Finn100 - Chapter 3

Chapter 3
Financial
Statements
and Analysis
Learning Goals
1. Review the contents of the stockholders’ report

2. Understand who uses financial ratios,
and how.
3. Use ratios to analyze a firm’s:
1. liquidity
2. activity.
3. debt
4. profitability and
5. market value
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-2

Learning Goals (cont.)
4. Use a summary of financial ratios and

the DuPont system of analysis to
perform a complete ratio analysis.

Context
• The guidelines used to prepare and maintain financial

records and reports are known as generally accepted
accounting principles (GAAP).
• GAAP is authorized by the Financial Accounting
Standards Board (FASB).
• The Sarbanes-Oxley Act of 2002, passed to eliminate
the many disclosure and conflict of interest problems of
corporations, established the Public Company
Accounting Oversight Board (PCAOB), which is a
not-for-profit corporation that overseas auditors.

Context (cont.)
• The PCAOB is charged with protecting the

interests of investors and furthering the public
interest in the preparation of informative, fair,
and independent audit reports.
• Public corporations with more than
$5 million in assets and more than 500
stockholders are required by the SEC to
provide their stockholders with an annual
stockholder's report.

1. The Four Key
Financial Statements

The Income Statement
• The income statement provides a financial

summary of a company’s operating results
during a specified period.
• Although they are prepared annually for
reporting purposes, they are generally
computed monthly by management and
quarterly for tax purposes.

Income
Statement
(Sample)

The Balance Sheet
• The balance sheet presents a summary of

a firm’s financial position at a given point
in time.
• Assets indicate what the firm owns,
equity represents the owners’ investment,
and liabilities indicate what the firm
has borrowed.

Balance Sheet (Sample)

Balance Sheet (cont.)

Statement of Retained Earnings
• The statement of retained earnings

reconciles the net income earned and
dividends paid during the year, with the
change in retained earnings.

Statement of Retained Earnings
(Sample)

Statement of Cash Flows
• The statement of cash flows provides a

summary of the cash flows over the period
of concern, typically the year just ended.
• This statement not only provides insight
into a company’s investment, financing
and operating activities, but also ties
together the income statement and
previous and current balance sheets.
Statement of Cash Flows (Sample)

2. Using Financial
Ratios

Interested Parties
• Ratio analysis involves methods of

calculating and interpreting financial ratios
to assess a firm’s financial condition
and performance.
• It is of interest to shareholders, creditors,
and the firm’s own management.

Types of Ratio Comparisons
• Trend or time-series analysis

– Used to evaluate a firm’s performance
over time

Types of Ratio Comparisons (cont.)
• Cross-sectional analysis
– Used to compare different firms at the same
point in time

– Industry comparative analysis
• One specific type of cross-sectional analysis.
Used to compare one firm’s financial performance
to the industry’s average performance

– Benchmarking
• A type of cross-sectional analysis in which the
firm’s ratio values are compared to those of a key
competitor or group of competitors that it wishes
to emulate


• Combined Analysis
– Combined analysis simply uses a
combination of both time series analysis and
cross-sectional analysis



Cautions for Doing Ratio Analysis
• Ratios must be considered together; a single

ratio by itself means relatively little.
• Financial statements that are being compared
should be dated at the same point in time.
• Use audited financial statements when possible.
• The financial data being compared should have
been developed in the same way.
• Be wary of inflation distortions.

3. Performing Ratio
Analysis

Ratio Analysis Example
• We will illustrate the use of financial ratios

for analyzing financial statements using
the Bartlett Company Income Statements
and Balance Sheets presented earlier in
Tables 2.1 and 2.2.

Ratio Analysis
• Liquidity Ratios
– Current Ratio
Current ratio = total current assets

total current liabilities
Current ratio = $1,233,000 = 1.97

$620,000

Ratio Analysis (cont.)
– Current Ratio
– Quick Ratio
Quick ratio = Total Current Assets - Inventory

total current liabilities
Quick ratio = $1,233,000 - $289,000 = 1.51

$620,000
• Activity Ratios
– Inventory Turnover
Inventory Turnover = Cost of Goods Sold

Inventory
Inventory Turnover = $2,088,000 = 7.2

$289,000
• Activity Ratios
– Average Age of Inventory
Average Age of Inventory = 365

Inventory Turnover
Inventory Turnover = 365 = 50.7 days

7.2
• Activity Ratios
– Average Collection Period
ACP = Accounts Receivable

Net Sales/365
ACP = $503,000 = 59.7 days

$3,074,000/365
• Activity Ratios
– Average Payment Period
APP = Accounts Payable

Annual Purchases/365
APP = $382,000 = 95.4 days

(.70 x $2,088,000)/365
• Activity Ratios
– Total Asset Turnover
Total Asset Turnover = Net Sales

Total Assets
Total Asset Turnover = $3,074,000 = .85

$3,597,000
• Activity Ratios
• Financial Leverage Ratios
– Debt Ratio
Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%

• Activity Ratios
• Leverage Ratios
– Times Interest Earned Ratio
Times Interest Earned = EBIT/Interest
Times Interest Earned = $418,000/$93,000 = 4.5

• Activity Ratios
• Leverage Ratios
– Fixed-Payment coverage Ratio (FPCR)
FPCR = EBIT + Lease Payments
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}

• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Common-Size Income Statements


• Activity Ratios
• Leverage Ratios
– Gross Profit Margin
GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%

• Activity Ratios
• Leverage Ratios
– Operating Profit Margin (OPM)
OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%

• Activity Ratios
• Leverage Ratios
– Net Profit Margin (NPM)
NPM = Earnings Available to Common Stockholders

Sales
NPM = $221,000/$3,074,000 = 7.2%

• Activity Ratios
• Leverage Ratios
– Earnings Per Share (EPS)
EPS = Earnings Available to Common Stockholders

Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90

• Activity Ratios
• Leverage Ratios
– Return on Total Assets (ROA)
ROA = Earnings Available to Common Stockholders

Total Assets
ROA = $221,000/$3,597,000 = 6.1%

• Activity Ratios
• Leverage Ratios
– Return on Equity (ROE)
ROE = Earnings Available to Common Stockholders

Total Equity
ROE = $221,000/$1,754,000 = 12.6%

• Activity Ratios
• Leverage Ratios
• Market Ratios
– Price Earnings (P/E) Ratio
P/E = Market Price Per Share of Common Stock

Earnings Per Share
P/E = $32.25/$2.90 = 11.1

• Activity Ratios
• Leverage Ratios
• Market Ratios
– Market/Book (M/B) Ratio
BV/Share = Common Stock Equity

Number of Shares of Common Stock
BV/Share = $1,754,000/72,262 = $23.00

• Activity Ratios
• Leverage Ratios
• Market Ratios
– Market/Book (M/B) Ratio
M/B Ratio = Market Price/Share of Common Stock

Book Value/Share of Common Stock
M/B Ratio = $32.25/$23.00 = 1.40

Summarizing All Ratios

Summarizing All Ratios (cont.)



4. DuPont System

DuPont System of Analysis
• The DuPont system of analysis is used to dissect
the firm’s financial statements and to assess its
financial condition.
• It merges the income statement and balance sheet into
two summary measures of profitability: ROA and ROE
as shown in the equation below and in Figure 2.2 on the
following slide.

DuPont System
of Analysis (cont.)

Modified DuPont Formula
• The Modified DuPont Formula relates the firm’s

ROA to its ROE using the financial leverage
multiplier (FLM), which is the ratio of total assets
to common stock equity:

Modified DuPont Formula (cont.)
• Use of the FLM to convert ROA into ROE

reflects the impact of financial leverage on the
owner’s return.
• Substituting the values for Bartlett Company’s
ROA of 6.1 percent calculated earlier, and
Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷
$1,754,000 common stock equity) into the
Modified DuPont formula yields:
ROE = 6.1% X 2.06 = 12.6%

Financial Leverage (Importance)
Insert Table 2.6 here

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Chapter 3

1. Review the contents of the stockholders’ report

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-2

4. Use a summary of financial ratios and

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-3

• The guidelines used to prepare and maintain financial

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-4

• The PCAOB is charged with protecting the

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-5

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-6

• The income statement provides a financial

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-7

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-8

• The balance sheet presents a summary of

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-9

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-10

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-11

• The statement of retained earnings

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-12

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-13

• The statement of cash flows provides a

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-15

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-16

• Ratio analysis involves methods of

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-17

• Trend or time-series analysis

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-18

• Trend or time-series analysis

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-19

• Trend or time-series analysis

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-20

• Trend or time-series analysis

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-21

• Trend or time-series analysis

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-22

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-23

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-24

• Ratios must be considered together; a single

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-25

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-26

• We will illustrate the use of financial ratios

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-27

Current ratio = total current assets

Current ratio = $1,233,000 = 1.97

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-28

Quick ratio = Total Current Assets - Inventory

Quick ratio = $1,233,000 - $289,000 = 1.51

Inventory Turnover = Cost of Goods Sold

Inventory Turnover = $2,088,000 = 7.2

Average Age of Inventory = 365

Inventory Turnover = 365 = 50.7 days

ACP = Accounts Receivable

ACP = $503,000 = 59.7 days

APP = Accounts Payable

APP = $382,000 = 95.4 days

Total Asset Turnover = Net Sales

Total Asset Turnover = $3,074,000 = .85

Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-35

Times Interest Earned = $418,000/$93,000 = 4.5

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 2-36

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}