Chapter 2

Introduction to Financial
Statement Analysis
Chapter Outline

2.1 Firms’ Disclosure of Financial Information

2.2 The Balance Sheet
2.3 Balance Sheet Analysis
2.4 The Income Statement
2.5 Income Statement Analysis
2.6 The Statement of Cash Flows
2.7 Other Financial Statement Information
2.8 Financial Reporting in Practice
Learning Objectives

• Know why the disclosure of financial information

through financial statements is critical to investors
• Understand the function of the balance sheet
• Use the balance sheet to analyze a firm
• Understand how the income statement is used
• Analyze a firm through its income statement,
including using the DuPont Identity
Learning Objectives (cont’d)

• Interpret a statement of cash flows

• Know what management’s discussion and analysis
and the statement of stockholders equity are
• Understand the main purpose and aspects of the
Sarbanes-Oxley reforms following Enron and
other financial scandals.
2.1 Firms’ Disclosure of Financial
Information
• Financial statements are accounting
reports issued periodically to present past
performance and a snapshot of the firm’s
assets and the financing of those assets.
• Investors, financial analysts, managers,
and other interested parties such as
creditors rely on financial statements to
obtain reliable information about a
corporation.
2.1 Firms’ Disclosure of Financial
Information
• Public companies must file financial results
with the Securities and Exchange
Commission (SEC)
– on a quarterly basis (10-Q)
– and an annual basis (10-K)
• The annual report with financial
statements must be sent to their
shareholders every year.
2.1 Firms’ Disclosure of Financial
Information
• Generally Accepted Accounting Principles
(GAAP)
– Set by the Financial Accounting Standards
Board (FASB) to provide a common set of rules
and a standard format for public companies’
reports.
– Corporations are required to hire an auditor to
• check the annual financial statements
• ensure they are  prepared according to GAAP
• provide evidence that the information is reliable.
2.1 Firms’ Disclosure of Financial
Information
• International Financial Reporting
Standards
– International Accounting Standards Board
(IASB)
• Established in 2001 by representatives from 10
countries, including the U.S.
• Since 2005 all publicly traded European Union
companies are required to follow IFRS.
• Used by many other countries, including Australia,
several countries in Latin America and Africa.
• Accepted by all major stock exchanges around the
world except U.S. and Japan.
2.1 Firms’ Disclosure of Financial
Information
• Convergence to IFRS in the United States
is likely in the near future.
– In 2008, the SEC eliminated the requirement
for foreign firms trading in the U.S. to reconcile
IFRS to U.S. GAAP.
– In 2010, the SEC affirmed its support of a
single standard, with IFRS as the preferred
method.
2.1 Firms’ Disclosure of Financial
Information
• The four financial statements required by
the SEC are
– The balance sheet,
– The income statement,
– The statement of cash flows, and the
– The statement of stockholders’ equity
2.2 The Balance Sheet

• Also called “Statement of Financial

Position”
• Lists the firm’s assets and liabilities
• Provides a snapshot of the firm’s financial
position at a given point in time.
Table 2.1 Global Corporation Balance
Sheet for 2010 and 2009
2.2 The Balance Sheet

• The Balance Sheet Identity

– The two sides of the balance sheet must
balance

Assets = Liabilities + Stockholders’ (Eq. 2.1)

Equity
2.2 The Balance Sheet

• Current Assets
– Cash and other marketable securities
• short-term, low-risk investments
• easily sold and converted to cash
– Accounts receivable
• amounts owed to the firm by customers who have
purchased on credit
– Inventories
• raw materials, work-in-progress and finished goods;
– Other current assets
• includes items such as prepaid expenses
2.2 The Balance Sheet

• Long-Term Assets
– Assets that produce benefits for more than one
year
– Reduced through a yearly deduction called
depreciation according to a schedule that
depends on an asset’s life.
• Depreciation is not an actual expense, but a way of
recognizing that fixed assets wear out and become
less valuable as they get older.
2.2 The Balance Sheet

• Long-Term Assets
– The book value of an asset is its acquisition
cost less its accumulated depreciation.
– Other assets can include such items as
property not used in business operations, start-
up costs in connection with a new business,
trademarks and patents, and property held for
sale
2.2 The Balance Sheet

• Current Liabilities
– Accounts payable
• the amounts owed to suppliers purchases made on
credit
– Notes payable
• loans that must be repaid in the next year
• repayment of long-term debt that will occur within
the next year
– Accrual items
• Items such as salary or taxes that are owed but have
not yet been paid, and deferred or unearned revenue
2.2 The Balance Sheet

• Net working capital

– The capital available in the short term to run
the business:

Net Working Capital = Current Assets – Current

Liabilities
(Eq. 2.2)
2.2 The Balance Sheet

• Long-Term Liabilities
– Long-term debt
• a loan or debt obligation maturing in more than a
year.
2.2 The Balance Sheet

• Stockholders’ Equity
– Book value of equity
• Net worth from an accounting perspective
• Assets – Liabilities = Equity
• True value of assets may be different from book value
– Market capitalization
• Market price per share times number of shares
• Does not depend on historical cost of assets.
Example 2.1
Market versus Book Value
Problem:
• If Global has 3.6 million shares outstanding, and these
shares are trading for a price of $10 per share, what is
Global’s market capitalization?
• How does the market capitalization compare to Global’s
book value of equity?
Example 2.1
Market versus Book Value (cont’d)
Solution:
Plan:
• Market capitalization is equal to price per share times
shares outstanding.
• We can find Global’s book value of equity at the bottom of
the right side of its balance sheet.
Example 2.1
Market versus Book Value (cont’d)
Execute:
• Global’s market capitalization is:
– (3.6 million shares)  ($10/share) = $36 million
• This market capitalization is significantly higher than
Global’s book value of equity:
– $22.2 million
Example 2.1
Market versus Book Value (cont’d)
Evaluate:
• Global must have sources of value that do not appear on
the balance sheet.
• These include
– opportunities for growth
– the quality of the management team
– relationships with suppliers and customers, etc.
Example 2.1a
Market versus Book Value
Problem:
• In July, 2010, Campbell Soup Co. (CPB) had 340 million
shares outstanding, trading for a price of $35.90 per share.
• What was Campbell’s market capitalization?
• How does the market capitalization compare to Campbell’s
book value of equity?
Example 2.1
Market versus Book Value (cont’d)
Solution:
Plan:
• Market capitalization is equal to price per share times
shares outstanding.
• We can find Campbell’s book value of equity at the bottom
of the right side of its balance sheet.
Example 2.1a
Market versus Book Value (cont’d)
Execute:
• Campbell’s market capitalization is:
– (340 million shares)  ($35.90/share) = $12,206 million
• This market capitalization is significantly higher than
Campbell’s book value of equity:
– $926 million
Example 2.1a
Market versus Book Value (cont’d)
Evaluate:
• Campbell’s must have sources of value that do not appear
on the balance sheet.
• These include
– opportunities for growth
– the quality of the management team
– relationships with suppliers and customers, etc.
2.3 Balance Sheet Analysis

• Book value of equity is sometimes used to

estimate liquidation value
• We can learn a great deal from a firm’s
balance sheet to assess:
– the firm’s value
– its leverage
– its short-term cash needs
2.3 Balance Sheet Analysis

Market to Book Ratio

• The ratio of a firm’s market capitalization
to the book value of stockholders’ equity:
Market Value of Equity
Market-to-Book Ratio 
Book Value of Equity (Eq. 2.3)

• Also called Price-to-Book ratio.

• Sometimes used to classify firms as value
(low M/B) or growth (high M/B).
Figure 2.1 Market-to-Book Ratios in
2010
2.3 Balance Sheet Analysis

Debt-Equity Ratio
• The debt-equity ratio is a common ratio
used to assess a firm’s leverage

Total Debt
Debt-Equity Ratio  (Eq. 2.4)
Total Equity
2.3 Balance Sheet Analysis

Enterprise value
– Assesses the value of the underlying business
assets, unencumbered by debt and separate
from cash and marketable securities

Enterprise Value = Market Value of Equity + Debt – Cash

(Eq. 2.4)
Example 2.2
Computing Enterprise Value
Problem:
• In April 2010, H.J. Heinz Co. (HNZ) had a share price of
$46.15, 316.2 million shares outstanding, a market-to-book
ratio of 7.99, a book debt-equity ratio of 2.64, and cash of
$562.3 million.
• What was Heinz’s market capitalization?
• What was its enterprise value?
Example 2.2
Computing Enterprise Value (cont’d)
Solution:
Plan:
Share Price $46.15
Shares outstanding 316.2 million
Market-to-book 7.99
Cash $562 million
Debt-to-equity (book) 2.64

We will solve the problem using Eq. 2.5:

Enterprise value = Market capitalization + Debt –
Cash
Example 2.2
Computing Enterprise Value (cont’d)
Execute:
• We can compute the market capitalization by
multiplying the share price by the shares
outstanding.
• We are given the amount of cash.
• We are not given the debt directly, but we are
given the book debt-to-equity ratio.
• Since we can compute the market value of equity
(market capitalization) and we have the market-
to-book ratio, we can compute the book value of
equity.
Example 2.2
Computing Enterprise Value (cont’d)

Execute (cont’d):
• Heinz had market capitalization of $46.15 
316.2 million shares = $14.59 billion.
– Since Heinz’s market-to-book = 7.99 = $14.59
billion / book equity, then book equity =
$14.59 billion / 7.99 = $1.83 billion.
– Given that book equity is $1.83 billion and
book debt-to-equity ratio is 2.64,
– the total value of Heinz’s debt is $1.83 billion 
2.64 = $4.83 billion.
Example 2.2
Computing Enterprise Value (cont’d)
Evaluate:
• Thus, Heinz’s enterprise value was
14.59 + 4.83 – .562 = $18.858 billion.
Example 2.2a
Computing Enterprise Value
Problem:
• As of July, 2010, Campbell’s Soup Co. (CPB) had a share
price of $35.90 and 340 million shares outstanding.
• At that time, the company had $5,350 million in total debt
and $254 million in cash.
• What was Campbell’s enterprise value?
Example 2.2a
Computing Enterprise Value (cont’d)
Solution:
Plan:

Share Price $35.90

Shares outstanding 340 million
Cash $254 million
Debt $5,350 million

We will solve the problem using Eq. 2.5:

Enterprise value = Market capitalization + Debt
– Cash
Example 2.2a
Computing Enterprise Value (cont’d)
Execute:
• As computed in Example 2.1a, Campbell’s had a
market capitalization of (340 million shares) 
($35.90/share) = $12,206

Enterprise Value = Market Value of Equity +

Debt – Cash
Example 2.2a
Computing Enterprise Value (cont’d)
Evaluate:
• Campbell’s Enterprise Value =
$12,206 + $5,350 – $254.0 = $17,302 million.
2.3 Balance Sheet Analysis

Current Ratio
• The ratio of current assets to current
liabilities

Current Assets
Current Ratio = (Eq. 2.6)
Current Liabilities
2.3 Balance Sheet Analysis

Quick Ratio
• The ratio of current assets other than
inventory to current liabilities.

Current Assets - Inventory (Eq. 2.7)

Quick Ratio =
Current Liabilities
Table 2.2 Balance Sheet Ratios
2.4 The Income Statement

• The income statement lists the firm’s

revenues and expenses over a period of
time.
– Sometimes called the profit and loss statement,
or “P&L.”
• The  last or “bottom” line of the income
statement shows net income,
– a measure of its profitability  during the period.
– also referred to as the firm’s earnings.  
Table 2.3 Global Corporation’s Income
Statement Sheet for 2010 and 2009
2.4 The Income Statement

Earnings Calculations
Revenues (net sales)
- Cost of Sales = Gross Profit
- Operating Expenses = Operating Income
+/- Other Income = Earnings Before Interest and
Taxes
+/- Interest income (expense) = Pretax Income
- Taxes
= Net Income
2.4 The Income Statement

Earnings per share

• Net income reported on a per-share basis

Net Income $2.0 million

EPS    $0.556 per share
Shares Outstanding 3.6 million shares
(Eq. 2.8)
2.4 The Income Statement

• Fully diluted EPS increases number of

shares by:
– Stock options issued to employees
• The right to buy a certain number of shares by a
specific date at a specific price.
– Shares issued due to conversion of convertible
bonds
• Convertible bonds are corporate bonds with a
provision that gives the bondholder an option to
convert each bond into a fixed number of shares of
common stock.
2.5 Income Statement Analysis

• The income statement provides useful

information regarding the profitability of a
firm’s business and how it relates to the
value of the firm’s shares.
• There are several ratios that are often
used to evaluate a firm’s performance and
value.
2.5 Income Statement Analysis

Profitability Ratios
– Gross Margin
– Operating Margin
– Net Profit Margin
2.5 Income Statement Analysis

Gross margin
– how much a company earns from each dollar of
sales after paying for the items sold.

Gross Profit
Gross Margin  (Eq. 2.9)
Sales
2.5 Income Statement Analysis

Operating margin
– how much a company earns before interest and
taxes from each dollar of sales

Operating Income
Operating Margin  (Eq. 2.10)
Sales
2.5 Income Statement Analysis

Net Profit Margin

• the fraction of each dollar in revenues that is available to
equity holders after the firm pays interest and taxes

Net Income (Eq. 2.11)

Net Profit Margin 
Sales
2.5 Income Statement Analysis

Asset Efficiency: Asset Turnover

• A first broad measure of efficiency is asset turnover

Sales
Asset Turnover =
Total Assets (Eq. 2.12)
2.5 Income Statement Analysis

Asset Efficiency: Fixed Asset Turnover

• Since total assets include assets that are not directly
involved in generating sales, a manager might also look at
fixed asset turnover

Sales
Fixed Asset Turnover = (Eq. 2.13)
Fixed Assets
2.5 Income Statement Analysis

Working Capital Ratios: Accounts Receivable Days

• The firm’s accounts receivable in terms of the number of days’ worth
of sales that it represents

Accounts Receivable (Eq. 2.14)

Accounts Receivable Days 
Average Daily Sales
2.5 Income Statement Analysis

Working Capital Ratios: Inventory Days and

Inventory Turnover
• Inventory Days is the number of days’ cost of goods sold
represented by inventory.
• Inventory Turnover tells how efficiently a company turns its
inventory into sales.

Cost of Goods Sold

Inventory Turnover = (Eq. 2.15)
Inventory
2.5 Income Statement Analysis

EBITDA
• Financial analysts often compute a firm’s
earnings before interest, taxes,
depreciation, and amortization, or EBITDA.
• Because depreciation and amortization are
not cash flows, this subtotal reflects the
cash a firm has earned from operations.
2.5 Income Statement Analysis

Leverage Ratios: Interest Coverage Ratio

• Also known as times interest earned (TIE).
• TIE = earnings divided by interest
• Can define earnings as operating income,
EBIT, or EBITDA.
• Assesses how easily a firm is able to cover
its interest payments.
2.5 Income Statement Analysis

Investment Returns: Return on Equity

• Evaluating the firm’s return on investment
by comparing its income to its investment

Net Income
Return on Equity = (Eq. 2.16)
Book Value of Equity
2.5 Income Statement Analysis

Investment Returns: Return on Assets

• Evaluating the firm’s return on investment
by comparing its income to its assets

Net Income
Return on Assets =
Total Assets
2.5 Income Statement Analysis

DuPont Identity
• This expression says that ROE can be
thought of as net income per dollar of
sales (profit margin) times the amount of
sales per dollar of equity

 Net Income  Sales   Net Income  Sales 

ROE =      
 Total Equity  Sales   Sales  Total Equity 
(Eq. 2.17)
2.5 Income Statement Analysis

DuPont Analysis
• This final expression says that ROE is
equal to
– net income per dollar of sales (profit margin) times
– sales per dollar of assets (asset turnover) times
– assets per dollar of equity (a measure of leverage called
the equity multiplier).

 Net Income  Sales  Total Assets   Net Income  Sales  Total Assets 
ROE =        
 Sales  Total Equity  Total Assets   Sales  Total Assets  Total Equity 

(Eq. 2.18)
Example 2.3 DuPont Analysis

Problem:
• The following table contains information about Wal-Mart
(WMT) and Nordstrom (JWN). Compute their respective
ROEs and then determine how much Wal-Mart would need
to increase its profit margin in order to match Nordstrom’s
ROE.

Profit Asset Equity

Margin Turnover Multiplier
Wal-Mart 3.6% 2.4 2.6  

Nordstrom 7.7% 1.7 2.4

 
Example 2.3 DuPont Analysis
(cont’d)
Solution:
Plan:
• We can compute the ROE of each company by multiplying
together its profit margin, asset turnover, and equity
multiplier.
• In order to determine how much Wal-Mart would need to
increase its margin to match Nordstrom’s ROE, we can set
Wal-Mart’s ROE equal to Nordstrom’s, keep its turnover and
equity multiplier fixed, and solve for the profit margin.
Example 2.3 DuPont Analysis
(cont’d)

Execute:
• Using the DuPont Identity, we have:
– ROEWMT = 3.6% x 2.4 x 2.6 = 22.5%
– ROEJWN = 7.7% x 1.7 x 2.4 = 31.4%
• Now, using Nordstrom’s ROE, but Wal-Mart’s asset turnover
and equity multiplier, we can solve for the margin that Wal-
Mart needs to achieve Nordstrom’s ROE:
– 31.4% = Margin x 2.4 x 2.6
– Margin = 31.4% / 6.24 = 5.0%
Example 2.3 DuPont Analysis
(cont’d)
Evaluate:
• Wal-Mart would have to increase its profit margin from
3.6% to 5% in order to match Nordstrom’s ROE.
• It would be able to achieve Nordstrom’s ROE even with a
lower margin than Nordstrom (5.0% vs. 7.7%) because of
its higher turnover and slightly higher leverage.
Example 2.3a DuPont Analysis

Problem:
• The following table contains information about
Campbell’s (CPB) and H.J. Heinz (HNZ). Compute
their respective ROEs and then determine how
much Heinz would need to increase its equity
multiplier in order to match Campbell’s ROE.

Profit Asset Equity

Margin Turnover Multiplier
Campbell’s 10.8% 1.22 6.78  

Heinz 8.22% 1.04 5.33

 
Example 2.3a DuPont Analysis
(cont’d)
Solution:
Plan:
• We can compute the ROE of each company by multiplying
together its profit margin, asset turnover, and equity
multiplier.
• In order to determine how much Heinz would need to
increase its equity multiplier to match Campbell’s ROE, we
can set Heinz’s ROE equal to Campbell’s, keep its profit
margin and turnover fixed, and solve for the equity
multiplier.
Example 2.3a DuPont Analysis
(cont’d)

Execute:
• Using the DuPont Identity, we have:
– ROECPB = 10.8% x 1.22 x 6.78 = 89.3%
– ROEHNZ = 8.22% x 1.04 x 5.33 = 45.6%
• Now, using Campbell’s ROE, but Heinz’s profit margin and
asset turnover, we can solve for the equity multiplier that
Heinz needs to achieve Campbell’s ROE:
– 89.3% = 8.22% x 1.04 x Equity Multiplier
– Equity Multiplier = 89.3% / 8.55% = 10.44
Example 2.3a DuPont Analysis
(cont’d)

Evaluate:
• Heinz would have to increase its equity multiplier from 5.33
to 10.44 in order to match Campbell’s ROE.
• This large increase in equity multiplier is required because of
its lower asset turnover (1.04 vs. 1.22) (lower efficiency) and
lower profit margin (8.22% vs. 10.8%).
Example 2.3b DuPont Analysis

Problem:
• The following table contains information about
Campbell’s (CPB) and H.J. Heinz (HNZ). Compute
their respective ROEs and then determine how
much Heinz would need to increase its asset
turnover in order to match Campbell’s ROE.

Profit Asset Equity

Margin Turnover Multiplier
Campbell’s 10.8% 1.22 6.78  

Heinz 8.22% 1.04 5.33

 
Example 2.3b DuPont Analysis
(cont’d)
Solution:
Plan:
• We can compute the ROE of each company by multiplying
together its profit margin, asset turnover, and equity
multiplier.
• In order to determine how much Heinz would need to
increase its asset turnover to match Campbell’s ROE, we
can set Heinz’s ROE equal to Campbell’s, keep its profit
margin and equity multiplier fixed, and solve for the asset
turnover.
Example 2.3b DuPont Analysis
(cont’d)

Execute:
• Using the DuPont Identity, we have:
– ROECPB = 10.8% x 1.22 x 6.78 = 89.3%
– ROEHNZ = 8.22% x 1.04 x 5.33 = 45.6%
• Now, using Campbell’s ROE, but Heinz’s profit margin and
equity multiplier, we can solve for the asset turnover that
Heinz needs to achieve Campbell’s ROE:
– 89.3% = 8.22% x Asset Turnover x 6.78
– Asset Turnover = 89.3% / 43.8% = 1.66
Example 2.3b DuPont Analysis
(cont’d)

Evaluate:
• Heinz would have to increase its asset turnover from 1.04 to
1.66 in order to match Campbell’s ROE.
• This large increase in asset turnover is required because of its
lower equity multiplier (1.04 vs. 1.22) (lower leverage) and
lower profit margin (8.22% vs. 10.8%).
2.5 Income Statement Analysis

Valuation Ratio: Price-Earnings Ratio

• Analysts and investors use a number of ratios to gauge the
market value of the firm.
• The most important is the firm’s price-earnings ratio (P/E)
– The P/E ratio is used to assess whether a stock is over-
or under-valued based on the idea that the value of a
stock should be proportional to the earnings it can
generate.

Market Capitalization Share Price

P / E Ratio   (Eq. 2.19)
Net Income Earnings per Share
2.5 Income Statement Analysis

Valuation Ratio: PEG Ratio

• P/E ratios can vary widely across industries and tend to be
higher for industries with higher growth rates.
• One way to capture the idea that a higher P/E ratio can be
justified by higher expected earnings growth.
• It is the ratio of the firm’s P/E to its expected earnings
growth rate.
• The higher the PEG ratio, the higher the price relative to
growth, so some investors avoid companies with PEG ratios
over 1.
Example 2.4
Computing Profitability and Valuation
Ratios
Problem:
• Consider the following data from 2010 for Wal-Mart Stores and Target
Corporation ($ billions):

Wal-Mart Stores Target Corporation

(WMT) (TGT)
Sales 408 65
Operating Income 24 5
Net Income 14 2
Market
Capitalization 203 41
Cash 8 2
Debt 41 17

• Compare Wal-Mart and Target’s operating margin, net profit margin, P/E
ratio, and the ratio of enterprise value to operating income and sales.
Example 2.4
Computing Profitability and Valuation
Ratios (cont’d)
Solution
Plan:
• The table contains all of the raw data, but we need to
compute the ratios using the inputs in the table.
– Operating Margin = Operating Income / Sales
– Net Profit Margin = Net Income / Sales
– P/E ratio = Price / Earnings
– Enterprise value to operating income = Enterprise
Value / Operating Income
– Enterprise value to sales = Enterprise Value / Sales
Example 2.4
Computing Profitability and Valuation
Ratios (cont’d)
Execute:
• Wal-Mart had
– an operating margin of 24/408=5.9%
– a net profit margin of 14/408=3.4%
– and a P/E ratio of 203/14=14.5.
– Its enterprise value was 203 + 41 - 8 billion:
• a ratio of 236/24=9.8 to operating income
and
• 236/408=0.58 to sales.
Example 2.4
Computing Profitability and Valuation
Ratios (cont’d)
Execute (cont’d):
• Target had
– an operating margin of 5/65 = 7.7%
– a net profit margin of 2/65=3.1%
– and a P/E ratio of 41/2=20.5.
– Its enterprise value was 41 + 17 – 2 = $56
billion:
• a ratio of 56/5 = 11.2 to operating income
• and 56/65 = 0.86 to sales.
Example 2.4
Computing Profitability and Valuation
Ratios (cont’d)
Evaluate:
• Note that despite their large difference in size, Target and
Wal-Mart’s P/E and enterprise value to operating income
ratios were very similar.
• Target’s profitability was somewhat higher than Wal-Mart’s.
• This explains the difference in the ratio of enterprise value
to sales.
Example 2.4a
Computing Profitability and Valuation
Ratios
Problem:
• Consider the following data from 2010 for Campbell Soup Co. and H.J.
Heinz Co. ($ millions):

Campbell’s Soup Co. (CPB) H.J. Heinz Co. (HNZ)

Sales 7,676.0 10,495.0
Operating Income 1,615.0 1,582.0
Net Income 830.0 862.7
Market Capitalization 12,206.0 14,809.0
Cash 254.0 483.3
Debt 5,350.0 8,184.4

• Compare Campbell’s and Heinz’s operating margin, net profit margin,

P/E ratio, and the ratio of enterprise value to operating income and
sales.
Example 2.4a
Computing Profitability and Valuation
Ratios (cont’d)
Solution
Plan:
• The table contains all of the raw data, but we need to
compute the ratios using the inputs in the table.
– Operating Margin = Operating Income / Sales
– Net Profit Margin = Net Income / Sales
– P/E ratio = Price / Earnings
– Enterprise value to operating income = Enterprise
Value / Operating Income
– Enterprise value to sales = Enterprise Value / Sales
Example 2.4a: Computing Profitability
and Valuation Ratios (cont’d)

Execute:
Ratio Campbell’s Heinz
Operating Margin 1,615.0/7,676.0=21.0% 1,582.0/10,495.0 = 15.1%

Net Profit Margin 830.0/7,676.0 = 10.8% 862.7/10,495.0 = 8.2%

P/E Ratio 12,206.0/830.0 = 14.71 14,809.0/862.7 = 17.17

Enterprise Value 12,206.0+5,350.0-254.0 = 14,809.0+8,184.4-483.3 =

17,302.0 22,510.10
Enterprise Value to 17,302.0/1,615.0= 10.71 22,510.0/1,582.0 = 14.23
Operating Income

Enterprise Value to 17,302.0/7,676.0= 2.25 22,510.0/10,495.0 = 2.14

Sales
Example 2.4a
Computing Profitability and Valuation
Ratios (cont’d)
Evaluate:
• Note that Campbell’s operating and net profit margins are
quite a bit larger than Heinz’s.
• Heinz had a larger P/E ratio, which can be explained in part
by Heinz’s greater use of leverage as seen in Example 2.3a.
Table 2.4
Income
Statement
Ratios
2.6 The Statement of Cash Flows

• The firm’s statement of cash flows uses

the information from the income statement
and balance sheet to determine:
– how much cash the firm has generated
– how that cash has been allocated during a set
period.
• Cash is important because it is needed to
pay bills and maintain operations and is
the source of any return of investment for
investors.
2.6 The Statement of Cash Flows

• The statement of cash flows is divided into

three sections which roughly correspond to
the three major jobs of the financial
manager:
– Operating activities
– Investment activities
– Financing activities  
Table 2.5
Global
Corporation’s
Statement of
Cash Flows for
2007 and 2006
2.6 The Statement of Cash Flows

• Operating Activity
• Use the following guidelines to adjust for
changes in working capital:
– Accounts receivable:
• When a sale is recorded as part of net income, but
the cash has not yet been received from the
customer, adjust the cash flows by deducting the
increases in accounts receivable.
• This increase represents additional lending by the
firm to its customers and it reduces the cash available
to the firm.
2.6 The Statement of Cash Flows

• Operating Activity (cont’d)

– Accounts payable:
• Similarly, we add increases in accounts payable.
• Accounts payable represents borrowing by the firm
from its suppliers.
• This borrowing increases the cash available to the
firm.
2.6 The Statement of Cash Flows

• Operating Activity (cont’d)

– Inventory:
• Finally, we deduct increases to inventory.
• Increases to inventory are not recorded as an
expense and do not contribute to net income
• However, the cost of increasing inventory is a cash
expense for the firm and must be deducted.
– We also add depreciation to net income, since
it is not a cash outflow
2.6 The Statement of Cash Flows

• Investment Activity
– Subtract the actual capital expenditure that the
firm made.
– Also deduct other assets purchased or
investments made by the firm, such as
acquisitions.
2.6 The Statement of Cash Flows

• Financing Activity
– The last section of the statement of cash flows
shows the cash flows from financing activities.
• Dividends paid
• Cash received from sale of stock or spent
repurchasing its own stock.
• Changes to short-term and long-term borrowing.
2.6 The Statement of Cash Flows

Payout Ratio and Retained Earnings

Retained Earnings = Net Income – (Eq. 2.20)

Dividends

Dividends
Payout Ratio =
Net Income (Eq. 2.21)
2.6 The Statement of Cash Flows

• The last line of the Statement of Cash Flows

combines the cash flows from these three
activities to calculate the overall change in the
firm’s cash balance over the time period.
Example 2.5
The Impact of Depreciation on Cash Flow

Problem:
• Suppose Global had an additional $1 million depreciation
expense in 2010.
• If Global’s tax rate on pretax income is 26%, what would be
the impact of this expense on Global’s earnings?
• How would it impact Global’s cash at the end of the year?
Example 2.5
The Impact of Depreciation on Cash Flow
(cont’d)
Solution:
Plan:
• Depreciation is an operating expense, so Global’s operating
income, EBIT, and pretax income would be affected.
• With a tax rate of 26%, Global’s tax bill will decrease by 26
cents for every dollar that pretax income is reduced.
• Recall that depreciation is not an actual cash outflow, even
though it is treated as an expense, so the only effect on cash
flow is through the reduction in taxes.
Example 2.5
The Impact of Depreciation on Cash Flow
(cont’d)
Execute:
• Global’s operating income, EBIT, and pretax income would
fall by $1 million because of the $1 million in additional
operating expense due to depreciation.
• This $1 million decrease in pretax income would reduce
Global’s tax bill by 26%  $1 million = $0.26 million.
Therefore, net income would fall by 1 – 0.26 = $0.74 million.
Example 2.5
The Impact of Depreciation on Cash Flow
(cont’d)
Execute (cont’d):
• On the statement of cash flows, net income would
fall by $0.74 million, but we would add back the
additional depreciation of $1 million because it is
not a cash expense.
• Thus, cash from operating activities would rise by –
0.74 + 1 = $0.26 million. Thus, Global’s cash
balance at the end of the year would increase by
$0.26 million, the amount of the tax savings that
resulted from the additional depreciation deduction.
Example 2.5
The Impact of Depreciation on Cash Flow
(cont’d)
Evaluate:
• The increase in cash balance comes completely from the
reduction in taxes.
• Because Global pays $0.26 million less in taxes even though
its cash expenses have not increased, it has $0.26 million
more in cash at the end of the year.
Example 2.5a
The Impact of Depreciation on Cash Flow

Problem:
• Suppose Global wants to accelerate its depreciation method
so that it can generate $2 million in cash.
• If its tax rate is 34%, how much additional depreciation
expense would it need to generate the extra cash?
Example 2.5a
The Impact of Depreciation on Cash Flow
(cont’d)
Solution:
Plan:
• With a tax rate of 34%, Global’s tax bill will decrease by 34
cents for every dollar that pretax income is reduced.
• In order to generate $2 million in extra cash, Global would
need to increase cash flow from operations (NI +
depreciation) by $2 million.
• CF from operations = (EBITDA-Dep)(1-t) + Dep = EBITDA +
t x Dep.
• Since there’s no change in EBITDA because of additional
depreciation, t x Dep must equal $2 million.
Example 2.5a
The Impact of Depreciation on Cash Flow
(cont’d)
Execute:
• 0.34 x Dep = $2 million
• Dep = $5.88 million
• This $5.88 million decrease in pretax income would reduce
Global’s tax bill by 34%  $5.88 million = $2 million.
Therefore, net income would fall by 5.88 – 2 = $3.88 million.
Example 2.5a
The Impact of Depreciation on Cash Flow
(cont’d)
Execute (cont’d):
• On the statement of cash flows, net income would
fall by $3.88 million, but we would add back the
additional depreciation of $5.88 million because it
is not a cash expense.
• Thus, cash from operating activities would rise by
-$3.88 + 5.88 = $2 million. Thus, Global’s cash
balance at the end of the year would increase by
$2 million, the amount of the tax savings that
resulted from the additional depreciation deduction.
Example 2.5
The Impact of Depreciation on Cash Flow
(cont’d)
Evaluate:
• The increase in cash balance comes completely from the
reduction in taxes.
• Because Global pays $2 million less in taxes even though its
cash expenses have not increased, it has $2 million more in
cash at the end of the year.
2.7 Other Financial Statement
Information
• Other pieces of information contained in
the financial statements:
– Management Discussion and Analysis
– Statement of Stockholders’ Equity
– Notes to the Financial Statements
2.8 Financial Reporting in Practice

• Even with safeguards such as GAAP and

auditors, though, financial reporting
abuses unfortunately do take place.
• One of the most infamous recent examples
is Enron.
2.8 Financial Reporting in Practice

• In 2002, Congress passed the Sarbanes-Oxley Act

(SOX). While SOX contains many  provisions, the
overall intent of the legislation was to improve the
accuracy of information given to both boards and
to shareholders. SOX attempted to achieve this
goal in three ways:  
– Overhauling incentives and independence in the auditing
process
– Stiffening penalties for providing false information
– Forcing companies to validate their internal financial
control processes.
Chapter Quiz

• What is the role of an auditor?

• What is depreciation designed to capture?
• What does a high debt-to-equity ratio tell
you?
• What do a firm’s earnings tell you?
• How do you use the price-earnings (P/E)
ratio to gauge the market value of a firm?
Chapter Quiz

• Why does a firm’s net income not

correspond to cash earned?
• What information do the notes to financial
statements provide?
• What is the Sarbanes-Oxley Act?