1. Working with financial statements

2. Standardised financial statements
Common-size balance sheets
Compute all accounts as a percentage of total assets
Common-size income statements
Compute all line items as a percentage of sales
Standardised 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.
Financial statements of one company are readily compared with those of other similar companies. It is almost impossible, however, to compare different companies owing to size and currency differences. The financial statements are standardised to facilitate comparison. One common way is to use percentages instead of total dollars (common-size statements).
Common-size statement: A standardised financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

3. Swagman Camping Ltd Balance sheet—Table 3.1
Swagman Camping balance sheet in actual dollar form.

4. Swagman Camping Ltd (cont.) Common-size balance sheet—Table 3.2
Table 3.2: Common-size balance sheet constructed from Table 3.1, by expressing each item as a percentage of total assets.
In this form, financial statements are relatively easy to read and compare. For example, just looking at the two balance sheets for Swagman Camping, we see that current assets were 19.7% of total assets in 2010, up from 19.1% in Current liabilities declined from 16.0% to 15.1% of total liabilities and equity over that same time. Similarly, total equity rose from 68.1% of total liabilities and equity to 72.2%.

5. Swagman Camping Ltd (cont.) Income statement—Table 3.3
Income statement in actual dollar form.

6. Swagman Camping Ltd (cont.) Common-size income statement—Table 3.4
These percentages are very useful for comparisons. For example, a very relevant figure is the cost percentage. For Swagman Camping, $0.582 of each $1.00 in sales goes to pay for goods sold. It would be interesting to compute the same percentage for Swagman Camping’s main competitors to see how Swagman Camping stacks up in terms of cost control.

7. Ratio analysis
Allows for better comparison over time or between companies
Used both internally and externally
For each ratio, several questions arise:
How is it computed ?
What is the ratio trying to measure and why is that information important?
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?
Financial ratios: Relationships determined from a firm’s financial information and used for comparison purposes.
One problem with ratios is that different people and different sources frequently do not compute them in exactly the same way, which leads to much confusion. The specific definitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are ever using ratios as a tool for analysis, be careful to document how you calculate each one and, if you are comparing your numbers with those of another source, be sure you know how their numbers are computed.

8. Categories of financial ratios
Short-term solvency or liquidity ratios
Long-term solvency or financial leverage ratios
Asset management or turnover ratios
Profitability ratios
Market value ratios

9. Common financial ratios Table 3.5

10. Short-term solvency or liquidity ratios
Current ratio = Current assets / Current liabilities
708 / 540 = 1.31 times
Quick ratio (or acid-test ratio) = (Current assets – Inventory) / Current liabilities
( ) / 540 = 0.53 times
Cash ratio= Cash / Current liabilities
98/ 540 = 0.18 times
Short-term solvency ratios as a group are intended to provide information about a firm’s liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm’s ability to pay, without undue stress, its bills that become payable in the short term. Consequently, these ratios focus on current assets and current liabilities.

11. Long-term solvency measures
Total debt ratio
(TA – TE) / TA
( ) / 3588 = 0.28 times
Debt/Equity
TD / TE
0.28/0.72) = 0.39 times
Equity multiplier
TA/TE = 1 + D/E
($1 /0.72) = 1.39
Note that these are often called leverage ratios.
TE = Total equity and TA = Total assets, the numerator in the total debt ratio could also be found by adding all of the current and long-term liabilities.
Another way to compute the D/E ratio if you already have the total debt ratio:
D/E = Total debt ratio / (1 – Total debt ratio) = .28/ ( ) = 0.39
The equity multiplier is one of the ratios that is used in the Du Pont Identity as a measure of the firm’s financial leverage.

12. Long-term solvency measures (cont.)
Times interest earned
EBIT/Interest
691/ 141 = 4.9 times
Cash coverage
(EBIT + Depreciation)/Interest
( ) / 141 = 6.9 times
EBIT=Earnings before income tax
EBIT+ Depreciation is often abbreviated to EBDIT (earnings before depreciation interests and taxes).
Remember that depreciation is a non-cash deduction. A better indication of a firm’s ability to meet interest payments may be to add back the depreciation to get an estimate of cash flow before taxes.
The times interest earned and cash coverage ratios are calculated using the income statement for Swagman Camping Ltd (Table 3.3); the arrow in the left corner is used to go back to the income statement slide.

13. Asset management: Inventory ratios
Inventory turnover = Cost of goods sold/Inventory
1344/422 = 3.2 times
Days’ sales in inventory = 365/Inventory turnover
365 / 3.2 = 114 days
COGS = Cost of goods sold.
The measures in this section are sometimes called asset utilisation ratios. The specific ratios we discuss
can all be interpreted as measures of turnover. What they are intended to measure is how efficiently, or intensively, a firm uses its assets to generate sales.
Inventory turnover can be computed using either ending inventory or average inventory when you have both beginning and ending figures. It is important to be consistent with whatever benchmark you are using to analyse the company’s strengths or weaknesses.
It is also important to consider seasonality in sales. If the balance sheet is prepared at a time when there is a large inventory build-up to meet seasonal demand, then the inventory turnover will be understated and you might believe that the company is not performing as well as it is. On the other hand, if the balance sheet is prepared when inventory has been drawn down owing to seasonal sales, the inventory turnover would be overstated and the company may appear to be doing better than it really is. Averages using annual data may not fix this problem. If a company has seasonal sales, you may want to look at quarterly averages to get a better indication of turnover.

14. Asset Management: Receivables Ratios
Receivables Turnover = Sales/Accounts Receivable
2311 / 188= 12.3 times
Days’ Sales in Receivables = 365/Receivables Turnover
365 / 12.3= 30 days
Technically, the sales figure should be credit sales. This is often difficult to determine from the income statements provided in annual reports. If you use total sales instead of credit sales, you will overstate your turnover level. You need to recognize this bias when credit sales are unavailable, particularly if a large portion of the sales are cash sales.
As with inventory turnover, you can use either ending receivables or an average of beginning and ending.
You also run into the same seasonal issues as discussed with inventory.
Probably the best benchmark for days’ sales in receivables is the company’s credit terms. If the company offers a discount (1/10 net 30), then you would like to see days’ sales in receivables less than 30. If the company does not offer a discount (net 30), then you would like to see days’ sales in receivables close to the net terms. If days’ sales in receivables is substantially larger than the net terms, then you first need to look for biases, such as seasonality in sales. If this does not provide an explanation for the difference, then the company may need to take another look at its credit policy (who it grants credit to and its collection procedures).

15. Asset management: Asset turnover ratios
Total asset turnover (TAT) = Sales/Total assets
2311/3588 = 0.64 times
Measure of asset use efficiency
Not unusual for TAT <1, especially if a firm has a large amount of fixed assets
Capital intensity ratio = 1/TAT
1/0.64 = 1.56
Having a TAT of less than one is not a problem for most firms. Fixed assets are expensive and are meant to provide sales over a long period of time. This is why the matching principle indicates that they should be depreciated instead of immediately expensed.
This is one of the ratios that will be used in the Du Pont identity.

16. Profitability measures
Profit margin = Net income/Sales
385/2311 = 16.7%
Return on assets (ROA) = Net income/Total assets
385/3588 = 10.73%
Return on equity (ROE) = Net income/Total equity
363 / 2591 = 14.9%
Profit margin is one of the components of the Du Pont Identity and is a measure of operating efficiency. It measures how well the firm controls the costs required to generate its revenues. It tells how much the firm earns for every dollar in sales.
Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return on investment). As with many of the ratios, there are variations in how they can be computed. The most important thing is to make sure that you are computing them the same way as the benchmark you are using.
ROE will always be higher than ROA as long as the firm has debt. The greater the leverage the larger the difference will be. ROE is often used as a measure of how well management is attaining the goal of owner wealth maximisation. The Du Pont Identity is used to identify factors that affect the ROE.

17. Market value measures Market price = $88 per share = PPS
Shares outstanding = 35 million
Earnings per share = EPS = Net income/Shares outstanding
385/35 = $11
PE ratio = Price per share (PPS )/ Earnings per share (EPS)
$88 / $11 = 8 times
Market-to-book ratio = Market value per share/ Book value per share
Book value per share = Total equity/Shares outstanding
= $2591/35 = $74
Market-to-book = $88/74 = 1.19 times
The P/E ratio measures how much investors are willing to pay per dollar of current earnings; higher P/Es are often taken to mean that the firm has significant prospects for future growth. Of course, if a firm had no, or almost no, earnings, its P/E would probably be quite large, so, as always, care is needed in interpreting this ratio .
Book value per share is an accounting number, it reflects historical costs. In a loose sense, the market/book ratio therefore compares the market value of the firm’s investments with their cost. A value less than 1 could mean that the firm has not been successful overall in creating value for its shareholders.

18. Swagman ratios

19. The Du Pont identity
Return on equity (ROE) = Net income (NI)/ Total equity (TE)= Basic formula
Du Pont identity
ROE = Profit margin (PM) * Total asset turnover (TAT) * Equity multiplier (EM)
PM = Net income / Sales
TAT = Sales / Total assets
EM = Total assets / Total equity
Du Pont identity: Popular expression breaking ROE into three parts: operating efficiency, asset-use efficiency and financial leverage. It is named after the Du Pont Corporation, which popularised its use.

20. Using the Du Pont identity
ROE = PM*TAT*EM
Profit margin (PM) is a measure of a firm’s operating efficiency—how well it controls costs.
Total asset turnover (TAT) is a measure of the firm’s asset-use efficiency—how well it manages its assets.
Equity multiplier (EM) is a measure of the firm’s financial leverage.
Improving our operating efficiency or our asset use efficiency will improve our return on equity. If the TAT is low compared with our benchmark, we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong we can look at fixed asset turnover and cash management.
We can also improve our ROE by increasing our leverage—up to a point. Debt affects a lot of other factors, including profit margin, so we have to be a little careful here. We want to make sure we have enough debt to utilise our interest tax credit effectively, but we don’t want to overdo it.

21. SWAGMAN—Du Pont identity
ROE = PM * TAT * EM
PM = 16.7%
TAT = .64
EM = 1.39
ROE = .167 x .64 x 1.39
= .149= 14.9%

22. An expanded Du Pont analysis
An expanded Du Pont analysis (Figure 3.1) is constructed for Billabong International, by using the financial statements data from Table 3.6.

23. An expanded Du Pont analysis
The left-hand side of the Du Pont chart in Figure 3.1 shows the items related to profitability. As always, profit margin is calculated as net income divided by sales. But, as the chart emphasises, net income depends on sales and a variety of costs, such as cost of goods sold (COGS) and general expenses.
Point out that Billabong can increase its ROE by increasing sales and also by reducing one or more of these
costs. The chart clearly shows us the areas on which we should focus.
The right-hand side of Figure 3.1 gives an analysis of the key factors underlying total asset turnover. It shows, for example, reducing inventory holdings through more efficient management reduces current assets, which reduces total assets, which then improves total asset turnover.

24. Internal and sustainable growth Dividend payout and earnings retention ratios
Dividend payout ratio (b) = Cash dividends/Net income
Retention ratio(1-b) = Additions to retained earnings/Net income = 1 – Payout ratio (b)
Note that these ratios can be computed either on a per share basis or on an actual basis.

25. Internal and sustainable growth Dividend payout and earnings retention ratios (cont.)
Dividend payout ratio (‘b’) =
Cash dividends / Net income (DIV / NI)
143/385 = 37%
Retention ratio (‘1 – b’) = (NI - DIV)/ NI
Addition to Retained earnings / Net income
$242/385 = 63%

26. Internal growth rate
The internal growth rate tells us how much the firm can grow assets using retained earnings (internal financing) as the only source of financing.
The internal growth rate calculated here is for Swagman Camping Limited.
Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in Chapter 13, the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.

27. 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.
Note that no new equity is issued.
The sustainable growth rate is substantially higher than the internal growth rate. This is because we are allowing the company to issue debt as well as use internal funds.

28. Determinants of growth
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
The first three components come from the ROE and the Du Pont identity.
It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important as long as the firm continues to maximise shareholder value.
The sustainable growth rate is a very useful number. What it illustrates is the explicit relationship between the firm’s four major areas of concern: its operating efficiency as measured by profit margin; its asset-use efficiency as measured by total asset turnover; its financial policy as measured by the debt/equity ratio; and its dividend policy as measured by the retention ratio.

29. Summary of internal and sustainable growth rates

30. Using financial information— Why evaluate financial statements?
Internal uses
Performance evaluation—compensation and comparison between divisions
Planning for the future—guide in estimating future cash flows
External uses
Creditors
Suppliers
Customers
Shareholders

31. Using financial statement information— Benchmarking
Ratios are not very helpful by themselves; they need to be compared with something
Time-trend analysis
Used to see how the firm’s performance is changing over time
Internal and external uses
Peer-group analysis
Compare with similar companies or within industries
GICS codes
International codes used to classify a firm by its type of business operations
Click on the information icon to go to < for more information on GICS codes.

32. Problems with financial statement analysis
Conglomerates
No readily available comparables
Global competitors
Different accounting procedures
Different fiscal year ends
Differences in capital structure
Seasonal variations and one-time events

33. Quick quiz
How do you standardise balance sheets and income statements?
Why is standardisation useful?
What are the major categories of ratios and how do you compute specific ratios within each category?
What are the major determinants of a firm’s growth potential?
What are some of the problems associated with financial statement analysis?
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh