2. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Working With Financial Statements Chapter 3

3. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.1 Prepare for Capital Budgeting Part 2: Understand financial statement and cash flow C2-Identify cash flow from financial statement C3-Financial statement and comparison Part 3: Valuation of future cash flow C4-Basic concepts C5-More exercise Part 4: Valuing stocks and bonds C6-Bond C7-Stock Part 5: Capital budgeting

4. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.2 Chapter Outline 1. Why Evaluate Financial Statements? 2. Categories of Financial Ratios 3. Du Pont Identity 4. Payout, Retention Ratios, and Growth Rate 5. Problems with Financial Statement

5. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.3 1.Evaluate Financial Statements Performance evaluation – identifying problematic operation and adjusting forecasting target Internal uses External uses Creditors, Stockholders Suppliers, Customers Planning for the future – estimating future cash flows

6. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.4 Benchmarking Time-Trend Analysis Used to see how the firm’s performance is changing through time Peer Group Analysis Compare to similar companies or within industries SIC (Standard Industrial Classification) and NAICS (North American Industry Classification System) codes

7. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.5 Standardized Financial Statements Common-Size Balance Sheets Compute all accounts as a percent of total assets Common-Size Income Statements Compute all line items as a percent of sales Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry

8. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.6 Balance Sheets

9. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.7 Common-Size Balance Sheets

10. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.8 Income Statements

11. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.9 Common-Size Income Statements

12. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.10 2. 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

13. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.11 Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios

14. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.12 Sample Balance Sheet Cash680,623A/P318,301 A/R1,051,438N/P4,613 Inventory300,459Other CL1,645,748 Other CA415,310Total CL1,968,662 Total CA2,447,830LT Debt909,814 Net FA3,415,159C/S2,984,513 Total Assets5,862,989Total Liab. & Equity5,862,989 Numbers in thousands

15. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.13 Sample Income Statement Revenues5,250,538 Cost of Goods Sold2,046,645 Expenses1,904,556 Depreciation & Amortization124,647 EBIT1,174,690 Interest Expense5,785 Taxable Income1,168,905 Taxes 412,495 Net Income756,410 EPS3.92 Dividends per share1.20 Numbers in thousands, except EPS & DPS

16. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.14 2.1 Short-term Solvency Measures: Liquidity Ratios Evaluate the firm’s ability to pay its bills over the short run without undue stress. Current Ratio = CA / CL 2,447,830 / 1,968,662 = 1.24 times Quick Ratio = (CA – Inventory) / CL (2,447,830 – 300,459) / 1,968,662 = 1.09 times Cash Ratio = Cash / CL 680,623 / 1,968,662 =.346 times

17. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.15 2.2 Long-term Solvency Measures Evaluate the firm’s ability to meet Long-term obligations. Leverage ratios Coverage ratios

18. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.16 Long-term Solvency Measures-1: Leverage Ratios Total Debt Ratio = TD/TA= (TA – TE) / TA (5,862,989 – 2,984,513) / 5,862,989 =.491 times or 49.1% The firm finances slightly over 49% of their assets with debt. Debt/Equity = TD / TE (5,862,989 – 2,984,513) / 2,984,513 =.964 times Equity Multiplier (EM) = TA / TE = 1 + D/E 1 +.964 = 1.964

19. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.17 Long-term Solvency Measures-2: Coverage Ratios Times Interest Earned = EBIT / Interest 1,174,900 / 5,785 = 203 times Cash Coverage = (EBIT + Depr. & Amort.) / Interest (1,174,900 + 124,647) / 5,785 = 225 times

20. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.18 2.3 Asset Management Measures Evaluate how efficiently the firm uses its asset to generate sales. Inventory ratios Receivable ratios Total asset turnover

21. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.19 Asset Management Measures-1: Inventory Ratios Inventory Turnover = Cost of Goods Sold / Inventory 2,046,645 / 300,459 = 6.81 times Days’ Sales in Inventory = 365 / Inventory Turnover 365 / 6.81 = 54 days

22. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.20 Asset Management Measures-2: Receivables Ratios Receivables Turnover = Sales / Accounts Receivable 5,250,538 / 1,051,438 = 4.99 times Days’ Sales in Receivables = 365 / Receivables Turnover 365 / 4.99 = 73 days

23. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.21 Asset Management Measures-3: Total Asset Turnover Total Asset Turnover = Sales / Total Assets 5,250,538 / 5,862,989 =.896 times Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

24. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.22 2.4 Profitability Measures: Profitability Ratios Evaluate the operation efficiency (the ability to control cost) of the firm. Profit Margin = Net Income / Sales 756,410 / 5,250,538 =.1441 times or 14.41% Return on Assets (ROA) = Net Income / Total Assets 756,410 / 5,862,989 =.1290 times or 12.90% Return on Equity (ROE) = Net Income / Total Equity 756,410 / 2,984,513 =.2534 times or 25.34%

25. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.23 2.5 Market Value Measures: Market Value Ratios Illustrate the difference between market and book value of the firm. Market Price (12/31/04) = $91.54 per share Shares outstanding = 189,813,459 PE Ratio = Price per share / Earnings per share 91.54 / 3.92 = 23.35 times Market-to-book ratio = market value per share / book value per share 91.54 / (2,984,513,000 / 189,813,459) = 5.82 times

26. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.24 Table 3.5 50%

27. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.25 Question ProfitTotal AssetEquity MarginTurnoverMultiplier Short-term Solvency Long-term Solvency Asset Management Profitability Market Value

28. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.26 3.Du Pont Identity

29. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.27 Deriving the Du Pont Identity ROE = NI / TE Multiply by 1 and then rearrange ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM Multiply by 1 again and then rearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM

30. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.28 Using the Du Pont Identity ROE = PM * TAT * EM Profit margin is a measure of the firm’s operating efficiency – how well does it control costs Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets Equity multiplier is a measure of the firm’s financial leverage 75%

31. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.29 4. Payout and Retention Ratios Dividend payout ratio = Cash dividends / Net income 1.20 / 3.92 =.3061 or 30.61% Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio = b (3.92 – 1.20) / 3.92 =.6939 = 69.39% Or 1 -.3061 =.6939 = 69.39%

32. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.30 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.

33. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.31 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.

34. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.32 Determinants of Growth Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

35. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.33 Table 3.6

36. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.34 5.Problems with Financial Statement Little financial theory and economic logic exists with financial statements Limits in comparability 1. Diversified business in conglomerates 2. Different accounting standards across nation 3. Different corporate structure 100%

37. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.35 Review Questions 1. How do you standardize balance sheets and income statements and why is standardization useful? 2. What are the major categories of ratios and what does each category of ratios measure? How to interpret each ratio? What are the relationships among three leverage ratios? 3. What is Du Pont Identity and what are the components of Du Pont Identity? 4. What is retention ratio, internal/sustainable growth rate? What are the major determinants of a firm’s internal and sustainable growth potential? 5. What are some of the problems associated with financial statement analysis?