Chapter 2
Financial Statements And Cash Flow
Analysis
Professor John Zietlow
MBA 621
Spring 2006
Chapter 2 Overview
• 2.1 Financial Statements
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–
–
–
Balance Sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flows
Notes to Financial Statements
• 2.2 Cash Flow Analysis
–
–
–
–
The Firm’s Cash Flows
Depreciation and Cash Flows
Sources and Uses of Cash
Developing and Interpreting the Statement of Cash Flows
• 2.3 Analyzing Performance Using Ratio Analysis
–
–
–
–
–
Liquidity Ratios
Activity Ratios
Debt Ratios
Profitability Ratios
Market Ratios
Four Key Financial Statements Are Required
By U.S. Securities & Exchange Commission
1. Income Statement
– Details Firm’s Revenues, Expenses & Profits During Period
– By Definition: Profit (Income) = Revenues - Expenses
2. Balance Sheet
– Details Firms Assets, Liabilities & Capital At Period’s End
– By Definition: Assets = Liabilities + Stockholders’ Equity
– Assets Listed In Decreasing Order of Liquidity; Cash First
3. Statement Of Retained Earnings
– Reconciles Net Income, Cash Dividends & Change In
Retained Earnings Between Beginning & End Of Period
4. The Statement Of Cash Flows
– Summarizes Firm’s Sources & Uses Of Cash and How Cash
Position Changes Over A Period
The Uses (And Misuses) Of Financial
Statements
• All Public Companies Must Provide These Statements
– Must Be Filed With SEC, Given To Shareholders
• Must Be Prepared & Audited According To GAAP
– U.S. Accounting Standards More “Rigorous” Than Most
– Enron Collapse Has Thrown U.S. Accounting Into Crisis
• Accrual Accounting: When Revenue & Expenses Realized?
– Realized When Sale Is Made; Not When Payment Received
• In U.S., Must Prepare Quarterly & Annual Statements
– Other Countries Only Require Semi-Annual Or Annual Filings
• Statements Are The Principal Tools Used To Evaluate Firm
– Used By Management, S/Hs, Creditors, Security Analysts
– Typically Use “Ratio Analysis” To Evaluate Firm’s Condition
• Are Imperfect Measures Of Firm’s Condition Or Prospects
– Though Essential, Statements Must Be Interpreted Cautiously
Global Petroleum Company Balance Sheet
Assets ($ Millions) December 31
Current assets
Cash & cash equivalents
Marketable securities
Accounts receivable
Inventories
Other (mostly prepaid expenses)
Total current assets
Fixed assets
Gross property, plant and equipment
Less accumulated depreciation
Net property, plant and equipment
Intangible assets and others
Net fixed assets
Total assets
2003
$440
35
1,619
615
170
$2,879
2002
$213
28
1,203
530
176
$2,150
$9,920
(3,968)
$5,952
758
$6,710
$9,589
$9,024
(3,335)
$5,689
471
$6,160
$8,310
Global Petroleum Company Balance Sheet
Liabilities & Stockholders’ Equity ($Mn) 12/31
Current liabilities
Accounts payable
Notes payable
Accrued expenses
Total current liabilities
Long-term liabilities
Deferred taxes
Long-term debt
Total long-term liabilities
Total liabilities
Shareholders’ equity
Preferred stock
Common stock ($1 par value)
Capital in excess of par
Retained earnings
Less treasury stock
Total shareholders’ equity
Total liabilities & stockholders’ equity
2003
$1,697
477
440
$2,614
2002
$1,304
587
379
$2,270
$907
1,760
$2,667
$5,281
$793
1,474
$2,267
$4,537
$30
373
248
4,271
(614)
$4,308
$9,589
$30
342
229
3,670
(498)
$3,773
$8,310
Global Petroleum Company Income
Statement ($ Millions) December 31
Sales revenue
Cost of goods sold
Gross margin
Operating and other expenses
Selling, general, administ expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current
Deferred
Net income
2003
2002
$12,843
(8,519)
$4,324
(1,544)
(616)
(633)
$1,531
140
$1,671
(123)
$1,548
(599)
(367)
(232)
$949
$9,110
(5,633)
$3,477
(1,521)
(584)
(608)
$764
82
$846
(112)
$734
(263)
(158)
(105)
$471
Global Petroleum Comp Income Statement
Dividends & Earnings Per Share ($Mn) 12/31
2003
2002
$949
$471
$3
$3
Retained earnings
$601
$142
Dividends
$345
$326
Earnings per share
$5.31
$2.54
Dividends per share
$1.93
$1.76
$76.25
$71.50
Net income
Preferred stock dividends
Per share data 1
Price per share
1
Based on 178,719,400 and 185,433,100 shares outstanding as of
December 31, 2003 and 2002, respectively.
Global Petroleum Co Statement Of Retained
Earnings ($ Mn), Year Ending Dec 31, 2003
$3,670
Retained earnings balance (Jan 1, 2003)
Plus: Net income (for 2003)
949
Less: Cash dividends (paid during 2003)
Preferred stock
($3)
Common stock
(345)
Total dividends paid
Retained earnings balance (Dec 31, 2003)
($348)
$4,271
Pattern of Cash Flows Through a Firm
Cash Flows
The firm’s cash flows
(1) Operating flows
Labor
Raw
Materials
Accrued
Wages
(2) Investment flows
Payment of accruals
Accounts
Payable
Purchase
Payment
of Credit
Purchases
Fixed
Assets
Sale
Depreciation
Work in
Process
Business
Interests
Overhead
Expenses
Purchase
Finished
Goods
Sale
Cash
and
Marketabale
Securities
Operating (incl.
Depreciation)
and
Interest Expense
(3) Financing flows
Borrowing
Payment
Repayment
Taxes
Debt
(Short Term
and Long Term)
Refund
Sales
Cash Sales
Sale of Stock
Repurchase of Stock
Accounts
Receivables
Collection of Credit Sales
Payment of Cash Dividends
Equity
Sources and Uses of Corporate Cash Flow
•
•
•
•
•
Sources
Decreases in any asset
Increase in any liability
Net profits after taxes
Depreciation and other
non-cash charges
Sale of stock
•
•
•
•
•
Uses
Increase in any asset
Decrease in any liability
Net loss
Dividends paid
Repurchase or
retirement of stock
Global Petroleum Co Statement Of Cash
Flows ($ Millions), Year Ending Dec 31, 2003
Cash Flow From Operating Activities
Net income (net profit after tax)
Depreciation
Increase in accounts receivable
Increase in inventories
Decrease in other assets
$949
633
(416)
(85)
6
Increase in accounts payable
393
Increase in accrued expenses
61
Cash provided by operating activities
$1,541
Cash Flow from Investment Activities
Increase in gross fixed assets
Increase in intangible and other assets
CF provided (consumed) by investments
($896)
(287)
($1,183)
Global Petroleum Comp Statement Of Cash
Flows ($Mn), Year Ending Dec 31, 2003
Cash Flow From Financing Activities
Decrease in notes payable
($110)
Increase in deferred taxes
114
Increase in long-term debt
286
Changes in stockholders’ equity
(66)
Dividends paid
CF provided (consumed) by financing
Net Increase in Cash & Cash Equivalents
(348)
($124)
$234
Five Basic Types Of Financial Ratios Used
To Analyze A Firm
• Liquidity Ratios measure a firm’s ability to satisfy its short-term
obligations as they come due. Greater liquidity preferred.
• Activity ratios measure the speed with which various accounts
are converted into sales or cash. Higher activity preferred.
• Debt Ratios indicate the amount of borrowed money being
used by the firm. Lower debt ratio implies greater safety.
• Profitability Ratios measure the returns of the firm to its sales,
assets, or equity. Higher profitability (almost) always preferred.
• Market ratios relate the firm’s market value as measured by its
current share price to certain accounting values. Higher
valuation ratios preferred.
Exxon Mobil Company Balance Sheet
Assets ($ Millions) December 31
Current assets
Cash & cash equivalents
Notes and accounts receivable, less
estimated doubtful amounts
Inventories
Crude oil, products and merchandise
Materials and supplies
Prepaid taxes and expenses
Total current assets
Fixed assets
Investments and advances
Property, plant and equipment, at cost, less
accumulated depreciation and depletion
Other assets, including intangibles, net
Total assets
2001
$6,547
19,549
2000
$7,080
22,996
6,743
1,161
1,681
$35,681
7,244
1,060
2,019
$40,399
$10,768
89,602
$12,618
89,829
7,123
6,154
$143,174
$149,000
Exxon Mobil Company Balance Sheet
Liabilities & Stockholders’ Equity ($Mn) 12/31
Current liabilities
Notes and loans payable
Accounts payable and accrued liabilities
Income taxes payable
Total current liabilities
Long-term liabilities
Deferred Income Taxes
Long-term debt
Other non-current liabilities
Minority interest
Total long-term liabilities
Total liabilities
Shareholders’ equity
Preferred stock
Common stock ($1 par value)
Total shareholders’ equity
Total liabilities & stockholders’ equity
2001
$3,703
22,862
3,549
$30,114
2000
$6,161
26,755
5,275
$38,191
$16,359
7,099
13,616
2,825
$39,899
$70,013
$16,442
7,280
13,100
3,830
$40,052
$78,243
0
73,161
$73,161
$143,174
0
70,757
$70,757
$149,000
Liquidity Ratios For Exxon Mobil
Corporation
The current ratio measures the firm’s ability to meet its short-term
obligations. Should be greater than 1.00.
Current ratio =
current assets $35,681

1.18
current liabilities $30,114
The quick ratio (also known as acid-test ratio) subtracts inventory
from current ratio. Theory: quick ratio measures current assets that
can be turned into cash quickly. Inventory difficult to liquidate fast.
current assets- inventory $35,681  7,904
Quick ratio =

 0.92
current liabilities
$30,114
Dell Computer Corporation Balance Sheet
Assets ($ Millions) February 1
Current assets
Cash & cash equivalents
Short-term investments
Account receivables, net
Inventories
Total current assets
Fixed assets
Property, plant and equipment, net
Investments
Other non-current assets
Total assets
2002
$3,641
273
2,269
278
$7,877
2001
$4,910
525
2,424
400
$9,726
826
4,373
459
996
2,418
530
$13,535
$13,670
Dell Computer Corporation Balance Sheet
Liabilities & Stockholders’ Equity ($Mn) 02/01
Current liabilities
Accounts payable
Accrued and other
Total current liabilities
Long-term liabilities
Long-term debt
Other non-current liabilities
Total liabilities
Shareholders’ equity
Common stock
Treasury stock, at cost
Retained earnings
Other comprehensive income
Other
Total shareholders’ equity
Total liabilities & stockholders’ equity
2002
$5,075
2,444
$7,519
2001
$4,286
2,492
$6,778
520
802
$8,841
509
761
$8,048
5,605
(2,249)
1,364
38
(64)
$4,694
$13,535
4,795
0
839
62
(74)
$5,622
$13,670
Dell Computer Corporation Income
Statement ($ Millions) February 1
Sales revenue
Cost of revenue
Gross margin
Operating expenses
Selling, general, administrative expenses
Research, development, and engineering
Special charges
Total operating expenses
Operating income
Investment and other income (loss), net
Income before income taxes and cumulative effect
of change in accounting principle
Provision for income taxes
Income before cumulative effect of change in
accounting principle
Cumulative effect of change in accounting
principle, net
Net income
2002
$31,168
(25,661)
$5,507
2001
$31,888
(25,445)
$6,443
(2,784)
(452)
(482)
$3,718
$1,789
(58)
(3,193)
(482)
(105)
$3,780
$2,663
531
1,731
3,194
485
958
1,246
2,236
-
59
$1,246
$2,177
Activity Ratios For Dell Computer
Corporation
Inventory turnover measures how many times each year the firm “turns
over” (sells) its inventory. Use cost of goods sold (“cost of revenue”) rather
than sales in the numerator of this ratio.
cost of goods sold $25,661
Inventory turnover =

 92.3
inventory
$278
Fixed asset turnover measures the efficiency with which the firm uses
its fixed assets to generate sales. This ratio varies greatly by industry;
Ratio will be low for capital-intensive firms (steelworks), high for laborintensive companies (grocery stores).
Fixed asset turn over =
sales
$31,168

 5.5
net fixed assets $5,658
Activity Ratios For Dell Computer Corporation
(Continued)
Average collection period is used to evaluate credit and collection
policies. Computed by dividing accounts receivable by average daily
sales, which must itself be computed by dividing annual sales by 365.
Average collection period =
Accounts receivable
$2,269

 26.57 days
Average sales per day $85.39
Average collection period is often called days’ sales outstanding (DSO).
This directly measures how much the firm has invested in A/R.
Annual sales $31,168
Average sales per day =

 $85.39
365
365
Activity Ratios For Dell Computer Corporation
(Continued)
Total asset turnover measures the efficiency with which the firm uses
all its assets to generate sales. This ratio also varies greatly by industry.
sales
$31,168
Total asset turn over =

 2.30
total assets $13,535
The Uses Of Debt Ratios
• Financial leverage : the use of fixed-cost financing by firms
to magnify returns to shareholders
– Also magnifies financial risk (risk of failure & default)
• There are two general types of debt measures:
– measures of the degree of indebtedness and
– measures of the ability to service debts.
• The degree of indebtedness measures debt relative to other
balance sheet amounts.
– A popular measure is the debt ratio.
• The ability to service debts measures a firm’s ability to
make contractual payments required over the life of a debt.
– The firm’s ability to pay certain fixed charges is measured by
using coverage ratios.
• Higher coverage ratios are preferred, but not too high.
– Almost all debt ratios show strong industry patterns
Lowe’s Companies, Inc. Balance Sheet
Assets ($ Millions) December 31
Current assets
Cash & cash equivalents
Receivables
Inventories
Other current assets
Total current assets
Non-Current Assets
Property, plant and equipment, gross
Accum. Depreciation & depletion
Property, plant and equipment, net
Intangibles
Other non-current assets
Non-current assets
Total Assets
2001
$798.8
165.6
3,610.8
345.2
$5,562
2000
$455.7
161.0
3,285.4
273.0
$5,973
10,632.3
1,978.9
8,653.4
0.0
162.4
$8,815.8
8,628.4
1,593.4
7,035.0
0.0
165.8
7,200.8
$13,736.2 11,375.8
Lowe’s Companies, Inc. Balance Sheet
Liabilities & Stockholders’ Equity ($Mn) 12/31
Current liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Non-current liabilities
Long term debt
Deferred income taxes
Other non-current liabilities
Total non-current liabilities
Total liabilities
Shareholder’s equity
Preferred stock equity
Common stock equity
Total equity
Total Liabilities and stock equity
2001
2000
1,718.8
159.3
1,142.8
3,016.8
1,732.0
292.2
904.5
2,928.6
3,743.0
304.7
6.2
4,044.9
7,061.8
2,697.7
251.5
3.2
2,952.4
5,881.1
0.0
6,674.4
$6,674.4
13,736.2
0.0
5,494.9
5,494.9
11,376.0
Lowe’s Companies, Inc. Income Statement
($ Millions) December 31
Sales
Cost of sales
Gross operating profit
Selling, general, administrative expenses
Other taxes
EBITDA
Depreciation and amortization
EBIT
Other income, net
Total income avail. for interest expense
Interest expense
Pre-tax income
Income taxes
Total net income
2001
200
$22,111.1 $18,778.6
15,744.2 13,486.9
6,366.9
5,291.7
4,053.2
3,479.9
0.0
0.0
2,313.7
1,811.8
534.1
409.5
1,779.6
1,402.3
24.7
0.0
1,804.3
1,402.3
180.0
120.8
1,624.3
1,281.5
601.0
471.6
1023.3
809.9
Debt Ratios For Lowe’s Companies, Inc.
The debt ratio measures the proportion of the firm’s total assets financed
by creditors. This is the broadest measure of indebtedness; includes loans
plus accounts payable, taxes payable and other accrued liabilities.
total liabilities $7,061.8
Debt ratio =

 0.513  51.3%
total assets $13,736.2
An alternative measure of indebtedness, the debt-equity ratio, focuses
only on long-term debt and equity. Thus often called a capitalization ratio.
Long  term debt
$3,734.0
Debt- equity ratio =

= 0.559  55.9%
Stockholde rs' equity $6,674.4
Debt Ratios For Lowe’s Companies, Inc.
(Continued)
The times interest earned ratio measures the firm’s ability to make
contractual interest payments. The higher the ratio, the more easily
the firm can make its interest payments. Does not measure ability to cover
principal repayments.
Times interest earned =
earnings before interest and taxes $1,779.6

 9.887
interest
$180.0
Using Profitability Ratios
• Profitability Ratios allow analysts to evaluate the firm’s
earnings with respect to sales, assets, or equity.
– Important indicator of current status, profitability ratios also
watched for signs of future problems
• A common-size income statement expresses revenues &
expenses as a percentage of sales.
– Especially useful in comparing performance across years
• Three frequently cited ratios of profitability are:
– The gross profit margin
– The operating profit margin, and
– The net profit margin
Wal-Mart Stores, Inc. Balance Sheet
Assets ($ Millions) December 31
Current assets
Cash & cash equivalents
Receivables
Inventories
Other current assets
Total current assets
Non-Current Assets
Property, plant and equipment, net
Intangible assets, net
Other non-current assets
Non-current assets
Total Assets
2001
$2,161
2,000
22,614
1,471
28,246
2000
$2,054
1,768
21,442
1,291
26,555
45,750 40,934
8,595
9,059
860
1,582
55,205 51,575
$83,451 $78,130
Wal-Mart Stores, Inc. Balance Sheet
Liabilities & Stockholders’ Equity ($Mn) 12/31
Current liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Non-current liabilities
Long term debt
Deferred income taxes
Minority interest
Total non-current liabilities
Total liabilities
Shareholder’s equity
Preferred stock equity
Common stock equity
Total equity
Total Liabilities and Stock. Equity
2001
2000
15,617
3,148
8,517
27,282
15,092
6,661
7,196
28,949
18,732
1,128
1,207
21,067
$48,349
15,655
1,043
1,140
17,838
$46,787
0.0
35,102
$35,102
$83,451
0.0
31,343
$31,343
$78,130
Wal-Mart Stores, Inc. Income Statement
($ Millions) December 31
Sales
Cost of sales
Gross operating profit
Selling, general, administrative expenses
Other taxes
EBITDA
Depreciation and amortization
EBIT
Other income, net
Total income avail. for interest expense
Interest expense
Pre-tax income
Income taxes
Total net income
2001
2000
$217,799 $191,329
168,272
147.387
49,527
43,942
36,173
31,550
0.0
0.0
13,354
12,392
3,290
2,868
10,064
9,524
2,013
1,966
12,077
11,490
1,326
1,374
10,751
10,116
3,897
3,692
6,671
6,295
Profitability Ratios for Wal-Mart Stores, Inc.
The gross profit margin measures the percentage of each sales dollar
remaining after the firm pays the direct costs of the goods produced
(gross profit = sales – cost of goods sold).
Gross profit margin =
Gross profits
$49,527
=
 0.227  22.7%
sales
$217,799
The operating profit margin measures profitability as EBIT divided by
sales. EBIT measures profits remaining after all costs deducted from
sales except interest and taxes.
Operating profit margin =
Earnings before interest & taxes $10,064

 0.046  4.6%
sales
$217,799
Profitability Ratios For Wal-Mart Stores, Inc.
(Continued)
The net profit margin measures the percentage of each sales dollar
remaining after all costs are deducted. Highly variable across industries.
Net profit margin =
Net income
$6,671

 0.0306  3.06%
sales
$217,799
Earnings per share measures net profit earned by the firm per share of
common stock outstanding.
Earnings per share =
Net income
$6,671

 $1.49
number of shares of common stock outstandin g 4.5 billion
Profitability Ratios For Wal-Mart Stores, Inc.
(Cont)
The return on total assets (ROA), often called the return on investment
(ROI), measures the overall effectiveness of management in generating
profits with its available assets.
Return on total assets =
Net income $6,671

 0.0799  7.99%
Total assets $83,451
The return on equity (ROE) measures the return earned on the owners’
investment in the firm. This is the closest thing to a single “universal” ratio
as a measure of performance.
Return on common equity =
Net income
$6,671

 0.19 19.0%
Stockholde rs' equity $35,102
Using Financial Ratios For Cross-Sectional
and Trend Analysis
• Cross-sectional analysis: comparing different firms’
financial ratios at the same point in time.
– Usually compared to firm(s) in same industry
– Sources of comparison data include D& B Industry Norms &
Key Business Ratios, RMA Studies
– In benchmarking, a firm compares its ratio values to those
of competitors that it wishes to emulate
• Trend analysis is applied when a financial analyst evaluates
performance over time.
– Developing trends can be seen using multiyear comparison
• The DuPont system used as a search technique to find the
key areas responsible for the firm’s financial condition.
The DuPont System of Analysis
• The DuPont system of analysis is used to dissect the firm’s
financial statements and to assess its financial condition.
– Developed by DuPont in late-1950s; still widely used
• The system merges the income statement and balance
sheet into two summary measures of profitability:
– return on assets (ROA) and
– return on equity (ROE).
• The DuPont system first brings together a firm’s net profit
margin with its total asset turnover.
– Profit margin measures the firm’s profitability on sales
– Turnover indicates how efficiently the firm has used its
assets to generate sales.
ROA = Net Profit Margin x Total Asset Turnover
Using The DuPont System of Analysis
Substituting the net profit margin and total asset turnover formulas into the
DuPont equation and simplifying results in the formula given earlier:
ROA =
Net income
sales
$6,671 $217,699
x


 7.99%
sales
total assets $217,799 $83,451
ROA =
Net income $6,671

 7.99%
total assets $83,451
If the 2001 values of the net profit margin and total asset turnover
for Wal-Mart, are substituted into the DuPont formula, the result is:
ROA = 3.06% x 2.608= 7.99%
Using The DuPont System of Analysis
(Continued)
The second step in the DuPont system uses the modified DuPont
formula. This formula relates the firm’s return on assets (ROA) to the
return on equity (ROE). ROE is calculated by multiplying the return
on assets (ROA) by the financial leverage multiplier, the ratio of total
assets to stockholders’ equity:
ROE =
Net income
total assets
$6,671 $83,451
x

x
 0.0799 x 2.377  18.99%
total assets Stockholde rs' equity $83,451 $35,102
ROE =
Net income
$6,671

 18.99%
Stockholde rs' equity $35,102
The advantage of the DuPont system is that it allows the firm to break its
ROE into a profit-on-sales component (net profit margin), an efficiency-ofasset-use component (total asset turnover), and a use-of-leverage
component (financial leverage multiplier).
PepsiCo, Inc. Balance Sheet
Liabilities & Stockholders’ Equity ($Mn) 12/29
Current liabilities
Short-term borrowings
Accounts payable and other current assets
Total current liabilities
Non-current liabilities
Long term debt
Deferred income taxes
Other non-current liabilities
Total non-current liabilities
Total liabilities
Shareholder’s equity
Common stock equity
Total equity
Total Liabilities and stock equity
2001
2000
$354
4,461
4,998
202
4,529
4,731
2,651
1,496
3,876
8,023
3,009
1,367
3,960
8,336
8,648
8,648
$21,695
7,604
7,604
$20,757
PepsiCo Inc. Income Statement
($ Millions) December 31
Sales
Costs and expenses
Cost of sales
Selling, general, administrative expenses
Amortization of intangible assets
Merger-related costs
Other impairment and restructuring charges
Total costs and expense
Operating profit
Bottling equity income and transaction gains/
(losses), net
Interest expense
Interest income
Income before taxes
Provision for income taxes
Total net income
Net income per common share
2001
$26,935
200
$25,479
10,754
11,608
165
356
31
22,914
4,021
10,226
11,104
147
184
21,661
3,818
160
(219)
67
4,029
1,367
$2,662
$1.47
130
(272)
85
3,761
1,218
$2,543
$1.42
Market Ratios For PepsiCo
The price/earnings (P/E) ratio measures the amount investors are willing
to pay for each dollar of the firm’s earnings. Varies widely by industry.
Price/earn ings (P/E) ratio =
market price per share of common stock $48.6

 33.06
earnings per share
$1.47
The market-to-book (M/B) ratio assesses how investors view the firm’s
past and expected future performance. It relates the market value of the
firm’s shares to their book (accounting) value. To calculate the M/B ratio
for PepsiCo, first need to find book value per share.
Book value per share =
common stock equity
$8,648 million

 $4.8
number of shares of common stock outstandin g
1.8 billion
Market/boo k (M/B) ratio 
Market value per share of common stock $48.6
=
= 10.125
Book value per share of common stock
$4.8
Caveats On The Use Of Ratio Analysis
• No single ratio can provide sufficient information to judge
the overall performance of the firm
– Only ROE remotely useful for comparing all firms
• The financial statements being compared should be dated
at the same point in time during the year
– Seasonality can be very important for certain firms
• Use audited financial statements whenever possible
• Financial data must be developed consistently
– Use of differing accounting treatments—especially relative to
inventory and depreciation—can distort ratio results
• Consider the effects of inflation in C-S or T-S comparisons.
• International comparisons should be viewed with suspicion
– Especially true comparing across systems (US vs German)
Demonstrating Translation Exposure
• Translation exposure is a purely accounting concept
– It measures the potential change in a consolidated financial
statement from a change in exchange rates
• Key measure is the difference between exposed assets and
exposed liabilities
– Exp assets: those whose $ value will change if ER changes
– Exp liabilities: those whose $ value will change if ER changes
– $ values of non-exposed assets do not change if ER changes
• Assume a US Firm has a UK subsidiary and that ER initially
$2.00/£, but then changes to $1.50/£ (pound depreciates)
– Under Current Rate method, all assets and liab translated at
new (current) ER of $1.50/£
– Equity accounts translated at old ER of $2.00/£
Translation Gains & Losses For US Firm
With UK Subsidiary After £ Depreciation
Account
Value in £
Initial $ Value New $ Value
($2.00/£)
($1.50/£)
Current assets
£10,000,000
$20,000,000
$15,000,000
Other assets
£5,000,000
$10,000,000
$7,500,000
£15,000,000
$30,000,000
$22,500,000
Total liabilities
£5,000,000
$10,000,000
$7,500,000
Equity (not exposed)
£10,000,000
$20,000,000
$20,000,000
£10,000,000
$30,000,000
$27,500,000
Total assets
Total liab & capital
Accounting For Translation Gains And
Losses
• In our example, US parent company suffered $5,000,000
translation loss
– $ value of assets declined by $7.5 mm ($30 mm - $22.5 mm)
– $ value of liab declined by only $2.5 mn ($30 mm-$27.5 mm)
– $ value of equity accounts remain unchanged; translated at
historical ER
• Translation loss accounted for in a “Cumulative Translation
Adjustment” equity account
– Debit (loss) balance increased by translation losses, reduced
by translation gains
– Not actually realized (run through income statement) unless
subsidiary sold or closed down.