Working With Financial Statements

1. Lecture 1b Chapter 3 Working With Financial Statements

2. Lecture Outline • Statement of Cash Flows • Standardized Financial Statements • Ratio Analysis • The Du Pont Identity • Using Financial Statement Information

3. Review of Lecture 1 • Organization of Business Enterprise • Main Goal – Maximizing Equity Value • Financial information about the firm is in • Balance Sheets • Income Statements • Cash Flow Statements

4. Sample Balance Sheet Numbers in thousands

5. Sample Income Statement Numbers in thousands, except EPS & DPS

6. Sample Statement of Cash Flows Numbers in thousands

7. 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

8. 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

9. Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios

10. Computing Liquidity Ratios • Current Ratio = CA / CL • 1,801,690 / 1,780,785 = 1.01 times • Quick Ratio = (CA – Inventory) / CL • (1,801,690 – 388,947) / 1,780,785 = .793 times • Cash Ratio = Cash / CL • 3,171 / 1,780,785 = .002 times

11. Computing Long-term Solvency Ratios • Total Debt Ratio = (TA – TE) / TA • (4,931,444 – 1,761,044) / 4,931,444 = .6429 times or 64.29% • The firm finances a little over 64% of its assets with debt. • Debt/Equity = TD / TE • (4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times • Equity Multiplier = TA / TE = 1 + D/E • 1 + 1.800 = 2.800

12. Computing Coverage Ratios • Times Interest Earned = EBIT / Interest • 820,183 / 52,841 = 15.5 times • Cash Coverage = (EBIT + Depreciation) / Interest • (820,183 + 362,325) / 52,841 = 22.38 times

13. Computing Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory • 1,762,721 / 388,947 = 4.53 times • Days’ Sales in Inventory = 365 / Inventory Turnover • 365 / 4.53 = 81 days

14. Computing Receivables Ratios • Receivables Turnover = Sales / Accounts Receivable • 4,335,491 / 1,095,118 = 3.96 times • Days’ Sales in Receivables = 365 / Receivables Turnover • 365 / 3.96 = 92 days

15. Computing Total Asset Turnover • Total Asset Turnover = Sales / Total Assets • 4,335,491 / 4,931,444 = .88 times • Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

16. Computing Profitability Measures • Profit Margin = Net Income / Sales • 471,916 / 4,335,491 = .1088 times or 10.88% • Return on Assets (ROA) = Net Income / Total Assets • 471,916 / 4,931,444 = . 0957 times or 9.57% • Return on Equity (ROE) = Net Income / Total Equity • 471,916 / 1,761,044 = .2680 times or 26.8%

17. Computing Market Value Measures • Market Price = $60.98 per share • Shares outstanding = 205,838,910 • PE Ratio = Price per share / Earnings per share • 60.98 / 2.41 = 25.3 times • Market-to-book ratio = market value per share / book value per share • 60.98 / (1,761,044,000 / 205,838,910) = 7.1 times

18. Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 and then rearrange • ROE = (NI / TE) (TA / TA) • ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 again and then rearrange • ROE = (NI / TA) (TA / TE) (Sales / Sales) • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = PM * TAT * EM

19. Using the Du Pont Identity • ROE = PM * TAT * EM • 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

20. 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

21. 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 • Finding Information on the Web: CNBC

22. Real World Example - I • International Business Machines Corp. Industry averages in parenthesis. • Liquidity ratios • Current ratio = 1.2 (1.4) • Quick ratio = 1.0 (1.0) • Long-term solvency ratio • Debt/Equity ratio (Debt / Worth) = 0.50 (0.32) • Coverage ratio • Times Interest Earned =88.6 (51.5).

23. Potential Problems • There is no underlying theory, so there is no way to know which ratios are most relevant • Benchmarking is difficult for diversified firms • Globalization and international competition makes comparison more difficult because of differences in accounting regulations • Varying accounting procedures, i.e. FIFO vs. LIFO • Different fiscal years • Extraordinary events