Presentation on theme: "Working with Financial Statements"— Presentation transcript:
1 Working with Financial Statements Chapter 3Working with Financial Statements
2 Key Concepts and Skills Know how to standardize financial statements for comparison purposesKnow how to compute and interpret important financial ratiosKnow the determinants of a firm’s profitability and growthUnderstand the problems and pitfalls in financial statement analysis
3 Chapter Outline Standardized Financial Statements Ratio Analysis The Du Pont Identity
4 Who needs to understand ratios? ManagersUse ratios to evaluate various aspects of the firmProfitabilityProductivityMarketersUse ratios dealing with costs, markups, and marginsProduction personnelUse ratios that deal with issues such as operating efficiency
5 Standardized Financial Statements Common-size statement: a standardized financial statement presenting all items in percentage termsCommon-size Balance SheetBalance sheet items shown as a percentage of total assetsCommon-size Income StatementIncome statement items shown as a percentage of total sales
6 Standardized Financial Statements (continued) Standardized statements make it easier to compare financial informationStandardized statements are useful for comparing companies of different sizes, especially within the same industry
7 Ratio AnalysisFinancial ratios: Relationships determined from a firm’s financial information and used for comparison purposesRatios allow for comparison over time or between firmsRatios are used both internally and externally
8 Categories of Financial Ratios Short-term solvency or liquidity ratiosLong-term solvency or financial leverage ratiosAsset management or turnover ratiosProfitability ratiosMarket value ratios
9 Analyzing ratios Questions to ask when analyzing ratios: How is the ratio computed?What does the ratio measure? Why do we care?What is the unit of measurement?What does a high/low value tell us? How might such values be misleading?How could this measure be improved?
10 Short-term Solvency/Liquidity Ratios Current RatioFormulaWhat does it measure?Quick (Acid Test) Ratio
11 Short-term Solvency/Liquidity Ratios (continued) Cash ratioFormulaWhat does it measure?
12 Financial Leverage Ratios Total Debt RatioFormulaWhat does it measure?Debt/Equity Ratio
13 Financial Leverage Ratios (continued) Equity MultiplierFormulaWhat does it measure?
14 Coverage Ratios Times Interest Earned ratio Cash Coverage ratio FormulaWhat does it measure?Cash Coverage ratio
15 Inventory Ratios Inventory Turnover ratio Days’ Sales in Inventory FormulaWhat does it measure?Days’ Sales in Inventory
16 Receivables ratios Receivables Turnover Days’ Sales in Receivables FormulaWhat does it measure?Days’ Sales in Receivables
17 Total Asset Turnover Total Asset Turnover ratio Formula Measures asset use efficiencyIt is not unusual for total asset turnover to be less than one, especially if the firm has a large amount of fixed assets
18 Profitability RatiosProfitability ratios are the best known and most widely used of all financial ratiosProfit MarginFormulaWhat does it measure?
19 Profitability Ratios (continued) Return On Assets (ROA)FormulaWhat does it measure?Return On Equity (ROE)
23 Market Value Measures Earnings per share Price to earnings (PE) ratio Net income/number of shares outstanding$200,000 NI/100,000 shares = $2.00 earnings per sharePrice to earnings (PE) ratioMeasures how much investors are willing to pay per dollar of current earningsHigher PE ratios are often interpreted to mean that the firm has significant prospects for future growth
24 Market Value Measures Price per share/Earnings per share $20 price per share/$2.00 earnings per share = PE ratio of 10
25 Market Value Measures (continued) Market-to-book ratioCompares the market value of the firm’s investments to their costMarket value per share/book value per share
26 The Du Pont FormulaThe Du Pont formula is named after the Du Pont Corporation, which popularized its useAllows us to break down ROE into its three basic componentsProfit margin, a measure of the firm’s operating efficiencyTotal asset turnover, a measure of how well the firm manages its assetsEquity multiplier, a measure of the firm’s financial leverage
27 The Du Pont Formula (continued) Profit margin x total asset turnover x equity multiplierROE = PM x TAT x EMIf ROE is unsatisfactory, Du Pont tells the financial manager where to start looking for the reasons why
28 QUIZ Why is it necessary to standardize financial statements? How are common-size balance sheets and common-size income statements formed?What are the five groups of ratios?Profitability ratios all have the same figure in the numerator. What is it? What do the profitability ratios measure?
29 QUIZ (continued)What two ratios can be computed if you are given the total debt ratio?ROA is the product of what two ratios?ROE is the product of what three ratios?