1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Working With Financial Statements Chapter Three

2. 3.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills Understand sources and uses of cash and the Statement of Cash Flows Know how to standardize financial statements for comparison purposes Know how to compute and interpret important financial ratios Be able to compute and interpret the Du Pont Identity Understand the problems and pitfalls in financial statement analysis

3. 3.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline Cash Flow and Financial Statements: A Closer Look Standardized Financial Statements Ratio Analysis The Du Pont Identity Using Financial Statement Information

4. 3.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Sample Balance Sheet 2000199920001999 Cash & Equivalents 3,1716,489A/P313,286340,220 A/R1,095,1181,048,991N/P227,84886,631 Inventory388,947295,255Other CL1,239,6511,098,602 Other CA314,454232,304Total CL1,780,7851,525,453 Total CA1,801,6901,583,039LT Debt1,389,615871,851 Net FA3,129,7542,535,072C/S1,761,0441,648,490 Total Assets4,931,4444,118,111Total Liab. & Equity 4,931,4444,118,111 Numbers are in thousands See 3.5: Sources & Uses of Cash

5. 3.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Sample Income Statement Revenues4,335,491 Cost of Goods Sold1,762,721 Expenses1,390,262 Depreciation362,325 EBIT820,183 Interest Expense52,841 Taxable Income767,342 Taxes 295,426 Net Income471,916 EPS2.29 Dividends per share0.54 Numbers are in thousands, except EPS & DPS

6. 3.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Sources and Uses of Cash 3.1 Sources –Cash inflow – occurs when we “sell” something –Decrease in asset account –Increase in liability or equity account Uses –Cash outflow – occurs when we “buy” something –Increase in asset account –Decrease in liability or equity account

7. 3.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

8. 3.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Sample Statement of Cash Flows Cash, beginning of year6,489Financing Activity Operating Activity Increase in Notes Payable 141,217 Net Income471,916 Increase in LT Debt517,764 Plus: Depreciation362,325 Decrease in C/S-248,209 Increase in Other CL141,049 Dividends Paid-111,153 Less: Increase in A/R-46,127 Net Cash from Financing 299,619 Increase in Inventory-93,692Net Decrease in Cash(+68,999) Increase in Other CA-82,150Cash End of Year(assume correct) 3,170* Decrease in A/P-26,934So we do not have to change all the figures (ratios) Net Cash from Operations726,387 Investment Activity Fixed Asset Acquisition-957,007 Net Cash from Investments-957,007*Difference due to rounding of dividends

9. 3.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Standardized Financial Statements 3.2 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

10. 3.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Ratio Analysis 3.3 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 is that information important Ratios are used both internally and externally

11. 3.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

12. 3.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Liquidity Ratios Current Ratio = CA / CL (s.t. liquidity) –1,801,690 / 1,780,785 = 1.01 times Quick Ratio = (CA – Inventory) / CL –(1,801,690 – 388,947) / 1,780,785 =.793 times Cash Ratio = Cash / CL –3,171 / 1,780,785 =.002 times

13. 3.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Long-term Solvency Ratios Total Debt Ratio = (TA – TE) / TA –(4,931,444 – 1,761,044) / 4,931,444 =.6429 times or 64.29% –The firm finances a little over 64% of its assets with debt. Debt/Equity = TD / TE –(4,931,444 – 1,761,044) / 1, 761,044 = 1.800 times Equity Multiplier = TA / TE = 1 + D/E –1 + 1.800 = 2.800

14. 3.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Coverage Ratios Times Interest Earned = EBIT / Interest –820,183 / 52,841 = 15.5 times Cash Coverage = (EBIT + Depreciation) / Interest –(820,183 + 362,325) / 52,841 = 22.38 times

15. 3.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / Inventory –1,762,721 / 388,947 = 4.53 times Days’ Sales in Inventory = 365 / Inventory Turnover –365 / 4.53 = 81 days

16. 3.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Receivables Ratios Receivables Turnover = Sales / Accounts Receivable –4,335,491 / 1,095,118 = 3.96 times Days’ Sales in Receivables = 365 / Receivables Turnover –365 / 3.96 = 92 days

17. 3.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Total Asset Turnover NWC Turnover = Sales / NWC –4,335,491 / (1,801,690 - 1,780,785) = 207.390 times Fixed Asset Turnover = Sales / Net Fixed Assets –4,335,491 / 3,129,754 = 1.385 times Total Asset Turnover = Sales / Total Assets –4,335,491 / 4,931,444 =.88 times Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

18. 3.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Profitability Measures Profit Margin = Net Income / Sales –471,916 / 4,335,491 =.1088 times or 10.88% Return on Assets (ROA) = Net Income / Total Assets –471,916 / 4,931,444 =.0957 times or 9.57% Return on Equity (ROE) = Net Income / Total Equity –471,916 / 1,761,044 =.2680 times or 26.8%

19. 3.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing Market Value Measures Market Price = $60.98 per share Shares outstanding = 205,838,910 PE Ratio = Price per share / Earnings per share –60.98 / 2.29 = 26.62 times Market-to-book ratio = market value per share / book value per share –60.98 / (1,761,044,000 / 205,838,910) = 7.1 times

20. 3.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Table 3.8 – Common Financial Ratios

21. 3.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Table 3.8 – Common Financial Ratios

22. 3.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Deriving the Du Pont Identity 3.4 ROE = NetInc / TE Multiply by 1 and then rearrange –ROE = (NI / TE) (TA / TA) –ROE = (NI / TA) (TA / TE) = ROA * EMult Multiply by 1 again and then rearrange –ROE = (NI / TA) (TA / TE) (Sales / Sales) –ROE = (NI / Sales) (Sales / TA) (TA / TE) –ROE = ProfMarg * TotAsTurnov * EMult

23. 3.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

24. 3.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Using Financial Statement Information 3.5 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

25. 3.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 –NAICS codes, Financial Post Datagroup, and Dun & Bradstreet Canada

26. 3.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Potential Problems There is no underlying theory, so there is no way to know 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 Varying accounting procedures, i.e. FIFO vs. LIFO Different fiscal years Extraordinary events

27. 3.26 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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?

28. 3.27 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 3.6 You should be able to: –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