Financial Planning Process





Forecasting the key external factors that determine the
demand for the firm’s products and its production costs.
Forecasting the firm’s revenues, expenses, cash flows,
and estimating the implied need for external financing.
Establishing performance targets.
Measuring actual performance, correcting actions and
adjusting targets.
Distributing the rewards and starting again the planning
cycle.
33
School of Management
Finance
An Illustration: GPC

Percent-of-sales method
– making a forecast of sales for the next year.
– assuming that most of the items on the income statement
and balance sheet will remain the same ratio to sales as
in the previous year.
Additional Financing Needed
＝ Change in Assets – Increase in Retained Earnings – Increase in Payables
34
School of Management
Finance
GPC Financial Statements: 2xx1-2xx3
2xx1
Sales revenues
Cost of goods sold
Gross margin
Gen sell, & admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
200.00
(110.00)
90.00
(30.00)
60.00
(30.00)
(12.00)
18.00
(5.40)
12.60
2xx2
2xx3
240.00
(132.00)
108.00
(36.00)
72.00
(45.21)
(10.72)
16.07
(4.82)
11.25
288.00
(158.40)
129.60
(43.20)
86.40
(64.04)
(8.94)
13.41
(4.02)
9.39
2xx0
2xx1
2xx2
2xx3
Assets
Cash & mkt'ble secs
Receivables
Inventories
Pp&e
600.00
10.00
40.00
50.00
500.00
720.00
12.00
48.00
60.00
600.00
864.00
14.40
57.60
72.00
720.00
1,036.80
17.28
69.12
86.40
864.00
liabilities
payables
300.00
407.40
540.15
703.56
Short-term debt
Long-term debt
30.00
120.00
150.00
36.00
221.40
150.00
43.20
346.95
150.00
51.84
501.72
150.00
Shareholders’ equ
300.00
312.60
323.85
333.24
Balance Sheet
35
School of Management
Finance
GPC Common-Size Financial Statements: 2xx1-2xx3
2xx1
2xx2
2xx3
100.0%
(55.0)
45.0
(15.0)
30.0
(15.0)
(6.0)
9.0
(2.7)
6.3
100.0%
(55.0)
45.0
(15.0)
30.0
(18.8)
(4.5)
6.7
(2.0)
4.7
100.0%
(55.0)
45.0
(15.0)
30.0
(22.2)
(3.1)
4.7
(1.4)
3.3
2xx1
2xx2
2xx3
360.0%
6.0
24.0
30.0
300.0
360.0%
6.0
24.0
30.0
300.0
360.0%
6.0
24.0
30.0
300.0
203.7
225.1
244.3
Short-term debt
Long-term debt
18.0
110.7
75.0
18.0
144.6
62.5
18.0
174.2
52.1
Shareholders’ equ
156.3
134.9
115.7
Sales revenues
Cost of goods sold
Gross margin
Gen sell, & admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
Balance Sheet
Assets
Cash & mkt'ble secs
Receivables
Inventories
Pp&e
liabilities
payables
36
School of Management
Finance
GPC Forecast Financial Statements: 2xx1-2xx3
2xx1
Sales revenues
Cost of goods sold
Gross margin
Gen sell, & admin exp
EBIT
Interest expense
taxes
Net income
dividends
Chg retained earn
200.00
(110.00)
90.00
(30.00)
60.00
(30.00)
(12.00)
18.00
(5.40)
12.60
2xx2
2xx3
2xx4e
240.00
(132.00)
108.00
(36.00)
72.00
(45.21)
(10.72)
16.07
(4.82)
11.25
288.00
(158.40)
129.60
(43.20)
86.40
(64.04)
(8.94)
13.41
(4.02)
9.39
345.60
(190.08)
155.52
(51.84)
103.68
(87.26)
(6.57)
9.85
(2.96)
6.90
15%
8%
2xx0
2xx1
2xx2
2xx3
2xx3
Assets
Cash & mkt'ble secs
Receivables
Inventories
Pp&e
600.00
10.00
40.00
50.00
500.00
720.00
12.00
48.00
60.00
600.00
864.00
14.40
57.60
72.00
720.00
1,036.80
17.28
69.12
86.40
864.00
1,244.16
20.74
82.94
103.68
1,036.80
liabilities
payables
300.00
407.40
540.15
703.56
904.02
Short-term debt
Long-term debt
30.00
120.00
150.00
36.00
221.40
150.00
43.20
346.95
150.00
51.84
501.72
150.00
62.21
691.81
150.00
Shareholders’ equ
300.00
312.60
323.85
333.24
340.14
Balance Sheet
37
School of Management
Finance
Sustainable Growth Rate

Assumptions:
– The firm will not issue any new equity shares, so that growth in
equity capital occurs only through the retention of earnings.
– The firm will not increase its ratio of debt to equity, so that
external debt financing will grow at the same rate as equity grows
through retained earnings.
Sustainable Growth Rate = Earings Retention Rate × ROE

Implications:
– The maximum sustainable growth rate is equal to the firm’s ROE.
– If a firm tries to grow faster than this rate, it will have to issue new
shares and/or increase its debt.
38
School of Management
Finance
An Illustration: Rapid Industries




Asset Turnover = 0.5 Times per Year
Debt/Equity Ratio = 1.0
Dividend Payout Ratio = 0.4
ROE = 20% per Year
2xx1
Sales
Net income
Dividends
Chg retained earn
&1,000,000
200,000
80,000
120,000
Sustainable Growth Rate
= 0.6 × 20%=12%
2xx2
&1,120,000
224,000
89,600
134,400
2xx3
&1,254,400
250,880
100,352
150,528
2xx0
2xx1
2xx2
Assets
$2,000,000
$2,240,000
$2,508,800
$2,809,856
Debt
1,000,000
1,120,000
1,254,400
1,404,928
Equity
1,000,000
1,120,000
1,254,400
1,404,928
Balance Sheet
2xx3
39
School of Management
Finance
Working Capital Management

In most cases cash must be paid out to cover expenses before
any cash is collected from the sale of the firm’s products.
– If a firm’s need for working capital is permanent rather than seasonal,
it usually seeks long-term financing for it.
– Seasonal financing needs are met through short-term financing
arrangements.

The main principle of efficient working capital management
– To minimize the amount of the firm’s investment in nonearning assets
such as receivables and inventories.
– To maximize the use of “free” credit such as prepayments by
customers, accrued wages, and accounts payable.
40
School of Management
Finance
The Cash Flow Cycle
Ordered
Finished Goods Sold
Arrives
Raw
Material
Purchased
Inventory Period
Cash Received
Receivables Period
Time
Payables Period
Cash Cycle Time
Invoice Received

Cash Paid
A firm can reduce its need for working capital by:
– reducing the amount of time that goods are held in inventory.
– collecting accounts receivable more quickly.
– paying its own bills more slowly.
41