Chapter 3: Working with Financial Statements

Learning Objectives

• Standardize financial statements for comparison purposes.

• Compute and interpret common financial ratios.

• Identify determinants of a firm’s profitability.

• Explain challenges in financial statement analysis.

Cash Flow and Financial Statements

• Sources and Uses of Cash:

  • Sources of Cash: Activities that generate cash.

  • Uses of Cash: Activities that expend cash.

  • Cash Flow Principles:

  • Increase in asset account = Use of cash (e.g., buying assets).

  • Decrease in asset account = Source of cash (e.g., selling assets).

• Importance of Cash Flow: An income statement is essential to trace cash flow through a firm during the year.

Statement of Cash Flows

• Summarizes cash sources and uses over a specified period:

  • Categories:

  • Operating activities

  • Investment activities

  • Financing activities

  • Prohibits reporting cash flow per share; only earnings per shares reported.

Standardized Financial Statements

• Need for Standardization:

  • Difficult to compare financial statements across companies due to size differences.

• Methods of Standardization:

  1. Common-size statements: Present items in percentage of total (e.g., balance sheets, income statements).

  2. Common-base year statements: Present items relative to a base year amount.

Ratio Analysis

• Purpose: Compare companies of different sizes.

• Categories of Financial Ratios:

  • Short-term solvency (liquidity) ratios

  • Long-term solvency (financial leverage) ratios

  • Asset management (turnover) ratios

  • Profitability ratios

  • Market value ratios

Short-term Solvency Ratios

• Common ratios:

  • Current Ratio = \frac{\text{Current Assets}}{\text{Current Liabilities}}

  • Quick Ratio = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}

• Interpretation: High ratios indicate better liquidity; however, can also signal inefficient use of assets.

Long-term Solvency Ratios

• Common ratios:

  • Debt Ratio = \frac{\text{Total Debt}}{\text{Total Assets}}

  • Debt-Equity Ratio = \frac{\text{Total Debt}}{\text{Total Equity}}

• Significance: Indicates the level of financial leverage and risk.

Asset Management Ratios

• Common ratios:

  • Inventory Turnover = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}

  • Receivables Turnover = \frac{\text{Sales}}{\text{Accounts Receivable}}

• Interpretation: Measures efficiency in managing assets and generating sales.

Profitability Ratios

• Common ratios:

  • Profit Margin = \frac{\text{Net Income}}{\text{Sales}}

  • Return on Assets (ROA) = \frac{\text{Net Income}}{\text{Total Assets}}

  • Return on Equity (ROE) = \frac{\text{Net Income}}{\text{Total Equity}}

• Significance: Indicates the firm's ability to generate profit from sales, assets, and equity.

Market Value Ratios

• Common ratios:

  • Price-Earnings Ratio = \frac{\text{Price per Share}}{\text{Earnings per Share}}

  • Market-to-Book Ratio = \frac{\text{Market Value per Share}}{\text{Book Value per Share}}

• Interpretation: Reflects investors' expectations about a firm's growth potential.

The DuPont Identity

• Breaks down ROE into:

  • Operating efficiency (Profit Margin)

  • Asset efficiency (Total Asset Turnover)

  • Financial leverage (Equity Multiplier)

• Formula: \text{ROE} = \text{Profit Margin} \times \text{Total Asset Turnover} \times \text{Equity Multiplier}

Importance of Financial Statement Analysis

• Uses:

  • Internal: Performance evaluation and planning.

  • External: Assessments by creditors, investors, suppliers, competitors, and credit agencies.

Selected Questions

• Benchmarking:

  • Use historical data (trend) or peer group analysis comparing similar firms.

• SIC Codes: Help identify firms in similar industries for comparative analysis.