4

Financial Statements —
Statement of Cash Flows

5-1
 STATEMENT OF CASH FLOWS

An important element of the objective of financial

reporting is

“assessing the amounts, timing, and

uncertainty of cash flows.”

IASB requires the statement of cash flows

(also called the cash flow statement).

5-2
 STATEMENT OF CASH FLOWS

Primary Purpose: To provide relevant information about

the cash receipts and cash payments of an enterprise
during a period.

Statement provides answers to the following questions:

1. Where did the cash come from?

2. What was the cash used for?

3. What was the change in the cash balance?

5-3
 STATEMENT OF CASH FLOWS

Content and Format

Operating Investing Financing
Activities Activities Activities
Transactions that Making and Transactions
enter into the collecting loans involving liability
determination of and acquiring and equity
net income and disposing of items
investments and
property, plant,
and equipment

5-4
 CONTENT AND FORMAT

5-5
 STATEMENT OF CASH FLOWS

Preparation of the Statement of Cash Flows

Sources of Information

Information obtained from several sources:

1. comparative statements of financial
position,
2. current income statement, and
3. selected transaction data.

5-6
 Preparation
Preparation of
of Statement
Statement of
of Cash
Cash Flows
Flows

Illustration: On January 1, 2015, in its first year of

operations, Telemarketing Inc. issued 50,000 ordinary shares
of $1 par value for $50,000 cash. The company rented its
office space, furniture, and telecommunications equipment and
performed marketing services throughout the first year. In June
2015, the company purchased land for $15,000.

The following Illustration shows the company’s comparative

statements of financial position at the beginning and end of
2015.

5-7
5-8
 Preparation of Statement of Cash Flows

Preparing the Statement of Cash Flows

Determine:
1. Net cash provided by (or used in) operating activities.

2. Net cash provided by (or used in) investing and financing

activities.

3. Determine the change (increase or decrease) in cash during

the period.

4. Reconcile the change in cash with the beginning and the

ending cash balances.

5-9
 Preparing the Statement of Cash Flows

Net cash provided by operating activities

 Excess of cash receipts over cash payments from operating
activities.
 Determined by converting net income on an accrual basis
to a cash basis.
 Add to or deduct from net income those items in the
income statement that do not affect cash.
 Requires an analysis of the current year’s income
statement, comparative statements of financial position
and selected transaction data.

5-10
 Increase in accounts receivable
reflects a non-cash increase of
$41,000 in revenues.

Cash provided by operating activities ILLUSTRATION 5-22

5-11
 Increase in accounts payable
reflects a non-cash increase of
$12,000 in expenses.

Cash provided by operating activities ILLUSTRATION 5-22

5-12
 Preparing the Statement of Cash Flows

Telemarketing Inc.’s investing and financing activities.

 Purchased land for $15,000.
 Issued ordinary shares for $50,000.
 Paid $14,000 in dividends.

5-13
Investing
and
Financing
Activities

Purchased land
for $15,000
(Investing)

5-14
Investing
and
Financing
Activities

Issued ordinary
shares for
$50,000
(Financing)

5-15
Investing
and
Financing
Activities

Paid $14,000 in
dividends
(Financing)

5-16
 Preparation of Statement of Cash Flows

BE 4-12: Keyser Beverage Company reported the following

items in the most recent year.
Activity
Net income $40,000 Operating
Dividends paid 5,000 Financing
Increase in accounts receivable 10,000 Operating
Increase in accounts payable 7,000 Operating
Purchase of equipment 8,000 Investing
Depreciation expense 4,000 Operating
Issue of notes payable 20,000 Financing

Required: Determine if each item should be classified as an

operating, investing, or financing activity.
5-17
 BE 4-12 Net income of $40,000

Statement of Cash Flow (in thousands)

Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-18
 BE 4-12 Dividends paid $5,000

Statement of Cash Flow (in thousands)

Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-19
 BE 4-12 Increase in accounts receivable of $10,000

Statement of Cash Flow (in thousands)

Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-20
 BE 4-12 Purchase equipment for $8,000

Statement of Cash Flow (in thousands)

Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-21
 BE 4-12 Increase in accounts payable of $7,000

Statement of Cash Flow (in thousands)

Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-22
 BE 4-12 Proceeds from notes payable of $20,000

Statement of Cash Flow (in thousands)

Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-23
 BE 4-12 Depreciation expense of $4,000

Statement of Cash Flow (in thousands)

Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-24
 BE 4-12
Statement of Cash Flow (in thousands)
Operating activities
Net income $ 40,000
Increase in accounts receivable (10,000)
Increase in accounts payable 7,000
Depreciation expense 4,000
Net cash provided by operating activities 41,000
Investing activities
Purchase of equipment (8,000)
Financing activities
Dividends paid (5,000)
Proceeds from notes payable 20,000
Net cash provided by financing activities 15,000
Increase in cash $ 48,000
5-25
 Preparation of Statement of Cash Flows

Question
In preparing a statement of cash flows, which of the following
transactions would be considered an investing activity?
a. Sale of equipment at book value
b. Sale of merchandise on credit
c. Declaration of a cash dividend
d. Issuance of bonds payable.

5-26
 Preparation of Statement of Cash Flows

Significant Non-Cash Activities

Reported in a separate note to the financial statements.

Examples include:
 Issuance of ordinary shares to purchase assets.
 Conversion of bonds into ordinary shares.
 Issuance of debt to purchase assets.
 Exchanges on long-lived assets.

5-27
5-28
 Usefulness of Statement of Cash Flows

Without cash, a company will not survive.

Cash flow from Operations:

 High amount - able to generate sufficient cash from
operations to pay its bills without further borrowing.
 Low or negative amount - may have to
► borrow or
► issue equity securities.

5-29
 Usefulness of Statement of Cash Flows

Financial Liquidity

Net Cash Provided by

Current Cash Operating Activities
Debt Coverage =
Ratio Average Current Liabilities

Ratio indicates the ability to pay off current liabilities from

operations.
Ratio near 1:1 is good.

5-30
 Usefulness of Statement of Cash Flows

Financial Flexibility

Net Cash Provided by

Cash Debt Operating Activities
Coverage =
Ratio Average Total Liabilities

Ratio indicates the ability to repay liabilities from net cash

provided by operating activities, without having to liquidate
assets employed in operations.

5-31
 Usefulness of Statement of Cash Flows

Free Cash Flow

Indicates the amount of discretionary cash flow available.

5-32
 Usefulness of Statement of Cash Flows

Question
The current cash debt coverage ratio is often used to
assess
a. financial flexibility.
b. liquidity.
c. profitability.
d. solvency.

The End
5-33
 Chapter 5
Financial Statement
Analysis

5-34
 Methods
Methods ofof
Financial
Financial Statement
Statement
Analysis
 Horizontal Analysis
Analysis
 Vertical Analysis
 Common-Size Statements
 Trend Percentages
 Ratio Analysis

5-35
 Horizontal
Horizontal Analysis
Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next

5-36
 Vertical
Vertical Analysis
Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
5-37
 Common-Size
Common-Size Statements
Statements
Financial statements that show
only percentages and no
absolute dollar amounts

5-38
 Trend
Trend Percentages
Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)

5-39
 Ratio
Ratio Analysis
Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)

5-40
 Horizontal
Horizontal Analysis
Analysis
Example
Example
The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.

5-41
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700

5-42
 Horizontal
Horizontal Analysis
Analysis
Example
Example
Calculating Change in Dollar Amounts

Dollar = Current Year – Base Year

Change Figure Figure

5-43
 Horizontal
Horizontal Analysis
Analysis
Example
Example
Calculating Change in Dollar Amounts

Dollar = Current Year – Base Year

Change Figure Figure

Since we are measuring the amount of the

change between 1998 and 1999, the dollar
amounts for 1998 become the “base” year
figures.

5-44
 Horizontal
Horizontal Analysis
Analysis
Example
Example
Calculating Change as a Percentage

Percentage = Dollar Change × 100%

Change Base Year Figure

5-45
 Horizontal
Horizontal Analysis
Analysis
Example
Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land
$12,000
40,000
– $23,500
40,000
=
Buildings and equipment, net $(11,500)
120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700

5-46
 Horizontal
Horizontal Analysis
Analysis
Example
Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment: ($11,500 ÷ $23,500) × 100% = 48.9%
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700

5-47
 Horizontal
Horizontal Analysis
Analysis
Example
Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7

5-48
 Horizontal
Horizontal Analysis
Analysis
Example
Example
Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.

5-49
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7

5-50
 Horizontal
Horizontal Analysis
Analysis
Example
Example
Now, let’s apply the
procedures to the
income statement.

5-51
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

5-52
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Sales increased
Net income before taxes
by 8.3%
25,000
while net
32,000 (7,000) (21.9)
Less income taxesincome
(30%) decreased
7,500by 21.9%.
9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

5-53
 There were increases in both cost of goods
sold (14.3%) and operating expenses (2.1%).
CLOVER CORPORATION
These increased costs more than offset the
Comparative Income Statements
increase For
in sales, yielding
the Years an overall31,decrease
Ended December 1999 and 1998
in net income. Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

5-54
 Vertical
Vertical Analysis
Analysis Example
Example
The management of Sample Company
asks you to prepare a vertical analysis
for the comparative balance sheets of
the company.

5-55
 Vertical
Vertical Analysis
Analysis Example
Example
S a m p le C o m p a n y
B a la n ce S h e e t (A sse ts)
A t D e ce m b e r 31, 1999 a n d 1998
% o f T o ta l A sse ts
1999 1998 1999 1998
C a sh $ 82,000 $ 30,000 17% 8%
A ccts. R e c. 120,000 100,000 25% 26%
In ve n to ry 87,000 82,000 18% 21%
La nd 101,000 90,000 21% 23%
Eq u ip m e n t 110,000 100,000 23% 26%
A ccu m . D e p r. (17,000) (15,000) -4% -4%
T o ta l $ 483,000 $ 387,000 100% 100%

5-56
 Vertical
Vertical Analysis
Analysis Example
Example
S a m p le C o m p a n y
B a la n ce S h e e t (A sse ts)
A t D e ce m b e r 31, 1999 a n d 1998
% o f T o ta l A sse ts
1999 1998 1999 1998
C a sh $ 82,000 $ 30,000 17% 8%
A ccts. R e c. 120,000 100,000 25% 26%
In ve n to ry 87,000 82,000 18% 21%
La nd 101,000 90,000 21% 23%
Eq u ip m e n t $82,000 ÷ $483,000100,000
110,000 = 17% rounded23% 26%
A ccu m . D e p r.$30,000 ÷ $387,000(15,000)
(17,000) = 8% rounded -4% -4%
T o ta l $ 483,000 $ 387,000 100% 100%

5-57
 Vertical
Vertical Analysis
Analysis Example
Example
Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000 50,000 10% 13%
Common Stock $76,000 170,000÷ $483,000
160,000 =35% 16% 41%rounded
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%

5-58
 Trend
Trend Percentages
Percentages
Example
Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

5-59
 Trend
Trend Percentages
Percentages
Example
Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

$1,991 - $1,820 = $171

5-60
 Trend
Trend Percentages
Percentages
Example
Example
Using 1995 as the base year, we develop
the following percentage relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%

$1,991 - $1,820 = $171

$171 ÷ $1,820 = 9% rounded
5-61
 Trend line
140 for Sales
130
% of 100 Base

120

110

100

90
1995 1996 1997 1998 1999
Sales
Years
Expenses

5-62
 Ratios
Ratios
Ratios can be expressed in three different
ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)
CAUTION!
“Using ratios and percentages without
considering the underlying causes may be
hazardous to your health!”
lead to incorrect conclusions.”

5-63
 Categories
Categories of
of Ratios
Ratios
 Liquidity Ratios
Indicate a company’s short-term
debt-paying ability
 Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity
financing in a company
 Profitability Tests
Relate income to other variables
 Market Tests
Help assess relative merits of stocks in the
marketplace

5-64
 10
10 Ratios
Ratios You
You Must
Must Know
Know
Liquidity Ratios
Current (working capital) ratio
 Acid-test (quick) ratio
 Cash flow liquidity ratio
Accounts receivable turnover
Number of days’ sales in accounts
receivable
Inventory turnover
 Total assets turnover 651

5-65
 10
10 Ratios
Ratios You
You Must
Must Know
Know
Equity (Long-Term Solvency)
Ratios
Equity (stockholders’ equity) ratio
 Equity to debt

5-66
 10
10 Ratios
Ratios You
You Must
Must Know
Know
Profitability Tests
 Return on operating assets
Net income to net sales (return on sales
or “profit margin”)
Return on average common $
stockholders’ equity (ROE)
 Cash flow margin
Earnings per share
 Times interest earned
 Times preferred dividends earned

5-67
 10
10 Ratios
Ratios You
You Must
Must Know
Know
Market Tests
 Earnings yield on common stock
Price-earnings ratio
 Payout ratio on common stock
 Dividend yield on common stock
 Dividend yield on preferred stock
 Cash flow per share of common stock

5-68
 Now, let’s look at
Norton Corporation’s
1999 and 1998
financial statements.

5-69
 NORTON CORP ORATION
Ba la nce S he e ts
De ce m be r 31, 1999 a nd 1998
1999 1998
Asse ts
Curre nt a sse ts:
Ca sh $ 30,000 $ 20,000
Accounts re ce iva ble , ne t 20,000 17,000
Inve ntory 12,000 10,000
P re pa id e x pe nse s 3,000 2,000
Tota l curre nt a sse ts 65,000 49,000
P rope rty a nd e quipm e nt:
La nd 165,000 123,000
Buildings a nd e quipm e nt, ne t 116,390 128,000
Tota l prope rty a nd e quipm e nt 281,390 251,000
Tota l a sse ts $ 346,390 $ 300,000

5-70
 NORTON CORPORATION
Ba la nce She e ts
De ce m be r 31, 1999 a nd 1998
1999 1998
Lia bilitie s a nd Stockholde rs' Equity
Curre nt lia bilitie s:
Accounts pa ya ble $ 39,000 $ 40,000
Note s pa ya ble , short-te rm 3,000 2,000
Tota l curre nt lia bilitie s 42,000 42,000
Long-te rm lia bilitie s:
Note s pa ya ble , long-te rm 70,000 78,000
Tota l lia bilitie s 112,000 120,000
S tockholde rs' e quity:
Com m on stock, $1 pa r va lue 27,400 17,000
Additiona l pa id-in ca pita l 158,100 113,000
Tota l pa id-in ca pita l 185,500 130,000
Re ta ine d e a rnings 48,890 50,000
Tota l stockholde rs' e quity 234,390 180,000
Tota l lia bilitie s a nd stockholde rs' e quity $ 346,390 $ 300,000

5-71
 NO RT O N CO RP O RAT IO N
In co m e S ta te m e n ts
F o r th e Ye a rs En d e d De ce m b e r 31, 1999 a n d 1998
1999 1998
N e t sale s $ 494,000 $ 450,000
C ost of goods sold 140,000 127,000
G ross margin 354,000 323,000
O pe rating e xpe nse s 270,000 249,000
N e t ope rating income 84,000 74,000
Inte re st e xpe nse 7,300 8,000
N e t income be fore taxe s 76,700 66,000
Le ss income taxe s (30% ) 23,010 19,800
N e t income $ 53,690 $ 46,200

5-72
 Now, let’s calculate the
10 ratios based on
Norton’s financial
statements.

5-73
 NORTON CORPORATION
1999
Cash $ 30,000
Accounts receivable, net
We will Beginning of year 17,000
use this End of year 20,000
information Inventory
to calculate Beginning of year 10,000
the liquidity
End of year 12,000
ratios for
Total current assets 65,000
Norton.
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
5-74
 Working
Working Capital*
Capital*
The excess of current assets over current
liabilities.

12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an
5-75 indication of a company’s liquidity.
 Current
Current (Working
(Working Capital)
Capital)
Ratio
Ratio
#1
Current = Current Assets
Ratio Current Liabilities
Current = $65,000 = 1.55 : 1
Ratio $42,000

Measures the ability

of the company to pay current
debts as they become due.
5-76
 Acid-Test
Acid-Test (Quick)
(Quick) Ratio
Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.

5-77
 Acid-Test
Acid-Test (Quick)
(Quick) Ratio
Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Norton Corporation’s quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.

5-78
 Acid-Test
Acid-Test (Quick)
(Quick) Ratio
Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Acid-Test $50,000
= = 1.19 : 1
Ratio $42,000

5-79
 Accounts
Accounts Receivable
Receivable
Turnover
Turnover
Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($17,000 + $20,000) ÷ 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
5-80
 Number
Number of
of Days’
Days’ Sales
Sales
in
in Accounts
Accounts Receivable
Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts =
26.70 Times = 13.67 days
Receivables

Measures, on average, how many

days it takes to collect an account
receivable.
5-81
 Number
Number of
of Days’
Days’ Sales
Sales
in
in Accounts
Accounts Receivable
Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts =
26.70 Times = 13.67 days
Receivables

In practice, would 45 days be a

desirable number of days in
receivables?
5-82
 Inventory
Inventory Turnover
Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

Measures the number of times

inventory is sold and
replaced during the year.
5-83
 Inventory
Inventory Turnover
Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

Would 5 be a
desirable number of times
for inventory to turnover?
5-84
 Equity,
Equity, or
or Long–Term
Long–Term
Solvency
Solvency Ratios
Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton
NORTON Corporation.
CORPORATION
1999
Net operating income $ 84,000
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
5-85
 NORTON CORPORATION
1999
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income $ 53,690
Here is the Stockholders' equity
rest of the
Beginning of year 180,000
information
End of year 234,390
we will
Dividends per share 2
use.
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
5-86
 Equity
Equity Ratio
Ratio
#6

Equity Stockholders’ Equity

=
Ratio Total Assets
Equity $234,390
= = 67.7%
Ratio $346,390
Measures the proportion
of total assets provided by
stockholders.
5-87
 Net
Net Income
Income to
to Net
Net Sales
Sales
A/K/A
A/K/A Return
Return on
on Sales
Sales or
or Profit
Profit
#7
Margin
Margin
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales
Measures the proportion of the sales dollar
which is retained as profit.
5-88
 Net
Net Income
Income to
to Net
Net Sales
Sales
A/K/A
A/K/A Return
Return on
on Sales
Sales or
or Profit
Profit
#7
Margin
Margin
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Would a 1% return on sales be good?

5-89
 Return
Return on
on Average
Average
Common
Common Stockholders’
Stockholders’
#8
Equity
Equity (ROE)
(ROE)
Return on Net Income
Stockholders’ = Average Common
Equity Stockholders’ Equity
Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity
Important measure of the
income-producing ability
5-90
of a company.
 Earnings
Earnings Per
Per Share
Share
#9
Earnings Available to Common Stockholders
Earnings
= Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) ÷ 2

The financial press regularly publishes

actual and forecasted EPS amounts.
5-91
 Earnings
Earnings Per
Per Share
Share
 Weighted-average calculation 644

Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
common shares outstanding
 Three alternatives for calculating weighted-
average number of shares

5-92
 Earnings
Earnings Per
Per Share
Share
 Weighted-average calculation 645

Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
Alternate #1 common shares outstanding

5-93
 Earnings
Earnings Per
Per Share
Share
645
Alternate #2

Alternate #3

5-94
 Earnings
Earnings Per
Per Share
Share
646

¶ EPS and Stock Dividends or Splits

Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital was
generated by the dividend or split

¶ Primary EPS and Fully Diluted EPS

5-95
 Price-Earnings
Price-Earnings Ratio
Ratio
A/K/A
A/K/A P/E
P/E Multiple
Multiple
#10

Price-Earnings Market Price Per Share

=
Ratio EPS
Price-Earnings $20.00
= = 8.3 : 1
Ratio $ 2.42

Provides some measure of whether the

stock is under or overpriced.
5-96
 Important
Important Considerations
Considerations

 Need for comparable data

 Data is provided by Dun &
Bradstreet, Standard & Poor’s etc.
 Must compare by industry
 Is EPS comparable?

 Influence of external factors

 General business conditions
 Seasonal nature of business operations
 Impact of inflation
5-97
 Question
Question
The
The current
current ratio
ratio is
is aa measure
measure of of liquidity
liquidity that
that
is
is computed
computed by by dividing
dividing total
total assets
assets by
by
total
total liabilities.
liabilities.
a.
a. True
True
b.False
b.False

5-98
 Question
The
The current
current ratio
ratio isis aa measure
measure of of liquidity
liquidity that
that isis
computed
computed by by dividing
dividing total
total assets
assets by by total
total
liabilities.
liabilities.
a.
a. True
True
b.False
b.False The
Thecurrent
currentratio
ratioisisaameasure
measureof
of
liquidity,
liquidity,but
butisiscomputed
computedby by
dividing
dividingcurrent
currentassets
assetsby
by
current
currentliabilities
liabilities

5-99
 Question
Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash, Marketable
Marketable
Securities
Securities and
and net
net receivables.
receivables.
a.
a. True
True
b.False
b.False

5-100
 Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash, Marketable
Marketable
Securities
Securities and
and net
net receivables.
receivables.
a.
a. True
True
b.False
b.False

5-101