1. Chapter 3 Working with Financial Statements
Homework: 13-17

2. Topics Sources and Uses of Cash Financial Ratio Analysis
The Du Pont Identity
Using Financial Statement Information

3. Sources and Uses of Cash
Sources of cash include:
Decrease in assets
Increase in liabilities
Increase in common stock
Increase in retained earnings
Uses of cash include:
Increase in assets
Decrease in liabilities
Decrease in common stock
Decrease in retained earnings

4. Investment Activities
Organizes cash flows into 3 main categories
Operating Activities
Revenues from sales of goods and services
Costs associated with productions
Investment Activities
Acquisition of a new production plan
Proceeds from selling equipment
Financing Activities
Issuing long-term debt
Payments associated with retiring long-term debt
Proceeds from issuing equity
Cash Dividends paid to shareholders

5. Statement of Cash Flows
Operating activities
+ Net income
+ 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 fixed assets
– Beginning fixed assets

6. Statement of Cash Flows (concluded)
Financing activities
– Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in common stock
– Dividends paid

7. Example: Hermetic, Inc., Balance Sheet
Balance Sheet as of December 31
($ in thousands)
Assets
Current Assets
Cash $ $ 50
Accounts receivable
Inventory
Total $ $ 745
Fixed assets
Net plant and equipment
Total assets $1610 $1845

8. Hermetic, Inc., Balance Sheet (concluded)
Liabilities and equity
Current liabilities
Accounts payable $ 210 $ 260
Notes payable
Total $ 320 $ 435
Long-term debt
Stockholders’ equity
Common stock and
paid-in surplus
Retained earnings
Total
Total liabilities and equity $1610 $1845

9. Hermetic, Inc., Income Statement
($ in thousands)
Net sales $710.00
Cost of goods sold
Depreciation 30.00
Earnings before interest and taxes $200.00
Interest 20.00
Taxable income
Taxes 53.45
Net income $126.55
Retained earnings $100.00
Dividends

10. Hermetic, Inc., Statement of Cash Flows
Operating activities
+ Net income
+ Depreciation
+ Increase in payables
– Increase in receivables –
– Increase in inventory –
91.55
Investment activities
+ Ending fixed assets +1,100.00
– Beginning fixed assets –
(145.00)

11. Hermetic, Inc., Statement of Cash Flows (concluded)
Financing activities
+ Increase in notes payable
+ Increase in long-term debt
– Dividends –
58.45
Putting it all together
91.55 – = 5.00

12. Financial Ratios Short-Term Solvency or Liquidity Long-Term Solvency
Ability to pay bills in the short-run
Long-Term Solvency
Ability to meet long-term obligations
Asset Management
Intensity and efficiency of asset use
Profitability
Market Value
Going beyond financial statements

13. Short-Term Liquidity Ratios
The Current Ratio
Current Assets
Current Ratio =
Current Liabilities
Indicates a firm's ability to meet its short-term obligations
What Does This Number Mean?
Question: If you are a short-term creditor, the higher the current ratio the better?

14. Changes in the trend are difficult to interpret
Current Ratio
Notes of Caution
Changes in the trend are difficult to interpret
Equal increases and decreases in current assets and current liabilities have different effects on the current ratio.
Depends on whether the current ratio is greater or less than one.

15. Includes only current assets that can be converted quickly to cash.
Quick Ratio
Includes only current assets that can be converted quickly to cash.
Current Assets - Inventory
Quick Ratio =
Current Liabilities

16. Short-term Solvency Ratios:
The Bottom Line
Use both measures when assessing a firm's short-term liquidity
Using only the current ratio will overstate a firm's liquidity in the short-term.
By using both measures, we can see why the firm's current assets are increasing over time.

17. Long-Term Solvency Ratios
The Total Debt Ratio
Takes into account all debt of all maturities of all creditors
Total Assets - Total Equity
Total Debt Ratio =
Total Assets

18. Long-Term Solvency Ratios
Debt/Equity Ratio
Variation of the total debt ratio.
Measures total debt as a multiple of total equity.
Total Debt
Debt/Equity Ratio =
Total Equity

19. Long-Term Solvency Ratios
Long-Term Debt Ratio
Most popular leverage ratio
Omits short-term liabilities which are changing often.
Account payables: more a reflection of trade practices than of debt management
Tot. Long-term Debt
Long-Term Debt Ratio =
Tot. L.T. Debt + Tot. Equity

20. Long-Term Solvency Ratios
Times Interest Earned Ratio
Also called interest coverage ratio.
Measures the multiple of interest expense that a firm could support given its current level of earnings.
EBIT
Times Interest Earned Ratio =
Interest expense
The Lower this ratio, the more levered the firm.

21. Long-Term Solvency Ratios
Cash Coverage Ratio
EBIT includes depreciation
Measures the multiple of interest expense that a firm could support given its level of cash.
EBIT + depreciation
Cash Coverage Ratio =
Interest Expense
The Lower this ratio, the more levered the firm.

22. Long-term Solvency Ratios
Measure a firm's ability to meet its long-term financial obligations.
Three Debt Ratios: The higher the ratios the more levered the firm.
Times Interest Earned and Cash Coverage Ratios: The lower the ratio the more levered the firm.
What is a good ratio?
Analysts vary the standard in direct relation to the stability of the firm's earnings and cash flows.
Different standards for different industries.

23. Asset Management Ratios
Inventory Turnover Ratio
Measures how many times a firm sold off its inventory
Cost of Goods Sold
Inventory Turnover Ratio =
Inventory

24. Asset Management Ratios
Days' Sale in Inventory Ratio
Measures how long it took a firm to sell inventory
365
Days' Sales in Inventory =
Inventory Turnover

25. Inventory Management Ratios
Measure how quickly a firm can convert inventory into cash.
Important in industries where inventory becomes obsolete relatively quickly.
Fashion industry
Inventory becomes obsolete and can't be converted into cash.
liquidate below costs => losses for the firm

26. Asset Management Ratios
Receivables Turnover Ratio
Measures how fast a firm collects on the credit sales of inventory
Sales
Receivables Turnover Ratio =
Accounts Receivable

27. Asset Management Ratios
Days' Sale in Receivables Ratio
Measures how long it took a firm to collect on its credit sales
365
Days' Sales in Receivables =
Receivables Turnover

28. Receivables Management Ratios
Measure how quickly a firm can convert receivables into cash.
If we observe an increase in days' sales in receivables, what does it indicate?
Loan officers will ask for a list of top customers and percentage of sales accounted by these customers.
Assess credit quality of the firm's main sources of revenues

29. Asset Management Ratios
NWC Turnover Ratio
Measures the efficiency of a firm's NWC
Sales
NWC Turnover Ratio =
NWC

30. Asset Management Ratios
Total Asset Turnover Ratio
Measures the efficiency of a firm's Total Assets
Sales
Total Asset Turnover Ratio =
Total Assets

31. Profitability Ratios Profit Margin Net Income Profit Margin = Sales
Measures how well a firm is managing its costs relative to its sales
Net Income
Profit Margin =
Sales

32. Profitability Ratios Return of Assets (ROA) Net Income ROA =
Measures how hard a firm's assets are working
Net Income
ROA =
Total Assets

33. Profitability Ratios Return of Equity (ROE) Net Income ROE =
Measures how efficient a firm's equity is being employed to generate profit
Net Income
ROE =
Total Equity

34. Price/Earnings (P/E) Ratio
Market Value Measures
Price/Earnings (P/E) Ratio
Measures what investors are willing to pay per $1 of current earnings
Price Per Share
P/E Ratio =
Earnings Per Share

35. Market Value Measures Market-to-Book Ratio
Measures the market value of the firm's investments to their historical costs.
Market Value Per Share
Mkt-to-Book =
Book Value Per Share

36. Example The Cross Companies
45 Million Shares Outstanding
Stock sells for $80 per share at fiscal year-end
Net Income = $675 million
Total Equity = $3,375 million

37. The Du Pont Identity
ROE Can be Decomposed into 3 Components:
ROE = Net income/Sales x Sales/Assets x Assets/Equity
ROE = Profit Margin x Asset Turnover x Equity Multiplier
Operating Efficiency
Financial Leverage
Asset Use Efficiency

38. Standardized Financial Statements
Common Size Balance Sheet
All items are presented as a percentage of total assets
=> Divided all items by total assets
Common Size Income Statement:
All items are presented as percentage of total sales
=> Divide all items by total sales
Common-Base Year Financial Statement
=> Present relative to a certain base year.

39. Things to Consider When Using Financial Ratios
What goes into a particular ratio?
Historical cost? Market values? Accounting conventions?
What is the unit of measurement?
Dollars? Days? Turns?
What would a desirable ratio value be? What is the benchmark?
Time-series analysis? Cross-sectional analysis?

40. Problems with Financial Analysis
Very little underlying financial theory
Differences in accounting practices
Finding comparable firms is difficult
Differences in fiscal-year ends
One-time events
Seasonal variations
Conglomerates
Choosing Benchmark: Which industry?