1. finance
2. accounting and auditing

WORKING WITH
FINANCIAL STATEMENTS
CHAPTER 3
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
Chapter Outline
 Cash Flow and Financial Statements: A Closer Look
 Standardized Financial Statements
 Ratio Analysis
 The Du Pont Identity
 Using Financial Statement Information
Introduction
 Why do we use financial statements when financial
managers are concerned with market value?
 What do numbers in the financial statements mean?
CFFA= CF to creditors+ CF to stockholders
 Sources of cash: activities that generate cash
 Uses of cash: activities in which the firm spend cash
Sample Balance Sheet
PRUFROCK COROPORATION
2008 & 2009 Balance Sheet
( $in millions)
2008
2009
CHANGE
ASSETS
LIABILITIES
Current Assets
Current liabilities
2008
2009
CHANGE
cash
84
98
+14
AP
312
344
+32
AR
165
188
+23
Notes payable
231
196
-35
393
422
+29
Total
543
540
-3
642
708
+66
Long-term debt
531
457
-74
Common stocks &
paid-in surplus
500
550
+50
Retained earnings
1,799
2,041
+242
Total
2,299
2,591
+292
Total liabilities &
owner’s equity
3,373
3,588
+215
inventory
Total
Fixed assets
Net plant &
equipment
Total assets
Owner’s equity
2,631
3,373
2,880
3,588
+149
+215
Sources and Uses
 Sources

Cash inflow – occurs when we “sell” something

Decrease in asset account


Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account

Accounts payable, other current liabilities, and common stock
Sources and Uses
 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
NET ADDITION TO CASH = SOURCES OF CASH – USES OF CASH
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
Taxes
1,131
(442)
Net Income
689
EPS
3.61
Dividends per share
1.08
EX 9 Page 82
 Based only on the following information for Bennington
Crop., did cash go up or down? By how much? Classify each
event as a source or use of cash.
Decrease in inventory
375
Decrease in AP
190
Increase in notes payable
210
Increase in AR
105
Ex 16 Page 83
JUST DEW IT COROPORATION
2008 &2009 Balance Sheets
ASSETS
LIABILITIES & OWNER’S EQUITY
Current Assets
2008
2009
Current liabilities
2008
2009
cash
8,436
10,156
AP
43,050
46,821
AR
21,530
23,406
Notes payable
18,384
17,382
Inventory
38,760
42,650
Total
61,434
64,203
Total
68,726
76,213
Long-term debt
25,000
32,000
Common stocks & paid-in
surplus
40,000
40,000
Retained earnings
168,998
188,316
Total
208,998
228,316
Total liabilities & owner’s equity
295,432
324,519
Owner’s equity
Total assets
295,432
324,519
Ex 16 Page 83
 For each account on this company’s balance sheet, show the
change in the account during 2009 and note whether this
change was a source or use of cash. Do your numbers add
up and make sense? Explain your answer for total assets as
compared to your answer for liabilities and owner’s equity
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
Cash, beginning of
year
84
Operating activity
Net Income
363
Plus:
Financing activities
Decrease in notes payable
-35
Decrease in long-term debt
-74
Dividend paid
-121
50
Depreciation
276
Increase in common stock
Increase in accounts
payable
32
Net cash from financing activities
Less:
Increase in accounts
receivable
-23
Increase in inventory
-29
Net cash from operating
activities
619
Investments
activities
Fixed assets acquisitions
-425
Net cash from
investment activities
-425
-180
Net increase in cash
14
Cash, end of year
98
Standardized Financial Statements
 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.
Standardized Financial Statements
 There are three kinds of standardized financial statements:
1.
COMMON-SIZE STATEMENTS
2. COMMON-BASE YEAR FINANCIAL STATEMENT
(Trend analysis)
3. COMBINED COMMON-SIZE AND BASE YEAR
ANALYSIS
Standardized Financial Statements
1.COMMON-SIZE STATMENTS
 Common-Size Balance Sheets

Compute all accounts as a percent of total assets
(Item/ TA) * 100
 Common-Size Income Statements

Compute all line items as a percent of sales
(Item/ SALES) * 100
Standardized Financial Statements
 2-COMMON-BASE YEAR STATEMENTS:TREND ANALYSIS
Item/ same item in the base year
 3-COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS
Summary of standardized Balance Sheets
Assets
Common-size
Assets
Common-Base
year Assets
Combined
Common-size
& Base year
Assets
2008
2009
2008
2009
2009
2009
Cash
84
98
2.5%
2.7%
1.17
1.08
AR
165
188
4.9
5.2
1.14
1.06
Inventory
393
422
11.7
11.8
1.07
1.01
Total CA
642
708
19.1
19.7
1.10
1.03
NFA
2,731
2,880
80.9
80.3
1.05
0.99
Total
Assets
3,373
3,588
100.0%
100.0%
1.06
1.00
Current
assets
JUST DEW IT COROPORATION
2008 & 2009 Balance Sheets
ASSETS
LIABILITIES & OWNER’S EQUITY
Current Assets
2008
2009
Current liabilities
2008
2009
cash
8,436
10,157
AP
43,050
46,821
AR
21,530
23,406
Notes payable
18,384
17,382
Inventory
38,760
42,650
Total
61,434
64,203
Total
68,726
76,213
Long-term debt
25,000
32,000
Common stocks & paid-in
surplus
40,000
40,000
Retained earnings
168,998
188,316
Owner’s equity
Net plant &
equipment
226,706
248,306
Total
208,998
228,316
Total assets
295,432
324,519
Total liabilities & owner’s equity
295,432
324,519
Ex 13, 14 & 15
 Prepare the 2009 common-size balance sheet for Just Dew
It
 Prepare the 2009 common-base year balance sheet for Just
Dew It
 Prepare the 2009 combined common-size, common-base
year balance sheet for Just Dew It
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
Categories of Financial Ratios
1.
Short-term solvency or liquidity ratios
2. Long-term solvency or financial leverage ratios: The
ability to meet long-term obligations
3. Asset management or turnover ratios: Efficiency of asset
use
4. Profitability ratios
5. Market value ratios
Short-term solvency or liquidity ratios
 The ability to pay bills in the short-run
 Provide information about the firm’s liquidity
 Advantage: BV & MV are similar
 Disadvantage: CA & CL change rapidly
PRUFROCK COROPORATION
2008 & 2009 Balance Sheet
( $in millions)
2008
2009
CHANGE
ASSETS
LIABILITIES
Current Assets
Current liabilities
2008
2009
CHANGE
cash
84
98
+14
AP
312
344
+32
AR
165
188
+23
Notes payable
231
196
-35
393
422
+29
Total
543
540
-3
642
708
+66
Long-term debt
531
457
-74
Common stocks &
paid-in surplus
500
550
+50
Retained earnings
1,799
2,041
+242
Total
2,299
2,591
+292
Total liabilities &
owner’s equity
3,373
3,588
+215
inventory
Total
Fixed assets
Net plant &
equipment
Total assets
Owner’s equity
2,631
3,373
2,880
3,588
+149
+215
Computing Liquidity Ratios
 Current ratio= CA
CL
 708 / 540= 1.31 times
 EX 3.1
 CA= 4
CL= 2
what happen to the Current ratio if:
1.
The firm pays off some of its creditors? If CA= 3 CL=1
2.
The firm buys some inventory?
3.
The firm sells some merchandize?
Computing Liquidity Ratios
 Q u i c k R at i o = ( C A – I n v e n t o ry ) ÷ C L
 (708 - 422) ÷ 540 = 0.53 times
 C a s h r at i o = c a s h
÷ Current liabilities
 98 ÷ 540 = 0.18 times
 N W C t o t o ta l a s s e t s = N W C
÷ t o ta l a s s e t s
 (708 – 540) ÷ 3,588 = 4.7%
 Interval measure = CA ÷ average daily operating costs
 1,344 ÷ 365 = 3.68 $ per day
 708 ÷ 3.68 = 192 days
Computing Long-term Solvency Ratios
 The ability to meet long-term obligations
 T o ta l d e b t r at i o = ( TA – T E )
 (3,588 – 2,951 ) ÷ 3,588 = 0.28 times
 D e b t- e q u i t y r at i o = T D ÷ T E
 E q u i t y = ( 1 - T D ) = (1- 0.28) = 0.72

0.28 ÷ 0.72 = 0.39 times
÷ TA
Computing Long-term Solvency Ratios
 E q u i t y m u lt i p l i e r = TA
÷ TE
 1 ÷0.72 = 1.39 times
 L o n g - t e r m d e b t r at i o = LT D
 457 ÷ (457 + 2,592) = 0.15 times
÷ ( LT D + T E )
Computing Coverage Ratios
 T i m e s i n t e r e s t e a r n e d r at i o = E B I T
÷interest
 691 ÷141 = 4.9 times

C a s h c o v e r a g e r at i o = ( E B I T + d e p r e c i at i o n ) ÷ i n t e r e s t
 (691 + 276) ÷ 141 = 6.9 times
Ex 1, 5 page 81
 SDJ, Inc,. Has net working capital 0f 1,370 $ , current
liabilities of 3,720 $, and inventory of 1,950$. What is the
current ratio? What is the quick ratio?
 Crystal Lake, Inc,. Has a total debt ratio of 0.63. what is its
debt-equity ratio? What is it equity multiplier?
Asset Management measures
 I n v e n t o ry t u r n o v e r = C O G S
÷ i n v e n t o ry
 1,344 ÷ 422 =3.2 times
 Days’ sales in inventory = 365 days ÷ inventory turnover
 365 ÷ 3.2 = 114 days
Computing Receivables Ratios
 Receivables turnover= sales ÷AR
 2,311 ÷ 188 = 12.3 times
 Days’ sales in receivables = 365 days ÷ receivables turnover
 365 ÷ 12.3 = 30 days
Computing Total Asset Turnover
 NWC turnover = sales ÷ NWC
 2,311 ÷ (708- 540) = 13.8 times
 Fixed asset turnover= sales ÷Net fixed assets
 2.311 ÷ 2,880 = 0.8 times
 Total asset turnover= sales ÷ total asset
 2,311 ÷ 3,588 = 0.64 times
Computing Profitability Measures
 Profit Margin = Net Income ÷ Sales
 363 ÷2,311 = 15.7 %
 Return on Assets (ROA) = Net Income ÷ Total Assets
 363 ÷ 3,588 = 10.12 %
 Return on Equity (ROE) = Net Income ÷ Total Equity
 363 ÷ 2,591= 14%
Computing Market Value Measures
 Prufrock has 33 million shares outstanding and the stock
sold for 88$ per share at the end of the year
 Price-Earning Ratio = Price per share ÷ Earnings per share
 EPS= net income ÷ shares outstanding
 363÷ 33 =11 $
 88 ÷ 11= 8 times
Computing Market Value Measures
 Price-sales ratio= price per share ÷ sales per share
 Sales per share = sales÷ shares out standing
 2,311 ÷ 33= 70$
 88 ÷ 70 = 1.26
Computing Market Value Measures
 Market-to-book ratio = market value per share ÷book
value per share
 Book value per share= TE ÷ SHARES OUTSTANDING
 2,591 ÷ 33 = 78.5$
 88 ÷ 78.5 = 1.12 times
Ex 2 Page 81
 Wakers, Inc., has sales of $29 million, total assets of $ 17.5
million, and total debt of $ 6.3 million. If the profit margin
is 8 percent, what is net income? What is ROA? What is
ROE?
Ex 3 Page 81
 Ortiz Lumber Yard has a current account receivable balance
of $431,287. credit sales for the year just ended were
$3,943,709. what is the receivable turnover? The days’
sales in receivables? How long did it take on average for
credit customers to pay off their accounts during the past
year?
Ex 6 Page 81
 Bach Crop. Had addition to retained earnings for the year
just ended of $430,000. the firm paid out $175,000 In cash
dividends, and it has ending total equity of $5.3 million. If
the company currently has 210,000 shares of common
stock outstanding, what are the earnings per share?
Dividend per share? Book value per share? If the stock
currently sells for $63 per share, what is the market-tobook ratio? The price-earnings ratio? If the company had
sales of $4.5 million , what is the price-sales ratio?
Deriving the Du Pont Identity
 Investigates what areas of the firm need improvement
 Provide a frame work that ties together a firm’s
profitability, assets efficiency & the use of debt
 Provide the impact of operations on returns
 Any weakness on operating assets or efficiency will result in
a lower ROE
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
Expanded Du Pont Analysis – Du Pont Data
Extended Du Pont Chart
Ex 7 , 8 Page 81
 If Roten Rooters, Inc., has an equity multiplier of 2.8, total
asset turnover of 1.15 , and profit margin of 5.5 percent,
what is the ROE?
 Braam Fire prevention Crop. Has a profit margin of 6.8
percent, total asset turnover of 1.95, and ROE of 18.27
percent. What is the firm’s debt-equity ratio?
Ex 18 Page 83
 Y3K, Inc., has sales of $5,276 , total assets in $ 3,105 , and a
debt- equity ratio of 1.4. if its return on equity is 15 percent,
what is its net income?
Why Evaluate Financial Statements?
 Internal uses
1.
2.
3.
Performance evaluation (Compensation )
Comparison between divisions
Planning for the future – guide in estimating future cash flows
 External uses

Creditors

Suppliers

Customers

Stockholders
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
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
Review
 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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