3-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Three Working with Financial Statements

3-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 3.1Cash Flow and Financial Statements: A Closer Look 3.2 Financial Statements of Publicly Listed Firms 3.3 The Du Pont Identity 3.4 Using Financial Statement Information Summary and Conclusions Chapter Organisation

3-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Identify the ways that firms obtain and use cash as reported in the Cash Flow Statement. Calculate and interpret key financial ratios. Discuss the Du Pont identity as a method of financial analysis. Understand the use of financial information for comparative purposes. Outline the problems associated with using financial ratios.

3-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Cash is generated by selling a product or service, asset or security. Cash is spent by paying for materials and labour to produce a product or service and by purchasing assets. Recall: Cash flow from assets = Cash flow to debtholders + Cash flow to shareholders

3-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Sources and Uses of Cash At the most fundamental level, firms do two things: generate cash and spend cash. Activities that bring in cash are called sources of cash. Activities that involve spending cash are called uses (or applications) of cash.

3-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Sources and Uses of Cash An increase in an asset account or a decrease in a liability or equity account is a use of cash. A decrease in an asset account or an increase in a liability or equity account is a source of cash.

3-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Sources and Uses of Cash ($000s) Sources of cash Increase in creditors $ 32 Increase in issued capital 50 Increase in retained earnings 264 Total sources $346 Uses of cash Increase in receivables $23 Increase in inventory 29 Decrease in notes payable 7 Decrease in non-current debt 74 Non-current asset acquisitions 149 Total uses $282 Net addition to cash $ 64

3-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow Statement A firm’s financial statement that summarises its sources and uses of cash over a specified period. The presentation of cash flows in annual reports is determined by an Accounting Standard. Changes are divided into three main categories: –Operating activities—includes net profit and changes in most current accounts. –Investment activities—includes changes in non-current assets. –Financing activities—includes changes in notes payable, long-term debt and equity accounts, as well as dividends.

3-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow Statement Operating activities + Net profit + Depreciation + Any decrease in current assets (except cash) + Increase in accounts payable – Any increase in current assets (except cash) – Decrease in accounts payable Investment activities + Ending non-current assets – Beginning non-current assets + Depreciation

3-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow Statement Financing activities – Decrease in notes payable + Increase in notes payable – Decrease in long-term debt + Increase in long-term debt + Increase in ordinary shares – Dividends paid

3-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Balance Sheet Assets ($’000s) Current assets Cash Accounts receivable Inventory Total Non-current assets Net plant and equipment TOTAL ASSETS $ $ $3 220 $ $ $3 690

3-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Balance Sheet Liabilities and equity ($’000s) Current liabilities Accounts payable Notes payable Total Long-term debt Shareholders’ equity Ordinary shares Retained earnings Total TOTAL LIABILITIES AND EQUITY $ $ 640 $ $2 170 $3 220 $ $ 870 $ $2 370 $3 690

3-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Income Statement ($000s) Sales $ Cost of goods sold Depreciation EBIT $ Interest Taxable income Tax Net profit$ Dividends Addition to retained earnings $200.00

3-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Cash Flow Statement Operating activities (+) Net profit $ 252 (+) Depreciation 60 (+) Increase in payables 100 (–) Increase in receivables (100) (–) Increase in inventory (130) $ 182 Investment activities (+) Ending non-current assets $2 200 (–) Beginning non-current assets (1 970) (+) Depreciation 60 ( $ 290)

3-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Cash Flow Statement Financing activities (+) Increase in notes payable $ 130 (+) Increase in long-term debt 40 (–) Dividends (52) $ 118 Putting it all together, the net addition to cash for the period is: $182 – = $10

3-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ‘Players’ in Accounting Standards Accountants Government Regulators Other users of financial statements.

3-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Ratio Analysis Financial ratios are relationships determined from a firm’s financial information and used for comparison purposes. Used to compare and investigate relationships between different pieces of financial information, either over time or between companies. Ratios eliminate the size problem.

3-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Categories of Financial Ratios Liquidity—measures the firm’s short-term solvency. Capital structure—measures the firm’s ability to meet long-run obligations (financial leverage). Asset management (or turnover)—measures the efficiency of asset usage to generate sales. Profitability—measures the firm’s ability to control expenses. Market value—per-share ratios.

3-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Ratio Analysis: Questions to Consider for Each Ratio How is it computed? What is it intended to measure, and why might we be interested? What is the unit of measurement? What might a high or low value be telling us? How might such values be misleading? How could this measure be improved?

3-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Liquidity Ratios

3-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Capital Structure Ratios

3-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Turnover Ratios

3-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Turnover Ratios (continued)

3-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Profitability Ratios

3-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Market Value Ratios

3-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Du Pont Identity Breaks ROE into three parts: –operating efficiency (as measured by profit margin) –asset use efficiency (as measured by total asset turnover) –financial leverage (as measured by the equity multiplier)

3-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example: The Du Pont Identity Sales are $7 000, net profit is $250, total assets are $3 500 and equity is $1 900.

3-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Why Evaluate Financial Statements? Internal uses: –performance evaluation –planning for the future External uses: –evaluation by outside parties –evaluation of main competitors –identifying potential takeover targets

3-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Benchmarks for Comparison Ratios are most useful when compared to a benchmark. Time-trend analysis—examine how a particular ratio(s) has performed historically. Peer group analysis—using similar firms (competitors) for comparison of results.

3-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Benchmarks for Comparison One common way of identifying potential peers is based on the Global Industry Classification Standard (GICS) used by the Australian Stock Exchange (ASX). - GICS is a code used globally to classify a firm by its type of business operations. - GICS consists of 23 industry groups, 59 industries, and 122 sub-industries; covering over companies globally. - The basis of classification is the area from which most revenue is generated.

3-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Problems with Financial Statement Analysis No underlying theory to identify correct ratios to use or appropriate benchmarks. Benchmarking is difficult for diversified firms. Firms may use different accounting procedures. Firms may have different recording periods. One-off events can severely affect financial performance.

3-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Activities that bring in cash are called ‘sources of cash’, and activities that involve spending cash are called ‘uses of cash’. A Cash Flow Statement summarises sources and uses of cash over a specified period. Financial ratios are grouped together into five main categories: Liquidity, Capital Structure, Asset Management, Profitability, and Market Value. Ratios are most useful when compared to a benchmark (e.g. time-trend and peer group analysis). Problems can arise in using financial statements.