Chapter 3

Working with Financial Statements

Key Concepts and Skills

Know how to standardize financial statements for comparison purposes

Know how to compute and interpret important financial ratios

Know the determinants of a firm’s profitability and growth

Understand the problems and pitfalls in financial statement analysis

Chapter Outline

Standardized Financial Statements Ratio Analysis The Du Pont Identity

Who needs to understand ratios?

Managers Use ratios to evaluate various aspects of the firm

Profitability Productivity

Marketers Use ratios dealing with costs, markups, and

margins Production personnel

Use ratios that deal with issues such as operating efficiency

Standardized Financial Statements

Common-size statement: a standardized financial statement presenting all items in percentage terms

Common-size Balance Sheet Balance sheet items shown as a

percentage of total assets Common-size Income Statement

Income statement items shown as a percentage of total sales

Standardized Financial Statements (continued)

Standardized statements make it easier to compare financial information

Standardized statements are useful for comparing companies of different sizes, especially within the same industry

Ratio Analysis

Financial ratios: Relationships determined from a firm’s financial information and used for comparison purposes

Ratios allow for comparison over time or between firms

Ratios are used both internally and externally

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

Analyzing ratios

Questions to ask when analyzing ratios: How is the ratio computed? What does the ratio measure? Why do

we care? What is the unit of measurement? What does a high/low value tell us? How

might such values be misleading? How could this measure be improved?

Short-term Solvency/Liquidity Ratios

Current Ratio Formula What does it measure?

Quick (Acid Test) Ratio Formula What does it measure?

Short-term Solvency/Liquidity Ratios (continued)

Cash ratio Formula What does it measure?

Financial Leverage Ratios Total Debt Ratio

Formula What does it measure?

Debt/Equity Ratio Formula What does it measure?

Financial Leverage Ratios (continued)

Equity Multiplier Formula What does it measure?

Coverage Ratios

Times Interest Earned ratio Formula What does it measure?

Cash Coverage ratio Formula What does it measure?

Inventory Ratios

Inventory Turnover ratio Formula What does it measure?

Days’ Sales in Inventory Formula What does it measure?

Receivables ratios

Receivables Turnover Formula What does it measure?

Days’ Sales in Receivables Formula What does it measure?

Total Asset Turnover

Total Asset Turnover ratio Formula Measures asset use efficiency It is not unusual for total asset

turnover to be less than one, especially if the firm has a large amount of fixed assets

Profitability Ratios

Profitability ratios are the best known and most widely used of all financial ratios

Profit Margin Formula What does it measure?

Profitability Ratios (continued) Return On Assets (ROA)

Formula What does it measure?

Return On Equity (ROE) Formula What does it measure?

Budweiser Profit margin

12.23% ROA 12.31% ROE 61.19%

YUM! Profit Margin

8.63% ROA 12.79% ROE

51.19%

GOOGLE! Profit margin

23.87% ROA 21.24% ROE 23.74%

Market Value Measures Earnings per share

Net income/number of shares outstanding $200,000 NI/100,000 shares = $2.00

earnings per share Price to earnings (PE) ratio

Measures how much investors are willing to pay per dollar of current earnings

Higher PE ratios are often interpreted to mean that the firm has significant prospects for future growth

Market Value Measures Price per share/Earnings per share $20 price per share/$2.00 earnings

per share = PE ratio of 10

Market Value Measures (continued)

Market-to-book ratio Compares the market value of the

firm’s investments to their cost Market value per share/book value

per share

The Du Pont Formula The Du Pont formula is named after the Du

Pont Corporation, which popularized its use Allows us to break down ROE into its three

basic components Profit margin, a measure of the firm’s operating

efficiency Total asset turnover, a measure of how well the

firm manages its assets Equity multiplier, a measure of the firm’s

financial leverage

The Du Pont Formula (continued)

Du Pont Formula Profit margin x total asset turnover x

equity multiplier ROE = PM x TAT x EM

If ROE is unsatisfactory, Du Pont tells the financial manager where to start looking for the reasons why

QUIZ Why is it necessary to standardize

financial statements? How are common-size balance sheets and

common-size income statements formed? What are the five groups of ratios? Profitability ratios all have the same figure

in the numerator. What is it? What do the profitability ratios measure?

QUIZ (continued)

What two ratios can be computed if you are given the total debt ratio?

ROA is the product of what two ratios?

ROE is the product of what three ratios?

The End of Chapter 3!