40 Ross−Westerfield−Jaffe: I. Overview 2.

Accounting Statements © The McGraw−Hill

Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

Chapter 2 Accounting Statements and Cash Flow 33

a. Determine the change in net working capital in 20X2.

b. Determine the cash flow during the year 20X2.

Appendix 2A FINANCIAL STATEMENT ANALYSIS

The objective of this appendix is to show how to rearrange information from financial state-
ments into financial ratios that provide information about five areas of financial performance:
1. Short-term solvency—the ability of the firm to meet its short-run obligations.
2. Activity—the ability of the firm to control its investment in assets.
3. Financial leverage—the extent to which a firm relies on debt financing.
4. Profitability—the extent to which a firm is profitable.
5. Value—the value of the firm.
Financial statements cannot provide the answers to the preceding five measures of per-
formance. However, management must constantly evaluate how well the firm is doing, and
financial statements provide useful information. The financial statements of the U.S.
Composite Corporation, which appear in Tables 2.1, 2.2, and 2.3, provide the information
for the examples that follow. (Monetary values are given in $ millions.)

Short-Term Solvency
Ratios of short-term solvency measure the ability of the firm to meet recurring financial ob-
ligations (that is, to pay its bills). To the extent a firm has sufficient cash flow, it will be able
to avoid defaulting on its financial obligations and, thus, avoid experiencing financial dis-
tress. Accounting liquidity measures short-term solvency and is often associated with net
working capital, the difference between current assets and current liabilities. Recall that
current liabilities are debts that are due within one year from the date of the balance sheet.
The basic source from which to pay these debts is current assets.
The most widely used measures of accounting liquidity are the current ratio and the
quick ratio.
Current Ratio To find the current ratio, divide current assets by current liabilities. For the
U.S. Composite Corporation, the figure for 20X2 is
Total current assets 761
Current ratio


1.57
Total current liabilities 486
If a firm is having financial difficulty, it may not be able to pay its bills (accounts payable)
on time or it may need to extend its bank credit (notes payable). As a consequence, current
liabilities may rise faster than current assets and the current ratio may fall. This may be the
first sign of financial trouble. Of course, a firm’s current ratio should be calculated over sev-
eral years for historical perspective, and it should be compared to the current ratios of other
firms with similar operating activities.
Quick Ratio The quick ratio is computed by subtracting inventories from current assets
and dividing the difference (called quick assets) by current liabilities:
Quick assets 492
Quick ratio


1.01
Total current liabilities 486
Quick assets are those current assets that are quickly convertible into cash. Inventories are
the least liquid current assets. Many financial analysts believe it is important to determine
a firm’s ability to pay off current liabilities without relying on the sale of inventories.
 Ross−Westerfield−Jaffe: I. Overview 2. Accounting Statements © The McGraw−Hill 41
Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

34 Part I Overview

Activity
Ratios of activity are constructed to measure how effectively the firm’s assets are being
managed. The level of a firm’s investment in assets depends on many factors. For example,
Toys ’R Us might have a large stock of toys at the peak of the Christmas season; yet that
same inventory in January would be undesirable. How can the appropriate level of invest-
ment in assets be measured? One logical starting point is to compare assets with sales for
the year to arrive at turnover. The idea is to find out how effectively assets are used to gen-
erate sales.
Total Asset Turnover The total asset turnover ratio is determined by dividing total oper-
ating revenues for the accounting period by the average of total assets. The total asset
turnover ratio for the U.S. Composite Corporation for 20X2 is
Total operating revenues 2,262
Total asset turnover8


1.25
Total assets 冠average冡 1,810.5
1,879  1,742
Average total assets

1,810.5
2
This ratio is intended to indicate how effectively a firm is using all of its assets. If the asset
turnover ratio is high, the firm is presumably using its assets effectively in generating sales.
If the ratio is low, the firm is not using its assets to their capacity and must either increase
sales or dispose of some of the assets. One problem in interpreting this ratio is that it is max-
imized by using older assets because their accounting value is lower than newer assets.
Also, firms with relatively small investments in fixed assets, such as retail and wholesale
trade firms, tend to have high ratios of total asset turnover when compared with firms that
require a large investment in fixed assets, such as manufacturing firms.
Receivables Turnover The ratio of receivables turnover is calculated by dividing sales by
average receivables during the accounting period. If the number of days in the year (365) is
divided by the receivables turnover ratio, the average collection period can be determined.
Net receivables are used for these calculations.9 The receivables turnover ratio and average
collection period for the U.S. Composite Corporation are
Total operating revenues 2,262
Receivables turnover


8.02
Receivables 冠average冡 282
294  270
Average receivables

282
2
Days in period 365
Average collection period


45.5 days
Receivables turnover 8.02
The receivables turnover ratio and the average collection period provide some information
on the success of the firm in managing its investment in accounts receivable. The actual
value of these ratios reflects the firm’s credit policy. If a firm has a liberal credit policy, the
amount of its receivables will be higher than would otherwise be the case. One common
rule of thumb that financial analysts use is that the average collection period of a firm should
not exceed the time allowed for payment in the credit terms by more than 10 days.

8
Notice that we use an average of total assets in our calculation of total asset turnover. Many financial analysts
use the end of period total asset amount for simplicity.
9
Net receivables are determined after an allowance for potential bad debts.
42 Ross−Westerfield−Jaffe: I. Overview 2. Accounting Statements © The McGraw−Hill
Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

Chapter 2 Accounting Statements and Cash Flow 35

Inventory Turnover The ratio of inventory turnover is calculated by dividing the cost of
goods sold by average inventory. Because inventory is always stated in terms of historical cost,
it must be divided by cost of goods sold instead of sales (sales include a margin for profit and
are not commensurate with inventory). The number of days in the year divided by the ratio of
inventory turnover yields the ratio of days in inventory. The ratio of days in inventory is the
number of days it takes to get goods produced and sold; it is called shelf life for retail and
wholesale trade firms. The inventory ratios for the U.S. Composite Corporation are
Cost of goods sold 1,655
Inventory turnover


6.03
Inventory 冠average冡 274.5
269  280
Average inventory

274.5
2
Days in period 365
Days in inventory


60.5 days
Inventory turnover 6.03
The inventory ratios measure how quickly inventory is produced and sold. They are signif-
icantly affected by the production technology of goods being manufactured. It takes longer
to produce a gas turbine engine than a loaf of bread. The ratios also are affected by the per-
ishability of the finished goods. A large increase in the ratio of days in inventory could sug-
gest an ominously high inventory of unsold finished goods or a change in the firm’s prod-
uct mix to goods with longer production periods.
The method of inventory valuation can materially affect the computed inventory ratios.
Thus, financial analysts should be aware of the different inventory valuation methods and
how they might affect the ratios.

Financial Leverage
Financial leverage is related to the extent to which a firm relies on debt financing rather than
equity. Measures of financial leverage are tools in determining the probability that the firm
will default on its debt contracts. The more debt a firm has, the more likely it is that the firm
will become unable to fulfill its contractual obligations. In other words, too much debt can
lead to a higher probability of insolvency and financial distress.
On the positive side, debt is an important form of financing, and provides a significant
tax advantage because interest payments are tax deductible. If a firm uses debt, creditors
and equity investors may have conflicts of interest. Creditors may want the firm to invest in
less risky ventures than those the equity investors prefer.
Debt Ratio The debt ratio is calculated by dividing total debt by total assets. We can also
use several other ways to express the extent to which a firm uses debt, such as the debt-to-
equity ratio and the equity multiplier (that is, total assets divided by equity). The debt ra-
tios for the U.S. Composite Corporation for 20X2 are
Total debt 1,074
Debt ratio


0.57
Total assets 1,879
Total debt 1,074
Debt-to-equity ratio


1.33
Total equity 805
Total assets 1,879
Equity multiplier


2.33
Total equity 805
Debt ratios provide information about protection of creditors from insolvency and the abil-
ity of firms to obtain additional financing for potentially attractive investment opportunities.
However, debt is carried on the balance sheet simply as the unpaid balance. Consequently,
 Ross−Westerfield−Jaffe: I. Overview 2. Accounting Statements © The McGraw−Hill 43
Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

36 Part I Overview

no adjustment is made for the current level of interest rates (which may be higher or lower
than when the debt was originally issued) or risk. Thus, the accounting value of debt may
differ substantially from its market value. Some forms of debt may not appear on the balance
sheet at all, such as pension liabilities or lease obligations.
Interest Coverage The ratio of interest coverage is calculated by dividing earnings (be-
fore interest and taxes) by interest. This ratio emphasizes the ability of the firm to generate
enough income to cover interest expense. This ratio for the U.S. Composite Corporation is
Earnings before interest and taxes 219
Interest coverage


4.5
Interest expense 49
Interest expense is an obstacle that a firm must surmount if it is to avoid default. The ratio
of interest coverage is directly connected to the ability of the firm to pay interest. However,
it would probably make sense to add depreciation to income in computing this ratio and to
include other financing expenses, such as payments of principal and lease payments.
A large debt burden is a problem only if the firm’s cash flow is insufficient to make the
required debt service payments. This is related to the uncertainty of future cash flows. Firms
with predictable cash flows are frequently said to have more debt capacity than firms with
high, uncertain cash flows. Therefore, it makes sense to compute the variability of the firm’s
cash flows. One possible way to do this is to calculate the standard deviation of cash flows
relative to the average cash flow.

Profitability
One of the most difficult attributes of a firm to conceptualize and to measure is profitabil-
ity. In a general sense, accounting profits are the difference between revenues and costs. Un-
fortunately, there is no completely unambiguous way to know when a firm is profitable. At
best, a financial analyst can measure current or past accounting profitability. Many business
opportunities, however, involve sacrificing current profits for future profits. For example,
all new products require large start-up costs and, as a consequence, produce low initial prof-
its. Thus, current profits can be a poor reflection of true future profitability. Another prob-
lem with accounting-based measures of profitability is that they ignore risk. It would be
false to conclude that two firms with identical current profits were equally profitable if the
risk of one was greater than the other.
The most important conceptual problem with accounting measures of profitability is
they do not give us a benchmark for making comparisons. In general, a firm is profitable in
the economic sense only if its profitability is greater than investors can achieve on their own
in the capital markets.
Profit Margin Profit margins are computed by dividing profits by total operating revenue
and thus they express profits as a percentage of total operating revenue. The most impor-
tant margin is the net profit margin. The net profit margin for the U.S. Composite Corpora-
tion is
Net income 86
Net profit margin


0.038 冠3.8%冡
Total operating revenue 2,262
Earnings before interest and taxes 219
Gross profit margin


0.097 冠9.7%冡
Total operating revenues 2,262
In general, profit margins reflect the firm’s ability to produce a product or service at a low cost
or a high price. Profit margins are not direct measures of profitability because they are based
on total operating revenue, not on the investment made in assets by the firm or the equity in-
vestors. Trade firms tend to have low margins and service firms tend to have high margins.
44 Ross−Westerfield−Jaffe: I. Overview 2. Accounting Statements © The McGraw−Hill
Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

Chapter 2 Accounting Statements and Cash Flow 37

Return on Assets One common measure of managerial performance is the ratio of income
to average total assets, both before tax and after tax. These ratios for the U.S. Composite
Corporation for 20X2 are
Net income 86
Net return on assets


0.0475 冠4.75%冡
Average total assets 1,810.5
Earnings before interest and taxes 219
Gross return on assets


0.121 冠12.1%冡
Average total assets 1,810.5
One of the most interesting aspects of return on assets (ROA) is how some financial ratios
can be linked together to compute ROA. One implication of this is usually referred to as the
DuPont system of financial control. This system highlights the fact that ROA can be ex-
pressed in terms of the profit margin and asset turnover. The basic components of the sys-
tem are as follows:
ROA
Profit margin  Asset turnover
Net income Total operating revenue
ROA (net)

Total operating revenue Average total assets
0.0475
0.038  1.25
Earnings before interest and taxes Total operating revenue
ROA (gross)

Total operating revenue Average total assets
0.121
0.097  1.25
Firms can increase ROA by increasing profit margins or asset turnover. Of course, compe-
tition limits their ability to do so simultaneously. Thus, firms tend to face a trade-off be-
tween turnover and margin. In retail trade, for example, mail-order outfits such as L. L.
Bean have low margins and high turnover, whereas high-quality jewelry stores such as
Tiffany’s have high margins and low turnover.
It is often useful to describe financial strategies in terms of margins and turnover. Suppose
a firm selling pneumatic equipment is thinking about providing customers with more liberal
credit terms. This will probably decrease asset turnover (because receivables would increase
more than sales). Thus, the margins will have to go up to keep ROA from falling.
Return on Equity This ratio (ROE) is defined as net income (after interest and taxes) di-
vided by average common stockholders’ equity, which for the U.S. Composite Corporation is
Net income 86
ROE


0.112 冠11.27%冡
Average stockholders' equity 765
805  725
Average stockholders' equity

765
2
The most important difference between ROA and ROE is due to financial leverage. To see
this, consider the following breakdown of ROE:
ROE
Profit margin  Asset turnover  Equity multiplier
Total operating Average
Net income revenue total assets

 
Total operating Average total Average stockholders'
revenue assets equity
0.112
0.038  1.25  2.36
From the preceding numbers, it would appear that financial leverage always magnifies
ROE. Actually, this occurs only when ROA (gross) is greater than the interest rate on debt.
 Ross−Westerfield−Jaffe: I. Overview 2. Accounting Statements © The McGraw−Hill 45
Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

38 Part I Overview

Payout Ratio The payout ratio is the proportion of net income paid out in cash dividends.
For the U.S. Composite Corporation
Cash dividends 43
Payout ratio


0.5
Net income 86
The retention ratio for the U.S. Composite Corporation is
Retained earnings 43
Retention ratio


0.5
Net income 86
Retained earnings
Net income  Dividends

The Sustainable Growth Rate

One ratio that is very helpful in financial analysis is called the sustainable growth rate.
It is the maximum rate of growth a firm can maintain without increasing its financial
leverage and using internal equity only. The precise value of sustainable growth can be
calculated as
Sustainable growth rate
ROE  Retention ratio
For the U.S. Composite Company, ROE is 11.2 percent. The retention ratio is 1/2, so we
can calculate the sustainable growth rate as
Sustainable growth rate
11.2  (1/2)
5.6%
The U.S. Composite Corporation can expand at a maximum rate of 5.6 percent per year
with no external equity financing or without increasing financial leverage. (We discuss sus-
tainable growth in Chapters 5 and 26.)

Market Value Ratios

We can learn many things from a close examination of balance sheets and income state-
ments. However, one very important characteristic of a firm that cannot be found on an ac-
counting statement is its market value.
Market Price The market price of a share of common stock is the price that buyers and
sellers establish when they trade the stock. The market value of the common equity of a
firm is the market price of a share of common stock multiplied by the number of shares
outstanding.
Sometimes the words “fair market value” are used to describe market prices. Fair mar-
ket value is the amount at which common stock would change hands between a willing
buyer and a willing seller, both having knowledge of the relevant facts. Thus, market prices
give guesses about the true worth of the assets of a firm. In an efficient stock market, mar-
ket prices reflect all relevant facts about firms, and thus market prices reveal the true value
of the firm’s underlying assets.
The market value of IBM is many times greater than that of Apple Computer. This may
suggest nothing more than the fact that IBM is a bigger firm than Apple (hardly a surpris-
ing revelation). Financial analysts construct ratios to extract information that is independ-
ent of a firm’s size.
Price-to-Earnings (P/E) Ratio One way to calculate the P/E ratio is to divide the current
market price by the earnings per share of common stock for the latest year. The P/E ratios
of some of the largest firms in the United States and Japan are as follows:
46 Ross−Westerfield−Jaffe: I. Overview 2. Accounting Statements © The McGraw−Hill
Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

Chapter 2 Accounting Statements and Cash Flow 39

P/E Ratios
2000

United States Japan

AT&T 24 Nippon Telegraph & Telephone 53
General Motors 8 Toyota Motor 44
Hewlett Packard 43 Sony 72

As can be seen, some firms have high P/E ratios (Sony, for example) and some firms have
low ones (General Motors).
Dividend Yield The dividend yield is calculated by annualizing the last observed dividend
payment of a firm and dividing by the current market price:
Dividend per share
Dividend yield

Market price per share
The dividend yields for several large firms in the United States and Japan are:
Dividend Yield (%)
2000
United States Japan
AT&T 0.9 Nippon Telegraph & Telephone 0.4
General Motors 2.0 Toyota Motor 0.5
Hewlett Packard 0.6 Sony 0.3

Dividend yields are related to the market’s perception of future growth prospects for firms.
Firms with high growth prospects will generally have lower dividend yields.
Market-to-Book (M/B) Value and the Q ratio The market-to-book value ratio is calcu-
lated by dividing the market price per share by the book value per share.
The market-to-book ratios of several of the largest firms in the United States and
Japan are:
Market-to-Book Ratios
2000

United States Japan

AT&T 1 Nippon Telegraph & Telephone 3.4
General Motors 2.4 Toyota Motor 2.8
Hewlett Packard 8 Sony 3.5

There is another ratio, called Tobin’s Q, that is very much like the M/B ratio.10 Tobin’s Q
ratio divides the market value of all of the firm’s debt plus equity by the replacement value
of the firm’s assets. The Q ratios for several firms are:
Q Ratio11
High Qs Coca-Cola 4.2
IBM 4.2
Low Qs National Steel 0.53
U.S. Steel 0.61

10
Kee H. Chung and Stephen W. Pruitt, “A Simple Approximation of Tobin’s Q,” Financial Management
Vol 23, No. 3 (Autumn 1994).
11
E. B. Lindberg and S. Ross, “Tobin’s Q and Industrial Organization,” Journal of Business 54 (January 1981).
 Ross−Westerfield−Jaffe: I. Overview 2. Accounting Statements © The McGraw−Hill 47
Corporate Finance, Sixth and Cash Flow Companies, 2002
Edition

40 Part I Overview

The Q ratio differs from the M/B ratio in that the Q ratio uses market value of the debt
plus equity. It also uses the replacement value of all assets and not the historical cost
value.
It should be obvious that if a firm has a Q ratio above 1 it has an incentive to in-
vest that is probably greater than a firm with a Q ratio below 1. Firms with high Q ra-
tios tend to be those firms with attractive investment opportunities or a significant com-
petitive advantage.

SUMMARY AND CONCLUSIONS

Much research indicates that accounting statements provide important information about
the value of the firm. Financial analysts and managers learn how to rearrange financial
statements to squeeze out the maximum amount of information. In particular, analysts and
managers use financial ratios to summarize the firm’s liquidity, activity, financial leverage,
and profitability. When possible, they also use market values. This appendix describes the
most popular financial ratios. You should keep in mind the following points when trying to
interpret financial statements:
1. Measures of profitability such as return on equity suffer from several potential deficien-
cies as indicators of performance. They do not take into account the risk or timing of
cash flows.
2. Financial ratios are linked to one another. For example, return on equity is determined
from the profit margins, the asset turnover ratio, and the financial leverage.

Appendix 2B STATEMENT OF CASH FLOWS

There is an official accounting statement called the statement of cash flows. This statement
helps explain the change in accounting cash, which for U.S. Composite is $33 million in
20X2. It is very useful in understanding financial cash flow. Notice in Table 2.1 that cash
increases from $107 million in 20X1 to $140 million in 20X2.
The first step in determining the change in cash is to figure out cash flow from operat-
ing activities. This is the cash flow that results from the firm’s normal activities producing
and selling goods and services. The second step is to make an adjustment for cash flow from
investing activities. The final step is to make an adjustment for cash flow from financing ac-
tivities. Financing activities are the net payments to creditors and owners (excluding inter-
est expense) made during the year.
The three components of the statement of cash flows are determined below.

Cash Flow from Operating Activities

To calculate cash flow from operating activities we start with net income. Net income can
be found on the income statement and is equal to 86. We now need to add back noncash ex-
penses and adjust for changes in current assets and liabilities (other than cash). The result
is cash flow from operating activities.