Chapter Three

Working with Financial

Statements
Copyright 2004 McGraw-Hill Australia
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PPTs t/a Fundamentals of Corporate Finance
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Chapter Organisation

3.1 Cash Flow and Financial Statements: A Closer

Look
3.2 Financial Statements of Publicly Listed Firms
3.3 The Du Pont Identity
3.4 Using Financial Statement Information
Copyright 2004
3.5 Summary andMcGraw-Hill Australia
Conclusions
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PPTs t/a Fundamentals of Corporate Finance
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Chapter Objectives

Identify the ways that firms obtain and use cash as

reported in the Statement of Cash Flows.
Calculate and interpret key financial ratios.
Discuss the Du Pont identity as a method of
financial analysis.
Copyright
Understand theMcGraw-Hill
2004 use of financial information for
Australia
Pty comparative
Ltd purposes.
PPTs t/a Fundamentals
Outline of Corporate
the problems Finance
associated with using
3e financial ratios.
Ross, Thompson, Christensen, Westerfield
and Jordan
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Cash

Cash is generated by selling a product or service,

asset or security.
Cash is spent by paying for materials and labour to
produce a product or service and by purchasing
assets.
Copyright
Recall: 2004 McGraw-Hill Australia
Pty Cash
Ltd flow from assets = Cash flow to debtholders
PPTs+ Cash flow to shareholders
t/a Fundamentals of Corporate Finance
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Cash Flow

Sources of cash are those activities that bring in

cash.

Uses of cash are those activities that involve

spending cash.
Copyright 2004 McGraw-Hill Australia
Pty Ltd firms statement of cash flows is the firms
The
PPTs t/a Fundamentals
financial statementofthat
Corporate Financeits sources
summarises
3e and uses of cash over a specified period.
Ross, Thompson, Christensen, Westerfield
and Jordan
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Statement of Financial Position
('000s)

Assets (000s) 2003 2004

Current assets
Cash $ 45 $ 50
Accounts receivable 260 310
Inventory 320 385
Total $ 625 $ 745
Copyright 2004 McGraw-Hill Australia
Pty Ltd
Fixed assets
PPTs t/a and
Net plant Fundamentals
equipment of Corporate Finance
985 1 100
3e
TOTAL ASSETS $1 610 $1 845
Ross, Thompson, Christensen, Westerfield
and Jordan
Slides prepared by Sue Wright 3-6
Statement of Financial Position
('000s)

Liabilities and equity (000s) 2003 2004

Current liabilities
Accounts payable $ 210 $ 260
Notes payable 110 175
Total $ 320 $ 435
Long-term debt $ 205 $ 225
Shareholders equity
Copyright 2004 McGraw-Hill Australia290 290
Ordinary shares
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Retained earnings 795 895
PPTs
Total t/a Fundamentals of Corporate Finance
$1 085 $1 185
3e
TOTAL LIABILITIES AND EQUITY $1 610 $1 845
Ross, Thompson, Christensen, Westerfield
and Jordan
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Statement of Financial Performance
('000s)

Net sales $710.00

Cost of goods sold 480.00
Depreciation 30.00
EBIT $200.00
Interest 20.00
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Taxable income 180.00
Pty
TaxLtd 53.45
PPTs
Net t/a Fundamentals of Corporate Finance
profit $126.55
3e
Dividends 26.55
Ross, Thompson, Christensen, Westerfield
Addition
and Jordanto retained earnings $100.00
Slides prepared by Sue Wright 3-8
Statement of Cash Flows

A statement that summarises the sources and uses

of cash.
Changes are divided into three main categories:
Operating activitiesincludes net profit and changes in
most current accounts
Investment activitiesincludes changes in fixed assets
Copyright 2004 McGraw-Hill Australia
Financing activitiesincludes changes in notes payable,
Pty Ltdlong-term debt and equity accounts as well as dividends.
PPTs t/a Fundamentals of Corporate Finance
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Statement of Cash Flows
Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
Any increase in current assets (except cash)
Copyright 2004
Decrease McGraw-Hill
in accounts payable Australia
Pty Ltd
Investment activities
PPTs+ t/a Fundamentals
Ending fixed assetsof Corporate Finance
3e Beginning fixed assets
Ross,+ Thompson,
Depreciation Christensen, Westerfield
and Jordan
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Statement of Cash Flows

Financing activities
Decrease in notes payable
+ Increase in notes payable
Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
Copyright 2004 McGraw-Hill Australia
Dividends paid
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PPTs t/a Fundamentals of Corporate Finance
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Statement of Cash Flows

Operating activities
+ Net profit + $ 126.55
+ Depreciation + 30.00
+ Increase in payables + 50.00
Increase in receivables 50.00
Increase in inventory 65.00
Copyright$ 91.55
2004 McGraw-Hill Australia
Investment
Pty Ltd activities
PPTs+ t/a
Ending fixed assetsof Corporate
Fundamentals +$1 100.00
Finance
3e Beginning fixed assets 985.00
+ Depreciation + 30.00
Ross, Thompson, Christensen, Westerfield
( $ 145.00)
and Jordan
Slides prepared by Sue Wright 3-12
Statement of Cash Flows

Financing activities
+ Increase in notes payable + $ 65.00
+ Increase in long-term debt + 20.00
Dividends 26.55
$ 58.45

Copyright 2004 McGraw-Hill Australia

PtyPutting
Ltd it all together, the net addition to cash for
the period is:
PPTs t/a Fundamentals of Corporate Finance
3e
$91.55
Ross, 145.00
Thompson, + 58.45 Westerfield
Christensen, = $5.00
and Jordan
Slides prepared by Sue Wright 3-13
Players in Accounting Standards

Accountants

Government

Regulators
Copyright 2004 McGraw-Hill Australia
Pty Ltd
Other users
PPTs t/a Fundamentals of Corporate Finance
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Ratio Analysis

Financial ratios are relationships determined from

a firms financial information.

Used to compare and investigate relationships

between different pieces of financial information,
either over
Copyright timeMcGraw-Hill
2004 or between Australia
companies.
Pty Ltd
PPTs t/a Fundamentals
Ratios of size
eliminate the Corporate Finance
problem.
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Categories of Financial Ratios

Liquiditymeasures the firms short-term solvency.

Capital structuremeasures the firms ability to
meet long-run obligations (financial leverage).
Asset management (turnover)measures the
efficiency of asset usage to generate sales.
Copyright
Profitabilitymeasures the firms
2004 McGraw-Hill ability to control
Australia
Pty expenses.
Ltd
PPTs t/a Fundamentals
Market of Corporate
valueper-share Finance
ratios.
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Liquidity Ratios

Current assets
Current ratio
Current liabilities

Copyright 2004 Current assets

McGraw-Hill Inventory
Australia
Quick ratio
Pty Ltd Current liabilities Bank overdraft
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3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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 Capital Structure Ratios

Total financial debt Cash

Net debt/equity ratio
Total equity Intangibles
Total debt
Debt/equity ratio
Total equity
Total assets
Equity multiplier
Total equity
Copyright 2004 EBIT
McGraw-Hill Australia
Net interest cover
Pty Ltd Interest finance charges
PPTstot/a Fundamentals Interest - bearing debt
Debt gross cash flow of Corporate Finance
3e Net profit after tax depreciation amortisation
Ross, Thompson, Christensen, Westerfield
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Turnover Ratios

Cost of goods sold

Inventory turnover
Inventory

365 days
Days' sales in inventory
Inventory
Copyright 2004 McGraw-Hill Australia turnover
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PPTs t/a Fundamentals of Corporate Finance
3e Sales
Receivables turnover Westerfield
Ross, Thompson, Christensen,Accounts receivable
and Jordan
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Turnover Ratios (continued)

365 days
Days' sales in receivables
Receivables turnover

Sales
Fixed asset turnover
Non -Australia
Copyright 2004 McGraw-Hill current assets
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PPTs t/a Fundamentals of Corporate Finance
3e Sales
Total asset turnover
Ross, Thompson, Christensen, Westerfield
Total assets
and Jordan
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Profitability Ratios

Net profit
Profit margin
Sales

Net profit
Return on assets (ROA) 100%
Total assets

Copyright 2004 McGraw-Hill

EBIT Australia
Return on investment 100%
Pty Ltd Total assets
PPTs t/a Fundamentals of Corporate Finance
3e Net profit
Return on equity (ROE) 100%
Ross, Thompson, Christensen, Westerfield
Total equity
and Jordan
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Market Value Ratios

Price per share

Price/earning ratio
Earnings per share

Copyright 2004 McGraw-Hill Market value per share

Australia
Ltd - to - book ratio Book value per share
Market
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The Du Pont Identity
Breaks ROE into three parts:
operating efficiency
asset use efficiency
financial leverage

Net profit Sales Assets

ROE
CopyrightSales
2004Assets Equity Australia
McGraw-Hill
Pty Ltd
Profit
PPTs t/a margin Total
Fundamentals of Corporate Equity multiplier
Finance
asset turnover
3e
Ross, Thompson,
ROA EquityChristensen,
multiplier Westerfield
and Jordan
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Uses for Financial Statement
Information

Internal uses:
performance evaluation
planning for the future

External uses:
evaluation by outside parties
Copyright 2004 McGraw-Hill Australia
evaluation of main competitors
Pty Ltd
identifying potential takeover targets
PPTs t/a Fundamentals of Corporate Finance
3e
Ross, Thompson, Christensen, Westerfield
and Jordan
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Benchmarks for Comparison

Ratios are most useful when compared to a

benchmark.
Time-trend analysisexamine how a particular
ratio(s) has performed historically.
Peer group analysisusing similar firms
(competitors)
Copyright 2004for comparisonAustralia
McGraw-Hill of results.
Global
Pty Ltd Industry Classification Standard (GICS)
PPTsused by ASX is a useful
t/a Fundamentals way toFinance
of Corporate find a peer
3e company.
Ross, Thompson, Christensen, Westerfield
and Jordan
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Problems with Ratio Analysis

No underlying theory to identify correct ratios to

use or appropriate benchmarks.
Benchmarking is difficult for diversified firms.
Firms may use different accounting procedures.
Firms may have different recording periods.
One-off
Copyright 2004 McGraw-Hill
events can severelyAustralia
affect financial
Pty performance.
Ltd
PPTs t/a Fundamentals of Corporate Finance
3e
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and Jordan
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