Finance 13e CH03 PPT

CHAPTER 3
W O R K I N G W I T H F I N A N C I A L S TAT E M E N T S
Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.
LEARNING OBJECTIVES
• Standardize financial statements for comparison

purposes
• Compute and more importantly, interpret some

common ratios
• Name the determinants of a firm’s profitability
• Explain some of the problems and pitfalls in financial

statement analysis
1-2
CHAPTER OUTLINE
• Cash Flow and Financial Statements: A Closer Look
• Standardized Financial Statements
• Ratio Analysis
• The DuPont Identity
• Using Financial Statement Information
1-3
CASH FLOW AND FINANCIAL STATEMENTS:
A CLOSER LOOK
• Activities that bring in cash are called sources of cash, while
activities that involve spending cash are called uses of cash
• An increase in a left-side (asset) account or a decrease in a
right-side (liability or equity) account is a use of cash
• Increase in an asset account means the firm, on a net basis,
bought some assets – a use of cash
• A decrease in a left-side (asset) account or an increase in a
right-side (liability or equity) account is a source of cash
• Decrease in an asset account, on a net basis, means the firm
sold some assets (i.e., a net source)
• To trace the flow of cash through a firm during the year in a
detailed fashion, an income statement is necessary
1-4
PRUFROCK CORPORATION:
2020 AND 2021 BALANCE SHEETS
1-5
SUMMARY OF SOURCES AND USES OF CASH
1-6
2021 INCOME STATEMENT
1-7
THE STATEMENT OF CASH FLOWS
• Statement of cash flows is a firm’s financial statement that

summarizes its sources and uses of cash over a specified period
• Exact form differs in detail from one preparer to the next, but
the basic idea is to group all changes into three categories:
• Operating activities
• Investment activities
• Financing activities
• Standard accounting practices expressly prohibits reporting
cash flow per share
• Cash flow is not an alternative to accounting income, so only
earnings per share are to be reported
1-8
CASH FLOWS
1-9
STANDARDIZED FINANCIAL STATEMENTS
• Nearly impossible to directly compare the financial statements for
two companies because of differences in size
• Similarly challenging to compare financial statements from different
points in time for the same company if the company’s size has
changed
• To make comparisons, standardize the financial statements
1. Common-size statements present all items in percentage terms
• Common-size balance sheets typically express each item as a
percentage of total assets
• Common-size income statements usually show each item as a
percentage of total sales
• Common-size statement of cash flows can be constructed from a
“sources and uses of cash” statement, expressing each item as a
percentage of total sources (or total uses)
2. Common-base year statements (i.e., trend analysis) present all 1-10
items
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PRUFROCK CORPORATION: SUMMARY OF
STANDARDIZED BALANCE SHEETS
1-11
RATIO ANALYSIS
• Another way of avoiding the problems involved in comparing
companies of different sizes is to calculate and compare
financial ratios
• Financial ratios are relationships determined from a firm’s
financial information and used for comparison purposes
• Financial ratios are traditionally grouped into the following
categories:
• Short-term solvency, or liquidity, ratios
• Long-term solvency, or financial leverage, ratios
• Asset management, or turnover, ratios
• Profitability ratios
• Market value ratios
• Different people and different sources seldom compute
ratios in the same way, leading to confusion
1-12
SHORT-TERM SOLVENCY, OR LIQUIDITY,
RATIOS
1-13
SHORT-TERM SOLVENCY, OR LIQUIDITY,
MEASURES
• Current ratio is a measure of short-term liquidity
• To a creditor, the higher this ratio, the better
• To a firm, a high current ratio may indicate an inefficient use of
cash and other short-term assets
• Normally expect to see a current ratio of at least 1
• Quick (or acid-test) ratio is computed just like the current ratio,
except inventory is omitted since it is often the least liquid
current asset
• Relatively large inventories are often a sign of short-term trouble
• Cash ratio may be of interest to a very short-term creditor
• Net working capital to total assets
• Low values might indicate relatively low levels of liquidity
• Interval measure indicates how long the business can continue
1-14
LONG-TERM SOLVENCY RATIOS
1-15
LONG-TERM SOLVENCY MEASURES
• Total debt ratio considers all debts of all maturities to all
creditors and has two useful variations:
• Debt-equity ratio
• Equity multiplier
• Long-term debt ratio is calculated as long-term debt divided by
the sum of long-term debt and total equity
• Times interest earned (TIE) ratio measures how well a company
has its interest obligations covered, and is often called the
interest coverage ratio
• Cash coverage ratio is a basic measure of the firm’s ability to
generate cash from operations and is frequently used as a
measure of cash flow available to meet financial obligations
• Calculated similarly to the TIE ratio, except the numerator is EBITD
(earnings before interest, taxes, and depreciation) instead of EBIT
1-16
ASSET MANAGEMENT, OR TURNOVER,
RATIOS
1-17
ASSET MANAGEMENT, OR TURNOVER,
MEASURES
• Inventory turnover tells us how many times the firm sold off or
turned over the entire inventory
• Days’ sales in inventory tells us how many days inventory sits (on
average) before it is sold
• Receivables turnover shows how many times a firm collects
outstanding credit accounts and reloans the money
• Days’ sales in receivables provides the average number of days it
takes for a firm to collect on its credit sales
• Asset turnover ratios
• NWC turnover measures how much “work” we get out of our working
capital
• Fixed asset turnover tells us how much the company generates in
sales for every dollar in fixed assets
• Total assets turnover tells us how much the company generates in
sales for every dollar in assets 1-18
PROFITABILITY RATIOS
1-19
PROFITABILITY MEASURES
• Profit margin measures how well a company makes money
(i.e., how much money it generates in profit for every dollar in
sales)
• All other things equal, a relatively high profit margin is desirable
• Significant variation in profit margins across industries
• Remember that ROA and ROE are accounting rates of return;

as such, they should properly be called return on book assets
and return on book equity
• Return on assets (ROA) is a measure of profit per dollar of assets
• Return on equity (ROE) is a measure of how the stockholders fared
during the year (i.e., how much money the company generated in
profit for every dollar in equity)
1-20
MARKET VALUE RATIOS
1-21
MARKET VALUE MEASURES
• Price-earnings (PE) ratio measures how much investors are
willing to pay per dollar of current earnings
• Vary significantly across companies, but, in 2020, a typical large
company in the U.S. had a PE in the 15-20 range
• Higher PEs are often taken to mean the firm has significant
prospects for future growth, but it could also mean a firm had no
(or almost no) earnings
• Price-sales ratio is useful if PE ratio is not meaningful due (e.g.,
firm has negative earnings for extended periods)
• Market-to-book ratio compares the market value of the firm’s
investments to their costs
• Value less than 1 could mean that the firm has not been successful
overall in creating value for its stockholders
• Focuses on historical costs, which are less relevant
1-22
MARKET VALUE MEASURES (CONTINUED)
• Tobin’s Q ratio is superior to the market-to-book ratio because
it focuses on what the firm is worth today relative to what it
would cost to replace it today
• Firms with high Q ratios tend to be those with attractive
investment opportunities or significant competitive advantages (or
both)
• Difficult to calculate with accuracy because estimating the
replacement cost of a firm’s assets is not an easy task and market
values for a firm’s debt are often unobservable
• Enterprise value-EBITDA multiple relates the value of all the
operating assets (i.e., enterprise value) to a measure of the
operating cash flow generated by those assets (EBITDA)
• Enterprise value is an estimate of the market value of the
company’s operating assets, which include all assets of the firm
except cash 1-23
THE DUPONT IDENTITY
• We could multiply ROE by Assets/Assets, which then expresses

the ROE as the product of ROA and the equity multiplier:
• We can further decompose ROE by multiplying by Sales/Sales:
1-24
THE DUPONT IDENTITY (CONTINUED)
• If we rearrange things a bit, we can partition ROA into its two
component parts – profit margin and total asset turnover
• The DuPont identity breaks ROE into three parts:

1. Operating efficiency, as measured by profit margin
2. Asset use efficiency, as measured by total asset turnover
3. Financial leverage, as measured by the equity multiplier
1-25
DUPONT BREAKDOWN:
AMAZON AND ALIBABA
1-26
USING FINANCIAL STATEMENT
INFORMATION
• Why evaluate financial statements?
• Internal uses include performance evaluation and planning
purposes
• Financial statements are also useful to parties external to the
firm:
• Short-term and long-term creditors
• Potential investors
• Suppliers and large customers
• Credit rating agencies
• Competitors
• Potential targets for acquisition
1-27
CHOOSING A BENCHMARK
• How do we choose a benchmark, or a standard of comparison,
given we want to evaluate a division or firm based on its
financial statements?
1. Time trend analysis uses a firm’s historical data as the standard
2. Peer group analysis compares firms to their peer group, firms
similar in the sense that they compete in the same markets,
have similar assets, and operate in similar ways
• One way to identify potential peers is based on standard
industrial classification (SIC) codes, four-digit codes established
by the U.S. government to classify a firm by its type of business
operations
• North American Industry Classification System (NAICS), a new
industry classification system initiated in 1997, will eventually
replace the older SIC codes
1-28
SELECTED TWO-DIGIT SIC CODES
1-29
PROBLEMS WITH FINANCIAL STATEMENT
ANALYSIS
• No underlying theory exists to help us identify which quantities
to look at and to use in establishing benchmarks
• Many firms are conglomerates, owning unrelated lines of
business, and consolidated financial statements for such firms
do not fit any neat industry category
• Major competitors and natural peer group members in an
industry may be scattered around the globe
• Financial statements from outside the U.S. do not necessarily
conform to all GAAP principles
• Even companies that are clearly in the same line of business
may not be comparable
• Different firms use different accounting procedures
• Different firms end their fiscal years at different times
• Unusual or transient events may affect financial performance
1-30
SELECTED CONCEPT QUESTIONS
• What is a source of cash? Give three examples.
• Name two types of standardized statements and describe

how each is formed.
• What are the five groups of ratios? Give two or three

examples of each kind.
• Return on equity, or ROE, can be express as the product of

three ratios. Which three?
• What are SIC codes and how might they be useful?

1-31
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.
1-32
END OF CHAPTER
CHAPTER 3
1-33

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CHAPTER 3

• Standardize financial statements for comparison

• Compute and more importantly, interpret some

• Name the determinants of a firm’s profitability

• Explain some of the problems and pitfalls in financial

• Cash Flow and Financial Statements: A Closer Look

• Standardized Financial Statements

• The DuPont Identity

• Using Financial Statement Information

• Statement of cash flows is a firm’s financial statement that

• Remember that ROA and ROE are accounting rates of return;

• We could multiply ROE by Assets/Assets, which then expresses

• We can further decompose ROE by multiplying by Sales/Sales:

• The DuPont identity breaks ROE into three parts:

• Name two types of standardized statements and describe

• What are the five groups of ratios? Give two or three

• Return on equity, or ROE, can be express as the product of

• What are SIC codes and how might they be useful?

• XYZ Corporation has the following financial information for

• Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD

• Compute the ROE using the DuPont Analysis.

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