Key Concepts and Skills

Chapter 3 • Understand sources and uses of cash and the

Statement of Cash Flows
• Know how to standardize financial statements for
comparison purposes
Working With • Know how to compute and interpret important
Financial Statements financial ratios
• Be able to compute and interpret the Du Pont
Identity
• Understand the problems and pitfalls in financial
statement analysis

Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.

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McGraw-Hill/Irwin

Chapter Outline Sample Balance Sheet

• Cash Flow and Financial Statements: 2011 2010 2011 2010

Cash 696 58 A/P 307 303

A Closer Look A/R 956 992 N/P 26 119

• Standardized Financial Statements Inventory 301 361 Other CL 1,662 1,353

• Ratio Analysis Other CA 303 264 Total CL 1,995 1,775

Total CA 2,256 1,675 LT Debt 843 1,091

• The Du Pont Identity Net FA 3,138 3,358 C/S 2,556 2,167

• Using Financial Statement Total Assets 5,394 5,033 Total Liab. & 5,394 5,033
Information Equity

Numbers in millions of dollars

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 Sample Income Statement Sources and Uses
Revenues 5,000 • Sources
Cost of Goods Sold (2,006) – Cash inflow – occurs when we “sell” something
Expenses (1,740) – Decrease in asset account (Sample B/S)
Depreciation (116) • Accounts receivable, inventory, and net fixed assets
– Increase in liability or equity account
EBIT 1,138
• Accounts payable, other current liabilities, and common
Interest Expense (7) stock
Taxable Income 1,131 • Uses
Taxes (442) – Cash outflow – occurs when we “buy” something
Net Income 689 – Increase in asset account
EPS 3.61 • Cash and other current assets
– Decrease in liability or equity account
Dividends per share 1.08 • Notes payable and long-term debt
Numbers in millions of dollars, except EPS & DPS
Number of shares outstanding = 190.9 million 3-4 3-5

Sample Statement of
Statement of Cash Flows
Cash Flows
• Statement that summarizes the sources Cash, beginning of year 58 Financing Activity

and uses of cash Operating Activity Decrease in Notes Payable -93

• Changes divided into three major

Net Income 689 Decrease in LT Debt -248

Plus: Depreciation 116 Decrease in C/S (minus RE) -94

categories Decrease in A/R 36 Dividends Paid -206

– Operating Activity – includes net income and Decrease in Inventory 60 Net Cash from Financing -641
Increase in A/P 4
changes in most current accounts
Increase in Other CL 309 Net Increase in Cash 638
– Investment Activity – includes changes in fixed Less: Increase in other CA -39

assets Net Cash from Operations 1,175 Cash End of Year 696

– Financing Activity – includes changes in notes Investment Activity

payable, long-term debt, and equity accounts, Sale of Fixed Assets 104
as well as dividends Net Cash from Investments 104

Numbers in millions of dollars

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2
 Standardized Financial
Ratio Analysis
Statements
• Common-Size Balance Sheets • Ratios allow for better comparison through
– Compute all accounts as a percent of total assets time or between companies
• Common-Size Income Statements • As we look at each ratio, ask yourself what
– Compute all line items as a percent of sales the ratio is trying to measure and why that
• Standardized statements make it easier to information is important
compare financial information, particularly as the
company grows
• Ratios are used both internally and
externally
• They are also useful for comparing companies of
different sizes, particularly within the same industry

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Categories of
Computing Liquidity Ratios
Financial Ratios
1. Short-term solvency or liquidity • Current Ratio = CA / CL
– 2,256 / 1,995 = 1.13 times
ratios
• Quick Ratio = (CA – Inventory) / CL
2. Long-term solvency or financial – (2,256 – 301) / 1,995 = .98 times
leverage ratios • Cash Ratio = Cash / CL
– 696 / 1,995 = .35 times
3. Asset management or turnover • NWC to Total Assets = NWC / TA
ratios – (2,256 – 1,995) / 5,394 = .05
4. Profitability ratios • Interval Measure = CA / average daily
operating costs
5. Market value ratios – 2,256 / ((2,006 + 1,740)/365) = 219.8 days
B/S
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3
 Computing Long-term
Computing Coverage Ratios
Solvency Ratios
• Times Interest Earned = EBIT /
• Total Debt Ratio = (TA – TE) / TA
– (5,394 – 2,556) / 5,394 = 52.61%
Interest
• Debt/Equity = TD / TE – 1,138 / 7 = 162.57 times
– (5,394 – 2,556) / 2,556 = 1.11 times • Cash Coverage = (EBIT +
• Equity Multiplier = TA / TE = 1 + D/E Depreciation) / Interest
– 1 + 1.11 = 2.11 – (1,138 + 116) / 7 = 179.14 times
• Long-term debt ratio = LTD / (LTD + TE)
– 843 / (843 + 2,556) = 24.80%

B/S B/S
I/S 3-12 I/S 3-13

Computing Receivables
Computing Inventory Ratios
Ratios
• Inventory Turnover = Cost of Goods • Receivables Turnover = Sales /
Sold / Inventory Accounts Receivable
– 2,006 / 301 = 6.66 times – 5,000 / 956 = 5.23 times
• Days’ Sales in Inventory = 365 / • Days’ Sales in Receivables = 365 /
Inventory Turnover Receivables Turnover
– 365 / 6.66 = 55 days – 365 / 5.23 = 70 days

B/S B/S
I/S 3-14 I/S 3-15

4
 Computing Total Asset Computing Profitability
Turnover Measures
• Total Asset Turnover = Sales / Total • Profit Margin = Net Income / Sales
Assets
– 689 / 5,000 = 13.78%
– 5,000 / 5,394 = .93
– It is not unusual for TAT < 1, especially if a • Return on Assets (ROA) = Net
firm has a large amount of fixed assets Income / Total Assets
• NWC Turnover = Sales / NWC
– 689 / 5,394 = 12.77%
– 5,000 / (2,256 – 1,995) = 19.16 times
• Fixed Asset Turnover = Sales / NFA • Return on Equity (ROE) = Net
– 5,000 / 3,138 = 1.59 times Income / Total Equity
– 689 / 2,556 = 26.96%
B/S B/S
I/S 3-16 I/S 3-17

Computing Market Value Deriving the Du Pont

Measures Identity
• Market Price = $87.65 per share • ROE = NI / TE
• Multiply by 1 (TA/TA) and then rearrange
• Shares outstanding = 190.9 million
– ROE = (NI / TE) (TA / TA)
• PE Ratio = Price per share / – ROE = (NI / TA) (TA / TE) = ROA * EM
Earnings per share • Multiply by 1 (Sales/Sales) again and then
– 87.65 / 3.61 = 24.28 times rearrange
– ROE = (NI / TA) (TA / TE) (Sales / Sales)
• Market-to-book ratio = market value – ROE = (NI / Sales) (Sales / TA) (TA / TE)
per share / book value per share – ROE = PM * TAT * EM
– 87.65 / (2,556 / 190.9) = 6.55 times
B/S
I/S 3-18 3-19

5
 Expanded Du Pont Analysis –
Using the Du Pont Identity
Du Pont Data
• ROE = PM * TAT * EM
– Profit margin is a measure of the firm’s
operating efficiency – how well it
controls 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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Extended Du Pont Chart Why Evaluate Financial

Statements?
• Internal uses
– Performance evaluation – compensation and
comparison between divisions
Insert Figure 3.1 (Extended DuPont Chart)
– Planning for the future – guide in estimating
future cash flows
• External uses
– Creditors
– Suppliers
– Customers
– Stockholders

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 Benchmarking Real World Example – I
• Ratios are not very helpful by themselves; • The ratios of The Hour Glass, a watch
they need to be compared to something retail chain, listed on the Singapore Stock
• Time-Trend Analysis Exchange are compared with those of the
– Used to see how the firm’s performance is industry.
changing through time • The ratios are obtained from Reuters.com
– Internal and external uses and can be easily accessed on the web for
• Peer Group Analysis free.
– Compare to similar companies or within
industries
– SIC and NAICS codes

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Real World Example – II

Real World Example – III
• Liquidity ratios • Asset management ratios:
Company Industry Company Industry
– Current ratio 3.68x 1.98x – Inventory turnover 2.08x 4.44x
– Quick ratio 1.02x 1.38x
– Receivables turnover 31.43x 61.17x
• Long-term solvency ratio (12 days) (6 days)
– Debt/Equity ratio 11.80x 24.16x
– Total asset turnover 1.71x 1.30x
• Coverage ratio
– Times Int Earned --- 5.53x
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 Real World Example – III Potential Problems
• Profitability ratios • There is no underlying theory, so there is no way
Company Industry to know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition makes
– Gross profit margin 24.23% 50.42%
comparison more difficult because of differences
– Operating margin 11.42% 10.53% in accounting regulations
– Net profit margin 15.72% 10.58% • Varying accounting procedures, i.e. FIFO vs.
– ROA 9.22% 6.56% LIFO
– ROE 20.82% 19.13% • Different fiscal years
• Extraordinary events

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Work the Web Example Quick Quiz

• The Internet makes ratio analysis much • What is the Statement of Cash Flows and how do
easier than it has been in the past you determine sources and uses of cash?
• How do you standardize balance sheets and
• Click on the web surfer to go to
income statements and why is standardization
www.reuters.com useful?
– Click on Stocks, then choose a company and • What are the major categories of ratios and how
enter its ticker symbol do you compute specific ratios within each
– Click on Ratios to see what information is category?
available • What are some of the problems associated with
financial statement analysis?

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 Ethics Issues Comprehensive Problem
• Should financial analysts be held liable for their • XYZ Corporation has the following
opinions regarding the financial health of firms?
financial information for the previous
• How closely should ratings agencies work with
the firms they are reviewing? I.e., what level of year:
independence is appropriate? • Sales: $8M, PM = 8%, CA = $2M, FA
= $6M, NWC = $1M, LTD = $3M
• Compute the ROE using the DuPont
Analysis.

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End of Chapter

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