0. Working With Financial Statements

1. Chapter Outline Cash Flow and Financial Statements: A Closer Look
Standardized Financial Statements
Ratio Analysis
The DuPont Identity
Using Financial Statement Information

2. Sample Balance Sheet Numbers in millions 2003 2002 Cash 696 58 A/P 307
303
A/R
956
992
N/P 26
119
Inventory
301
361
Other CL
1,662
1,353
Other CA
264
Total CL
1,995
1,775
Total CA
2,256
1,675
LT Debt
843
1,091
Net FA
3,138
3,358
C/S
2,556
2,167
Total Assets
5,394
5,033
Total Liab. & Equity
The numbers in this sample balance sheet are based on the 2003 annual report for McGraw-Hill. The categories were condensed and rounded for simplicity.

3. Sample Income Statement
Numbers in millions, except EPS & DPS
Revenues
5,000
Cost of Goods Sold
2,006
Expenses
1,740
Depreciation
116
EBIT
1,138
Interest Expense 7
Taxable Income
1,131
Taxes
442
Net Income
689
EPS
3.61
Dividends per share
1.08
This sample income statement is based on information from the McGraw-Hill 2003 annual report, the net income figure and EPS are based on income from continuing operations. There are million shares outstanding.

4. Sources and Uses Sources Uses
Cash inflow – occurs when we “sell” something
Decrease in asset account (Sample B/S)
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
Accounts payable, other current liabilities, and common stock
Uses
Cash outflow – occurs when we “buy” something
Increase in asset account
Cash and other current assets
Decrease in liability or equity account
Notes payable and long-term debt
Click on Sample B/S to go to the Balance Sheet to illustrate the accounts that are sources and uses, On the B/S Click on the small green arrow to return to this slide.

5. Statement of Cash Flows
Statement that summarizes the sources and uses of cash
Changes divided into three major categories
Operating Activity – includes net income and changes in most current accounts
Investment Activity – includes changes in fixed assets
Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends

6. Sample Statement of Cash Flows
Numbers in millions
Cash, beginning of year 58
Financing Activity
Operating Activity
Decrease in Notes Payable
-93
Net Income
689
Decrease in LT Debt
-248
Plus: Depreciation
116
Decrease in C/S (minus RE)
-94
Decrease in A/R 36
Dividends Paid
-206
Decrease in Inventory 60
Net Cash from Financing
-641
Increase in A/P 4
Net Increase in Cash
638
Increase in Other CL
309
Cash End of Year
696
Less: Increase in CA
-39
Net Cash from Operations
1,175
Investment Activity
Sale of Fixed Assets
104
Net Cash from Investments
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 it’s negative then we sold fixed assets.
3138 – = -104 so we sold 104 million worth of fixed assets
Remind students 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 = 483
Change in C/S = 2556 – 2167 – 483 = -94

7. 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. 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 is important
Ratios are used both internally and externally

9. 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
The ratios in the following slides will be computed using the 2003 information from the Sample Balance Sheet and Income Statement.

10. Computing Liquidity Ratios
Current Ratio = CA / CL
2256 / 1995 = 1.13 times
Quick Ratio = (CA – Inventory) / CL
(2256 – 1995) / 1995 = times
Cash Ratio = Cash / CL
696 / 1995 = .35 times
NWC to Total Assets = NWC / TA
(2256 – 1995) / 5394 = .05
Interval Measure = CA / average daily operating costs
2256 / (( )/365) = days
The firm is just barely able to cover current liabilities with it’s current assets in A short-term creditor might find this a bit disconcerting and may reduce the likelihood that they would lend money to the company. The ratio should be compared to the industry – it’s possible that this industry has a substantial amount of cash flow and that they can meet their current liabilities out of cash flow instead of relying solely on the liquidation of current assets that are on the books. Also, the CR for 2002 was .94, so the company has improved from the previous year.
The quick ratio is quite a bit lower than the current ratio, so inventory seems to be an important component of current assets.
This company carries a low cash balance, although the cash ratio has increased substantially from the previous year (.03 in 2002). This may be an indication that they are aggressively investing in assets that will provide higher returns. We need to make sure that we have enough cash to meet our obligations, but too much cash reduces the return earned by the company.
The NWC to TA measure seems relatively low, but is consistent with the current ratio.
The Interval Measure indicates that the company can meet average daily expenses with current assets for almost 220 days.

11. Computing Long-term Solvency Ratios
Total Debt Ratio = (TA – TE) / TA
(5394 – 2556) / 5394 = 52.61%
Debt/Equity = TD / TE
(5394 – 2556) / 2556 = 1.11 times
Equity Multiplier = TA / TE = 1 + D/E
= 2.11
Long-term debt ratio = LTD / (LTD + TE)
843 / ( ) = 24.80%
Note that these are often called leverage ratios.
TE = total equity and TA = total assets, the numerator in the total debt ratio could also be found by adding all of the current and long-term liabilities.
The firm finances almost 53% of its assets with debt. This is down from about 57% from the previous year.
Another way to compute the D/E ratio if you already have the total debt ratio:
D/E = Total debt ratio / (1 – total debt ratio) = / ( ) = 1.11
The EM is one of the ratios that is used in the DuPont Identity as a measure of the firm’s financial leverage.
The Long-term debt ratio is down from 33.49% in 2002.

12. Computing Coverage Ratios
Times Interest Earned = EBIT / Interest
1138 / 7 = times
Cash Coverage = (EBIT + Depreciation) / Interest
( ) / 7 = times
Even though the company is financed with over 64% debt, they have a substantial amount of operating income available to cover the required interest payments.
Remember that depreciation is a non-cash deduction. A better indication of a firm’s ability to meet interest payments may be to add back the depreciation to get an estimate of cash flow before taxes.

13. Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
2006 / 301 = 6.66 times
Days’ Sales in Inventory = 365 / Inventory Turnover
365 / 6.66 = 55 days
Inventory turnover can be computed using either ending inventory or average inventory when you have both beginning and ending figures. It is important to be consistent with whatever benchmark you are using to analyze the company’s strengths or weaknesses.
It is also important to consider seasonality in sales. If the balance sheet is prepared at a time when there is a large inventory build-up to meet seasonal demand, then the inventory turnover will be understated and you might believe that the company is not performing as well as it is. On the other hand, if the balance sheet is prepared when inventory has been drawn down due to seasonal sales, then the inventory turnover would be overstated and the company may appear to be doing better than it really is. Averages using annual data may not fix this problem. If a company has seasonal sales, you may want to look at quarterly averages to get a better indication of turnover.
The previous edition of these slides used the 2000 annual report for McGraw-Hill and the Days’ Sales in Inventory at that time was 81 days, so they have significantly improved their inventory turnover during the last 3 years.

14. Computing Receivables Ratios
Receivables Turnover = Sales / Accounts Receivable
5000 / 956 = 5.23 times
Days’ Sales in Receivables = 365 / Receivables Turnover
365 / 5.23 = 70 days
Technically, the sales figure should be credit sales. This is often difficult to determine from the income statements provided in annual reports. If you use total sales instead of credit sales, you will overstate your turnover level. You need to recognize this bias when credit sales are unavailable, particularly if a large portion of the sales are cash sales.
As with inventory turnover, you can use either ending receivables or an average of beginning and ending.
You also run into the same seasonal issues as discussed with inventory.
Probably the best benchmark for days’ sales in receivables is the company’s credit terms. If the company offers a discount (1/10 net 30), then you would like to see days’ sales in receivables less than 30. If the company does not offer a discount (net 30), then you would like to see days’ sales in receivables close to the net terms. If days’ sales in receivables is substantially larger than the net terms, then you first need to look for biases, such as seasonality in sales. If this does not provide an explanation for the difference, then the company may need to take another look at its credit policy (who it grants credit to and its collection procedures).
From the 2000 annual report, the days’ sales in receivables was 92 days, so the company has substantially improved its average collection period as well.

15. Computing Total Asset Turnover
Total Asset Turnover = Sales / Total Assets
5000 / 5394 = .93
It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
NWC Turnover = Sales / NWC
5000 / (2256 – 1995) = times
Fixed Asset Turnover = Sales / NFA
5000 / 3138 = 1.59 times
Having a TAT of less than one is not a problem for most firms. Fixed assets are expensive and are meant to provide sales over a long period of time. This is why the matching principle indicates that they should be depreciated instead of immediately expensed.
This is one of the ratios that will be used in the DuPont identity.

16. Computing Profitability Measures
Profit Margin = Net Income / Sales
689 / 5000 = 13.78%
Return on Assets (ROA) = Net Income / Total Assets
689 / 5394 = 12.77%
Return on Equity (ROE) = Net Income / Total Equity
689 / 2556 = 26.96%
You can also compute the gross profit margin and the operating profit margin.
GPM = (Sales – COGS) / Sales = (5000 – 2006) / 5000 = 59.88%
OPM = EBIT / Sales = 1138 / 5000 = 22.76%
Profit margin is one of the components of the DuPont identity and is a measure of operating efficiency. It measures how well the firm controls the costs required to generate the revenues. It tells how much the firm earns for every dollar in sales. In the example, the firm earns almost $0.14 for each dollar in sales.
Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return on investment). As with many of the ratios, there are variations in how they can be computed. The most important thing is to make sure that you are computing them the same way as the benchmark you are using.
ROE will always be higher than ROA as long as the firm has debt. The greater the leverage the larger the difference will be. ROE is often used as a measure of how well management is attaining the goal of owner wealth maximization. The DuPont identity is used to identify factors that affect the ROE.

17. Computing Market Value Measures
Market Price = $87.65 per share
Shares outstanding = million
PE Ratio = Price per share / Earnings per share
87.65 / 3.61 = times
Market-to-book ratio = market value per share / book value per share
87.65 / (2556 / 190.9) = 6.56 times
The price is as of Nov. 9, 2004

18. The DuPont Identity (1)
The DuPont Identity = Relationship of ROI and ROE:
ROI: Return on Investment (sometimes called ROA-return on assets): Initially compares income as a percentage of total investment, a basic measure of profitability
ROI = Net Income
Total Assets
The DuPont model divides this into two factors: profit margin & asset turnover, illustrating both profitability of operations (profit margin) and efficient use of assets (turnover)
ROI = Net Income x Sales
Sales Total Assets
ROI = (Profit margin) x (Asset Turnover)

19. The DuPont Identity (2)
Return on Equity = basic measure of profitability on assets actually provided by owners of a firm:
Net Income
ROE = Owner’s Equity
The DuPont identity combines ROI & ROE into a three part analysis:
ROE = Net Income x Sales x Total Assets
Sales Total Assets Owner’s Equity
Or ROE = Return on Investment x Equity Multiplier
Or ROE = Profit Margin x Asset Turnover x Equity Multiplier

20. The DuPont Identity (3)
Putting it all together gives the DuPont identity:
ROE = ROA x Equity multiplier = Profit margin x Total asset turnover x Equity multiplier
Profitability (or the lack thereof!) thus has three parts:
Operating efficiency (profit margin)
Asset use efficiency (asset turnover)
Financial leverage (equity multiplier)

21. The DuPont Identity (4)
The successful financial manager must be able to make effective decisions influencing all three elements:
To survive at all, the firm must be effective in its use of revenues to generate profits (operating efficiency--profit margin)
To generate profitability, the firm must utilize its investment in assets wisely to convert revenues to profit (asset turnover-efficiency)
But if a firm can generate a return on assets greater than its net borrowing costs, it can return profits to investors more effectively by financial leverage—using borrowed money to generate profits rather than tying up owners’ funds (equity multiplier)

22. Expanded DuPont Analysis – Aeropostale Data
Balance Sheet Data
Cash = 138,356
Inventory = 61,807
Other CA = 12,284
Fixed Assets = 94,601
EM = 1.654
Computations
TA = 307,048
TAT = 2.393
Income Statement Data
Sales = 734,868
COGS = 505,152
SG&A = 141,520
Interest = (760)
Taxes = 34,702
Computations
NI = 54,254
PM = 7.383%
ROA = %
ROE = %
Aeropostale did not have any accounts receivable
TA = 138, , , ,601 = 307,048
TAT = 734,868 / 307,048 = 2.393
NI = 734,868 – 505,152 – 141,520 – (760) – 34,702 = 54,254
PM = 54,254 / 734,868 = 7.383%
ROA = TAT*PM = 2.393*7.383% = %
ROE = ROA*EM = %*1.654 = %

23. Aeropostale Extended DuPont Chart  + +
Note that costs are listed as outflows – this is why there is an addition sign between total costs and sales.

24. Why Evaluate Financial Statements?
Internal uses
Performance evaluation – compensation and comparison between divisions
Planning for the future – guide in estimating future cash flows
External uses
Creditors
Suppliers
Customers
Stockholders

25. Benchmarking
Ratios are not very helpful by themselves; they need to be compared to something
Time-Trend Analysis
Used to see how the firm’s performance is changing through time
Internal and external uses
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes
SIC codes have been used many years to identify industries and allow for comparison with industry average ratios. The SIC codes are limited however and have not kept pace with a rapidly changing environment. Consequently, the North American Industry Classification System was introduced in 1997 to alleviate some of the problems with SIC codes.
www: Click on the web surfer to go the NAICS home page. It provides information on the change to the NAICS and conversion between SIC and NAICS codes.

26. Real World Example - I
Ratios are figured using financial data from the 2003 Annual Report for Home Depot
Compare the ratios to the industry ratios in Table 3.12 in the book
Home Depot’s fiscal year ends Feb. 1
Be sure to note how the ratios are computed in the table so that you can compute comparable numbers.
Home Depot sales = $64,816 MM
Technically, Home Depot has an SIC code of 5211, but EDGAR did not list any nationally known companies with the SIC codes listed in Tables 3.11 and 3.12.
www: The annual report was downloaded from the company’s web site and that is the hot link that is provided above.
It would be a good exercise to have the students print the balance sheet and income statement for the latest year and work through these ratios in class. They could then compare the ratios to the table in the book. If you do this, be sure to point out that you should technically use benchmark data for the same time period.

27. Real World Example - II Liquidity ratios Long-term solvency ratio
Current ratio = 1.40x; Industry = 1.8x
Quick ratio = .45x; Industry = .5x
Long-term solvency ratio
Debt/Equity ratio (Debt / Worth) = .54x; Industry = 2.2x.
Coverage ratio
Times Interest Earned = 2282x; Industry = 3.2x
The industry number reported above is the median from the table. I also used the 25MM and over column to better match size.
Liquidity ratio: Home Depot has a current ratio below the median and slightly above the lower quartile. Is this good or bad? Short-term creditors like high current ratios, so the company may have more difficulty securing short-term financing. However, it could also mean that this company does a better job managing its current assets and is better able to meet short-term liabilities from current cash flow.
Quick ratio: Home Depot is still below the median, but much closer.
Debt/Equity ratio: Home Depot is well below the industry average and has much less debt than 75% of the companies in the industry. Creditors like this, however, the firm may be foregoing valuable tax benefits associated with interest payments. Based on industry figures, Home Depot may have substantial unused debt capacity and might be able to increase shareholder wealth by taking on some additional debt.
Times Interest Earned: This ratio is substantially higher than the industry median and is another indication that the company may have significant debt capacity available. Home Depot carries quite a substantial amount of cash and equivalents. The interest received on the excess cash can be used to pay the interest expense on debt – in fact for the fiscal year ended Feb. 1, 2004, Home Depot had 59MM in interest income and 62MM in interest expense. This is another reason for the extremely high TIE.

28. Real World Example - III
Asset management ratios:
Inventory turnover = 4.9x; Industry = 3.5x
Receivables turnover = 59.1x (6 days); Industry = 24.5x (15 days)
Total asset turnover = 1.9x; Industry = 2.3x
Profitability ratios
Profit margin before taxes = 10.6%; Industry = 2.7%
ROA (profit before taxes / total assets) = 19.9%; Industry = 4.9%
ROE = (profit before taxes / tangible net worth) = 34.6%; Industry = 23.7%
Inventory Turnover: The inventory turnover is substantially higher than the industry median and is also higher than the upper quartile. Either the company is very good at managing inventory relative to the industry or they are running short on inventory. It is important for the company to examine why this ratio is so different from the industry.
Receivables are collected substantially faster than the industry median and almost equal to the upper quartile. This may be because the majority of Home Depot’s sales are actually cash sales and the industry may in general sell more on credit.
Total Asset Turnover: The company is below the industry median and right at the lower quartile. The problem is probably related to excess cash and fixed assets since both inventory and receivables are turning so quickly.
Profit margin before taxes (From Table 3.11): Home Depot’s profit margin is substantially higher than the median. This is generally good as long as the company is not foregoing necessary expenses just to increase the bottom line.
ROA: The ROA is substantially higher than the upper quartile for the industry. This shows excellent return characteristics relative to the industry.
ROE: The ROE is higher than the median, but not as high as the upper quartile. The different results between ROE and ROA can be directly attributed to the lower levels of debt for Home Depot (remember the DuPont analysis).
Note that ROA and ROE are computed using profit before taxes to be consistent with the numbers in the table.

29. Potential Problems
There is no underlying theory, so there is no way to know which ratios are most relevant
Benchmarking is difficult for diversified firms
Globalization and international competition makes comparison more difficult because of differences in accounting regulations
Varying accounting procedures, i.e. FIFO vs. LIFO
Different fiscal years
Extraordinary events

30. Work the Web Example
The Internet makes ratio analysis much easier than it has been in the past
Click on the web surfer to go to
Choose a company and enter its ticker symbol
Click on Ratios and then Financial Condition and see what information is available
Note that you will have to join – but it is free.

31. End of Chapter