© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

Working With Financial Statements

Chapter

Three

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3.2 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

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3.3 Chapter Outline

• Standardized Financial Statements

• Ratio Analysis

• The Du Pont Identity

• Using Financial Statement Information

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3.4 Sample Balance Sheet

2000 1999 2000 1999

Cash & Equivalents

3,171 6,489 A/P 313,286 340,220

A/R 1,095,118 1,048,991 N/P 227,848 86,631

Inventory 388,947 295,255 Other CL 1,239,651 1,098,602

Other CA 314,454 232,304 Total CL 1,780,785 1,525,453

Total CA 1,801,690 1,583,039 LT Debt 1,389,615 871,851

Net FA 3,129,754 2,535,072 C/S 1,761,044 1,648,490

Total Assets 4,931,444 4,118,111 Total Liab. & Equity

4,931,444 4,118,111

Numbers in thousands

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3.5 Sample Income Statement

Revenues 4,335,491

Cost of Goods Sold 1,762,721

Expenses 1,390,262

Depreciation 362,325

EBIT 820,183

Interest Expense 52,841

Taxable Income 767,342

Taxes 295,426

Net Income 471,916

EPS 2.41

Dividends per share 0.93

Numbers in thousands, except EPS & DPS

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3.6 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

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3.7 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

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3.8 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

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3.9 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

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3.10 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

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3.11 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

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3.12 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

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3.13 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

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3.14 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

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3.15 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%

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3.16 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

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3.17 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

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

3.18 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

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3.19 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

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3.20 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

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3.21 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

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3.22 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?