Working With Financial Statements

P.V. Viswanath

For use with

Fundamentals of Corporate Finance

Brealey, Myers and Marcus, 4th ed.

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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

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Chapter Outline

Standardized Financial Statements Ratio Analysis The Du Pont Identity Internal and Sustainable Growth Using Financial Statement Information

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Standardized Financial Statements

Common-Size Balance Sheets Compute all accounts as a percent of total assets

Common-Size Income Statements Compute all line items as a percent of sales

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

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Ratio Analysis

Ratios also 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 is that information important

Ratios are used both internally and externally

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Categories of Financial Ratios

Liquidity ratios Short-term solvency or how easily the firm can lay its hands on

cash.

Financial leverage ratios Show long-term solvency; how heavily the firm is in debt.

Efficiency or turnover ratios Indicate how productively the firm is using its assets

Profitability ratios Used to measure the firm’s return on its investments

Market value ratios

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Sample Balance Sheet

Cash 6,489 Acc Payable 340,220

Acc Receiv 1,052,606 Notes Pay 86,631

Inventory 295,255 Other Curr Li 1,098,602

Other Curr A 199,375 Total CL 1,525,453

Total CA 1,553,725 LT Debt 871,851

Net Fixed A 2,535,072 Comm Stock 1,691,493

Total Assets 4,088,797 Tot Liab & Eq 4,088,797

Numbers in thousands

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Sample Income Statement

Revenues 3,991,997

Cost of Goods Sold 1,738,125

Expenses 1,269,479

Depreciation 308,355

EBIT 739,987

Interest Expense 42,013

Taxable Income 697,974

Taxes 272,210

Net Income 425,764

EPS 2.17

Dividends per share (DPS) 0.86

Numbers in thousands, except EPS & DPS

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Computing Leverage Ratios

Total Debt Ratio = (Tot Assets – Tot Eq) / TA (4,088,797 – 1,691,493) / 4,088,797 = .5863 times or 58.63% The firm finances almost 59% of their assets with debt.

Debt/Equity = Tot Debt / Tot Eq (4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times

These numbers can also be computed for long-term debt: Long Term Debt Ratio = LT Debt/ (LT Debt + Eq) =

871,851/(871851+ 1, 691,493) = 0.34

Long Term Debt/Equity = 871851/ 1, 691,493 = 0.515

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Data from last year

Inventory = 280,044 Accounts Receivable = 940,044 Total Assets = 3,998,256 Total Equity = 1,480,493

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Computing Coverage Ratios

Times Interest Earned = EBIT / Interest 739,987 / 42,013 = 17.6 times

Cash Coverage = (EBIT + Depreciation) / Interest (739,987 + 308,355) / 42,013 = 24.95 times

Determinant of the riskiness of a firm’s debt

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Computing Liquidity Ratios

Current Ratio = CA / CL 1,553,725 / 1,525,453 = 1.02 times

Quick Ratio = (CA – Inventory) / CL (1,553,725 – 295,225) / 1,525,453 = 0.825 times

Cash Ratio = Cash / CL 6,489 / 1,525,453 = .004 times

Net Working Capital to TA Ratio = NWC/TA (1,553,725 - 1,525,453)/ 4,088,797 = 0.007

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Computing Inventory Ratios

Inventory Turnover = Cost of Goods Sold / Average Inventory

1,738,125 / [(295,255 + 280,044)/2] = 6.04 times

Days’ Sales in Inventory = 365 / Inventory Turnover = Av Inv/(COGS/365)

365 / 6.04 = 60.41 days When you have ratios with I/S numbers in the numerator and B/S

numbers in the denominator, use average of year beginning and year end quantities.

Last year’s Inventory = 280,044.

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Computing Receivables Ratios

Receivables Turnover = Sales / Av Accounts Receivable 3,991,997 / [(1,052,606 + 940,044)/2] = 4.01 times

Average Collection Period = Days’ Sales in Receivables = 365 / Receivables Turnover = Av Receiv/ (Av Sales) 365 / 4.01 = 91.1 days

Ac Rec last year = 940,044

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Computing Total Asset Turnover

Total Asset Turnover = Sales / Av Total Assets 3,991,997 / [(4,088,797 + 3,998,256)/2] = 0.99 times

Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a

large amount of fixed assets

Total Assets last year = 3,998,256

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Computing Profitability Measures

Profit Margin = Net Income / Sales 425,764 / 3,991,997 = 0.1067 times or 10.67%

Operating Profit Margin = (NI + Int) / Sales (425,764 + 42013) / 3,991,997 = 0.1172 times or 11.72%

Return on Assets (ROA) = (Net Income + Interest) / Av TA (425,764 + 42013) / [(4,088,797 + 3,998,256)/2] = 0.11.57 times or

11.57%

Return on Equity (ROE) = Net Income / Average Equity 425,764 / [(1,691,493 +1,480,493)/2] = 0.2685 times or 26.85%

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Computing Market Value Measures

Market Price = $61.625 per share Shares outstanding = 205,838,594 P/E Ratio = Price per share / Earnings per share

61.625 / 2.17 = 28.4 times

Market-to-book ratio = market value per share / book value per share 61.625 / (1,691,493,000 / 205,838,594) = 7.5 times

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Payout and Retention Ratios

Dividend payout ratio = Cash dividends / Net income 0.86 / 2.17 = .3963 or 39.63%

Plowback ratio = Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio 1.31 / 2.17 = 0.6037 = 60.37% Or 1 - .3963 = 0.6037 = 60.37%

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Sustainable Growth

The sustainable growth rate tells us how fast the firm can grow, without increasing financial leverage.

Sustainable growth rate = Growth in equity from plowback = plowback ratio x ROE

0.6037 x 0.2685 = 0.1621 or 16.21% If the firm can continue to earn 26.85% on its equity and can plow back

60% of earnings into operations, its earnings and equity should both grow at 16.21% p.a.

Growth at this rate requires external financing to grow at the existing rate. Without any additional external financing, the firm can only grow at what is called the Internal Growth Rate.

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Internal Growth

0.1621 x (1,691,493 +1,480,493) /(4,088,797 + 3,998,256) = 0.1621 x 0.3922 = 0.0636 or 6.36%

assets total

equityx

equity

incomenet x

incomenet

earnings retained

assets total

earnings retained

rategrowth

Internal

assets total

equityx

RateGrowth

eSustainabl

rategrowth

Internal

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Determinants of Growth

Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to

shareholders versus reinvesting in the firm

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Deriving the Du Pont Identity

ROE = NI / TE Multiply by 1 and then rearrange

ROE = (NI / TA) * (TA / TE) = ROA * Equity Multiplier

Multiply by 1 again and then rearrange ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = Profit Margin * Total Asset Turnover * Equity

Multiplier

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Deriving the Du Pont Identity

ROA = (NI + Interest)/ TA Multiply by 1 and rearrange ROA = [(NI + Int)/ TA]*(Sales / TA) ROA = (Operating Profit Margin)*(Asset Turnover)

ROE = NI / TE ROE = (NI/Sales]*(Sales/TA)*(TA/TE) = Net Profit Margin*Asset Turnover*Equity Multiplier ROE = [NI/(NI+Int)]*[(NI +Int)/ Sales]*(Sales/TA)*(TA/TE) = Debt Burden * Op Profit Margin * Asset Turnover*Eq Multiplier = Debt Burden * ROA*Equity Multiplier

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Using the Du Pont Identity

ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier Net Profit margin is a measure of the firm’s operating

efficiency – how well does it control 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

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Table 3.6

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Why Evaluate Financial Statements?

Internal uses Performance evaluation – compensation and comparison between

divisions Planning for the future – guide in estimating future cash flows

External uses Creditors Suppliers Customers Stockholders

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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

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Work the Web Example

The Internet makes ratio analysis much easier than it has been in the past

Go to Multex Investor (yahoo.multexinvestor.com) Choose a company and enter its ticker symbol

Click on Ratios and see what comparative information is available

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Quick Quiz

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 the major determinants of a firm’s growth potential?

What are some of the problems associated with financial statement analysis?