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

4. Who needs to understand ratios?
Managers
Use ratios to evaluate various aspects of the firm
Profitability
Productivity
Marketers
Use ratios dealing with costs, markups, and margins
Production personnel
Use ratios that deal with issues such as operating efficiency

5. Standardized Financial Statements
Common-size statement: a standardized financial statement presenting all items in percentage terms
Common-size Balance Sheet
Balance sheet items shown as a percentage of total assets
Common-size Income Statement
Income statement items shown as a percentage of total sales

6. Standardized Financial Statements (continued)
Standardized statements make it easier to compare financial information
Standardized statements are useful for comparing companies of different sizes, especially within the same industry

7. Ratio Analysis
Financial ratios: Relationships determined from a firm’s financial information and used for comparison purposes
Ratios allow for comparison over time or between firms
Ratios are used both internally and externally

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. Analyzing ratios Questions to ask when analyzing ratios:
How is the ratio computed?
What does the ratio measure? Why do we care?
What is the unit of measurement?
What does a high/low value tell us? How might such values be misleading?
How could this measure be improved?

10. Short-term Solvency/Liquidity Ratios
Current Ratio
Formula
What does it measure?
Quick (Acid Test) Ratio

11. Short-term Solvency/Liquidity Ratios (continued)
Cash ratio
Formula
What does it measure?

12. Financial Leverage Ratios
Total Debt Ratio
Formula
What does it measure?
Debt/Equity Ratio

13. Financial Leverage Ratios (continued)
Equity Multiplier
Formula
What does it measure?

14. Coverage Ratios Times Interest Earned ratio Cash Coverage ratio
Formula
What does it measure?
Cash Coverage ratio

15. Inventory Ratios Inventory Turnover ratio Days’ Sales in Inventory
Formula
What does it measure?
Days’ Sales in Inventory

16. Receivables ratios Receivables Turnover Days’ Sales in Receivables
Formula
What does it measure?
Days’ Sales in Receivables

17. Total Asset Turnover Total Asset Turnover ratio Formula
Measures asset use efficiency
It is not unusual for total asset turnover to be less than one, especially if the firm has a large amount of fixed assets

18. Profitability Ratios
Profitability ratios are the best known and most widely used of all financial ratios
Profit Margin
Formula
What does it measure?

19. Profitability Ratios (continued)
Return On Assets (ROA)
Formula
What does it measure?
Return On Equity (ROE)

20. Budweiser
Profit margin 12.23%
ROA %
ROE %

21. YUM!
Profit Margin 8.63%
ROA %
ROE %

22. GOOGLE!
Profit margin %
ROA %
ROE %

23. Market Value Measures Earnings per share Price to earnings (PE) ratio
Net income/number of shares outstanding
$200,000 NI/100,000 shares = $2.00 earnings per share
Price to earnings (PE) ratio
Measures how much investors are willing to pay per dollar of current earnings
Higher PE ratios are often interpreted to mean that the firm has significant prospects for future growth

24. Market Value Measures Price per share/Earnings per share
$20 price per share/$2.00 earnings per share = PE ratio of 10

25. Market Value Measures (continued)
Market-to-book ratio
Compares the market value of the firm’s investments to their cost
Market value per share/book value per share

26. The Du Pont Formula
The Du Pont formula is named after the Du Pont Corporation, which popularized its use
Allows us to break down ROE into its three basic components
Profit margin, a measure of the firm’s operating efficiency
Total asset turnover, a measure of how well the firm manages its assets
Equity multiplier, a measure of the firm’s financial leverage

27. The Du Pont Formula (continued)
Profit margin x total asset turnover x equity multiplier
ROE = PM x TAT x EM
If ROE is unsatisfactory, Du Pont tells the financial manager where to start looking for the reasons why

28. QUIZ Why is it necessary to standardize financial statements?
How are common-size balance sheets and common-size income statements formed?
What are the five groups of ratios?
Profitability ratios all have the same figure in the numerator. What is it? What do the profitability ratios measure?

29. QUIZ (continued)
What two ratios can be computed if you are given the total debt ratio?
ROA is the product of what two ratios?
ROE is the product of what three ratios?

30. The End of Chapter 3!