1. Working With Financial Statements
Chapter 3
Working With Financial Statements

2. Key Concepts and Skills
Know how to standardize financial statements for comparison purposes
Know how to compute and interpret important financial ratios
Know the determinants of a firm’s profitability and growth
Understand the problems and pitfalls in financial statement analysis

3. Chapter Outline Standardized Financial Statements Ratio Analysis
The Du Pont Identity
Internal and Sustainable Growth
Using Financial Statement Information

4. Standardized Financial Statements
Common-Size Balance Sheets
Compute all accounts as a percent of total assets
Common-Size Income Statements
Compute all line items as a percent of sales
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

5. Ratio Analysis
Ratios also 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

6. 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

7. Sample Balance Sheet Numbers in thousands Cash 680,623 A/P 318,301 A/R
1,051,438
N/P
4,613
Inventory
300,459
Other CL
1,645,748
Other CA
415,310
Total CL
1,968,662
Total CA
2,447,830
LT Debt
909,814
Net FA
3,415,159
C/S
2,984,513
Total Assets
5,862,989
Total Liab. & Equity
The numbers in this sample balance sheet are based on the 2004 annual report for McGraw-Hill. The categories were condensed for simplicity.

8. Sample Income Statement
Numbers in thousands, except EPS & DPS
Revenues
5,250,538
- Cost of Goods Sold
(2,046,645)
- Expenses
(1,904,556)
- Depreciation & Amortization
(124,647)
EBIT
1,174,690
- Interest Expense
(5,785)
Taxable Income
1,168,905
- Taxes
(412,495)
Net Income
756,410
EPS (193,000 shares outstanding)
3.92
Dividends per share
1.20
This sample income statement is based on information from the McGraw-Hill 2004 annual report.
The net income figure above ignores a 587 loss from discontinued operations.

9. Computing Liquidity Ratios
Current Ratio = CA / CL
2,447,830 / 1,968,662 = 1.24 times
Quick Ratio = (CA – Inventory) / CL
(2,447,830 – 300,459) / 1,968,662 = 1.09 times
Cash Ratio = Cash / CL
680,623 / 1,968,662 = .346 times
The firm is just barely able to cover current liabilities with its current assets. A short-term creditor might find this a bit disconcerting and may reduce the likelihood that they would lend money to the company. The ratio should be compared to the industry – it’s possible that this industry has a substantial amount of cash flow and that they can meet their current liabilities out of cash flow instead of relying solely on the liquidation of current assets that are on the books.
The quick ratio is a little lower than the current ratio. Inventory seems to be a small component of current assets.
The “cash” balance used on the slide is the “cash and equivalents” item from the balance sheet. Note 1 indicates that much of this is actually in the form of marketable securities with 3-month or shorter maturities. This company actually carries a very low cash balance, consistent with investing in assets that will provide higher returns. We need to make sure that we have enough cash to meet our obligations, but too much cash reduces the return earned by the company.

10. Computing Leverage Ratios
Total Debt Ratio = (TA – TE) / TA
(5,862,989 – 2,984,513) / 5,862,989 = .491 times or 49.1%
The firm finances slightly over 49% of their assets with debt.
Debt/Equity = TD / TE
(5,862,989 – 2,984,513) / 2,984,513 = .964 times
Equity Multiplier = TA / TE = 1 + D/E
= 1.964
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) = .491 / ( ) = .964
The equity multiplier (EM) is one of the ratios that is used in the Du Pont Identity as a measure of the firm’s financial leverage.

11. Computing Coverage Ratios
Times Interest Earned = EBIT / Interest
1,174,900 / 5,785 = 203 times
Cash Coverage = (EBIT + Depr. & Amort.) / Interest
(1,174, ,647) / 5,785 = 225 times
Even though the company is financed with over 49% debt, they have a substantial amount of operating income available to cover the required interest payments.
Remember that depreciation and amortization are non-cash deductions. A better indication of a firm’s ability to meet interest payments may be to add back the depreciation and amortization to get an estimate of cash flow before taxes.

12. Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
2,046,645 / 300,459 = 6.81 times
Days’ Sales in Inventory = 365 / Inventory Turnover
365 / 6.81 = 54 days
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 analyze 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 due to seasonal sales, then 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.

13. Computing Receivables Ratios
Receivables Turnover = Sales / Accounts Receivable
5,250,538 / 1,051,438 = 4.99 times
Days’ Sales in Receivables = 365 / Receivables Turnover
365 / 4.99 = 73 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 receivables.
You also run into the same seasonal issues when analyzing 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, but offers 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 (to whom it grants credit, and its collection procedures).

14. Computing Total Asset Turnover
Total Asset Turnover = Sales / Total Assets
5,250,538 / 5,862,989 = .896 times
Measure of asset use efficiency
Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
Having a total asset turnover (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.

15. Computing Profitability Measures
Profit Margin = Net Income / Sales
756,410 / 5,250,538 = times or 14.41%
Return on Assets (ROA) = Net Income / Total Assets
756,410 / 5,862,989 = times or 12.90%
Return on Equity (ROE) = Net Income / Total Equity
756,410 / 2,984,513 = times or 25.34%
You can also compute the gross profit margin and the operating profit margin.
Profit margin (PM) 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 the revenues. It tells how much the firm earns for every dollar in sales. In the example, the firm earns over $0.14 for each 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 (in absolute value) 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 maximization. The Du Pont identity is used to identify factors that affect the ROE.

16. Computing Market Value Measures
Market Price (12/31/04) = $91.54 per share
Shares outstanding = 189,813,459
PE Ratio = Price per share / Earnings per share
91.54 / 3.92 = times
Market-to-book ratio = market value per share / book value per share
91.54 / (2,984,513,000 / 189,813,459) = 5.82 times
Be sure to point out that the numbers in the tables are presented in thousands, so the BV of equity has to have the extra three zeros in order for the market-to-book ratio to work.

17. Table 3.5

18. Deriving the Du Pont Identity
ROE = NI / TE
Multiply by 1 and then rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM

19. Using the Du Pont Identity
ROE = PM * TAT * EM
Profit margin is a measure of the firm’s operating efficiency – how well does it control costs
Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets
Equity multiplier 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 to our benchmark, then we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong, then 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 utilize our interest tax credit effectively, but we don’t want to overdo it. The choice of leverage is discussed in more detail in chapter 13.

20. Payout and Retention Ratios
Dividend payout ratio (“d”) = Cash dividends / Net income
1.20 / 3.92 = or 30.61%
Retention ratio (“1 – d”) = Addn. to R/E / Net income = (EPS – DPS) / EPS
(3.92 – 1.20) / 3.92 = = 69.39%
Or: Retention ratio = 1 – Dividend Payout Ratio
= = 69.39%
Note that these ratios can be computed either on a per share basis or on an actual basis.

21. 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.
This firm could grow assets at 4.11% without raising additional external capital.
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, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.

22. 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.
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.

23. 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 so long as it continues to maximize shareholder value.

24. Table 3.7

25. 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
Stockholders

26. Benchmarking
Ratios are not very helpful by themselves; they need to be compared to something
Time-Trend Analysis
Used to see how the firm’s performance is changing through time
Internal and external uses
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes
SIC codes have been used many years to identify industries and allow for comparison with industry average ratios. The SIC codes are limited, however, and have not kept pace with a rapidly changing environment. Consequently, the North American Industry Classification System was introduced in 1997 to alleviate some of the problems with SIC codes.
www: Click on the Web surfer to go the NAICS home page. It provides information on the change to the NAICS and conversion between SIC and NAICS codes.

27. Real World Example - I
Ratios are figured using financial data from the 02/01/2004 Annual Report for Home Depot
Compare the ratios to the industry ratios in Table 3.10 in the book
Home Depot’s fiscal year ends Feb. 1
Be sure to note how the ratios are computed in the table so you can compute comparable numbers.
Home Depot sales = $64,816 MM
www: The annual report was downloaded from the company’s Web site and that is the hot link that is provided above.
It would be a good exercise to have the students print the balance sheet and income statement for the latest year and work through these ratios in class. They could then compare the ratios to the table in the book. If you do this, be sure to point out that you should technically use benchmark data for the same time period.

28. Real World Example - II Liquidity ratios Long-term solvency ratio
Current ratio = 1.40x; Industry = 1.8x
Quick ratio = .45x; Industry = .6x
Long-term solvency ratio
Debt/Equity ratio (Debt / Worth) = .54x; Industry = 1.4x
Coverage ratio
Times Interest Earned = 2,282x; Industry = 4.8x
The industry number reported above is the median from the table. I also compare Home Depot to the 25MM and over column to better match size.
Liquidity ratio: Home Depot has a current ratio below the median and slightly below the lower quartile. Is this good or bad? Short-term creditors like high current ratios, so the company may have more difficulty securing short-term financing. However, it could also mean that this company does a better job managing its current assets and is better able to meet short-term liabilities from current cash flow.
Quick ratio: Home Depot is still below the median, but much closer versus the comparison of current ratios.
Debt/Equity ratio: Home Depot is well below the industry average and has much less debt than 75% of the companies in the industry. Creditors like this, however, the firm may be foregoing valuable tax benefits associated with interest payments. Based on industry figures, Home Depot may have substantial unused debt capacity and might be able to increase shareholder wealth by taking on some additional debt.
Times Interest Earned: This ratio is substantially higher than the industry median and is another indication that the company may have significant debt capacity available. Home Depot carries quite a substantial amount of cash and equivalents. The interest received on the excess cash can be used to pay the interest expense on debt – in fact for the fiscal year ended Feb. 1, 2004, Home Depot had 59MM in interest income and 62MM in interest expense. This is another reason for the extremely high TIE.

29. Real World Example - III
Asset management ratios:
Inventory turnover = 4.9x; Industry = 4.2x
Receivables turnover = 59.1x (every 6 days); Industry = 21.3x (every 17 days)
Total asset turnover = 1.9x; Industry = 2.8x
Profitability ratios
Profit margin before taxes = 10.6%; Industry = 3.0%
ROA (profit before taxes / total assets) = 19.9%; Industry = 7.3%
ROE = (profit before taxes / tangible net worth) = 34.6%; Industry = 16.8%
Inventory Turnover: The inventory turnover is substantially higher than the industry median but slightly below the upper quartile. Either the company is very good at managing inventory relative to the industry or they are running short on inventory. It is important for the company to examine why this ratio is different from the industry.
Receivables are collected substantially faster than the industry median and upper quartile. This may be because the majority of Home Depot’s sales are actually cash sales and the industry may, in general, sell more on credit.
Total Asset Turnover: The company is below the industry median and just barely below the lower quartile. The problem is probably related to excess cash and fixed assets since both inventory and receivables are turning so quickly.
Profit margin before taxes: Home Depot’s profit margin is substantially higher than the median (calculated from Table 3.9). This is generally good as long as the company is not foregoing necessary expenses just to increase the bottom line.
ROA: The ROA is substantially higher than the upper quartile for the industry. This shows excellent return characteristics relative to the industry.
ROE: The ROE is higher than the median, but not as high as the upper quartile. The different results between ROE and ROA can be directly attributed to the lower levels of debt for Home Depot (remember the DuPont analysis).
Note that ROA and ROE are computed using profit before taxes to be consistent with the numbers in the table.

30. Example: Work the Web
The Internet makes ratio analysis much easier than it has been in the past
Click on the Web surfer to go to Moneycentral.com
Choose a company and enter its ticker symbol
Click on “Financial Results” and “Key Ratios” to compare the firm to its industry and the S&P 500 for various ratio categories
Change the ratio category using the links to the left of the chart.

31. Quick Quiz
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 the major determinants of a firm’s growth potential?
What are some of the problems associated with financial statement analysis?

32. Comprehensive Problem
XYZ Corporation has the following financial information for the previous year:
Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M
Compute the ROE using the DuPont Analysis.
Total assets = CA + FA = $2M + $6M = $8M
TAT = Sales / TA = $8M / $8M = 1
NWC = CA – CL CL = CA – NWC = $2M - $1M = $1M
Total liabs. = CL + LTD = $1M + $3M = $4M
Total equity = total assets – total liabs. = $8M - $4M = $4M
EM = assets / equity = $8M / $4M = 2
ROE = PM X TAT X EM = 8% X 1 X 2 = 16%
Without using DuPont, ROE = NI / total equity = PM * sales / total equity = 8% X $8M / 4M = 16%