FINA2010 Financial Management

Lecture 2: Financial Statement Analysis

Instructor: Prof. Si Cheng

CUHK Business School

1
 Last Lecture
• Financial management: capital budgeting,
capital structure, working capital management
• Forms of business organization: sole
proprietorship, partnership, corporation
• Financial Markets
– Primary Markets vs. Secondary Markets
– Money Markets vs. Capital Markets

2
 Lecture Outline
• Financial Statements
– Balance Sheet
– Income Statement
– Statement of Cash Flows
• Ratio Analysis
• The Du Pont Identity
• Using Financial Statement Information

3
 Learning Objectives
• Explain and list the type of information found in
financial statements
• Know how to determine a firm’s cash flow from
its financial statements
• Be able 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

4
 The Annual Report
• An annual report is a report issued annually by a
corporation to its stockholders. It contains basic
financial statements as well as management’s
analysis of the firm’s past operations and future
prospects.
• Example: Berkshire Hathaway’s website: visit
www.berkshirehathaway.com for its annual reports.
• In general, see also
https://www.sec.gov/edgar/searchedgar/companyse
arch.html

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6
 Berkshire Hathaway Inc.
2019 Annual Report

Source: https://www.berkshirehathaway.com/2019ar/2019ar.pdf
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 Example: Accounting Fraud
• Enron Scandal At-A-Glance
• In just 15 years, Enron grew from nowhere to be
America’s seventh largest company, employing 21,000
staff in more than 40 countries. But the firm’s success
turned out to have involved an elaborate scam.
• Enron lied about its profits and stands accused of a
range of shady dealings, including concealing debts so
they didn’t show up in the company’s accounts.
• As the depth of the deception unfolded, investors and
creditors retreated, forcing the firm into Chapter 11
bankruptcy in December 2001.
• Source: 22 August 2002, BBC News

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Example: Accounting Fraud

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 Example: Accounting Fraud
• Enron’s Fall Raised the Bar in Regulation
• Enron’s collapse in 2001 was followed in quick succession by
revelations of fraud at Tyco, Adelphia Communications,
WorldCom and HealthSouth and a dozen Wall Street banks
were hit with allegations of biased research.
• The hit parade of fraud also prompted the US Congress to
pass the still controversial Sarbanes-Oxley corporate
accountability law, which forces corporate executives to take
personal responsibility for the accuracy of company accounts
and requires organizations to put in place measures to
prevent fraud.
• Source: 2 December 2011, Financial Times
10
 Financial Statements
• Balance Sheet: provides a snapshot of a firm’s
assets and liabilities at a given point in time.
• Income Statement: summarizes a firm’s
revenues and expenses over a given period of
time.
• Statement of Cash Flows: reports the impact
of a firm’s activities on cash flows over a given
period of time.

11
 What a
firm owns
The Balance Sheet

< 1 year

What a
< 1 year
firm owes

• Net working capital is usually positive in a healthy firm.

12
Sample Balance Sheet
• Balance Sheet Identity:
Assets = Liabilities +
Shareholders’ Equity
• Resources must equal
Claims
• Order of listing: highest
to lowest liquidity
• Value of items:
generally at original
cost (also known as
historical cost, book
value)

13
Balance Sheet Characteristics: Liquidity
• Liquidity: ability to convert to cash quickly without a
significant loss in value.
– Current assets: cash and cash equivalents; short-term
investments; accounts receivable; inventory; etc.
– Fixed assets: long-term investments; property, plant and
equipment; goodwill; intangible assets; etc.
• Liquid firms are less likely to experience financial distress.
• But liquid assets typically earn a lower return.
• Trade-off to find balance between liquid and illiquid
assets.

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 Balance Sheet Characteristics:
Debt vs. Equity
• Creditors: first claim to the firm’s cash flow.
• Equity holders: the residual value.
– Shareholders’ equity = Assets − Liabilities
• The use of debt in a firm’s capital structure is
called financial leverage.

15
 Balance Sheet Characteristics:
Market Value vs. Book Value
• The balance sheet provides the book value of the
assets, liabilities, and equity.
– Determined by U.S. Generally Accepted Accounting
Principles (GAAP) or International Financial Reporting
Standards (IFRS)
• Market value is the price at which the assets,
liabilities, or equity can actually be bought or sold.
– Market value of shareholders’ equity (market
capitalization) = Share price x Number of shares
outstanding

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Example: Market Value vs. Book Value
• Market value and book value are often very different.
Company Market Value of Equity Book Value of Equity
Apple 2,169 billions USD 65 billions USD
Amazon 1,569 billions USD 83 billions USD
Facebook 700 billions USD 118 billions USD
•
Tesla 801 billions USD 16 billions USD
United Airlines 13.5 billions USD 7 billions USD
Cathay Pacific 46 billions HKD 49 billions HKD
HK Exchanges and Clearing 584 billions HKD 47 billions HKD

• Which is more important to the decision making

process?
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 Income Statement Characteristics
• Income Statement Equation: Revenues − Expenses = Income
• Recognition or Realization Principle: recognize revenue when
the earnings process is virtually complete and the value of an
exchange of goods or services is known or can be reliably
determined.
– Recognize revenue at the time of sale, not necessarily when the
cash comes in.
• Matching Principle: match revenues with the costs associated
with producing them.
– Depreciation: e.g., purchase a machine for $5,000 to be used for
5 years, deduct $1,000 each year in straight-line depreciation.
– Book value = Historical costs − Accumulated depreciation
• The figures on the income statement may not be
representative of the actual cash inflows and outflows.
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 Sample Income Statement

deducted before the calculation of

Taxes → Interest Tax Shield

not tax deductible

∆Retained earnings = Net income − Dividends

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Retained Earnings

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 The Importance of Cash Flows
• Cash is King: firms generate cash and they
spend it.
• Sources of cash (activities that bring in cash):
– decreases in assets (other than cash)
– increases in equity and liabilities
• Uses of cash (activities that involve cash
outflows):
– increases in assets (other than cash)
– decreases in equity and liabilities

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 Statement of Cash Flows
• This accounting statement summarizes the
sources and uses of cash over the period under
consideration.
• Changes divided into 3 major categories:
– Operating Activity: includes net income and changes
in most current accounts (accounts payable, accounts
receivable, inventory)
– Investment Activity: includes changes in fixed assets
– Financing Activity: includes changes in notes payable,
long-term debt, equity accounts, and dividends

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Sample Statement of Cash Flows

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Sample Statement of Cash Flows

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 Sample Statement of Cash Flows

• Fixed asset acquisitions = ∆Net fixed assets + Depreciation = 149 + 276 = $425
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 Sample Statement of Cash Flows

• ∆Cash = 619 − 425 − 180 = $14

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Sample Statement of Cash Flows

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 Quick Review MCQ
• A firm has $2,100 in net income, a tax rate of
35 percent, and interest expense of $700.
What is EBIT?
A. $3,535
B. $4,100
C. $6,700
D. $3,931
E. $4,520
• Answer: 2,100/(1 − 35%) + 700 = $3,931

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 Quick Review MCQ
• Which of the following is a source of cash?
A. The purchase of new fixed assets.
B. Dividends paid.
C. A decrease in long-term debt.
D. A decrease in inventory.
E. The repurchase of outstanding common stock.

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 Cash Flow From Assets (CFFA)
• In finance, our concept of “Cash Flow From Assets” is
different than the accounting “Statement of Cash
Flows”.
• Balance Sheet Identity: Assets = Liabilities +
Shareholders’ Equity
• Cash Flow Identity: Cash flow from assets = Cash flow
to creditors + Cash flow to stockholders
• Cash flow from assets (CFFA) = Operating cash flow
(OCF) − Net capital spending (NCS) − Changes in net
working capital (∆NWC)
• Cash flow from assets is also known as free cash flow.
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 Cash Flow From Assets: Example

• OCF (I/S) = Earnings before interest and taxes (EBIT) +

Depreciation − Taxes = 691 + 276 − 187 = $780
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Cash Flow From Assets: Example
• NCS (B/S and I/S) =
Ending net fixed
assets − Beginning
net fixed assets +
Depreciation =
2,880 − 2,731 + 276
= $425

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Cash Flow From Assets: Example
• Changes in NWC
(B/S) = Ending NWC
– Beginning NWC =
(708 − 540) − (642 −
543) = $69
• CFFA = 780 − 425 −
69 = $286

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Cash Flow From Assets: Example
• CF to Creditors (B/S
and I/S) = Interest
paid − Net new
borrowing = 141 −
(457 − 531) = $215
– Net New Borrowing
= Ending long-term
debt – Beginning
long-term debt

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Cash Flow From Assets: Example
• CF to Stockholders
(B/S and I/S) =
Dividends paid – Net
new equity raised =
121 − (550 − 500) =
$71
– Net new equity raised
= Ending common
stock and paid-in
surplus – Beginning
common stock and
paid-in surplus
• CFFA = 215 + 71 =
$286, the cash flow
identity holds.
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 Ratio Analysis
• Ratios allow for better comparison through time
or between companies.
• Time Trend Analysis (over time)
– Used to see how the firm’s performance is changing
through time
• Peer Group Analysis (with others)
– Compare to similar companies or within industries
– Standard Industrial Classification (SIC) and North
American Industry Classification System (NAICS) codes

36
 Things To Consider Concerning
Financial Ratios
• What aspects of the firm are we attempting to
analyze?
• What information goes into computing a particular
ratio and how does that information relate to the
aspect of the firm being analyzed?
• What is the unit of measurement (times, days,
percent)?
• What are the benchmarks used for comparison?
What makes a ratio “good” or “bad”?
• Introduce 5 major categories of ratios
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 1. Liquidity Ratios
• Short-term solvency (liquidity) ratios indicate a firm’s
ability to meet its maturing short-term obligations.
• Can we make required payments as they fall due?
“This is not just a rainy day fund. When you live
in a monsoon climate like the auto industry, you
don’t put away cash on the chance that
someday it might rain. It will rain. You plan for
it.” ─ Robert J. Eaton, former Chairman and CEO
of Chrysler Corporation

• Is high liquidity always good?

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 Example: How Much Cash is Too Much?

• Chrysler Investor Bids For Company

• Reclusive Las Vegas billionaire Kirk Kerkorian made a surprise
$22.8 billion takeover bid for Chrysler Corp., and Kerkorian
already owns 10 percent of the company, a $2 billion stake.
• Chrysler is expected to announce that it ended the first
quarter of 1995 with $8.4 billion in cash and marketable
securities. Kerkorian believed Chrysler’s financial reserves
were too large and that the failure to apply large sums of that
money to stockholder dividends contributed to the chronic
undervaluation of the company’s stock.
• Source: 13 April 1995, The Washington Post

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Computing Liquidity Ratios
• Current ratio = Current
assets/Current liabilities =
708/540 = 1.31 times
• Quick ratio = (Current assets –
Inventory)/Current liabilities =
(708 − 422)/540 = 0.53 times
• Cash ratio = Cash/Current
liabilities = 98/540 = 0.18 times
• Net working capital (NWC) to
total assets = NWC/TA = (708 –
540)/3,588 = 4.7%

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 2. Long-term Solvency Ratios
• Long-term solvency (financial leverage) ratios show
how heavily the company is in debt.
• Do we have the right mix of debt and equity?
• Generally, the more debt a firm has, the more likely it
is the firm will become unable to fulfill its contractual
obligations.
• Measure two aspects of leverage: level of
indebtedness and the ability to service this debt

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Computing Long-term Solvency Ratios
• Total debt ratio = (Total assets –
Total equity)/Total assets = (3,588
– 2,591)/3,588 = 0.28 times
• Debt-equity ratio
= Total debt/Total equity
= 0.28/(1 – 0.28) = 0.39 times
• Equity multiplier
= Total assets/Total equity
= 1/(1 – 0.28) = 1.39 times
= 1 + Debt-equity ratio
• Long-term debt ratio = Long-term
debt/(Long-term debt + Total
equity) = 457/(457 + 2,591) = 0.15
times
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 Computing Long-term Solvency Ratios

• Times interest earned (TIE) ratio = EBIT/Interest = 691/141 =

4.9 times; also known as interest coverage ratio
• Cash coverage ratio = (EBIT + Depreciation)/Interest = (691 +
276)/141 = 6.9 times
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 3. Asset Management Ratios
• Asset management (turnover/efficiency/asset
utilization) ratios measure how effectively the firm’s
assets are being managed.
• Do we have the right amount of assets for the level of
sales?
• Inventory turnover ratios measure how quickly
inventory is produced and sold.
• Receivable turnover ratios provide information on the
success of the firm in managing its collection from
credit customers.
• Asset turnover ratios show how effective the firm is in
using its assets to generate sales.

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Computing Asset Management Ratios

• Inventory turnover = Cost of

goods sold/Inventory =
1,344/422 = 3.2 times
• Days’ sales in inventory =
365/Inventory turnover =
365/(1,344/422) = 115 days

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Computing Asset Management Ratios

• Receivables turnover =
Sales/Accounts receivable =
2,311/188 = 12.3 times
• Days’ sales in receivables =
365/Receivables turnover =
365/(2,311/188) = 30 days

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Computing Asset Management Ratios

• NWC turnover = Sales/NWC =

2,311/(708 − 540) = 13.8 times
• Fixed asset turnover = Sales/Net
fixed assets = 2,311/2,880 = 0.8
times
• Total asset turnover = Sales/Total
assets = 2,311/3,588 = 0.64 times

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 4. Profitability Ratios
• Profitability ratios measure how successfully a
business earns a return on its investment.
• Do sales prices exceed unit costs, and are sales
high enough?
• Show the combined effects of liquidity, asset
management, and debts on operating results.

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Computing Profitability Ratios

• Profit margin = Net income/Sales

= 363/2,311 = 15.71%
• Basic earning power = EBIT/Total
assets = 691/3,588 = 19.26%

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Computing Profitability Ratios

• Return on assets (ROA) = Net

income/Total assets = 363/3,588
= 10.12%
• Return on equity (ROE) = Net
income/Total equity = 363/2,591
= 14.01%

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 More on ROE
• ROE is often used as a measure of how well
management is attaining the goal of owner
wealth maximization.
• Problems with ROE:
– ROE focuses only on return and does not consider risk.
– ROE does not consider the amount of capital invested
(E.g., Project A $100 at ROE 50% vs. Project B $1,000
at ROE 40%).
– Might encourage managers to turn down profitable
projects (E.g., your division’s ROE 30%, cost of capital
10%, estimated new project’s ROE 20%).

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 5. Market Value Ratios
• Market value ratios provide indications on the
firm’s prospects and how the market values the
firm.
• Do investors like what they see as reflected in
Price-Earnings and Market-to-Book ratios?
– Price-Earnings Ratio: How much investors are willing
to pay for $1 of earnings.
– Market-to-Book Ratio: How much investors are willing
to pay for $1 of book value equity.
• For each ratio, the higher the number, the better.

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 Computing Market Value Ratios
• Assume:
• Market price = $88
per share
• Shares outstanding
= 33 million

• Earnings per share (EPS) = Net income/Shares outstanding =

363/33 = $11
• Price-earnings (PE) ratio = Price per share/Earnings per share
= 88/11 = 8 times
• Price-sales ratio = Price per share/Sales per share =
88/(2,311/33) = 1.26 times

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Computing Market Value Ratios

• Market-to-book ratio = Market

value per share/Book value per
share = 88/(2,591/33) = 1.12
times
– Book value: total equity (not
just common stock)

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 The Du Pont System
• Some profitability and efficiency measures can
be linked in useful ways.
• These relationships are often referred to as
the Du Pont system in recognition of the
chemical company that popularized them.
• Du Pont Identity: ROE = PM × TAT × EM
– where ROE is return on equity; PM is profit
margin; TAT is total asset turnover; EM is equity
multiplier

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 Three Ratios of the Du Pont Identity
• ROE = PM × TAT × EM
• Profit margin (PM) is a measure of the firm’s
operating efficiency – how well does it control
costs
• Total asset turnover (TAT) is a measure of the
firm’s asset use efficiency – how well does it
manage its assets
• Equity multiplier (EM) is a measure of the
firm’s financial leverage
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 Expanded Du Pont Analysis

• Why Alphabet’s ROE is so much higher?

• What accounts for the decrease in Yahoo!’s ROE?

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Extended Du Pont Chart

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 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: firm’s financial health
– Creditors (E.g., assess overall creditworthiness)
– Suppliers (E.g., grant/extend credit)
– Customers (E.g., long-term business)
– Stockholders (E.g., profitability, growth)

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 Potential Problems with Financial Statement Analysis

• No underlying theory, difficult to know which ratios and

benchmarks are most relevant.
• Different ratios may give different signals, difficult to tell the
financial condition of a company.
• Benchmarking (with industry averages) is difficult for
diversified firms (firms operate many different divisions).
• Globalization and international competition makes
comparison more difficult due to different accounting and
operating practices.
• Different fiscal years and seasonal factors can distort ratios.
• Extraordinary events can give misleading signals.
• Window dressing techniques can make statements and ratios
look better.

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 Some Qualitative Factors
• Analysts should consider when evaluating a company’s likely
future financial performance:
• Are the company’s revenues tied to a single customer?
• To what extent are the company’s revenues tied to a single
product?
• To what extent does the company rely on a single supplier?
• What percentage of the company’s business is generated
overseas?
• What is the competitive situation?
• What is the company’s legal and regulatory environment?

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 Summary
• The main financial statements in the annual
report: Balance Sheet, Income Statement, and
Statement of Cash Flows
• Cash flow from assets (CFFA) = OCF − NCS −
∆NWC
• Five major categories of ratios: liquidity, long-
term solvency, asset management,
profitability, and market value ratios
• Du Pont Identity: ROE = PM × TAT × EM
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 Information on the Web
• The Internet makes ratio analysis much easier
than it has been in the past.
• Go to https://finance.yahoo.com/
– Enter the ticker symbol of a company, e.g., ‘AAPL’
for Apple Inc., ‘0005.HK’ for HSBC Holdings
– Click on ‘Financials’ and ‘Statistics’ to see what
information is available

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Appendix (Not Examinable)

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 Appendix: Statement of Cash Flows Characteristics

• Balance Sheet Identity:

Assets = Liabilities + Shareholders’ Equity
• Assets = Current assets + Net fixed assets = Cash + Current
assets other than cash + Net fixed assets
• Liabilities = Current liabilities + Long-term debt
• Shareholders’ Equity = Common stock + Retained earnings
→ Cash + Current assets other than cash + Net fixed assets =
Current liabilities + Long-term debt + Common stock + Retained
earnings
→ Cash = Current liabilities − Current assets other than cash −
Net fixed assets + Long-term debt + Common stock + Retained
earnings

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Appendix: Statement of Cash Flows Characteristics

• Since Cash = Current liabilities − Current assets other than

cash − Net fixed assets + Long-term debt + Common stock +
Retained earnings
• ∆Cash = ∆Current liabilities − ∆Current assets other than cash
− ∆Net fixed assets + ∆Long-term debt + ∆Common stock +
∆Retained earnings
• Recall: from Income Statement, ∆Retained earnings = Net
income − Dividends
→ ∆Cash = Net income + ∆Current liabilities − ∆Current assets
other than cash − ∆Net fixed assets + ∆Long-term debt +
∆Common stock − Dividends

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Appendix: Statement of Cash Flows Characteristics

• Since ∆Cash = Net income + ∆Current liabilities − ∆Current

assets other than cash − ∆Net fixed assets + ∆Long-term
debt + ∆Common stock − Dividends
• ∆Cash = Net income + Depreciation + ∆Current liabilities −
∆Current assets other than cash − ∆Net fixed assets −
Depreciation + ∆Long-term debt + ∆Common stock −
Dividends
• Recall: Fixed asset acquisitions = ∆Net fixed assets +
Depreciation
→ ∆Cash = (Net income + Depreciation + ∆Current liabilities −
∆Current assets other than cash) − Fixed asset acquisitions +
(∆Long-term debt + ∆Common stock − Dividends)
• Refer to Slides 23 to 27 as an example

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 Appendix: Deriving the Du Pont Identity
• ROE = NI/TE
– ROE: Return on equity; NI: Net income; TE: Total equity
• Multiply by 1 (TA/TA) and then rearrange
→ ROE = (NI/TE) × (TA/TA)
→ ROE = (NI/TA) × (TA/TE) = ROA × EM
– TA: Total assets; ROA: Return on assets; EM: Equity multiplier
• Multiply by 1 (Sales/Sales) again and then rearrange
→ ROE = (NI/TA) × (TA/TE) × (Sales/Sales)
→ ROE = (NI/Sales) × (Sales/TA) × (TA/TE)
• ROE = PM × TAT × EM (Du Pont Identity)
– PM: Profit margin; TAT: Total asset turnover

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