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3Working With Financial Statements

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1. Know how to standardize financial statements for comparison purposes

2. Know how to compute and interpret important financial ratios

3. Be able to compute and interpret the DuPont Identity

4. Understand the problems and pitfalls in financial statement analysis

Key Concepts and Skills

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Sample Income Statement

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

Numbers in millions, except EPS & DPS

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Sample common size Income Statement

Revenues 5,000 100%

Cost of Goods Sold (2,006) (40.1)

Expenses (1,740) (34.8)

Depreciation (116) (2.3)

EBIT 1,138 22.8

Interest Expense (7) (0.1)

Taxable Income 1,131 22.6

Taxes (442) (8.8)

Net Income 689 13.8

EPS 3.61

Dividends per share 1.08

Numbers in millions, except EPS & DPS

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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

Standardized Financial Statements

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Common base year Income Statement

2005 2006 2007 2008

Revenues 5000 6000 6500 7000Cost of Goods 2006 2230 2400 2700

EBIT1138 1300 1400 1450

Net Income689 730 751 770

2005 2006 2007 2008

Revenues 100% 120% 130% 140%Cost of Goods 100% 111% 119% 135%

EBIT100% 114% 123% 127%

Net Income100% 106% 109% 112%

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Combined common size and base year Balance Sheet

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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 that information is important

Ratios are used both internally and externally

Ratio Analysis

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Short-term solvency or liquidity ratios Long-term solvency or financial leverage

ratios Asset management or turnover ratios Profitability ratios Market value ratios

Categories of Financial Ratios

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Sample Income Statement

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

Numbers in millions, except EPS & DPS

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Sample Balance Sheet

2007 2006 2007 2006

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

Numbers in millions

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Current Ratio = CA / CL◦ 2,256 / 1,995 = 1.13 times

Quick Ratio = (CA – Inventory) / CL◦ (2,256 – 301) / 1,995 = .98 times

Cash Ratio = Cash / CL◦ 696 / 1,995 = .35 times

NWC to Total Assets = NWC / A◦ (2,256 – 1,995) / 5,394 = .05

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

Liquidity Ratios for 2007

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Total Debt Ratio = (A –E) / A◦ (5,394 – 2,556) / 5,394 = 52.61%

Debt/Equity = D / E◦ (5,394 – 2,556) / 2,556 = 1.11 times

Equity Multiplier = A / E = 1 + D/E◦ 1 + 1.11 = 2.11

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

Computing Long-term Solvency Ratios

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Times Interest Earned = EBIT / Interest◦ 1,138 / 7 = 162.57 times

Cash Coverage = (EBIT + Depreciation) / Interest◦ (1,138 + 116) / 7 = 179.14 times

Computing Coverage Ratios

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Inventory Turnover = Cost of Goods Sold / Inventory◦ 2,006 / 301 = 6.66 times

Days’ Sales in Inventory = 365 / Inventory Turnover◦ 365 / 6.66 = 55 days

Computing Inventory Ratios

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Receivables Turnover = Sales / Accounts Receivable◦ 5,000 / 956 = 5.23 times

Days’ Sales in Receivables = 365 / Receivables Turnover◦ 365 / 5.23 = 70 days

Computing Receivables Ratios

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Total Asset Turnover = Sales / Total Assets◦ 5,000 / 5,394 = .93◦ It is not unusual for TAT < 1, especially if a firm

has a large amount of fixed assets NWC Turnover = Sales / NWC

◦ 5,000 / (2,256 – 1,995) = 19.16 times Fixed Asset Turnover = Sales / NFA

◦ 5,000 / 3,138 = 1.59 times

Computing Total Asset Turnover

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Profit Margin = Net Income / Sales◦ 689 / 5,000 = 13.78%

Return on Assets (ROA) = Net Income / Total Assets◦ 689 / 5,394 = 12.77%

Return on Equity (ROE) = Net Income / Total Equity◦ 689 / 2,556 = 26.96%

Computing Profitability Measures

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Market Price = $87.65 per share Shares outstanding = 190.9 million PE Ratio = Price per share / Earnings per

share◦ 87.65 / 3.61 = 24.28 times

Market-to-book ratio = market value per share / book value per share◦ 87.65 / (2,556 / 190.9) = 6.55 times

Computing Market Value Measures

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ROE = NI / E Multiply by 1 (A/A) and then rearrange

◦ ROE = (NI / E) (A / A)◦ ROE = (NI / A) (A / E) = ROA * EM

Multiply by 1 (Sales/Sales) again and then rearrange◦ ROE = (NI / A) (A / E) (Sales / Sales)◦ ROE = (NI / Sales) (Sales / A) (A / E)◦ ROE = PM * TAT * EM

Deriving the DuPont Identity

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ROE = PM * TAT * EM◦ Profit margin is a measure of the firm’s operating

efficiency – how well it controls 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

Using the DuPont Identity

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Bal. Sheet (1/28/06) Data (millions, $U.S.)◦ Cash = 225.27◦ Inventory = 91.91◦ Other CA = 22.16◦ Fixed Assets = 164.62

Computations◦ TA = 503.96◦ TAT = 2.39◦ EM = 1.77

2006 Inc. Statement Data (millions, $U.S.)◦ Sales = 1,204.35◦ COGS = 841.87◦ SG&A = 227.04◦ Interest = (3.67)◦ Taxes = 55.15

Computations◦ NI = 83.96◦ PM = 6.97%◦ ROA = 16.66%◦ ROE = 29.49%

Expanded DuPont Analysis – Aeropostale Data

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Aeropostale Extended DuPont Chart

x

x

++

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A firm has an equity multiplier of 1.90, an asset turnover of 1.2 and a profit margin of 8%. What is the firm’s ROA, and ROE.

Example : Du-Pont Identity

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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

Real World Example – Home Depot

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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%

Real World Example – Home Depot

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Internal uses

External uses

Why Evaluate Financial Statements?

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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

Benchmarking

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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

Potential Problems

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The Story of Enron

Enron - a natural gas, natural gas liquids, electricity, exploration and production, operator of power plants and natural gas pipelines.

Enron stock price fell from $75 to nothing due to bankruptcy. One aspect of their collapse was the way they managed to keep debt off their balance sheet and hid commitments to honor the debt. Without full disclosure, no one knew the true situation.

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Off balance sheet practice is more common than you think

Make companies and managers look good because return on capital looks better.

Investors and regulators do not freak out when debt balloons.

Spreads confusion These off balance sheet debt obligations are

typically triggered (parent requited to pay debt) if stock falls bellow a certain level or its debt is downgraded.

That is why the SEC is taking care of these issues.

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How do you standardize balance sheets and income statements and why is standardization useful?

What are the major categories of ratios and what are they good for?

What are some of the problems associated with financial statement analysis?

Quick Quiz

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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.

Comprehensive Problem

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Working Capital A Simple Cycle of Operations:

CASHCASH

RAW MATERIALS INVENTORY

FINISHED GOODS INVENTORY

RECEIVABLESRECEIVABLES

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Assume: AVG. Inventory – 352.5; AVG AR=285; AVG AP=235; COGS=480; Sales (all on credit) = 710 – calculate cash cycle:

Calculating the cash cycle