Chap 003

Chapter 3

Working With Financial Statements

1 McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter Outline • • • • •

Standardized Financial Statements Ratio Analysis The Du Pont Identity Internal and Sustainable Growth Using Financial Statement Information

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Standardized Financial Statements

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• 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 3

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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 that information is important • Ratios are used both internally and externally

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Categories of Financial Ratios 1. Short-term solvency or liquidity ratios 2. Long-term solvency or financial leverage ratios 3. Asset management or turnover ratios 4. Profitability ratios 5. Market value ratios

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Table 3.5

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Sample Balance Sheet Numbers in thousands Cash A/Receivable

680,623 A Payable

318,301

1,051,438 N Payable

4,613

Inventory

300,459 Other CL

1,645,748

Other CA

415,310 Total CL

1,968,662

Total CA

2,447,830 LT Debt

909,814

Net Fixed Assets

3,415,159 Total Equity

2,984,513

Total Assets

5,862,989 Total Liab. & Equity

5,862,989

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Sample Income Statement

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Numbers in thousands Revenues

5,250,538

- Cost of Goods Sold

(2,046,645)

- Expenses

(1,904,556)

- Depreciation & Amortization

(124,647)

EBIT

1,174,690

- Interest Expense Taxable Income - Taxes

(5,785) 1,168,905 (412,495)

Net Income

756,410

Additional to Retained Earnings

524,810

Total Dividends Number of shares outstanding (unit)

231,600 193,000 8

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1. Computing Liquidity Ratios • Current Ratio = CA / CL • Quick Ratio = (CA – Inventory) / CL • Cash Ratio = Cash / CL

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2. Computing Leverage Ratios • Total Debt Ratio = (TA – TE) / TA

• Debt/Equity = TD / TE

• Equity Multiplier = TA / TE = 1 + D/E 10

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…Computing Leverage Ratios • Times Interest Earned = EBIT / Interest

• Cash Coverage = (EBIT+Depr & Amort)/Interest

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3. Computing Inventory Ratios • Inventory Turnover = COGS / Inventory • Days’ Sales in Inventory = 365/ Inv t/o

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3. Computing Receivables Ratios • Receivables Turnover = Sales/A Rec. • Days’ Sales in Receivables = 365 /Rec t/o

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3. Computing Payables Ratios

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3. Computing Total Asset Turnover

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• Total Asset Turnover = Sales / TA

• Measure of asset use efficiency • Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets 15

4. Computing Profitability Measures

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• Profit Margin = Net Income / Sales

• Return on Assets (ROA) = Net Income / TA

• Return on Equity (ROE) = Net Income / TE

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5. Computing Market Value Measures

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• Additional information: – Market Price (Dec 31,2007) = $91.54 / share

• PE Ratio = Price per share / EPS

• Market-to-book ratio = MV pershare / BV pershare

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Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 and then rearrange – ROE = (NI / TE) (TA / TA) – ROE = (NI / TA) (TA / TE) Multiply by 1 again and then rearrange – ROE = (NI / TA) (TA / TE) (Sales / Sales) – ROE = (NI / Sales) (Sales / TA) (TA / TE)

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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 19

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Payout and Retention Ratios • Dividend payout = Total Div / NI

• Retention ratio (b) = Add.R/E / NI

• Retention ratio (b) = 1 – Div payout

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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. Internal Growth Rate =

ROA × b 1 - (ROA × b)

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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. Sustainabl e Growth Rate =

ROE × b 1- (ROE × b)

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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 23

Why Evaluate Financial Statements?

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• 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 24

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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

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Quick Quiz • 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 the major determinants of a firm’s growth potential?

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Tutorial • Problem 26 of page 86 • Problem 34 and 35 of page 88, • Problem 42 of page 89

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