Chapter
Three
Working With
Financial
Statements
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
3.1
• Understanding Cash Flow and Financial
Statements: A Closer Look
• Standardized Financial Statements
• Ratio Analysis – Computation and
Interpretation
• The Du Pont Identity
• Using Financial Statement Information
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Sample Balance Sheet
3.2
Numbers in thousands
Cash &
Equivalents
A/R
2000
1999
2000
1999
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
1,389,615
871,851
Net FA
3,129,754
2,535,072 C/S
1,761,044
1,648,490
Total Assets
4,931,444
4,118,111 Total Liab.
& Equity
4,931,444
4,118,111
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Sample Income Statement
3.3
Numbers 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
EPS
2.41
Dividends per share
0.93
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Sources and Uses
3.4
• 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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Statement of Cash Flows
3.5
• Statement that summarizes the sources and
uses of cash
• Changes can be 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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Sample Statement of Cash Flows
3.6
Numbers 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
-36,159
141,049
Dividends Paid
-395,521
Increase in Other CL
Less: Increase in A/R
-46,127
Net Cash from Financing
227,301
Increase in Inventory
-93,692 Net Decrease in Cash
-3,319
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
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-957,007
-957,007 *Difference due to rounding of dividends
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3.7
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.
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Financial Ratios
3.8
• Ratios also allow for comparisons over time or
between companies on a consistent basis.
 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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Computing Liquidity Ratios
3.9
• Current Ratio = CA / CL
1,801,690 / 1,780,785 = 1.01
• Quick Ratio = (CA – Inventory) / CL =
(1,801,690 – 314,454) / 1,780,785 = .835
• Cash Ratio = Cash / CL
3,171 / 1,780,785 = .002
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3.10
Computing Long-term Solvency Ratios
• Total Debt Ratio = (TA – TE) / TA
= (4,931,444 – 1,761,044) / 4,931,444 = .6429 or
64.29%
The firm finances a little over 64% of its assets with debt.
• Debt/Equity Ratio = TD / TE
= (4,931,444 – 1,761,044) / 1, 761,044 = 1.80 times
• Equity Multiplier = TA / TE = 1 + TD/TE
= 1 + 1.80 = 2.80
[Multiply both sides of this equation by TE to get TA = TE + TD].
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3.11
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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3.12
Computing Inventory and Receivables 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
• 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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3.13
Computing Total Asset Turnover
• 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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3.14
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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3.15
Computing Market Value Measures
• Market Price = $60.98 per share
• Shares outstanding = 205,838,910
• PE Ratio = Price per share / Earnings per share
= 60.98 / 2.41 = 25.3 times
• 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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Deriving the Du Pont Identity
3.16
• 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
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Using the Du Pont Identity
3.17
• ROE = PM * TAT * EM
– Profit margin is a measure of the firm’s operating
efficiency – how well it controls costs.
– Total asset turnover is a measure of the firm’s
asset use efficiency – how well it manages its
assets.
– Equity multiplier is a measure of the firm’s
financial leverage.
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3.18
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 & Lenders
Suppliers
Customers
Stockholders
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Benchmarking
3.19
• Ratios are not usually helpful by themselves;
they need to be compared to something
• 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
• Checkpoint for validating reasonableness of
forecasts.
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Potential Problems
3.20
• Determining relevance is not always easy.
• 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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Work the Web Example
3.21
• The Internet makes ratio analysis much easier
than it has been in the past
• Click on the web surfer to go to Multex
Investor
– Choose a company and enter its ticker symbol
– Click on comparison and see what information is
available
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