2.1

Chapter

2Intro to Financial Statements Analysis

2.2

Key Concepts and Skills

Know the difference between book value and market value

Know the difference between accounting income and cash flow

Know the difference between average and marginal tax rates

Know how to determine a firm’s cash flow from its financial statements

2.3

Key Concepts and Skills

Know how to standardize financial statements for comparison purposes

Know how to compute and interpret important financial ratios

Know the determinants of a firm’s profitability and growth

Understand the problems and pitfalls in financial statement analysis

2.4

Chapter Outline

The Balance SheetThe Income StatementTaxesCash Flow

2.5

Balance Sheet

The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time

Assets are listed in order of liquidityEase of conversion to cashWithout significant loss of value

Balance Sheet IdentityAssets = Liabilities + Stockholders’ Equity

2.6

Balance SheetAssets = Liabilities + Owners’ Equity

2.7

Market Vs. Book ValueThe balance sheet provides the book value of

the assets, liabilities and equity.Market value is the price at which the assets,

liabilities or equity can actually be bought or sold.

Market value and book value are often very different. Why?

Which is more important to the decision-making process?

2.8

Income Statement

2.9

Income Statement

The income statement is more like a video of the firm’s operations for a specified period of time.

You generally report revenues first and then deduct any expenses for the period

Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue

2.10

Ratio Analysis

Ratios also 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 is that information important

Ratios are used both internally and externally

2.11

Standardized Financial StatementsCommon-Size Balance Sheet

Compute all accts as % of Tot. AssetsCommon-Size Income Statements

Compute all accts as % of Sales

Standardized stmts make it easier to compare financial info, particularly as firm grows

Also useful for comparing co.’s of different sizes, particularly in same industry

2.12

Categories of Financial Ratios

Short-term solvency or liquidity ratiosLong-term solvency or financial leverage ratiosAsset management or turnover ratiosProfitability ratiosMarket value ratios

2.13

Sample Balance SheetCash 6,489 A/P 340,220

A/R 1,052,606 N/P 86,631

Inventory 295,255 Other CL 1,098,602

Other CA 199,375 Total CL 1,525,453

Total CA 1,553,725 LT Debt 871,851

Net FA 2,535,072 C/E 1,691,493

Total Assets 4,088,797 Total Liab. & Equity

4,088,797

Numbers in thousands

2.14

Sample Income StatementRevenues 3,991,997

Cost of Goods Sold 1,738,125

Gross Profit 2,253,872

Expenses 1,269,479

Depreciation 308,355

EBIT 739,987

Interest Expense 42,013

Taxable Income 697,974Taxes 272,210

Net Income 425,764

# Shs outstanding = 205,838.594

EPS $2.17

Dividends per share $0.86

Numbers in thousands, except EPS & DPS

2.15

Computing Liquidity Ratios

Current Ratio = CA / CL = 1.02 times

Quick Ratio = (CA – Inventory) / CL = .825 times

Cash Ratio = Cash / CL = .004 timesNet Working Capital= CA-CL

=

2.16

Long-term Solvency Measures

Total Debt Ratio = (TA – TE) / TA = .5863 times or 58.63%The firm finances almost 59% of their assets with

debt.

Debt/Equity = TD / TE = 1.417 times

Equity Multiplier = TA / TE = 1 + D/E = 2.417

2.17

Computing Coverage Ratios

Times Interest Earned = EBIT / Interest = 17.6 times

Cash Coverage = (EBIT + Depreciation) / Interest = 24.95 times

2.18

ASSET MGMT RATIOS:Computing Inventory RatiosInventory Turnover = Sales / Inventory

= 13.52 times

Days’ Sales in Inventory = 365 / Inventory Turnover = 27 days

2.19

Computing Receivables Ratios

Receivables Turnover = Sales / Accounts Receivable = 3.79 times

Days’ Sales in Receivables = 365 / Receivables Turnover = 96 days

2.20

Computing Total Asset Turnover

Total Asset Turnover = Sales / Total Assets = .98 times

Measure of asset use efficiencyNot unusual for TAT < 1, especially if a firm

has a large amount of fixed assets

2.21

Computing Profitability Measures

Profit Margin = Net Income / Sales = .1067 times or 10.67%

Return on Assets (ROA) = Net Income / Total Assets = .1041 times or 10.41%

Return on Equity (ROE) = Net Income / Total Equity = .2517 times or 25.17%

2.22

Computing Market Value Measures

Market Price = $61.625 per shareShares outstanding = 205,838,594PE Ratio = Price per share / Earnings per share

= 28.4 times

Market-to-book ratio = market value per share / book value per share = 7.5 times

2.23

Market Value MeasuresValue Stocks: Firms w/ low Mrkt to Book

ratios Growth Stocks: Firms w/ high Mrkt to Book

ratiosMarket Capitalization = Mrkt Value of

Common EquityEnterprise Value= MV equity + MV debt –

Cash – mrktbl securities. Measures value of firm’s underlying business

2.24

Using the Du Pont Identity

ROE = PM * TAT * EMProfit margin is a measure of the firm’s operating

efficiency – how well does it control costsTotal asset turnover is a measure of the firm’s asset

use efficiency – how well does it manage its assetsEquity multiplier is a measure of the firm’s financial

leverage

2.25

Payout and Retention Ratios

Dividend payout ratio = Cash dividends / Net income = .3963 or 39.63%

Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio = .6037 = 60.37%Or = .6037 = 60.37%

2.26

The Internal Growth Rate

The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

%71.6

0671.bROA - 1

bROA RateGrowth Internal

2.27

The Sustainable Growth Rate

The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

%92.17

1792.bROE-1

bROE RateGrowth eSustainabl

2.28

Determinants of Growth

Profit margin – operating efficiencyTotal asset turnover – asset use efficiencyFinancial leverage – choice of optimal debt

ratioDividend policy – choice of how much to pay

to shareholders versus reinvesting in the firm

2.29

Why Evaluate Financial Statements?Internal uses

Performance evaluation – compensation and comparison between divisions

Planning for the future – guide in estimating future cash flows

External usesCreditorsSuppliersCustomersStockholders

2.30

BenchmarkingRatios are not very helpful by themselves; they

need to be compared to somethingTime-Trend Analysis

Used to see how the firm’s performance is changing through time

Internal and external usesPeer Group Analysis

Compare to similar companies or within industriesSIC and NAICS codes

2.31

Quick QuizHow 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 the major determinants of a firm’s growth

potential?What are some of the problems associated with

financial statement analysis?

2.32

Taxes

The one thing we can rely on with taxes is that they are always changing

Marginal vs. average tax ratesMarginal – the percentage paid on the next dollar

earnedAverage – the tax bill / taxable income

Other taxes

2.33

Example: Marginal Vs. Average RatesSuppose your firm earns $4 million in taxable

income.What is the firm’s tax liability?What is the average tax rate?What is the marginal tax rate?

If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?

2.34

The Concept of Cash FlowCash flow is one of the most important pieces

of information that a financial manager can derive from financial statements

The statement of cash flows does not provide us with the same information that we are looking at here

We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

2.35

2.36

Cash Flow Problem 2-19Belyk Paving has sales of $2,000,000. COGS,

SGA, and depreciation expenses were $1,200,000, $300,000, & $400,000 respectively. It also had interest expense of $150,000, & a 35% tax rate. Ignore any tax loss carry back or forward provisions,

What is the Net Income?What is the Operating Cash Flow?

2.37

2.38

Quick QuizWhat is the difference between book value and

market value? Which should we use for decision making purposes?

What is the difference between accounting income and cash flow? Which do we need to use when making decisions?

What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

How do we determine a firm’s cash flows? What are the equations and where do we find the information?