Chapter III

Financial Statements and Long-term Financial Planning

Working with Financial Statements
1. Introduction
Prices to Earnings comparisons are financial ratios
There are a wide variety of financial ratios
Next it is discussed how to compute and financial ratios
And how to use financial ratios analysing corporate finance
2. Cash Flow A Closer Look
Every profit making firm do two things:

They generate cash, and

They Spend cash

(i) Cash is generated by selling:

Products,

Assets, or

Securities.
(ii) Cash is spent in paying for:
Materials and labour to produce a product,
Purchasing assets and
Payment to creditors and owners
We know that:
Cash flow from assets = Cash flow to creditors + Cash flow to owners
3. Sources of Cash and Uses of Cash
Firm earns cash either by selling assets or getting payments
Firm uses cash either by buying assets or making payments
3.1 Sources of Cash
Activities those bring cash are sources of cash
Sources of Cash are identified by:

Decrease in Account Receivable (getting back sales credit)

Decrease in Inventory (selling goods)

Decrease in Fixed Asset (selling machines, plant, etc)

Increase in Account Payable (getting suppliers credit)

Increase in Notes Payable (getting suppliers credit)

Increase in Long-term Liability

Increase in Equity

Increase in Common Stock & Paid in Surplus

Increase in Retained Earnings

3.2 Uses of Cash
Activities those involve in spending of cash are uses of cash
Sources of Cash are identified by:

Increase in Account Receivable (providing sales credit)

Increase in Inventory (producing goods)

Increase in Fixed Asset (buying machines, plant, etc)

Decrease in Account Payable (paying suppliers credit)

Decrease in Notes Payable (paying suppliers credit)

Decrease in Long-term Liability

1

Decrease in Equity
Decrease in Common Stock & Paid in Surplus
Decrease in Retained Earnings
Problem
Balance Sheet of PAUFROCK CORPORATION (in millions) is given below calculate
cash flows and cash uses.

Assets
1. Current Assets
1.1 Cash
1.2 Accounts Receivable
1.3 Inventory
Total Current Assets
2. Fixed Assets
2.1 Net Plant & Equipment
Total Assets (C. Assets + F. Assets)
Liabilities and Owners Equity
3 Current Liability
3.1 Accounts Payable
3.2 Notes Payable
Total Current liabilities
4. Long Term Debt (Liability)
Total Liability
5. Owners equity
5.1 Common Stock & paid in surplus
5.2 Retained Earnings
Total Owners equity
Total Liability & Owners Equity

2003

2004

Change

$84
$165
$393
$642

$98
$188
$422
$708

+ $14
+ $23
+ $29
+ $66

$273
1
$337
3

$2880

+ $149

$3.58
8

+ $215

$312
$231
$543
$531
$107
4

$344
$196
$540
$457
$997

+ $32
- $35
- $3
- $74
- $77

$500
$179
9
$229
9
$337
3

$550
$2041

+ $50
+ $242

$2591

+ $292

$3588

+ $215

Solution
We know that
Activities those involve in spending of cash are uses of cash
So, Uses of cash

Increase in Account Receivable (providing sales credit)

Increase in Inventory (producing goods)

Increase in Fixed Asset (buying machines, plant, etc)

Decrease in Notes Payable (paying suppliers credit)

Decrease in Long-term Liability

So, Uses of Cash
Categories
2003 2004 Change
Accounts Receivable
$165 $188
23
Inventory
$393 $422
29
Net Plant & Equipment
$273 $288
149
1
0
Notes Payable
$231 $196
35
2

Long Term Debt (Liability)

$531 $457
74
Total Uses of Cash
310
We know that
Activities those bring cash are sources of cash
So, Sources of Cash:

Increase in Account Payable (getting suppliers credit)

Increase in Common Stock & Paid in Surplus

Increase in Retained Earnings

Sources of Cash
Categories
2003 2004 Change
Accounts Payable
$312 $344
32
Common Stock & paid in $500 $550
50
surplus
Retained Earnings
$179 $204
242
9
1
Total Sources of Cash
324
Net addition to cash = Total Sources of Cash Total Uses of Cash
Net addition to cash = $324 $310 = $14
4. Standardization of Financial Statements
It is almost impossible to directly compare financial statements
To enable comparisons, the financial statements are standardized
Next we discuss:
How to compare financial statements of different companies
4.1 Standardized Balance Sheets
4.1.1 Common-Size Balance Sheets
It is almost impossible to directly compare balance sheet
One way to compare balance sheet is to:
Construct a common-size balance sheet
Common-size balance sheet is prepared by:
Expressing each item as a percentage of total assets
Problem
Prepare common-size balance sheets of Prufrock's for 2003 and 2004 to compare the
financial development of the firm.
Assets
1. Current Assets
1.1 Cash
1.2 Accounts Receivable
1.3 Inventory
Total Current Assets
2. Fixed Assets
2.1 Net Plant & Equipment
Total Assets (Current Assets + Fixed Assets)
3 Current Liability
3.1 Accounts Payable
3.2 Notes Payable
Total Current liabilities
3

2003

2004

$84
$165
$393
$642

$98
$188
$422
$708

$273
1
$337
3

$288
0
$358
8

$312
$231
$543

$344
$196
$540

4. Long Term Debt (Liability)

5. Owners equity
5.1 Common Stock & paid in surplus
5.2 Retained Earnings
Total Owners equity
Total Liability & Owners Equity (3 + 4 + 5)

$531

$457

$500
$179
9
$229
9
$337
3

$550
$204
1
$259
1
$358
8

Solution
We know that:

Common-size balance sheet is prepared by:

Expressing each item as a percentage of total assets
So:
Assets
1. Current Assets
1.1 Cash
1.2 Accounts Receivable
1.3 Inventory
Total Current Assets
2. Fixed Assets
2.1 Net Plant & Equipment
Total Assets (Current Assets + Fixed Assets )
3. Current Liability
3.1 Accounts Payable
3.2 Notes Payable
Total Current Liability
4. Long Term Debt (Liability)
5. Owners equity
5.1 Common Stock & paid in surplus
5.2 Retained Earnings
Total Owners equity
Total Liability & Owners Equity (3+4+5)

1998

1999

Change

2.5%
4.9%
11.7%
19.1%

2.7%
5.2%
11.8%
19.7%

+
+
+
+

80.9%
100%

80.3%
100%

- .6%
0.0%

9.2%
6.8%
16.0%
15.7%

9.6%
5.5%
15.1%
12.7%

+ .4%
- 1.3%
- .9%
- 3.0%

14.8%
53.3%
68.1%
100%

15.3%
56.9%
72.2%
100%

5 .5%
+ 3.6%
+ 4.1%
0.0%

.2%
.3%
.1%
.6%

The common-size balance sheet shows that:

2003 current assets of Prufrock were 19,1% of the total assets
In 2004 it increases to 19.7% of the total assets
It means a 0.6% increase of total assets
At the same time the current liabilities decline from 16.0% to 15.1%
It means an absolute decline of 0.9%
Total equity rose from 68.1% to 72.2%
Similarly, Retained Earnings from 53.3% to 56.9%
The common-size balance sheet shows that the financial condition has improved from
2003 to 2004.
4.1.2 Common-Base Year Balance Sheet - Trend Analysis

To investigate financial trends development Common-Base Year Balance

Sheet is used

As for instance, let we want to know trend in debt development

(Balance Sheets from last 10 years are known)
4

Common-base year Balance Sheet is prepared by expressing each item

relative to the base year amount

Problem
Balance Sheet of Prufrock's from 1999, 2002 and 2004 are given below. Show the
trend development of important items of Prufrock.
Asset (millions)
1. Current Assets
1.1 Cash
1.2 Accounts Receivable
1.3 Inventory
Total Current Assets
2. Fixed Assets
2.1 Net Plant & Equipment
Total Assets

2003

2004

$84
$165
$393
$642

$98
$188
$422
$708

$2731
$3373

$2880
$3.588

Solution
We know that:
Common-base year Balance Sheet is prepared by expressing each item relative to the
base amount
Asset (millions)
1. Current Assets
1.1 Cash
1.2 Accounts Receivable
1.3 Inventory
Total Current Assets
2. Fixed Assets
2.1 Net Plant &
Equipment
Total Assets

1999

2002

2004

Trend
(1999-02)

Trend
(2002-04)

116.65
113.94
107.38
110.28

147.62
121.21
127.23
116.82

105.46

111.68

106.37

117.11

$84
$165
$393
$642

$98
$188
$422
$708

$124
$200
$500
$750

$273
1
$337
3

$2880

$305
0
$395
0

$3.58
8

04.2 Standardization of Income Statement

4.2.1 Common-Size Income Statement
It is almost impossible to directly compare income statement
To enable comparisons, the income statements are standardized
Next we discuss:
How to compare income statements of different companies
One way to enable comparison of income statement is to:
Construct a common-size income statement
Common-size income statement is prepared by:
Expressing each item as a percentage of total sales
Problem
Prepare Common-Size Income Statements of PRUFROCK from 2003 and 2004 and
analyse its financial development from data given below:
Income Statement
Net sales
Cost of goods sold

2003
$2311
$1344

2004
$3220
2550
5

Depreciation
Interest paid
Taxes
Dividends: 1/3 rd of Net Earnings

$276
$141
$187
-

350
170
200
-

Solution
Solution
We know that:
Common-Size Income Statements is prepared by:
Expressing each item as a percentage of total sales
Income Stement
Net sales
- Cost of goods sold
- Depreciation
Earnings before interest and
taxes
- Interest paid
Taxable income
- Taxes
Net income
Dividends
Addition to retained earnings

2003
Mio $
%
$2311
100%
- $1344
58.2%
- $276
11.9%
$691
29.9%
- $141
$550
- $187
$363
$121
$242

6.1%
23.8%
8.1%
15.7%
5.2%
10.5%

2004
Mio $
%
$3230
100%
-$2150
66.45%
-$350
10.80%
$730
22.50%
-$170
$560
-$200
$360
$120
$240

5.25%
17.30%
6.18%
11.12%
3.71%
7.42%

The common-size income statement shows that:

From 2003 to 2004 the sales of Prufrock increased to 39.77%
Earnings before interest and taxes decreased from 29.9% to 22.50% of sales
Income decreased from 58.2% to 66.45% of sales
Taxable income of the firm decreased from 23.8% to 17.30% of sales
Net income of the firm decreased from 15.7% to 11.12% of sales
Dividends of the firm decreased from 5.2% to 3.71% of sales
Additional Retained Earnings of the firm decreased from 10.5% to 7.42% of sales
The common-size income statement shows that the financial condition has deteriorated
in all respect from 2003 to 2004.
4.2.2 Common-Base-Year Income Statements
Analysing trend development of different items Common-Base-Year Income Statement
is prepared
Next we discuss:
How to compute Common-Base-Year Income Statement
Common-base Year income statement is prepared by:
Expressing each item as a percentage of the base year
Problem
Prepare Common-base Year Income Statements of PRUFROCK from 1998 and 2000,
2002 and 2004 and analyse its financial trend development.
Income Statement
Net sales
Cost of goods sold
Depreciation
Interest paid

1998
$2300
$1100
$350
$150

2002
$3220
2550
350
150
6

2004
$4220
3550
350
150

Taxes
Dividends: 1/3 rd of Net Earnings

$100
-

300
-

400
-

Solution
We know that:
Common-base Year Income Statements is prepared by:
Expressing each item as a percentage of base year
Income Statement

1998
(Mio $)

2002
(Mio $)

Net sales
Cost of goods sold

$2300
-$1100
-$350
$850

$3200
$1550
-$350
$1300

-$150
$700
$100
$600
$200

-$150
$1150
$250
$900
$300

Depreciation
Earnings before Interest and
Tax
Interest paid
Earnings before Tax
Taxes
Net Income
Dividends: 1/3 rd of Net Earnings

Trend
(1998-04)
139.13%
140.91%
100%
152.94%
100%
164.28%
250%
150%
150%

2004
(Mio $)

$4300
$2250
-$350
$1700
-$150
$1550
$350
$1200
$400

Trend
(1998-04)
186.96%
204.54%
100%
200%
100%
221.43%
350%
200%
200%

Common-base Year Income Statements shows that:

From 1999 to 2002 the sales of Prufrock increased to 39.77%
Compare to 1999 in 2004 the sales of Prufrock increased to 86.96%
This shows that sales increased from 1999 to 2004 continuously
Cost of goods sold increased from 1999 to 2004 more quickly
Earnings before Interest and Tax also increased approximatelty at the same rate of cost
Earnings before Tax increased faster that the cost (from 164.5% to 221.4%)
Net income increased also faster (from 150% to 200%)
Common-base Year Income Statements shows that:
Though cost increased fast, EBIT, EBT, and Net Income also increased quickly
And the increase of EBIT, EBT, and Net Income must be indicated satisfactory
Common-base Year Income Statements shows that the financial condition has
improved in all respect from 1999 to 2004.