CHAPTER 3

W O R K I N G W I T H F I N A N C I A L S TAT E M E N T S

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 SAMPLE BALANCE SHEET
Numbers in millions of dollars

2018 2017 2018 2017

Cash 108 58 A/P 307 303

A/R 1,156 992 N/P 26 119

Inventory 501 361 Other CL 1,662 1,353

Other CA 403 264 Total CL 1,995 1,775
Total CA 2,168 1,675 LT Debt 843 1,091

Net FA 3,438 3,358 C/S 2,768 2,167

Total 5,606 5,033 Total Liab. 5,606 5,033

Assets & Equity

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 SAMPLE INCOME STATEMENT
Numbers in millions of dollars, except EPS & DPS

Revenues 5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (238)
Net Income 893
EPS (Earnings per Share) 4.68
Dividends per share (DPS) 1.53

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 SOURCES AND USES OF CASH

• Sources
 Cash inflow – occurs when we “sell” something
 Decrease in asset account (Sample B/S)
• Accounts receivable, inventory, and net fixed assets
 Increase in liability or equity account
• Accounts payable, other current liabilities, and common stock

• Uses
 Cash outflow – occurs when we “buy” something
 Increase in asset account
• Cash and other current assets
 Decrease in liability or equity account
• Notes payable and long-term debt

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 STATEMENT OF CASH FLOWS
• Statement that summarizes the sources and uses of cash

• Changes divided into three major categories

 Operating Activity – includes net income and changes in most current

accounts

 Investment Activity – includes changes in fixed assets

 Financing Activity – includes changes in notes payable, long-term debt,

and equity accounts, as well as dividends

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 SAMPLE STATEMENT OF CASH FLOWS
Cash, beginning of year 58 Financing Activity

Operating Activity Decrease in Notes Payable -93

Net Income 893 Decrease in LT Debt -248

Plus: Depreciation 116 Change in C/S (less RE) 0

Increase in A/P 4 Dividends Paid -292

Increase in Other CL 309 Net Cash from Financing -633
Less: Increase in other CA -139
Increase in A/R -164 Net Increase in Cash 50
Increase in Inventory -140
Net Cash from Operations 879 Cash End of Year 108

Investment Activity
Purchase of Fixed Assets -196
Net Cash from Investments -196

Numbers in millions of
dollars
3-6
 STANDARDIZED FINANCIAL
STATEMENTS
• Common-Size Balance Sheets
 Compute all accounts as a percent of total assets

• Common-Size Income Statements

 Compute all line items as a percent of sales

• Standardized statements make it easier to compare financial

information, particularly as the company grows.

• They are also useful for comparing companies of different

sizes, particularly within the same industry.
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 WHY EVALUATE FINANCIAL
STATEMENTS?
• Internal uses
 Performance evaluation – compensation
and comparison between divisions
 Planning for the future – guide in
estimating future cash flows

• External uses
 Creditors
 Suppliers
 Customers
 Stockholders
3-8
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 BENCHMARKING

• Ratios are not very helpful by themselves; they need to

be compared to something.

• Time-Trend Analysis
 Used to see how the firm’s performance
is changing through time
 Internal and external uses

• Peer Group Analysis

 Compare to similar companies or within industries
 SIC and NAICS codes

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 RATIO ANALYSIS
• Ratios allow for better comparison
through time or between companies.

• As we look at each ratio, ask yourself

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

• Ratios are used both internally and externally.

• The goal of ratio analysis is to take the numerous lines

from both the income statement and balance sheet and to
interpret this information in a meaningful way. Another
way of avoiding the problems involved in comparing
different firms. 3-10
 POTENTIAL PROBLEMS

• There is no underlying theory, so there is no way to know

which ratios are most relevant.

• Benchmarking is difficult for diversified firms.

• Globalization and international competition makes comparison

more difficult because of differences in accounting regulations.

• Varying accounting procedures, i.e. FIFO vs. LIFO

• Different fiscal years

• Extraordinary events

3-11
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 CATEGORIES OF FINANCIAL
RATIOS
• Short-term solvency, or liquidity, ratios

• Long-term solvency, or financial leverage, ratios

• Asset management, or turnover, ratios

• Profitability ratios

• Market value ratios

3-12
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FINANCIAL RATIOS CALCULATION EXAMPLES

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 COMPUTING LIQUIDITY RATIOS

• **Current Ratio = CA / CL B/S

 2,168 / 1,995 = 1.09 times
I/S

• **Quick Ratio = (CA - Inventory) / CL

 (2,168 - 501) / 1,995 = .84 times

3-14
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 COMPUTING LONG - TERM SOLVENCY RATIOS

• **Total Debt Ratio = (TA - TE) / TA

B/S
 (5,606 - 2,768) / 5,606 = 50.62%
I/S

• **Debt/Equity = TD / TE
 (5,606 - 2,768) / 2,768 = 1.03 times

3-15
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 COMPUTING COVERAGE RATIOS

• Times Interest Earned = EBIT / Interest B/S

 1,138 / 7 = 162.57 times I/S

• Cash Coverage = (EBIT + Depreciation) / Interest

 (1,138 + 116) / 7 = 179.14 times

3-16
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 COMPUTING INVENTORY RATIOS

• **Inventory Turnover = Sales/ Inventory

 5,000 / 501 = 10.00 times

• **Days’ Sales in Inventory = 365 / Inventory Turnover

 365 / 10.00 = 36.5 days

B/S
I/S

3-17
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 COMPUTING RECEIVABLES
RATIOS
• **Receivables Turnover = B/S
Sales / Accounts Receivable I/S
 5,000 / 1,156 = 4.33 times

• **Days’ Sales in Receivables =

365 / Receivables Turnover
 365 / 4.33 = 84 days

3-18
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 COMPUTING TOTAL ASSET
TURNOVER
B/S
• **Total Asset Turnover =
I/S
Sales / Total Assets
 5,000 / 5,606 = .89
 It is not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets

• Fixed Asset Turnover = Sales / NFA

 5,000 / 3,438 = 1.45 times

3-19
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 COMPUTING PROFITABILITY
MEASURES
B/S
• **Profit Margin = Net Income / Sales
I/S
 893 / 5,000 = 17.86%

• **Return on Assets (ROA) = Net Income / Total Assets

 893 / 5,606 = 15.93%

• **Return on Equity (ROE) = Net Income / Total Equity

 893 / 2,768 = 32.26%

3-20
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 COMPUTING MARKET VALUE
MEASURES – I
• Market Price = $87.65 per share
• Shares outstanding = 190.9 million
• **PE Ratio = Price per share / Earnings per share
 87.65 / 4.68 = 18.73 times

• **Market-to-book ratio = Market value per

share / Book value per share
 87.65 / (2,768 / 190.9) = 6.04 times

3-21
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 COMPUTING MARKET VALUE
MEASURES – II
• Enterprise value = market value of stock
+ book value of liabilities - cash
 16,732 + 2,838 - 108 = $19,462

• EBITDA ratio = Enterprise value / EBITDA

 19,462 / (1,138 + 116) = 15.52 times

3-22
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 DERIVING THE DUPONT IDENTITY

• ROE = NI / TE

• Multiply by 1 (TA/TA) and then rearrange

 ROE = (NI / TE) (TA / TA)
 ROE = (NI / TA) (TA / TE) = ROA × EM

• Multiply by 1 (Sales/Sales) again and then rearrange

 ROE = (NI / TA) (TA / TE) (Sales / Sales)
 ROE = (NI / Sales) (Sales / TA) (TA / TE)
 ROE = PM × TAT × EM

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 USING THE DUPONT IDENTITY

• ROE = PM × TAT × EM
 Profit margin is a measure of the firm’s operating
efficiency – how well it controls costs.

 Total asset turnover is a measure of the firm’s asset use

efficiency – how well does it manage its assets.

 Equity multiplier is a measure of the firm’s financial

leverage.

3-24
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 EXERCISE 3-1:

• What is the Statement of Cash Flows, and how

do you determine sources and uses of cash?

• How do you standardize balance sheets and income

statements and why is standardization useful?

• What are the major categories of ratios and how do you

compute specific ratios within each category?

• What are some of the problems associated

with financial statement analysis?

3-25
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 EXERCISE 3-2:

• XYZ Corporation has the following financial information

for the previous year:

• Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M,

LTD = $3M

• Compute the ROE using the DuPont Analysis.

3-26
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