CHAPTER 3

ASSESSING FIRM’S FINANCIAL PERFORMANCE

 CHAPTER 3
W O R K I N G W I T H F I N A N C I A L S TAT E M E N T S

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 CHAPTER OUTLINE

• Standardized Financial Statements

• Ratio Analysis

• The DuPont Identity

• Using Financial Statement Information

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 CHAPTER OUTLINE

• Cash Flow and Financial Statements: A Closer Look

• Standardized Financial Statements

• Ratio Analysis

• The DuPont Identity

• Using Financial Statement Information

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CASH FLOW AND FINANCIAL STATEMENTS: A
CLOSER LOOK
• Activities that bring in cash are called sources of cash, while activities that
involve spending cash are called uses of cash
• An increase in a left-side (asset) account or a decrease in a right-side (liability or
equity) account is a use of cash
• Increase in an asset account means the firm, on a net basis, bought some assets – a use
of cash
• A decrease in a left-side (asset) account or an increase in a right-side (liability or
equity) account is a source of cash
• Decrease in an asset account, on a net basis, means the firm sold some assets (i.e., a net
source)
• To trace the flow of cash through a firm during the year in a detailed fashion, an
income statement is necessary
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 PRUFROCK CORPORATION:
2020 AND 2021 BALANCE SHEETS

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 PRUFROCK CORPORATION:
SUMMARY OF SOURCES AND USES OF CASH

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 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

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 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

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 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

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 THE STATEMENT OF CASH FLOWS

• Statement of cash flows is a firm’s financial statement that summarizes its

sources and uses of cash over a specified period
• Exact form differs in detail from one preparer to the next, but the basic idea is to
group all changes into three categories:
• Operating activities
• Investment activities
• Financing activities
• Standard accounting practices expressly prohibits reporting cash flow per share
• Cash flow is not an alternative to accounting income, so only earnings per share are
to be reported

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 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

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 PRUFROCK CORPORATION:
CASH FLOWS

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 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

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 STANDARDIZED FINANCIAL STATEMENTS

• Nearly impossible to directly compare the financial statements for two companies
because of differences in size
• Similarly challenging to compare financial statements from different points in time for
the same company if the company’s size has changed
• To make comparisons, standardize the financial statements
1. Common-size statements present all items in percentage terms
• Common-size balance sheets typically express each item as a percentage of total assets
• Common-size income statements usually show each item as a percentage of total sales
• Common-size statement of cash flows can be constructed from a “sources and uses of
cash” statement, expressing each item as a percentage of total sources (or total uses)
2. Common-base year statements (i.e., trend analysis) present all items relative to a
certain base year amount

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 STANDARDIZED FINANCIAL STATEMENTS

• Common-Size Balance Sheets

 Compute all accounts as a percent of total assets
 https://www.youtube.com/watch?v=0P5LnD6brQ0
• 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.
• https://www.youtube.com/watch?v=9a1_BVc4Vzk.

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COMMON SIZE FINANCIAL STATEMENT

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PRUFROCK CORPORATION: SUMMARY OF
STANDARDIZED BALANCE SHEETS

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 RATIO ANALYSIS
• Another way of avoiding the problems involved in comparing companies of
different sizes is to calculate and compare financial ratios
• Financial ratios are relationships determined from a firm’s financial information and
used for comparison purposes
• Financial ratios are traditionally grouped into the following categories:
• Short-term solvency, or liquidity, ratios
• Long-term solvency, or financial leverage, ratios
• Asset management, or turnover, ratios
• Profitability ratios
• Market value ratios
• Different people and different sources seldom compute ratios in the same way,
leading to confusion

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 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.

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 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

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 SHORT-TERM SOLVENCY, OR LIQUIDITY, MEASURES
• Current ratio is a measure of short-term liquidity
• To a creditor, the higher this ratio, the better
• To a firm, a high current ratio may indicate an inefficient use of cash and other short-
term assets
• Normally expect to see a current ratio of at least 1
• Quick (or acid-test) ratio is computed just like the current ratio, except inventory is
omitted since it is often the least liquid current asset
• Relatively large inventories are often a sign of short-term trouble
• Cash ratio may be of interest to a very short-term creditor
• Net working capital to total assets
• Low values might indicate relatively low levels of liquidity
• Interval measure indicates how long the business can continue

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 LONG-TERM SOLVENCY RATIOS

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 COMPUTING LIQUIDITY RATIOS
• Current Ratio = CA / CL
 2,168 / 1,995 = 1.09 times B/S
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

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 LONG-TERM SOLVENCY MEASURES
• Total debt ratio considers all debts of all maturities to all creditors and has two
useful variations:
• Debt-equity ratio
• Equity multiplier
• Long-term debt ratio is calculated as long-term debt divided by the sum of long-
term debt and total equity
• Times interest earned (TIE) ratio measures how well a company has its interest
obligations covered, and is often called the interest coverage ratio
• Cash coverage ratio is a basic measure of the firm’s ability to generate cash from
operations and is frequently used as a measure of cash flow available to meet
financial obligations
• Calculated similarly to the TIE ratio, except the numerator is EBITD (earnings before
interest, taxes, and depreciation) instead of EBIT
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ASSET MANAGEMENT, OR TURNOVER,
RATIOS

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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%
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 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

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 ASSET MANAGEMENT, OR TURNOVER, MEASURES
• Inventory turnover tells us how many times the firm sold off or turned over the entire
inventory
• Days’ sales in inventory tells us how many days inventory sits (on average) before it is sold
• Receivables turnover shows how many times a firm collects outstanding credit
accounts and reloans the money
• Days’ sales in receivables provides the average number of days it takes for a firm to collect
on its credit sales
• Asset turnover ratios
• NWC turnover measures how much “work” we get out of our working capital
• Fixed asset turnover tells us how much the company generates in sales for every dollar in
fixed assets
• Total assets turnover tells us how much the company generates in sales for every dollar in
assets

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 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

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 COMPUTING RECEIVABLES RATIOS

• Receivables Turnover = B/S

Sales / Accounts Receivable I/S
 5,000 / 1,156 = 4.33 times

• Days’ Sales in Receivables =

365 / Receivables Turnover
 365 / 4.33 = 84 days

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 COMPUTING TOTAL ASSET TURNOVER
B/S
• Total Asset Turnover =
I/S
Sales / Total Assets
 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
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 PROFITABILITY RATIOS

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 PROFITABILITY MEASURES
• Profit margin measures how well a company makes money (i.e., how much money
it generates in profit for every dollar in sales)
• All other things equal, a relatively high profit margin is desirable
• Significant variation in profit margins across industries

• Remember that ROA and ROE are accounting rates of return; as such, they should
properly be called return on book assets and return on book equity
• Return on assets (ROA) is a measure of profit per dollar of assets
• Return on equity (ROE) is a measure of how the stockholders fared during the year (i.e.,
how much money the company generated in profit for every dollar in equity)

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 COMPUTING PROFITABILITY MEASURES
B/S
• Profit Margin = Net Income / Sales
I/S
 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%

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 MARKET VALUE RATIOS

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 MARKET VALUE MEASURES
• Price-earnings (PE) ratio measures how much investors are willing to pay per
dollar of current earnings
• Vary significantly across companies, but, in 2020, a typical large company in the
U.S. had a PE in the 15-20 range
• Higher PEs are often taken to mean the firm has significant prospects for future
growth, but it could also mean a firm had no (or almost no) earnings
• Price-sales ratio is useful if PE ratio is not meaningful due (e.g., firm has
negative earnings for extended periods)
• Market-to-book ratio compares the market value of the firm’s investments to
their costs
• Value less than 1 could mean that the firm has not been successful overall in
creating value for its stockholders
• Focuses on historical costs, which are less relevant
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 MARKET VALUE MEASURES (CONTINUED)
• Tobin’s Q ratio is superior to the market-to-book ratio because it focuses on what
the firm is worth today relative to what it would cost to replace it today
• Firms with high Q ratios tend to be those with attractive investment opportunities or
significant competitive advantages (or both)
• Difficult to calculate with accuracy because estimating the replacement cost of a firm’s
assets is not an easy task and market values for a firm’s debt are often unobservable
• Enterprise value-EBITDA multiple relates the value of all the operating assets (i.e.,
enterprise value) to a measure of the operating cash flow generated by those assets
(EBITDA)
• Enterprise value is an estimate of the market value of the company’s operating assets,
which include all assets of the firm except cash

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 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 (Available to the common stockholders/ No
of shares outstanding)
 87.65 / (2,768 / 190.9) = 6.04 times
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COMPUTING MARKET VALUE MEASURES – II

• Enterprise value =
market value of stock + book value of liabilities - cash
=16,732 + 2,838 - 108 = $19,462 Note= MVS= Mkt price * No of shares outstanding=
$87.65 *190.9 million=

• EBITDA ratio = Enterprise value / EBITDA

 19,462 / (1,138 + 116) = 15.52 times

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 SUMMARY

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 SUMMARY

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 SUMMARY

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