Working With Financial Statements Chapter 3

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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

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

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

Computing Liquidity Ratios Current ratio= CA CL 708 / 540= 1.31 times EX 3.1 CA= 4 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?

Computing Liquidity Ratios Quick Ratio = (CA – Inventory) ÷ CL (708 - 422) ÷ 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 ÷ 3.68 = 192 days

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) = (1- 0.28) = 0.72 0.28 ÷ 0.72 = 0.39 times

Computing Long-term Solvency Ratios Equity multiplier = TA ÷ TE 1 ÷ 0.72 = 1.39 times Long-term debt ratio= LTD ÷ (LTD + TE) 457 ÷ (457 + 2,592) = 0.15 times

Computing Coverage Ratios Times interest earned ratio = EBIT ÷ interest 691 ÷ 141 = 4.9 times Cash coverage ratio=( EBIT + depreciation) ÷ interest (691 + 276) ÷ 141 = 6.9 times

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 0.63. what is its debt-equity ratio? What is it equity multiplier?

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

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

Computing Total Asset Turnover NWC turnover = sales ÷ NWC 2,311 ÷ (708- 540) = 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

Computing Profitability Measures Profit Margin = Net Income ÷ Sales 363 ÷ 2,311 = 15.7 % Return on Assets (ROA) = Net Income ÷ Total Assets 363 ÷ 3,588 = 10.12 % Return on Equity (ROE) = Net Income ÷ Total Equity 363 ÷ 2,591= 14%

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

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

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

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?

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?

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?

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

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

Expanded Du Pont Analysis – Du Pont Data

Extended Du Pont Chart

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 18.27 percent. What is the firm’s debt-equity ratio?

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?

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

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

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

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? 3-50