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Chapter 3

Working with Financial Statements


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Key Concepts and Skills

• Know the sources and uses of a firm’s cash flows


• Understand how to standardize financial statements
for comparison purposes.
• Know how to compute and interpret common
financial ratios.
• Be able to understand the determinants of a firm’s
profitability.
• Understand some of the problems and pitfalls in
financial statement analysis.

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Chapter Outline

3.1 Cash Flow and Financial Statements: A Closer


Look
3.2 Standardized Financial Statements
3.3 Ratio Analysis
3.4 The Du Pont Identity
3.5 Using Financial Statement Information
Summary and Conclusions

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3.1 Cash Flow and Financial


Statements: A Closer Look
Example Statement of Financial Position (‘000s)
2021 2020 2021 2020
Cash & $3,171 $6,489 A/P $313,286 $340,220
Equivalents
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
Retained 76,395 0
Earnings
Net FA 3,129,754 2,535,072 C/S 1,684,649 1,720,807

Total Assets $4,931,444 $4,118,111 Total Liab. $4,931,444 $4,118,111


& Equity
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3.1 Cash Flow and Financial


Statements: A Closer Look
Example (cont.) Statement of Comprehensive Income(‘000s)
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
Additions to retained earnings ?
Dividends Paid $395,521
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3.1 Cash Flow and Financial


Statements: A Closer Look
Sources and Uses of Cash
• Sources
− Cash inflow occurs when we “sell” something.
− Decrease in asset account.
− Increase in liability or equity account.
• Uses
− Cash outflow occurs when we “buy” something.
− Increase in asset account.
− Decrease in liability or equity account.

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3.1 Cash Flow and Financial


Statements: A Closer Look
Statement of Cash Flows
• Statement that summarizes the sources and uses of
cash.
• Changes divided into three major categories
− Operating Activity includes net income and
changes in most current accounts.
− Investment Activity includes changes in fixed
assets.
− Financing Activity includes changes in notes
payable, long-term debt and equity accounts as well
as dividends.
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3.1 Cash Flow and Financial
Statements: A Closer Look
Example (cont.) Statement of Cash Flows (‘000s)
Cash, beginning of year 6,489 Financing Activity

Operating Activity Increase in Notes Payable 141,217


Net Income 471,916 Increase in LT Debt 517,764
Plus: Depreciation 362,325 Decrease in C/S –36,158
Increase in Other CL 141,049 Dividends Paid –395,521
Less: Increase in A/R –46,127 Net Cash from Financing 227,302
Increase in Inventory –93,692 Net Decrease in Cash –3,318
Increase in Other CA –82,150 Cash End of Year 3,170*
Decrease in A/P –26,934
Net Cash from Operations 726,387
Investment Activity
Fixed Asset Acquisition –957,007

Net Cash from Investments –957,007 *Difference due to rounding of dividends

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3.2 Standardized Financial Statements

• Common-Size Statements of Financial Position


− Compute all accounts as a percent of total assets.
• Common-Size Statements of Comprehensive
Income
− Compute all line items as a percent of sales.

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3.2 Standardized Financial Statements

Why do we use standardized financial statements?


• 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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3.3 Ratio Analysis

• Ratios 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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3.3 Ratio Analysis

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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3.3 Ratio Analysis

Example (cont.)
Liquidity Ratios
• Current Ratio = CA/CL
= $1,801,690/$1,780,785 = 1.01
• Quick Ratio = (CA – Inventory)/CL
= ($1,801,690 – $388,947)/$1,780,785
= 0.793
• Cash Ratio = Cash/CL
= $3,171/$1,780,785 = 0.002
− Cash means cash + cash equivalents
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3.3 Ratio Analysis

Example (cont.)
Long-term Solvency Ratios
• Total Debt Ratio = (TA – TE)/TA
= ($4,931,444 – $1,761,044)/$4,931,444
= 0.6429
− 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
= 1.80
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3.3 Ratio Analysis

Example (cont.)
Long-term Solvency Ratios
• Debt/Equity = TD/TE
= ($4,931,444 – $1,761,044)/$1,761,044
= 1.80
• Equity Multiplier = TA/TE = 1 + D/E
= 1 + 1.800 = 2.800

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3.3 Ratio Analysis

Long-term Solvency Ratios


• Times Interest Earned = EBIT/Interest
= $820,183/$52,841
= 15.5
• Cash Coverage = (EBIT + Depreciation)/Interest
= ($820,183 + $362,325)/$52,841
= 22.38

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3.3 Ratio Analysis

Example (cont.)
Asset Management
• Inventory Turnover = Cost of Goods Sold/Inventory
= $1,762,721/$388,947
= 4.53
• Days’ Sales in Inventory = 365/Inventory Turnover
= 365/4.53
= 81 days

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3.3 Ratio Analysis

Example (cont.)
Asset Management
• Receivables Turnover = Sales/Accounts Receivable
= $4,335,491/$1,095,118
= 3.96
• Days’ Sales in Receivables = 365/Receivables Turno.
= 365/3.96
= 92 days

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3.3 Ratio Analysis

Example (cont.)
Asset Management
• NWC Turnover = Sales/NWC
= $4,335,491/($1,801,690 – $1,780,785)
= 207.390
• Fixed Asset Turnover = Sales/Net Fixed Assets
= $4,335,491/$3,129,754
= 1.385

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3.3 Ratio Analysis

Example (cont.)
Asset Management
• Total Asset Turnover = Sales/Total Assets
= $4,335,491/$4,931,444
= 0.88
− 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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3.3 Ratio Analysis

Example (cont.)
Profitability ratios
• Profit Margin = Net Income/Sales
= $471,916/$4,335,491 = 0.1088
• Return on Assets (ROA) = Net Income/Total Assets
= $471,916/$4,931,444
= 0.0957
• Return on Equity (ROE) = Net Income/Total Equity
= $471,916/$1,761,044
= 0.2680
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3.3 Ratio Analysis

Example (cont.)
Market value ratios
• PE Ratio = Price per share/Earnings per share
= $60.98/$2.29
= 26.6
Where Earnings per share = Net Income/Shares
Outstanding

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3.3 Ratio Analysis

Example (cont.)
Market value ratios
• Market-to-book ratio = Market Value Per Share/
Book Value Per Share
= 7.1
• Enterprise Value (EV)/EBITDA = 11.85
Where Enterprise Value = Market Value of Equity
+ Market Value of Interest-bearing Debt
– Cash (and Cash Equivalent)

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3.3 Ratio Analysis

Table 3.8 - Common Financial Ratios


II. Long-Term Solvency or Financial Leverage
I. Short-Term Solvency or Liquidity Ratios Ratios
Current assets Total assets  Total equity
Current ratio  Total debt ratio 
Current liabilities Total assets
Current assets  Inventory Total debt
Quick ratio  Debt/equity ratio 
Current liabilities Total equity
Cash Total assets
Cash ratio  Equity multiplier 
Current liabilities Total equity
Net working capital
Net working capital  Long-term debt ratio 
Long-term debt
Total assets Long-term debt  Total equity
Current assets
Interval measure  EBIT
Average daily operating costs Times interest earned 
Interest
EBIT  Depreciation
Cash coverage ratio 
Interest

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3.3 Ratio Analysis

Table 3.8 – Common Financial Ratios (cont.)


III. Asset Utilization Turnover Ratios IV. Profitability Ratios

Cost of goods sold Net income


Inventory turnover  Profit margin 
Inventory Sales

365 days Net income


Days' sales in inventory  Return on assets (ROA) 
Inventory turnover Total assets
Net income
Receivables turnover 
Sales Return on equity (ROE) 
Accounts receivable Total equity

365 days Net income Sales Assets


Days' sales in receivables  ROE   
Receivables turnover Sales Assets Equity

Sales
NWC turnover 
NWC
Sales
Fixed asset turnover 
Net fixed assets
Sales
Total asset turnover 
Total assets
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3.3 Ratio Analysis

Table 3.8 - Common Financial Ratios (cont.)


V. Market Value Ratios
Price per share
Price-earning ratio 
Earnings per share

PEG ratio = P/E ratio/Expected future earnings growth rate*100


Market value per share
Market-to-book ratio 
Book value per share

EV/EBITDA  [Market value of equity  Market value of interest-bearing debt 


Cash(and cash equivalent)]/EBITDA

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3.4 The Du Pont Identity

• ROE = NI/TE
• Multiply by 1 and then rearrange
NI TA NI TA
ROE = × = × = ROA × EM
TE TA TA TE

• Multiply by 1 again and then rearrange


NI TA Sales NI Sales TA
ROE = × × = × ×
TA TE Sales Sales TA TE
ROE = PM × TAT × EM

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3.4 The Du Pont Identity

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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3.5 Using Financial Statement


Information
• 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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3.5 Using Financial Statement


Information
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.
− NAICS codes, Financial Post Datagroup, and Dun
& Bradstreet Canada.
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3.5 Using Financial Statement


Information
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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Summary and Conclusions

• You should be able to:


− Identify sources and uses of cash.
− Understand the Statement of Cash Flows.
− Understand how to make standardized financial
statements and why they are useful.
− Calculate and evaluate common ratios.
− Understand the Du Pont identity.
− Describe how to establish benchmarks for
comparison purposes and understand some key
problems that can arise.
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Quick Quiz

• What is the Statement of Cash Flows and how do


you determine sources and uses of cash?
• How do you standardize statements of financial
position and statements of comprehensive income
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?

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