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Chapter3

McGraw-Hill/Irwin Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Working With Financial

Statements

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3-2

Chapter Outline

Cash Flow and Financial Statements: ACloser Look

Standardized Financial Statements Ratio Analysis

The DuPont Identity

Using Financial Statement Information

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3-3

Sample Balance Sheet

2002200320022003

5,394

2,556

843

1,995

1,662

26

307

5,394

3,138

2,256

303

301

956

696

5,033Total Liab.& Equity

5,033TotalAssets

2,167C/S3,358Net FA

1,091LT Debt1,675Total CA

1,775Total CL264Other CA

1,353Other CL361Inventory

119N/P992A/R

303A/P58Cash

Numbers in millions

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3-4

Sample Income Statement

3.61EPS

2,006Cost of Goods Sold

116Depreciation

1.08Dividends per share

689Net Income

442Taxes

1,131Taxable Income

7Interest Expense

1,138EBIT

1,740Expenses

5,000RevenuesNumbers in millions, except EPS & DPS

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3-5

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

Cash and other current assets

Decrease in liability or equity account

Notes payable and long-term debt

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Statement of Cash Flows

Statement that summarizes the sourcesand uses of cash

Changes divided into three majorcategories Operating Activity includes net income and

changes in most current accounts

Investment Activity includes changes in fixedassets

Financing Activity includes changes in notespayable, long-term debt and equity accounts as well

as dividends

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Sample Statement of CashFlows

696

638

-641

-206

-94

-248

-93

Cash End of Year

Net Increase in Cash

Net Cash from Financing

Dividends Paid

Decrease in C/S (minus RE)

Decrease in LT Debt

Decrease in Notes Payable

Financing Activity

104Net Cash from Investments

104Sale of Fixed Assets

Investment Activity

1,175Net Cash from Operations

-39Less: Increase in CA

309Increase in Other CL

4Increase in A/P

60Decrease in Inventory

36Decrease in A/R

116Plus: Depreciation

689Net Income

Operating Activity

58Cash, beginning of year

Numbers in millions

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Standardized FinancialStatements

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 tocompare financial information, particularly as thecompany grows

They are also useful for comparing companies ofdifferent sizes, particularly within the same

industry

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Ratio Analysis

Ratios also allow for better comparisonthrough time or between companies

As we look at each ratio, ask yourself whatthe ratio is trying to measure and why isthat information is important

Ratios are used both internally andexternally

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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

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Computing Liquidity Ratios

Current Ratio = CA / CL 2256 / 1995 = 1.13 times

Quick Ratio = (CA Inventory) / CL

(2256 1995) / 1995 = .1308 times Cash Ratio = Cash / CL

696 / 1995 = .35 times

NWC to Total Assets = NWC / TA

(2256 1995) / 5394 = .05 Interval Measure = CA / average daily operating

costs 2256 / ((2006 + 1740)/365) = 219.8 days

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Computing Long-term SolvencyRatios

Total Debt Ratio = (TA TE) / TA

(5394 2556) / 5394 = 52.61%

Debt/Equity = TD / TE (5394 2556) / 2556 = 1.11 times

Equity Multiplier = TA / TE = 1 + D/E

1 + 1.11 = 2.11

Long-term debt ratio = LTD / (LTD + TE)

843 / (843 + 2556) = 24.80%

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Computing Coverage Ratios

Times Interest Earned = EBIT / Interest

1138 / 7 = 162.57 times

Cash Coverage = (EBIT + Depreciation) /Interest

(1138 + 116) / 7 = 179.14 times

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Computing Inventory Ratios

Inventory Turnover = Cost of Goods Sold /Inventory

2006 / 301 = 6.66 times Days Sales in Inventory = 365 / Inventory

Turnover

365 / 6.66 = 55 days

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Computing Receivables Ratios

Receivables Turnover = Sales / AccountsReceivable

5000 / 956 = 5.23 times Days Sales in Receivables = 365 /

Receivables Turnover

365 / 5.23 = 70 days

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Computing Total Asset Turnover

Total Asset Turnover = Sales / TotalAssets

5000 / 5394 = .93 It is not unusual for TAT < 1, especially if afirm has a large amount of fixed assets

NWC Turnover = Sales / NWC

5000 / (2256 1995) = 19.16 times Fixed Asset Turnover = Sales / NFA

5000 / 3138 = 1.59 times

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Computing ProfitabilityMeasures

Profit Margin = Net Income / Sales

689 / 5000 = 13.78%

Return on Assets (ROA) = Net Income /Total Assets

689 / 5394 = 12.77%

Return on Equity (ROE) = Net Income /Total Equity

689 / 2556 = 26.96%

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Computing Market ValueMeasures

Market Price = $87.65 per share

Shares outstanding = 190.9 million

PE Ratio = Price per share / Earnings pershare

87.65 / 3.61 = 24.28 times

Market-to-book ratio = market value pershare / book value per share

87.65 / (2556 / 190.9) = 6.56 times

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The DuPont Identity (1)

The DuPont Identity = Relationship of ROI and ROE:

ROI: Return on Investment(sometimes called ROA-return on assets):Initially compares income as a percentage of total investment, abasic measure of profitability

ROI = Net Income

Total Assets

The DuPont model divides this into two factors: profit margin & assetturnover, illustrating both profitability of operations (profit margin) andefficient use of assets (turnover)

ROI = Net Income x Sales

Sales Total Assets

ROI = (Profit margin) x (Asset Turnover)

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The DuPont Identity (2)

Return on Equity = basic measure of profitability on assets actuallyprovided by owners of a firm:

Net Income

ROE = Owners Equity

The DuPont identity combines ROI & ROE into a three part analysis:

ROE = Net Income x Sales x Total Assets

Sales Total Assets Owners Equity

Or ROE = Return on Investment x Equity Multiplier

Or ROE = Profit Margin x Asset Turnover x Equity Multiplier

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The DuPont Identity (3)

Putting it all together gives the DuPont identity:

ROE = ROA x Equity multiplier

= Profit margin x Total asset turnover x Equity multiplier

Profitability (or the lack thereof!) thus has three parts:

Operating efficiency (profit margin)

Asset use efficiency (asset turnover)

Financial leverage (equity multiplier)

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The DuPont Identity (4)

The successful financial manager must be able tomake effective decisions influencing all threeelements:

To survive at all, the firm must be effective in its use ofrevenues to generate profits (operating efficiency--profitmargin)

To generate profitability, the firm must utilize its investment inassets wisely to convert revenues to profit (asset turnover-efficiency)

But if a firm can generate a return on assets greater than itsnet borrowing costs, it can return profits to investors moreeffectively by financial leverageusing borrowed money togenerate profits rather than tying up owners funds (equitymultiplier)

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Expanded DuPont Analysis Aeropostale Data

Balance Sheet Data Cash = 138,356

Inventory = 61,807

Other CA = 12,284 Fixed Assets = 94,601

EM = 1.654

Computations

TA = 307,048 TAT = 2.393

Income Statement Data Sales = 734,868

COGS = 505,152

SG&A = 141,520 Interest = (760)

Taxes = 34,702

Computations

NI = 54,254 PM = 7.383%

ROA = 17.668%

ROE = 29.223%

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Aeropostale Extended DuPontChart

ROE = 29.223%

ROA = 17.668% EM = 1.654

PM = 7.383% TAT = 2.393

NI = 54,254 Sales = 734,868 Sales = 734,868 TA = 307,048

Total Costs = - 680,614 Sales = 734,868

COGS = - 505,152 SG&A = - 141,520

Interest = - (760) Taxes = - 34,702

Fixed Assets = 94,601 Current Assets = 212,447

Cash = 138,356

Other CA = 12,284

Inventory = 61,807

x

x

++

Wh E l t Fi i l

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Why Evaluate FinancialStatements?

Internal uses Performance evaluation compensation and

comparison between divisions

Planning for the future guide in estimatingfuture 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 firms performance ischanging through time

Internal and external uses

Peer Group Analysis Compare to similar companies or within

industries

SIC and NAICS codes

http://www.naics.com/http://www.naics.com/

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Real World Example - I

Ratios are figured using financial data fromthe 2003 Annual Report for Home Depot

Compare the ratios to the industry ratios inTable 3.12 in the book

Home Depots fiscal year ends Feb. 1

Be sure to note how the ratios arecomputed in the table so that you cancompute comparable numbers.

Home Depot sales = $64,816 MM

http://ir.homedepot.com/annual.cfmhttp://ir.homedepot.com/annual.cfm

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Real World Example - II

Liquidity ratios Current ratio = 1.40x; Industry = 1.8x

Quick ratio = .45x; Industry = .5x Long-term solvency ratio Debt/Equity ratio (Debt / Worth) = .54x;

Industry = 2.2x.

Coverage ratio Times Interest Earned = 2282x; Industry =

3.2x

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Real World Example - III

Asset management ratios: Inventory turnover = 4.9x; Industry = 3.5x Receivables turnover = 59.1x (6 days); Industry =

24.5x (15 days) Total asset turnover = 1.9x; Industry = 2.3x Profitability ratios

Profit margin before taxes = 10.6%; Industry =

2.7% ROA (profit before taxes / total assets) = 19.9%;Industry = 4.9%

ROE = (profit before taxes / tangible net worth) =34.6%; Industry = 23.7%

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Potential Problems

There is no underlying theory, so there is no wayto know which ratios are most relevant

Benchmarking is difficult for diversified firms Globalization and international competitionmakes comparison more difficult because ofdifferences in accounting regulations

Varying accounting procedures, i.e. FIFO vs.LIFO

Different fiscal years

Extraordinary events

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Work the Web Example

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

Click on the web surfer to go towww.investor.reuters.com

Choose a company and enter its ticker symbol

Click on Ratios and then Financial Conditionand see what information is available

http://www.investor.reuters.com/

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Chapter3

M G Hill/I i C i ht 2006 b Th M G Hill C i I All i ht d

End of Chapter