Course: 7183M – Capital Planning and Investment

Financial Statements
and Analysis
Session 2
 Learning Goals
Review the contents of the stockholder’s report, and the procedures for
consolidating financial statements.
Understand who uses financial ratios and how.
Use ratios to analyze a firm’s liquidity and activity.
Discuss the relationship between debt and financial leverage and the
ratios used to analyze a firm’s debt.
Use ratios to analyze a firm’s profitability and its
market value.
Use the DuPont system of analysis to perform
a complete ratio analysis.

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 The Stockholders’ Report
• 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).
• 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 stockholders’ report.

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 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.

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 Financial Statements

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Table 8.1 (Panel 1)
 Financial Statements

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Table 8.1 (Panel 2)
 Financial Statements
• 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.

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 Financial Statements

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Table 8.2 (Panel 1)
 Financial Statements

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Table 8.2 (Panel 2)
 Financial Statements
• 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.

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 Financial Statements

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Table 8.3
 Financial Statements
• 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
and financing and operating activities, but also ties together the
income
statement and previous and current balance sheets.

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 Financial Statements

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Table 8.4
 Consolidating International
Financial Statements
• FASB 52 mandated that companies based in the United States
translate their foreign-currency denominated assets and liabilities
into dollars using the current rate (translation) method.
• Under the translation method, companies translate foreign-currency-
denominated assets and liabilities
into dollars for consolidation with the parent company’s financial
statements.
• Income statement items are usually treated similarly, although they
can also be translated at the average exchange rate during the period
(year).

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 Consolidating International
Financial Statements
• Equity accounts, on the other hand, are translated
into dollars by using the exchange rate that prevailed when the
parent’s equity investment was made
(the historical rate).
• Retained earnings are adjusted to reflect each year’s operating profits
(or losses), but do not consider any profits or losses resulting from
currency changes.
• Instead, translation gains and losses are accumulated
in an equity reserve account called the cumulative translation
adjustment.

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 Consolidating International
Financial Statements
• Translation gains (losses) increase (decrease)
this account balance.
• However, the gains and losses are not “realized” until
the parent company sells or shuts down the subsidiary.

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 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.

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 Types of Ratio Comparisons
• Trend or Time-Series Analysis
– Used to evaluate a firm’s performance over time.
• 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.
• Combined Analysis
– Combined analysis simply uses a combination
of both time-series analysis and cross-sectional analysis.

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 Types of Ratio Comparisons

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Figure 8.1
 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.

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 Ratio Analysis Example
• Using Daton Company Financial Statements
– Liquidity ratios
– Activity ratios
– Financial leverage ratio
– Leverage ratios
– Profitability ratios

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 Ratio Analysis
• Liquidity Ratios
– Current Ratio

Total current assets

Current ratio =
Total current liabilities

$1,233,000
Current ratio = = 1.97
$620,000

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 Ratio Analysis
• Liquidity Ratios
– Quick ratio

Total current assets - Inventory

Quick ratio =
Total current liabilities

$1,233,000 - $289,000
Quick ratio = = 1.51
$620,000

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 Ratio Analysis
• Activity Ratios
– Inventory Turnover

Cost of goods sold

Inventory turnover =
Inventory

$2,088,000
Inventory turnover = = 7.2
$289,000

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 Ratio Analysis
• Activity Ratios
– Average collection period

Accounts receivable
ACP =
Net sales/360

$503,000
ACP = = 58.9 days
$3,074,000/360

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 Ratio Analysis
• Activity Ratios
– Average payment period

Accounts payable
APP =
Annual purchases/360

$382,000
ACP = = 94.1 days
(.70 x $2,088,000)/360

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 Ratio Analysis
• Activity Ratios
– Total asset turnover

Net sales
Total asset turnover =
Total assets

$3,074,000
Total asset turnover = = .85
$3,579,000

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 Ratio Analysis
• Financial Leverage Ratio
– Debt ratio

Total liabilities
Debt ratio =
Total assets

$1,643,000
Debt ratio = = 45.7%
$3,579,000

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 Ratio Analysis
• Leverage Ratios
– Times interest earned ratio

EBIT
Times interest earned =
Interest

$418,000
Times interest earned = = 4.5
$93,000

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 Ratio Analysis
• Leverage Ratios
– Fixed-payment coverage ratio (FPCR)

EBIT + Lease pymts

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

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

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 Ratio Analysis
• Profitability Ratios
– Common-size
income statements

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Table 8.6
 Ratio Analysis
• Profitability Ratios
– Gross profit margin

Gross profit
GPM =
Net sales

$986,000
GPM = = 32.1%
$3,074,000

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 Ratio Analysis
• Profitability Ratios
– Operating profit margin

EBIT
OPM =
Net sales

$418,000
OPM = = 13.6%
$3,074,000

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 Ratio Analysis
• Profitability Ratios
– Net profit margin

Net profits after taxes

NPM =
Net sales

$231,000
NPM = = 7.5%
$3,074,000

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 Ratio Analysis
• Profitability Ratios
– Return on total assets (ROA)

Net profits after taxes

ROA =
Total assets

$231,000
ROA = = 6.4%
$3,597,000

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 Ratio Analysis
• Profitability Ratios
– Return on equity (ROE)

Net profits after taxes

ROE =
Stockholders’ equity

$231,000
ROE = = 11.8%
$1,954,000

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 Ratio Analysis
• Profitability Ratios
– Earnings per share (EPS)

Earnings available to common stockholder

EPS =
Number of shares outstanding

$221,000
EPS = = $2.90
76,262

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 Ratio Analysis
• Profitability Ratios
– Price earnings (P/E) ratio

Market price per share of common stock

P/E =
Earnings per share

$32.25
P/E = = 11.1
$2.90

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 Ratio Analysis
• Profitability Ratios
– Market/book (M/B) ratio

Market price per share of common stock

M/B =
Book value per share of common stock

$32.25
M/B = = 1.40
$23.00

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 Summarizing All Ratios

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Table 8.7 (Panel 1)
 Summarizing All Ratios

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Table 8.7 (Panel 2)
 DuPont System of Analysis
• The DuPont system 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 Figure 8.2 on the following slide.
• The top portion focuses on the income statement,
and the bottom focuses on the balance sheet.
• The advantage of the DuPont system is that it allows
you to break ROE into a profit-on-sales component,
an efficiency-of-asset-use component, and a use-of- leverage component.

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 DuPont System of Analysis

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Figure 8.2
 DuPont System of Analysis

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Figure 8.2 (Panel 1)
 DuPont System of Analysis

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Figure 8.2 (Panel 2)