Ch. 3

Chapter 3: Working with Financial Statements

Key Concepts and Skills

• Standardization of Financial Statements: Understand how to standardize financial statements for comparative analysis.

• Financial Ratios: Know how to compute and interpret important financial ratios.

• Determinants of Profitability and Growth: Understand the factors influencing a firm’s profitability and growth.

• Statement Analysis Problems: Recognize the problems and pitfalls in financial statement analysis.

Chapter Outline

1. Standardized Financial Statements

2. Ratio Analysis

3. The DuPont Identity

4. Internal and Sustainable Growth

5. Using Financial Statement Information

Sources and Uses of Cash

PRUFROCK CORPORATION Balance Sheets (in millions)

• Current Assets:

  • Cash:

  • 2020: $84

  • 2021: $146

  • Change: +$62

  • Accounts Receivable:

  • 2020: $165

  • 2021: $188

  • Change: +$23

  • Inventory:

  • 2020: $393

  • 2021: $422

  • Change: +$29

• Total Current Assets:

  • 2020: $642

  • 2021: $756

  • Change: +$114

• Total Fixed Assets:

  • Net Plant and Equipment:

  • 2020: $2,731

  • 2021: $2,880

  • Change: +$149

• Total Assets:

  • 2020: $3,373

  • 2021: $3,636

  • Change: +$263

Liabilities and Owners' Equity

• Current Liabilities:

  • Accounts Payable:

  • 2020: $312

  • 2021: $344

  • Change: +$32

  • Notes Payable:

  • 2020: $231

  • 2021: $196

  • Change: -$35

• Total Current Liabilities:

  • 2020: $543

  • 2021: $540

  • Change: -$3

• Long-term Debt:

  • 2020: $531

  • 2021: $457

  • Change: -$74

• Owners' Equity:

  • Common Stock and Paid-in Surplus:

  • 2020: $500

  • 2021: $550

  • Change: +$50

  • Retained Earnings:

  • 2020: $1,799

  • 2021: $2,089

  • Change: +$290

• Total Liabilities and Owners' Equity:

  • 2020: $2,299

  • 2021: $2,639

  • Change: +$340

• Total Liabilities and Owners' Equity:

  • 2020: $3,373

  • 2021: $3,636

  • Change: +$263

Summarized Sources and Uses of Cash

Sources of Cash:

• Increase in Accounts Payable: $32

• Increase in Common Stock: $50

• Increase in Retained Earnings: $290

• Total Sources: $372

Uses of Cash:

• Increase in Accounts Receivable: $23

• Increase in Inventory: $29

• Decrease in Notes Payable: $35

• Decrease in Long-term Debt: $74

• Net Fixed Asset Acquisitions: $149

• Total Uses: $310

• Net Addition to Cash: $62

Income Statement

PRUFROCK CORPORATION Income Statement - 2021 (in millions)

• Sales: $2,311

• Cost of Goods Sold: $1,344

• Depreciation: $276

• Earnings Before Interest and Taxes (EBIT): $691

• Interest Paid: $141

• Taxable Income: $550

• Taxes (21%): $116

• Net Income:

  • $145

  • Dividends: $290

  • Addition to Retained Earnings: $435

Cash Flow Statement

PRUFROCK CORPORATION Statement of Cash Flows - 2021 (in millions)

• Cash, Beginning of Year: $84

• Operating Activity:

  • Net Income: $435

  • Depreciation: $276

  • Increase in Accounts Payable: $32

  • Less:

  • Increase in Accounts Receivable: $23

  • Increase in Inventory: $29

  • Net Cash from Operating Activity: $691

• Investment Activity:

  • Fixed Asset Acquisitions: $425

  • Net Cash from Investment Activity: -$425

• Financing Activity:

  • Decrease in Notes Payable: $35

  • Decrease in Long-term Debt: $74

  • Dividends Paid: $145

  • Increase in Common Stock: $50

  • Net Cash from Financing Activity: -$204

• Net Increase in Cash: $62

• Cash, End of Year: $146

Standardized Financial Statements

Common-Size Financial Statements

• Common-Size Balance Sheets: All accounts expressed as a percentage of total assets (%TA).

• Common-Size Income Statements: All line items expressed as a percentage of sales or revenue (%SLS).

• Uses of Standardized Statements:

  • Facilitates year-to-year comparison.

  • Allows comparisons between companies of different sizes within the same industry.

Common-Size Statements Example

PRUFROCK CORPORATION Common-Size Balance Sheets (2020 and 2021 Percentages)

• Current Assets:

  • Cash:

  • 2020: 2.5%

  • 2021: 4.0%

  • Accounts Receivable:

  • 2020: 4.9%

  • 2021: 5.2%

  • Inventory:

  • 2020: 11.7%

  • 2021: 11.6%

  • Total Current Assets:

  • 2020: 19.0%

  • 2021: 20.8%

• Total Assets: 100% (both years)

• Total Liabilities and Owners' Equity: 100% (both years)

Ratio Analysis

Importance of Ratios

• Ratios provide a framework for better comparison over time and between companies.

• Key Questions for Ratios:

  • What is the ratio measuring?

  • Why is that information significant?

• Ratios are used for both internal and external analysis.

Categories of Financial Ratios

1. Liquidity Ratios (Short-term solvency)

2. Financial Leverage Ratios (Long-term solvency)

3. Asset Management Ratios (Turnover ratios)

4. Profitability Ratios

5. Market Value Ratios

Financial Ratios Table

1. Liquidity Ratios:

   • Current Ratio: $ext{Current Assets} / ext{Current Liabilities}$

   • Quick Ratio: $( ext{Current Assets} - ext{Inventory}) / ext{Current Liabilities}$

   • Cash Ratio: $ext{Cash} / ext{Current Liabilities}$

2. Long-term Solvency Ratios:

   • Total Debt Ratio: $( ext{Total Assets} - ext{Total Equity}) / ext{Total Assets}$

   • Debt-Equity Ratio: $ext{Total Debt} / ext{Total Equity}$

   • Equity Multiplier: $ext{Total Assets} / ext{Total Equity}$

3. Asset Management Ratios:

   • Inventory Turnover: $ext{Cost of Goods Sold} / ext{Inventory}$

   • Days' Sales in Inventory: $365 / ext{Inventory Turnover}$

   • Receivables Turnover: $ext{Sales} / ext{Accounts Receivable}$

   • Days' Sales in Receivables: $365 / ext{Receivables Turnover}$

   • Payables Turnover: $ext{Cost of Goods Sold} / ext{Accounts Payable}$

   • Days' Costs in Payables: $365 / ext{Payables Turnover}$

   • Total Asset Turnover: $ext{Sales} / ext{Total Assets}$

4. Profitability Ratios:

   • Profit Margin: $ext{Net Income} / ext{Sales}$

   • Return on Assets (ROA): $ext{Net Income} / ext{Total Assets}$

   • Return on Equity (ROE): $ext{Net Income} / ext{Total Equity}$

5. Market Value Ratios:

   • Price-Earnings Ratio: $ext{Price per Share} / ext{Earnings per Share}$

   • Market-to-Book Ratio: $ext{Market Value per Share} / ext{Book Value per Share}$

The DuPont Identity

Basic Formula

• ROE: $ext{ROE} = rac{ ext{Net Income}}{ ext{Total Equity}}$

• Extended DuPont: $ext{ROE} = ext{Profit Margin} imes ext{Total Asset Turnover} imes ext{Equity Multiplier}$

• Components:

  • PM (Net Income/Sales)

  • TAT (Sales/Total Assets)

  • EM (Total Assets/Total Equity)

Growth Rates

Internal Growth Rate (IGR)

• Definition: Growth using retained earnings as the only financing source.

• Formula:

  • Retention Ratio (b): $rac{ ext{Net Income} - ext{Dividends}}{ ext{Net Income}}$

  • Return on Assets (ROA): $ext{ROA} = rac{ ext{Net Income}}{ ext{Total Assets}}$

Sustainable Growth Rate (SGR)

• Definition: Growth by using internally generated funds and maintaining a constant debt ratio.

• Formula:

  • $ext{ROE} = rac{ ext{Net Income}}{ ext{Total Owners’ Equity}}$

Financial Statement Evaluation

Internal Uses

• Performance Evaluation: Assess organizational performance.

• Compensation: Guided decisions on compensation relative to performance.

• Planning: Aid in forecasting future cash flows.

External Uses

• Creditors and Suppliers: Assess creditworthiness.

• Customers and Stockholders: Gauge financial health and viability.

Benchmarking

• Time-Trend Analysis: Evaluating firm performance over time.

• Peer Group Analysis: Comparing against similar companies within industries using SIC and NAICS codes.

Example: Use of the Internet in Ratio Analysis

• The internet facilitates financial analysis.

• Access tools such as Reuters for real-time financial comparisons and historical data.

Comprehensive Problem Example

Calculating Sustainable Growth Rate

1. Given Data:

   • Sales = $2M, Net Income = $0.4M, Dividends = $0.1M

   • Current Assets = $0.4M, Fixed Assets = $3.6M

   • Current Liabilities = $0.2M, Long-term Debt = $1M

   • Common Stock = $2M, Retained Earnings = $0.8M

2. Formulas Used:

   • ROE: $ext{ROE} = rac{ ext{Net Income}}{ ext{Shareholders’ Equity}}$

   • Payout Ratio: $ext{Payout Ratio} = rac{ ext{Dividends}}{ ext{Net Income}}$

   • Plowback Ratio (b): $b = 1 - ext{Payout Ratio}$

   • Sustainable Growth Rate:
     $ext{SGR} = rac{ ext{ROE} imes b}{1 - ext{ROE} imes b}$

   • Profit Margin: $ext{Profit Margin} = rac{ ext{Net Income}}{ ext{Sales}}$

   • Projected Net Income: $ext{Projected Net Income} = ext{Profit Margin} imes ext{Projected Sales}$

   • Projected Addition to Retained Earnings: $ext{Projected Addition to Retained Earnings} = ext{Projected Net Income} imes (1 - ext{Payout Ratio})$

3. Additional Calculations for forecasting external financing needs, change in sales, total assets, etc., based on the provided data points.

End of Chapter