- 1. Chapter 3 Working With Financial Statements
2. 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 firms profitability and growth
- Understand the problems and pitfalls in financial statement
analysis
3. Chapter Outline
- Standardized Financial Statements
- Internal and Sustainable Growth
- Using Financial Statement Information
4. Standardized Financial Statements
- Common-Size Balance Sheets
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- Compute all accounts as a percent of total assets
- Common-Size Income Statements
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- 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
5. 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
6. Categories of Financial Ratios
- Short-term solvency or liquidity ratios
- Long-term solvency or financial leverage ratios
- Asset management or turnover ratios
7. Sample Balance Sheet Numbers in thousands 4,088,797 Total
Liab. & Equity 4,088,797 Total Assets 1,691,493 C/S 2,535,072
Net FA 871,851 LT Debt 1,553,725 Total CA 1,525,453 Total CL
199,375 Other CA 1,098,602 Other CL 295,255 Inventory 86,631 N/P
1,052,606 A/R 340,220 A/P 6,489 Cash 8. Sample Income Statement
Numbers in thousands, except EPS & DPS 2.17 EPS 1,738,125 Cost
of Goods Sold 308,355 Depreciation 0.86 Dividends per share 425,764
Net Income 272,210 Taxes 697,974 Taxable Income 42,013 Interest
Expense 739,987 EBIT 1,269,479 Expenses 3,991,997 Revenues 9.
Computing Liquidity Ratios
- Quick Ratio = (CA Inventory) / CL
10. Long-term Solvency Measures
- Total Debt Ratio = (TA TE) / TA
-
- The firm finances almost 59% of their assets with debt.
- Equity Multiplier = TA / TE = 1 + D/E
11. Computing Coverage Ratios
- Times Interest Earned = EBIT / Interest
- Cash Coverage = (EBIT + Depreciation) / Interest
12. Computing Inventory Ratios
- Inventory Turnover = Cost of Goods Sold / Inventory
- Days Sales in Inventory = 365 / Inventory Turnover
13. Computing Receivables Ratios
- Receivables Turnover = Sales / Accounts Receivable
- Days Sales in Receivables = 365 / Receivables Turnover
14. Computing Total Asset Turnover
- Total Asset Turnover = Sales / Total Assets
- Measure of asset use efficiency
- Not unusual for TAT < 1, especially if a firm has a large
amount of fixed assets
15. Computing Profitability Measures
- Profit Margin = Net Income / Sales
- Return on Assets (ROA) = Net Income / Total Assets
- Return on Equity (ROE) = Net Income / Total Equity
16. Computing Market Value Measures
- Market Price = $61.625 per share
- Shares outstanding = 205,838,594
- PE Ratio = Price per share / Earnings per share
- Market-to-book ratio = market value per share / book value per
share
17. Deriving the Du Pont Identity
- Multiply by 1 and then rearrange
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- ROE = (NI / TE) (TA / TA)
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- ROE = (NI / TA) (TA / TE) = ROA * EM
- Multiply by 1 again and then rearrange
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- ROE = (NI / TA) (TA / TE) (Sales / Sales)
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- ROE = (NI / Sales) (Sales / TA) (TA / TE)
18. Using the Du Pont Identity
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- Profit margin is a measure of the firms operating efficiency
how well does it control costs
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- Total asset turnover is a measure of the firms asset use
efficiency how well does it manage its assets
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- Equity multiplier is a measure of the firms financial
leverage
19. Payout and Retention Ratios
- Dividend payout ratio = Cash dividends / Net income
- Retention ratio = Additions to retained earnings / Net income =
1 payout ratio
20. The Internal Growth Rate
- The internal growth rate tells us how much the firm can grow
assets using retained earnings as the only source of
financing.
21. The Sustainable Growth Rate
- The sustainable growth rate tells us how much the firm can grow
by using internally generated funds and issuing debt tomaintain a
constant debt ratio.
22. 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
23. Why Evaluate Financial Statements?
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- Performance evaluation compensation and comparison between
divisions
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- Planning for the future guide in estimating future cash
flows
24. Benchmarking
- Ratios are not very helpful by themselves; they need to be
compared to something
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- Used to see how the firms performance is changing through
time
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- Internal and external uses
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- Compare to similar companies or within industries
25. Real World Example
- Ratios are figured using financial data from the 1999 Annual
Report for Ethan Allen
- Compare the ratios to the industry ratios in Table 3.9 in the
book
- Ethan Allens fiscal year end is June 30.
- Be sure to note how the ratios are computed in the table so
that you can compute comparable numbers.
- Ethan Allan sales = $762 MM
26. Real World Example - II
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- Current ratio = 2.433x; Industry = 1.4x
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- Quick ratio = .763x; Industry = .6x
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- Debt/Equity ratio (Debt / Worth) = .371x; Industry = 1.9x.
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- Times Interest Earned = 70.6x; Industry = 3.4x
27. Real World Example - III
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- Inventory turnover = 2.8x; Industry = 3.6x
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- Receivables turnover = 22.2x (16 days); Industry = 17.7x (21
days)
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- Total asset turnover = 1.6x; Industry = 2.2x
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- Profit margin before taxes = 17.4%; Industry = 3.1%
-
- ROA (profit before taxes / total assets) = 27.6%; Industry =
5.8%
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- ROE = (profit before taxes / tangible net worth) = 37.9%;
Industry = 17.6%
28. 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 firms growth
potential?
- What are some of the problems associated with financial
statement analysis?