Chapter 3

Chapter 3Working With Financial Statements

Key Concepts and SkillsKnow how to standardize financial statements for comparison purposesKnow how to compute and interpret important financial ratiosKnow the determinants of a firms profitability and growthUnderstand the problems and pitfalls in financial statement analysisCash Flow and Financial StatementSources and Uses of CashThe statement of cash flow or sources and uses of cash reflects an enterprises major sources of cash receipts and cash payment.-Activities that bring cash in are sources. Firms raise cash by selling assets, borrowing money or selling securities.-Activities that involve cash outflows are uses. Firms use cash to buy assets, pay off debt, repurchase stock or pay dividends.Mechanical Rules for Determining Sources and Uses Sources:Decrease in asset accountIncrease in liabilities or equity accountUses:Increase in asset accountDecrease in liabilities or equity account

Sources of cash:Increase in accounts payable $32Increase in common stock 50Increase in retained earnings242Total sources $324Uses of cash:Increase in accounts receivable$23Increase in inventory 29Decrease in notes payable 35Decrease in long term debt 74Net fixed assets acquisitions 149Total uses $310Net additional cash 14The Statement of Cash FlowsProvides a summary of cash flows over the period concerned, typically the year just ended. Sometimes call sources and uses statement. The idea is to group cash flows into one of three categories: operating activities, investing activities, and financing activities.

Prufrock Corporation2008 Statement of Cash Flows ($ in millions)Cash, beginning of year84Operating activities: Net Income363 Plus: Depreciation276 Increase in A/P32 Less: Increase in A/R-23 Increase in inventory-29 Net cash flow from operating activities619Investing activities: Fixed assets acquisitions-425 Net cash flow from investing activities-425Financing activities: Decrease in N/P-35 Decrease in long-term debt-74 Dividend paid-121 Increase in common stock50 Net cash flow from financing activities-180Net increase in cash14Cash, end of year98Prufrock Corporation2008 Statement of Cash Flows ($ in millions)Cash, beginning of year84Sources of cash Operations: Net income363 Depreciation276639 Working capital: Increase in accounts payable32 Long term financing: Increase in common stock50 Total sources of cash721Uses of cash Working capital: Increase in A/R23 Increase in inventory29 Decrease in N/P35 Long-term financing: Decrease in long-term debt74 Fixed asset acquisitions425 Dividends paid121 Total uses of cash707Net addition to cash14Cash, end of year98Standardized Financial StatementStandardized 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.Common-size statementsUseful in comparison of unequal size:Common-size balance sheet: express each account as a percentage of total assets.Common-size income statement: express each item as a percentage of sales.

Ratio AnalysisFinancial ratios are traditionally grouped into the following categories:1. Short-term solvency or liquidity ratios.2. Long-term solvency or financial leverage ratios.3. Asset management or turnover, ratios.4. Profitability ratios.5. Market value ratios.

Short-Term Solvency or Liquidity RatiosCurrent RatioMeasures short-term liquidity, the ability of a firm to meet need for cash they arise.

To a creditor, particularly a short-term creditor such as a supplier, the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets.

Quick RatioMeasures short-term liquidity more rigorously than current ratio by eliminating inventory, generally the least liquid current asset.

The quick ratio here tells a somewhat different story than the current ratio, because inventory accounts for more than half of Prufrock's current assets. To exaggerate the point, if this inventory consisted of, say, unsold nuclear power plants, then this would be a cause for concern.

Long-Term Solvency MeasuresTotal Debt RatioMeasures the prudence of the firms debt management policies.

Prufrock has $.28 in debt for every $1 in assets. Therefore, there is $.72 in equity ($1 - .28) for every $.28 in debt. With this in mind, we can define two useful variations on the total debt ratio, the debt-equity ratio and the equity multiplier:

Time Interest Earned RatioMeasures how many times interest expense is covered by operating earnings.

Cash Coverage Ratio Measures how many times interest expense is covered by cash available.

Asset Management, or Turnover, MeasuresInventory TurnoverMeasures efficiency of the firm in managing and selling inventory.

In a sense, we sold off, or turned over, the entire inventory 3.2 times. As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we are managing inventory.

If we know that we turned our inventory over 3.2 times during the year, then we can immediately figure out how long it took us to turn it over on average. The result is the average days' sales in inventory:Days Sales in InventoryMeasures how long the inventory sells in the average term.

This tells us that, roughly speaking, inventory sits 114 days on average before it is sold. Alternatively, assuming we used the most recent inventory and cost figures, it will take about 114 days to work off our current inventory.Receivables TurnoverIndicates how many times receivables are collected during a year on average.

Loosely speaking, we collected our outstanding credit accounts and reloaned the money 12.3 times during the year.This ratio makes more sense if we convert it to days, so the days' sales in receivables is:

Days Sales in Receivable or Average Collection PeriodIndicates how many day receivables are collected on average.

Therefore, on average, we collect on our credit sales in 30 days. For obvious reasons, this ratio is very frequently called the average collection period (ACP).Asset Turnover RatiosNWC TurnoverThis ratio measures how much work we get out of our working capital.NWC Turnover = Sales / NWC = 2,311/ (708 -540) = 13.8 timesFixed Asset TurnoverMeasures efficiency of the firm in managing fixed assets.

Fixed Asset Turnover = Sales / Fixed Assets = 2,311 / 2,880 = 0.80 timesTotal Asset TurnoverMeasures efficiency of the firm in managing all assets.

Profitability MeasuresThese measures are based on book values, so they are not comparable with returns that you see on publicly traded assets:Profit MarginMeasures profit generated after consideration of all expenses and revenues.

This tells us that Prufrock, in an accounting sense, generates a little less than 16 cents in profit for every dollar in sales.

Return on AssetsMeasures overall efficiency firm in managing assets and generate profits.

Return on EquityMeasures rate of return on common stockholders (owners) investment.

Market Value MeasuresEarning per share shows about net income for one share. We assume that Prufrock has 33 million shares outstanding and the stock sold for $88 per share at the end of the year.

Price-earning Ratio Price earning ratio measures the price of the share in market to net income per share.

Market-to-Book RatioIt shows about the stock price in the market to stock price in the book.

The Du Pont IdentityThe Du Pont Identity provides a way to breakdown ROE and it is popular expression breaking ROE into three parts:1. Operating efficiency (as measured by profit margin)2. Asset use efficiency ( as measured by total asset turnover)3. Financial leverage ( as measured by the equity multiplier) efficiency, and financial leverage.

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.Common Financial Ratios

End of Chapter 3

1-The Hooya Company has a long-term debt ratio (i.e. the ratio of long-term debt to long-term debt plus equity) of 0.60 and a current ratio of 1.3. Current liabilities are $900, sales are $6,590, profit margin is 9 percent, and ROE is 16 percent. What is the amount of the firm's net fixed assets?2-Kaleb's Karate Supply had a profit margin of 9 percent, sales of $17 million, and total assets of $7 million. What was t0tal asset turnover? If management set a goal of increasing total asset turnover to 2.75 times, what would the new sales figure need to be, assuming no increase in total assets?