Working with financial statements

Chapter 3

Key concepts and skills

• Know how to standardise financial statements for comparison purposes

• Know how to compute and interpret important financial ratios

• Know the determinants of a firm’s profitability and growth

• Understand the problems and pitfalls in financial statement analysis

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Chapter outline

• Standardised financial statements• Ratio analysis• The Du Pont identity• Internal and sustainable growth• Using financial statement information

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Standardised financial statements

• Common-size balance sheets– Compute all accounts as a percentage of total

assets• Common-size income statements

– Compute all line items as a percentage of sales• Standardised 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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Swagman Camping LtdBalance sheet—Table 3.1

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Swagman Camping Ltd (cont.)Common-size balance sheet—Table 3.2

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Swagman Camping Ltd (cont.)Income statement—Table 3.3

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Swagman Camping Ltd (cont.)Common-size income statement—

Table 3.4

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Ratio analysis• Allows for better comparison over time or

between companies• Used both internally and externally• For each ratio, several questions arise:

– How is it computed ?– What is the ratio trying to measure and why is that

information important?– What is the unit of measurement?– What might a high or low value be telling us? How

might such values be misleading? – How could this measure be improved?

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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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Common financial ratiosTable 3.5

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Short-term solvency or liquidity ratios

• Current ratio = Current assets / Current liabilities708 / 540 = 1.31 times

• Quick ratio (or acid-test ratio) = (Current assets – Inventory) / Current liabilities

(708-422) / 540 = 0.53 times • Cash ratio= Cash / Current liabilities

98/ 540 = 0.18 times

ASSETS Liabilities & Owners EquityCurrent Assets Current Liabilities

Cash 98$ Accounts Payable 344$ Accounts Receivable 188$ Notes Payable 196$ Inventory 422$ Total 540$

Total 708$ Long term debt 457$ Owners' Equity

Common Stock and paid in surplus 550$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$

SWAGMAN CAMPING LTDBalance Sheet -2010

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Long-term solvency measures

• Total debt ratio – (TA – TE) / TA

(3588-2591) / 3588 = 0.28 times• Debt/Equity

– TD / TE0.28/0.72) = 0.39 times

• Equity multiplier – TA/TE = 1 + D/E

($1 /0.72) = 1.39

ASSETS Liabilities & Owners EquityCurrent Assets Current Liabilities

Cash 98$ Accounts Payable 344$ Accounts Receivable 188$ Notes Payable 196$ Inventory 422$ Total 540$

Total 708$ Long term debt 457$ Owners' Equity

Common Stock and paid in surplus 550$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$

SWAGMAN CAMPING LTDBalance Sheet -2010

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Long-term solvency measures (cont.)

• Times interest earned– EBIT/Interest

691/ 141 = 4.9 times• Cash coverage

– (EBIT + Depreciation)/Interest(691 + 276) / 141 = 6.9 times

Sales 2,311$ COGS 1,344$ Depreciation 276$ EBIT 691$ Interest 141$ Taxable Income 550$ Taxes 165$ Net Income 385$

Dividends 143$ Addition to RE 242$

SWAGMAN CAMPING LTDIncome Statement - 2010

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Asset management: Inventory ratios

• Inventory turnover = Cost of goods sold/Inventory1344/422 = 3.2 times

• Days’ sales in inventory = 365/Inventory turnover365 / 3.2 = 114 days

ASSETS Liabilities & Owners Equity Sales 2,311$ Current Assets Current Liabilities COGS 1,344$

Cash 98$ Accounts Payable 344$ Depreciation 276$ Accounts Receivable 188$ Notes Payable 196$ EBIT 691$ Inventory 422$ Total 540$ Interest 141$

Total 708$ Long term debt 457$ Taxable Income 550$ Owners' Equity Taxes 165$

Common Stock and paid in surplus 550$ Net Income 385$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$ Dividends 143$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$ Addition to RE 242$

SWAGMAN CAMPING LTDBalance Sheet -2010

SWAGMAN CAMPING LTDIncome Statement - 2010

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Asset Management: Receivables Ratios

• Receivables Turnover = Sales/Accounts Receivable2311 / 188= 12.3 times

• Days’ Sales in Receivables = 365/Receivables Turnover365 / 12.3= 30 days

ASSETS Liabilities & Owners Equity Sales 2,311$ Current Assets Current Liabilities COGS 1,344$

Cash 98$ Accounts Payable 344$ Depreciation 276$ Accounts Receivable 188$ Notes Payable 196$ EBIT 691$ Inventory 422$ Total 540$ Interest 141$

Total 708$ Long term debt 457$ Taxable Income 550$ Owners' Equity Taxes 165$

Common Stock and paid in surplus 550$ Net Income 385$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$ Dividends 143$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$ Addition to RE 242$

SWAGMAN CAMPING LTDBalance Sheet -2010

SWAGMAN CAMPING LTDIncome Statement - 2010

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Asset management: Asset turnover ratios

• Total asset turnover (TAT) = Sales/Total assets– 2311/3588 = 0.64 times

• Measure of asset use efficiency• Not unusual for TAT <1, especially if a firm has a large amount of fixed

assets• Capital intensity ratio = 1/TAT

– 1/0.64 = 1.56

ASSETS Liabilities & Owners Equity Sales 2,311$ Current Assets Current Liabilities COGS 1,344$

Cash 98$ Accounts Payable 344$ Depreciation 276$ Accounts Receivable 188$ Notes Payable 196$ EBIT 691$ Inventory 422$ Total 540$ Interest 141$

Total 708$ Long term debt 457$ Taxable Income 550$ Owners' Equity Taxes 165$

Common Stock and paid in surplus 550$ Net Income 385$

Fixed Assets Retained Earnings 2,041$ Net Plant & Equipment 2,880$ Total 2,591$ Dividends 143$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$ Addition to RE 242$

SWAGMAN CAMPING LTDBalance Sheet -2010

SWAGMAN CAMPING LTDIncome Statement - 2010

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Profitability measures

• Profit margin = Net income/Sales385/2311 = 16.7%

• Return on assets (ROA) = Net income/Total assets385/3588 = 10.73%

• Return on equity (ROE) = Net income/Total equity363 / 2591 = 14.9%

ASSETS Liabilities & Owners Equity Sales 2,311$

Current Assets Current Liabilities COGS 1,344$

Cash 98$ Accounts Payable 344$ Depreciation 276$

Accounts Receivable 188$ Notes Payable 196$ EBIT 691$

Inventory 422$ Total 540$ Interest 141$

Total 708$ Long term debt 457$ Taxable Income 550$

Owners' Equity Taxes 165$

Common Stock and paid in surplus 550$ Net Income 385$

Fixed Assets Retained Earnings 2,041$

Net Plant & Equipment 2,880$ Total 2,591$ Dividends 143$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$ Addition to RE 242$

SWAGMAN CAMPING LTDBalance Sheet -2010

SWAGMAN CAMPING LTDIncome Statement - 2010

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Market value measures• Market price = $88 per share = PPS• Shares outstanding = 35 million

• Earnings per share = EPS = Net income/Shares outstanding– 385/35 = $11

• PE ratio = Price per share (PPS )/ Earnings per share (EPS)– $88 / $11 = 8 times

• Market-to-book ratio = Market value per share/ Book value per share– Book value per share = Total equity/Shares outstanding

= $2591/35 = $74– Market-to-book = $88/74 = 1.19 times

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Swagman ratios

Current Ratio 1.31 Total Debt Ratio 0.28Quick Ratio 0.53 Debt to Equity 0.39Cash Ratio 0.18 Equity Multiplier 1.39

Times Interest Earned 4.9Inventory Turnover 3.20 Cash Coverage 6.9Days' Sales in Inventory 114Receivables Turnover 12.30 Profit Margin 16.70%Days' Sales in Receivables 30 ROA 10.73%Total Asset Turnover 0.64 ROE 14.90%Capital Intensity Ratio 1.56

Market Price 88.00$ Shares Outstanding 35 mEPS 11.00$ PE Ratio 8.0 Book value per share $74.00Market to Book 1.19

Market Value Measures

SWAGMAN CAMPING LTD RECAPFinancial Leverage Ratios

Profitability Measures

Asset Management Ratios

Liquidity Ratios

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The Du Pont identity

• Return on equity (ROE) = Net income (NI)/ Total equity (TE)= Basic formula

• Du Pont identity– ROE = Profit margin (PM) * Total asset turnover (TAT)

* Equity multiplier (EM)• PM = Net income / Sales• TAT = Sales / Total assets• EM = Total assets / Total equity

TE

NI

TE

TA

TA

Sales

Sales

NIROE

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Using the Du Pont identity

• ROE = PM*TAT*EM– Profit margin (PM) is a measure of a firm’s

operating efficiency—how well it controls costs.

– Total asset turnover (TAT) is a measure of the firm’s asset-use efficiency—how well it manages its assets.

– Equity multiplier (EM) is a measure of the firm’s financial leverage.

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SWAGMAN—Du Pont identity

• ROE = PM * TAT * EM– PM = 16.7%– TAT = .64– EM = 1.39

• ROE = .167 x .64 x 1.39 = .149= 14.9%

Current Ratio 1.31 Total Debt Ratio 0.28Quick Ratio 0.53 Debt to Equity 0.39Cash Ratio 0.18 Equity Multiplier 1.39

Times Interest Earned 4.9Inventory Turnover 3.20 Cash Coverage 6.9Days' Sales in Inventory 114Receivables Turnover 12.30 Profit Margin 16.70%Days' Sales in Receivables 30 ROA 10.73%Total Asset Turnover 0.64 ROE 14.90%Capital Intensity Ratio 1.56

Market Price 88.00$ Shares Outstanding 35 mEPS 11.00$ PE Ratio 8.0 Book value per share $74.00Market to Book 1.19

Market Value Measures

SWAGMAN CAMPING LTD RECAPFinancial Leverage Ratios

Profitability Measures

Asset Management Ratios

Liquidity Ratios

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An expanded Du Pont analysisTable 3.6

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An expanded Du Pont analysis (cont.)—Figure 3.1

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Internal and sustainable growthDividend payout and earnings retention

ratios• Dividend payout ratio (b) = Cash

dividends/Net income• Retention ratio(1-b) = Additions to

retained earnings/Net income = 1 – Payout ratio (b)

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Internal and sustainable growthDividend payout and earnings retention ratios

(cont.)

• Dividend payout ratio (‘b’) =– Cash dividends / Net income (DIV / NI)– 143/385 = 37%

• Retention ratio (‘1 – b’) = (NI - DIV)/ NI– Addition to Retained earnings / Net income – $242/385 = 63%

ASSETS Liabilities & Owners Equity Sales 2,311$

Current Assets Current Liabilities COGS 1,344$

Cash 98$ Accounts Payable 344$ Depreciation 276$

Accounts Receivable 188$ Notes Payable 196$ EBIT 691$

Inventory 422$ Total 540$ Interest 141$

Total 708$ Long term debt 457$ Taxable Income 550$

Owners' Equity Taxes 165$

Common Stock and paid in surplus 550$ Net Income 385$

Fixed Assets Retained Earnings 2,041$

Net Plant & Equipment 2,880$ Total 2,591$ Dividends 143$

Total Asets 3,588$ Total Liabilties & Owners' Equity 3,588$ Addition to RE 242$

SWAGMAN CAMPING LTDBalance Sheet -2010

SWAGMAN CAMPING LTDIncome Statement - 2010

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Internal growth rate

• The internal growth rate tells us how much the firm can grow assets using retained earnings (internal financing) as the only source of financing.

7.23%

.667.10121

.667.1012

bROA - 1

bROA Rate Growth Internal

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Sustainable growth rate

• The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

%36.10

1036.63.149.1

63.149.bROE-1

bROE RateGrowth eSustainabl

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Determinants of growth

• Profit margin—operating efficiency• Total asset turnover—asset use efficiency• Financial leverage—choice of optimal debt

ratio• Dividend policy—choice of how much to

pay to shareholders versus reinvesting in the firm

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Summary of internal and sustainable growth rates

Table 3.6

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Using financial information— 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– Shareholders

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Using financial statement information— Benchmarking

• Ratios are not very helpful by themselves; they need to be compared with something

• Time-trend analysis– Used to see how the firm’s performance is

changing over time– Internal and external uses

• Peer-group analysis– Compare with similar companies or within

industries– GICS codes

• International codes used to classify a firm by its type of business operations

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Problems with financial statement analysis

• Conglomerates – No readily available comparables

• Global competitors• Different accounting procedures• Different fiscal year ends• Differences in capital structure• Seasonal variations and one-time events

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Example: Work the Web• The Internet makes ratio analysis much easier than

it has been in the past.• Click on the information icon to go to <

www.asx.com.au >.• Go to ‘Prices Research and Announcements’.• Click on ‘Company Research’ and enter DJS

(company code for David Jones).• Look under ‘Company Announcements’ and find

the latest annual report.• Extract the relevant number from the balance

sheet to calculate the financial ratios.

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Quick quiz

• How do you standardise balance sheets and income statements?– Why is standardisation useful?

• What are the major categories of ratios and how do you compute specific ratios within each category?

• What are the major determinants of a firm’s growth potential?

• What are some of the problems associated with financial statement analysis?

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Chapter 3

END