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Working With Financial Statements

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  1. Chapter Three Working With Financial Statements

  2. Key Concepts and Skills • Understand sources and uses of cash and the Statement of Cash Flows • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Be able to compute and interpret the Du Pont Identity • Understand the problems and pitfalls in financial statement analysis

  3. Chapter Outline • Cash Flow and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The Du Pont Identity • Using Financial Statement Information

  4. Balance Sheet, As of Dec 31 See 3.5: Sources & Uses of Cash

  5. Income Statement: Jan 1 – Dec 31, 2000 Numbers are in thousands, except EPS & DPS

  6. Sources and Uses of Cash 3.1 • Sources • Cash inflow – occurs when we “sell” something • Decrease in asset account (sell inventory, fixed assets, etc) • Increase in liability or equity account (sell a bond, common stock, etc) • Uses • Cash outflow – occurs when we “buy” something • Increase in asset account (buy inventory or fixed assets) • Decrease in liability or equity account (Redeem bonds or shares)

  7. Statement of Cash Flows • Statement of Cash Flows – the 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

  8. Sample Statement of Cash Flows Numbers are in thousands From the B/S

  9. Standardized Financial Statements 3.2 • 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

  10. Common Size Income Statement: Example Income Common Size Statement Income Statement Revenue $70,134 100.0% Cost of Goods Sold $44,221 63.1% Gross Profit $25,913 36.9% SG&A $13,531 19.3% Operating Income $12,382 17.7% Interest Expense $2,862 4.1% Taxes $3,766 5.4% Net Income $5,754 8.2%

  11. Common Size: Balance Sheet Common Size Assets Balance Sheet Balance Sheet Cash & Securities $ 6,029 15.1% Accounts Receivable $14,378 36.0% Inventory $17,136 42.9% Total Current Assets $37,543 93.9% Plant & Equipment $ 2,442 6.1% Total Assets $39,985 100%

  12. Common Size: Balance Sheet Common Size Liabilities Balance Sheet Balance Sheet Current Liabilities $ 14,251 35.6% Long Term Debt $12,624 31.6% Total Liabilities $26,875 67.2% Shareholder’s Equity $13,110 32.8% Total Liab. & Equity $39,985 100%

  13. Ratio Analysis 3.3 • Ratios also allow for better comparison through time or between companies • As we look at each ratio, ask yourself • How is the ratio computed? • What is it intended to measure (and why do I care about measuring this variable)? • What might a high or a low value tell us? How might such a value be misleading? • How could this measure be improved? • Ratios are used both internally and externally

  14. Categories of Financial Ratios • Liquidity ratios (Measure short term solvency) • Financial leverage ratios (Long-term solvency) • Asset management ratios • Profitability ratios • Market value ratios

  15. Liquidity Ratios • Current Ratio = Current Assets / Current Liabilities • 1,801,690 / 1,780,785 = 1.01 times • Quick Ratio = Current Assets – Inventory Current Liabilities • (1,801,690 – 388,947) / 1,780,785 = .793 times • Cash Ratio = Cash / Current Liabilities • 3,171 / 1,780,785 = .002 times

  16. Computing Long-term Solvency Ratios • Total Debt Ratio = Total Assets – Total Equity Total Assets • (4,931,444 – 1,761,044) / 4,931,444 = .6429 times or 64.29% • The firm finances approximately 64% of its assets with debt. • Debt/Equity = Total Debt / Total Equity • (4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times • Equity Multiplier = Total Assets / Total Equity = 1 + D/E • 1 + 1.800 = 2.800

  17. Computing Coverage Ratios • Times Interest Earned = EBIT / Interest • 820,183 / 52,841 = 15.5 times • Cash Coverage = (EBIT + Depreciation) / Interest • (820,183 + 362,325) / 52,841 = 22.38 times

  18. Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory • 1,762,721 / 388,947 = 4.53 times • Days’ Sales in Inventory = 365 / Inventory Turnover • 365 / 4.53 = 81 days

  19. Computing Receivables Ratios • Receivables Turnover = Sales / Accounts Receivable • 4,335,491 / 1,095,118 = 3.96 times • Days’ Sales in Receivables = 365 / Receivables Turnover • 365 / 3.96 = 92 days

  20. Computing Total Asset Turnover • NWC Turnover = Sales / NWC • 4,335,491 / (1,801,690 - 1,780,785) = 207.390 times • Fixed Asset Turnover = Sales / Net Fixed Assets • 4,335,491 / 3,129,754 = 1.385 times • Total Asset Turnover = Sales / Total Assets • 4,335,491 / 4,931,444 = .88 times • Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

  21. Computing Profitability Measures • Profit Margin = Net Income / Sales • 471,916 / 4,335,491 = .1088 times or 10.88% • Return on Assets (ROA) = Net Income / Total Assets • 471,916 / 4,931,444 = .0957 times or 9.57% • Return on Equity (ROE) = Net Income / Total Equity • 471,916 / 1,761,044 = .2680 times or 26.8%

  22. Computing Market Value Measures • Market Price = $60.98 per share • Shares outstanding = 205,838,910 • PE Ratio = Price per share / Earnings per share • 60.98 / 2.41 = 25.3 times • Market-to-book ratio = market value per share / book value per share • 60.98 / (1,761,044,000 / 205,838,910) = 7.1 times

  23. Table 3.8 – Common Financial Ratios

  24. Table 3.8 – Common Financial Ratios

  25. Deriving the Du Pont Identity 3.4 • Multiply by 1 and then rearrange NI = Net Income TE = Total Equity TA = Total Assets

  26. Deriving the Du Pont Identity • Multiply by 1 again and then rearrange

  27. Using the Du Pont Identity • ROE = PM * AY * EM • Profit margin is a measure of the firm’s operating efficiency – how well does it control costs • Asset Yield (Total asset turnover) is a measure of the firm’s asset use efficiency – how well does it manage its assets in driving sales • Equity multiplier is a measure of the firm’s financial leverage

  28. Using Financial Statement Information 3.5 • Internal uses • Performance evaluation – compensation and comparison between divisions • Planning for the future – guide in estimating future cash flows • External uses • Creditors • Suppliers • Customers • Stockholders

  29. Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something • Time-Trend Analysis • Used to see how the firm’s performance is changing through time • Internal and external uses • Peer Group Analysis • Compare to similar companies or within industries • NAICS (North American Industry Classification System) codes, RMA, Financial Post Datagroup, and Dun & Bradstreet Canada

  30. Potential Problems with Ratios • 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

  31. 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?

  32. Summary 3.6 • You should be able to: • Identify sources and uses of cash • Understand the Statement of Cash Flows • Understand how to make standardized financial statements and why they are useful • Calculate and evaluate common ratios • Understand the Du Pont identity • Describe how to establish benchmarks for comparison purposes and understand some key problems that can arise