Working WithFinancial Statements

Chapter 3

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Topics1. How To Standardize Financial

Statements For Comparison Purposes

2. How To Compute And Interpret Some Common Ratios

3. The Determinants Of A Firm’s Profitability And Growth

4. Some Problems And Pitfalls In Financial Statement Analysis

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Financial Statements:

Financial statements convey information from within the firm controlled by managers to outside the firm (owners, investors, bankers, suppliers, customers, other constituents)

Internal managers also use the information internally to guide the firm to a profitable future

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Financial Statements:1. Financial managers would like to have

market value information, but often times this is not possible so financial managers rely on financial statements

2. “Accounting numbers are just pale reflections of economic reality, but they frequently are the best available information”

3. So, let’s learn how to use and interpret financial statements:1. Common sized statements2. Ratio analysis

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Standardized Financial Statements:Common-Size Balance SheetCommon-Size Income StatementStandardized statements make it easier to

compare financial information:As the company grows, comparing one year to

the nextFor comparing different companies of different

sizes, particularly within the same industryFor comparing companies when the statements

are in different currencies

Standardized statements use % instead of dollars

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Balance Sheet RAD Corp

Balance SheetAs of 12/31/2005

Cash 6,489 A/P 340,220A/R 1,052,606 N/P 86,631Inventory 295,255 Other CL 1,098,602Other CA 199,375 Total CL 1,525,453Total CA 1,553,725 LT Debt 871,851Net FA 2,535,072 Total Liability 2,397,304

C/S 1,691,493Total Assets 4,088,797 Total Liab. & Equity 4,088,797Common-

Size Balance SheetCompute allaccounts as apercent oftotal assets

RAD CorpBalance SheetAs of 12/31/2005

Cash A/PA/R N/PInventory Other CLOther CA Total CLTotal CA LT DebtNet FA Total Liability

C/STotal Assets Total Liab. & Equity

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IncomeStatement

Common-Size Income StatementCompute all line items as a percent of sales

RAD CorpIncome Statement

For The Year Ended 12/31/2005Revenues 3,991,997Cost of Goods Sold 1,738,125Expenses 1,269,479Depreciation 308,355EBIT 676,038Interest Expense 42,013Taxable Income 634,025Taxes 272,210Net Income 361,815

EPS $2.17Dividends per share $0.86

RAD CorpIncome Statement

For The Year Ended 12/31/2005RevenuesCost of Goods SoldExpensesDepreciationEBITInterest ExpenseTaxable IncomeTaxesNet Income

EPS $2.17Dividends per share $0.86

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Standardized:RAD Corp

Balance SheetAs of 12/31/2005

Cash 0.16% A/P 8.32%A/R 25.74% N/P 2.12%Inventory 7.22% Other CL 26.87%Other CA 4.88% Total CL 37.31%Total CA 38.00% LT Debt 21.32%Net FA 62.00% Total Liability 58.63%

C/S 41.37%Total Assets 100.00% Total Liab. & Equity 100.00%

RAD CorpIncome Statement

For The Year Ended 12/31/2005Revenues 100.00%Cost of Goods Sold 43.54%Expenses 31.80%Depreciation 7.72%EBIT 16.93%Interest Expense 1.05%Taxable Income 15.88%Taxes 6.82%Net Income 9.06%

EPS $2.17Dividends per share $0.86

Krispy Kream

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How To Compute And Interpret Some Common Ratios

Liquidity, or short-term solvency ratios Current ratio Quick ratio Cash ratio

Leverage, or long-term solvency ratios Total debt ratio Debt/equity ratio Equity multiplier Times interest earned

ratio Cash coverage ratio

Asset turnover, or utilization ratios Inventory Turnover Days’ sales in

inventory Receivables turnover Days’ sales in

receivables Total asset turnover Capital intensity

Profitability ratios Profit margin Return on assets Return on equity Du Pont Identity

Market value ratios Price-earnings ratio Market-to-book ratio

Ratio Analysis Ratios also allow for better

comparison through time or between companies

Ratios are used both internally and externally

Ratios are computed differently by different people The ones we see in this book are only

one of many possible ways to compute them!

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Hints About Financial Ratios1. In calculating any ratio, we mean

the ratio of one thing to something else When we write the ratio as a fraction,

we put the of part in the numerator and the to part in the denominator

Example: Current ratio: find the ratio of current

assets to current liabilities (Current Assets)/(Current Liabilities) =

$45,000/$30,000 = 1.5

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Hints About Financial Ratios If you keep the unit of measure (dollars)

in both the numerator and denominator, the answer will hint at what the ratio means

(Current Assets)/(Current Liabilities) = $45,000/$30,000 = $1.50/$1.00

In this case the ratio indicates that for every $1.00 of current liabilities, there is $1.50 worth of current assets to use to pay off the current liabilities

In general, this trick can be used with all ratios

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Financial Ratios: Who uses them? Why we might be interested?

Stock analysts Should I buy/sell this stock?

Auditors Are the financial statements free from material

misstatement? Internal Managers

How is the firm doing? Investors

Should I sell/buy this stock? Banks

Will the borrower be able to pay back the loan? Basically: almost everyone

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Questions To Ask When You Use Ratios:

How is it computed?! Not everyone agrees about how to calculate a

given ratio What is it intended to measure and why

might we be interested? What is the unit of measure? What might a high or low value be telling

us? How might such values be misleading?

Accounting behind the numbers…? Does a low CA/CL mean trouble for a large

firm? How could the measure be improved?

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Liquidity, Or Short-term Solvency Ratios Current ratio Quick ratio Cash ratio

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Current Ratio Current Ratio = CA/CL Measure of short term liquidity $2/$1 = $2 CA for every $1 of CL1. If you were to sell all CA and pay off all CL, you

would have $2 for every $1 of CL2. Above 1, in general is good3. Less than 1, in general is not so good4. High could mean firm saving up cash to make

acquisition, or it could mean that they do not see profitable fixed assets to purchase

5. Low could mean that they may have a hard time paying short-term debt

6. CA/CL is used in debt contracts as indicator of short term liquidity

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Current Ratio5. If you incur long-term debt, CA/CL,

(CA/CL) 6. If you pay off short-term creditors: 5/2 =

2.5 (5-1)/(2-1) = 4/1 = 4 Firms may do these things before the report

there numbers at the end of the period

7. An apparent low CA/CL may not be bad for a company with a large reserve of untapped borrowing power

8. Firm buys inventory with $, CA/CL stays same

9. Firm sells inventory for more than they have it on the books for, (CA/CL)

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Quick Ratio (Acid Test) Quick Ratio = (CA-INV)/CL = (Quick Assets)/CL1. Measure of immediate short-term liquidity2. Why take out inventory?

Inventory may not be at market value May be hard to sell May be obsolete

3. Using cash to buy inventory reduces the Quick Ratio

4. People who are interested in whether firm can pay bills or purchase assets in the short term may use this ratio:

Creditors, internal managers, investors

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Cash Ratio Cash Ratio = Cash/CL Do we even need to define this?

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Liquidity, Or Short-term Solvency Ratios Current Ratio = CA/CL Quick Ratio = (CA-INV)/CL Cash Ratio = Cash/CL

What does it mean when these ratios are greater than 1?

What does it mean when these ratios are less than 1?

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Leverage, Or Long-term Solvency Ratios Total debt ratio Debt/equity ratio Equity multiplier Times interest earned ratio Cash coverage ratio

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Leverage, Or Long-term Solvency Ratios Capital Structure = Relationship

Between Debt & Equity A = L + E 10 = 2 + 8

Solvency = “the position of having enough money to cover expenses and debts”

Banks, Investors look at these ratios

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VariablesEquity = TE = ELiability = Debt = TL = DAssets = TA = A

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Leverage (Capital Structure) Total Debt Ratio

Total Debt Ratio = TL/TA = (TA–TE)/TA Amount of debt for every $1 of assets

How much of every $1 of assets is financed with debt

Debt/Equity Ratio Debt/Equity Ratio = TL/TE = D/E Amount of debt for every $1 of equity

Equity Multiplier Equity Multiplier = Leverage = TA/TE =

(1+D/E) For every $1 of equity how many dollars of

assets are there Shows us the amount of leverage

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TL/TA, TL/TE, TA/TE:From one, you can find the others

TL/TA TL/TE TA/TESame Capital Structure 0.20 = 2/10 then ==> 2/(10-2) = 2/8 = 0.25 then ==> 10/8 = 1.25

Same Capital Structure 0.25 = 2.5/10 then ==> 2.5/(10-2.5) = 2.5/7.5 = 0.33 then ==> 10/7.5 = 1.333

Same Capital Structure 0.50 = 5/10 then ==> 5/(10-5) = 5/5 = 1 then ==> 20/10 = 2

Same Capital Structure 0.80 = 8/10 then ==> 8/(10-8) = 8/2 = 4 then ==> 10/2 = 5

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Times Interest Earned Ratio Times Interest Earned Ratio

=EBIT/Interest How many times over interest can

be paid Who might be interested in this

ratio?

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Cash Coverage Ratio Cash Coverage Ratio = (EBIT+Depr.)/Interest

=EBDIT/Interest One possible measure of cash flow to meet

financial obligations If the company has a great deal of non-cash

deprecation expense, then it makes sense to use this one

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Asset Turnover, Or Utilization Ratios Inventory Turnover Days’ sales in inventory Receivables turnover Days’ sales in receivables Total asset turnover Capital intensity

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Inventory Turnover Inventory Turnover =COGS/Inv.

Alternative = COGS/((Beg.Inv.+EndInv.)/2)

1. How many times we run inventory down to zero and then immediately restock

2. How many times did we buy and sell our inventory during the year

3. As long as we are not running out of stock and foregoing sales, the higher the ratio, the more efficient we are at managing inventory

4. Example: COGS/Inv.=5,000/1,000 = 5

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Days’ Sales In Inventory Days’ Sales In Inventory = 365/Inv. Turn1. How long inventory sits before it is sold2. Example:

If Inv. Turn = 5 Days’ Sales In Inventory = 365days/5 =

73 days

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Receivables Turnover Receivables Turnover = Sales/AR

Alternative = (Credit_Sales)/((Beg.AR+EndAR)/2)

How fast we collect our receivable # of times we collect and reloan the $ per

year Example: 10,000/1,000 = 10

Days’ Sales In Receivables = 365/(Days’ Sales In Receivables) Average time it takes to collect the AR Example: 365days/10 = 36.5 days

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Payables Turnover Payables Turnover = COGS/AP1. Example:

COGS/AP = 5,600/800 = 7 365 days/7 52 days to pay bill

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What does this tell us?

Operating cycle = days inventory sits + days to collect after selling

Cash cycle = operating cycle – payables period

COGS $5,000.00 Sales $10,000.00 COGS $5,600.00INV. $1,000.00 AR $1,000.00 AP $800.00COGS/INV. 5 Sales/AR 10 COGS/AP 7

365 365 365Days to sell 73 Days to collect 36.5 Days to pay 52.1428571

Operating Cycle = Days to sell + Days to collect = = 73 + 36.5 + 109.5Cash Cycle = Operating Cycle - Payables Period = 109.5 - Days to pay = 57.3571428571429

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Asset Turnover Total Asset Turnover = Sales/TA

Alternative = (Total_Operating_Revenue)/((Beg.TA+EndTA)/2)

1. How many sales do we generate from $1 of assets2. The higher, the better, or the more efficient3. Sales/TA, more efficient use of assets!4. If a firm has newer assets that have not been

depreciated, book value for assets may be high and may temporarily lower the ratio

5. Measure of asset use efficiency6. Not unusual for TAT < 1, especially if a firm has a

large amount of fixed assets Capital Intensity = TA/Sales

1. For every $1 of sales how many $ of assets did it take to generate that $1

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Profitability Ratio Profit margin Return on assets Return on equity Du Pont Identity

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Profit Margin Profit Margin = NI/Sales

1. For every $1 of sales, what is the profit?

2. Example: $60/$400 = .153. High PM corresponds to low expense

ratios relative to sales4. High PM:

1. Internal managers could be managing cost efficiently

2. Product/service could be superior to others and could thus demand a high price

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Return On Assets Return On Assets = NI/TA = ROA

1. Profit per $1 of asset

1. ROA = NI/Sales*Sales/TA2. ROA = Profit Margin*Asset Turnover

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Return On Equity Return On Equity = ROE = NI/Equity

1.Return to shareholders2.What is the profit per $1 of equity?

The key: When there is no debt, ROE = ROA When there is debt this should happen: ROE > ROA Why? Because the assets must earn a return for both

the creditors and owners The more debt there is, the higher (ROE – ROA) must

be!

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Return On Equity ROE = NI/Equity ROE = NI/Equity x TA/TA ROE = NI/TA x TA/Equity Since

ROA = NI/TA Equity/TA = Equity Multiplier = (1+D/E)

ROE = ROA x Equity Multiplier ROE = ROA x (1+D/E)

ROE = ROA + (ROA – Rd)*D/E (chapter 13)

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ROE If ROE goes up or down, what

causes this?

The financial managers at DuPont Copr. Came up with a metric that helps analyze a few of the reasons that may cause ROE to change: Profit margin Efficient use of assets (Asset Turnover) Leverage (Equity Multiplier)

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ROE = NI/Equity =

NI/Equity x Sales/Sales x TA/TA =

(NI x Sales x TA)/(Equity x Sales x TA) =

NI/Sales x Sales/TA x TA/EquityNI/Sales x Sales/TA x TA/EquityNI/Sales x Sales/TA x TA/Equity

Du Pont Identity Decomposing Into Component Parts

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Analyze With The Du Pont Identity

ROE = Profitability x Efficiency x LeverageROE = Operating efficiency Asset Efficiency Financial leverageROE = Profit Margin x Asset Turnover x Equity MultiplierNI/Equity = NI/Sales x Sales/Assets x Assets/Equity

ROE =

Profits generated from $1 of sales, are expenses being kept low? x

Sales generated by $1 of assets, efficient utilization of assets? x

For every $1 of owner investment, how many $ of assets were purchased?

ROE = NI/Assets x Assets/EquityROE = ROA x Equity MultiplierROE = ROA x (1 + D/E)ROE = ROA x (1/(1-D/TA))

"Leverage up" ROE by increasing the amount of debt

ROA

ROE

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Du Pont Analysis:Why did the firm’s ROE go down?

1998 ROE = NI/Equity = $205,000/$1,090,000 = 18.81%

1999 ROE = NI/Equity = $180,000/$1,468,000 = 12.26%

ROE = Profitability x Efficiency x LeverageROE = Profit Margin x Asset Turnover x Equity MultiplierNI/Equity = NI/Sales x Sales/Assets x Assets/Equity1998 ROE =18.81% = $205,000/$6,600,000 x $6,600,000/$2,191,000 x $2,191,000/$1,090,000

18.81% = 3.11% x 3.01 x 2.01

1999 ROE =12.26% = $180,000/$5,700,000 x $5,700,000/$2,278,000 x $2,278,000/$1,468,00012.26% = 3.16% x 2.50 x 1.55

ROE went down, not because of a decrease in profitability of sales, but:Assets are used less efficiently to generate sales!Firm is less effective at leveraging stockholders' investment in the firm.In 1998 the financial managers were able to turn each $1 of invested funds into $2.01 of assets.In 1999 the financial managers only managed to turn $1 of equity into $1.55 of assets.

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Market Value Ratios (For publicly traded companies)

Price-Earnings Ratio = (Market Price per Share)/EPS) Note: EPS = NI/(# Shares Outstanding) $ paid for $1 of earnings “Surrogate for growth”

Market-To-Book Ratio Note: Book Value per Share = TE/(# Shares

Outstanding) (Market Value per Share)/(Book Value per Share) >1, stock market believes that firm is worth more

than the book value of equity <1, stock market believes that firm is worth less

than the book value of equity

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The Determinants Of A Firm’s Profitability And Growth Payout and Retention Ratios The Internal Growth Rate The Sustainable Growth Rate Determinants of Growth

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Firm Growth In the long run if firm wants to increase

Net Income, they must increase Sales, which in turn means they must buy more Assets

Assets cost $ The $ come from E, D, or Retained

Earnings Remember: Net Income gets divided up:

Paid out as dividends Dividends/NI = Dividend payout rate = DPR

Kept as retained earnings (Retained earnings)/NI = plowback rate = b

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The Internal Growth Rate The internal growth rate tells us how

much the firm can grow assets using retained earnings as the only source of financing They won’t go issue new equity or debt

D/A will go down over time Firm gets funds to buy assets from

retained earnings

ROA*bInternal Growth Rate

1 - ROA*b

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The Sustainable Growth Rate The sustainable growth rate tells us

how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio (issues no new equity) Firm gets funds to buy assets from

retained earnings and debt

ROE*bSustainable Growth Rate

1-ROE*b

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Table 3.6

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Example:

ROA = $377/$3,760 =

ROE = $377/$2,677 =

DPR = $94/$377 =

b = $283/$377 =

SUM =

Internal Growth Rate = ROA*b/(1-ROA*b) =

Sustainable Growth Rate = ROE*b/(1-ROE*b) =

2002 2003

AssetsCurrent assets

Cash $127 $141Accounts receivable 208 231Inventory 436 465

Total current assets $771 $837Fixed assets

Net plant and equipment 2774 2923Total assets $3,545 $3,760

Liabilities and Owners' EquityCurrent liabilities

Accounts payable 355 387Notes payable 274 239

Total current liabilities $629 $626Long-term debt 531 457

Total liabilities $1,160 $1,083Owners' equity

Common stock and paid-in surplus 543 593Retained earnings 1842 2084

Total owners' equity $2,385 $2,677Total liabilities and owners' equity $3,545 $3,760

Sales $2,354COGS 1387Depreciation $276EBIT $691Interest Paid $120Taxable income $571Taxes (34%) $194Net Income $377

Dividends $94Addition to RE $283

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Determinantsof Growth ROE = NI/Sales*Sales/Assets*Assets/Equity Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to

shareholders versus reinvesting in the firm You could also sell more shares

Note, our formula is ok if we use Ending Equity, but, if you use Beginning Equity, then the formula is ROE*b

ROE b

1-ROE b

ROE Numerator up

Denominator down

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The Sustainable Growth Rate

NI Add to RE Add to RE*

Equity NI Equity =

NI Add to RE Add to RE1- * 1-

Equity NI Equity

Add to REAdd to REEquity

Equity -Add to RE Equity -Add to REEquity

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Increase The Sustainable Growth Rate: The Firm Must Increase Profit Margin, Increase Asset Efficiency, Increase Leverage, Retain Earnings Or Issue New Equity

NI Sales Assets* * *b

Sales Assets Equity

NI Debt1- * 1+ *b

Assets Equity

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Using Financial Statement Information Why Evaluate Financial Statements?

The primary reason that we look at accounting information is that we don’t usually have market information

Internal: To make improvements To make projections for the future

External: Financial statements convey information from

inside the firm to the outside: Creditors, Investors, Competitors, Suppliers

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Choosing a Benchmark Time trend:

Over time, have things changed? Management by exception:

Directing attention to deviations

Peer group: Firms that compete in the same markets Have similar assets Operate in similar ways

Standard Industrial Classification code = SIC page 69

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Problems with Financial Statement Analysis It’s accounting!

Not market value Some conglomerates do not have parallel

peers or industries International and National firms may use

different standards and procedures than others Making financial statements difficult to

compare Analysts often calculate ratios in different

manners