1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Working With Financial Statements Chapter Three

2. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.1 Key Concepts and Skills 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

3. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.2 Chapter Outline Standardized Financial Statements Ratio Analysis The Du Pont Identity Using Financial Statement Information

4. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.3 Sample Balance Sheet 2000199920001999 Cash & Equivalents 3,1716,489A/P313,286340,220 A/R1,095,1181,048,991N/P227,84886,631 Inventory388,947295,255Other CL1,239,6511,098,602 Other CA314,454232,304Total CL1,780,7851,525,453 Total CA1,801,6901,583,039LT Debt1,389,615871,851 Net FA3,129,7542,535,072C/S1,761,0441,648,490 Total Assets4,931,4444,118,111Total Liab. & Equity 4,931,4444,118,111 Numbers in thousands

5. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.4 Sample Income Statement Revenues4,335,491 Cost of Goods Sold1,762,721 Expenses1,390,262 Depreciation362,325 EBIT820,183 Interest Expense52,841 Taxable Income767,342 Taxes 295,426 Net Income471,916 EPS2.41 Dividends per share0.93 Numbers in thousands, except EPS & DPS

6. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.5 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

7. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.6 Ratio Analysis Ratios also 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 is that information important Ratios are used both internally and externally

8. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.7 Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios

9. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.8 Computing Liquidity Ratios Current Ratio = CA / CL –1,801,690 / 1,780,785 = 1.01 times Quick Ratio = (CA – Inventory) / CL –(1,801,690 – 314,454) / 1,780,785 =.835 times Cash Ratio = Cash / CL –3,171 / 1,780,785 =.002 times

10. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.9 Computing Long-term Solvency Ratios Total Debt Ratio = (TA – TE) / TA –(4,931,444 – 1,761,044) / 4,931,444 =.6429 times or 64.29% –The firm finances a little over 64% of its assets with debt. Debt/Equity = TD / TE –(4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times Equity Multiplier = TA / TE = 1 + D/E –1 + 1.800 = 2.800

11. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.10 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

12. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.11 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

13. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.12 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

14. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.13 Computing Total Asset Turnover 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

15. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.14 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%

16. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.15 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

17. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.16 Deriving the Du Pont 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

18. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.17 Using the Du Pont 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

19. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.18 Why Evaluate Financial Statements? 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

20. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.19 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 –SIC and NAICS codes

21. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.20 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

22. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3.21 Quick Quiz 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?