1. Working With Financial Statements Chapter 3

2. Topics

How To Standardize Financial Statements For Comparison Purposes

How To Compute And Interpret Some Common Ratios

The Determinants Of A Firms Profitability And Growth

Some Problems And Pitfalls In Financial Statement Analysis

3. Financial Statements:

Financial statements convey information from within the firm controlled by managers to outside the firm (owners, investors, bankers, suppliers, customers, other constituents)

Internal managers also use theinformation internally to guide the firm to a profitable future

4. Financial Statements:

Financial managers would like to have market value information, but often times this is not possible so financial managers rely on financial statements

Accounting numbers are just pale reflections of economic reality, but they frequently are the best available information

So, lets learn how to use and interpret financial statements:

• Common sized statements

• Ratio analysis

5. Standardized Financial Statements: Common-Size Balance Sheet Common-Size Income Statement

Standardized statements make it easier to compare financial information:

• As the company grows, comparing one year to the next

• For comparing different companies of different sizes, particularly within the same industry

• For comparing companies when the statements are in different currencies

Standardized statements use % instead of dollars

6. Balance Sheet Common-Size Balance Sheet Compute all accounts as a percent of total assets 7. Income Statement Common-Size Income Statement Compute all line items as a percent of sales 8. Standardized: Krispy Kream 9. How To Compute And Interpret Some Common Ratios

Liquidity, or short-term solvency ratios

• Current ratio

• Quick ratio

• Cash ratio

Leverage, or long-term solvency ratios

• Total debt ratio

• Debt/equity ratio

• Equity multiplier

• Times interest earned ratio

• Cash coverage ratio

Asset turnover, or utilization ratios

• Inventory Turnover

• Days sales in inventory

• Receivables turnover

• Days sales in receivables

• Total asset turnover

• Capital intensity

Profitability ratios

• Profit margin

• Return on assets

• Return on equity

• Du Pont Identity

Market value ratios

• Price-earnings ratio

• Market-to-book ratio

10. Ratio Analysis

Ratios also allow for better comparison through time or between companies

Ratios are used both internally and externally

Ratios are computed differently by different people

• The ones we see in this book are only one of many possible ways to compute them!

3. 11. Hints About Financial Ratios

In calculating any ratio, we mean the ratio of one thing to something else

• When we write the ratio as a fraction, we put theofpart in the numerator and thetopart in the denominator

• Example:

• • Current ratio: find the ratio of current assets to current liabilities

• • (Current Assets)/(Current Liabilities) = $45,000/$30,000 = 1.5

12. Hints About Financial Ratios

If you keep the unit of measure (dollars) in both the numerator and denominator, the answer will hint at what the ratio means

• (Current Assets)/(Current Liabilities) = $45,000/$30,000 = $1.50/$1.00

• In this case the ratio indicates that for every $1.00 of current liabilities, there is $1.50 worth of current assets to use to pay off the current liabilities

• In general, this trick can be used with all ratios

13. Financial Ratios:

Who uses them? Why we might be interested?

• Stock analysts

• • Should I buy/sell this stock?

• Auditors

• • Are the financial statements free from material misstatement?

• Internal Managers

• • How is the firm doing?

• Investors

• • Should I sell/buy this stock?

• Banks

• • Will the borrower be able to pay back the loan?

• Basically: almost everyone

14. Questions To Ask When You Use Ratios:

How is it computed?!

• Not everyone agrees about how to calculate a given ratio

What is it intended to measure and why might we be interested?

What is the unit of measure?

What might a high or low value be telling us?

How might such values be misleading?

• Accounting behind the numbers?

• Does a low CA/CL mean trouble for a large firm?

How could the measure be improved?

15. Liquidity, Or Short-term Solvency Ratios

Current ratio

Quick ratio

Cash ratio

16. Current Ratio

Current Ratio = CA/CL

Measure of short term liquidity

$2/$1 = $2 CA for every $1 of CL

If you were to sell all CA and pay off all CL, you would have $2 for every $1 of CL

Above 1, in general is good

Less than 1, in general is not so good

High could mean firm saving up cash to make acquisition, or it could mean that they do not see profitable fixed assets to purchase

Low could mean that they may have a hard time paying short-term debt

CA/CL is used in debt contracts as indicator of short term liquidity

17. Current Ratio

If you incur long-term debt, CA /CL, (CA/CL)

If you pay off short-term creditors: 5/2 = 2.5(5-1)/(2-1) = 4/1 = 4

• Firms may do these things before the report there numbers at the end of the period

An apparent low CA/CL may not be bad for a company with a large reserve of untapped borrowing power

Firm buys inventory with $, CA/CL stays same

Firm sells inventory for more than they have it on the books for, (CA/CL)

18. Quick Ratio (Acid Test)

Quick Ratio = (CA-INV)/CL = (Quick Assets)/CL

Measure of immediate short-term liquidity

Why take out inventory?

• Inventory may not be at market value

• May be hard to sell

• May be obsolete

Using cash to buy inventory reduces the Quick Ratio

People who are interested in whether firm can pay bills or purchase assets in the short term may use this ratio:

• Creditors, internal managers, investors

19. Cash Ratio

Cash Ratio = Cash/CL

Do we even need to define this?

20. Liquidity, Or Short-term Solvency Ratios

Current Ratio = CA/CL

Quick Ratio = (CA-INV)/CL

Cash Ratio = Cash/CL

What does it mean when these ratios are greater than 1?

What does it mean when these ratios are less than 1?

21. Leverage, Or Long-term Solvency Ratios

Total debt ratio

Debt/equity ratio

Equity multiplier

Times interest earned ratio

Cash coverage ratio

22. Leverage, Or Long-term Solvency Ratios

Capital Structure = Relationship Between Debt & Equity

• A = L + E

• 10 = 2 + 8

Solvency = the position of having enough money to cover expenses and debts

Banks, Investors look at these ratios

23. Variables

Equity = TE = E

Liability = Debt = TL = D

Assets = TA = A

24. Leverage (Capital Structure)

Total Debt Ratio

• Total Debt Ratio = TL/TA = (TATE)/TA

• Amount of debt for every $1 of assets

• • How much of every $1 of assets is financed with debt

Debt/Equity Ratio

• Debt/Equity Ratio = TL/TE = D/E

• Amount of debt for every $1 of equity

Equity Multiplier

• Equity Multiplier = Leverage = TA/TE = (1+D/E)

• For every $1 of equity how many dollars of assets are there

• Shows us the amount ofleverage

25. TL/TA, TL/TE, TA/TE: From one, you can find the others 26. Times Interest Earned Ratio

Times Interest Earned Ratio =EBIT/Interest

How many times over interest can be paid

Who might be interested in this ratio?

27. Cash Coverage Ratio

Cash Coverage Ratio = (EBIT+Depr.)/Interest =EBDIT/Interest

One possible measure of cash flow to meet financial obligations

If the company has a great deal of non-cash deprecation expense, then it makes sense to use this one

28. Asset Turnover, Or Utilization Ratios

Inventory Turnover

Days sales in inventory

Receivables turnover

Days sales in receivables

Total asset turnover

Capital intensity

29. Inventory Turnover

Inventory Turnover =COGS/Inv.

• Alternative = COGS/((Beg.Inv.+EndInv.)/2)

How many times we run inventory down to zero and then immediately restock

How many times did we buy and sell our inventory during the year

As long as we are not running out of stock and foregoing sales, the higher the ratio, the more efficient we are at managing inventory

Example: COGS/Inv.=5,000/1,000 = 5

30. Days Sales In Inventory

Days Sales In Inventory = 365/Inv. Turn

How long inventory sits before it is sold

Example:

• If Inv. Turn = 5

• Days Sales In Inventory = 365days/5 =73 days

31. Receivables Turnover

Receivables Turnover = Sales/AR

• Alternative = (Credit _ Sales)/((Beg.AR+EndAR)/2)

• How fast we collect our receivable

• • # of times we collect and reloan the $ per year

• Example: 10,000/1,000 = 10

Days Sales In Receivables = 365/(Days Sales In Receivables)

• Average time it takes to collect the AR

• Example: 365days/10 = 36.5 days

32. Payables Turnover

Payables Turnover = COGS/AP

Example:

• COGS/AP = 5,600/800 = 7

• 365 days/752 days to pay bill

33. What does this tell us?

Operating cycle = days inventory sits + days to collect after selling

Cash cycle = operating cycle payables period

34. Asset Turnover

Total Asset Turnover = Sales/TA

• Alternative = (Total _ Operating _ Revenue)/((Beg.TA+EndTA)/2)

• How many sales do we generate from $1 of assets

• The higher, the better, or the more efficient

• Sales/TA , more efficient use of assets!

• If a firm has newer assets that have not been depreciated, book value for assets may be high and may temporarily lower the ratio

• Measure of asset use efficiency

• Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

Capital Intensity = TA/Sales

• For every $1 of sales how many $ of assets did it take to generate that $1

35. Profitability Ratio

Profit margin

Return on assets

Return on equity

Du Pont Identity

36. Profit Margin

Profit Margin = NI/Sales

• For every $1 of sales, what is the profit?

• Example: $60/$400 = .15

• High PM corresponds to low expense ratios relative to sales

• High PM:

• • Internal managers could be managing cost efficiently

• • Product/service could be superior to others and could thus demand a high price

37. Return On Assets

Return On Assets = NI/TA = ROA

• Profit per $1 of asset

ROA = NI/Sales*Sales/TA

ROA = Profit Margin*Asset Turnover

38. Return On Equity

Return On Equity = ROE = NI/Equity

• Return to shareholders

• What is the profit per $1 of equity?

The key:

• When there is no debt, ROE = ROA

• When there is debt this should happen: ROE > ROA

• Why? Because the assets must earn a return for both the creditors and owners

• The more debt there is, the higher (ROE ROA) must be!

39. Return On Equity

ROE = NI/Equity

ROE = NI/Equity x TA/TA

ROE = NI/TA x TA/Equity

Since

• ROA = NI/TA

• Equity/TA = Equity Multiplier = (1+D/E)

ROE = ROA xEquity Multiplier

ROE = ROA x(1+D/E)

ROE = ROA + (ROA R d )*D/E (chapter 13)

40. ROE

If ROE goes up or down, what causes this?

The financial managers at DuPont Copr. Came up with a metric that helps analyze a few of the reasons that may cause ROE to change:

• Profit margin

• Efficient use of assets (Asset Turnover)

• Leverage (Equity Multiplier)

41.

ROE= NI/Equity =

NI/Equity x Sales/Sales x TA/TA =

(NI x Sales x TA)/(Equity x Sales x TA) =

NI/Salesx Sales/TA x TA/Equity

Du Pont Identity Decomposing Into Component Parts NI/Sales x Sales/TAx TA/Equity NI/Sales x Sales/TA x TA/Equity 42. Analyze With TheDu Pont Identity ROA ROE 43. Du Pont Analysis: Why did the firms ROE go down? 44. Market Value Ratios(For publicly traded companies)

Price-Earnings Ratio = (Market Price per Share)/EPS)

• Note: EPS = NI/(# Shares Outstanding)

• $ paid for $1 of earnings

• Surrogate for growth

Market-To-Book Ratio

• Note:Book Value per Share = TE/ (# Shares Outstanding)

• (Market Value per Share)/(Book Value per Share)

• >1, stock market believes that firm is worth more than the book value of equity