1. business and industrial

MGMT 31000
Financial Management
CHAPTER 3:
Working with Financial
Statements
Agenda
1. Cash Flow and Financial Statements: A
Closer Look

Understand sources and uses of cash
2. Ratio Analysis

Know how to compute and interpret important
financial ratios
3. The Du Pont Identity

Be able to compute and interpret the Du Pont
Identity
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Sources and Uses of Cash
Sources
1.
2.
Cash inflow – occurs when we “sell” something
Decrease in asset account

3.
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account

Accounts payable, other current liabilities, and common stock
Uses
1.
2.
Cash outflow – occurs when we “buy” something
Increase in asset account

3.
Cash and other current assets
Decrease in liability or equity account

Notes payable and long-term debt
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Source vs. Use?
Source
Increase in accounts payable
Use
√
Increase in accounts receivable
√
Decrease in notes payable
√
Increase in retained earnings
√
Increase in common stock
√
Net fixed assets acquisitions
Decrease in inventory
√
√
Decrease in long-term debt
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√
5
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2. Ratio Analysis
 The goal of ratio analysis is to take the numerous
lines from both the income statement and balance sheet
and to interpret this information in a meaningful way.
 There is simply too much information to grasp at
one time.
 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 Ratios
 Short-term solvency or liquidity ratios
 The ability to pay bills in the short-run
 Long-term solvency or financial leverage ratios
 The ability to meet long-term obligations
 Asset management or turnover ratios
 Efficiency of asset use
 Profitability ratios
 Efficiency of operations and how that translates to
profit
 Valuation ratios
 The MV of the firm relative to the BV
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Categories of Financial Ratios
3-9
Short-term Solvency Ratios

Current Ratio: Ability to pay current liabilities
Current Ratio 

Quick Ratio: Ability to pay current liabilities without
converting inventory to sales
Quick Ratio 

Current Assets
Current Liabilitie s
(Current Assets - Inventory)
Current Liabilitie s
Cash Ratio: Ability to pay current liabilities with cash on hand
Cash Ratio 
Cash
Current Liabilitie s
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Long-term Solvency Ratios

Total Debt Ratio: Measure of all debts and maturities
Total Debt Ratio 

Total Debt
E
 1
Total Assets
A
Debt-Equity Ratio: Use of debt and equity in capital structure
Debt-Equity Ratio 

Total Debt
Total Equity
Equity Multiplier: A company’s total assets per dollar of equity
Equity Multiplier 
Total Assets
D
 1
Total Equity
E
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Long-term Solvency Ratios (cont’d)

Times Interest Earned: Ability to pay its interest expense
Times Interest Earned Ratio 
EBIT
Interst Expenses
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Turnover Ratios

Inventory Turnover: Number of times each year inventory is
turned.
Inventory Turnover 

Cost of Goods Sold
Inventory
Days’ Sales in Inventory: How long inventory sits before
being turned.
Days' Sales in Inventory 

365 days
Inventory Turnover
Total Asset Turnover: How many sales are generated per
dollar of assets.
Asset Turnover 
Sales
Total Assets
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Turnover Ratios (cont’d)

Receivables Turnover: How fast receivables are collected.
Receivables Turnover 

Sales
Account Receivable
Days’ sales in Receivables: How long it takes to collect on
credit sales.
365 days
Days' Sales in Receivables 
Receivables Turnover
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Profitability Ratios

Profit Margin: Profit for every dollar in sales
Profit Margin 

Return on Assets (ROA): Profit per dollar of assets.
ROA 

Net Income
Sales
Net Income
Total Assets
Return on Equity (ROE): Profit per dollar of stockholders’
equity.
ROE 
Net Income
Total Book Value of Equity
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Market Value Ratios

Earnings Per Share (EPS): Profitability available to each share
EPS 

Price-Earnings (P/E) Ratio: How much investors are willing to
pay per dollar of current earnings.
P/E Ratio 

Net Income
# Shares Outstanding
Market Capitalization Share Price

Net Income
EPS
Market-to-Book Ratio: Compare how investors value the stock
to the financial statement value.
Market - to - Book Ratio 
Market Value of Equity
Book Value of Equity
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Market Value Ratios (cont’d)


EBITDA

Earnings Before Interest, Taxes, Depreciation, and Amortization.

A rough measure of the cash a firm has ‘earned’ from its
operations (i.e. a rough measure of operating cash flows).
Enterprise Value: Estimate how much it would cost to take
over the business (i.e. purchase all of the equity and repay the
debt).
EV  Market Value of Equity  Book Value of Liabilities - Cash

EV-EBITDA ratio
Enterprise Value - EBITDA Ratio =
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EV
EBITDA
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Exercise..
Global’s 2012 B/S (Excerpted)
Current Assets
Current liabilities
Cash
21.2
Accounts payable
Accounts Receivable
18.5
Notes payable/short-term debt
Inventories
15.3
Current maturities of long-term debt
Other Current Assets
Total Current Assets
2.0
57.0
Other current liabilities
Total current liabilities

Current Ratio = 57.0/48.0=1.19

Quick Ratio = (57.0-15.3)/48.0=0.87

Cash Ratio = 21.2/48.0=0.44
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29.2
3.5
13.3
2.0
48.0
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Exercise…
Global’s 2012 B/S
Assets
2009 Liabilities and Stockholders' Equity
Current Assets
Current liabilities
Cash
21.2
Accounts payable
Accounts Receivable
18.5
Notes payable/short-term debt
Inventories
15.3
Current maturities of long-term debt
Other Current Assets
Total Current Assets
2.0
57.0
Long-Term Assets
Other current liabilities
Total current liabilities
22.2
Long-term debt
Buildings
36.5
Capital lease obligations
Equipment
39.7
(18.7)
Total debt
13.3
2.0
48.0
99.9
0.0
99.9
7.6
Other long-term liabilities
0.0
79.7
Goodwill and intangible assets
20.0
Other Long-term assets
21.0 Total Liabilities
Total assets
3.5
Deferred taxes
Net Property, plant, and equipment
Total long-term assets
29.2
 Total Debt Ratio =
(177.7-22.2)/177.7
=0.88
 Debt-Equity Ratio =
(3.5+13.3+99.9)
/22.2 = 5.26
Long-Term Liabilities
Land
Less Accumulated Depreciation
2009
Total long-term liabilities
120.7 Stockhoders' Equity
177.7 Total Liabilities and Stockholders' Equity
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 Equity Multiplier =
177.7/22.2= 8.00
107.5
155.5
22.2
177.7
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Exercise…
Global’s 2012 I/S
Total Sales
Cost of Sales
Gross Profit
Selling, general, and administrative expense
Research and development
Depreciation and amortization
Operating Income
Other income
Earnings before interest and taxes (EBIT)
Interest income (expense)
Pretax income
Taxes
Net Income
2009
186.7
(153.4)
33.3
(13.5)
(8.2)
(1.2)
10.4
0.0
10.4
(7.7)
2.7
(0.7)
2.0
 Times Interest Earned =
10.4/7.7= 1.35
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Exercises..
Global’s 2012 B/S (Excerpted)
Assets
Current Assets
Cash
Accounts Receivable
Inventories
Other Current Assets
Total Current Assets
2009
21.2
18.5
15.3
2.0
57.0
Long-Term Assets
Total long-term assets
120.7
Total assets
177.7
Global’s 2009 I/S (Excerpted)
Total Sales
Cost of Sales
Gross Profit
2009
186.7
(153.4)
33.3
 Asset Turnover
=186.7/177.7=1.05
 Inventory Turnover
=153.4/15.3=10.03
 Days’ sales in inventory =
365/10.03 =36.40
 Receivables Turnover =
186.7/18.5=10.09
 Days’ sales in receivables =
365/10.09=36.17
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Exercises..
Global’s 2012 I/S (Excerpted)
Total Sales
Cost of Sales
Gross Profit
SG&A
Research and development
Depreciation and amortization
Operating Income
Other income
Earnings before interest and taxes (EBIT)
Interest income (expense)
Pretax income
Taxes
Net Income
2009
186.7
(153.4)
33.3
(13.5)
(8.2)
(1.2)
10.4
0.0
10.4
(7.7)
2.7
(0.7)
2.0
 Profit Margin=2.0/186.7=0.01
 EBITDA= EBIT + Depreciation &
Amortization = 10.4+1.2=11.6
 ROA=2.0/177.7=0.01
 ROE=2.0/22.2=0.09
• Book Assets = 177.7
• Book Equity = 22.2
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3. The Du Pont Identity
ROE = NI / TE
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM
 Profit margin (PM) is a measure of the firm’s
operating efficiency

how well it controls costs
 Total asset turnover (TAT) is a measure of the firm’s
asset use efficiency

how well does it manage its assets
 Equity multiplier (EM) is a measure of the firm’s
financial leverage
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Using the Du Pont Identity
XYZ Corporation has the following financial information for
the previous year:
 Sales: $8M
 Profit Margin (PM) = 8%
 Current Assets (CA) = $2M
 Fixed Assets (FA) = $6M
 Net Working Capital (NWC) = $1M
 Long Term Debt (LTD) = $3M
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Using the Du Pont Identity
Compute the ROE using the DuPont Analysis.
1.
2.
3.
4.
5.
6.
7.
8.
Total assets = CA + FA = $2M + $6M = $8M
TAT = Sales / TA = $8M / $8M = 1
NWC = CA – CL CL = CA – NWC = $2M - $1M = $1M
Total liabs. = CL + LTD = $1M + $3M = $4M
Total equity = total assets – total liabs. = $8M - $4M = $4M
EM = assets / equity = $8M / $4M = 2
ROE = PM x TAT x EM = 8% x 1 x 2 = 16%
Without DuPont, ROE = NI / TE = PM * Sales / TE = 8% x $8M /
4M = 16%
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Potential Problems
1. There is no underlying theory, so there is no way to
know which ratios are most relevant
2. Benchmarking is difficult for diversified firms
3. Globalization and international competition makes
comparison more difficult because of differences in
accounting regulations
4. Varying accounting procedures, i.e. FIFO vs. LIFO
5. Different fiscal years
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Example: Determinants of ROE
 Problem:

For the year ended November 2012, Wal-Mart Stores and
Target had the following accounting measures:
(in $ billion)
Wal-Mart
Target
403.9
65.3
Net Income
13.7
2.6
Total Assets
167.8
47.0
Book Equity
65.5
13.6
Sales

Compare the two firms’ profitability, asset turnover, equity
multiplier, and ROE during this period.

If Target had been able to match Wal-Mart’s asset turnover in
2012, what would its ROE have been?
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Example: (cont’d)
 Solution:
Wal-Mart
Target
Net profit margin
13.7/403.9=3.39%
2.6/65.3=3.98%
Asset turnover
403.9/167.8=2.41
65.3/47.0=1.39
Equity multiplier
167.8/65.5=2.56
47.0/13.6=3.46
ROE
13.7/65.5=20.91%
2.6/13.6=19.1%

Mainly due to its lower asset turnover, Target had a lower ROE
than Wal-Mart.

If Target had been able to match Wal-Mart’s asset turnover, its
ROE would have been 3.98%× 2.41× 3.46=33.2%
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Example: Computing EV
 Problem:


In January 2009, H.J. Heinz Co. (HNZ) had

A share price of $36.95

314.44 million shares outstanding

A market-to-book ratio of 7.99

A book debt-equity ratio of 3.7

Cash of $0.93 billion.
What was Heinz’s enterprise value?
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Example: (cont’d)
 Solution:

Heinz’s market cap = $36.95 × 314.44 million shares =
$11.62 billion.

Heinz’s book value of equity =11.62/7.99=$1.45 billion.

Given a book debt-equity ratio of 3.7, Heinz had total debt
of 1.45 X 3.7 = $5.37 billion.

Thus, Heinz’s EV was 11.62+5.37–0.93 = $16.06 billion.
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More Exercises on EV..
 Problem
 In January 2009, Rylan Corporation had a market
capitalization of 110 million, a market-to-book ratio
of 2.2, a book debt to equity ratio of 1.4, and cash of
$6.3 million. What was Rylan’s enterprise value?
 Solution:
 Rylan’s book value of equity is 11/2.2=$50 million.
 Given a book debt-equity ratio of 1.4, Rylan had total
debt of 1.4 X 50 = $70 million.
 Thus, Rylan’s EV was 110+70–6.3 = $173.7 million.
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Quick Quiz
1. How do you determine sources and uses of cash?
2. What are the major categories of ratios and how do you
interpret them?
•
You do not need to memorize the formulas for any of the
ratios studied. They will be provided to you during exams.
3. What are some of the problems associated with financial
statement analysis?
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Practice Question 9. (p 85)
 Sources and Uses of Cash [LO4] Based only
on the following information for Shinoda Corp.,
did cash go up or down? By how much?
Classify each event as a source or use of cash.
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Practice Question 18. (p 86)
 Using the DuPont Identity [LO3] Y3K, Inc.,
has sales of $6,189, total assets of $2,805,
and a debt–equity ratio of 1.40. If its return on
equity is 13 percent, what is its net income?
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Practice Question 22. (p 86)
 Return on Equity [LO2] Firm A and firm B
have debt–total asset ratios of 45% and 35%
and returns on total assets of 9% and 12%,
respectively. Which firm has a greater return
on equity?
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Practice Question 24. (p 86)
 Cost of Goods Sold [LO2] Saunders Corp.
has current liabilities of $435,000, a quick ratio
of .95, inventory turnover of 6.2, and a current
ratio of 1.6. What is the cost of goods sold for
the company?
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