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Chapter 3

Chapter 3. Working with Financial Statements. Key Concepts and Skills. Know how to standardize financial statements for comparison purposes Know how to compute and interpret important financial ratios Know the determinants of a firm’s profitability and growth

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Chapter 3

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  1. Chapter 3 Working with Financial Statements

  2. Key Concepts and Skills • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Know the determinants of a firm’s profitability and growth • Understand the problems and pitfalls in financial statement analysis

  3. Chapter Outline • Standardized Financial Statements • Ratio Analysis • The Du Pont Identity

  4. Who needs to understand ratios? • Managers • Use ratios to evaluate various aspects of the firm • Profitability • Productivity • Marketers • Use ratios dealing with costs, markups, and margins • Production personnel • Use ratios that deal with issues such as operating efficiency

  5. Standardized Financial Statements • Common-size statement: a standardized financial statement presenting all items in percentage terms • Common-size Balance Sheet • Balance sheet items shown as a percentage of total assets • Common-size Income Statement • Income statement items shown as a percentage of total sales

  6. Standardized Financial Statements (continued) • Standardized statements make it easier to compare financial information • Standardized statements are useful for comparing companies of different sizes, especially within the same industry

  7. Ratio Analysis • Financial ratios: Relationships determined from a firm’s financial information and used for comparison purposes • Ratios allow for comparison over time or between firms • Ratios are used both internally and externally

  8. 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

  9. Analyzing ratios • Questions to ask when analyzing ratios: • How is the ratio computed? • What does the ratio measure? Why do we care? • What is the unit of measurement? • What does a high/low value tell us? How might such values be misleading? • How could this measure be improved?

  10. Short-term Solvency/Liquidity Ratios • Current Ratio • Formula • What does it measure? • Quick (Acid Test) Ratio • Formula • What does it measure?

  11. Short-term Solvency/Liquidity Ratios (continued) • Cash ratio • Formula • What does it measure?

  12. Financial Leverage Ratios • Total Debt Ratio • Formula • What does it measure? • Debt/Equity Ratio • Formula • What does it measure?

  13. Financial Leverage Ratios (continued) • Equity Multiplier • Formula • What does it measure?

  14. Coverage Ratios • Times Interest Earned ratio • Formula • What does it measure? • Cash Coverage ratio • Formula • What does it measure?

  15. Inventory Ratios • Inventory Turnover ratio • Formula • What does it measure? • Days’ Sales in Inventory • Formula • What does it measure?

  16. Receivables ratios • Receivables Turnover • Formula • What does it measure? • Days’ Sales in Receivables • Formula • What does it measure?

  17. Total Asset Turnover • Total Asset Turnover ratio • Formula • Measures asset use efficiency • It is not unusual for total asset turnover to be less than one, especially if the firm has a large amount of fixed assets

  18. Profitability Ratios • Profitability ratios are the best known and most widely used of all financial ratios • Profit Margin • Formula • What does it measure?

  19. Profitability Ratios (continued) • Return On Assets (ROA) • Formula • What does it measure? • Return On Equity (ROE) • Formula • What does it measure?

  20. Budweiser • Profit margin 12.23% • ROA 12.31% • ROE 61.19%

  21. YUM! • Profit Margin 8.63% • ROA 12.79% • ROE 51.19%

  22. GOOGLE! • Profit margin 23.87% • ROA 21.24% • ROE 23.74%

  23. Market Value Measures • Earnings per share • Net income/number of shares outstanding • $200,000 NI/100,000 shares = $2.00 earnings per share • Price to earnings (PE) ratio • Measures how much investors are willing to pay per dollar of current earnings • Higher PE ratios are often interpreted to mean that the firm has significant prospects for future growth

  24. Market Value Measures • Price per share/Earnings per share • $20 price per share/$2.00 earnings per share = PE ratio of 10

  25. Market Value Measures (continued) • Market-to-book ratio • Compares the market value of the firm’s investments to their cost • Market value per share/book value per share

  26. The Du Pont Formula • The Du Pont formula is named after the Du Pont Corporation, which popularized its use • Allows us to break down ROE into its three basic components • Profit margin, a measure of the firm’s operating efficiency • Total asset turnover, a measure of how well the firm manages its assets • Equity multiplier, a measure of the firm’s financial leverage

  27. The Du Pont Formula (continued) • Du Pont Formula • Profit margin x total asset turnover x equity multiplier • ROE = PM x TAT x EM • If ROE is unsatisfactory, Du Pont tells the financial manager where to start looking for the reasons why

  28. QUIZ • Why is it necessary to standardize financial statements? • How are common-size balance sheets and common-size income statements formed? • What are the five groups of ratios? • Profitability ratios all have the same figure in the numerator. What is it? What do the profitability ratios measure?

  29. QUIZ (continued) What two ratios can be computed if you are given the total debt ratio? ROA is the product of what two ratios? ROE is the product of what three ratios?

  30. The End of Chapter 3!

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