Chapter 3.

WORKING WITH
FINANCIAL STATEMENTS

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 Overview
Cash Flow and Financial Statements
Standardized Financial Statements
Ratio Analysis
The DuPont Identity
Using Financial Statement Information

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CASH FLOW AND FINANCIAL STATEMENTS
□Why is cash flow so important for financial managers?
▫ The ultimate goal of financial management is to maximize firm value.
▫ A firm value is calculated based on future “cash flows”.

□From the B.S., you can identify sources of cash and uses of cash.
▫ Sources of cash: Activities that bring in cash
▫ Uses of cash: Activities that involve spending cash

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□A decrease in an asset account is a source of cash.
▫ Decrease in an asset account, on a net basis, means the firm sold some assets.
□An increase in an asset account is a use of cash
▫ Increase in an asset account means the firm bought some assets.

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□An increase in a right-side (liability or equity) account is a source of
cash.
□A decrease in a right-side (liability or equity) account is a use of cash

□+ To understand cash flows regarding ‘retained earnings’ in Equity

section, you need an income statement.
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Prufrock corporation: summary of sources and
uses of cash

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Prufrock corporation: 2021 income statement

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The Statement of Cash Flows
□Statement of cash flows is a firm’s financial statement that summarizes
its sources and uses of cash over a specified period.
□Country by country, exact form differs in detail, but the basic idea is to
group all changes into three categories:
▫ Operating activities
▫ Investment activities
▫ Financing activities

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Prufrock corporation: CASH FLOWS

*rearrange

+ items:
sources of
cash

- items:
uses of cash

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Difference?

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Standardized Financial Statements
□Suppose that you compare two different financial statements.
▫ Comparison with competitors
▫ Comparison with the focal firm’s prior figures.
□Nearly impossible to directly compare because of differences in size.
□“Standardize” the financial statements.
▫ Common-size statements present all items in percentage terms
− Common-size balance sheets typically express each item as a percentage of total assets.
− Common-size income statements usually show each item as a percentage of total sales.
− Common-size statement of cash flows can be constructed from a “sources and uses of cash”
statement, expressing each item as a percentage of total sources (or total uses).
▫ Common-base year statements (i.e., trend analysis) present all items relative to a
certain base year amount.

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Prufrock corporation:
Summary of standardized balance sheets

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Ratio Analysis
□Another way of comparison is to calculate financial ratios.
□Financial ratios are typically grouped into the following 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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Short-term solvency or liquidity ratios

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Short-term solvency or liquidity ratios
□ Current ratio is a measure of short-term liquidity
▫ To a creditor, the higher this ratio, the better.
▫ To a firm, typically, the higher this ratio, the better. However, a too high current ratio may indicate an
inefficient use of current assets.
− Should be used in meaningful investments.
▫ Normally, investors expect to see a current ratio of at least 1.
□ Quick ratio
▫ You may want to ignore inventory when measuring liquidity, because inventory is regarded as the
least liquid current asset.
▫ (Relatively large inventories are often a sign of short-term trouble.)
□ Cash ratio may be of interest to a very short-term creditor.
□ Net working capital to total assets
▫ It takes into account the amount of current liabilities
□ Interval measure indicates how long the business can continue without earnings.
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Long-term solvency ratios

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Long-term solvency ratios
□ Total debt ratio considers all debts of all maturities to all creditors and has two useful variations:
▫ Debt-equity ratio
▫ Equity multiplier
▫ Q. Assume that a firm’s total debt ratio is 0.75. What is its debt-equity ratio? And equity multiplier?
□ Long-term debt ratio
▫ Focusing on long-term stability.
▫ Short-term debt is constantly changing.
□ Times interest earned (TIE) ratio
▫ How well a company has its interest obligations covered,
▫ It is often called the interest coverage ratio.
□ Cash coverage ratio
▫ Not accounting earnings, but “cash flow”
▫ It is a measure of cash flow available to meet financial obligations.

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Asset management or turnover ratios

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Asset management or turnover ratios
□Inventory turnover: How many times the firm sold off the entire inventory.
▫ Days’ sales in inventory: How many days inventory sits before it is sold, on average.
□Receivables turnover: How many times a firm collects outstanding credit
accounts and reloans the money .
▫ Days’ sales in receivables: The average number of days it takes for a firm to collect its
credit sales.
□Asset turnover ratios
▫ NWC turnover: How much of sales the firm generates by using its working capital.
▫ Fixed asset turnover: How much of sales the firm generates for every dollar in fixed
assets.
▫ Total assets turnover: How much of sales the firm generates for every dollar in total
assets.

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Profitability ratios

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Profitability ratios
□Profit margin
▫ How much money it generates in profit for every dollar in sales.
▫ Significant variation in profit margins across industries.

□ROA and ROE are accounting rates of return;

▫ Return on assets (ROA): A measure of profit per dollar of assets.
▫ Return on equity (ROE): A measure of profit per dollar of equity.

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ROA vs. ROE
□Assume that you invested your money in a small building in Seoul. You
only had 200 million KRW. The price of a target building was 1 billion
KRW. You borrowed 800 million KRW from a bank, and finally bought
the one. After 2 years, the building’s price dramatically increased to 1.4
billion KRW. Thus, the asset generated the income of 400 million KRW.
□ROA = 400 million / 1 billion = 40%
□ROE = 400 million / 200 billion = 200%
□Which is more meaningful for you?

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Market value ratios

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Market value ratios
□ Price-earnings ratio (PER): How much investors are willing to pay per dollar of
current earnings.
▫ Vary significantly across companies.
▫ Typical large firms in the US have PERs in the 15-20 range.
▫ Higher PERs often indicate that the firm has significant prospects for future growth, but it could
also mean a firm’s stock price is overvalued.
▫ Somethings, analysts compare PERs with earnings growth rates => PEG ratio.
□ Price-sales ratio (PSR) is useful when PER is not measurable (e.g., firm has
negative earnings).
□ Market-to-book ratio compares the market value of equity to the book value of
equity.
▫ An asset’s book value is basically calculated from historical costs of the asset. (+ depreciation.)
▫ Value less than 1 could mean that the firm has not been successful overall in creating value by
utilizing its assets.

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Market value ratios(continued)
□Tobin’s Q ratio
▫ It is similar to the market-to-book ratio in terms of meaning, but it is superior because it
focuses on what the firm is worth today relative to what it would cost to replace it today
(not historical costs).
▫ Difficult to calculate with accuracy because estimating the replacement cost of a firm’s
assets is not an easy task, and market values for a firm’s debt are often unobservable.
□Enterprise value-EBITDA multiple (EVEBITDA)
▫ Enterprise value = total market value of the stock + book value of all liabilities – cash ;
− You can buy the business by this value.
▫ This ratio relates the enterprise value to a measure of the operating cash flow
generated by the assets (EBITDA).

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The DuPont Identity

□ We could multiply ROE by Assets/Assets, which then expresses the ROE as the
product of ROA and the equity multiplier:

(ROA) (Equity
Multiplier)

□ We can further decompose ROE by multiplying by Sales/Sales:

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The DuPont Identity (continued)
□ If we rearrange things a bit, we can partition ROA into its two component parts –
profit margin and total asset turnover.

□ The DuPont identity breaks ROE into three parts:

▫ Operating efficiency, as measured by profit margin.
▫ Asset use efficiency, as measured by total asset turnover.
▫ Financial leverage, as measured by the equity multiplier.
□ This identity is useful when ROE is unsatisfactory.
▫ It might tell you where to start looking for reasons.

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Dupont breakdown: Amazon and Alibaba

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Extended DuPont Chart

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Uses of financial statement information
□Internal uses
▫ Performance evaluation
▫ Planning purposes
□External uses
▫ Short-term and long-term creditors
▫ Potential investors
▫ Suppliers and large customers
▫ Credit rating agencies
▫ Competitors
▫ Potential targets for acquisition
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Choosing a benchmark
□How do we choose a benchmark?
▫ Time trend analysis uses a firm’s historical data as the standard.
▫ Peer group analysis compares firms to their peer group,
− Peer group: Firms that compete in the same markets, have similar assets, and operate in
similar ways.
• One way to identify peers is based on standard industrial classification (SIC) codes, four-digit
codes established by the U.S. government to classify a firm by its type of business operations.
• Analysts often identify a set of primary competitors and then compute a set of averages based on
just this group.
− Sometimes, you may want to compare your firm with an aspirant group, which includes only
the top firms in the same industry.

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Selected two-digit sic codes

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Problems with financial statement analysis
□1) No underlying theory for which ratios to look at.
□2) Many firms are conglomerates, owning unrelated lines of business.
▫ Consolidated financial statements for such firms do not fit any industry category.
▫ Difficult to find good peers.
□3) Major competitors and natural peer group members in an industry
may be scattered around the globe.
▫ Financial statements from different countries do not necessarily conform to the
country of the focal (i.e. GAAP vs. IFRS).

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□End of lecture

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 Combined
Common-Size Assets Common-
Common-Size
Base Year
and Base Year
Assets
Assets
2020 2021
2021
2021

Inventories

PP&E
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Individual assignment
□Choose one firm and one competitor firm (All should be listed firms).
□Choose one financial ratio from each of five categories.
□Calculate financial ratios (from the 2022 annual reports)
▫ => Table 1
□Complete Dupont identity with variables (ROE, profit margin, total asset
turnover, equity multiplier) for the selected company and the competitor.
▫ => Table 2
□Conclusion with your interpretation
▫ Your firm is good at what? and bad at what? Compared to the competitor.
□Submit a short report (within 3 pages (not too long) to our TA)
□Due date: Sep 15th 24:00.

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