BUS 349 1

Working With Financial Statements

Chapter 2 & 3
(Bringham et al., 2023)
Dr. Felicia Chong
Felicia.chong@ufv.ca

BUS 349
 Learning Objectives (C2 & C3)

1.Understanding the uses of 4 main financial statements

2.Explain how these statements are related
3.Calculate NOPAT and FCF
4.Explain the uses of FCF
5.Understanding the need for financial statement analysis
6.Applying the following:
1. Common Size Statements – Standardizing Financial Information
2. Using Financial Ratios
3. Selecting a Performance Benchmark
4. The Limitations of Ratio Analysis

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 CHAPTER 2
FINANCIAL STATEMENTS
& CASH FLOWS

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 Financial Statements and
Reports
• A company’s annual reports describes the
operating results from the past year and
new plans for the coming year with four
financial statements:
– Balance sheet
– Income statement
– Statement of shareholders’ equity
– Statement of cash flows

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 Financial Statements and
Reports
• Canda adopted IFRS in 2011 for publicly
traded companies.
• Canadian private companies use either IFRS
or ASPE.
• As of 2011, Canadian GAAP ceased to exist.
• In this class, we refer to IFRS in dealing
with specific accounting issues.

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Financial Statements and
Reports

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The Financial Statements

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Comprehensive Income in
IFRS
• Comprehensive income in IFRS consists of net
income plus other comprehensive income
(OCI).
• OCI examples are unrealized gains or losses in
asset value as a result of asset re-evaluation
and gains or losses on foreign exchange
instruments.

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Statement of Changes in
Equity

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Statement of Changes in
Equity

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 Statement of Cash Flows
• Summarizes the changes in a firm’s cash
position resulting from the firm’s operation
(activities) during a period of time
• Separates the firm’s activities into three
categories:
– Operating activities
– Investing activities
– Financing activities
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Net Cash Flow (NCF)

NCF = NI − Noncash revenues + Noncash charges

NCF = NI + Depreciation and amortization

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 Free Cash Flows (FCFs)

• Financial managers and analysts focus on the

stream of cash flows that the firm will
generate now and in the future.
• Specifically, they focus on free cash flows
(FCF), the cash flow available for distribution
to all investors after making all investments
necessary to sustain ongoing operations.

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Calculating Free Cash Flow

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Net Operating Profit After Taxes (NOPAT)

Net Operating Working Capital (NOWC)

NOWC = Operating current assets –
Operating current liabilities

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Canada, Inc.
 Total Net Operating Capital
(Also Called Operating Capital)
Total net operating capital, (TN)OC
= NOWC + Operating long-term assets

Alternative to Calculating Total Net Operating Capital

Total investor supplied capital
= Notes payable + Long-term bonds +
Preferred stock + Common equity

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 Uses of FCF
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay cash dividends.
4. Buy back stock.
5. Buy non-operating assets (e.g., marketable
securities, investments in other
companies).
FCF = NOPAT – Net investment in operating capital

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 CHAPTER 3
FINANCIAL STATEMENT ANALYSIS

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Financial Analysis
• Financial analysis involves
– Comparing a firm’s performance with that of its
competitors
– Evaluating trends in the firm’s financial position over
time
• Three main groups use ratio analysis:
– Managers
– Credit analysts
– Stock analysts

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 Financial Analysis Process

• Gather data and examine cash flow

statement
• Calculate and examine return on invested
capital and FCF
• Begin ratio analysis

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Common Size Statements –
Standardizing Financial Information

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Common Size Statements –
Standardizing Financial Information

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Sample Income Statement:
H.J. Boswell

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Common Size Income
Statement (H.J. Boswell)

Same
numbers
expressed in
percentage
(sales)

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Observations

The previous table is created by dividing each entry

in the income statement found in by firm sales for
2010.
– Cost of goods sold make up 75% of the firm’s sales
resulting in a gross profit of 25%.
– Selling expenses account for about 3% of sales. Income
taxes account for 4.1% of the firm’s sales.
– After accounting for all expenses, the firm generates
net income of 7.6% of firm’s sales.

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Example - The Balance
H.J. Boswell

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 Common Size
Balance Sheet
(H. J. Boswell, Inc.)

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Observations

The previous table is created by dividing each entry in

the balance sheet by total assets for the year.
– Total current assets increased by 5.6% in 2010 while
total current liabilities declined by 2%.
– Long-term debt account for 39.2% of firm’s assets,
showing a decline of 1.7%.
– Retained earnings increased by 5.8% in 2010.

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Using Financial Ratios

Financial ratios provide a second method for

standardizing the financial information on the income
statement and balance sheet.
•A ratio by itself may have no meaning. Hence, a given ratio is
compared to: (a) ratios from previous years; or (b) ratios of other
firms in the same industry.
•If the differences in the ratios are significant, more in-depth
analysis must be done.

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Category of Financial Ratios

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 Income Statement
2022 2021
Net sales $3,000.0 $2,850.0
Cost of goods sold except depreciation 2,100.0 2,000.0
Depreciation and amortization 100.0 90.0
Other operating expenses 516.2 497.0
EBIT $283.8 $263.0
Int. expense 88.0 60.0
EBT $195.8 $203.0
Taxes (40%) 78.3 81.2
Net income $117.5 $121.8
Preferred dividends 4.0 4.0
Net income available to shareholders (NI) $113.5 $117.8
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3-32
Canada, Inc.
 Balance Sheets: Assets
2022 2021
Cash 10 15
S-T invest. 0 65
AR 375 315
Inventories 615 415
Total CA $1,000 $810
Net FA 1,000 870
Total assets $2,000 $1,680

Copyright © 2023 Cengage Learning

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Canada, Inc.
Balance Sheets: Liabilities and
Equity
2022 2021
Accts. payable 60 30
Notes payable 110 60
Accruals $140 $130
Total CL $310 $220
Long-term bonds 754 580
Total liabilities $1,064 $800
Pref. stock (400,000 shares) 40 40
Com. stock (50,000,000 shares) 130 130
Ret. earnings 766 710
Total common equity $896 $840
Total L&E $2,000 $1,680

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Canada, Inc.
 Other Data
2022 2021
Stock price $23.00 $26.00
Number of shares 50,000,000 50,000,000
EPS $2.27 $2.36
DPS $1.15 $1.06
CFPS $4.27 $4.16
BVPS $17.92 $16.80
Lease payments $28 $28
Tax rate 0.4 0.4

Copyright © 2023 Cengage Learning

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Canada, Inc.
Liquidity Ratios

Liquidity ratios address a basic question: How liquid is

the firm?
A firm is financially liquid if it is able to pay its bills on
time. We can analyze a firm’s liquidity from two
perspectives:
– Overall or general firm liquidity: comparing the firm’s
current asset to its current liability
– Liquidity of specific current asset accounts e.g., how fast
A/R can be converted to cash

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LO3
Computing Liquidity Ratios

Current Ratio: Current Ratio compares a firm’s current

(liquid) assets to its current (short-term) liabilities.

Quick Ratio or Acid Ratio: This ratio excludes the

inventory from current assets as inventory may not
always be very liquid

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Liquidity Ratios: Current Ratio
and Quick Ratios
Using information from Slides 31 – 34, calculate the
following
a)Current and Quick ratios for 2021 and 2022.
b)What do your findings tell you?

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Can a Firm Have Too Much
Liquidity?

A high investment in liquid assets will enable the firm to

repay its current liabilities in a timely manner.

However, an excessive investments in liquid assets can

prove to be costly as liquid assets (such as cash)
generate minimal return.

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Capital Structure Ratios

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Capital Structure Ratios

Debt ratio measures the proportion of the firm’s

assets that are financed by borrowing or debt
financing

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Capital Structure Ratios

Using information from Slides 31 – 34, calculate the

following
a)Debt ratios for 2021 and 2022.
b)What do your findings tell you?

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Capital Structure Ratios

Times Interest Earned Ratio measures the ability of the

firm to service its debt or repay the interest on debt.

We use EBIT or operating income as interest expense is

paid before a firm pays its taxes.

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Capital Structure Ratios

Using information from Slides 31 – 34, calculate the

following
a)Times interest earned for 2021 and 2022.
b)What do these number indicate?

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Activity - Asset Management
Efficiency Ratios

Total Asset Turnover Ratio represents the number of sales

generated per dollar invested in firm’s assets.

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Activity - Asset Management
Efficiency Ratios

Fixed asset turnover ratio measures firm’s efficiency in

utilizing its fixed assets (such as property, plant and
equipment)

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Fixed Assets and Total Assets
Turnover Ratios

• FA turnover is equal to the industry average,

suggesting that the firm has about the right amount
of fixed assets in relation to other firms.
• Note the inflation impact and the different
accounting policies in recording fixed assets when
comparing two firms’ FA ratios.
• TA turnover is not up to industry average and is
caused by excessive current assets (A/R and
inventory).

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Asset Management Efficiency Ratios

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Profitability Ratios

• Profitability ratios address a very fundamental

question: Has the firm earned adequate returns on
its investments?

• We answer this question by analyzing the firm’s

profit margin, which predict the ability of the firm to
control its expenses, and the firm’s rate of return on
investments.

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Profitability Ratios

• Two fundamental determinants of firm’s profitability

and returns on investments are the following:
– Cost Control
• Is the firm controlling costs and earning reasonable
profit margin?

– Efficiency of asset utilization

• Is the firm efficiently utilizing the assets to generate
sales?

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Profitability Ratios: Profit
Margins
• Gross profit margin shows how well the firm’s management
controls its expenses to generate profits.

• Operating Profit Margin measures how much profit is

generated from each dollar of sales after accounting for both
costs of goods sold and operating expenses.
Operating profit margin = EBIT/Sales
• Net Profit Margin measures how much income is generated
from each dollar of sales after adjusting for all expenses
(including income taxes).

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 Profitability Ratios: Rate of Returns on
Investments
• Operating Return on Assets or Basic Earning Power (BEP)
ratio is the summary measure of operating profitability,
which takes into account both the management’s success
in controlling expenses, contributing to profit margins, and
its efficient use of assets to generate sales.

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Profitability Ratios: Rate of Returns
on Investments
• Return on Assets (ROA): Measures the net income that has
been generated using the entire investments of the firm’s
capital in the assets.

• Return on Equity ratio measures the accounting return on the

common stockholders’ investment.

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Effects of Debt on ROA and ROE
• ROA is lowered by debt: Interest expense lowers net
income, which also lowers ROA.

• However, the use of debt lowers equity, and if equity

is lowered more than net income, ROE would
increase. (the denominator effect)

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Using the DuPont Method for
Decomposing the ROE ratio

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Using the DuPont Method for
Decomposing the ROE ratio

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Using the DuPont Method for
Decomposing the ROE ratio

Gitman & Zutter (2015)

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Market Value Ratios

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 Market Value Ratios
• Price-Earnings (PE) Ratio indicates how much investors are
currently willing to pay for $1 of reported earnings.

• Market-to-Book Ratio measures the relationship between the

market value and the accumulated investment in the firm’s
equity.

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 Market Value Ratios

Using information from Slides 31 – 34, calculate the following

a)P/E ratios for 2021 and 2022.
b)M/B ratios for 2021 and 2022.
c)What do your findings tell you if you gathered the following
from the market?
– P/E 2022: 15.3x ; P/E 2021: 14.5x
– M/B 2022: 1.5x ; M/B 2021: 1.7x

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 Summing up the Financial
Analysis.

• Liquidity: The company’s liquidity position have

weakened. The next step will be to see how these ratios
can be improved.

• Financial Leverage: The firm uses more debt than

previous year, which exposes the firm to a higher degree
of financial risk or potential default on its debt in the
future.

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Summing up the Financial
Analysis of H. J. Boswell, Inc.

• Profitability: Profitability margin was very bad in 2022

because of high costs involved. It resulted from
inefficient operations and/or heavy use of debt.

• Market Value Ratios: These ratios suggest that the

market is not very pleased with the firm as indicated by
the lower stock valuations.

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Selecting a Performance
Benchmark

There are two types of benchmarks that are commonly

used:
– Trend Analysis – involves comparing a firm’s financial
statements over time.
– Peer Group Comparisons – involves comparing the subject
firm’s financial statements with those of similar, or “peer”
firms. The benchmark for peer groups typically consists of
firms from the same industry or industry average financial
ratios.

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Trend Analysis

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The Limitations of Ratio Analysis

1. Picking an industry benchmark can sometimes be difficult.

2. Published peer-group or industry averages are not always
representative of the firm being analyzed.
3. An industry average is not necessarily a desirable target or
norm.
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in their
operations.
6. Financial ratios offer only clues. We need to analyze the
numbers in order to fully understand the ratios.
7. The results of financial analysis are dependent on the
quality of the financial statements.

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 Ratios Summary

1. Liquidity Ratios: 2. Financial Leverage Ratios:

Cash Ratio = Cash / Current Equity Multiplier = Total Assets /

Liabilities Total Equity

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 Ratios Summary
3. Asset Management 4. Profitability

Total Asset Turnover (TATO) = Sales / Total

Assets

Total Fixed-asset Turnover = Sales / Total Fixed-

assets

ROA = Net Income / Total Assets

Du Pont Identity:
Days Sales in Invetory= 365÷ inventory turnover ROE = Net Profit Margin × Total Asset Turnover
ratio Ratio × Total Asset/Total Equity
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Ratios Summary

5. Market Value

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End of W2 Lecture

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