2. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Working With Financial Statements Chapter 3

3. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.1 Prepare for Capital Budgeting Part 2: Understand financial statement and cash flow C2-Identify cash flow from financial statement C3-Financial statement and comparison Part 3: Valuation of future cash flow C4-Basic concepts C5-More exercise Part 4: Valuing stocks and bonds C6-Bond C7-Stock Part 5: Capital budgeting

4. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.2 Chapter Outline 1. Why Evaluate Financial Statements? 2. Categories of Financial Ratios 3. Du Pont Identity 4. Payout and Retention Ratios 5. Problems with Financial Statement

5. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.3 1.Why Evaluate Financial Statements? Internal uses Planning for the future – estimating future cash flows Performance evaluation – improving problematic operation and adjusting forecasting target External uses Creditors, Stockholders Suppliers, Customers

6. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.4 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 Peer Group Analysis Compare to similar companies or within industries SIC (Standard Industrial Classification) and NAICS (North American Industry Classification System) codes

7. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.5 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

8. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.6 Common-Size Balance Sheets

9. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.7 Common-Size Income Statements

10. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.8 Ratio Analysis 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.9 2.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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.10 Sample Balance Sheet Cash6,489A/P340,220 A/R1,052,606N/P86,631 Inventory295,255Other CL1,098,602 Other CA199,375Total CL1,525,453 Total CA1,553,725LT Debt871,851 Net FA2,535,072C/S1,691,493 Total Assets4,088,797Total Liab. & Equity 4,088,797 Numbers in thousands

13. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.11 Sample Income Statement Revenues3,991,997 Cost of Goods Sold1,738,125 Expenses1,269,479 Depreciation308,355 EBIT739,987 Interest Expense42,013 Taxable Income697,974 Taxes 272,210 Net Income425,764 EPS2.17 Dividends per share0.86 Numbers in thousands, except EPS & DPS

14. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.12 Short-term Solvency Measures: Liquidity Ratios Evaluate the firm’s ability to pay its bills over the short run without undue stress. Current Ratio = CA / CL 1,553,725 / 1,525,453 = 1.02 times Quick Ratio = (CA – Inventory) / CL (1,553,725 – 295,225) / 1,525,453 =.825 times Cash Ratio = Cash / CL 6,489 / 1,525,453 =.004 times

15. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.13 Long-term Solvency Measures Evaluate the firm’s ability to meet Long-term obligations.

16. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.14 Long-term Solvency Measures-1: Leverage Ratios Total Debt Ratio = (TA – TE) / TA = TD/TA (4,088,797 – 1,691,493) / 4,088,797 =.5863 times or 58.63% The firm finances almost 59% of their assets with debt. Debt/Equity = TD / TE (4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times Equity Multiplier (EM) = TA / TE = 1 + D/E 1 + 1.417 = 2.417

17. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.15 Long-term Solvency Measures-2: Coverage Ratios Times Interest Earned = EBIT / Interest 739,987 / 42,013 = 17.6 times Cash Coverage = (EBIT + Depreciation) / Interest (739,987 + 308,355) / 42,013 = 24.95 times

18. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.16 Asset Management Measures Evaluate how efficiently the firm uses its asset to generate sales.

19. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.17 Asset Management Measures-1: Inventory Ratios Inventory Turnover = Cost of Goods Sold / Inventory 1,738,125 / 295,255 = 5.89 times Days’ Sales in Inventory = 365 / Inventory Turnover 365 / 5.89 = 62 days

20. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.18 Asset Management Measures-2: Receivables Ratios Receivables Turnover = Sales / Accounts Receivable 3,991,997 / 1,052,606 = 3.79 times Days’ Sales in Receivables = 365 / Receivables Turnover 365 / 3.79 = 96 days

21. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.19 Asset Management Measures-3: Total Asset Turnover Total Asset Turnover (TAT) = Sales / Total Assets 3,991,997 / 4,088,797 =.98 times Measure of asset use efficiency Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

22. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.20 Profitability Measures: Profitability Ratios Evaluate the operation efficiency of the firm. Profit Margin (PM) = Net Income / Sales 425,764 / 3,991,997 =.1067 times or 10.67% Return on Assets (ROA) = Net Income / Total Assets 425,764 / 4,088,797 =.1041 times or 10.41% Return on Equity (ROE) = Net Income / Total Equity 425,764 / 1,691,493 =.2517 times or 25.17%

23. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.21 Market Value Measures: Market Value Ratios Illustrate the difference between market and book value of the firm. Market Price = $61.625 per share Shares outstanding = 205,838,594 PE Ratio = Price per share / Earnings per share 61.625 / 2.17 = 28.4 times Market-to-book ratio = market value per share / book value per share 61.625 / (1,691,493,000 / 205,838,594) = 7.5 times

24. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.22 Table 3.5

25. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.23 3.Du Pont Identity

26. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.24 Deriving the Du Pont Identity ROE = NI / TE Multiply by 1 and then rearrange ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM Multiply by 1 again and then rearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM

27. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.25 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

28. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.26 4.Payout and Retention Ratios Dividend payout ratio = Cash dividends / Net income 0.86 / 2.17 =.3963 or 39.63% Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio = b 1.31 / 2.17 =.6037 = 60.37% Or 1 -.3963 =.6037 = 60.37%

29. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.27 The Internal Growth Rate The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.

30. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.28 The Sustainable Growth Rate The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

31. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.29 Determinants of Growth Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

32. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.30 Table 3.6

33. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.31 5.Problems with Financial Statement Little financial theory and economic logic exists with financial statements Limits in comparability 1. Diversified business in conglomerates 2. Different accounting standards across nation 3. Different corporate structure

34. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.32 Review Questions 1. How do you standardize balance sheets and income statements and why is standardization useful? 2. What are the major categories of ratios and what does each category of ratios measure? How to interpret each ratio? 3. What is Du Pont Identity and what are the components of Du Pont Identity? 4. How is retention ratio?What are the major determinants of a firm’s internal and sustainable growth potential? 5. What are some of the problems associated with financial statement analysis?

35. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.33 Sample Question 1 Which of the following would decrease the financial leverage of a firm A. Total assets increase and the debt to equity ratio remains constant B. Total debt increases and total assets remain constant C. Net new equity is issued and existing bonds are paid off D. Net new bonds are sold and short-term notes payable are paid off

36. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.34 Sample Question 2 If a firm has a total debt ratio of 0.5, what is its equity multiplier?

37. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3.35 Sample Question 3 Given ROE = 25%, D/E = 1.25, and assets = $600 calculate sales.