Chapter McGraw-Hill Ryerson © 2013 McGraw-Hill Ryerson Limited Working With Financial Statements Prepared by Anne Inglis 3

3-1 Key Concepts and Skills Know the sources and uses of a firm’s cash flows. Understand how to standardize financial statements for comparison purposes Know how to compute and interpret common financial ratios Be able to understand the determinants of a firm’s profitability Understand some of the problems and pitfalls in financial statement analysis © 2013 McGraw-Hill Ryerson Limited

3-2 Chapter Outline Cash Flow and Financial Statements: A Closer Look Standardized Financial Statements Ratio Analysis The Du Pont Identity Using Financial Statement Information Summary and Conclusions © 2013 McGraw-Hill Ryerson Limited

3-3 Sample Statement of Financial Position Cash & Equivalents 3,1716,489A/P313,286340,220 A/R1,095,1181,048,991N/P227,84886,631 Inventory388,947295,255Other CL1,239,6511,098,602 Other CA314,454232,304Total CL1,780,7851,525,453 Total CA1,801,6901,583,039LT Debt Retained Earnings 1,389,615 76, ,851 0 Net FA3,129,7542,535,072C/S1,684,6491,720,807 Total Assets4,931,4444,118,111Total Liab. & Equity 4,931,4444,118,111 Numbers are in thousands © 2013 McGraw-Hill Ryerson Limited

3-4 Sample Statement of Comprehensive Income Revenues4,335,491 Cost of Goods Sold1,762,721 Expenses1,390,262 Depreciation362,325 EBIT820,183 Interest Expense52,841 Taxable Income767,342 Taxes 295,426 Net Income471,916 Additions to retained earnings? Dividends Paid395,521 Numbers are in thousands, except EPS & DPS © 2013 McGraw-Hill Ryerson Limited

3-5 Sources and Uses of Cash 3.1 Sources Cash inflow – occurs when we “sell” something Decrease in asset account Increase in liability or equity account Uses Cash outflow – occurs when we “buy” something Increase in asset account Decrease in liability or equity account LO1 © 2013 McGraw-Hill Ryerson Limited

3-6 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 LO1 © 2013 McGraw-Hill Ryerson Limited

3-7 Sample Statement of Cash Flows Cash, beginning of year6,489Financing Activity Operating Activity Increase in Notes Payable141,217 Net Income471,916 Increase in LT Debt517,764 Plus: Depreciation362,325 Decrease in C/S-36,158 Increase in Other CL141,049 Dividends Paid-395,521 Less: Increase in A/R-46,127 Net Cash from Financing227,302 Increase in Inventory-93,692Net Decrease in Cash-3,318 Increase in Other CA-82,150Cash End of Year3,170* Decrease in A/P-26,934 Net Cash from Operations726,387 Investment Activity Fixed Asset Acquisition- 957,007 Net Cash from Investments - 957,007 *Difference due to rounding of dividends Numbers are in thousands LO1 © 2013 McGraw-Hill Ryerson Limited

3-8 Standardized Financial Statements 3.2 Common-Size Statements of Financial Position Compute all accounts as a percent of total assets Common-Size Statements of Comprehensive Income Compute all line items as a percent of sales LO2 © 2013 McGraw-Hill Ryerson Limited

3-9 Why do we use 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 LO2 © 2013 McGraw-Hill Ryerson Limited

3-10 Ratio Analysis 3.3 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 LO3 © 2013 McGraw-Hill Ryerson Limited

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 LO3 © 2013 McGraw-Hill Ryerson Limited

3-12 Computing Liquidity Ratios Current Ratio = CA / CL 1,801,690 / 1,780,785 = 1.01 times Quick Ratio = (CA – Inventory) / CL (1,801,690 – 388,947) / 1,780,785 =.793 times Cash Ratio = Cash / CL 3,171 / 1,780,785 =.002 times Cash means cash + cash equivalents LO3 © 2013 McGraw-Hill Ryerson Limited

3-13 Computing Long-term Solvency Ratios Total Debt Ratio = (TA – TE) / TA (4,931,444 – 1,761,044) / 4,931,444 =.6429 times or 64.29% The firm finances a little over 64% of its assets with debt. LO3 © 2013 McGraw-Hill Ryerson Limited

3-14 Long-Term Solvency Ratios continued Debt/Equity = TD / TE (4,931,444 – 1,761,044) / 1, 761,044 = times Equity Multiplier = TA / TE = 1 + D/E = LO3 © 2013 McGraw-Hill Ryerson Limited

3-15 Computing Coverage Ratios Times Interest Earned = EBIT / Interest 820,183 / 52,841 = 15.5 times Cash Coverage = (EBIT + Depreciation) / Interest (820, ,325) / 52,841 = times LO3 © 2013 McGraw-Hill Ryerson Limited

3-16 Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / Inventory 1,762,721 / 388,947 = 4.53 times Days’ Sales in Inventory = 365 / Inventory Turnover 365 / 4.53 = 81 days LO3 © 2013 McGraw-Hill Ryerson Limited

3-17 Computing Receivables Ratios Receivables Turnover = Sales / Accounts Receivable 4,335,491 / 1,095,118 = 3.96 times Days’ Sales in Receivables = 365 / Receivables Turnover 365 / 3.96 = 92 days LO3 © 2013 McGraw-Hill Ryerson Limited

3-18 Computing Total Asset Turnover NWC Turnover = Sales / NWC 4,335,491 / (1,801, ,780,785) = times Fixed Asset Turnover = Sales / Net Fixed Assets 4,335,491 / 3,129,754 = times LO3 © 2013 McGraw-Hill Ryerson Limited

3-19 Asset Turnover Ratios continued Total Asset Turnover = Sales / Total Assets 4,335,491 / 4,931,444 =.88 times Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets LO3 © 2013 McGraw-Hill Ryerson Limited

3-20 Computing Profitability Measures Profit Margin = Net Income / Sales 471,916 / 4,335,491 =.1088 times or 10.88% Return on Assets (ROA) = Net Income / Total Assets 471,916 / 4,931,444 =.0957 times or 9.57% Return on Equity (ROE) = Net Income / Total Equity 471,916 / 1,761,044 =.2680 times or 26.8% LO3 © 2013 McGraw-Hill Ryerson Limited

3-21 Computing Market Value Measures Market Price of Stock = $60.98 per share Shares outstanding = 205,838,910 Market Value of LTD = $1,461,874,980 EPS = Net Income / Shares Outstanding 471,916,000 / 205,838,910 = 2.29 LO3 © 2013 McGraw-Hill Ryerson Limited

3-22 Market Value Measures Continued PE Ratio = Price per share / Earnings per share / 2.29 = 26.6 times © 2013 McGraw-Hill Ryerson Limited LO3

3-23 Market Value Ratios continued Market-to-book ratio = Market Value Per Share / Book Value Per Share / (1,761,044,000 / 205,838,910) = 7.1 times LO3 © 2013 McGraw-Hill Ryerson Limited

3-24 Table 3.8 – Common Financial Ratios LO3 © 2013 McGraw-Hill Ryerson Limited

3-25 Table 3.8 – Common Financial Ratios LO3 © 2013 McGraw-Hill Ryerson Limited

3-26 Deriving the Du Pont Identity 3.4 ROE = NI / TE Multiply by 1 and then rearrange Multiply by 1 again and then rearrange LO4 © 2013 McGraw-Hill Ryerson Limited

3-27 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 LO4 © 2013 McGraw-Hill Ryerson Limited

3-28 Using Financial Statement Information 3.5 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 LO5 © 2013 McGraw-Hill Ryerson Limited

3-29 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 NAICS codes, Financial Post Datagroup, Dominion Bond Rating Service (DBRS) and Dun & Bradstreet Canada LO5 © 2013 McGraw-Hill Ryerson Limited

3-30 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 LO5 © 2013 McGraw-Hill Ryerson Limited

3-31 Summary 3.6 You should be able to: Identify sources and uses of cash Understand the Statement of Cash Flows Understand how to make standardized financial statements and why they are useful Calculate and evaluate common ratios Understand the Du Pont identity Describe how to establish benchmarks for comparison purposes and understand some key problems that can arise © 2013 McGraw-Hill Ryerson Limited

Homework 1, 2, 5, 18,