Working With Financial Statements Chapter Three Working With Financial Statements

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

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

See 3.5: Sources & Uses of Cash Balance Sheet, As of Dec 31 2006 2005 Cash & Equivalents 3,171 6,489 A/P 313,286 340,220 A/R 1,095,118 1,048,991 N/P 227,848 86,631 Inventory 388,947 295,255 Other CL 1,239,651 1,098,602 Other CA 314,454 232,304 Total CL 1,780,785 1,525,453 Total CA 1,801,690 1,583,039 LT Debt 1,389,615 871,851 Net FA 3,129,754 2,535,072 C/S 1,761,044 1,648,490 Total Assets 4,931,444 4,118,111 Total Liab. & Equity The numbers in this sample balance sheet are based on the 2000 annual report for McGraw-Hill. The categories were condensed for simplicity. See 3.5: Sources & Uses of Cash

Income Statement: Jan 1 – Dec 31, 2006 Revenues 4,335,491 Cost of Goods Sold 1,762,721 Expenses 1,390,262 Depreciation 362,325 EBIT 820,183 Interest Expense 52,841 Taxable Income 767,342 Taxes 295,426 Net Income 471,916 EPS (Earnings Per Share) 2.41 Dividends per share 0.93 This sample income statement is based on information from the McGraw-Hill 2000 annual report. Numbers are in thousands, except EPS & DPS

Sources and Uses of Cash 3.1 Cash inflow – occurs when we “sell” something Decrease in asset account (sell inventory, fixed assets, etc) Increase in liability or equity account (sell a bond, common stock, etc) Uses Cash outflow – occurs when we “buy” something Increase in asset account (buy inventory or fixed assets) Decrease in liability or equity account (Redeem bonds or shares) 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.

Statement of Cash Flows Statement of Cash Flows – the 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

Sample Statement of Cash Flows Numbers are in thousands Cash, beginning of year 6,489 Financing Activity Operating Activity Increase in Notes Payable 141,217 Net Income 471,916 Increase in LT Debt 517,764 Plus: Depreciation 362,325 Decrease in C/S -36,159 Increase in Other CL 141,049 Dividends Paid -395,521 Less: Increase in A/R -46,127 Net Cash from Financing 227,301 Increase in Inventory -93,692 Net Decrease in Cash -3,319 Increase in Other CA -82,150 Cash End of Year 3,170* Decrease in A/P -26,934 Net Cash from Operations 726,387 Investment Activity Fixed Asset Acquisition -957,007 Net Cash from Investments *Difference due to rounding of dividends 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. Additions to RE = 471,916 – 395,521 = 76,395 Change in C/S = 1,761,044 – 1,648,490 - 76,395 = -36,159 From the B/S

Standardized Financial Statements 3.2 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

Common Size Income Statement: Example Income Common Size Statement Income Statement Revenue $70,134 100.0% Cost of Goods Sold $44,221 63.1% Gross Profit $25,913 36.9% SG&A $13,531 19.3% Operating Income $12,382 17.7% Interest Expense $2,862 4.1% Taxes $3,766 5.4% Net Income $5,754 8.2%

Common Size: Balance Sheet Assets Balance Sheet Balance Sheet Cash & Securities $ 6,029 15.1% Accounts Receivable $14,378 36.0% Inventory $17,136 42.9% Total Current Assets $37,543 93.9% Plant & Equipment $ 2,442 6.1% Total Assets $39,985 100%

Common Size: Balance Sheet Liabilities Balance Sheet Balance Sheet Current Liabilities $ 14,251 35.6% Long Term Debt $12,624 31.6% Total Liabilities $26,875 67.2% Shareholder’s Equity $13,110 32.8% Total Liab. & Equity $39,985 100%

As we look at each ratio, ask yourself Ratio Analysis 3.3 Ratios also allow for better comparison through time or between companies As we look at each ratio, ask yourself How is the ratio computed? What is it intended to measure (and why do I care about measuring this variable)? What might a high or a low value tell us? How might such a value be misleading? How could this measure be improved? 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.

Categories of Financial Ratios Liquidity ratios (Measure short term solvency) Financial leverage ratios (Long-term solvency) Asset management ratios Profitability ratios Market value ratios

Liquidity Ratios Current Ratio = Current Assets / Current Liabilities 1,801,690 / 1,780,785 = 1.01 times Quick Ratio = Current Assets – Inventory Current Liabilities (1,801,690 – 388,947) / 1,780,785 = .793 times Cash Ratio = Cash / Current Liabilities 3,171 / 1,780,785 = .002 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.

Computing Long-term Solvency Ratios Total Debt Ratio = Total Assets – Total Equity Total Assets (4,931,444 – 1,761,044) / 4,931,444 = .6429 times or 64.29% The firm finances approximately 64% of its assets with debt. Debt/Equity = Total Debt / Total Equity (4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times Equity Multiplier = Total Assets / Total Equity = 1 + D/E 1 + 1.800 = 2.800 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) = .6429 / (1 - .6429) = 1.800 The EM is one of the ratios that is used in the Du Pont Identity as a measure of the firm’s financial leverage.

Computing Coverage Ratios Times Interest Earned = EBIT / Interest 820,183 / 52,841 = 15.5 times Cash Coverage = (EBIT + Depreciation) / Interest (820,183 + 362,325) / 52,841 = 22.38 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.

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 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.

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 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).

Computing Total Asset Turnover NWC Turnover = Sales / NWC 4,335,491 / (1,801,690 - 1,780,785) = 207.390 times Fixed Asset Turnover = Sales / Net Fixed Assets 4,335,491 / 3,129,754 = 1.385 times 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 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.

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% 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.

Computing Market Value Measures Market Price = $60.98 per share Shares outstanding = 205,838,910 PE Ratio = Price per share / Earnings per share 60.98 / 2.41 = 25.3 times Market-to-book ratio = market value per share / book value per share 60.98 / (1,761,044,000 / 205,838,910) = 7.1 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.

Table 3.8 – Common Financial Ratios

Table 3.8 – Common Financial Ratios

Deriving the Du Pont Identity 3.4 Multiply by 1 and then rearrange NI = Net Income TE = Total Equity TA = Total Assets

Deriving the Du Pont Identity Multiply by 1 again and then rearrange

Using the Du Pont Identity ROE = PM * AY * EM Profit margin is a measure of the firm’s operating efficiency – how well does it control costs Asset Yield (Total asset turnover) is a measure of the firm’s asset use efficiency – how well does it manage its assets in driving sales 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.

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

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 (North American Industry Classification System) codes, RMA, Financial Post Datagroup, and Dun & Bradstreet Canada 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.

Potential Problems with Ratios 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

Quick Quiz 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?

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