Working Wit H Financ Ial State Me Nts

CHAPTER
3
WORKING WITH
F I N A N C I A L S TAT E M E N T S
Key Concepts and
Skills
Standardize financial statements for
comparison purposes
Compute, and more importantly, interpret some
common ratios
Name the determinants of a firm’s profitability
Explain some of the problems and pitfalls in
financial statement analysis
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Cash Flow and Financial Statements:
A Closer Look
Standardized Financial Statements
Chapter Ratio Analysis

Outline
The DuPont Identity
Using Financial Statement Information
Balance Sheet
Current Assets Current Liabilities
Long Term Liabilities

a. Loans
b. Bonds
Fixed Assets
Owner’s Equity (Stock)

and Retained Earnings
Sample Balance Sheet
2018 2017 2018 2017
Cash 108 58 A/P 307 303
A/R 1,156 992 N/P 26 119
Inventory 501 361 Other CL 1,662 1,353

Other CA 403 264 Total CL 1,995 1,775
Total CA 2,168 1,675 LT Debt 843 1,091
Net FA 3,438 3,358 C/S 2,768 2,167
Total 5,606 5,033 Total Liab. 5,606 5,033

Assets & Equity
Numbers in millions of dollars

Sample Income Statement
Revenues 5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (238)
Net Income 893
EPS 4.68
Dividends per share 1.53
Numbers in millions of dollars, except EPS & DPS

Statement of Cash Flows
Statement that summarizes the sources and uses of
cash
Changes 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
Sources and Uses of Cash
Sources
Cash inflow – occurs when we “sell” something
Decrease in asset account (Sample B/S)
◦ Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
◦ Accounts payable, other current liabilities, and common stock
Uses
Cash outflow – occurs when we “buy” something
Increase in asset account
◦ Cash and other current assets
Decrease in liability or equity account
◦ Notes payable and long-term debt
Sources and Uses of Cash Flow
Sources Uses
Decrease in Assets Increase in Assets
Increase in Liabilities Decrease in Liabilities
Depreciation and/ or Amortization Decrease in Stockholders’ Equity
Increase in Stockholders’ Equity Dividends Paid Out
 Categories and Sources of Data

included in the Statement of Cash
B. Cash Flows from Investing
Flows
Activities:
A. Cash Flows from Operating  Changes in gross fixed assets
Activities:  Changes in business interests
 Net Profits after taxes
C. Cash Flows from Financing
 Depreciation and other non-cash charges
Activities:
 Changes in all current assets other than cash
and marketable securities
 Changes in notes payable
 Changes in all current liabilities other than
 Changes in long term debt
notes payable  Changes in stockholders’ equity other than
retained earnings
 Dividends paid
Sample Statement of Cash Flows
Cash, beginning of year 58 Financing Activity
Operating Activity Decrease in Notes Payable -93
Net Income 893 Decrease in LT Debt -248
Plus: Depreciation 116 Change in C/S (less RE) 0
Increase in A/P 4 Dividends Paid -292

Increase in Other CL 309 Net Cash from Financing -633
Less: Increase in other CA -139
Increase in A/R -164 Net Increase in Cash 50
Increase in Inventory -140
Net Cash from Operations 879 Cash End of Year 108
Investment Activity
Purchase of Fixed Assets -196
Net Cash from Investments -196
Numbers in millions of dollars

Standardized Financial
Statements
It’s almost impossible to directly compare the financial statements for two
companies because of differences in size.
It’s difficult even to compare financial statements from different points in time for
the same company if the company’s size has changed. The size problem is
compounded if we try to compare GM and, say, Toyota. If Toyota’s financial
statements are denominated in yen, then we have size and currency differences.
To start making comparisons, one obvious thing we might try to do is to somehow
standardize the financial statements. One common and useful way of doing this is
to work with percentages instead of total dollars. In this section, we describe two
different ways of standardizing financial statements along these lines.
Statements
To get started, a useful way of standardizing financial statements is to
express each item on the balance sheet as a percentage of assets and to
express each item on the income statement as a percentage of sales. The
resulting financial statements are called common-size statements
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.
Common-Size Balance Sheets
PRUFROCK CORPORATION
Common-Size Balance Sheets 2008 and 2009

2008 2009 Change
Assets
Current assets
Cash 2.5% 2.7% + .2%
Accounts receivable 4.9 5.2 + .3
Inventory 11.7 11.8 + .1
Total 19.1 19.7 + .6
Fixed assets
Net plant and equipment 80.9 80.3 − .6
Total assets 100.0% 100.0 .0
%
Liabilities and Owners’ Equity
Current liabilities
Accounts payable 9.2% 9.6% + .4%
Notes payable 6.8 5.5 −1.3
Total 16.0 15.1 − .9
Long-term debt 15.7 12.7 −3.0
Owners’ equity
Common stock and paid-in surplus 14.8 15.3 + .5
Retained earnings 53.3 56.9 +3.6
Total 68.1 72.2 +4.1
Total liabilities and owners’ equity 100.0% 100.0 .0
%
Common-Size Income
Statement
PRUFROCK CORPORATION
Common-Size Income Statement 2009
Sales 100.0%
Cost of goods sold 58.2
Depreciation 11.9
Earnings before interest and taxes 29.9
Interest paid 6.1

Taxable income 23.8
Taxes (34%) 8.1
Net income 15.7%
Dividends 5.2%
Addition to retained earnings 10.5
COMMON–BASE
YEAR FINANCIAL
STATEMENTS:
TREND ANALYSISA standardized financial
statement presenting all items relative to a
certain base year amount.
Imagine we were given balance sheets for the
last 10 years for some company and we were
trying to investigate trends in the firm’s pattern
of operations. Does the firm use more or less
debt? Has the firm grown more or less liquid?
COMMON–BASE YEAR
FINANCIAL STATEMENTS:
The trend analysis we have been discussing can be
combined with the common-size analysis discussed
earlier. The reason for doing this is that as total assets
grow, most of the other accounts must grow as well
For example, looking at Table 3.7, we see that
COMBINED Prufrock’s accounts receivable were $165, or 4.9
percent of total assets, in 2008. In 2009, they had
COMMON- risen to $188, which was 5.2 percent of total assets. If
we do our analysis in terms of dollars, then the 2009
SIZE AND figure would be $188/165 = 1.14, representing a 14
percent increase in receivables. However, if we work
BASE YEAR with the common-size statements, then the 2009
figure would be 5.2%/4.9% = 1.06. This tells us
ANALYSIS accounts receivable, as a percentage of total assets,
grew by 6 percent. Roughly speaking, what we see is
that of the 14 percent total increase, about 8 percent
(= 14% − 6%) is attributable simply to growth in
total assets.
B. Financial
Ratio
Analysis
Ratio analysis involves
methods of calculating and
interpreting financial ratios
to assess a firm’s financial
condition and performance.
It is of interest to
shareholders, creditors, and
the firm’s own management.
Why Evaluate Financial
Statements?
Internal uses External uses

Performance evaluation – Creditors
compensation Suppliers
and comparison between divisions
Customers
Planning for the future – guide in
estimating future cash flows Stockholders
Using Financial
Ratios:
Types of Ratio
Comparisons
Trend or time-series analysis

◦ Used to evaluate a firm’s
performance over time
Using Financial Ratios:
Types of Ratio Comparisons (cont.)
 Trend or time-series analysis
 Cross-sectional analysis
 Used to compare different firms at the same point in time
 Industry comparative analysis
One specific type of cross sectional analysis. Used to compare one firm’s
financial performance to the industry’s average performance
 Benchmarking (Peer Group Analysis)
A type of cross sectional analysis in which the firm’s ratio values are
compared to those of a key competitor or group of competitors.
Compare to similar companies or within industries
SIC codes
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.
Different fiscal years
Extraordinary events
Ratio Analysis
Ratios 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 that
information is important.
Ratios are used both internally and
externally.
Using Financial
Ratios:
Types of Ratio
Comparisons
(cont.)
Trend or time-series
analysis
Cross-sectional analysis
Combined Analysis
◦ Combined analysis
simply uses a
combination of both
time series analysis and
cross-sectional analysis
Using Financial Ratios:
Cautions for Doing Ratio Analysis
Ratios must be considered together; a single ratio by itself

means relatively little.
Financial statements that are being compared should be dated
at the same point in time.
Use audited financial statements when possible.
The financial data being compared should have been
developed in the same way.
Be wary of inflation distortions.
Categories of Financial Ratios
1.Short-term solvency, or liquidity, ratios
2.Long-term solvency, or financial leverage, ratios
3.Asset management, or turnover (Activity), ratios
4. Profitability ratios
5. Market value ratios
1.Computing Liquidity Ratios
B/S
Current Ratio = CA / CL
2,168 / 1,995 = 1.09 times I/S
Quick Ratio = (CA - Inventory) / CL

(2,168 - 501) / 1,995 = .84 times
Cash Ratio = Cash / CL

108 / 1,995 = .05 times
NWC to Total Assets = NWC / TA

(2,168 - 1,995) / 5,606 = .03
Interval Measure = CA / average daily operating costs

2,168 / ((2,006 + 1,740)/365) = 211.2 days
2. Computing Long-term
Solvency Ratios
Total Debt Ratio = (TA - TE) / TA B/S
(5,606 - 2,768) / 5,606 = 50.62%
I/S
Debt/Equity = TD / TE
(5,606 - 2,768) / 2,768 = 1.03 times
Equity Multiplier = TA / TE = 1 + D/E

1 + 1.03 = 2.03
Long-term debt ratio = LTD / (LTD + TE)

843 / (843 + 2,768) = 23.35%
2.Computing Coverage Ratios
Times Interest Earned = EBIT / Interest B/S
 1,138 / 7 = 162.57 times I/S
Cash Coverage = (EBIT + Depreciation) / Interest

 (1,138 + 116) / 7 = 179.14 times
3. Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
 2,006 / 501 = 4.00 times
Days’ Sales in Inventory = 365 / Inventory Turnover

 365 / 4.00 = 91 days
B/S
I/S
3. Computing Receivables Ratios
B/S
Receivables Turnover = Sales / Accounts Receivable I/S
 5,000 / 1,156 = 4.33 times
Days’ Sales in Receivables = 365 / Receivables Turnover

 365 / 4.33 = 84 days
3. Computing Total Asset
Turnover
B/S
Total Asset Turnover = Sales / Total Assets I/S

5,000 / 5,606 = .89
It is not unusual for TAT < 1, especially if a firm has a large
amount of fixed assets
NWC Turnover = Sales / NWC

5,000 / (2,168 - 1,995) = 28.90 times
Fixed Asset Turnover = Sales / NFA

5,000 / 3,438 = 1.45 times
4.Computing Profitability
Measures
B/S
I/S
Profit Margin = Net Income / Sales
 893 / 5,000 = 17.86%
Return on Assets (ROA) = Net Income / Total Assets

 893 / 5,606 = 15.93%
Return on Equity (ROE) = Net Income / Total Equity

 893 / 2,768 = 32.26%
5. Computing Market Value
Measures – I
Market Price = $87.65 per share

Shares outstanding = 190.9 million
PE Ratio = Price per share / Earnings per share
 87.65 / 4.68 = 18.73 times
Market-to-book ratio = Market value per share /

Book value per share
 87.65 / (2,768 / 190.9) = 6.04 times
5. Computing Market Value
Measures – II
Enterprise value = market value of stock + book value of
liabilities - cash
 16,732 + 2,838 - 108 = $19,462
EBITDA ratio = Enterprise value / EBITDA

 19,462 / (1,138 + 116) = 15.52 times
Deriving the DuPont Identity
ROE = NI / TE
Multiply by 1 (TA/TA) and then rearrange

ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA × EM
Multiply by 1 (Sales/Sales) again and then rearrange

ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM × TAT × EM
Using the DuPont Identity
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 does it manage its assets.
Equity multiplier is a measure of the firm’s financial

leverage.
Expanded DuPont Analysis –
DuPont Data
Extended
DuPont
Chart
Work the Web Example
The Internet makes ratio analysis much easier than

it has been in the past.
Go to Reuters website.
Click on Markets, then Stocks, then choose a company and
enter its ticker symbol.
Click on Financials to see what information is available.
Quick Quiz
What is the Statement of Cash Flows, and how do you determine sources
and uses of cash?
How do you standardize balance sheets and income statements and why
is standardization useful?
What are the major categories of ratios and how do you compute specific
ratios within each category?
What are some of the problems associated with financial statement
analysis?
Comprehensive Problem
XYZ Corporation has the following financial information for the previous year:
Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M
Compute the ROE using the DuPont Analysis.
End of Chapter
CHAPTER 3

Working Wit H Financ Ial State Me Nts

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CHAPTER

Standardized Financial Statements

Chapter Ratio Analysis

Using Financial Statement Information

Long Term Liabilities

Owner’s Equity (Stock)

A/R 1,156 992 N/P 26 119

Inventory 501 361 Other CL 1,662 1,353

Net FA 3,438 3,358 C/S 2,768 2,167

Total 5,606 5,033 Total Liab. 5,606 5,033

Numbers in millions of dollars

Numbers in millions of dollars, except EPS & DPS

Changes divided into three major categories

 Categories and Sources of Data

Operating Activity Decrease in Notes Payable -93

Net Income 893 Decrease in LT Debt -248

Plus: Depreciation 116 Change in C/S (less RE) 0

Increase in A/P 4 Dividends Paid -292

Numbers in millions of dollars

Common-Size Balance Sheets 2008 and 2009

Interest paid 6.1

Internal uses External uses

Trend or time-series analysis

Ratios must be considered together; a single ratio by itself

1.Short-term solvency, or liquidity, ratios

2.Long-term solvency, or financial leverage, ratios

3.Asset management, or turnover (Activity), ratios

5. Market value ratios

Quick Ratio = (CA - Inventory) / CL

Cash Ratio = Cash / CL

NWC to Total Assets = NWC / TA

Interval Measure = CA / average daily operating costs

Equity Multiplier = TA / TE = 1 + D/E

Long-term debt ratio = LTD / (LTD + TE)

Cash Coverage = (EBIT + Depreciation) / Interest

Days’ Sales in Inventory = 365 / Inventory Turnover

Days’ Sales in Receivables = 365 / Receivables Turnover

Total Asset Turnover = Sales / Total Assets I/S

NWC Turnover = Sales / NWC

Fixed Asset Turnover = Sales / NFA

Return on Assets (ROA) = Net Income / Total Assets

Return on Equity (ROE) = Net Income / Total Equity

Market Price = $87.65 per share

Market-to-book ratio = Market value per share /

EBITDA ratio = Enterprise value / EBITDA

Multiply by 1 (TA/TA) and then rearrange

Multiply by 1 (Sales/Sales) again and then rearrange

Total asset turnover is a measure of the firm’s asset use

Equity multiplier is a measure of the firm’s financial

The Internet makes ratio analysis much easier than

Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M

Compute the ROE using the DuPont Analysis.

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