Chapter 3

Working With Financial Statements

Learning Objectives
To explain the ratio categories and calculation of ratio.
To define the financial ratios.
To explain the use of financial ratios in trend and
cross sectional analysis in valuing the companys
performance.
To explain the execution of common size analysis.
To elaborate the DuPont analysis and connection
between ratios.
To clarify the boundaries of ratio analysis.
3-1
Statement of Cash Flows
Statement that summarizes the sources and
uses of cash
Changes divided into three major categories
Operating Activity includes net income and
changes in most current accounts
Investment Activity includes changes in fixed
assets
Financing Activity includes changes in notes
payable, long-term debt, and equity accounts, as
well as dividends
3-2
Sources and Uses
Sources
Cash inflow occurs when we sell something
Decrease in asset account (Sample B/S)
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
Accounts payable, other current liabilities, and common stock
Uses
Cash outflow occurs when we buy something
Increase in asset account
Accounts receivable, inventory
Decrease in liability or equity account
Notes payable and long-term debt
3-3
3-4
2011 2010 2011 2010
Cash 696 58 A/P 307 303
A/R 956 992 N/P 26 119
Inventory 301 361 Other CL 1,662 1,353
Other CA 303 264 Total CL 1,995 1,775
Total CA 2,256 1,675 LT Debt 843 1,091
Net FA 3,138 3,358 C/S 2,556 2,167
Total
Assets
5,394 5,033 Total
Liab. &
Equity
5,394 5,033
Revenues 5,000
Cost of Goods
Sold
(2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes
(442)
Net Income 689
EPS 3.61
Dividends per
share
1.08
Additional information: Market Price = $87.65 per share and Shares outstanding = 190.9 million
Sample Statement of
Cash Flows
Cash, beginning of year 58 Financing Activity
Operating Activity Decrease in Notes Payable -93
Net Income 689 Decrease in LT Debt -248
Plus: Depreciation 116 Decrease in C/S (minus RE) -94
Decrease in A/R 36 Dividends Paid -206
Decrease in Inventory 60 Net Cash from Financing -641
Increase in A/P 4
Increase in Other CL 309 Net Increase in Cash 638
Less: Increase in other CA -39
Net Cash from Operations 1,175 Cash End of Year 696
Investment Activity
Sale of Fixed Assets 104
Net Cash from Investments 104
3-5
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
Common-base year statement: a standardized financial
statement presenting all items relative to certain base year
amount

3-6
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

3-7
Ratio Analysis
Financial ratios: relationship determined from a firms
financial information and used for comparison purposes.
Ratios allow for better comparison through time (Time-Trend
Analysis) or between companies (Peer Group Analysis)
As we look at each ratio, ask yourself what the ratio is trying
to measure and why that information is important
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
3-8
1)Liquidity Ratios:
1) Current ratio = Current assets/Current liabilities
This ratio measures the degree of liquidity by comparing its current
assets to its current liabilities. Higher figure means that the business
financial condition is better as it has enough liquid assets for its
operation.
Current Ratio = CA / CL
= 2,256 / 1,995 = 1.13 times
2) Quick ratio = (current assets-inventory/current liabilities)
This ratio is a more stringent measure of liquidity than the current
ratio. It excludes inventories and other current assets that are least
liquid from current assets. Higher ratio shows that the business has
enough quick assets or liquid assets to cover its short term debt
immediately.
Quick Ratio = (CA Inventory) / CL
= (2,256 301) / 1,995 = .98 times




9
3) Cash ratio = cash/current liabilities
= 696 / 1,995 = .35 times

4) Net working capital to total assets= net working
capital/ total assets.
NWC to Total Assets = NWC / TA
= (2,256 1,995) / 5,394 = .05

5) Interval measures=current asset/ average daily operating
cost
average daily operating cost = COGS/365 days

Interval Measure = CA / average daily operating costs
=2,256 / ((2,006 + 1,740)/365) = 219.8 days

10
2) ASSET MANAGEMENT/ ACTIVITY/
EFFICIENCY RATIOS
1) Average collection periods (ACP)= Accounts receivable/ (Annual
credit sales/365)
ACP = Accounts receivable/Daily sales
= 956/ (5000/365) = 70 days
Days Sales in Receivables = 365 / Receivables Turnover
= 365 / 5.23 = 70 days
The ratio measures how long a firm takes to collect its credit accounts.
The lower the figure is better.
2) Account receivable turnover = sales/accounts receivables
= 5,000 / 956 = 5.23 times
This ratio measures how often accounts receivables are rolled
over during a year. Higher ratio illustrates that the firm can collect
its debt more frequent and thus has few bad debts.



11
3) Inventory turnover = costs of good sold/inventory
It measures the number of times a firms inventories are sold and
replaced during the year. Higher ratio indicates that inventory can
be sold and replaced more frequently.
Inventory turnover = 2,006 / 301 = 6.66 times
4) Days dales in inventory= 365 days/inventory turnover
= 365 / 6.66 = 55 days
5) Fixed asset turnover = sales/net fixed assets
This ratio is an overall measure of asset efficiency based on the
relation between firms sales and the total assets. Higher ratio
indicates that firm is managing its assets more effectively.
Fixed Asset Turnover = 5,000 / 3,138 = 1.59 times
6) Total asset turnover = sales/total assets
Higher ratio is favored because it indicates the effectiveness of the
firm in generating sales from its total assets.
Total Asset Turnover = 5,000 / 5,394 = .93
7) NWC Turnover = sales/NWC
= 5,000 / (2,256 1,995) = 19.16 times


12
3)PROFITABILITY RATIOS
1) Gross profit margin= gross profit/ sales
The gross profit margin is a measure of the gross profit earned on
sales. The gross profit margin considers the firm's cost of goods sold,
but does not include other costs. Higher ratio is better.
Gross profit Margin = Gross profit / Sales
= 2994 / 5,000 = 59.88%
2) Net profit margin = Net income/sales
A higher profit margin indicates a more profitable company that has
better control over its costs compared to its competitors.
Profit Margin = Net Income / Sales
= 689 / 5,000 = 13.78%
3) Operating Profit Margin(OPM) = Operating profit/Sales
OPM examines how effective the company is in managing its cost of
goods sold and operating expenses that determine the operating profit.
Operating profit Margin = Operating profit / Sales
= 1254 / 5,000 = 25.08%





13
4) Return on assets (ROA) = Net income/total assets
This evaluates how effectively the company employs its
assets to generate a return. It measures efficiency.
Higher ratio is better.
Return on Assets (ROA) = Net Income / Total Assets
=689 / 5,394 = 12.77%

5) Return on equity (ROE) = Net income/ common equity
Return on equity is the bottom line measure for the shareholders,
measuring the profits earned for each dollar invested in the firm's
stock. Higher ratio is favored because the firm can generate better
return to the owner of the firm.
Return on Equity (ROE) = Net Income / Total Equity
= 689 / 2,556 = 26.96%

14
4)LEVERAGE RATIOS
1) Debt ratio = total debt/total assets
This ratio measures the extent to which a firm has been financed with debt.
More debt financing results in more financial risk.
Total Debt Ratio =2,838/ 5,394 = 52.61%
2) Times interest earned= EBIT/interest
The times interest earned ratio indicates how well the firm's earnings can
cover the interest payments on its debt. Higher ratio shows better ability in
meeting interest payment.
Times Interest Earned =1,138 / 7 = 162.57 times
3) Debt to equity ratio = total debt/total equity
This ratio indicates what proportion of equity and debt the company is using to
finance its assets. A high debt to equity ratio could indicate that the company
may be overleveraged, and should look for ways to reduce its debt.
Debt/Equity =2,838 / 2,556 = 1.11 times
4) Equity multiplier = total assets/total equity or = 1+ (total debt/total equity)
= 1 + 1.11 = 2.11
5) Cash coverage =(EBIT+depreciation) / interest= (1,138 + 116)/ 7=179.14 times

6) Long-term debt ratio = LTD / (LTD + TE) = 843 / (843 + 2,556) = 24.80%




5)MARKET VALUE RATIOS
1) Earning per share (EPS) = Net income/number of shares outstanding
It represents the portion of a firm's earnings that is allocated to each share of common
stock.
= 689 / 190.9 = $3.61
2) Price earning ratio (PE) = price per share/earnings per share
The ratio indicates how much investors are willing to pay per dollar of current earnings.
As such, high P/E Ratios are associated with growth stocks. The most common
measure of how expensive a stock is.
= 87.65 / 3.61 = 24.28 times
3) Price (market) to book ratio=price per share/book value per share
his ratio measures how much a company worth at present, in comparison with the
amount of capital invested by current and past shareholders into it.
= 87.65 / (2,556 / 190.9) = 6.55 times
4) Book value per share= Total equity/Number of shares outstanding
The ratio of stockholder equity to the number of common stocks. Book value per
share should not be thought of as an indicator of economic worth, since it reflects
accounting valuation (and not necessarily market valuation).
= 2,556 / 190.9 = $13.44
5) price/sales per share = price per share/ sales per share
where sales per share= sales / number of shares outstanding
= 87.65 / (5000/190.9) = 3.34 times




16
Deriving the Du Pont Identity
ROE = NI / TE
Multiply by 1 (TA/TA) and then rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE)
= ROA * EM
Multiply by 1 (Sales/Sales) again and then
rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM
Profit margin is a measure of the firms operating efficiency how well it controls costs
Total asset turnover is a measure of the firms asset use efficiency how well does it
manage its assets
Equity multiplier is a measure of the firms financial leverage


3-17
3.7 Dupont Analysis
18
STEP 1
STEP 2
STEP 3
Expanded Du Pont Analysis
Du Pont Data
3-19
Extended Du Pont Chart
Insert Figure 3.1 (Extended DuPont Chart)
3-20
21
Uses of Financial Ratios:
Within the Firm
Identify deficiencies in a firms performance and take
corrective action.
Evaluate employee performance and determine
incentive compensation.
Compare the financial performance of different
divisions within the firm.
Prepare, at both firm and division levels, financial
projections.
Understand the financial performance of the firms
competitors.
Evaluate the financial condition of a major supplier.

22
Uses of Financial Ratios:
Outside the Firm
Financial ratios are used by:
Lenders in deciding whether or not to make a loan to
a company.
Credit-rating agencies in determining a firms credit
worthiness.
Investors (shareholders and bondholders) in deciding
whether or not to invest in a company.
Major suppliers in deciding to whether or not to grant
credit terms to a company.
23
The Limitations of Financial
Ratio Analysis
It is sometimes difficult to identify industry categories
or comparable peers.
The published peer group or industry averages are
only approximations.
Industry averages may not provide a desirable target
ratio.
Accounting practices differ widely among firms.
A high or low ratio does not automatically lead to a
specific conclusion.
Seasons may bias the numbers in the financial
statements.
ADDITIONAL QUESTIONS
Question 1
Secular Electric has total equity of RM560,000; sales of RM2,250,000;
current assets of RM700,000; and total liabilities of RM435,000. What is
Secular Electrics total assets turnover?
Total assets turnover = sales/total assets = 2,250,000/total assets
Total assets = fixed assets + current assets
Total assets = total equity + total liabilities
= 560,000 + 435,000
Thus, total assets = 995,000
Find total assets turnover = 2,250,000/995,000 = 2.26x

Question 2
SRC has a debt ratio of 0.4, current liabilities of RM18,000, and total assets of
RM100,000. What is the level of SRCs total liabilities?
Debt ratio = total debt/total assets = 0.4
0.4 = total debt/100,000
total debt/liabilities = RM40,000



24
Question 3
XYZ Corporation has the following financial information for the previous year:

Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M
Compute the ROE using the DuPont Analysis.
Total assets = CA + FA = $2M + $6M = $8M
TAT = Sales / TA = $8M / $8M = 1
NWC = CA CL CL = CA NWC = $2M - $1M = $1M
Total liabs. = CL + LTD = $1M + $3M = $4M
Total equity = total assets total liabs. = $8M - $4M = $4M
EM = assets / equity = $8M / $4M = 2
ROE = PM X TAT X EM = 8% X 1 X 2 = 16%



3-25
26
Table 4-1
27
Table 4-2
1) LIQUIDITY RATIO
RATIO FORMULA DAVIES INC. PEER GROUP
1) Current ratio Current
assets/current
liabilities
$143m/$64m
=2.23
1.80
2) Quick ratio (current assets-
inventory/
current liabilities)
($143m-$84m)/$64m
=0.92
0.89
3) Cash Ratio Cash/current
liabilities
4) Net working
capital to
total assets
NWC/total assets
5)Interval
measure
Current
assets/average daily
operating cost
28
2)ASSET MANAGEMENT/
ACTIVITY/EFFICIENCY RATIOS
RATIO FORMULA DAVIES INC. PEER GROUP
1) Average collection
periods (ACP)

Accounts
receivable/(Annual
credit sales/365)
$36m/($600m/365)
= 21.90 days
25 days
2)Account receivable
turnover

sales/accounts
receivables
$600m/$36m
=16.67x
14.6x
3)Inventory turnover

costs of good
sold/inventory
$460m/$84m
=5.48x
7.00x
4)Fixed asset turnover

sales/net fixed assets $600m/$295m
=2.03x
1.75x
5)Total asset turnover

sales/total assets $600m/$438m
=1.37x
1.15x
6) Days sales in
inventory
365 days/inventory
turnover
7) NWC Sales/NWC
29
3)PROFITABILITY RATIOS
RATIO FORMULA DAVIES INC. PEER GROUP
1)Gross profit margin gross profit/sales $140m/$600m
=0.233=23.3%
25%
2)Net profit margin Net income/sales

$42m/$600m
=0.07=7%
6.5%
3)Operating Profit
Margin(OPM)
Operating profit/Sales $75m/$600m
=0.125=12.5%
15.5%
4)Return on assets
(ROA)
Net income/total assets

$42m/$438m
=0.096=9.6%
10%
5)Return on equity
(ROE)
Net income/ common
equity
$42m/$203m
=0.207=20.7%
18%
30
4)LEVERAGE RATIOS
31
RATIO FORMULA DAVIES INC. PEER GROUP
1)Debt ratio total debt/total assets $235m/
$438m
=0.537=
53.7%
35%
2)Times interest
earned
EBIT/interest $75m/$15m
=5.0x
7.0x
3)Debt to equity ratio total debt/total equity $235m/
$203m
=1.16x
2.05x
4) Equity multiplier Total assets/total equity
5) Cash coverage (EBIT+depreciation)
/interest
5)MARKET VALUE RATIOS
RATIO FORMULA DAVIES INC. PEER GROUP
1)Earning per share
(EPS)
Net income/number of
shares outstanding
$42m/20m=$2.10 $1.89
2) Price earning ratio
(PE)
price per
share/earnings per
share

(assume the market
price for Davies stock
was $32 per share)
$32/$2.10=15.24x 19.0x
3)Price (market) to
book ratio
price per share/book
value per share
$32/$10.15=3.15x 3.7x
4)Book value per share Total equity/Number of
shares outstanding

$203m/20m
=$10.15
$11.05
32