CHAPTER 3: Understanding Financial Statements, Taxes, and Cash Flows

A. Four basic financial statements and basic information for eachi. Income Statement – includes the revenue, expense, and profit made by the firm over

a specific period of timeii. Balance Sheet – is a snapshot of the firms assets, liabilities, and owner’s equity for a

particular dateiii. Cash Flow Statement – cash received and spent over a specific period of time.

Operating Activities – includes sales and expenses (cash activity that affects net income)

Investment Activities – includes cash flow that arise out of the purchase and sale of long-term assets such as plant and equipment

Financing Activities – represents changes in debts and equity. It includes the sale of new shares of stock, the repurchase of outstanding shares, and the payment of dividends

iv. Statement of Shareholder’s Equity – provides detailed accounts on firm’s activities such as:

Common and Preferred stock accounts Retained earning accounts Changes in owner’s equity that do not appear in the income statement

B. Three uses of financial statements in management1) Financial Statement Analysis – asses current performance2) Financial Control – monitor and control operations using accounting measures3) Financial Forecasting or Planning – financial statements are universally understood

format for describing operations and is used as a prototype for financial planning models

Income StatementFor the year end December 31, 2010

Sales $ xxxCost of goods sold (xxx)

Gross Profit xxxOperating Expenses

Selling Expense $ (xxx)General and administrative expense (xxx)Depreciation and amortization expense (xxx)Total Operating Expenses (xxx)

Net Operating Income $ xxxInterest Expense (xxx)

Earnings before taxes $ xxxIncome tax (xxx)

Net Income $ xxx

Additional Information:Dividends paid to stockholders during 2010 xxNumber of common shares outstanding xx

Earnings per share xxDividends per share xx

Balance SheetFor the year end December 31, 2010

Assets Liabilities and Owner’s EquityCash $ xxx Accounts payable $ xxxAccounts receivables xxx Accrued expenses xxxInventory xxx Short-term notes xxxOther Current Assets xxx Total current liabilities $ xxx

Total current assets $ xxx Long-term debt xxxGross plant and property and equipment xxx Total liabilities $ xxx

Less accumulated depreciation (xxx) Common stockholders’ equityNet plant and equipment $ xxx Common stock-par value xxxTotal Assets $ xxx Pain in capital xxx

Retained earnings xxxTotal common stockholders’ equity $ xxxTotal liability and stockholders’ equity $ xxx

CHAPTER 4: Financial Analysis

Questions: Category of Ration Used to Address the Questions

1. How liquid is the firm? Will it be able to pay its bills as they come due?

Liquidity Ratio

2. How has the firm finance the purchase of its assets?

Capital Structure Ratio

3. How efficient has the firm’s management been in utilizing its assets to generate sales?

Asset Management Efficiency Ratios

4. Has the firm earned adequate returns on its investments?

Profitability Ratio

5. Are the firm’s managers creating value for shareholders?

Market Value Ratio

A. Liquidity RatioMeasures of the ability of the firm to pay its bills in a timely manner when they come due

i. Current Ratio Assumes that the firm’s accounts receivable will be collected and turned into cash into cash on a timely basis and that its inventories can be sold without an extended delay

ii. Acid Test (Quick) Ratio Assumes that the firm’s inventories might not be very liquid

iii. Average Collection Period (Daily Collection) Measures how many days it takes for the firm to collect its receivables

iv. Accounts Receivables Turnover Ratio (Collections in a year) Measures how any times accounts receivables are “rolling over” during a year

v. Inventory Turnover Ratio A key indication of the quality of a firm’s inventory length is the length of time it is held before bing sold.Shorter inventory cycle leads to greater liquidity since the items in the inventory are converted to cash more quickly.

Inventory Turnover Ratio = Cost of Goods Sold Inventories

Accounts Receivable Turnover Ratio = Annual Credit Sales Accounts Receivable

Average Collection Period = Accounts Receivables Annual Credit Sales/365 days

Acid Test Ratio = Current Assets - Inventories Current Liabilities

Current Ratio = Current Assets Current Liabilities

B. Capital Structure RatioThe mix of debts and equity securities a firm uses to finance its assets

i. Debt Ratio Measures the percentage of the firm’s assets that were financed using current plus long-term liabilities

ii. Times Interest Earned Measures the firm’s ability to serve its debts or pay the interest on the debt.Computation indicates if a firm can afford to pay interest expense with the net operating income it earns.

C. Assets Management Efficiency RatiosMeasures how well assets are managed to generate sales

i. Total Asset Turnover Measures how well a firm’s assets are managed.Represents the amount of sales generated per dollar invested in the firm’s assets.

ii. Fixed Asset Turnover Measures how well the inventory assets generate sales

C. Market Value RatioAnswers the question: How are the firm’s shares valued in the stock market?

i. Price / Earnings Ratio Indicate how much investors have been willing to pay for $1 of reported earnings.

ii. Market-to-Book Ratio A market-to-book ratio greater than 1 indicates that the market value of the firm’s shares is greater than the book value of the accumulated investment in the firm’s equity. Conversely, a ratio less than 1 suggests that the stocks is worth less than the accumulated investment made by shareholders in the firm.

Times Interest Earned = Net Operating Income/EBIT Interest Expense

Debt Ratio = Total Debt Total Assets

Total Asset Turnover = Sales . Total Assets

Fixed Asset Turnover = Sales . Net Plant and Equipment

Price / Earnings Ratio = Market Price per Share Earning Price per Share

Market-to-Book Ratio = Market Price per Share Book Value per Share

E. Profitability RatioAnswer the question: Has the firm earned adequate returns on its investments?The fundamental determinants to a firm’s profitability and returns on investment:

Cost Control- how well the firm controlled its costs?Efficiency of asset utilization-How efficient is the firm’s management at using the firm’s assets to generate sales?

i. Gross Profit Margin Indicates how well the firm’s management controls its expenses determines the firm’s profit margin

ii. Operating Profit Margin (OPM) Indicates how much profit is generated from each dollar of sales after accounting for both costs of good sold and operating expense.

iii. Net Profit Margin (NPM) Shows how well the firm has controlled its costs but does not show efficiency in asset use to generate sale.

iv. Operating Return on Assets Shows how well the firm has controlled its costs and the efficiency in using assets to generate sale

v. Return on Equity A measure of the return rate of earned on the common shareholders’ investment in the firm equal to net income divided by common equity.

Gross Profit Margin = Gross Profit Sales

Operating Profit Margin = Net Operating Income / EBIT Sales

Net Profit Margin = Net Income Sales

Operating Return on Assets = Net Operating Income / EBIT Total Assets

Return on Equity = Net Income . Common Equity