3

Working With Financial

Statements

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 Key Concepts and Skills
 Understand sources and uses of cash and the Statement
of Cash Flows
 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 DuPont Identity
 Understand the problems and pitfalls in financial
statement analysis

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 Chapter Outline
 Cash Flow and Financial Statements: A
Closer Look
 Standardized Financial Statements
 Ratio Analysis
 The DuPont Identity
 Using Financial Statement Information

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 Sample Balance Sheet
Numbers in millions
2007 2006 2007 2006
Cash 696 58 A/P 307 303

A/R 956 992 N/P 26 119

Inventory 301 361 Other CL 1,662 1,353

Other CA 303 264 Total CL 1,995 1,775
Total CA 2,256 1,675 LT Debt 843 1,091

Net FA 3,138 3,358 C/S 2,556 2,167

Total Assets 5,394 5,033 Total Liab. & 5,394 5,033

Equity

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Sample Income Statement
Numbers in millions, except EPS & DPS
Revenues 5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (442)
Net Income 689
EPS 3.61
Dividends per share 1.08

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 Sources and Uses
 Sources
 Cash inflow – occurs when we “sell” something
 Decrease in asset account (Sample B/S)
• Accounts receivable, inventory, and net fixed assets
 Increase in liability or equity account
• Accounts payable, other current liabilities, and common stock
 Uses
 Cash outflow – occurs when we “buy” something
 Increase in asset account
• Cash and other current assets
 Decrease in liability or equity account
• Notes payable and long-term debt

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 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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Sample Statement of Cash
Flows
Numbers in millions
Cash, beginning of year 58 Financing Activity

Operating Activity Decrease in Notes Payable -93

Net Income 689 Decrease in LT Debt -248

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

Decrease in A/R 36 Dividends Paid -206

Decrease in Inventory 60 Net Cash from Financing -641
Increase in A/P 4 Net Increase in Cash 638
Increase in Other CL 309 Cash End of Year 696
Less: Increase in other CA -39
Net Cash from Operations 1,175
Investment Activity
Sale of Fixed Assets 104
Net Cash from Investments 104

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 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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Common-Size Income Statement

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 Ratio Analysis
 Ratios also allow for better comparison through
time (Time trend analysis) or between
companies (Peer group analysis)
 As we look at each ratio, ask yourself what the
ratio is trying to measure and why that
information is important
 Ratios are used both internally and externally

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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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 Computing Liquidity Ratios
 Current Ratio = CA / CL
 2,256 / 1,995 = 1.13 times
 Quick Ratio = (CA – Inventory) / CL
 (2,256 – 301) / 1,995 = .98 times
 Cash Ratio = Cash / CL
 696 / 1,995 = .35 times
 NWC to Total Assets = NWC / TA
 (2,256 – 1,995) / 5,394 = .05
 Interval Measure = CA / average daily
operating costs
 2,256 / ((2,006 + 1,740)/365) = 219.8 days

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Computing Long-term Solvency
Ratios
 Total Debt Ratio = (TA – TE) / TA
 (5,394 – 2,556) / 5,394 = 52.61%
 Debt/Equity = TD / TE
 (5,394 – 2,556) / 2,556 = 1.11 times
 Equity Multiplier = TA / TE = 1 + D/E
 1 + 1.11 = 2.11
 Long-term debt ratio = LTD / (LTD + TE)
 843 / (843 + 2,556) = 24.80%

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 Computing Coverage Ratios
 Times Interest Earned = EBIT / Interest
 1,138 / 7 = 162.57 times
 Cash Coverage = (EBIT + Depreciation) /
Interest
 (1,138 + 116) / 7 = 179.14 times

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 Activity Ratios
a) Inventory Turnover = Cost of Goods Sold / Inventory.
b) Day’s Sales in Inventory= 365/Inventory Turnover
c) Accounts Receivables Turnover = Sales/Accounts receivables.
d) Average Collection Period = 365 / Receivables Turnover.
e) Accounts Payable Turnover = Credit Purchase/Accounts Payable
f) Average Payment Period = 365/Accounts Payable Turnover
g) Net Working Capital Turnover= Sales/NWC
h) Total Asset Turnover = Sales / Total Assets.
i) Fixed Asset Turnover = Sales / Fixed Assets.

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 Computing Inventory Ratios
 Inventory Turnover = Cost of Goods Sold /
Inventory
 2,006 / 301 = 6.66 times
 Days’
Sales in Inventory = 365 / Inventory
Turnover
 365 / 6.66 = 55 days

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Computing Receivables Ratios
 Receivables Turnover = Sales / Accounts
Receivable
 5,000 / 956 = 5.23 times
 Days’
Sales in Receivables = 365 /
Receivables Turnover
 365 / 5.23 = 70 days

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 Computing Total Asset
Turnover
 Total Asset Turnover = Sales / Total Assets
 5,000 / 5,394 = .93
 It is not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets
 NWC Turnover = Sales / NWC
 5,000 / (2,256 – 1,995) = 19.16 times
 Fixed Asset Turnover = Sales / NFA
 5,000 / 3,138 = 1.59 times

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Computing Profitability Measures
 Profit Margin = Net Income / Sales
 689 / 5,000 = 13.78%
 Return on Assets (ROA) = Net Income /
Total Assets
 689 / 5,394 = 12.77%
 Return on Equity (ROE) = Net Income /
Total Equity
 689 / 2,556 = 26.96%

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Computing Market Value Measures
 Market Price = $87.65 per share
 Shares outstanding = 190.9 million
 PE Ratio = Price per share / Earnings per
share
 87.65 / 3.61 = 24.28 times
 Market-to-book ratio = market value per
share / book value per share
 87.65 / (2,556 / 190.9) = 6.55 times

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 Deriving the DuPont Identity
 ROE = NI / TE
 Multiply by 1 (TA/TA) and then rearrange
 ROE = (NI / TE) (TA / TA)
 ROE = (NI / TA) (TA / TE) = ROA * EM
 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

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 Using the DuPont Identity
 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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 Expanded DuPont Analysis –
Aeropostale Data
 Bal. Sheet (1/28/06) Data  2006 Inc. Statement Data
(millions, $U.S.) (millions, $U.S.)
 Cash = 225.27  Sales = 1,204.35
 Inventory = 91.91  COGS = 841.87
 Other CA = 22.16  SG&A = 227.04
 Fixed Assets = 164.62  Interest = (3.67)
 Total Equity = 284.71  Taxes = 55.15

 Computations  Computations
 TA = 503.96  NI = 83.96
 TAT = 2.39  PM = 6.97%
 EM = 1.77  ROA = 16.66%
 ROE = 29.49%

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 Aeropostale Extended DuPont
Chart
ROE = 29.49%

ROA = 16.66% EM = 1.77

x
PM = 6.97%
x TAT = 2.39

NI = 83.96
 Sales = 1,204.35 Sales = 1,204.35
 TA = 503.96

Total Costs = - 1,120.39

+ Sales = 1,204.35 Fixed Assets = 164.62 + Current Assets = 339.34

COGS = - 841.87 SG&A = - 227.04 Cash = 225.27 Inventory = 91.9

Interest = - (3.67) Taxes = - 55.15 Other CA = 22.16

 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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 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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 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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 Work the Web Example
 The Internet makes ratio analysis much easier
than it has been in the past
 Click on the web surfer to go to
www.investor.reuters.com
 Choose a company and enter its ticker symbol
 Click on Ratios and then Financial Condition and see
what information is available

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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 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?

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 3
End of Chapter

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 Comprehensive Problem
 XYZ Corporation has the following
financial information for the previous year:
 Sales: $8M, PM = 8%, CA = $2M, FA =
$6M, NWC = $1M, LTD = $3M
 Compute the ROE using the DuPont
Analysis.

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