Chapter Three: Working With Financial Statements

Chapter Three
Working with Financial

Statements
Copyright  2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan 3-1
Slides prepared by Sue Wright
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
3.5 Summary and Conclusions

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.
• Understand the use of financial information for
comparative purposes.
• Outline the problems associated with using
financial ratios.

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.
• Recall:
Cash flow from assets = Cash flow to debtholders
+ Cash flow to shareholders

Cash Flow
• Sources of cash are those activities that bring in

cash.
• Uses of cash are those activities that involve

spending cash.
• The firm’s statement of cash flows is the firm’s

financial statement that summarises its sources
and uses of cash over a specified period.

Statement of Financial Position
('000s)
Assets (‘000s) 2003 2004
Current assets
Cash $ 45 $ 50
Accounts receivable 260 310
Inventory 320 385
Total $ 625 $ 745
Fixed assets
Net plant and equipment 985 1 100
TOTAL ASSETS $1 610 $1 845

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
Ordinary shares 290 290
Retained earnings 795 895
Total $1 085 $1 185
TOTAL LIABILITIES AND EQUITY $1 610 $1 845

Statement of Financial Performance
('000s)
Net sales $710.00
Cost of goods sold 480.00
Depreciation 30.00
EBIT $200.00
Interest 20.00
Taxable income 180.00
Tax 53.45
Net profit $126.55
Dividends 26.55
Addition to retained earnings $100.00
Statement of Cash Flows
• A statement that summarises the sources and uses

of cash.
• Changes are divided into three main categories:
– Operating activities—includes net profit and changes in
most current accounts
– Investment activities—includes changes in fixed assets
– Financing activities—includes changes in notes payable,
long-term debt and equity accounts as well as dividends.

• Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
– Any increase in current assets (except cash)
– Decrease in accounts payable
• Investment activities
+ Ending fixed assets
– Beginning fixed assets
+ Depreciation
• Financing activities
– Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
– Dividends paid

• Operating activities
+ Net profit + $ 126.55
+ Depreciation + 30.00
+ Increase in payables + 50.00
– Increase in receivables – 50.00
– Increase in inventory – 65.00
$ 91.55
• Investment activities
+ Ending fixed assets +$1 100.00
– Beginning fixed assets – 985.00
+ Depreciation + 30.00
( $ 145.00)
• Financing activities
– + Increase in notes payable + $ 65.00
– + Increase in long-term debt + 20.00
– – Dividends – 26.55
$ 58.45
Putting it all together, the net addition to cash for

the period is:
$91.55 – 145.00 + 58.45 = $5.00

‘Players’ in Accounting Standards
• Accountants
• Government
• Regulators
• Other users

Ratio Analysis
• Financial ratios are relationships determined from

a firm’s financial information.
• Used to compare and investigate relationships

between different pieces of financial information,
either over time or between companies.
• Ratios eliminate the size problem.

Categories of Financial Ratios
• Liquidity—measures the firm’s short-term solvency.

• Capital structure—measures the firm’s ability to
meet long-run obligations (financial leverage).
• Asset management (turnover)—measures the
efficiency of asset usage to generate sales.
• Profitability—measures the firm’s ability to control
expenses.
• Market value—per-share ratios.

Liquidity Ratios
Current assets
Current ratio 
Current liabilities
Current assets  Inventory

Quick ratio 
Current liabilities  Bank overdraft

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
EBIT
Net interest cover 
Interest  finance charges
Interest - bearing debt
Debt to gross cash flow 
Net profit after tax  depreciation  amortisation

Turnover Ratios
Cost of goods sold

Inventory turnover 
Inventory
365 days
Days' sales in inventory 
Inventory turnover
Sales
Receivables turnover 
Accounts receivable
Turnover Ratios (continued)
365 days
Days' sales in receivables 
Receivables turnover
Sales
Fixed asset turnover 
Non - current assets
Sales
Total asset turnover 
Total assets
Profitability Ratios
Net profit
Profit margin 
Sales
Net profit
Return on assets (ROA)   100%
Total assets
EBIT
Return on investment  100%
Total assets
Net profit
Return on equity (ROE)  100%
Total equity
Market Value Ratios
Price per share

Price/earning ratio 
Earnings per share
Market value per share

Market - to - book ratio 
Book value per share

The Du Pont Identity
• Breaks ROE into three parts:
– operating efficiency
– asset use efficiency
– financial leverage
Net profit Sales Assets

ROE   
Sales Assets Equity
 Profit margin  Total asset turnover  Equity multiplier
 ROA  Equity multiplier

Uses for Financial Statement
Information
• Internal uses:
– performance evaluation
– planning for the future
• External uses:
– evaluation by outside parties
– evaluation of main competitors
– identifying potential takeover targets

Benchmarks for Comparison
• Ratios are most useful when compared to a

benchmark.
• Time-trend analysis—examine how a particular
ratio(s) has performed historically.
• Peer group analysis—using similar firms
(competitors) for comparison of results.
• Global Industry Classification Standard (GICS)
used by ASX is a useful way to find a peer
company.

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 events can severely affect financial
performance.


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Chapter Three

Working with Financial

Copyright  2004 McGraw-Hill Australia Pty Ltd

3.1 Cash Flow and Financial Statements: A Closer

Copyright  2004 McGraw-Hill Australia Pty Ltd

• Identify the ways that firms obtain and use cash as

Copyright  2004 McGraw-Hill Australia Pty Ltd

• Cash is generated by selling a product or service,

Copyright  2004 McGraw-Hill Australia Pty Ltd

• Sources of cash are those activities that bring in

• Uses of cash are those activities that involve

• The firm’s statement of cash flows is the firm’s

Copyright  2004 McGraw-Hill Australia Pty Ltd

Assets (‘000s) 2003 2004

TOTAL ASSETS $1 610 $1 845

Liabilities and equity (‘000s) 2003 2004

Copyright  2004 McGraw-Hill Australia Pty Ltd

• A statement that summarises the sources and uses

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

Putting it all together, the net addition to cash for

$91.55 – 145.00 + 58.45 = $5.00

Copyright  2004 McGraw-Hill Australia Pty Ltd

• Financial ratios are relationships determined from

• Used to compare and investigate relationships

• Ratios eliminate the size problem.

Copyright  2004 McGraw-Hill Australia Pty Ltd

• Liquidity—measures the firm’s short-term solvency.

Copyright  2004 McGraw-Hill Australia Pty Ltd

Current assets  Inventory

Copyright  2004 McGraw-Hill Australia Pty Ltd

Total financial debt  Cash

Copyright  2004 McGraw-Hill Australia Pty Ltd

Cost of goods sold

Price per share

Market value per share

Copyright  2004 McGraw-Hill Australia Pty Ltd

Net profit Sales Assets

 Profit margin  Total asset turnover  Equity multiplier

 ROA  Equity multiplier

Copyright  2004 McGraw-Hill Australia Pty Ltd

• Ratios are most useful when compared to a

Copyright  2004 McGraw-Hill Australia Pty Ltd

• No underlying theory to identify correct ratios to

Copyright  2004 McGraw-Hill Australia Pty Ltd

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