1. Working With Financial Statements Chapter 3

2. Key Concepts and Skills
Understand sources and uses of cash and the Statement of Cash Flows
Know how to standardize financial statements for comparison purposes
Know how to compute and interpret important financial ratios
Be able to compute and interpret the Du Pont Identity
Understand the problems and pitfalls in financial statement analysis

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

4. CFFA= CF to creditors+ CF to stockholders
Introduction
Why 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 stockholders
Sources of cash: activities that generate cash
Uses of cash: activities in which the firm spend cash

5. PRUFROCK COROPORATION
Sample Balance Sheet
PRUFROCK COROPORATION
2008 & 2009 Balance Sheet
( $in millions)
CHANGE
2009
2008
LIABILITIES
Current liabilities
ASSETS
Current Assets
+32
344
312 AP
+14 98 84
cash
-35
196
231
Notes payable
+23
188
165 AR -3
540
543
Total
+29
422
393
inventory
-74
457
531
Long-term debt
+66
708
642
Owner’s equity
Fixed assets
+50
550
500
Common stocks & paid-in surplus
+149
2,880
2,631
Net plant & equipment
+242
2,041
1,799
Retained earnings
+292
2,591
2,299
+215
3,588
3,373
Total liabilities & owner’s equity
Total assets

6. Sources and Uses Sources Cash inflow – occurs when we “sell” something
Decrease in asset account
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
Accounts payable, other current liabilities, and common stock

7. NET ADDITION TO CASH = SOURCES OF CASH – USES OF CASH
Sources and Uses
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
NET ADDITION TO CASH = SOURCES OF CASH – USES OF CASH

8. Sample Income Statement
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

9. EX 9 Page 82
Based 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.
375
Decrease in inventory
190
Decrease in AP
210
Increase in notes payable
105
Increase in AR

10. JUST DEW IT COROPORATION
Ex 16 Page 83
JUST DEW IT COROPORATION
2008 &2009 Balance Sheets
LIABILITIES & OWNER’S EQUITY
ASSETS
2009
2008
Current liabilities
Current Assets
46,821
43,050 AP
10,156
8,436
cash
17,382
18,384
Notes payable
23,406
21,530 AR
64,203
61,434
Total
42,650
38,760
Inventory
32,000
25,000
Long-term debt
76,213
68,726
Owner’s equity
40,000
Common stocks & paid-in surplus
188,316
168,998
Retained earnings
228,316
208,998
324,519
295,432
Total liabilities & owner’s equity
Total assets

11. Ex 16 Page 83
For each account on this company’s 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 owner’s equity

12. 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

13. 50 -180 14 98 Financing activities 84 Cash, beginning of year -35
Decrease in notes payable
Operating activity
-74
Decrease in long-term debt
363
Net Income
-121
Dividend paid
Plus: 50
Increase in common stock
276
Depreciation
-180
Net cash from financing activities 32
Increase in accounts payable 14
Net increase in cash
Less: 98
Cash, end of year
-23
Increase in accounts receivable
-29
Increase in inventory
619
Net cash from operating activities
Investments activities
-425
Fixed assets acquisitions
Net cash from investment activities

14. Standardized Financial Statements
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.

15. Standardized Financial Statements
There are three kinds of standardized financial statements:
COMMON-SIZE STATEMENTS
COMMON-BASE YEAR FINANCIAL STATEMENT (Trend analysis)
COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS

16. Standardized Financial Statements
1.COMMON-SIZE STATMENTS
Common-Size Balance Sheets
Compute all accounts as a percent of total assets
(Item/ TA) * 100
Common-Size Income Statements
Compute all line items as a percent of sales
(Item/ SALES) * 100

17. Standardized Financial Statements
2-COMMON-BASE YEAR STATEMENTS:TREND ANALYSIS
Item/ same item in the base year
3-COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS

18. Summary of standardized Balance Sheets
Combined Common-size & Base year Assets
Common-Base year Assets
Common-size Assets
Assets
2009
2008
Current assets
1.08
1.17
2.7%
2.5% 98 84
Cash
1.06
1.14
5.2
4.9
188
165 AR
1.01
1.07
11.8
11.7
422
393
Inventory
1.03
1.10
19.7
19.1
708
642
Total CA
0.99
1.05
80.3
80.9
2,880
2,731
NFA
1.00
100.0%
3,588
3,373
Total Assets

19. JUST DEW IT COROPORATION
2008 & 2009 Balance Sheets
LIABILITIES & OWNER’S EQUITY
ASSETS
2009
2008
Current liabilities
Current Assets
46,821
43,050 AP
10,157
8,436
cash
17,382
18,384
Notes payable
23,406
21,530 AR
64,203
61,434
Total
42,650
38,760
Inventory
32,000
25,000
Long-term debt
76,213
68,726
Owner’s equity
40,000
Common stocks & paid-in surplus
188,316
168,998
Retained earnings
228,316
208,998
248,306
226,706
Net plant & equipment
324,519
295,432
Total liabilities & owner’s equity
Total assets

20. Ex 13, 14 & 15
Prepare the 2009 common-size balance sheet for Just Dew It
Prepare the 2009 common-base year balance sheet for Just Dew It
Prepare the 2009 combined common-size, common-base year balance sheet for Just Dew It

21. Ratio Analysis
Ratios 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 that information is important
Ratios are used both internally and externally

22. Categories of Financial Ratios
Short-term solvency or liquidity ratios
Long-term solvency or financial leverage ratios: The ability to meet long-term obligations
Asset management or turnover ratios: Efficiency of asset use
Profitability ratios
Market value ratios

23. Short-term solvency or liquidity ratios
The ability to pay bills in the short-run
Provide information about the firm’s liquidity
Advantage: BV & MV are similar
Disadvantage: CA & CL change rapidly

24. PRUFROCK COROPORATION
2008 & 2009 Balance Sheet
( $in millions)
CHANGE
2009
2008
LIABILITIES
Current liabilities
ASSETS
Current Assets
+32
344
312 AP
+14 98 84
cash
-35
196
231
Notes payable
+23
188
165 AR -3
540
543
Total
+29
422
393
inventory
-74
457
531
Long-term debt
+66
708
642
Owner’s equity
Fixed assets
+50
550
500
Common stocks & paid-in surplus
+149
2,880
2,631
Net plant & equipment
+242
2,041
1,799
Retained earnings
+292
2,591
2,299
+215
3,588
3,373
Total liabilities & owner’s equity
Total assets

25. Computing Liquidity Ratios
Current ratio= CA CL
708 / 540= 1.31 times
EX 3.1
CA= CL= 2
what happen to the Current ratio if:
The firm pays off some of its creditors? If CA= 3 CL=1
The firm buys some inventory?
The firm sells some merchandize?

26. Computing Liquidity Ratios
Quick Ratio = (CA – Inventory) ÷ CL
( ) ÷ 540 = 0.53 times
Cash ratio = cash ÷ Current liabilities
98 ÷ 540 = 0.18 times
NWC to total assets = NWC ÷ total assets
(708 – 540) ÷ 3,588 = 4.7%
Interval measure = CA ÷ average daily operating costs
1,344 ÷ 365 = 3.68 $ per day
708 ÷ = 192 days

27. Computing Long-term Solvency Ratios
The ability to meet long-term obligations
Total debt ratio = ( TA – TE) ÷ TA
(3,588 – 2,951 )÷ 3,588 = 0.28 times
Debt-equity ratio = TD ÷ TE
Equity = (1- TD) = ( ) = 0.72
0.28 ÷ = 0.39 times

28. Computing Long-term Solvency Ratios
Equity multiplier = TA ÷ TE
1 ÷ 0.72 = 1.39 times
Long-term debt ratio= LTD ÷ (LTD + TE)
457 ÷ ( ,592) = 0.15 times

29. Computing Coverage Ratios
Times interest earned ratio = EBIT ÷ interest
691 ÷ 141 = 4.9 times
Cash coverage ratio=( EBIT + depreciation) ÷ interest
( ) ÷ 141 = 6.9 times

30. Ex 1, 5 page 81
SDJ, 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 what is its debt-equity ratio? What is it equity multiplier?

31. Asset Management measures
Inventory turnover= COGS ÷ inventory
1,344 ÷ 422 =3.2 times
Days’ sales in inventory = 365 days ÷ inventory turnover
365 ÷ 3.2 = 114 days

32. Computing Receivables Ratios
Receivables turnover= sales ÷ AR
2,311 ÷ 188 = 12.3 times
Days’ sales in receivables = 365 days ÷ receivables turnover
365 ÷ = 30 days

33. Computing Total Asset Turnover
NWC turnover = sales ÷ NWC
2,311 ÷ ( ) = 13.8 times
Fixed asset turnover= sales ÷ Net fixed assets
2.311 ÷ 2,880 = 0.8 times
Total asset turnover= sales ÷ total asset
2,311 ÷ 3,588 = 0.64 times

34. Computing Profitability Measures
Profit Margin = Net Income ÷ Sales
363 ÷ 2,311 = 15.7 %
Return on Assets (ROA) = Net Income ÷ Total Assets
363 ÷ 3,588 = %
Return on Equity (ROE) = Net Income ÷ Total Equity
363 ÷ 2,591= 14%

35. Computing Market Value Measures
Prufrock has 33 million shares outstanding and the stock sold for 88$ per share at the end of the year
Price-Earning Ratio = Price per share ÷ Earnings per share
EPS= net income÷ shares outstanding
363÷ 33 =11 $
88 ÷ 11= 8 times

36. Computing Market Value Measures
Price-sales ratio= price per share ÷ sales per share
Sales per share = sales÷ shares out standing
2,311 ÷ 33= 70$
88÷ 70 = 1.26

37. Computing Market Value Measures
Market-to-book ratio = market value per share ÷book value per share
Book value per share= TE ÷ SHARES OUTSTANDING
2,591 ÷ 33 = 78.5$
88 ÷ 78.5 = 1.12 times

38. Ex 2 Page 81
Wakers, 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?

39. Ex 3 Page 81
Ortiz 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?

40. Ex 6 Page 81
Bach 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?

41. Deriving the Du Pont Identity
Investigates what areas of the firm need improvement
Provide a frame work that ties together a firm’s profitability, assets efficiency & the use of debt
Provide the impact of operations on returns
Any weakness on operating assets or efficiency will result in a lower ROE

42. Using the Du Pont Identity
ROE = PM * TAT * EM
Profit margin is a measure of the firm’s operating efficiency – how well it controls 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

43. Expanded Du Pont Analysis – Du Pont Data

44. Extended Du Pont Chart

45. Ex 7 , 8 Page 81
If 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 percent. What is the firm’s debt-equity ratio?

46. Ex 18 Page 83
Y3K, 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?

47. Why Evaluate Financial Statements?
Internal uses
Performance evaluation (Compensation )
Comparison between divisions
Planning for the future – guide in estimating future cash flows
External uses
Creditors
Suppliers
Customers
Stockholders

48. Benchmarking Compare to similar companies or within industries
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

49. 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

50. Review
What 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?
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