0. Chapter 3
Working With Financial Statements

1. 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. Chapter Outline Standardized Financial Statements Ratio Analysis
The Du Pont Identity
Internal and Sustainable Growth
Using Financial Statement Information

3. 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

4. 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
www: Click on the web surfer to go to CNBC’s stock screener. Choose the “Advanced Search” option to show students the wide range of ratios that can be used for making investment decisions.

5. 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

6. Sample Balance Sheet Cash 6,489 A/P 340,220 A/R 1,052,606 N/P 86,631
Numbers in thousands
Cash
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/S
1,691,493
Total Assets
4,088,797
Total Liab. & Equity
The numbers in this sample balance sheet are based on the 1999 annual report for McGraw-Hill. The categories were condensed for simplicity.

7. Sample Income Statement
Numbers in thousands, except EPS & DPS
Revenues
3,991,997
Cost of Goods Sold
1,738,125
Expenses
1,269,479
Depreciation
308,355
EBIT
739,987
Interest Expense
42,013
Taxable Income
697,974
Taxes
272,210
Net Income
425,764
EPS
2.17
Dividends per share
0.86
This sample income statement is based on information from the McGraw-Hill 1999 annual report.

8. Computing Liquidity Ratios
Current Ratio = CA / CL
= 1.02 times
Quick Ratio = (CA – Inventory) / CL
= .825 times
Cash Ratio = Cash / CL
= .004 times
The firm is just barely able to cover current liabilities with it’s current assets. 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.
The quick ratio is a little lower than the current ratio, but overall inventory seems to be a small component of current assets.
This company carries a very low cash balance. 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.

9. Long-term Solvency Measures
Total Debt Ratio = (TA – TE) / TA
= times or 58.63%
The firm finances almost 59% of their assets with debt.
Debt/Equity = TD / TE
= times
Equity Multiplier = TA / TE = 1 + D/E
= 2.417
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.
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) = / ( ) = 1.417
The EM is one of the ratios that is used in the Du Pont Identity as a measure of the firm’s financial leverage.

10. Computing Coverage Ratios
Times Interest Earned = EBIT / Interest
= 17.6 times
Cash Coverage = (EBIT + Depreciation) / Interest
= times
Even though the company is financed with over 58% 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.

11. Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
= 5.89 times
Days’ Sales in Inventory = 365 / Inventory Turnover
= 62 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.

12. Computing Receivables Ratios
Receivables Turnover = Sales / Accounts Receivable
= 3.79 times
Days’ Sales in Receivables = 365 / Receivables Turnover
= 96 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).

13. Computing Total Asset Turnover
Total Asset Turnover = Sales / Total Assets
= .98 times
Measure of asset use efficiency
Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
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 Du Pont identity.

14. Computing Profitability Measures
Profit Margin = Net Income / Sales
= times or 10.67%
Return on Assets (ROA) = Net Income / Total Assets
= times or 10.41%
Return on Equity (ROE) = Net Income / Total Equity
= times or 25.17%
You can also compute the gross profit margin and the operating profit margin.
Profit margin is one of the components of the Du Pont 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 $0.11 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 Du Pont identity is used to identify factors that affect the ROE.

15. Computing Market Value Measures
Market Price = $ per share
Shares outstanding = 205,838,594
PE 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
Be sure and point out that the numbers in the tables are presented in thousands, so the BV of equity has to have the extra three zeros in order for the market-to-book ratio to work.

16. 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

17. 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
Improving our operating efficiency or our asset use efficiency will improve our return on equity. If the TAT is low compared to our benchmark, then we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong then we can look at fixed asset turnover and cash management.
We can also improve our ROE by increasing our leverage – up to a point. Debt affects a lot of other factors, including profit margin, so we have to be a little careful here. We want to make sure we have enough debt to utilize our interest tax credit effectively, but we don’t want to overdo it. The choice of leverage is discussed in more detail in chapter 13.

18. Payout and Retention Ratios
Dividend payout ratio = Cash dividends / Net income
= or 39.63%
Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio
= = 60.37%
Or = = 60.37%
Note that these ratios can be computed either on a per share basis or on an actual basis.

19. 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.
This firm could grow assets at 6.71% without raising additional external capital.
Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in chapter 13, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.

20. 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.
Note that no new equity is issued.
The sustainable growth rate is substantially higher than the internal growth rate. This is because we are allowing the company to issue debt as well as use internal funds.

21. 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
The first three components come from the ROE and the Du Pont identity.
It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important so long as it continues to maximize shareholder value.

22. 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

23. 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.

24. Real World Example
Ratios are figured using financial data from the 1999 Annual Report for Ethan Allen
Compare the ratios to the industry ratios in Table 3.9 in the book
Ethan Allen’s fiscal year end is June 30.
Be sure to note how the ratios are computed in the table so that you can compute comparable numbers.
Ethan Allan sales = $762 MM
www: The annual report was downloaded from the company’s web site and that is the hot link that is provided above. As time passes and the company produces new annual reports, the information may change, although it is linked directly to 1999, so hopefully it will still be available. If it isn’t, you can either update the ratios, or I have provided summary information in the Instructor’s manual for 1999.
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.

25. Real World Example - II Liquidity ratios Long-term solvency ratio
Current ratio = 2.433x; Industry = 1.4x
Quick ratio = .763x; Industry = .6x
Long-term solvency ratio
Debt/Equity ratio (Debt / Worth) = .371x; Industry = 1.9x.
Coverage ratio
Times Interest Earned = 70.6x; Industry = 3.4x
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: Ethan Allan has an industry well above the median and it is right at the upper quartile. Is this good or bad? Short-term creditors like high current ratios, so the company should have little difficulty receiving short-term financing. However, short-term assets also tend to earn lower returns than do long-term assets, so the company may be passing up returns by holding more short-term assets. Finally, a high current ratio may be indicative of too much inventory or receivables problems.
Quick ratio: Ethan Allan is still above the industry median, but below the upper quartile. This may be an indication of substantial amounts of inventory relative to the industry.
Debt/Equity ratio: Ethan Allan 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, Ethan Allan 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. Ethan Allan carries quite a bit of notes receivables. The interest received on the notes receivables can be used to offset interest expense paid on debt. This is another reason for the extremely high TIE.

26. Real World Example - III
Asset management ratios:
Inventory turnover = 2.8x; Industry = 3.6x
Receivables turnover = 22.2x (16 days); Industry = 17.7x (21 days)
Total asset turnover = 1.6x; Industry = 2.2x
Profitability ratios
Profit margin before taxes = 17.4%; Industry = 3.1%
ROA (profit before taxes / total assets) = 27.6%; Industry = 5.8%
ROE = (profit before taxes / tangible net worth) = 37.9%; Industry = 17.6%
Inventory Turnover: The inventory turnover is substantially lower than the industry median and is right at the lower quartile. This is consistent with the high current ratio and the significant drop in the quick ratio relative to the current ratio. The company may want to examine its current inventory management policies to see if there are ways to maintain less inventory without incurring significant stock-out costs. This may also be a problem with a different accounting method than most firms in the industry or a different fiscal period (note that Ethan Allen’s fiscal year ends in June, but the data in the table is running April to March).
Receivables are collected a little faster than the industry median, however, it is not outside the boundaries of the upper and lower quartiles. There is probably not much of a concern with the firm’s credit policy at this point.
Total Asset Turnover: The company is a little below the industry median, but they are within the boundaries of the upper and lower quartiles. The problem with inventory seems to be mitigated somewhat by the efficient use of other assets.
Profit margin before taxes (From Table 3.8): Ethan Allen’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. The same comments hold for ROE.
Note that ROA and ROE are computed using profit before taxes to be consistent with the numbers in the table.

27. Quick Quiz
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 the major determinants of a firm’s growth potential?
What are some of the problems associated with financial statement analysis?