Working with Financial Statements Why Use Financial Statements? External Users External Users Internal Users Internal Users Trend Analysis – Time Series Trend Analysis – Time Series Comparing Firms Comparing Firms The only good number on a stand alone basis is a phone number (old saying) Different Objectives makes comparisons more difficult Why compare firms…limited investment resources

Working with Financial Statements The Pitfalls of Financial Statements it is not a cookbook – don’t read to much into a single ratio or comparison it is not a cookbook – don’t read to much into a single ratio or comparison financial statements are backward looking financial statements are backward looking financial decisions are forward looking financial decisions are forward looking comparing firms… comparing firms… different industries different timing on recording information different goals different constraints

Working with Financial Statements Ratio Analysis Estimating the Health of the Firm Estimating the Health of the Firm Exxon, McDonalds, Intel, Wal-Mart Which firm is the healthiest? Using Ratios as proxies for health of firm Using Ratios as proxies for health of firm Most profitable Fastest Growing Most stable Recession Proof Long term Survival

Working with Financial Statements Examining the Firm

Working with Financial Statements Four Types of Ratios Liquidity Liquidity The ability to meet obligations on a timely basis Activity Activity Management of assets Debt Debt The borrowing structure of the firm Profitability Profitability The most abused ratios – measure (potential) return

Working with Financial Statements Liquidity Net Working Capital Net Working Capital Current Ratio Current Ratio Quick Ratio Quick Ratio Chapter 2 – Problem 8 Analyze Current and Quick Ratio Analyze Current and Quick Ratio Trend Analysis Trend Analysis Evaluation Evaluation

Working with Financial Statements Activity Ratios Inventory Turnover Inventory Turnover Average Collection Period Average Collection Period Average Payment Period Average Payment Period Asset Turnover Asset Turnover Chapter 2 – Problem 11

Working with Financial Statements Debt Ratios Debt Ratio Debt Ratio Total Liabilities / Total Assets Debt Percent ( 1 – Debt Percent = Equity Percent) Times Interest Earned Times Interest Earned Must make interest payments…failure means the firm is in technical bankruptcy Note before taxes as government is paid after interest Chapter 2 – Problem 12

Working with Financial Statements Profitability Ratios (Most Abused) ROA – Return on Assets ROA – Return on Assets ROE – Return on Equity ROE – Return on Equity P/E Ratio (not in text but very common) P/E Ratio (not in text but very common) Operating Profit Margin Operating Profit Margin % profit per sale dollar before interest and taxes Net Profit Margin Net Profit Margin % profit per sale dollar What is available to shareholders

Working with Financial Statements DuPont System Target is ROE Target is ROE Breaks down into components of ROE ROE = Profit Margin x Total Asset Turnover x ROE = Profit Margin x Total Asset Turnover x Equity Multiplier Profit Margin is Net Income/Sales Profit Margin is Net Income/Sales Asset Turnover is Sales/Assets Asset Turnover is Sales/Assets Equity Multiplier is Assets/Total Equity Equity Multiplier is Assets/Total Equity Chapter 2 – Problem 14