Working with Financial Statements

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Chapter 3

• Working with Financial Statements

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After studying this chapter, you should be able
to

• Identify sources and uses of cash
• Calculate and interpret measures of a firms
  leverage, liquidity, profitability, asset
  management and market valuation
• Use the DuPont formula to understand the
  determinants of the firms return on assets and
  equity
• Evaluate the potential pitfalls of ratios based
  on accounting data
• Interpret the companys earning record

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Accounting Data

• objectively determinable current values of many
  assets do not exist. Faced with a trade-off
  between relevant, but subjective current values,
  and irrelevant, but objective historical costs,
  accountants have opted for irrelevant, but
  objective historical costs. This means that it is
  the users responsibility to make adjustments.
• Robert Higgins

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Sources and Uses of Cash

• Sources of cash
• Decrease in asset account
• Increase in liabilities or equity account
• Uses of cash
• Increase in asset account
• Decrease in liabilities or equity account
• Sources of cash Uses of cash Net addition
  to cash

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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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Statement of Cash Flows

• Operating Activities
• Net Income
• Depreciation
• Decrease in current asset accounts (except
  cash)
• Increase in current liability accounts (except
  notes payable)
• - Increase in current asset accounts (except
  cash)
• - Increase in current liability accounts (except
  notes payable)

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Statement of Cash Flows

• Investment Activities
• Ending net fixed assets
• - Beginning net fixed assets
• Depreciation
• Financing Activities
• Change in notes payable
• Change in long-term debt
• Change in common stock
• - Dividends

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Statement of Cash Flows

• Putting it all together
• Net cash flow from operating activities
• Fixed asset acquisition
• Net cash flow from financing activities
• Net increase (decrease) in cash over the period

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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

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Standardized Financial Statements

• 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

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Ratio Analysis

• Why are ratios useful?
• Standardize numbers Facilitate comparisons
• Used to highlight weaknesses and strengths

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Ratio Analysis

• Things to keep in mind about a ratio
• How is it calculated?
• What is it intended to measure? Why might we be
  interested?
• What is the unit of measurement?
• What might a high or low value be telling us? How
  can it be misleading?
• How could these measures be improved?

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Ratio Categories

• 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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Liquidity Ratios

• Current ratio
• Acid-test ratio

Current Assets Current Liabilities
Current Assets Inventories Current
Liabilities
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Other Liquidity Ratios
Cash

• Cash Ratio
• NWC to Assets
• Interval Measure

Current Liabilities
Net working capital
Total Assets
Current Assets
Average daily operating costs
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Long-Term Solvency Ratios

• Total debt ratio
• Debt-equity ratio
• Equity multiplier

Total Assets Total Equity
Total Assets
Total Debt
Total Equity
Total Assets
Total Equity
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Long-Term Solvency Ratios

• Long-term debt ratio
• Times interest earned ratio
• Cash coverage ratio

Long-Term Debt
Long-Term Debt Total Equity
EBIT
Interest
EBIT Depreciation
Interest
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Turnover Ratios

• Inventory turnover
• Days sales in inventory

Cost of Goods Sold
Inventory
365 days
Inventory Turnover
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Turnover Ratios

• Receivables turnover
• Days sales in receivables

Sales
Accounts Receivable
365 days
Receivables Turnover
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Asset Turnover Ratios

• NWC turnover
• Fixed asset turnover
• Total asset turnover

Sales
NWC
Sales
Net Fixed Assets
Sales
Total Assets
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Profitability Ratios

• Profit margin
• Return on assets
• Return on equity

Net Income
Sales
Net Income
Total Assets
Net Income
Total Equity
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Market Value Ratios

• Earnings per share
• Price-earnings ratio
• Market-to-book ratio

Net Income
Shares Outstanding
Price per Share
Earnings per Share
Market Value per Share
Book Value per Share
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The Du Pont Identity

• ROA

Net Income
Total Assets
Sales
Net Income


Total Assets
Sales
Total asset turnover
Profit margin
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The Du Pont Identity
Net Income

• ROE

Total Equity
Net Income
Sales
Total Assets



Total Equity
Sales
Total Assets
Net Income
Sales
Total Assets



Total Equity
Sales
Total Assets
Profit margin
Asset turnover
Equity multiplier
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Benchmarking

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• Used to see how the firms performance is
  changing through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes

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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