© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.1
Lecture Outline
• Statement of Cash Flows
• Standardized Financial Statements
• Ratio Analysis
• The Du Pont Identity
• Using Financial Statement Information
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.2
Review of Lecture 1
• Organization of Business Enterprise
• Main Goal – Maximizing Equity Value
• Financial information about the firm is in
– Balance Sheets
– Income Statements
– Cash Flow Statements
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.3
Sample Balance Sheet
Numbers in thousands
2000 1999
Cash &
Equivalents
A/R
3,171 6,489 A/P
1,095,118 1,048,991 N/P
2000
313,286
1999
340,220
Inventory
Other CA
388,947 295,255 Other CL
314,454 232,304 Total CL
227,848 86,631
1,239,651 1,098,602
1,780,785 1,525,453
Total CA
Net FA
1,801,690
3,129,754
1,583,039 LT Debt
2,535,072 C/S
1,389,615
1,761,044
871,851
1,648,490
Total Assets 4,931,444 4,118,111 Total Liab.
& Equity
McGraw-Hill/Irwin
4,931,444 4,118,111
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.4
Sample Income Statement
Numbers in thousands, except EPS & DPS
Revenues 4,335,491
Cost of Goods Sold 1,762,721
Expenses 1,390,262
Depreciation
EBIT
Interest Expense
Taxable Income
Taxes
362,325
820,183
52,841
767,342
295,426
Net Income
EPS
Dividends per share
McGraw-Hill/Irwin
471,916
2.41
0.93
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.7
Sample Statement of Cash Flows
Cash, beginning of year
Operating Activity
Net Income
Plus: Depreciation
Increase in Other CL
Less: Increase in A/R
Increase in Inventory
Increase in Other CA
Decrease in A/P
Numbers in thousands
6,489 Financing Activity
Increase in Notes Payable
471,916
362,325
141,049
Increase in LT Debt
Decrease in C/S
Dividends Paid
-46,127 Net Cash from Financing
-93,692 Net Decrease in Cash
-82,150 Cash End of Year
-26,934
Net Cash from Operations
Investment Activity
Fixed Asset Acquisition
Net Cash from Investments
726,387
-957,007
-957,007 *Difference due to rounding of dividends
141,217
517,764
-36,159
-395,521
227,301
-3,319
3,170*
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.8
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.9
Ratio Analysis
• 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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.10
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.11
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.12
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.
• 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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.13
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.14
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.15
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.16
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.17
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%
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.18
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.19
Deriving the Du Pont Identity
• 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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.20
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.21
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
– Suppliers
– Customers
– Stockholders
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.22
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
– SIC and NAICS codes
• Finding Information on the Web:
CNBC
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.23
Real World Example - I
• International Business Machines Corp.
Industry averages in parenthesis.
• Liquidity ratios
– Current ratio = 1.2 (1.4)
– Quick ratio = 1.0 (1.0)
• Long-term solvency ratio
– Debt/Equity ratio (Debt / Worth) = 0.50 (0.32)
• Coverage ratio
– Times Interest Earned =88.6 (51.5).
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

3.25
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
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.