mcgraw-hill/irwin ©2001 the mcgraw-hill companies all rights reserved 3.0 chapter 3 working with...

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved

3.1

Chapter

3Working With Financial Statements


3.2

Key Concepts and Skills

Know how to standardize financial statements for comparison purposes

Know how to compute and interpret important financial ratios

Know the determinants of a firm’s profitability and growth

Understand the problems and pitfalls in financial statement analysis


3.3

Chapter Outline

Standardized Financial StatementsRatio AnalysisThe Du Pont IdentityInternal and Sustainable GrowthUsing Financial Statement Information


3.4

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


3.5

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


3.6

Categories of Financial Ratios

Short-term solvency or liquidity ratiosLong-term solvency or financial leverage ratiosAsset management or turnover ratiosProfitability ratiosMarket value ratios


3.7

Sample Balance Sheet

Cash 6,489 A/P 340,220

A/R 1,052,606 N/P 86,631

Inventory 295,255 Other CL 1,098,602

Other CA 199,375 Total CL 1,525,453

Total CA 1,553,725 LT Debt 871,851

Net FA 2,535,072 C/S 1,691,493

Total Assets 4,088,797 Total Liab. & Equity

4,088,797

Numbers in thousands


3.8

Sample Income Statement

Revenues 3,991,997

Cost of Goods Sold 1,738,125

Expenses 1,269,479

Depreciation 308,355

EBIT 739,987

Interest Expense 42,013

Taxable Income 697,974

Taxes 272,210

Net Income 425,764

EPS 2.17

Dividends per share 0.86

Numbers in thousands, except EPS & DPS


3.9

Computing Liquidity Ratios

Current Ratio = CA / CL1,553,725 / 1,525,453 = 1.02 times

Quick Ratio = (CA – Inventory) / CL(1,553,725 – 295,225) / 1,525,453 = .825 times

Cash Ratio = Cash / CL6,489 / 1,525,453 = .004 times


3.10

Long-term Solvency Measures

Total Debt Ratio = (TA – TE) / 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 = TA / TE = 1 + D/E1 + 1.417 = 2.417


3.11

Computing Coverage Ratios

Times Interest Earned = EBIT / Interest739,987 / 42,013 = 17.6 times

Cash Coverage = (EBIT + Depreciation) / Interest(739,987 + 308,355) / 42,013 = 24.95 times


3.12

Computing Inventory Ratios

Inventory Turnover = Cost of Goods Sold / Inventory1,738,125 / 295,255 = 5.89 times

Days’ Sales in Inventory = 365 / Inventory Turnover365 / 5.89 = 62 days


3.13

Computing Receivables Ratios

Receivables Turnover = Sales / Accounts Receivable3,991,997 / 1,052,606 = 3.79 times

Days’ Sales in Receivables = 365 / Receivables Turnover365 / 3.79 = 96 days


3.14

Computing Total Asset Turnover

Total Asset Turnover = Sales / Total Assets3,991,997 / 4,088,797 = .98 times

Measure of asset use efficiencyNot unusual for TAT < 1, especially if a firm

has a large amount of fixed assets


3.15

Computing Profitability Measures

Profit Margin = Net Income / Sales425,764 / 3,991,997 = .1067 times or 10.67%

Return on Assets (ROA) = Net Income / Total Assets425,764 / 4,088,797 = .1041 times or 10.41%

Return on Equity (ROE) = Net Income / Total Equity425,764 / 1,691,493 = .2517 times or 25.17%


3.16

Computing Market Value Measures

Market Price = $61.625 per shareShares outstanding = 205,838,594PE 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 share61.625 / (1,691,493,000 / 205,838,594) = 7.5 times


3.17

Deriving the Du Pont Identity

ROE = NI / TEMultiply by 1 and then rearrange

ROE = (NI / TE) (TA / TA)ROE = (NI / TA) (TA / TE) = ROA * EM

Multiply by 1 again and then rearrangeROE = (NI / TA) (TA / TE) (Sales / Sales)ROE = (NI / Sales) (Sales / TA) (TA / TE)ROE = PM * TAT * EM


3.18

Using the Du Pont Identity

ROE = PM * TAT * EMProfit margin is a measure of the firm’s operating

efficiency – how well does it control costsTotal asset turnover is a measure of the firm’s asset

use efficiency – how well does it manage its assetsEquity multiplier is a measure of the firm’s financial

leverage


3.19

Payout and Retention Ratios

Dividend payout ratio = Cash dividends / Net income0.86 / 2.17 = .3963 or 39.63%

Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio1.31 / 2.17 = .6037 = 60.37%Or 1 - .3963 = .6037 = 60.37%


3.20

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.

%71.6

0671.6037.1041.1

6037.1041.bROA - 1

bROA RateGrowth Internal


3.21

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.

%92.17

1792.6037.2517.1

6037.2517.bROE-1

bROE RateGrowth eSustainabl


3.22

Determinants of Growth

Profit margin – operating efficiencyTotal asset turnover – asset use efficiencyFinancial leverage – choice of optimal debt

ratioDividend policy – choice of how much to pay

to shareholders versus reinvesting in the firm


3.23

Why Evaluate Financial Statements?

Internal usesPerformance evaluation – compensation and

comparison between divisionsPlanning for the future – guide in estimating future

cash flowsExternal uses

CreditorsSuppliersCustomersStockholders


3.24

Benchmarking

Ratios are not very helpful by themselves; they need to be compared to something

Time-Trend AnalysisUsed to see how the firm’s performance is changing

through timeInternal and external uses

Peer Group AnalysisCompare to similar companies or within industriesSIC and NAICS codes


3.25

Real World Example

Ratios are figured using financial data from the 1999 Annual Report for Ethan Allen

Compare the ratios to the industry ratios in Table 3.9 in the book

Ethan Allen’s fiscal year end is June 30.Be sure to note how the ratios are computed in

the table so that you can compute comparable numbers.

Ethan Allan sales = $762 MM


3.26

Real World Example - II

Liquidity ratiosCurrent ratio = 2.433x; Industry = 1.4xQuick ratio = .763x; Industry = .6x

Long-term solvency ratioDebt/Equity ratio (Debt / Worth) = .371x; Industry =

1.9x.

Coverage ratioTimes Interest Earned = 70.6x; Industry = 3.4x


3.27

Real World Example - III

Asset management ratios: Inventory turnover = 2.8x; Industry = 3.6x Receivables turnover = 22.2x (16 days); Industry = 17.7x

(21 days) Total asset turnover = 1.6x; Industry = 2.2x

Profitability ratios Profit margin before taxes = 17.4%; Industry = 3.1% ROA (profit before taxes / total assets) = 27.6%; Industry

= 5.8% ROE = (profit before taxes / tangible net worth) = 37.9%;

Industry = 17.6%


3.28

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?

What are some of the problems associated with financial statement analysis?

mcgraw-hill/irwin ©2001 the mcgraw-hill companies all rights reserved 3.0 chapter 3 working with...

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