Slide 1

Working With Financial Statements

Chapter 3

Key Concepts and SkillsUnderstand sources and uses of cash and the Statement of Cash FlowsKnow how to standardize financial statements for comparison purposesKnow how to compute and interpret important financial ratiosBe able to compute and interpret the Du Pont IdentityUnderstand the problems and pitfalls in financial statement analysisChapter OutlineCash Flow and Financial Statements: A Closer LookStandardized Financial StatementsRatio AnalysisThe Du Pont IdentityUsing Financial Statement InformationIntroductionWhy do we use financial statements when financial managers are concerned with market value?What do numbers in the financial statements mean?CFFA= CF to creditors+ CF to stockholdersSources of cash: activities that generate cashUses of cash: activities in which the firm spend cash

Sample Balance SheetPRUFROCK COROPORATION2008 & 2009 Balance Sheet( $in millions)CHANGE20092008CHANGE20092008LIABILITIES

Current liabilitiesASSETS

Current Assets+32344312AP+149884 cash-35196231Notes payable+23188165 AR-3540543Total+29422393 inventory-74457531Long-term debt+66708642TotalOwners equityFixed assets+50550500Common stocks & paid-in surplus+1492,8802,631 Net plant & equipment+2422,0411,799Retained earnings+2922,5912,299Total+2153,5883,373Total liabilities & owners equity+2153,5883,373Total assets

Sources and UsesSourcesCash inflow occurs when we sell somethingDecrease in asset account Accounts receivable, inventory, and net fixed assetsIncrease in liability or equity accountAccounts payable, other current liabilities, and common stock

UsesCash outflow occurs when we buy somethingIncrease in asset accountCash and other current assetsDecrease in liability or equity accountNotes payable and long-term debtNET ADDITION TO CASH = SOURCES OF CASH USES OF CASHSources and UsesSample Income StatementRevenues5,000Cost of Goods Sold(2,006)Expenses(1,740)Depreciation(116)EBIT1,138Interest Expense(7)Taxable Income1,131Taxes(442)Net Income689EPS3.61Dividends per share1.08EX 9 Page 82Based only on the following information for Bennington Crop., did cash go up or down? By how much? Classify each event as a source or use of cash.

375Decrease in inventory190Decrease in AP210Increase in notes payable105Increase in AREx 16 Page 83JUST DEW IT COROPORATION2008 &2009 Balance SheetsLIABILITIES & OWNERS EQUITYASSETS20092008Current liabilities20092008Current Assets

46,82143,050AP10,1568,436cash17,38218,384Notes payable23,40621,530AR64,20361,434Total42,65038,760Inventory32,00025,000Long-term debt76,21368,726TotalOwners equity40,00040,000Common stocks & paid-in surplus188,316168,998Retained earnings228,316208,998Total324,519295,432Total liabilities & owners equity324,519295,432Total assetsFor each account on this companys balance sheet, show the change in the account during 2009 and note whether this change was a source or use of cash. Do your numbers add up and make sense? Explain your answer for total assets as compared to your answer for liabilities and owners equityEx 16 Page 83Statement of Cash FlowsStatement that summarizes the sources and uses of cashChanges divided into three major categoriesOperating Activity includes net income and changes in most current accountsInvestment Activity includes changes in fixed assetsFinancing Activity includes changes in notes payable, long-term debt, and equity accounts, as well as dividendsFinancing activities84Cash, beginning of year-35Decrease in notes payableOperating activity-74Decrease in long-term debt363Net Income-121Dividend paidPlus:50Increase in common stock276Depreciation-180Net cash from financing activities32Increase in accounts payable14Net increase in cashLess:98Cash, end of year-23Increase in accounts receivable-29Increase in inventory619Net cash from operating activitiesInvestments activities-425Fixed assets acquisitions-425Net cash from investment activitiesStandardized statements make it easier to compare financial information, particularly as the company growsThey are also useful for comparing companies of different sizes, particularly within the same industry.

Standardized Financial StatementsThere are three kinds of standardized financial statements:COMMON-SIZE STATEMENTSCOMMON-BASE YEAR FINANCIAL STATEMENT (Trend analysis)COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS

Standardized Financial StatementsStandardized Financial Statements1.COMMON-SIZE STATMENTSCommon-Size Balance SheetsCompute all accounts as a percent of total assets(Item/ TA) * 100Common-Size Income StatementsCompute all line items as a percent of sales(Item/ SALES) * 100

2-COMMON-BASE YEAR STATEMENTS:TREND ANALYSISItem/ same item in the base year3-COMBINED COMMON-SIZE AND BASE YEAR ANALYSISStandardized Financial StatementsSummary of standardized Balance SheetsCombined Common-size & Base year AssetsCommon-Base year AssetsCommon-size AssetsAssets200920092009200820092008Current assets1.081.172.7%2.5%9884Cash1.061.145.24.9188165AR1.011.0711.811.7422393Inventory1.031.1019.719.1708642Total CA0.991.0580.380.92,8802,731NFA1.001.06100.0%100.0%3,5883,373Total AssetsJUST DEW IT COROPORATION2008 & 2009 Balance SheetsLIABILITIES & OWNERS EQUITYASSETS20092008Current liabilities20092008Current Assets

46,82143,050AP10,1578,436cash17,38218,384Notes payable23,40621,530AR64,20361,434Total42,65038,760Inventory32,00025,000Long-term debt76,21368,726TotalOwners equity40,00040,000Common stocks & paid-in surplus188,316168,998Retained earnings228,316208,998Total248,306226,706Net plant & equipment324,519295,432Total liabilities & owners equity324,519295,432Total assetsEx 13, 14 & 15Prepare the 2009 common-size balance sheet for Just Dew ItPrepare the 2009 common-base year balance sheet for Just Dew ItPrepare the 2009 combined common-size, common-base year balance sheet for Just Dew It

Ratio AnalysisRatios allow for better comparison through time or between companiesAs we look at each ratio, ask yourself what the ratio is trying to measure and why that information is importantRatios are used both internally and externallyCategories of Financial RatiosShort-term solvency or liquidity ratios Long-term solvency or financial leverage ratios: The ability to meet long-term obligationsAsset management or turnover ratios: Efficiency of asset useProfitability ratiosMarket value ratiosShort-term solvency or liquidity ratiosThe ability to pay bills in the short-runProvide information about the firms liquidityAdvantage: BV & MV are similarDisadvantage: CA & CL change rapidly

PRUFROCK COROPORATION2008 & 2009 Balance Sheet( $in millions)CHANGE20092008CHANGE20092008LIABILITIES

Current liabilitiesASSETS

Current Assets+32344312AP+149884 cash-35196231Notes payable+23188165 AR-3540543Total+29422393 inventory-74457531Long-term debt+66708642TotalOwners equityFixed assets+50550500Common stocks & paid-in surplus+1492,8802,631 Net plant & equipment+2422,0411,799Retained earnings+2922,5912,299Total+2153,5883,373Total liabilities & owners equity+2153,5883,373Total assets

Current ratio= CA CL708 / 540= 1.31 timesEX 3.1CA= 4 CL= 2 what happen to the Current ratio if:The firm pays off some of its creditors? If CA= 3 CL=1The firm buys some inventory?The firm sells some merchandize?

Computing Liquidity RatiosQuick Ratio = (CA Inventory) CL(708 - 422) 540 = 0.53 timesCash ratio = cash Current liabilities98 540 = 0.18 timesNWC to total assets = NWC total assets(708 540) 3,588 = 4.7%Interval measure = CA average daily operating costs1,344 365 = 3.68 $ per day708 3.68 = 192 days

Computing Liquidity RatiosComputing Long-term Solvency Ratios The ability to meet long-term obligationsTotal debt ratio = ( TA TE) TA(3,588 2,951 ) 3,588 = 0.28 timesDebt-equity ratio = TD TEEquity = (1- TD) = (1- 0.28) = 0.72 0.28 0.72 = 0.39 times

Equity multiplier = TA TE1 0.72 = 1.39 timesLong-term debt ratio= LTD (LTD + TE)457 (457 + 2,592) = 0.15 timesComputing Long-term Solvency Ratios Computing Coverage RatiosTimes interest earned ratio = EBIT interest691 141 = 4.9 timesCash coverage ratio=( EBIT + depreciation) interest(691 + 276) 141 = 6.9 times

Ex 1, 5 page 81SDJ, Inc,. Has net working capital 0f 1,370 $ , current liabilities of 3,720 $, and inventory of 1,950$. What is the current ratio? What is the quick ratio?Crystal Lake, Inc,. Has a total debt ratio of 0.63. what is its debt-equity ratio? What is it equity multiplier?Asset Management measuresInventory turnover= COGS inventory1,344 422 =3.2 timesDays sales in inventory = 365 days inventory turnover365 3.2 = 114 daysReceivables turnover= sales AR2,311 188 = 12.3 timesDays sales in receivables = 365 days receivables turnover365 12.3 = 30 daysComputing Receivables RatiosNWC turnover = sales NWC2,311 (708- 540) = 13.8 timesFixed asset turnover= sales Net fixed assets2.311 2,880 = 0.8 timesTotal asset turnover= sales total asset 2,311 3,588 = 0.64 timesComputing Total Asset TurnoverProfit Margin = Net Income Sales363 2,311 = 15.7 %Return on Assets (ROA) = Net Income Total Assets363 3,588 = 10.12 %Return on Equity (ROE) = Net Income Total Equity363 2,591= 14%

Computing Profitability MeasuresPrufrock has 33 million shares outstanding and the stock sold for 88$ per share at the end of the yearPrice-Earning Ratio = Price per share Earnings per shareEPS= net income shares outstanding363 33 =11 $88 11= 8 times

Computing Market Value MeasuresPrice-sales ratio= price per share sales per shareSales per share = sales shares out standing2,311 33= 70$88 70 = 1.26

Computing Market Value MeasuresMarket-to-book ratio = market value per share book value per shareBook value per share= TE SHARES OUTSTANDING2,591 33 = 78.5$88 78.5 = 1.12 times

Computing Market Value MeasuresEx 2 Page 81Wakers, Inc., has sales of $29 million, total assets of $ 17.5 million, and total debt of $ 6.3 million. If the profit margin is 8 percent, what is net income? What is ROA? What is ROE?Ex 3 Page 81Ortiz Lumber Yard has a current account receivable balance of $431,287. credit sales for the year just ended were $3,943,709. what is the receivable turnover? The days sales in receivables? How long did it take on average for credit customers to pay off their accounts during the past year?Ex 6 Page 81Bach Crop. Had addition to retained earnings for the year just ended of $430,000. the firm paid out $175,000 In cash dividends, and it has ending total equity of $5.3 million. If the company currently has 210,000 shares of common stock outstanding, what are the earnings per share? Dividend per share? Book value per share? If the stock currently sells for $63 per share, what is the market-to-book ratio? The price-earnings ratio? If the company had sales of $4.5 million , what is the price-sales ratio?Investigates what areas of the firm need improvementProvide a frame work that ties together a firms profitability, assets efficiency & the use of debtProvide the impact of operations on returnsAny weakness on operating assets or efficiency will result in a lower ROE

Deriving the Du Pont IdentityUsing the Du Pont IdentityROE = PM * TAT * EMProfit margin is a measure of the firms operating efficiency how well it controls costsTotal asset turnover is a measure of the firms asset use efficiency how well does it manage its assetsEquity multiplier is a measure of the firms financial leverageExpanded Du Pont Analysis Du Pont Data

Extended Du Pont Chart

Ex 7 , 8 Page 81If Roten Rooters, Inc., has an equity multiplier of 2.8, total asset turnover of 1.15 , and profit margin of 5.5 percent, what is the ROE?Braam Fire prevention Crop. Has a profit margin of 6.8 percent, total asset turnover of 1.95, and ROE of 18.27 percent. What is the firms debt-equity ratio?Ex 18 Page 83Y3K, Inc., has sales of $5,276 , total assets in $ 3,105 , and a debt- equity ratio of 1.4. if its return on equity is 15 percent, what is its net income?Why Evaluate Financial Statements?Internal usesPerformance evaluation (Compensation ) Comparison between divisionsPlanning for the future guide in estimating future cash flowsExternal usesCreditorsSuppliersCustomersStockholders

BenchmarkingRatios are not very helpful by themselves; they need to be compared to somethingTime-Trend AnalysisUsed to see how the firms performance is changing through timeInternal and external usesPeer Group AnalysisCompare to similar companies or within industriesSIC and NAICS codesPotential ProblemsThere is no underlying theory, so there is no way to know which ratios are most relevantBenchmarking is difficult for diversified firmsGlobalization and international competition makes comparison more difficult because of differences in accounting regulationsVarying accounting procedures, i.e. FIFO vs. LIFODifferent fiscal yearsExtraordinary eventsWhat 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?3-50Review