0. Agenda
Minicase Ch 1
Chapter 2
Chapter 3
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1. Chapter 2 Book value and market value Accounting income and CF
Average and marginal tax rates
How to determine a firm’s CF from its financial statements
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2. Balance Sheet What does the Balance Sheet do? What does this mean?
A = L + SE

3. Balance Sheet
The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time
Assets are listed in order of decreasing liquidity
Ease of conversion to cash
Without significant loss of value
Balance Sheet Identity
Assets = Liabilities + Stockholders’ Equity
The Lecture Tip in the IM focuses on helping students see the big picture: all decisions relate to either investment or financing.
Liquidity is a very important concept. Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.
Also, point out that a firm can be TOO liquid. Excess cash holdings lead to overall lower returns. See the Lecture Tip in the IM for a more complete discussion of this issue.
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4. The Balance Sheet - Figure 2.1
The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are a direct result of management’s investment decisions. (Please emphasize that “investment decisions” are not limited to investments in financial assets.)
Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets – total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of management’s financing decisions.
Remember that shareholders’ equity consists of several components and that total equity includes all of these components, not just the “common stock” item. In particular, remind students that retained earnings belong to the shareholders. See the Lecture Tip in the IM for further discussion.
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5. Net Working Capital and Liquidity
= Current Assets – Current Liabilities
Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out
Usually positive in a healthy firm
Liquidity
Ability to convert to cash quickly without a significant loss in value
Liquid firms are less likely to experience financial distress
But liquid assets typically earn a lower return
Trade-off to find balance between liquid and illiquid assets
After a basic accounting class, students may believe a higher current ratio (or, similarly, more cash on hand) is always better. So, it is good to remind students that a cash balance is a use of funds and has an opportunity cost. (See the Lecture Tip in the IM for more detail.)
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6. US Corporation Balance Sheet – Table 2.1
The first example computing CFs has a link to the information in this table. The arrow in the corner is used to return you to the example.
Here is an example of a simplified balance sheet. Many students make it through business school without ever seeing an actual balance sheet, particularly those who are not majoring in finance or accounting. I encourage you to bring in some annual reports and let the students see the differences between the simplified statements they see in textbooks and the real thing.
This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are.
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7. Market Value vs. Book Value
The balance sheet provides the book value of the assets, liabilities, and equity.
Market value is the price at which the assets, liabilities ,or equity can actually be bought or sold.
Market value and book value are often very different. Why?
Which is more important to the decision-making process?
Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities, and equity of the firm.
Assets are listed at historical costs less accumulated depreciation – this may bear little resemblance to what they could actually be sold for today. The balance sheet also does not include the value of many important assets, such as human capital. Consequently, the “Total Assets” line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth. (See the Lecture Tip in the IM for more detail on this issue.)
Liabilities are listed at face value. When interest rates change or the risk of the firm changes, the value of those liabilities Δthe market as well. This is especially true for longer-term liabilities.
Equity is the ownership interest in the firm. The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the market’s estimation of the current value of ALL of the assets of the firm.
The best estimate of the market value of the firm’s assets is market value of liabilities + market value of equity.
Market values are generally more important for the decision making process because they are more reflective of the CFs that would occur today.
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8. Ch 2 Problem 1
Find the value of Shareholders’ Equity and of Net Working Capital…
To find owner’s equity, we must construct a balance sheet :
Balance Sheet
CA $5,100 CL $4,300
NFA 23,800 LTD 7,400
OE ??
TA $28,900 TL & OE $28,900
We know that total liabilities and owner’s equity (TL & OE) must equal total assets of $28,900. We also know that TL & OE is equal to current liabilities plus long-term debt plus owner’s equity, so owner’s equity is:
OE = $28,900 – 7,400 – 4,300 = $17,200
NWC = CA – CL = $5,100 – 4,300 = $800

9. Ch 2 Problem 5 Find the Book Value and the Market Value of assets…
To find the book value of current assets, we use NWC = CA – CL
Rearranging to solve for current assets, we get:
CA = NWC + CL = $380, ,400,000 = $1,480,000
Market Value of Current Assets is given ($1.6 million).

10. Income Statement What does the Income Statement do?
What does “matching” achieve, and why is it important?

11. Income Statement
The income statement is a summary of the firm’s finances for a specified period of time.
You generally report revenues first and then deduct any expenses for the period
Matching principle – GAAP says to show revenue when it accrues and match the expenses required to generate the revenue
Matching principle – this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the CF during the period.
Similar to a previous Lecture Tip, consider discussing that the top half of the income statement addresses investment decisions, whereas the bottom half deals with financing.
See the IM for a discussion of Global Crossing’s record “profit” during the first quarter of 2004.
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12. US Corporation Income Statement – Table 2.2
Insert new Table 2.2 here (US Corp Income Statement)
The first example computing CFs has a link to the information in this table. The arrow in the corner is used to return you to the example.
Remember that these are simplified income statements for illustrative purposes.
Earnings before interest and taxes is often called operating income.
COGS would include both the fixed costs and the variable costs needed to generate the revenues.
Analysts often look at EBITDA (earnings before interest, taxes, depreciation, and amortization) as a measure of the operating CF of the firm. It is not true in the strictest sense because taxes are an operating CF as well, but it does provide a reasonable estimate for analysis purposes.
The IM provides a discussion of Cendant and the problems that the company ran into when fraudulent accounting practices were discovered.
It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statements. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the IRS. In this instance, the “life” of the asset for depreciation purposes may be very different from the useful life of the asset. Statements that are prepared for investors often use straight-line depreciation because it will tend to have a lower depreciation charge than MACRs early in the asset’s life. This reduces the “expense,” and thus increases the firm’s reported EPS. This is a good illustration of why it is important to look at a firm’s CF and not just its EPS.
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13. Ch 2 Problem 2
Find the Net Income…

14. Ch 2 Problems 3
If they had paid a cash dividend of $73,000, what would happen to Retained Earnings?
What is Retained Earnings?
Net income = Dividends + Addition to retained earnings
Addition to retained earnings = Net income – Dividends = $171,600 – 73,000 = $98,600

15. Ch 2 Problem 4 Find the EPS and Dividends Per Share…
EPS = Net income / Shares = $171,600 / 85,000 = $2.02 per share
DPS = Dividends / Shares = $73,000 / 85,000 = $0.86 per share

16. Taxes
What is the difference between the Marginal Tax Rate and the Average Tax Rate?
Why is this important to know?

17. Taxes
The one thing we can rely on with taxes is that they are always changing
Marginal vs. average tax rates
Marginal tax rate – the percentage paid on the next dollar earned
Average tax rate – the tax bill / taxable income
Other taxes
Point out that taxes can be a very important component of the decision making process, but what students learn about tax specifics now could change tomorrow. (See Lecture Tip in the IM.) Consequently, it is important to keep up with the changing tax laws and to utilize specialists in the tax area when making decisions where taxes are involved.
www: Click on the web surfer icon to go to the IRS web site for the most up-to-date tax information.
It is important to point out that we are concerned with the taxes that we will pay if a decision is made. Consequently, the marginal tax rate is what we should use in our analysis.
Point out that the tax rates discussed in the book are just federal taxes. Many states and cities have income taxes as well, and those taxes should figure into any analysis that we conduct.
See the IM for an interesting Lecture Tip surrounding the discussion of abolishing corporate taxes.
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18. Corporate Tax Rate Schedule
EXAMPLE: What if a company has before tax earnings of $250,000?
Average tax rate = 32.3%
Marginal tax rate (on the next $85,000) = 39%

19. Example: Marginal Vs. Average Rates
Suppose your firm earns $4 million in taxable income.
What is the firm’s tax liability?
What is the average tax rate?
What is the marginal tax rate?
If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?
Tax liability:
.15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,360,000
Average rate: 1,360,000 / 4,000,000 = .34 or 34% Marginal rate comes from the table and it is 34% also, but they are not always the same.
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20. Ch 2 Problem 6 & 7 Find Renata Co.’s 2009 Income Tax Expense
= 0.15($50K) ($25K) ($25K) ($236K – 100K)
= $75,290
The average tax rate is the total tax paid divided by net income, so:
Average tax rate = $75,290 / $236,000 = 31.90%
The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%.

21. Cash Flows Why is CF important?
What if you have a business model with no cash flows?
What are the types of CFs, and what is the significance of each?

22. Cash Flows
CF is one of the most important pieces of information that a financial manager can derive from financial statements
The statement of CFs does not provide us with the same information that we are looking at here
We will look at how cash is generated from utilizing assets
We will examine how cash is paid to those that finance the purchase of assets
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23. CF Summary
This provides a summary for the various CF calculations. It is a good place to refer back when working on CFs in the capital budgeting section.
From which financial statement does each piece of information come from?
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24. US Corporation Balance Sheet – Table 2.1
The first example computing CFs has a link to the information in this table. The arrow in the corner is used to return you to the example.
Here is an example of a simplified balance sheet. Many students make it through business school without ever seeing an actual balance sheet, particularly those who are not majoring in finance or accounting. I encourage you to bring in some annual reports and let the students see the differences between the simplified statements they see in textbooks and the real thing.
This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are.
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25. US Corporation Income Statement – Table 2.2
Insert new Table 2.2 here (US Corp Income Statement)
The first example computing CFs has a link to the information in this table. The arrow in the corner is used to return you to the example.
Remember that these are simplified income statements for illustrative purposes.
Earnings before interest and taxes is often called operating income.
COGS would include both the fixed costs and the variable costs needed to generate the revenues.
Analysts often look at EBITDA (earnings before interest, taxes, depreciation, and amortization) as a measure of the operating CF of the firm. It is not true in the strictest sense because taxes are an operating CF as well, but it does provide a reasonable estimate for analysis purposes.
The IM provides a discussion of Cendant and the problems that the company ran into when fraudulent accounting practices were discovered.
It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statements. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the IRS. In this instance, the “life” of the asset for depreciation purposes may be very different from the useful life of the asset. Statements that are prepared for investors often use straight-line depreciation because it will tend to have a lower depreciation charge than MACRs early in the asset’s life. This reduces the “expense,” and thus increases the firm’s reported EPS. This is a good illustration of why it is important to look at a firm’s CF and not just its EPS.
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26. Example: US Corporation – Part I
OCF (I/S) = EBIT + depreciation – taxes = $547
NCS (B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130
Changes in NWC (B/S) = ending NWC – beginning NWC = $330
CFFA = OCF – NCS – ΔNWC =547 – 130 – 330 = $87
Use the information from the balance sheet and income statement presented previously to work through this example. There is a hyperlink on “I/S” that will take you to that slide. Another one exists on “B/S.” The arrows on the Income Statement and Balance Sheet slides will bring you back here.
OCF = – 212 = 547
NCS = 1709 – = 130
Students often have a difficult time understanding why a cash outflow has a positive sign and a cash inflow has a negative sign. Emphasize that we are talking about SPENDING in the net capital spending formula and Investment in NWC. The formula for CFFA takes care of reducing CF when NCS is positive and increasing CF when it is negative.
Ending NWC = 1403 – 389 = 1014
Beginning NWC = 1112 – 428 = 684
Changes in NWC = 1014 – 684 = 330
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27. Example: US Corporation – Part II
CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24
CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $63
CFFA = CF to Creditors + CF to Stockholders = = $87
CFFA = OCF – NCS – ΔNWC =547 – 130 – 330 = $87
OCF – NCS – ΔNWC = CF to Creditors + CF to Stockholders
Use the information from the balance sheet and income statement presented previously to work through this example. There is a hyperlink on “I/S” that will take you to that slide. Another one exists on “B/S.” The arrows on the Income Statement and Balance Sheet slides will bring you back here.
Net New Borrowing = ending LT debt – beginning LT debt = 454 – 408 = 46
CF to creditors = 70 – 46 = 24
Net New Equity = 640 – 600 = 40 (Be sure to point out that we want equity raised in the capital markets, not retained earnings).
CF to Stockholders = 103 – 40 = 63
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28. Example: Balance Sheet and Income Statement Information
Current Accounts
2009: CA = 3625; CL = 1787
2008: CA = 3596; CL = 2140
Fixed Assets and Depreciation
2009: NFA = 2194; 2008: NFA = 2261
Depreciation Expense = 500
Long-term Debt and Equity
2009: LTD = 538; Common stock & APIC = 462
2008: LTD = 581; Common stock & APIC = 372
Income Statement
EBIT = 1014; Taxes = 368
Interest Expense = 93; Dividends = 285
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29. Example: CFs
OCF = 1, – 368 = 1,146
NCS = 2,194 – 2, = 433
Changes in NWC = (3,625 – 1,787) – (3,596 – 2,140) = 382
CFFA = 1,146 – 433 – 382 = 331
CF to Creditors = 93 – (538 – 581) = 136
CF to Stockholders = 285 – (462 – 372) = 195
CFFA = = 331
The CF identity holds
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30. Ch 2 Problem 8 Find OCF… First, we need the income statement
Sales $27,500
Costs 13,280
Depreciation 2,300
EBIT $11,920
Interest 1,105
Taxable income $10,815
Taxes (35%) 3,785
Net income $ 7,030
OCF = EBIT + Depreciation – Taxes = $11, ,300 – 3,785 = $10,435

31. Ch 2 Problem 9 Find NCS (Net Capital Spending)…
Net capital spending = NFAend – NFAbeg + Depreciation
Net capital spending = $4,200,000 – 3,400, ,000
Net capital spending = $1,185,000

32. Ch 2 Problem 10 Find ΔNWC (Change in Net Working Capital)…
ΔNWC = NWCend – NWCbeg
ΔNWC = (CAend – CLend) – (CAbeg – CLbeg)
ΔNWC = ($2,250 – 1,710) – ($2,100 – 1,380)
ΔNWC = $540 – 720 = –$180

33. Ch 2 Problem 11 Find CF to Creditors…
CF to creditors = Interest paid – Net new borrowing
CF to creditors = Interest paid – (LTDend – LTDbeg)
CF to creditors = $170,000 – ($2,900,000 – 2,600,000)
CF to creditors = –$130,000

34. Ch 2 Problem 12 Find CF to Stockholders…
CF to stockholders = Dividends paid – Net new equity
CF to stockholders = Dividends paid – [(Commonend + APISend) – (Commonbeg + APISbeg)] (APIS is the additional paid-in surplus)
CF to stockholders = $490,000 – [($815, ,500,000) – ($740, ,200,000)]
CF to stockholders = $115,000

35. Ch 2 Problem 13 Find OCF (Operating Cash Flow)…
First, we need CFFA (Cash Flow From Assets)
CFFA = CF to creditors + CF to stockholders = –$130, ,000 = –$15,000
Since CFFA = –$15,000 and OCF – ΔNWC – Net capital spending Therefore –$15,000 = OCF – (–$85,000) – 940,000
Rearranging to find –$15,000 – 85, ,000 = OCF
OCF = $840,000

36. Chapter 3 Statement of Cash Flows, and sources and uses of cash
Standardizing financial statements for comparison purposes
Important financial ratios
Problems and pitfalls in financial statement analysis
Digital Equipment’s CEO stated: “Make your numbers or I’m sure your successor will.”
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37. Financial Statement Analysis

38. Statement of Cash Flows
What is the purpose of the Statement of Cash Flows?
What are the three sections, and why is it divided that way?
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39. Statement of Cash Flows
Statement that summarizes the sources and uses of cash
Changes divided into three major categories
Operating Activity – includes net income and changes in most current accounts
Investment Activity – includes changes in fixed assets
Financing Activity – includes changes in notes payable, long-term debt, and equity accounts, as well as dividends
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40. Sources and Uses of Cash
Cash inflow – occurs when we “sell” something…always?
Decrease in asset account (Sample B/S)
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
Accounts payable, other current liabilities, and common stock
Uses
Cash outflow – occurs when we “buy” something…always?
Increase in asset account
Cash and other current assets
Decrease in liability or equity account
Notes payable and long-term debt
Click on Sample B/S to go to the Balance Sheet to illustrate the accounts that are sources and uses, On the B/S Click on the small green arrow to return to this slide.
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41. Sample Balance Sheet Numbers in millions of dollars 2009 2008 Cash 69658
A/P
307
303
A/R
956
992
N/P 26
119
Inventory
301
361
Other CL
1,662
1,353
Other CA
264
Total CL
1,995
1,775
Total CA
2,256
1,675
LT Debt
843
1,091
Net FA
3,138
3,358
C/S
2,556
2,167
Total Assets
5,394
5,033
Total Liab. & Equity
The opening Lecture Tip in the IM explains the relevance of accounting data, even given its potential downfalls. The subsequent Tip is designed to help students understand that in increase in the cash account is a use of funds.
Numbers in millions of dollars
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42. Sample Income Statement
Revenues
5,000
Cost of Goods Sold
(2,006)
Expenses
(1,740)
Depreciation
(116)
EBIT
1,138
Interest Expense
(7)
Taxable Income
1,131
Taxes
(442)
Net Income
689
EPS
3.61
Dividends per share
1.08
The net income figure and EPS are based on income from continuing operations. There are million shares outstanding.
Numbers in millions of dollars, except EPS & DPS
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43. Sample Statement of Cash Flows
Cash, beginning of year 58
Financing Activity
Operating Activity
Decrease in Notes Payable
-93
Net Income
689
Decrease in LT Debt
-248
Plus: Depreciation
116
Decrease in C/S (minus RE)
-94
Decrease in A/R 36
Dividends Paid
-206
Decrease in Inventory 60
Net Cash from Financing
-641
Increase in A/P 4
Increase in Other CL
309
Net Increase in Cash
638
Less: Increase in other CA
-39
Net Cash from Operations
1,175
Cash End of Year
696
Investment Activity
Sale of Fixed Assets
104
Net Cash from Investments
Investment activity: change in net fixed assets + depreciation (have to add back depreciation because it was deducted from the fixed asset account to get the net fixed asset figure). If the number is positive, then we acquired fixed assets; if it’s negative, then we sold fixed assets.
3138 – = -104 so we sold 104 million worth of fixed assets
Remind students that part of the increase in the C/S account shown on the balance sheet is the increase in Retained Earnings. That is already incorporated in the net income under operating activity.
Dividends paid = 190.9*1.08 = 206 million
Additions to RE = 689 – 206 = 483
Change in C/S = 2556 – 2167 – 483 = -94
Numbers in millions of dollars
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44. 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
Lecture Tip: Discuss with students that the ratios that are most important to a firm are those that best represent their business. So, whereas inventory turnover may be relevant for a retailer or manufacturer, it is less important for a service firm. The best ratios may be those that are uniquely developed for the business under review.
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45. 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
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46. Ch 3 Problem 13, 14 & 15
How did we get here? What does it really tell us?

47. Ratio Analysis
Ratios allow for better comparison through time or between companies
Ratios are used both internally and externally
Consider what each ratio is trying to measure and why that information is important
Avoid creating rounding issues!
Lecture Tip: Be sure that your students understand that “real-world” financial statements are not as straightforward as the simplified ones presented in the textbook. Actually reviewing some financial statements of companies with which they are familiar may help.
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48. 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
The ratios in the following slides will be computed using the 2007 information from the Sample Balance Sheet and Income Statement.
Lecture Tip: Remind students that the point of the analysis is not simply the ability to compute the ratios, but rather the ability to interpret them.
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49. Computing Liquidity Ratios
Current Ratio = CA / CL
2,256 / 1,995 = 1.13 times
Quick Ratio = (CA – Inventory) / CL
(2,256 – 301) / 1,995 = .98 times
Cash Ratio = Cash / CL
696 / 1,995 = .35 times
NWC to Total Assets = NWC / TA
(2,256 – 1,995) / 5,394 = .05
Interval Measure = CA / average daily operating costs
2,256 / ((2, ,740)/365) = days
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. Also, the CR for 2008 was .94, so the company has improved from the previous year.
The quick ratio is quite a bit lower than the current ratio, so inventory seems to be an important component of current assets.
This company carries a low cash balance, although the cash ratio has increased substantially from the previous year (.03 in 2008). This may be an indication that they are aggressively 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.
The NWC to TA measure seems relatively low, but is consistent with the current ratio.
The Interval Measure indicates that the company can meet average daily expenses with current assets for almost 220 days. The Lecture Tip in the IM discusses the importance of this measure for entrepreneurs.
Lecture Tip: Remind students that a high current ratio may actually be a negative, as current assets generally produce a lower return than fixed assets. To build on this understanding, make students evaluate the interaction among ratios. For example, suggest a scenario in which the current ratio exhibits no change over a two- or three-year period, while the quick ratio experiences a steady decline. How could this occur?
B/S
I/S
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50. Ch 3 Problem 1 Find the Current Ratio and the Quick Ratio…
Using the formula for NWC, we get:
NWC = CA – CL
CA = CL + NWC = $3, ,370 = $5,090
So, the current ratio is:
Current ratio = CA / CL = $5,090/$3,720 = 1.37 times
And the quick ratio is:
Quick ratio = (CA – Inventory) / CL = ($5,090 – 1,950) / $3,720 = 0.84 times

51. Computing Long-term Solvency Ratios
Total Debt Ratio = (TA – TE) / TA
(5,394 – 2,556) / 5,394 = 52.61%
Debt/Equity = TD / TE
(5,394 – 2,556) / 2,556 = 1.11 times
Equity Multiplier = TA / TE = 1 + D/E
= 2.11
Long-term debt ratio = LTD / (LTD + TE)
843 / ( ,556) = 24.80%
Note that these are often called leverage ratios. Following the Lecture Tip in the IM, note that this group of ratios measures two aspects of leverage: level of indebtedness and the ability to service this debt.
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.
The firm finances almost 53% of its assets with debt. This is down from about 57% from the previous year.
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) = / ( ) = 1.11
The EM is one of the ratios that is used in the Du Pont Identity as a measure of the firm’s financial leverage.
The Long-term debt ratio is down from 33.49% in 2008.
B/S
I/S
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52. Ch 3 Problem 5 Total debt ratio = TD / TA = 0.63
(which could also be written as 0.63 / 1.00)
TA = total debt plus total equity
therefore 0.63 = TD / (TD + TE)
and (1 – 0.63) = TE / (TD + TE) = 0.37
therefore 0.63(TE) = 0.37(TD)
Debt/equity ratio = TD / TE = 0.63 / 0.37 = 1.70
Equity multiplier = 1 + D/E = 2.70
(The Equity Multiplier is equal to the Financial Leverage
Multiplier, which is calculated as Total Assets / Common Equity.
In this case 1.00 / 0.37 = 2.70, so our numbers check out.)

53. Computing Coverage Ratios
Times Interest Earned = EBIT / Interest
1,138 / 7 = times
Cash Coverage = (EBIT + Depreciation) / Interest
(1, ) / 7 = times
Even though the company is financed with over 64% debt, they have a substantial amount of operating income available to cover the required interest payments.
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.
Lecture Tip: The importance of coverage ratios is sometimes overlooked, particularly when one considers their importance to all types of creditors.
B/S
I/S
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54. Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
2,006 / 301 = 6.66 times
Days’ Sales in Inventory = 365 / Inventory Turnover
365 / 6.66 = 55 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.
Lecture Tip: You may wish to mention that there may be significant inconsistencies in the methods used to compute ratios by financial advisory firms. When using ratios supplied by others, it is important to be aware of the exact financial items used. A manufacturer would typically consider inventory at cost, and thus, relate inventory to cost of goods sold. However, a retailer might maintain its inventory level based on retail price. In the latter case, inventory should be related to sales to compute inventory turnover. The markup would cancel in the numerator and denominator and give an accurate indication of turnover based on cost. Furthermore, some analysts use average inventory over some period instead of ending inventory. The same is true for the other assets used in the various turnover ratios.
B/S
I/S
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55. Computing Receivables Ratios
Receivables Turnover = Sales / Accounts Receivable
5,000 / 956 = 5.23 times
Days’ Sales in Receivables = 365 / Receivables Turnover
365 / 5.23 = 70 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).
Lecture Tip: Be sure to remind students that ratio analysis is a means to an end, not an end in itself. The results of the analysis provide us with red flags or items for additional investigation.
Lecture Tip: Students also need to realize that comparisons across industries can be problematic.
B/S
I/S
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56. Computing Total Asset Turnover
Total Asset Turnover = Sales / Total Assets
5,000 / 5,394 = .93
It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
NWC Turnover = Sales / NWC
5,000 / (2,256 – 1,995) = times
Fixed Asset Turnover = Sales / NFA
5,000 / 3,138 = 1.59 times
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.
B/S
I/S
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57. Computing Profitability Measures
Profit Margin = Net Income / Sales
689 / 5,000 = 13.78%
Return on Assets (ROA) = Net Income / Total Assets
689 / 5,394 = 12.77%
Return on Equity (ROE) = Net Income / Total Equity
689 / 2,556 = 26.96%
You can also compute the gross profit margin and the operating profit margin.
GPM = (Sales – COGS) / Sales = (5,000 – 2,006) / 5,000 = 59.88%
OPM = EBIT / Sales = 1,138 / 5,000 = 22.76%
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 the revenues. It tells how much the firm earns for every dollar in sales. In the example, the firm earns almost $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 terms) 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.
A Lecture Tip in the IM discusses Economic Value Added and its relevance to ratio analysis.
B/S
I/S
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58. Computing Market Value Measures
Market Price = $87.65 per share
Shares outstanding = million
PE Ratio = Price per share / Earnings per share
87.65 / 3.61 = times
Market-to-book ratio = market value per share / book value per share
87.65 / (2,556 / 190.9) = 6.55 times
Lecture Tip: It is good for students to understand that average is not always best. Further, average levels may vary through time with the economy, and this is particularly relevant for market value measures. Further, comparisons across countries may be difficult due to differences in accounting and reporting standards.
A good discussion may be asking the question: “does a market-to-book ratio below one indicate a good investment?” It may be an indication of undervaluation; however, such a ratio may also indicate negative consensus regarding the future viability of the firm.
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59. ROA vs ROE
What is the difference between Return on Equity and Return on Assets?
Both use Net Income as the numerator. The difference is financial leverage.
Net Income
Total Assets
Net Income
Total Equity

60. Deriving the Du Pont Identity
ROE = NI / TE
Multiply by 1 (TA/TA) and then rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 (Sales/Sales) again and then rearrange
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM
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61. Using the Du Pont Identity
ROE = PM * TAT * EM
Profit margin is a measure of the firm’s operating efficiency – how well it controls 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.
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62. Expanded Du Pont Analysis – Du Pont Data
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63. Extended Du Pont Chart
Insert Figure 3.1 (Extended DuPont Chart)
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64. Ratio Analysis How can we make ratios useful?
What are the contexts in which we might be examining performance?
In examining a ratio, what makes a particular number good or bad?

65. Ratio Analysis
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.
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66. Real World Example - I
Ratios are figured using financial data from the 2007 Annual Report for Home Depot
Compare the ratios to the industry as they are reported in Tables 3.11 and 3.12 in the book
Home Depot’s fiscal year ends Feb. 3
Be sure to note how the ratios are computed in the table so you can compute comparable numbers
Home Depot sales = $77,349 MM
Technically, Home Depot has an SIC code of 5211, but EDGAR did not list any nationally known companies with the SIC codes listed in Tables 3.11 and Also, although the annual report is denoted as 2007, the fiscal year actually ends in I find it helpful to discuss with students why Home Depot has chosen not to use a calendar year (i.e., allow Christmas holiday issues to work through the system prior to closing).
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.
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67. Real World Example - II Liquidity ratios Long-term solvency ratio
Current ratio = 1.15x; Industry = 1.7x
Quick ratio = .23x; Industry = .4x
Long-term solvency ratio
Debt/Equity ratio (Debt / Worth) = 1.5x; Industry = 1.1x.
Coverage ratio
Times Interest Earned = 11.6x; Industry = 4.5x
The industry number reported above is the median from the table. I also used the 25MM and over column to better match size.
Liquidity ratio: Home Depot has a current ratio below the median, as well as 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.
Debt/Equity ratio: Home Depot is above the industry average, which implies it has relatively more debt than the average company in the industry. Creditors may not like this; however, the firm may be taking advantage of favorable tax benefits associated with interest payments. (It is interesting to note that in the prior edition, this relation was reversed, as HD had unused debt capacity. So, it appears they have taken the suggestion to leverage up to capture tax benefits and increase ROE.)
Times Interest Earned: This ratio is substantially higher than the industry median, which indicates that the company is able to easily cover the relatively high debt percentage calculated just above. Note, the interest received on investments can be used to pay the interest expense on debt – in fact for the fiscal year ended Feb. 3, 2007, Home Depot had 74MM in interest income and 696MM in interest expense
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68. Real World Example - III
Asset management ratios:
Inventory turnover = 4.4x; Industry = 3.8x
Receivables turnover = 61.4x (6 days); Industry = 26.9x (14 days)
Total asset turnover = 1.7x; Industry = 2.6x
Profitability ratios
Profit margin before taxes = 8.6%; Industry = 2.5%
ROA (profit before taxes / total assets) = 14.9%; Industry = 6.4%
ROE = (profit before taxes / tangible net worth) = 37.4%; Industry = 11.9%
Inventory Turnover: The inventory turnover is higher than the industry median and is approaching the upper quartile. Either the company is very good at managing inventory relative to the industry or they are running short on inventory.
Receivables are collected substantially faster than the industry median and also faster than the 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 the lower quartile. The problem is likely related to fixed assets since both inventory and receivables are turning so quickly. In fact, calculating NFA turnover results in a value of 2.8x, relative to industry at 14.2x.
Profit margin before taxes (From Table 3.11): Home Depot’s profit margin is substantially higher than the median. 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. This result suggests that the low asset turnover is offset by the higher profit margin.
ROE: The ROE is higher than the upper quartile. Reviewing this in the context of the Du Pont Identity suggests that the greatest area for potential improvement is in asset turnover (particularly net fixed assets).
Note that ROA and ROE are computed using profit before taxes to be consistent with the numbers in the table.
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69. Problems & Pitfalls
Analysts have different opinions of which ratios are most relevant
Benchmarking is difficult for diversified firms
Globalization and international competition makes comparison more difficult because of differences in accounting regulations
Circumstances may require more detailed analysis
Accounting procedures (e.g. FIFO vs. LIFO)
Extraordinary events
Fundamental changes over time
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70. Problems to pay attention to…
Ch 3 Problems cover the basics. You should be able to do these easily.
Problems 18 – 30 may also be a good idea to study for the exam.

71. Next Time… Minicase Ch 2 Minicase Ch 3 Chapters 4 & 5
Prepare the Income Statement & Balance Sheet
Calculate the Cash Flows
Address the 2 questions
Minicase Ch 3
Calculate all 14 ratios
Address the questions
Chapters 4 & 5