1. Working With Financial Statements

2. Chapter Outline Cash Flow and Financial Statements: A Closer Look
Ratio Analysis
The DuPont Identity

3. Sources and Uses of Cash Flows
Cash inflow occurs when we “sell” something
Decrease in asset account (Sample B/S)
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
Accounts payable, other current liabilities, and common stock
Uses
Cash outflow occurs when we “buy” something
Increase in asset account
current assets, fixed assets
Decrease in liability or equity account
Notes payable and long-term debt
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.

4. Sample Balance Sheet Numbers in millions 2009 2008 Cash 696 58 A/P 307
303
A/R
956
992
N/P 26
119
Inventory
301
361
Other CL
1,662
1,353
Other CA
264
Total CL
1,995
1,775
Total CA
2,256
1,675
LT Debt
843
1,091
Net FA
3,138
3,358
C/S+RE
2,556
2,167
Total Assets
5,394
5,033
Total Liab. & Equity
Net FA in 2009 = 3358 –Depreciation – Net Selling fixed assets = 3,138
Net Selling fixed assets = Cash inflows from selling assets= –Dep.

5. Sample Income Statement
Numbers in millions, except EPS & DPS
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 = Earnings per share
$ 3.61
Dividends per share
$ 1.08
This sample income statement is based on information from the McGraw-Hill 2003 annual report, the net income figure and EPS are based on income from continuing operations. There are million shares outstanding.
How many equities are outstanding? 689/3.61 = million

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.

7. Sample Statement of Cash Flows
Numbers in millions
Cash, beginning of year 58
Financing Activity
Operating Activity
Decrease in Notes Payable
-93
Net Income
689
Decrease in LT Debt
-248
Plus: Depreciation
116
Decrease in C/S (minus RE)
-94
Decrease in A/R 36
Dividends Paid
-206
Decrease in Inventory 60
Net Cash from Financing
-641
Increase in A/P 4
Net Increase in Cash
638
Increase in Other CL
309
Cash, End of Year
696
Less: Increase in other CA
-39
Net Cash from Operations
1,175
Investment Activity
Sale of Fixed Assets
104
Net Cash from Investments
Investment activity: change in net fixed assets + depreciation (have to add back depreciation because it was deducted from the fixed asset account to get the net fixed asset figure) If the number is positive, then we acquired fixed assets, if it’s negative then we sold fixed assets.
3138 – = -104 so we sold 104 million worth of fixed assets
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.
Dividends paid = 190.9*1.08 = 206 million
Additions to RE = 689 – 206 = 483
Change in C/S = 2556 – 2167 – 483 = -94
change in [CS+RE] = $ 389 = CS(-94) +RE(689 – 206)

8. Standardized Financial Statements
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

9. Ratio Analysis
Ratio Analysis allows us to measure a firm’s performance.
The trend of the performance
Comparison of companies
Need to understand what the ratios are trying to measure and what the ratios imply.

10. Categories of Financial Ratios
Liquidity ratios for short-term solvency
Financial leverage ratios for long-term solvency
Turnover ratios for asset management
Profitability ratios
Market value ratios

11. Computing Liquidity Ratios
Current Ratio = CA / CL
2256 / 1995 = 1.13 times
Quick Ratio = (CA – Inventory) / CL
(2256 – 301) / 1995 = times
Inventory (often least liquid asset, least reliable as measures of the market value, large inventory may indicates signs of short-term trouble)
Cash Ratio = Cash / CL
696 / 1995 = .35 times
NWC to Total Assets = NWC / TA
(2256 – 1995) / 5394 = .05
Amount of short-term liquidity that a firm has.
Interval Measure = CA / average daily operating costs
2256 / (( )/365) = days
The firm is just barely able to cover current liabilities with it’s current assets in 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. Also, the CR for 2002 was .94, so the company has improved from the previous year.
The quick ratio is quite a bit lower than the current ratio, so inventory seems to be an important component of current assets.
This company carries a low cash balance, although the cash ratio has increased substantially from the previous year (.03 in 2002). 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.
The NWC to TA measure seems relatively low, but is consistent with the current ratio.
The Interval Measure indicates that the company can meet average daily expenses with current assets for almost 220 days.

12. Computing Long-term Solvency Ratios
Total Debt Ratio = (TA – TE) / TA
(5394 – 2556) / 5394 = 52.61%
Debt/Equity = TD / TE
(5394 – 2556) / 2556 = 1.11 times
Equity Multiplier = TA / TE = 1 + D/E
= 2.11
Long-term debt ratio = LTD / (LTD + TE)
843 / ( ) = 24.80%

13. Computing Coverage Ratios
Times Interest Earned = EBIT / Interest
1138 / 7 = times
Cash Coverage = (EBIT + Depreciation) / Interest
( ) / 7 = times

14. Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
2006 / 301 = 6.66 times
The company turns over its inventory 6.66 times a year.
Days’ Sales in Inventory = 365 / Inventory Turnover
365 / 6.66 = 55 days
Roughly, it takes 55 days for inventory to be sold.

15. Computing Receivables Ratios
Receivables Turnover = Sales / Accounts Receivable
5000 / 956 = 5.23 times
The company collects Accounts Receivables and liquidate them 5.23 times during the year.
Days’ Sales in Receivables = 365 / Receivables Turnover
365 / 5.23 = 70 days
It takes 70 days for accounts receivable to be liquidated.

16. Computing Total Asset Turnover
Total Asset Turnover = Sales / Total Assets
5000 / 5394 = .93
It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets.
NWC Turnover = Sales / NWC
5000 / (2256 – 1995) = times
Fixed Asset Turnover = Sales / NFA
5000 / 3138 = 1.59 times
Every dollar of NFA generates $1.59 of sale a year.

17. Computing Profitability Measures
Profit Margin = Net Income / Sales
689 / 5000 = 13.78%
Every dollar in sale generates cents of profits.
Return on Assets (ROA) = Net Income / Total Assets
689 / 5394 = 12.77%
Return on Equity (ROE) = Net Income / Total Equity
689 / 2556 = 26.96%
Every dollar of equity generates cents of profits.
You can also compute the gross profit margin and the operating profit margin.
GPM = (Sales – COGS) / Sales = (5000 – 2006) / 5000 = 59.88%
OPM = EBIT / Sales = 1138 / 5000 = 22.76%
Profit margin is one of the components of the DuPont 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 $0.14 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 DuPont identity is used to identify factors that affect the ROE.

18. Computing Market Value Measures
Market price of a share =Stock price = $87.65 per share
Shares outstanding = million
PE Ratio = Price per share / Earnings per share
87.65 / 3.61 = times
A firm’s stock price is times as high as the earnings that the firm generates for the year.
Market-to-book ratio = market value per share / book value per share
87.65 / (2556 / 190.9) = 6.56 times

19. Deriving the DuPont Identity
ROE = NI / TE
Multiply by 1 and then rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM

20. Using the DuPont 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

21. 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.
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes

22. 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.
Differences in accounting regulations.
Varying accounting procedures, i.e. FIFO vs. LIFO
Different fiscal years
Extraordinary events

23. 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?

24. End of Chapter