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Financial Statements
The Income Statement

The income statement provides a financial
summary of a company’s operating results
during a specified period.
Although they are prepared annually for reporting
purposes, they are generally computed monthly
by management and quarterly for tax purposes.
Copyright © 2001 Addison-Wesley 8-3

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Copyright © 2001 Addison-Wesley Table 8.1 (Panel 1) 8-4


The Balance Sheet

The balance sheet presents a summary of a firm’s
financial position at a given point in time.
Assets indicate what the firm owns, equity represents
the owners’ investment, and liabilities indicate what
the firm has borrowed.



Statement of Retained Earnings

The statement of retained earnings reconciles
the net income earned and dividends paid during
the year with the change in retained earnings.

Copyright © 2001 Addison-Wesley Table 8.3 8-10

Statement of Cash Flows

The statement of cash flows provides a summary
of the cash flows over the period of concern,
typically the year just ended.
This statement not only provides insight into a
company’s investment and financing and operating
activities, but also ties together the income
statement and previous and current balance sheets.


Consolidating International
FASB 52 mandated that companies based in the United
States translate their foreign-currency denominated
assets and liabilities into dollars using the current rate
(translation) method.
Under the translation method, companies translate
foreign-currency-denominated assets and liabilities
into dollars for consolidation with the parent company’s
financial statements.
Income statement items are usually treated similarly,
although they can also be translated at the average
exchange rate during the period (year).
Equity accounts, on the other hand, are translated
into dollars by using the exchange rate that prevailed
when the parent’s equity investment was made
(the historical rate).
Retained earnings are adjusted to reflect each year’s
operating profits (or losses), but do not consider any
profits or losses resulting from currency changes.
Instead, translation gains and losses are accumulated
in an equity reserve account called the cumulative
translation adjustment.

Translation gains (losses) increase (decrease)
this account balance.
However, the gains and losses are not “realized” until
the parent company sells or shuts down the subsidiary.

Using Financial Ratios
Interested Parties
Ratio analysis involves methods of calculating
and interpreting financial ratios to assess a firm’s
financial condition and performance.
It is of interest to shareholders, creditors,
and the firm’s own management.

Types of Ratio Comparisons
Trend or Time-Series Analysis

Used to evaluate a firm’s performance over time.
Cross-Sectional Analysis
Used to compare different firms at the same point in time.
Industry comparative analysis
• One specific type of cross sectional analysis. Used to compare
one firm’s financial performance to the industry’s average performance.
Combined Analysis
Combined analysis simply uses a combination
of both time-series analysis and cross-sectional analysis.

Types of Ratio Comparisons
Copyright © 2001 Addison-Wesley Figure 8.1 8-18

Cautions for Doing Ratio Analysis
Ratios must be considered together;

a single ratio by itself means relatively little.
Financial statements that are being compared
should be dated at the same point in time.
Use audited financial statements when possible.
The financial data being compared should have been
developed in the same way.
Be wary of inflation distortions.

Ratio Analysis Example
Using Daton Company Financial Statements

Liquidity ratios
Activity ratios
Financial leverage ratio
Leverage ratios
Profitability ratios

Ratio Analysis
Liquidity Ratios
Current Ratio
Total current assets

Current ratio =
Total current liabilities
$1,233,000
Current ratio = = 1.97
$620,000

Ratio Analysis
Liquidity Ratios
Quick ratio
Total current assets - Inventory

Quick ratio =
Total current liabilities
$1,233,000 - $289,000
Quick ratio = = 1.51
$620,000

Ratio Analysis
Activity Ratios
Inventory Turnover
Cost of goods sold

Inventory turnover =
Inventory
$2,088,000
Inventory turnover = = 7.2
$289,000

Ratio Analysis
Activity Ratios
Average collection period
Accounts receivable
ACP =
Net sales/360
$503,000
ACP = = 58.9 days
$3,074,000/360

Ratio Analysis
Activity Ratios
Average payment period
Accounts payable
APP =
Annual purchases/360
$382,000
ACP = = 94.1 days
(.70 x $2,088,000)/360

Ratio Analysis
Activity Ratios
Total asset turnover
Net sales
Total asset turnover =
Total assets
$3,074,000
Total asset turnover = = .85
$3,579,000

Ratio Analysis
Financial Leverage Ratio

Debt ratio
Total liabilities
Debt ratio =
Total assets
$1,643,000
Debt ratio = = 45.7%
$3,579,000

Ratio Analysis
Leverage Ratios
Times interest earned ratio
EBIT
Times interest earned =
Interest
$418,000
Times interest earned = = 4.5
$93,000

Ratio Analysis
Leverage Ratios
Fixed-payment coverage ratio (FPCR)
EBIT + Lease pymts

FPCR =
Interest + Lease pymts + {(Princ pymts + PSD) x [1/(1 - t)]}
$418,000 + $35,000
FPCR = = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1 - .29)]}

Ratio Analysis
Profitability Ratios
Common-size
income statements

Ratio Analysis
Gross profit margin
Gross profit
GPM =
Net sales
$986,000
GPM = = 32.1%
$3,074,000

Ratio Analysis
Operating profit margin
EBIT
OPM =
Net sales
$418,000
OPM = = 13.6%
$3,074,000

Ratio Analysis
Net profit margin
Net profits after taxes

NPM =
Net sales
$231,000
NPM = = 7.5%
$3,074,000

Ratio Analysis
Return on total assets (ROA)

ROA =
Total assets
$231,000
ROA = = 6.4%
$3,597,000

Ratio Analysis
Return on equity (ROE)

ROE =
Stockholders’ equity
$231,000
ROE = = 11.8%
$1,954,000

Ratio Analysis
Earnings per share (EPS)
Earnings available to common stockholder

EPS =
Number of shares outstanding
$221,000
EPS = = $2.90
76,262

Ratio Analysis
Price earnings (P/E) ratio
Market price per share of common stock

P/E =
Earnings per share
$32.25
P/E = = 11.1
$2.90

Ratio Analysis
Market/book (M/B) ratio
Market price per share of common stock

M/B =
Book value per share of common stock
$32.25
M/B = = 1.40
$23.00

Summarizing All Ratios

Summarizing All Ratios

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The Income Statement

Copyright © 2001 Addison-Wesley 8-3

Copyright © 2001 Addison-Wesley Table 8.1 (Panel 1) 8-4

Copyright © 2001 Addison-Wesley Table 8.1 (Panel 2) 8-5

The Balance Sheet

Copyright © 2001 Addison-Wesley 8-6

Copyright © 2001 Addison-Wesley Table 8.2 (Panel 1) 8-7

Copyright © 2001 Addison-Wesley Table 8.2 (Panel 2) 8-8

Statement of Retained Earnings

Copyright © 2001 Addison-Wesley 8-9

Copyright © 2001 Addison-Wesley Table 8.3 8-10

Statement of Cash Flows

Copyright © 2001 Addison-Wesley 8-11

Copyright © 2001 Addison-Wesley Table 8.4 8-12

Copyright © 2001 Addison-Wesley 8-14

Copyright © 2001 Addison-Wesley 8-15

Copyright © 2001 Addison-Wesley 8-16

Trend or Time-Series Analysis

Copyright © 2001 Addison-Wesley 8-17

Copyright © 2001 Addison-Wesley Figure 8.1 8-18

Ratios must be considered together;

Copyright © 2001 Addison-Wesley 8-19

Using Daton Company Financial Statements

Copyright © 2001 Addison-Wesley 8-20

Total current assets

Copyright © 2001 Addison-Wesley 8-21

Total current assets - Inventory

Copyright © 2001 Addison-Wesley 8-22

Cost of goods sold

Copyright © 2001 Addison-Wesley 8-23

Copyright © 2001 Addison-Wesley 8-24

Copyright © 2001 Addison-Wesley 8-25

Copyright © 2001 Addison-Wesley 8-26

Financial Leverage Ratio

Copyright © 2001 Addison-Wesley 8-27

Copyright © 2001 Addison-Wesley 8-28

EBIT + Lease pymts

Copyright © 2001 Addison-Wesley 8-29

Copyright © 2001 Addison-Wesley Table 8.6 8-30

Copyright © 2001 Addison-Wesley 8-31

Copyright © 2001 Addison-Wesley 8-32

Net profits after taxes

Copyright © 2001 Addison-Wesley 8-33

Net profits after taxes

Copyright © 2001 Addison-Wesley 8-34

Net profits after taxes

Copyright © 2001 Addison-Wesley 8-35

Earnings available to common stockholder

Copyright © 2001 Addison-Wesley 8-36

Market price per share of common stock

Copyright © 2001 Addison-Wesley 8-37

Market price per share of common stock

Copyright © 2001 Addison-Wesley 8-38

Copyright © 2001 Addison-Wesley Table 8.7 (Panel 1) 8-39

Copyright © 2001 Addison-Wesley Table 8.7 (Panel 2) 8-40

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