WORKING WITH

FINANCIAL STATEMENTS

CHAPTER 3

Key Concepts and Skills

Understand sources and uses of cash and the

Statement of Cash Flows

Know how to standardize financial statements for

comparison purposes
Know how to compute and interpret important

financial ratios
Be able to compute and interpret the Du Pont Identity
Understand the problems and pitfalls in financial statement

analysis

Chapter Outline
Cash Flow and Financial Statements: A Closer Look
Standardized Financial Statements
Ratio Analysis
The Du Pont Identity
Using Financial Statement Information

Introduction
Why do we use financial statements when financial

managers are concerned with market value?

What do numbers in the financial statements mean?

CFFA= CF to creditors+ CF to stockholders

Sources of cash: activities that generate cash
Uses of cash: activities in which the firm spend cash

Sample Balance Sheet

PRUFROCK COROPORATION
Balance Sheet 2009 & 2008
(in millions) $
CHANGE

2009

2008

CHANGE

LIABILITIES

ASSETS

Current liabilities

Current Assets

2009

2008

32+

344

312

AP

14+

98

84

cash

35-

196

231

Notes payable

23+

188

165

AR

3-

540

543

Total

29+

422

393

inventory

74-

457

531

Long-term debt

66+

708

642

Total

Owners equity
50+

550

500

Common stocks &

paid-in surplus

242+

2,041

1,799

Retained earnings

292+

2,591

2,299

Total

215+

3,588

3,373

Total liabilities &

owners equity

Fixed assets
149+

2,880

2,631

Net plant &

equipment

215+

3,588

3,373

Total assets

Sources and Uses

Sources

Cash inflow occurs when we sell something

Decrease in asset account

Accounts receivable, inventory, and net fixed assets

Increase in liability or equity account

Accounts payable, other current liabilities, and common stock

Sources and Uses

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

NET ADDITION TO CASH = SOURCES OF CASH USES OF CASH

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
Taxes

1,131
(442)

Net Income

689

EPS

3.61

Dividends per share

1.08

EX 9 Page 82
Based only on the following information for Bennington

Crop., did cash go up or down? By how much? Classify each

event as a source or use of cash.
375

Decrease in inventory

190

Decrease in AP

210

Increase in notes payable

105

Increase in AR

Ex 16 Page 83
JUST DEW IT COROPORATION
Balance Sheets 2009 &2008

LIABILITIES & OWNERS EQUITY

2009

2008

46,821

43,050

17,382

ASSETS

2009

2008

Current Assets

AP

10,156

8,436

cash

18,384

Notes payable

23,406

21,530

AR

64,203

61,434

Total

42,650

38,760

Inventory

32,000

25,000

Long-term debt

76,213

68,726

Total

324,519

295,432

Total assets

Current liabilities

Owners equity
40,000

40,000

Common stocks & paid-in

surplus

188,316

168,998

Retained earnings

228,316

208,998

Total

324,519

295,432

Total liabilities & owners equity

Ex 16 Page 83
For each account on this companys balance sheet, show the

change in the account during 2009 and note whether this

change was a source or use of cash. Do your numbers add
up and make sense? Explain your answer for total assets as
compared to your answer for liabilities and owners equity

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

Financing activities

84

Cash, beginning of
year

35-

Decrease in notes payable

74-

Decrease in long-term debt

121-

Dividend paid

50

Increase in common stock

276

Depreciation

Net cash from financing activities

32

Increase in accounts
payable

18014

Net increase in cash

98

Cash, end of year

Operating activity
363

Net Income
:Plus

:Less
23-

Increase in accounts
receivable

29-

Increase in inventory

619

Net cash from operating

activities
Investments
activities

425-

Fixed assets acquisitions

425-

Net cash from

investment activities

Standardized Financial Statements

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

There are three kinds of standardized financial statements:
1.

COMMON-SIZE STATEMENTS

2. COMMON-BASE YEAR FINANCIAL STATEMENT

(Trend analysis)
3. COMBINED COMMON-SIZE AND BASE YEAR

ANALYSIS

Standardized Financial Statements

1.COMMON-SIZE STATMENTS
Common-Size Balance Sheets

Compute all accounts as a percent of total assets

(Item/ TA) * 100

Common-Size Income Statements

Compute all line items as a percent of sales

(Item/ SALES) * 100

Standardized Financial Statements

2-COMMON-BASE YEAR STATEMENTS:TREND ANALYSIS

Item/ same item in the base year

3-COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS

Summary of standardized Balance Sheets

Combined
Common-size
& Base year
Assets

Common-Base
year Assets

2009

2009

Common-size
Assets

2009

2008

Assets

2009

2008
Current
assets

1.08

1.17

2.7%

2.5%

98

84

Cash

1.06

1.14

5.2

4.9

188

165

AR

1.01

1.07

11.8

11.7

422

393

Inventory

1.03

1.10

19.7

19.1

708

642

Total CA

0.99

1.05

80.3

80.9

2,880

2,731

NFA

1.00

1.06

100.0%

100.0%

3,588

3,373

Total
Assets

JUST DEW IT COROPORATION

Balance Sheets 2009 & 2008

LIABILITIES & OWNERS EQUITY

2009

2008

Current Assets

AP

10,157

8,436

cash

18,384

Notes payable

23,406

21,530

AR

64,203

61,434

Total

42,650

38,760

Inventory

32,000

25,000

Long-term debt

76,213

68,726

Total

2009

2008

46,821

43,050

17,382

Current liabilities

ASSETS

Owners equity
40,000

40,000

Common stocks & paid-in

surplus

188,316

168,998

Retained earnings

228,316

208,998

Total

248,306

226,706

Net plant &

equipment

324,519

295,432

Total liabilities & owners equity

324,519

295,432

Total assets

Ex 13, 14 & 15
Prepare the 2009 common-size balance sheet for Just Dew

It
Prepare the 2009 common-base year balance sheet for Just

Dew It
Prepare the 2009 combined common-size, common-base

year balance sheet for Just Dew It

Ratio Analysis
Ratios 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

Categories of Financial Ratios

1.

Short-term solvency or liquidity ratios

2. Long-term solvency or financial leverage ratios: The

ability to meet long-term obligations

3. Asset management or turnover ratios: Efficiency of asset

use
4. Profitability ratios
5. Market value ratios

Short-term solvency or liquidity ratios

The ability to pay bills in the short-run
Provide information about the firms liquidity
Advantage: BV & MV are similar
Disadvantage: CA & CL change rapidly

PRUFROCK COROPORATION
Balance Sheet 2009 & 2008
(in millions) $
CHANGE

2009

2008

CHANGE

LIABILITIES

ASSETS

Current liabilities

Current Assets

2009

2008

32+

344

312

AP

14+

98

84

cash

35-

196

231

Notes payable

23+

188

165

AR

3-

540

543

Total

29+

422

393

inventory

74-

457

531

Long-term debt

66+

708

642

Total

Owners equity
50+

550

500

Common stocks &

paid-in surplus

242+

2,041

1,799

Retained earnings

292+

2,591

2,299

Total

215+

3,588

3,373

Total liabilities &

owners equity

Fixed assets
149+

2,880

2,631

Net plant &

equipment

215+

3,588

3,373

Total assets

Computing Liquidity Ratios

Current ratio= CA

CL
708 / 540= 1.31 times
EX 3.1
CA= 4

CL= 2
:what happen to the Current ratio if

1.

The firm pays off some of its creditors? If CA= 3 CL=1

2.

The firm buys some inventory?

3.

The firm sells some merchandize?

Computing Liquidity Ratios

Quick Ratio = (CA Inventory) CL
(708 - 422) 540 = 0.53 times
Cash ratio = cash

Current liabilities

98 540 = 0.18 times

NWC to total assets = NWC

total assets

(708 540) 3,588 = 4.7%

Interval measure = CA average daily operating costs
1,344 365 = 3.68 $ per day
708 3.68 = 192 days

Computing Long-term Solvency Ratios

The ability to meet long-term obligations
To t a l d e b t r a t i o = ( TA T E )
(3,588 2,951 ) 3,588 = 0.28 times
Debt-equity ratio = TD TE
E q u i t y = ( 1 - T D ) = (1- 0.28) = 0.72
0.28 0.72 = 0.39 times

TA

Computing Long-term Solvency Ratios

E q u i t y m u l t i p l i e r = TA

TE

1 0.72 = 1.39 times

L o n g - t e r m d e b t r a t i o = LT D
457 (457 + 2,592) = 0.15 times

( LT D + T E )

Computing Coverage Ratios

Times interest earned ratio = EBIT

interest

691 141 = 4.9 times

Cash coverage ratio=( EBIT + depreciation)

interest

(691 + 276) 141 = 6.9 times

Ex 1, 5 page 81
SDJ, Inc,. Has net working capital 0f 1,370 $ , current

liabilities of 3,720 $, and inventory of 1,950$. What is the

current ratio? What is the quick ratio?
Crystal Lake, Inc,. Has a total debt ratio of 0.63. what is its

debt-equity ratio? What is it equity multiplier?

Asset Management measures

Inventory turnover= COGS

inventory

1,344 422 =3.2 times

Days sales in inventory = 365 days inventory

turnover

365 3.2 = 114 days

Computing Receivables Ratios

Receivables turnover= sales AR

2,311 188 = 12.3 times

Days sales in receivables = 365 days receivables

turnover

365 12.3 = 30 days

Computing Total Asset Turnover

NWC turnover = sales NWC

2,311 (708- 540) = 13.8 times

Fixed asset turnover= sales Net fixed assets

2.311 2,880 = 0.8 times

Total asset turnover= sales total asset

2,311 3,588 = 0.64 times

Computing Profitability Measures

Profit Margin = Net Income Sales

363 2,311 = 15.7 %

Return on Assets (ROA) = Net Income Total Assets

363 3,588 = 10.12 %

Return on Equity (ROE) = Net Income Total Equity

363 2,591= 14%

Computing Market Value Measures

Prufrock has 33 million shares outstanding and the stock

sold for 88$ per share at the end of the year

Price-Earning Ratio = Price per share Earnings per share
EPS= net income shares outstanding

363 33 =11 $
88 11= 8 times

Computing Market Value Measures

Price-sales ratio= price per share sales per share
Sales per share = sales shares out standing

2,311 33= 70$

88 70 = 1.26

Computing Market Value Measures

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

value per share

Book value per share= TE SHARES OUTSTANDING

2,591 33 = 78.5$
88 78.5 = 1.12 times

Ex 2 Page 81
Wakers, Inc., has sales of $29 million, total assets of $ 17.5

million, and total debt of $ 6.3 million. If the profit margin

is 8 percent, what is net income? What is ROA? What is
ROE?

Ex 3 Page 81
Ortiz Lumber Yard has a current account receivable balance

of $431,287. credit sales for the year just ended were

$3,943,709. what is the receivable turnover? The days sales
in receivables? How long did it take on average for credit
customers to pay off their accounts during the past year?

Ex 6 Page 81
Bach Crop. Had addition to retained earnings for the year

just ended of $430,000. the firm paid out $175,000 In cash

dividends, and it has ending total equity of $5.3 million. If
the company currently has 210,000 shares of common
stock outstanding, what are the earnings per share?
Dividend per share? Book value per share? If the stock
currently sells for $63 per share, what is the market-tobook ratio? The price-earnings ratio? If the company had
sales of $4.5 million , what is the price-sales ratio?

Deriving the Du Pont Identity

Investigates what areas of the firm need improvement
Provide a frame work that ties together a firms

profitability, assets efficiency & the use of debt

Provide the impact of operations on returns
Any weakness on operating assets or efficiency will result in

a lower ROE

Using the Du Pont Identity

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

Expanded Du Pont Analysis Du Pont Data

Extended Du Pont Chart

Ex 7 , 8 Page 81
If Roten Rooters, Inc., has an equity multiplier of 2.8, total

asset turnover of 1.15 , and profit margin of 5.5 percent,

what is the ROE?
Braam Fire prevention Crop. Has a profit margin of 6.8

percent, total asset turnover of 1.95, and ROE of 18.27

percent. What is the firms debt-equity ratio?

Ex 18 Page 83
Y3K, Inc., has sales of $5,276 , total assets in $ 3,105 , and a

debt- equity ratio of 1.4. if its return on equity is 15 percent,

what is its net income?

Why Evaluate Financial Statements?

Internal uses
1.
2.
3.

Performance evaluation (Compensation )

Comparison between divisions
Planning for the future guide in estimating future cash flows

External uses
Creditors
Suppliers
Customers
Stockholders

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 is changing

through time

Internal and external uses

Peer Group Analysis

Compare to similar companies or within industries

SIC and NAICS codes

Potential Problems
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

Review
What is the Statement of Cash Flows and how do you

determine sources and uses of cash?

How do you standardize balance sheets and income

statements and why is standardization useful?

What are the major categories of ratios and how do you

compute specific ratios within each category?

What are some of the problems associated with financial

statement analysis?
50-3