Chapter 3

Working With
Financial Statements

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
 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 Du Pont
Identity
• Understand the problems and pitfalls in financial
statement analysis

3-2
 Chapter Outline
• Cash Flow and Financial Statements:
A Closer Look
• Standardized Financial Statements
• Ratio Analysis
• The Du Pont Identity
• Using Financial Statement
Information

3-3
 Sample Balance Sheet
2009 2008 2009 2008
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 5,394 5,033 Total Liab. 5,394 5,033

Assets & Equity

Numbers in millions of dollars

3-4
Sample Income Statement
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

Numbers in millions of dollars, except EPS & DPS 3-5

 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
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
Increase in Other CL 309 Net Increase in Cash 638
Less: Increase in other CA -39
Net Cash from Operations 1,175 Cash End of Year 696

Investment Activity
Sale of Fixed Assets 104
Net Cash from Investments 104

Numbers in millions of dollars

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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

3-9
 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 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
B/S
I/S 3-12
 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%

B/S
I/S 3-13
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

B/S
I/S 3-14
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

B/S
I/S 3-15
 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

B/S
I/S 3-16
 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

B/S
I/S 3-17
 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%
B/S
I/S 3-18
 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 Du Pont
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 Du Pont 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 Du Pont Analysis –
Du Pont Data

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Extended Du Pont Chart

Insert Figure 3.1 (Extended DuPont Chart)

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 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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 Real World Example - I
• Ratios are figured using financial data
from the 2007 Annual Report for Home
Depot
• Compare the ratios to the industry as they
are reported in Tables 3.11 and 3.12 in the
book
• Home Depot’s fiscal year ends Feb. 3
• Be sure to note how the ratios are
computed in the table so you can compute
comparable numbers
• Home Depot sales = $77,349 MM
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 Real World Example - II
• Liquidity ratios
– Current ratio = 1.15x; Industry = 1.7x
– Quick ratio = .23x; Industry = .4x
• Long-term solvency ratio
– Debt/Equity ratio (Debt / Worth) = 1.5x;
Industry = 1.1x.
• Coverage ratio
– Times Interest Earned = 11.6x; Industry
= 4.5x

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 Real World Example - III
• Asset management ratios:
– Inventory turnover = 4.4x; Industry = 3.8x
– Receivables turnover = 61.4x (6 days); Industry =
26.9x (14 days)
– Total asset turnover = 1.7x; Industry = 2.6x
• Profitability ratios
– Profit margin before taxes = 8.6%; Industry = 2.5%
– ROA (profit before taxes / total assets) = 14.9%;
Industry = 6.4%
– ROE = (profit before taxes / tangible net worth) =
37.4%; Industry = 11.9%

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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.reuters.com
– Click on Stocks, then choose a company and
enter its ticker symbol
– Click on Ratios to 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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 Ethics Issues
• Should financial analysts be held liable for their
opinions regarding the financial health of firms?
• How closely should ratings agencies work with
the firms they are reviewing? I.e., what level of
independence is appropriate?

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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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End of Chapter

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