§3.

WORKING WITH FINANCIAL

STATEMENTS
FIN 360: PRINCIPLES OF FINANCIAL MANAGEMENT
© JOSEPH FARIZO
TABLE OF CONTENTS
Sources and Uses of Cash ............................................................................................................... 3
Constructing the Statement of Cash Flow ...................................................................................... 4
Financial Statement Analysis .......................................................................................................... 8
Internal Uses ................................................................................................................................ 9
External Uses............................................................................................................................... 9
Comparison and Benchmarking .................................................................................................. 9
Common Size Statements ........................................................................................................ 9
Ratio Analysis ........................................................................................................................ 12
DuPont Analysis............................................................................................................................ 17
The Operating Cycle and Cash Conversion .................................................................................. 19
In Summary ................................................................................................................................... 21
Critical Thinking & Conceptual Questions ................................................................................... 22
Analytical Questions ..................................................................................................................... 24
Notes & References ...................................................................................................................... 25

[2]
SOURCES AND USES OF CASH
____________________________ are activities that bring in cash, including:
 Decrease in an asset account:
o Decrease in accounts receivable (receiving cash and decreasing money the firm has
yet to be paid)
o Decrease in inventory (selling inventories)
o Decrease in fixed assets (selling off fixed assets)

 Increase in a liability or equity account:

o Increase in accounts payable (effectively “borrowed” cash)
o Increase in other current liabilities (effectively “borrowed” cash)
o Increase in common stock (cash increases as stock issued)

_________________________ are activities that result in cash expenditures, including:

 Increase in an asset account:
o Increase in receivables (spending cash and increasing money to be paid to the firm
later)
o Increase in inventory (buying inventories)
o Increase in fixed assets (purchasing fixed assets)

 Decrease in liability or equity account:

o Decrease in accounts payable (cash paid, reducing amounts due)
o Decrease in other current liabilities (cash paid for other previously due accounts)
o Decrease in common stock (firm repurchases its own stock)1

Think carefully about these relationships. They may seem counterintuitive at first.
In sum:

Sources: ↓Assets ↑Liabilities

Uses: ↑Assets ↓Liabilities

[3]
CONSTRUCTING THE STATEMENT OF CASH FLOW
Recall the ______________________________________ consists of _________________,
_________________, and _________________ activities. The change in cash at a firm (as
reflected on the balance sheet) is the cash inflows minus the cash outflows.
Figure 1: Royal Caribbean’s Statement of Cash Flow

[4]
 Notice why the separation of cash flows into operating, investing, and
financing activites is imporant. Consider the three firms below:

Cash Flows Firm 1 Firm 2 Firm 3

Operating $400 $0 ($250)
Investing ($250) $400 $0
Financing $0 ($250) $400
Net increase (decrease) in cash $150 $150 $150

Based on only the information presented, comment on the health of the cash
flows of each.

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

To construct the statement of cash flow, we translate income statement and balance sheet items
into their relevant cash amounts. We compute the difference in balance sheet items and address
any non-cash expenses, such as depreciation and amortization.

Be mindful of whether changes in the various accounts are sources or uses of cash.
Carefully note the signs (+ or – ) of the cash flows.

[5]
PRACTICE: Given the financial statement information below, construct a statement of
cash flow. Use the Excel file Statement of Cash Flow and Ratios available at
josephfarizo.com/fin360.html to see additional examples.

SOLUTION: First, find the difference in balance sheet items from the previous year to
the current year. Be mindful to subtract the earlier year from the most recent year, and
keep track of the signs.

CONSOLIDATED BALANCE SHEET

(in millions)
2023 2022 Difference
ASSETS
Current assets
Cash and cash equivalents $ 726 $ 576
Accounts receivable 162 165
Inventories 409 404
Total current assets 1,297 1,145

Fixed Assets
Gross property and equipment $ 2,503 $ 2,606
Accumulated Depreciation (314) (161)
Net plant and equipment 2,189 2,445

Total assets 3,486 3,590

LIABILITIES AND EQUITY

Current liabilities
Accounts payable, other accrued liab. $ 300 $ 315
Notes payable 198 202
Total current liabilities 498 517

Long term debt $ 496 $ 501

Total liabilities $ 994 $ 1,018

Owners Equity
Common stock and paid-in surplus $ 354 $ 546
Retained earnings 2,138 2,026

Total equity $ 2,492 $ 2,572

Total liabilities and equity $ 3,486 $ 3,590

[6]
Next, identify if the change from one period to the next is a “source” or a “use” of cash.
In this example, assume the firm pays dividends of $318, has a net income of $430, and
a depreciation expense of $153.

SOURCES AND USES

(in millions)
Flow Source/Use Hint
Accounts Receivable A/R falls as firm collects
Accounts Payable A/P falls as firm pays
Inventory Firm pays to increase inventory
Gross Fixed Assets Firm sells fixed assets
Notes Payable N/P falls as firm pays
Long Term Debt LTD falls as firm pays off loans
Common Stock C/S falls as firm “repurchases” shares
Dividends Dividends paid to investors

Now, complete the statement of cash flows by sorting the accounts into Operating,
Financing, and Investing activities. Begin by “adding back” Depreciation to Net
Income.

Again, be careful with the signs! Use the above table with sources and
uses you’ve just created. Sources will be increases to cash while uses will
be reductions in cash in the statement of cash flow.

Use gross fixed assets instead of net fixed assets because net fixed
assets includes non-cash depreciation.

The cash flow we compute in the statement of cash flow matches

the change in cash from 2022 to 2023 that we computed above.

The retained earnings on the balance sheet in the most recent year
is the retained earnings in the preceding year plus the net income
earned and minus the dividends paid.

[7]
 STATEMENT OF CASH FLOW
(in millions)
Operating Activities
Net Income $
Depreciation
Accounts Receivable
Accounts Payable
Inventory
CF from Operating Activities $ 566

Investing
Gross Fixed Assets
CF from Investing Activities $ 103

Financing
Notes Payable
Long Term Debt
Common Stock
Dividends
CF from Financing Activities $ (519)

Cash Flow $ 150

INTERPRETATION: A common investment banking interview question is “if you can

only have one financial statement to evaluate a firm, which would it be, and why?” The
answer is the statement of cash flow because it reflects the true cash generating ability
of a firm. Often, a follow-up trick question is “if you can only have two statements,
which would you choose?” The answer is the balance sheet and the income statement:
with those two, you can build the statement of cash flow!

FINANCIAL STATEMENT ANALYSIS

Understanding the cash generating ability of a firm by examining its statement of cash flow is a
crucial first step in analyzing a company. _____________________________________________
goes further in analyzing a company’s financial statements for decision-making purposes. It has
both internal and external uses.

[8]
INTERNAL USES
 Performance evaluation for managers, comparing divisions, and compensation
 Planning for the future, a guide for estimating future cash flows

EXTERNAL USES
 Creditors (the lenders) assessing the financial strength of the firm and the likelihood they
will be paid back
 Suppliers understanding the reliability of their customer
 Customers predicting the longevity of the firm
 Stockholders and investors determining the profitability and growth prospects of the firm

COMPARISON AND BENCHMARKING

The dollar values on the financial statements are difficult to compare from one firm to another.
Two ways that we overcome this challenge are with _____________________________________
(or ___________________________________________) and ___________________________.

Common Size Statements

_____________________________________________ present balance sheet items as a
percentage of total assets and income statement items as a percentage of net revenue. There is no
clear “denominator” for the statement of cash flows, though you might present each source or use
of cash as a percentage of total sources and total uses of cash.

Once we compute common size values, we can ________________________ to the firm’s (1)
own past and to (2) its peers within its same industry. Firms self-report their _________________,
a 4-digit identifier that increases in granularity with more digits. Comparable firms often share the
same first 2 or 3 digits.2
[9]
EXAMPLE: Using the common size statements below, comment on how the firm’s (1)
liquidity, (2) selling/buying on credit, (3) use of long-term assets and growth, and (4)
use of long-term debt and equity financing changes.

Liquidity:

Credit:

[10]
Fixed assets and growth:

Long-term debt and equity financing:

EXAMPLE: Looking to the income statement, comment on the profit margins and costs.
How do these values compare to the industry?

Recall __________________________ are the percentage of revenue

that remains as profit after expenses are deducted.

Gross profit margin = Gross Profit ÷ Revenue

Operating profit margin = EBIT ÷ Revenue
Net profit margin = Net Income ÷ Revenue

Unless otherwise specified, the “profit margin” usually refers to the

“net profit margin.”

[11]
 Profit Margins (Gross, Operating, and Net):

Costs:

We can think of this firm as having an accounting profit of $0.20 for every dollar of sales (the net
income is 20% of the sales by the common size income statement in 2023.) While understanding
these comparisons is important, note how in some ways the firm may be “better” then the industry,
and in other ways “worse” than the industry. Common size statements are just a small part of
analyzing a firm.

Ratio Analysis
_______________________ is the evaluation of various financial metrics in relation to one
another. Hundreds of ratios (with varying degrees of usefulness) can be computed, so we’ll focus
on the more relevant ones here. Just like with common size statements, we might use ratios to
compare a firm to itself overtime, but more likely to compare the firm to its peers and its industry.
We’ll look at 5 categories:

 Short-Term Solvency and Liquidity

 Leverage and Long-Term Solvency
 Turnover
 Market Value
 Profitability

[12]
 Ratio computations are simple. It is the interpretation that matters! Understand what
the ratios tell us about the firm. Observe how ratios vary from one period to the
next or relative to the firm’s peers.

Table 1: Short-Term Solvency and Liquidity Ratios

Ratio Formula
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Quick Ratio (Acid 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Test) 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 (𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡) =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

_____________________________________________________ ratios measure the ability of

the firm to meet its short-term borrowing obligations. While inventory is a current asset, it may
take some time to sell, leading some investors to prefer to use the acid test to assess short term
liquidity, particularly for firms with large inventories.

Interpret a firm’s current ratio of 1.3 and quick ratio of 0.8.

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

[13]
 Table 2: Leverage and Long-Term Solvency

Ratio Formula
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
Total Debt 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐷𝑒𝑏𝑡
Debt to Equity (D/E) 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝐸𝑞𝑢𝑖𝑡𝑦

Equity Multiplier 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =

𝐸𝐵𝐼𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Cash Coverage 𝐶𝑎𝑠ℎ 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

_____________________________________________________ ratios reveal the firm’s ability

to meet its longer-term borrowing obligations. Notice that here, “debt” refers to all liabilities.3

Interpret a total debt ratio of 0.31, a D/E ratio of 0.44, an equity multiplier of
1.44, and a cash coverage ratio of 6.28.

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

[14]
 While too much leverage can be problematic for a firm, some amount of leverage
can be a good thing. Borrowing allows firms to take on investment opportunities
that they might not otherwise be able to afford, though at increased risk.
Additionally, there are tax advantages to debt.

Table 3: Turnover

Ratio Formula
𝐶𝑂𝐺𝑆
Inventory Turnover 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝑆𝑎𝑙𝑒𝑠
Total Asset Turnover 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

___________________ (or TO) ratios tell us about asset utilization and efficiency. How quickly
is the firm selling through its inventory? How is it able to generate sales from its assets?

A firm has an inventor turnover ratio of 2.97 and a total asset turnover of 0.60.
Last year, the firm’s inventory turnover and total asset turnover were 1.8 and
0.5, respectively. What does this tell us?

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

[15]
 Table 4: Market Value4

Ratio Formula

Earnings per Share 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝐸𝑃𝑆 =
(EPS) 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Price to Earnings 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Ratio (PE or P/E) 𝑃𝐸 =
𝐸𝑃𝑆

_________________________________ provide measures of relative value of a share for publicly

traded firms.

Two similar software firms have an EPS of $10 and $100, with P/E ratios of 2
and 5, respectively. On the basis of these ratios, which appears to be a “better
deal” for an investor?

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

[16]
 Table 5: Profitability

Ratio Formula

Profit Margin (Gross,

Operating, Net)
𝐺𝑃𝑀 = 𝑂𝑃𝑀 = 𝑃𝑀 =

Return on Assets 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

(ROA) 𝑅𝑂𝐴 =
𝐴𝑠𝑠𝑒𝑡𝑠

Return on Equity 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑅𝑂𝐸 =
(ROE) 𝐸𝑞𝑢𝑖𝑡𝑦

______________________ ratios signal the income generating ability of the firm relative to
revenues, assets, or equity.

Interpret a firm’s ROA of 0.12 and ROE of 0.17.

__________________________________________________________

__________________________________________________________

__________________________________________________________

DUPONT ANALYSIS
The _____________________________ lets us decompose a firm’s ROE into its component parts.
Doing this allows us to separately examine how operating efficiency (profitability), asset use
efficiency, and finanical leverage drive return to equity holders. A high ROE, however, can mask
high levels of debt.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑅𝑂𝐸 = × × = = 𝑅𝑂𝐸
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦

[17]
Or,

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑅𝑂𝐸 = × × = = 𝑅𝑂𝐸
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦

Alternatively,

𝑅𝑂𝐸 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟

For the balance sheet and income statement examples above:

430 2,125 3,486 430
𝑅𝑂𝐸 = × × = = 17.26%
2,125 3,486 2,492 2,492

𝑅𝑂𝐸 = 20.2% × 0.61 × 1.40 = 17.26%

How do we interpret high and low values of each of the Dupont components?
Do we generally wish to see high or low values of each? Suppose two firms
have similar profit margins and total asset turnover, but one has a substantially
higher equity multiplier. What might this imply?

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

__________________________________________________________

[18]
THE OPERATING CYCLE AND CASH CONVERSION
In short-term finance, there are a number of events and activities financial managers are concerned
with in the ____________________________, the period between the acquisition of inventory
and the collection of cash from receivables after selling products. For a typical firm, this may look
like this:

Figure 2: The Operating Cycle

Inventory Inventory
Purchased Sold

Inventory Accounts
Period Receivable Period

Accounts
Cash Cycle
Payable Period

Cash Paid for Cash

Inventory Received for
Goods

The firm pays for inventory on account, beginning the accounts payable period and the inventory
period, then pays the supplier in cash, ending the accounts payable period and beginning the
________________________. Although the inventory is sold to a customer, it is done so on credit,
with the cash cycle (and accounts receivable period) ending only once the cash is received.

The _____________________________________ is therefore:

𝐶𝐶𝐶 = (𝐷𝑎𝑦𝑠 𝑖𝑛 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐷𝑎𝑦𝑠 𝑖𝑛 𝐴𝑐𝑐𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒) − 𝐷𝑎𝑦𝑠 𝑖𝑛 𝐴𝑐𝑐𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑦𝑐𝑙𝑒

[19]
However, we will need to deduce the number of days for each of these components using ratios:

365 𝐷𝑎𝑦𝑠
𝐷𝑎𝑦𝑠 𝑖𝑛 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
𝐶𝑂𝐺𝑆/𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

365 𝐷𝑎𝑦𝑠
𝐷𝑎𝑦𝑠 𝑖𝑛 𝐴𝑐𝑐𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 =
𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠/𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

365 𝐷𝑎𝑦𝑠
𝐷𝑎𝑦𝑠 𝑖𝑛 𝐴𝑐𝑐𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 =
𝐶𝑂𝐺𝑆/𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

Note that the average for inventory, accounts receivable, and accounts payable is the average
between the beginning and ending balances for each (i.e., the average of last year’s and this year’s
inventory, A/R, and A/P as listed on the balance sheet).

EXAMPLE: For the financial statements presented above, assuming 100% of sales on
credit:

365 𝐷𝑎𝑦𝑠 365 𝐷𝑎𝑦𝑠

𝐶𝐶𝐶 = +
𝐶𝑂𝐺𝑆/𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠/𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
365 𝐷𝑎𝑦𝑠
−
𝐶𝑂𝐺𝑆/𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

365 365 365

𝐶𝐶𝐶 = + − = 58.17
1201/407 2125/164 1201/308

INTERPRETATION: On average, there are 58.17 days between the time the firm pays cash
for inventory to the time the firm collects cash from customers for that sold inventory.
Ideally, this number should be low. It implies the firm is managing inventory efficiently
and converting its sales from account to cash quickly.
[20]
IN SUMMARY

We have covered several useful ratios for financial analysis. Use the Excel file
Statement of Cash Flow and Ratios available at josephfarizo.com/fin360.html for
randomized practice problems. Be sure to understand the interpretation of each
ratio.

While ratios are useful in assessing firms, they are not perfect. Comparing to competitors and the
industry can be challenging, particularly for _______________________________ that operate in
many industries (i.e., Apple and Netflix both offer streaming services, should they be compared?)

Some ratios are more relevant for certain industries than others (i.e., inventory turnover matters
more for heavy manufacturing firms than service firms.) Different inventory valuation techniques
or depreciation schedules may also make the comparison between firms difficult.

Ratios should be computed consistently and frequently for a firm, its competitors, and its industry,
and tracked overtime. Understanding how the ratios are interpreted, and what might be considered
a “healthy” ratio, is crucial.

Even within a firm, some ratios may appear healthy while other similar ratios for
that same firm appear unhealthy. Ratios are part of the many tools a financial
analyst can use. There is never a firm that will appear perfectly healthy (or
unhealthy) in all measures. There will always be room for interpretation, and
different analysts can and do reach different conclusions.

[21]
CRITICAL THINKING & CONCEPTUAL QUESTIONS
1. Explain the intuition behind why each of the following represent a source of cash:
a. Decrease in A/R, inventory, and fixed assets
b. Increase in A/P, current liabilities, common stock
2. Explain the intuition behind why each of the following represent a use of cash:
a. Increase in A/R, inventory, and fixed assets
b. Decrease in A/P, current liabilities, and common stock
3. Indicate whether each of the following would be found in the operating, investing, or financing
section of a firm’s statement of cash flow. Explain why each is found in its appropriate section.
a. Depreciation and amortization
b. Dividends
c. Change in Notes payable
d. Change in Accounts receivable
e. Change in Accounts payable
f. Change in Fixed assets
g. Change in Inventory
h. Change in Long term debt
i. Change in Common stock
4. How can we determine a firm’s current year retained earnings given last year’s balance sheet,
and this year’s income statement and dividends?
5. Explain what positive and negative values for operating, investing, and financing activities
imply for a firm. Is a positive or negative value for each considered healthy?
6. How can we verify the accuracy of the statement of cash flow using a firm’s balance sheet for
the current year and previous year?
7. Describe the internal and external uses of financial statement analysis. Which is more often
associated with “corporate finance” decisions? Which is more often associated with
“investing”?
8. Explain how common size financial statements are useful in comparing the firm to (1) itself
through time and (2) comparable companies.
9. Why would comparing company ratios for two firms in very different industries be
problematic?
10. How are gross, operating, and net profit margins computed? What do each tell us?
11. Name the ratios you would use to characterize the short-term liquidity of the firm? What do
higher and lower values of these ratios tell us?
12. What is the rationale for subtracting inventory from current assets in the quick ratio? How does
this change the ratio’s interpretation relative to the current ratio?
13. Explain the benefits and costs of leverage. How might an investor or manager determine
whether a firm’s leverage is “too high” or “too low”?
14. What does a higher equity multiplier tell us about a firm’s use of leverage?
15. What does the numerator of the cash coverage ratio try to tell us about the firm? How do you
interpret the cash coverage ratio?

[22]
16. Explain why an investor would be willing to pay a higher stock price for a share of a company
than that company’s earnings per share?
17. All else equal, is a lower or higher P/E ratio preferable for an investor buying a stock? Why?
18. Explain the components of the Dupont analysis, and why “decomposing” ROE into
components is important in the first place. Explain what higher and lower values for each
component means.
19. All else equal, which component of ROE do you think is always better if higher?
20. Given your understanding of Dupont analysis, explain how a firm can manipulate and increase
its ROE by its own choice of borrowing.
21. If the equity multiplier is “high,” what other ratio(s) should be “low” in order to indicate that
the firm has not taken on an unhealthy amount of leverage?
22. Why is the cash conversion cycle more relevant for manufacturing firms than service firms?
23. All else equal, is a longer or shorter cash conversion cycle generally preferable for a firm?
24. Explain why, all else equal, a firm would prefer a shorter A/R period but a longer A/P period.
25. Explain what a stock repurchase is and how it adds value for a shareholder of a firm. What
happens to a company’s earnings per share after a share repurchase? Why? Given this change
to EPS following a repurchase, how should we be careful when we think about comparing
firms on the basis of their EPS?
26. How would you compute the cash conversion cycle if less than 100% of sales are on credit?
27. Which one (or more) of the ratios that we have discussed would you use to address the
following items:
a. The firm’s ability to pay its near-term liabilities
b. The firm’s liquidity
c. The firm’s ability to cover it interest expense
d. The firm’s efficiency in generating sales given the strength of its balance sheet
e. The frequency through which a firm sells through its inventory
f. The firm’s common stock “value” relative to its accounting profitability

[23]
ANALYTICAL QUESTIONS
1. Below is a table from Professor Aswath Damodaran’s website showing industry ROE ratios.5
Use it to answer the questions that follow.

a. You are considering an investment in a soft drink company that has an ROE of 18.88% or
an auto parts manufacturing company with an ROE of 9.8%. On the basis of ROE alone,
which might be a better investment and why?
b. What portion of the Dupont identity do you think explains the negative values for
broadcasting and diversified chemicals?
c. Why might you “trust” the average ROE in the table to more accurately reflect the
“business and consumer services” industry than the “chemicals (diversified)” industry?
d. Name an industry that you think might have a low total asset turnover. Why? What effect
would this have on the industry’s ROE?

[24]
NOTES & REFERENCES
1
Stock buybacks: https://www.wsj.com/articles/stock-buybacks-what-every-investor-needs-to-know-11607185864
2
See https://www.osha.gov/data/sic-manual for SIC code listings. You can view a firm’s SIC code on EDGAR.
3
This is consistent with Ross, Westerfield, and Jordan Fundamentals of Corporate Finance. Other texts and sources
will not consider short term liabilities in the computation.
4
Quarterly EPS announced in corporate earnings announcements is usually the net income for the quarter divided by
the number of shares. PE ratios are typically trailing twelve months (TTM) and use the annual trailing 12-month EPS.
5
See https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html for the full results.

[25]