Chapter 3

Working With Financial Statements

Learning ObjectivesTo explain the ratio categories and calculation of ratio.To define the financial ratios.To explain the use of financial ratios in trend and cross sectional analysis in valuing the companys performance.To explain the execution of common size analysis.To elaborate the DuPont analysis and connection between ratios.To clarify the boundaries of ratio analysis.3-*

Statement 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 dividends3-*

Sources and UsesSourcesCash inflow occurs when we sell somethingDecrease in asset account (Sample B/S)Accounts receivable, inventory, and net fixed assetsIncrease in liability or equity accountAccounts payable, other current liabilities, and common stockUsesCash outflow occurs when we buy somethingIncrease in asset accountAccounts receivable, inventoryDecrease in liability or equity accountNotes payable and long-term debt3-*

3-*Additional information: Market Price = $87.65 per share and Shares outstanding = 190.9 million

2011201020112010Cash69658A/P307303A/R956992N/P26119Inventory301361Other CL1,6621,353Other CA303264Total CL1,9951,775Total CA2,2561,675LT Debt8431,091Net FA3,1383,358C/S2,5562,167Total Assets5,3945,033Total Liab. & Equity5,3945,033

Revenues5,000Cost of Goods Sold(2,006)Expenses(1,740)Depreciation(116)EBIT1,138Interest Expense(7)Taxable Income1,131Taxes(442)Net Income689EPS3.61Dividends per share1.08

Sample Statement of Cash Flows3-*

Cash, beginning of year58 Financing ActivityOperating Activity Decrease in Notes Payable-93 Net Income689 Decrease in LT Debt-248 Plus: Depreciation116 Decrease in C/S (minus RE)-94 Decrease in A/R36 Dividends Paid-206 Decrease in Inventory60 Net Cash from Financing-641 Increase in A/P4 Increase in Other CL309 Net Increase in Cash638 Less: Increase in other CA-39 Net Cash from Operations1,175 Cash End of Year696

Investment Activity Sale of Fixed Assets104 Net Cash from Investments104

Standardized Financial StatementsCommon-Size Balance SheetsCompute all accounts as a percent of total assetsCommon-Size Income StatementsCompute all line items as a percent of salesStandardized 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 industryCommon-base year statement: a standardized financial statement presenting all items relative to certain base year amount

3-*

Standardized Financial StatementsCommon-Size Balance SheetsCompute all accounts as a percent of total assetsCommon-Size Income StatementsCompute all line items as a percent of salesStandardized 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

3-*

Ratio AnalysisFinancial ratios: relationship determined from a firms financial information and used for comparison purposes.Ratios allow for better comparison through time (Time-Trend Analysis) or between companies (Peer Group Analysis)As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is importantCategories of Financial RatiosShort-term solvency or liquidity ratiosLong-term solvency or financial leverage ratiosAsset management or turnover ratiosProfitability ratiosMarket value ratios3-*

1)Liquidity Ratios:1) Current ratio = Current assets/Current liabilities This ratio measures the degree of liquidity by comparing its current assets to its current liabilities. Higher figure means that the business financial condition is better as it has enough liquid assets for its operation. Current Ratio = CA / CL = 2,256 / 1,995 = 1.13 times2) Quick ratio = (current assets-inventory/current liabilities)This ratio is a more stringent measure of liquidity than the current ratio. It excludes inventories and other current assets that are least liquid from current assets. Higher ratio shows that the business has enough quick assets or liquid assets to cover its short term debt immediately.Quick Ratio = (CA Inventory) / CL = (2,256 301) / 1,995 = .98 times

*

3) Cash ratio = cash/current liabilities = 696 / 1,995 = .35 times

4) Net working capital to total assets= net working capital/ total assets. NWC to Total Assets = NWC / TA = (2,256 1,995) / 5,394 = .05

5) Interval measures=current asset/ average daily operating cost average daily operating cost = COGS/365 days

Interval Measure = CA / average daily operating costs =2,256 / ((2,006 + 1,740)/365) = 219.8 days

*

2) ASSET MANAGEMENT/ ACTIVITY/ EFFICIENCY RATIOSAverage collection periods (ACP)= Accounts receivable/ (Annual credit sales/365) ACP = Accounts receivable/Daily sales = 956/ (5000/365) = 70 days Days Sales in Receivables = 365 / Receivables Turnover = 365 / 5.23 = 70 daysThe ratio measures how long a firm takes to collect its credit accounts. The lower the figure is better.Account receivable turnover = sales/accounts receivables = 5,000 / 956 = 5.23 times This ratio measures how often accounts receivables are rolled over during a year. Higher ratio illustrates that the firm can collect its debt more frequent and thus has few bad debts.

*

Inventory turnover = costs of good sold/inventoryIt measures the number of times a firms inventories are sold and replaced during the year. Higher ratio indicates that inventory can be sold and replaced more frequently. Inventory turnover = 2,006 / 301 = 6.66 times4) Days dales in inventory= 365 days/inventory turnover = 365 / 6.66 = 55 days5) Fixed asset turnover = sales/net fixed assetsThis ratio is an overall measure of asset efficiency based on the relation between firms sales and the total assets. Higher ratio indicates that firm is managing its assets more effectively.Fixed Asset Turnover = 5,000 / 3,138 = 1.59 times6) Total asset turnover = sales/total assetsHigher ratio is favored because it indicates the effectiveness of the firm in generating sales from its total assets. Total Asset Turnover = 5,000 / 5,394 = .937) NWC Turnover = sales/NWC = 5,000 / (2,256 1,995) = 19.16 times

*

3)PROFITABILITY RATIOS1) Gross profit margin= gross profit/ salesThe gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. Higher ratio is better.Gross profit Margin = Gross profit / Sales = 2994 / 5,000 = 59.88%2) Net profit margin = Net income/salesA higher profit margin indicates a more profitable company thathas better control overits costs compared toits competitors.Profit Margin = Net Income / Sales = 689 / 5,000 = 13.78%3) Operating Profit Margin(OPM) = Operating profit/Sales OPM examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit.Operating profit Margin = Operating profit / Sales = 1254 / 5,000 = 25.08%

*

4) Return on assets (ROA) = Net income/total assets This evaluates how effectively the company employs its assets to generate a return. It measures efficiency. Higher ratio is better.Return on Assets (ROA) = Net Income / Total Assets =689 / 5,394 = 12.77%

5) Return on equity (ROE) = Net income/ common equity Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Higher ratio is favored because the firm can generate better return to the owner of the firm.Return on Equity (ROE) = Net Income / Total Equity = 689 / 2,556 = 26.96%

*

4)LEVERAGE RATIOS1) Debt ratio = total debt/total assetsThis ratio measures the extent to which a firm has been financed with debt. More debt financing results in more financial risk. Total Debt Ratio =2,838/ 5,394 = 52.61%2) Times interest earned= EBIT/interestThe times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. Higher ratio shows better ability in meeting interest payment. Times Interest Earned =1,138 / 7 = 162.57 times3) Debt to equity ratio = total debt/total equity This ratio indicates what proportion of equity and debt the company is using to finance its assets. A high debt to equity ratio could indicate that the company may be overleveraged, and should look for ways to reduce its debt.Debt/Equity =2,838 / 2,556 = 1.11 times Equity multiplier = total assets/total equity or = 1+ (total debt/total equity) = 1 + 1.11 = 2.11Cash coverage =(EBIT+depreciation) / interest= (1,138 + 116)/ 7=179.14 times

Long-term debt ratio = LTD / (LTD + TE) = 843 / (843 + 2,556) = 24.80%

5)MARKET VALUE RATIOS1) Earning per share (EPS) = Net income/number of shares outstanding It represents the portion of a firm's earnings that is allocated to each share of common stock. = 689 / 190.9 = $3.612) Price earning ratio (PE) = price per share/earnings per share The ratio indicates how much investors are willing to pay per dollar of current earnings. As such, high P/E Ratios are associated with growth stocks. The most common measure of how expensive a stock is.= 87.65 / 3.61 = 24.28 times3) Price (market) to book ratio=price per share/book value per share his ratio measures how much a company worth at present, in comparison with the amount of capital invested by current and past shareholders into it. = 87.65 / (2,556 / 190.9) = 6.55 times4) Book value per share= Total equity/Number of shares outstanding The ratio of stockholder equity to the number of common stocks. Book value per share should not be thought of as an indicator of economic worth, since it reflects accounting valuation (and not necessarily market valuation). = 2,556 / 190.9 = $13.44price/sales per share = price per share/ sales per share where sales per share= sales / number of shares outstanding= 87.65 / (5000/190.9) = 3.34 times

*

Deriving the Du Pont IdentityROE = NI / TEMultiply by 1 (TA/TA) and then rearrangeROE = (NI / TE) (TA / TA)ROE = (NI / TA) (TA / TE) = ROA * EMMultiply by 1 (Sales/Sales) again and then rearrangeROE = (NI / TA) (TA / TE) (Sales / Sales)ROE = (NI / Sales) (Sales / TA) (TA / TE)ROE = 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 leverage

3-*

3.7 Dupont Analysis*STEP 1STEP 2STEP 3

Expanded Du Pont Analysis Du Pont Data 3-*

Extended Du Pont ChartInsert Figure 3.1 (Extended DuPont Chart)3-*

*Uses of Financial Ratios: Within the FirmIdentify deficiencies in a firms performance and take corrective action.Evaluate employee performance and determine incentive compensation.Compare the financial performance of different divisions within the firm.Prepare, at both firm and division levels, financial projections.Understand the financial performance of the firms competitors.Evaluate the financial condition of a major supplier.

*Uses of Financial Ratios: Outside the FirmFinancial ratios are used by: Lenders in deciding whether or not to make a loan to a company.Credit-rating agencies in determining a firms credit worthiness.Investors (shareholders and bondholders) in deciding whether or not to invest in a company.Major suppliers in deciding to whether or not to grant credit terms to a company.

*The Limitations of Financial Ratio AnalysisIt is sometimes difficult to identify industry categories or comparable peers.The published peer group or industry averages are only approximations.Industry averages may not provide a desirable target ratio.Accounting practices differ widely among firms.A high or low ratio does not automatically lead to a specific conclusion.Seasons may bias the numbers in the financial statements.

ADDITIONAL QUESTIONS Question 1 Secular Electric has total equity of RM560,000; sales of RM2,250,000; current assets of RM700,000; and total liabilities of RM435,000. What is Secular Electrics total assets turnover?Total assets turnover = sales/total assets = 2,250,000/total assetsTotal assets = fixed assets + current assetsTotal assets = total equity + total liabilities = 560,000 + 435,000 Thus, total assets = 995,000Find total assets turnover = 2,250,000/995,000 = 2.26x

Question 2 SRC has a debt ratio of 0.4, current liabilities of RM18,000, and total assets of RM100,000. What is the level of SRCs total liabilities? Debt ratio = total debt/total assets = 0.40.4 = total debt/100,000 total debt/liabilities = RM40,000

*

Question 3XYZ Corporation has the following financial information for the previous year:

Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3MCompute the ROE using the DuPont Analysis.Total assets = CA + FA = $2M + $6M = $8MTAT = Sales / TA = $8M / $8M = 1NWC = CA CL CL = CA NWC = $2M - $1M = $1MTotal liabs. = CL + LTD = $1M + $3M = $4MTotal equity = total assets total liabs. = $8M - $4M = $4MEM = assets / equity = $8M / $4M = 2ROE = PM X TAT X EM = 8% X 1 X 2 = 16%

3-*

*Table 4-1

*Table 4-2

1) LIQUIDITY RATIO*

RATIOFORMULADAVIES INC.PEER GROUP1) Current ratioCurrent assets/current liabilities$143m/$64m=2.231.802) Quick ratio (current assets-inventory/current liabilities)($143m-$84m)/$64m =0.920.893) Cash RatioCash/current liabilities4) Net working capital to total assetsNWC/total assets5)Interval measureCurrent assets/average daily operating cost

2)ASSET MANAGEMENT/ ACTIVITY/EFFICIENCY RATIOS*

RATIOFORMULADAVIES INC.PEER GROUP1) Average collection periods (ACP)Accounts receivable/(Annual credit sales/365)$36m/($600m/365)= 21.90 days25 days2)Account receivable turnover sales/accounts receivables$600m/$36m=16.67x14.6x3)Inventory turnover costs of good sold/inventory$460m/$84m=5.48x7.00x4)Fixed asset turnover sales/net fixed assets$600m/$295m=2.03x1.75x5)Total asset turnover sales/total assets$600m/$438m=1.37x1.15x6) Days sales in inventory365 days/inventory turnover7) NWCSales/NWC

3)PROFITABILITY RATIOS*

RATIOFORMULADAVIES INC.PEER GROUP1)Gross profit margingross profit/sales$140m/$600m=0.233=23.3%25%2)Net profit margin Net income/sales$42m/$600m=0.07=7%6.5%3)Operating Profit Margin(OPM) Operating profit/Sales$75m/$600m=0.125=12.5%15.5%4)Return on assets (ROA) Net income/total assets$42m/$438m=0.096=9.6%10%5)Return on equity (ROE) Net income/ common equity$42m/$203m=0.207=20.7%18%

4)LEVERAGE RATIOS*

RATIOFORMULADAVIES INC.PEER GROUP1)Debt ratio total debt/total assets$235m/$438m=0.537=53.7%35%2)Times interest earnedEBIT/interest$75m/$15m=5.0x7.0x3)Debt to equity ratio total debt/total equity$235m/$203m=1.16x2.05x4) Equity multiplierTotal assets/total equity5) Cash coverage (EBIT+depreciation) /interest

5)MARKET VALUE RATIOS*

RATIOFORMULADAVIES INC.PEER GROUP1)Earning per share (EPS)Net income/number of shares outstanding$42m/20m=$2.10$1.892) Price earning ratio (PE)price per share/earnings per share

(assume the market price for Davies stock was $32 per share) $32/$2.10=15.24x19.0x3)Price (market) to book ratioprice per share/book value per share$32/$10.15=3.15x3.7x4)Book value per shareTotal equity/Number of shares outstanding$203m/20m=$10.15$11.05

3.*3.*3.*3.*Investment activity: change in net fixed assets + depreciation (have to add back depreciation because it was deducted from the fixed asset account to get the net fixed asset figure). If the number is positive, then we acquired fixed assets; if its negative, then we sold fixed assets.

3138 3358 + 116 = -104 so we sold 104 million worth of fixed assets

that part of the increase in the C/S account shown on the balance sheet is the increase in Retained Earnings. That is already incorporated in the net income under operating activity.

Dividends paid = 190.9*1.08 = 206 million

Additions to RE = 689 206 = 483Change in C/S = 2556 2167 483 = -943.*3.*3.*******3.*