1. Chapter 3 Working With Financial Statements
T3.1 Chapter Outline
Chapter 3 Working With Financial Statements
Chapter Organization
3.1 Cash Flow and Financial Statements: A Closer Look
3.2 Standardized Financial Statements
3.3 Ratio Analysis
3.4 The Du Pont Identity
3.5 Using Financial Statement Information
3.6 Summary and Conclusions
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copyright © 2002 McGraw-Hill Ryerson, Ltd.

2. Working With Financial Statements - Introduction
Chapter 2 - looked at the basic financial statement components; the balance sheet and income statement and the concept of cash flow
Cash Flow -
cash flow identity - cash flow from assets = to cash flow paid to the suppliers of capital to the firm - creditors and shareholders
how to calculate cash flow from assets
operating cash flow
net capital spending
changes in net working capital
Chapter 3 - expands on the use of financial statements from a corporate finance perspective

3. Financial Statements and the role of Corporate Finance
capital budgeting - where and how much should we invest
long term financing - capital structure
short term financing - working capital management
risk management - derivative securities and hedging
A good working knowledge of financial statements is important as F/S are the primary means of communicating financial information both internally and externally.
many different ways of using F/S - or components
many different users
The connection between accounting information contained in financial statements and shareholder value is tenuous

4. Financial Statements and Shareholder Value
share price as established by the market
dividends paid from internally generated cash flow
Relationship or ‘line of sight’ between business decision and the creation of shareholder value is usually not that clear
analysis ->understanding of financial statements is a starting point - understand the impact of business/financial decisions in terms of the balance sheet, income and cash flow
the next step in establishing the connection between the business decision and the creation of shareholder value is complex and not well understood

5. Financial Statements and Cash Flow
Financial statements present cash flow with a focus on the sources and uses of cash (vs. the cash flow identity)
Statement of Changes in Financial Position - sources and uses of cash

6. T3.2 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

7. T3.2 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

8. T3.3 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
Dividends $
Addition to retained earnings

9. T3.4 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

10. T3.4 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

11. T3.5 Hermetic, Inc. Statement of Cash Flows
Operating activities
+ Net income + $
+ Depreciation
+ Increase in payables
– Increase in receivables –
– Increase in inventory – $
Investment activities
+ Ending fixed assets +$1,100.00
– Beginning fixed assets –
+ Depreciation
($ )

12. T3.5 Hermetic, Inc. Statement of Cash Flows (concluded)
Financing activities
+ Increase in notes payable + $ 65.00
+ Increase in long-term debt
– Dividends –
$ 58.45
Putting it all together, the net addition to cash for the period is:
$91.55 – = $5.00

13. Standardized Financial Statements
A standardized financial statement presenting all items in percentage terms.
Balance sheets are shown as a % of assets
Income statements are shown as a % of sales
An attempt to make comparisons of companies, who may be vastly different in terms of size, more effective.
There are two general approaches to standardized financial statements:
common size
common base year

14. Financial Statement Analysis
Common - Size Statements
a standardized financial statement expressing all items in percentage terms
the balance sheet as a % of assets and
the income statement as a % of sales
Common-Base Year Financial Statement - Trend Analysis
A standardized financial statement presenting all items relative to a certain base year amount
useful in trend analysis
lends itself to plotting the trends graphically .

15. T3.6 Hermetic, Inc. Common-Size Balance Sheet
Assets
Current Assets
Cash % 2.7%
Accounts receivable
Inventory
Total 38.8% 40.4%
Fixed assets
Net plant and equipment 61.2% 59.6%
Total assets 100% 100%

16. T3.6 Hermetic, Inc., Common-Size Balance Sheet (continued)
Liabilities and equity
Current liabilities
Accounts payable 13.0% 14.1%
Notes payable
Total 19.9% 23.6%
Long-term debt 12.7% 12.2%
Stockholders’ equity
Common stock and paid-in surplus 18.0% 15.7%
Retained earnings
Total
Total liabilities and equity 100% %

17. T3.6 Hermetic, Inc., Common-Size Balance Sheet
More on Standardized Statements
Suppose we ask: “What happened to Hermetic’s net plant and equipment (NP&E) over the period?”
1. Based on the 1999 and 2000 B/S, NP&E rose from $985 to $1100, so NP&E rose by $115 (a use of cash).
2. If we standardized the 2000 numbers by dividing each by the number, we get a common base year statement. In this case, $1100/$985 = 1.117, so NP&E rose by 11.7% over this period.

18. T3.6 Hermetic, Inc., Common-Size Balance Sheet (concluded)
More on Standardized Statements
3. Did the firm’s NP&E go up or down? Obviously, it went up, but so did total assets. In fact, looking at the standardized statements, NP&E went from 61.2% of total assets to 59.6% of total assets.
4. If we standardized the 2000 common size numbers by dividing each by the 1999 common size number, we get a combined common size, common base year statement. In this case, 59.6%/ 61.2% = 97.4%, so NP&E fell by 2.6% as a percentage of assets.
(. *.) In absolute terms, NP&E is up by $115, or 11.7%, but relative to total assets, NP&E fell by 2.6%.

19. T3.7 Hermetic, Inc. Common-Size Income Statement
Net sales %
Cost of goods sold 67.6
Depreciation 4.2
Earnings before interest and taxes 28.2
Interest 2.8
Taxable income 25.4
Taxes 7.5
Net income %
Dividends %
Addition to retained earnings %

20. Wide range of users of financial ratios:
Ratio Analysis
relationships determined from a firm’s financial information and used for comparison purposes
Similar to Common Size and Base Year Financial Statements, the use of financial ratios is an attempt to make comparisons of different sized companies more effective.
We eliminate the size problem in ratios by focusing only on percentages, or multiples or time periods
Wide range of users of financial ratios:
Investment:
financial analysts with major brokerage firms
pension fund managers & money management firms
Bond Rating Firms
Lenders
Table 3.8 in the text is a good summary
Ratio Analysis

21. T3.8 Things to Consider When Using Financial Ratios
What aspect of the firm or its operations are we attempting to analyze?
Firm performance can be measured along “dimensions”
-liquidity, capital structure, performance
What goes into a particular ratio?
Historical cost? Market values?
What is the unit of measurement?
Dollars? Days? Turns?
What would a desirable ratio value be? What is the benchmark? Is there an industry standard?
Time-series analysis? Peer Group Analysis

22. T3.9 Categories of Financial Ratios
Short-Term Solvency, or Liquidity
Ability to pay bills in the short-run
Long-Term Solvency, or Financial Leverage
Ability to meet long-term obligations
Asset Management, or Turnover
Intensity and efficiency of asset use
Profitability
The ability to control expenses
Market Value
focusing on share market price

23. T3.10 Common Financial Ratios (Table 3.8)
I. Short-Term Solvency, or Liquidity, Ratios
Current assets
Current ratio =
Current liabilities
Quick ratio = (Current assets - inventory) / Current liabilities
Cash ratio = Cash / Current liabilities
Interval measure =
Average daily operating costs

24. T3.10 Common Financial Ratios (Table 3.8) (continued)
II. Long-Term Solvency, or Financial Leverage Ratios
Total assets - Total equity
Total debt ratio =
Total assets
Debt/equity ratio = Total debt/Total equity
Equity multiplier = Total assets/Total equity
Long-term debt
Long-term debt ratio =
Long-term debt + Total equity
EBIT
Times interest earned ratio =
Interest
EBIT + depreciation
Cash coverage ratio =

25. T3.10 Common Financial Ratios (Table 3.8) (continued)
III. Asset Utilization, or Turnover, Ratios
Cost of goods sold
Inventory turnover =
Inventory
365 days
Days’ sales in inventory =
Inventory turnover
Sales
Receivables turnover =
Accounts receivable
Days’ sales in receivables =
Receivables turnover
NWC turnover =
NWC
Fixed asset turnover =
Net fixed assets
Total asset turnover =
Total assets

26. T3.10 Common Financial Ratios (Table 3.8) (continued)
IV. Profitability Ratios
Net income
Profit margin =
Sales
Return on assets (ROA) =
Total assets
Return on equity (ROE) =
Total equity
Operating Margin Op. Income o

27. T3.10 Common Financial Ratios (Table 3.8) (concluded)
V. Market Value Ratios
Price per share
Price-earnings ratio =
Earnings per share
Market value per share
Market-to-book ratio =
Book value per share
Dividend yield Dividend per share/
current market price

28. Financial Ratios - Oil & Gas Industry
There exists a unique set of ratios which are utilized in the oil & gas industry and with some variation in other resource based industries e.g.
Reserve Life Index
looks at how long the current reserve base will support a given level of production
calculated as - year end proven producing reserves/year end production
Operating Costs per BOE - annual operating costs divided by yearly production on a BOE basis
General and Administrative Costs per BOE
Finding and Onstream Cost per BOE
important efficiency ratio measuring costs to add new reserves over a specified period of time
Financial Ratios - Oil & Gas Industry

29. Financial Ratios - Oil & Gas
Price to cash flow multiple
share price / cash from operations per share
as opposed to the traditional P/E ratio
emphasizes cash flow instead of earnings

30. T The Du Pont Identity
1. Return on equity (ROE) can be decomposed as follows:
ROE = Net income/Total equity = Net income/Total equity Total assets/Total assets = Net income/Total assets Total assets/Total equity = _____________ Equity multiplier
2. Return on assets (ROA) can be decomposed as follows:
ROA = Net income/Total assets Sales/Sales = Net income/Sales Sales/Total assets = ______________ _______________

31. T The Du Pont Identity
1. Return on equity (ROE) can be decomposed as follows:
ROE = Net income/Total equity = Net income/Total equity Total assets/Total assets = Net income/Total assets Total assets/Total equity = ROA Equity multiplier
2. Return on assets (ROA) can be decomposed as follows:
ROA = Net income/Total assets Sales/Sales = Net income/Sales Sales/Total assets = Profit margin Total asset turnover

32. T The Du Pont Identity
3. Putting it all together gives the Du Pont identity:
ROE = ROA Equity multiplier = Profit margin Total asset turnover Equity multiplier
4. Profitability (or the lack thereof!) thus has three parts:
Operating efficiency
Asset use efficiency
Financial leverage

33. T3.11 The Du Pont Identity (concluded)

34. T3.12 Using Financial Statement Information
Why evaluate Financial Statements?
Internal Uses
Allocate capital by division
Measure and reward performance
Corporate/ Financial Planning
External Uses
Extend trade credit to customers
Investor Community Ratio Analysis
Banks requiring loan covenants
Competitor Analysis
Valuing a target in an acquisition
Benchmarks
Year on year
Peer group

35. T3.12 Using Financial Statement Information
Problems with Financial Statement Analysis
The need for theory
what is the connection between financial statements and a firm’s true value and the associated risk ?
Which ratios matter most?
What is the “right” value for the ratio
The difficulty in establishing appropriate benchmarks
Conglomerates or diversified firms
Not identified in a single industry or sector
Hard to find comparables
Global reach
Comparability of financial statements between countries with differences in accounting regulations

36. Quick Quiz
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?

37. You should be able to: Summary Identify sources and uses of cash
Understand the Statement of Cash Flows
Understand how to make standardized financial statements and why they are useful
Calculate and evaluate common ratios
Understand the Du Pont identity
Describe how to establish benchmarks for comparison purposes and understand some key problems that can arise