Chapter 3

Working with Financial

Statements

 PhD, Phan Hong Mai

 School of Banking and Finance
 National Economics University
 hongmaik@neu.edu.vn
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Chapter Outline

3.1 Standardized Financial Statement

3.2 Ratio Analysis
3.3 DuPont System

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 3.1 Standardized Financial Statements

 Using financial statement information:

 Internal uses: the managers, stockholders use it to
evaluate and compensate firm performance; compare
the performance of the firms’ divisions; plan for the
future (generate projects and check the realism of
assumptions made in them).
 External uses: stakeholders (suppliers, creditors…)
and potential investors use it to make financial
decisions. The managers use other firms’ statements
to evaluate their main competitors or identify
potential target for acquisition.
-> Financial statements should be standardized for
comparison. 3-3
 3.1 Standardized Financial Statements

Common-size Statements:
 A standardized financial statement presenting all
items in percentage terms.
 Common-Size Balance Sheets: Compute each
account as a percent of total assets.
 Common-Size Income Statements: Compute
each line item as a percent of sales.
 Useful for comparing companies of different
sizes, particularly within the same industry.
-> see table 3.5, 3.6 Prufrock corporation (page 54, 55)
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 3.1 Standardized Financial Statements

Common-base year Statements:

 A standardized financial statement presenting
all items relative to a certain base year amount.
 Choose the base year and then express each
item relative to the base amount.
 Make it easier to compare financial information,
particularly as the company grows.
-> see table 3.7 Prufrock corporation (page 56)

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 3.1 Standardized Financial Statements

Combined Common-size and base year analysis

 Base year can be combined with the common-size
analysis.
 As total assets grow, most of the other accounts
must grow as well. By first forming the common-
size statements, the effect of this overall growth
can be eliminated .

-> see table 3.7 Prufrock corporation (page 56)

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 3.2 Ratio Analysis

 Ratio analysis: Another way of avoiding the

problems involved in comparing companies of
different sizes because the size effectively
divides out.
 There are so many accounting numbers out
there, we could examine a huge number of
possible ratios. -> As a financial analyst, you
can always decide how to compute your own
ratios

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 3.2 Ratio Analysis

 Highlight strengths and weaknesses.

 Compare through time and with competitors
(Trend analysis and Peer/or industry analysis.)

-> As looking at each ratio, ask yourself

what the ratio is trying to measure and why that
information is important.

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 3.2 Ratio Analysis

Five Major Categories of Ratios

 Liquidity: Can we make required payments?
 Financial Leverage: Right mix of debt and equity?
 Asset management: right amount of assets vs.
sales?
 Profitability: Do sales prices exceed unit costs, and
are sales high enough as reflected in PM, ROE, and
ROA?
 Market value: Do investors like what they see as
reflected in P/E and M/B ratios?
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 3.2.1 Liquidity or Short-term solvency

 Short-term solvency ratios provide

information about a firm’s ability to pay its bills
over the short run without undue stress.
 These ratios focus on current assets and current
liabilities -> Their book values and market values
are likely to be similar. However, current assets
and liabilities can change fairly rapidly -> Today’s
amounts may not be a reliable guide to the
future.
 Current ratio, Quick ratio, Cash ratio.
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 3.2.1 Liquidity or Short-term solvency

Current ratio measures whether or not a firm has

enough resources to meet its short-term obligations.

Current assets $708

Current ratio    1.31 times
Current liabilitie s $540

-> in 2012, Prufrock has $1.31 in current assets

for every $1 in liabilities. So it has enough
resources to pay off its short-term liabilities.
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 3.2.1 Liquidity or Short-term solvency

 Quick ratio is designed to show investors and

creditors how quickly a company can pay off its
short-term debt.
 Assets like cash, marketable securities, and
accounts receivable can quickly be converted
into cash and used to pay off current liabilities.
 Inventory is the least liquid asset so it should be
subtracted from current assets.

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3.2.1 Liquidity or Short-term solvency

(Current assets - Inventory )

Quick ratio 
Current liabilitie s
($708  422)

$540
 0.53 times
-> in 2012, without selling inventory, Prufrock
only has its current liabilities covered 0.53
times over. Or Prufrock can’t pay off its short-
term debt without inventory.
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 3.2.1 Liquidity or Short-term solvency

Cash ratio measures the ability of a firm to repay

its current liabilities by only using its cash and cash
equivalents and nothing else.
Cash $98
Cash ratio    0.18 times
Current liabilitie s $540
-> in 2012, only using cash, Prufrock can repay
18% of its current liabilities.

-> see more other liquidity ratios: Net working capital to

total assets & Interval measure. 3-16
3.2.1 Liquidity or Short-term solvency

 Example 3.1 – Current event

 Suppose a firm pays off some of its suppliers
and short-term creditors by cash. What happens
to the current ratio?
 Suppose a firm buys some inventory by cash.
What happens in this case?
 What happens if a firm sells some goods and
collects money immediately?

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3.2.2 Leverage level or Long-term solvency

 Long-term solvency ratios address the firm’s

long-term ability to meet its obligations, or, its
financial leverage.
 Total debt ratio, Debt-Equity ratio, Equity multiplier,
Times interest earned ratio, Cash cover ratio.

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 3.2.2 Leverage level or Long-term solvency

 Total debt ratio can be interpreted as the

proportion of a company's assets that are
financed by debt.

Total debt $540  457

Total debt ratio    0.28 times
Total assets $3588
-> Prufrock finances almost 28% of its assets with debt.

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 3.2.2 Leverage level or Long-term solvency

 Debt-Equity ratio indicates the relative

proportion of shareholders’ equity and debt used
to finance a firm's assets.

Total debt $540  457

Debt - Equity ratio    0.38 times
Total equity $2591

-> Prufrock’s assets are funded 0.38 – to - 1 by

creditors to investors.

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 3.2.2 Leverage level or Long-term solvency

 Equity multiplier measures the amount of a

firm's assets that are financed by its shareholders.

Total assets $3588

Equity multiplier    1.38 times
Total equity $2591
-> 72% (=1/1.38) of Prufrock’s assets are financed by
equity
-> Total debt ratio = 1 – 1/Equity multiplier
-> Debt-equity ratio = Equity multiplier – 1
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 3.2.2 Leverage level or Long-term solvency

 Times interest earned ratio (TIE) or Interest

coverage ratio measures how well a company
has its interest obligations covered.

EBIT $691
Times interest earned ratio    4.9 times
Interest $141
-> For Prufrock, the interest bill is covered 4.9 times
over.
-> Prufrock has $4.9 in EBIT for every $1 in interest
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 3.2.2 Leverage level or Long-term solvency

 Cash coverage ratio is a measure of cash

available to pay interest.
EBIT  Depreciati on EBITD
Cash coverage ratio  
Interest Interest
$691  276
  6.9 times
$141
 EBITD is a basic measure of the firm’s ability
to generate cash from operations.
-> Prufrock has $6.9 in cash flow for every $1 in
interest. 3-23
3.2.3 Asset management or Turnover measures

 Asset management ratios describe how

efficiently or intensively a firm uses its assets
to generate sales.
 Inventory turnover, Day’s sale in inventory,
Receivables turnover, Day’s sale in
receivables, Asset turnover (fixed assets
turnover, total assets turnover).

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3.2.3 Asset management or Turnover measures

 Inventory turnover reflects how many times

the firm’s inventory is sold and replaced over a
period of time.
 It can be calculated as Cost of goods sold divided
by ending inventory or average inventory.
 The higher this ratio is, the more efficiently the
firm manages its inventory.

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3.2.3 Asset management or Turnover measures

Cost of goods sold $1344

Inventory turnover    3.2
Ending inventory $422
Or
Cost of goods sold $1344
Inventory turnover    3.3
Average inventory ($393  422) / 2

-> The inventory of Prufrock is sold and replaced

3.2 times or cycles (or 3.3 times) over a year.
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3.2.3 Asset management or Turnover measures

 Days’ sales in inventory can be computed as

the days in period divided by the inventory
turnover.
 It describes how many days the firm takes to sell
its inventory on hand.

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3.2.3 Asset management or Turnover measures

Days in period
Days' sales in inventory 
Inventory turnover
365days
  115 days
3.2
or
365 days
  111days
3.3
-> Prufrock’s inventory sits 115 days (or 111 days)
before it is sold. 3-28
3.2.3 Asset management or Turnover measures

 Receivables turnover is the number of times

per period that a firm collects its receivables.
 It can be calculated as Sales divided by ending
accounts receivable or average accounts
receivable.
 This ratio evaluates the ability of a firm to
efficiently issue credit to its customers and collect
funds from them in a timely manner.

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 3.2.3 Asset management or Turnover measures

Sales $2311
Receivable s turnover    12.3
Ending receivable s $188
Or
Sales $2311
Receivable s turnover    13.1
Average receivable s ($165  188) / 2

-> Prufrock collected its outstanding credit accounts

and re-loaned the money 12.3 times or cycles (or
13.1 times) during the year.
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3.2.3 Asset management or Turnover measures

 Days’ sales in receivables can be computed as

the days in period divided by the receivables
turnover.
 It describes how many days the firm collects on
its credit sales.
-> Average collection period

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3.2.3 Asset management or Turnover measures

Days in period
Days' sales in receivable 
Receivable s turnover
365days
  30 days
12.3
or
365 days
  28days
13.1
-> Prufrock collected on its credit sales in 30 days
(or 28 days). 3-32
3.2.3 Asset management or Turnover measures

 Fixed assets turnover indicates how well the

firm is using its fixed assets to generate sales.
 It can be calculated as Sales divided by ending
net fixed assets or average net fixed assets.
 A declining ratio may indicate that the firm is
over-invested in plant, equipment, or other fixed
assets.

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3.2.3 Asset management or Turnover measures

Sales $2311
Fixed assets turnover    0.80
Ending net fixed assets $2880
Or
Sales $2311
Fixed assets turnover    0.82
Average net fixed assets ($2731  2880) / 2

-> For every $100 in fixed assets, Prufrock

generated $80 (or $82) in sales.
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3.2.3 Asset management or Turnover measures

 Total assets turnover measures a firm's ability

to generate sales from its assets.
 It can be calculated as Sales divided by ending
total assets or average total assets.

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3.2.3 Asset management or Turnover measures

Sales $2311
Total assets turnover    0.64
Ending total assets $3588
Or
Sales $2311
Total assets turnover    0.66
Average total assets ($3373  3588) / 2

-> For every $100 in total assets, Prufrock

generated $64 (or $66) in sales.
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3.2.4 Profitability measures

 Profitability ratios are intended to measure

how efficiently a firm uses its assets and
manages its operations -> to generate net
income.
 The focus in this group is net income or return.
 They are expressed as a percentage.
 Profit margin (ROS), Return on Assets (ROA),
Return on Equity (ROE).

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3.2.4 Profitability measures

 Profit margin measures how much out of

every dollar of sales a firm actually keeps in
earnings.

Net income $363

Profit margin    15.7%
Sales $2311

-> For every $100 in sales, Prufrock kept $15.7

in earnings.
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3.2.4 Profitability measures

 Return on Assets shows the percentage of

profit a firm earns in relation to its total assets.
 It can be calculated as Net income divided by
ending total assets or average total assets.

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3.2.4 Profitability measures

Net income $363

Return on Assets    10.12%
Ending total assets $3688
Or
Net income $363
Return on Assets    10.43%
Average total assets ($3373  3588) / 2

-> Prufrock earned $10.12 (or $10.43) profit per

$100 of total assets.
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3.2.4 Profitability measures

 Return on Equity measures the ability of a

firm to generate profits from its shareholders’
investments in the company.
 In other words, the return on equity ratio shows
how much profit each dollar of common
stockholders' equity generates.
 It can be calculated as Net income divided by
ending total equity or average total equity.

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3.2.4 Profitability measures

Net income $363

Return on Equity    14.01%
Ending total equity $2591
Or
Net income $363
Return on Equity    14.85%
Average total equity ($2299  2591) / 2

-> For every $100 in equity, Prufrock generated

$14.01 (or $14.85) in profit.
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3.2.5 Market value measures

 Market value ratios evaluate the economic

status of a publicly-traded company in the wider
marketplace.
 These ratios are based on information not
necessarily contained in financial statements (the
market price per share). -> they can be computed
directly only for publicly traded companies.
 Earnings per share (EPS), Price – Earnings ratio,
Price – Sales ratio, Market-to-Book ratio.

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3.2.5 Market value measures

 Earnings per share (EPS) measures the amount

of net income earned per share of stock
outstanding.
-> Assume that Prufrock has 33 millions shares
outstanding and the stock sold for $88 per share
at the end of 2012.

Net income $363

EPS    $11
Share outstandin g 33
-> On average, Prufrock’s stockholders earned
$11 in profit per share on hand. 3-44
3.2.5 Market value measures

 Price-Earnings ratio (PE ratio) shows the sum of

money the investors are ready to pay for each
dollar worth of a firm’s earnings.

Price per share $88

PE ratio    8times
Earnings per share $11

-> The investors are willing to pay $8 for each

$1 in Prufrock’s earnings.

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3.2.5 Market value measures

 Price-Sales ratio shows the sum of money the

investors are willing to pay for each dollar of
annual sales.
Price per share $88
Price - sales ratio    1.26times
Sales per share $2311
33

-> The investors are willing to pay $1.26 for

each $1 in Prufrock’s sales.

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3.2.5 Market value measures

 Market-to-book ratio compares the market value of

the firm’s investment to their cost. A value less than 1
could mean that the firm has not been successful
overall in creating value for its stockholders.
Market val ue per share
Market - to - book ratio 
Book value per share
$88
  1.12 times
$2591
33
-> The investors are ready to pay 1.12 times the
book value of Prufrock. 3-47
 3.3 DUPONT Identity

 Dupont analysis was developed by the Dupont

Corporation in the year 1920.
 Dupont identity breaks down ROE ratio into
three components: profit margin, asset turnover,
and financial leverage.
 Dupont identity is used to identify what exactly
is generating a firm's return, i.e. whether it is
high profit margin, efficient use of assets to
generate more sales and/or use of more debt in
its capital structure.
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 3.3 DUPONT Identity

Total Equity

Profit margin

1/ (1 – Total Debt ratio)

-> Why does ROE increase?

Whether it is high profit margin, efficient use of
assets to generate more sales and/or use of
more debt in its capital structure? 3-49
 3.3 DUPONT Identity

Total Equity

Profit margin

ROE  15.7% x 0.64 x 1.39  14.01%

-> Assume that DUPONT identity for Prufrock in 2011:

ROE = 10.2% x 0.64 x 1.39 = 9.07%
-> Prufrock improved its profitability by rising operating
efficiency.
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3.3 DUPONT Identity

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 Summary and Conclusions

 “Sources and uses of cash”: describe how to

trace the flow of cash through a business over
the period.
 “Standardized statements”: formed to make
comparisons easier.
 “Financial ratios”: determined from firms’
financial information and used for comparison
purposes.
 “Ratio analysis”: a way to evaluate firm
performance.
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 HOMEWORKS

 Concepts review: 1, 2, 5, 7.
 Questions and Problems: 1, 2, 3, 4, 5,
6, 7, 12, 24.

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