Cash Flow and Financial Statements: A Closer LookCash Flow and Financial Statements: A Closer Look

Standardized Financial StatementsStandardized Financial Statements

Ratio AnalysisRatio Analysis

The Du Pont IdentityThe Du Pont Identity

Using Financial Statement InformationUsing Financial Statement Information

Summary and ConclusionsSummary and Conclusions

Chapter 3 Working With Financial Statements

Chapter OrganizationChapter Organization

Corporate Finance 1

Hermetic, Inc. Balance SheetHermetic, Inc. Balance SheetHermetic, Inc.Hermetic, Inc.

Balance Sheet as of December 31Balance Sheet as of December 31

($ in thousands)($ in thousands)AssetsAssets 19981998 19991999Current AssetsCurrent Assets

CashCash $ 45$ 45 $ 50$ 50Accounts receivableAccounts receivable 260260 310310InventoryInventory 320320 385385 TotalTotal $ 625$ 625 $ 745$ 745

Fixed assetsFixed assetsNet plant and equipmentNet plant and equipment 985985 11001100

Total assetsTotal assets $1610$1610 $1845$1845

Corporate Finance 2

Hermetic, Inc. Balance Sheet (concluded)Hermetic, Inc. Balance Sheet (concluded)

Liabilities and equityLiabilities and equity 1998199819991999

Current liabilitiesCurrent liabilitiesAccounts payableAccounts payable $ 210$ 210 $ 260$ 260Notes payableNotes payable 110110 175175 TotalTotal $ 320$ 320 $ 435$ 435

Long-term debtLong-term debt 205205225225

Stockholders’ equityStockholders’ equityCommon stock and Common stock and paid-in surpluspaid-in surplus 290290 290290Retained earningsRetained earnings 795795 895895TotalTotal 10851085 11851185

Total liabilities and equityTotal liabilities and equity $1610$1610$1845$1845

Corporate Finance 3

Hermetic, Inc., Income StatementHermetic, Inc., Income Statement($ in thousands)($ in thousands)

Net salesNet sales $710.00$710.00

Cost of goods soldCost of goods sold 480.00480.00

DepreciationDepreciation 30.0030.00

Earnings before Earnings before interest and taxesinterest and taxes $200.00$200.00

InterestInterest 20.0020.00

Taxable incomeTaxable income 180.00180.00

TaxesTaxes 53.4553.45

Net incomeNet income $126.55$126.55

Dividends $ 26.55Dividends $ 26.55

Addition to retained earnings 100.00Addition to retained earnings 100.00

Corporate Finance 4

Statement of Cash FlowsStatement of Cash Flows

Operating activitiesOperating activities + Net income+ Net income + Depreciation+ Depreciation + Any decrease in current assets (except cash)+ Any decrease in current assets (except cash) + Increase in accounts payable+ Increase in accounts payable – – Any increase in current assets (except cash)Any increase in current assets (except cash) – – Decrease in accounts payableDecrease in accounts payable

Investment activitiesInvestment activities + Ending fixed assets+ Ending fixed assets – – Beginning fixed assetsBeginning fixed assets + Depreciation+ Depreciation

Corporate Finance 5

Statement of Cash Flows (concluded)Statement of Cash Flows (concluded)

Financing activitiesFinancing activities – – Decrease in notes payableDecrease in notes payable

+ Increase in notes payable+ Increase in notes payable

– – Decrease in long-term debtDecrease in long-term debt

+ Increase in long-term debt+ Increase in long-term debt

+ Increase in common stock+ Increase in common stock

– – Dividends paidDividends paid

Corporate Finance 6

Hermetic, Inc. Statement of Cash FlowsHermetic, Inc. Statement of Cash Flows Operating activitiesOperating activities

+ Net income+ Net income + $ 126.55+ $ 126.55 + Depreciation+ Depreciation + 30.00+ 30.00 + Increase in payables+ Increase in payables + 50.00+ 50.00 – – Increase in receivablesIncrease in receivables – 50.00– 50.00 – – Increase in inventoryIncrease in inventory – 65.00– 65.00

$ 91.55$ 91.55

Investment activitiesInvestment activities + Ending fixed assets+ Ending fixed assets +$1,100.00+$1,100.00 – – Beginning fixed assetsBeginning fixed assets – 985.00– 985.00 + Depreciation+ Depreciation + 30.00+ 30.00

($ 145.00)($ 145.00)

Corporate Finance 7

Hermetic, Inc. Statement of Cash Flows (concluded)Hermetic, Inc. Statement of Cash Flows (concluded)

Financing activitiesFinancing activities

+ Increase in notes payable+ Increase in notes payable + $ 65.00+ $ 65.00

+ Increase in long-term debt+ Increase in long-term debt + 20.00+ 20.00

– – DividendsDividends – 26.55– 26.55 $$ 58.4558.45

Putting it all together, the net addition to cash for the period is:Putting it all together, the net addition to cash for the period is:

$91.55 – 145.00 + 58.45 = $5.00$91.55 – 145.00 + 58.45 = $5.00

Corporate Finance 8

Hermetic, Inc. Common-Size Balance SheetHermetic, Inc. Common-Size Balance Sheet

AssetsAssets 19981998 1999 1999

Current AssetsCurrent Assets

CashCash 2.8% 2.8% 2.7% 2.7%

Accounts receivableAccounts receivable 16.1 16.1 16.8 16.8

InventoryInventory 19.9 19.9 20.9 20.9

TotalTotal 38.8% 38.8% 40.4%40.4%

Fixed assetsFixed assets

Net plant and equipmentNet plant and equipment 61.2%61.2% 59.6%59.6%

Total assetsTotal assets 100%100% 100% 100%

Corporate Finance 9

Hermetic, Inc., Common-Size Balance Sheet (continued)Hermetic, Inc., Common-Size Balance Sheet (continued)

Liabilities and equityLiabilities and equity 1998 1998 19991999Current liabilitiesCurrent liabilities

Accounts payableAccounts payable 13.0%13.0% 14.1%14.1%Notes payableNotes payable 6.8 6.8 9.59.5 TotalTotal 19.9%19.9% 23.6%23.6%

Long-term debtLong-term debt 12.7%12.7% 12.2%12.2%Stockholders’ equityStockholders’ equity

Common stock and Common stock and paid-in surpluspaid-in surplus 18.0%18.0% 15.7%15.7%

Retained earningsRetained earnings 49.449.4 48.548.5 TotalTotal 67.467.4 64.264.2

Total liabilities and equityTotal liabilities and equity 100%100% 100% 100%

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More on Standardized StatementsMore on Standardized Statements

Suppose we ask: “What happened to Hermetic’s net plant and Suppose we ask: “What happened to Hermetic’s net plant and equipment (NP&E) over the period?”equipment (NP&E) over the period?”

1.1. Based on the 1998 and 1999 B/S, NP&E rose from $985 to $1100, so Based on the 1998 and 1999 B/S, NP&E rose from $985 to $1100, so NP&E NP&E rose by $115 (a rose by $115 (a useuse of cash). of cash).

2.2. If we standardized the 1999 numbers by dividing each by the 1998 If we standardized the 1999 numbers by dividing each by the 1998 number, number, we get a we get a common base yearcommon base year statement. In this case, statement. In this case, $1100/$985 = 1.117, so NP&E $1100/$985 = 1.117, so NP&E rose by 11.7% over this period.rose by 11.7% over this period.

3.3. Did the firm’s NP&E go up or down? Obviously, it went up, but so did Did the firm’s NP&E go up or down? Obviously, it went up, but so did totaltotal assets. In fact, looking at the standardized statements, assets. In fact, looking at the standardized statements, NP&E NP&E

went from 61.2% of total assets to 59.6% of total assets.went from 61.2% of total assets to 59.6% of total assets.

4.4. If we standardized the 1999 common size numbers by dividing If we standardized the 1999 common size numbers by dividing each by the 1998 common size number, we get a combined each by the 1998 common size number, we get a combined common common

sizesize, , common base yearcommon base year statement. In this case, 59.6%/ statement. In this case, 59.6%/ 61.2% = 97.4%, so NP&E 61.2% = 97.4%, so NP&E fellfell by 2.6% as a percentage of assets. by 2.6% as a percentage of assets.

(.(. .).) In absolute terms, NP&E is up by $115, or 11.7%, but relative to In absolute terms, NP&E is up by $115, or 11.7%, but relative to total assets, NP&E total assets, NP&E fellfell by 2.6%. by 2.6%.

Which is more relevant?Which is more relevant?

Hermetic, Inc., Common-Size Balance Sheet (concluded)Hermetic, Inc., Common-Size Balance Sheet (concluded)

.

Corporate Finance 11

Hermetic, Inc. Common-Size Income StatementHermetic, Inc. Common-Size Income Statement

Net salesNet sales 100.0 %100.0 %

Cost of goods soldCost of goods sold 67.667.6

DepreciationDepreciation 4.24.2

Earnings before interest Earnings before interest and taxesand taxes 28.228.2

InterestInterest 2.82.8

Taxable incomeTaxable income 25.425.4

TaxesTaxes 7.57.5

Net incomeNet income 17.8 %17.8 %

DividendsDividends 3.7 %3.7 %

Addition to retained earningsAddition to retained earnings 14.1 %14.1 %

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Things to Consider When Using Financial RatiosThings to Consider When Using Financial Ratios

What aspect of the firm or its operations are we What aspect of the firm or its operations are we attempting to analyze?attempting to analyze? Firm performance can be measured along “dimensions”Firm performance can be measured along “dimensions”

What goes into a particular ratio?What goes into a particular ratio? Historical cost? Market values? Accounting conventions?Historical cost? Market values? Accounting conventions?

What is the unit of measurement?What is the unit of measurement? Dollars? Days? Turns?Dollars? Days? Turns?

What would a desirable ratio value be? What is the What would a desirable ratio value be? What is the benchmark?benchmark? Time-series analysis? Cross-sectional analysis?Time-series analysis? Cross-sectional analysis?

Corporate Finance 13

Categories of Financial RatiosCategories of Financial Ratios

Short-Term Solvency, or LiquidityShort-Term Solvency, or Liquidity Ability to pay bills in the short-runAbility to pay bills in the short-run

Long-Term Solvency, or Financial LeverageLong-Term Solvency, or Financial Leverage Ability to meet long-term obligationsAbility to meet long-term obligations

Asset Management, or TurnoverAsset Management, or Turnover Intensity and efficiency of asset useIntensity and efficiency of asset use

ProfitabilityProfitability The ability to control expensesThe ability to control expenses

Market ValueMarket Value Going beyond financial statementsGoing beyond financial statements

Corporate Finance 14

Common Financial RatiosCommon Financial Ratios

I. Short-Term Solvency, or Liquidity, RatiosI. Short-Term Solvency, or Liquidity, Ratios

Current assetsCurrent assets

Current ratio =Current ratio = Current liabilitiesCurrent liabilities

Quick ratio = (Current assets - inventory) / Current liabilitiesQuick ratio = (Current assets - inventory) / Current liabilities

Cash ratio = Cash / Current liabilitiesCash ratio = Cash / Current liabilities

Current assetsCurrent assets

Interval measure =Interval measure = Average daily operating costsAverage daily operating costs

Corporate Finance 15

Common Financial Ratios (continued)Common Financial Ratios (continued)

II. Long-Term Solvency, or Financial Leverage RatiosII. Long-Term Solvency, or Financial Leverage Ratios

Total assets - Total equityTotal assets - Total equity

Total debt ratio =Total debt ratio = Total assetsTotal assets

Debt/equity ratio = Total debt/Total equityDebt/equity ratio = Total debt/Total equity

Equity multiplier = Total assets/Total equityEquity multiplier = Total assets/Total equity

Long-term debtLong-term debt

Long-term debt ratio =Long-term debt ratio = Long-term debt + Total equityLong-term debt + Total equity

EBITEBIT

Times interest earned ratio =Times interest earned ratio = InterestInterest

EBIT + depreciationEBIT + depreciation

Cash coverage ratio =Cash coverage ratio = InterestInterest

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Common Common Financial Financial

Ratios Ratios (continued)(continued)

III. Asset Utilization, or Turnover, RatiosIII. Asset Utilization, or Turnover, Ratios Cost of goods soldCost of goods sold

Inventory turnover =Inventory turnover = InventoryInventory

365 days365 days

Days’ sales in inventory =Days’ sales in inventory = Inventory turnoverInventory turnover

SalesSales

Receivables turnover =Receivables turnover = Accounts receivableAccounts receivable

365 days365 days

Days’ sales in receivables =Days’ sales in receivables = Receivables turnoverReceivables turnover

SalesSales

NWC turnover =NWC turnover = NWCNWC

SalesSales

Fixed asset turnover =Fixed asset turnover = Net fixed assetsNet fixed assets

SalesSales

Total asset turnover =Total asset turnover = Total assetsTotal assets

Corporate Finance 17

Common Financial Ratios (continued)Common Financial Ratios (continued)

IV. Profitability RatiosIV. Profitability Ratios

Net incomeNet income

Profit margin =Profit margin = SalesSales

Net incomeNet income

Return on assets (ROA) =Return on assets (ROA) = Total assetsTotal assets

Net incomeNet income

Return on equity (ROE) =Return on equity (ROE) = Total equityTotal equity

Corporate Finance 18

Common Financial Ratios (concluded)Common Financial Ratios (concluded)

V. Market Value RatiosV. Market Value Ratios

Price per sharePrice per share

Price-earnings ratio =Price-earnings ratio = Earnings per shareEarnings per share

Market value per shareMarket value per share

Market-to-book ratio =Market-to-book ratio = Book value per shareBook value per share

Corporate Finance 19

1.1. Return on equity (ROE) can be decomposed as follows:Return on equity (ROE) can be decomposed as follows:

ROE ROE = = Net income/Total equityNet income/Total equity

= = Net income/Total equity Net income/Total equity XX Total assets/Total assets Total assets/Total assets

= = Net income/Total assets Net income/Total assets XX Total assets/Total equity Total assets/Total equity

= = _____________ _____________ XX Equity multiplier Equity multiplier

2.2. Return on assets (ROA) can be decomposed as follows:Return on assets (ROA) can be decomposed as follows:

ROA ROA = = Net income/Total assets Net income/Total assets XX Sales/Sales Sales/Sales

= = Net income/Sales Net income/Sales XX Sales/Total assets Sales/Total assets

= = ______________ ______________ X X _______________ _______________

The Du Pont IdentityThe Du Pont Identity

Corporate Finance 20

The Du Pont Identity (concluded)The Du Pont Identity (concluded)

3.3. Putting it all together gives the Du Pont identity:Putting it all together gives the Du Pont identity:

ROE ROE = ROA = ROA X X Equity multiplier Equity multiplier

= = Profit margin Profit margin X X Total asset turnover Total asset turnover X X Equity multiplier Equity multiplier

4.4. Profitability (or the lack thereof!) thus has Profitability (or the lack thereof!) thus has threethree parts: parts:

Operating efficiencyOperating efficiency

Asset use efficiencyAsset use efficiency

Financial leverageFinancial leverage

Corporate Finance 21

Chapter 3 Quick QuizChapter 3 Quick Quiz

Wal-Mart, Venture Stores, and KMart collectively represent the majority of Wal-Mart, Venture Stores, and KMart collectively represent the majority of sales in the discount retail industry in this country. The following data are sales in the discount retail industry in this country. The following data are from quarterly financial statements filed with the SEC and retrieved from the from quarterly financial statements filed with the SEC and retrieved from the SEC website.SEC website.

ROEROEWal-MartWal-Mart = (.0276)(.6578)(2.463) = .0447 = (.0276)(.6578)(2.463) = .0447

Current share price = $ 26.875Current share price = $ 26.875 52 week high share price = $28.2552 week high share price = $28.25

ROEROEVentureVenture = (-.0116)(.4474)(3.073) = -.0159 = (-.0116)(.4474)(3.073) = -.0159

Current share price = $ 3.25Current share price = $ 3.25 52 week high share price = $8.50 52 week high share price = $8.50

ROEROEKMartKMart = (.0041)(.5276)(2.534) = .0055 = (.0041)(.5276)(2.534) = .0055

Current share price = $ 9.75Current share price = $ 9.75 52 week high share price = $14.25 52 week high share price = $14.25

Which firm is the market leader? Do you think its ROE is the Which firm is the market leader? Do you think its ROE is the causecause or the or the resultresult of its leadership position? of its leadership position?The two secondary firms have not performed as well as the leader. In what The two secondary firms have not performed as well as the leader. In what area(s) have they done particularly poorly? area(s) have they done particularly poorly?

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