Understanding Understanding Financial Financial StatementsStatements

Types of Financial Statement

Income StatementBalance SheetStatement of Change in EquityStatement of Cash Flows

Income Statement

SALES

- EXPENSES

= PROFIT

•Cost of Goods Sold•Operating Expenses (marketing, administrative)•Financing Costs•Taxes

Income Statement SALES

- Cost of Goods Sold

GROSS PROFIT

- Operating Expenses

OPERATING INCOME (EBIT)

- Interest Expense

EARNINGS BEFORE TAXES (EBT)

- Income Taxes

EARNINGS AFTER TAXES (EAT)

- Preferred Stock Dividends

- NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

Income Statement SALES

- Cost of Goods Sold

GROSS PROFIT

- Operating Expenses

OPERATING INCOME (EBIT)

- Interest Expense

EARNINGS BEFORE TAXES (EBT)

- Income Taxes

EARNINGS AFTER TAXES (EAT)

- Preferred Stock Dividends

- NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

Income Statement SALES

- Cost of Goods Sold

GROSS PROFIT

- Operating Expenses

OPERATING INCOME (EBIT)

- Interest Expense

EARNINGS BEFORE TAXES (EBT)

- Income Taxes

EARNINGS AFTER TAXES (EAT)

- Preferred Stock Dividends

- NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

Balance Sheet

Total Assets =

OutstandingDebt

+Shareholders’

Equity

Balance Sheet

Current Assets Cash Marketable Securities Accounts Receivable Inventories

Prepaid Expenses

Fixed Assets Machinery &

Equipment Buildings and Land

Other AssetsInvestments & patents

Assets Liabilities (Debt) & Equity

Current LiabilitiesCurrent Liabilities Accounts PayableAccounts Payable Accrued ExpensesAccrued Expenses Short-term notesShort-term notesLong-Term LiabilitiesLong-Term Liabilities Long-term notes Long-term notes MortgagesMortgagesEquityEquity Preferred Stock Preferred Stock Common Stock (Par Common Stock (Par value)value) Paid in CapitalPaid in Capital Retained EarningsRetained Earnings

AssetsCurrent Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

AssetsCurrent Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Fixed Assets: machinery

and equipment, buildings,

and land.

AssetsCurrent Assets: assets that are relatively liquid, and are expected to be converted to cash within a year.Cash, marketable securities, accounts receivable, inventories, prepaid expenses.

Fixed Assets: machinery and equipment, buildings, and land.

Other Assets: any asset that is not a current asset or fixed asset.Intangible assets, such as patents and copyrights.

FinancingDebt Capital: financing provided by a creditor.

Short-term debt: borrowed money that must be repaid within the next 12 months. Accounts payable, other payables such as interest or taxes payable, accrued expenses, short-term notes.

Long-term debt: loans from banks or other sources that lend money for longer than 12 months.

FinancingEquity Capital: shareholders’ investment in the firm.

Preferred Stockholders: receive fixed dividends, and have higher priority than common stockholders in event of liquidation of the firm.

Common Stockholders: residual owners of a business. They receive whatever is left after creditors and preferred stockholders are paid.

Free Cash Flows

Free cash flow: cash flow that is free and available to be distributed to the firm’s investors (both debt and equity investors).

The Interrelations among the Financial The Interrelations among the Financial StatementsStatements

Income Statement Income Statement 20102010

Statement of Cash Flows Statement of Cash Flows 20102010

Statement of Retained EarningsStatement of Retained Earnings20102010

Balance SheetBalance Sheet20092009

Balance SheetBalance Sheet20102010

Evaluating a Firm’s Financial Performance

Financial Ratio Analysis

Are our decisions maximizing shareholder wealth?

We will want to answer questions about the firm’s

LiquidityEfficient use of AssetsLeverage (financing)Profitability

We will want to answer questions about the firm’s

LiquidityEfficient use of AssetsLeverage (financing)Profitability

Financial Ratios

Tools that help us determine the financial health of a company.

We can compare a company’s financial ratios with its ratios in previous years (trend analysis).

We can compare a company’s financial ratios with those of its industry (benchmark)

Liquidity Ratios

Do we have enough liquid assets to meet approaching obligations?

Efficiency Ratios

Do firm has good ability to use its assets on its operations?

Measure how efficiently Measure how efficiently

the firm’s assets generatethe firm’s assets generate

operating profitsoperating profits..

Leverage Ratios(financing decisions)

Measure the impact of using debt capital to finance assets.

Firms use debt to lever (increase) returns on common equity.

Profitability Ratios

Measure the ability of the company to produce earnings/profit.

LIQUIDITY RATIOs

Current Ratio (CR)

current assets current liabilities

Acid Test Ratio (Quick Ratio/QR)

current assets - inventoriescurrent liabilities

Cash Ratio (CR)

cash + marketable securitiescurrent liabilities

EFFICIENCY RATIOS

Inventory Turnover

cost of goods soldinventory

Day’s Sales in Inventory

Low inventory turnover:

The firm may have too much

inventory, which is expensive

because:

Inventory takes up costly

warehouse space.

Some items may become

spoiled or obsolete.

Accounts Receivable Turnover

Average Collection Period(Day’s sales outstanding)

Total Asset Turnover

Fixed Asset Turnover

Leverage RATIOs

Debt Ratio

total debt total assets

Debt to Equity RatioDebt to Equity Ratio

total debt total equity

Equity Ratio

total equitytotal assets

Equity MultiplierEquity Multiplier

Times Interest Earned Ratio

operating income (EBIT)interest expense

PROFITABILITY RATIOS

Gross Profit MarginGross Profit Margin

Operating Profit MarginOperating Profit Margin

operating income (EBIT)sales

Net Profit MarginNet Profit Margin

Net incomeNet sales

Operating Income Return on Investment (OIROI) / EBIT Return on Assets (EROA)

operating income (EBIT)total assets

•The OIROI reflects product pricing and the firm’s ability to keep costs down.

Return on Asset (ROA)?Return on Asset (ROA)?

Net Income (EAT)Total Assets

Return on Equity

How well are the firm’s managers maximizing shareholder wealth?

Return on Equity (ROE)Return on Equity (ROE)

net income (EAT)total equity

MARKET VALUE RATIOS

Earnings Per Shares (EPS)Earnings Per Shares (EPS)

Net Income (EAT) Shares Outstanding

Dividend Per Shares (DPS)Dividend Per Shares (DPS)

Dividend Payout Ratio (DPR)Dividend Payout Ratio (DPR)

Plowback RatioPlowback Ratio

DuPont AnalysisDuPont Analysis

The DuPont Model

Brings together:

ProfitabilityEfficiencyLeverage

DuPont System DuPont System (1)(1)

• A diagnostic tool that uses financial ratios to evaluate a company’s financial health

• The process has three steps:1. Management assesses the company’s financial

health using the DuPont ratios.2. If any problems are identified, management

corrects them.3. Management monitors the firm’s financial

performance over time, looking for differences from ratios established as benchmarks by management.

DuPont System DuPont System (2)(2)

The system identifies three areas where management should focus its efforts in order to maximize the firm’s ROE:

1. How much profit management can earn on sales2. How efficient management is in using the firm’s

assets3. How much financial leverage management is

using.

DuPont EquationDuPont Equation