Chapte

r3

Working with Financial

Statements

3-1

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

• Cash Flows and Financial

Statements: A Closer Look
• Sources and uses of cash
• Standardized Financial
Statements
• Ratio Analysis
• The DuPont Identity
• Using Financial Statement
3-2 Information
 Sample Balance Sheet
XYZ Corporation
December 31, 202X
(Figures in millions of dollars)
2021 2020 202 202
1 0
Cash 696 58 A/P 307 303
A/R 956 992 N/P 26 119
Inventory 301 361 Other CL 1,66 1,35
2 3
Other CA 303 264 Total CL 1,99 1,7
5 75
Total CA 2,25 1,67 LT Debt 843 1,09
6 5 1
Net
3-3
FA 3,138 3,358 C/S 2,55 2,16
 Sample Income Statement
XYZ Corporation
January 1 – December 31, 202X
( Figures in millions of dollars)
Revenues $5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (442)
Net Income $689
EPS $3.61
3-4 Dividends per share $1.08
 Sources and Uses of
Cash
Sources
Cash inflow – occurs when we
“sell” something and we add to
the cash account
• Decrease in asset account
• Accounts receivable, inventory,
and net fixed assets

• Increase in liability or equity

account
• Accounts payable, other current
liabilities, long-term liability
and common stock
3-5
 Sources and Uses of
Cash
Uses
Cash outflow – occurs when
we “buy” something
• Increase in asset account
• Cash and other current
assets. Fixed assets
• Decrease in liability or
equity account
• Notes payable and long-
term debt
3-6
 Sources and Uses of Cash
XYZ Corporation - December 31, 202X

ASSETS 2020 2021 Change

Cash 58 696 638
A/R 992 956 -36
Inventory 361 301 -60
Other CA 264 303 39
Total CA 1,675 2,256 581
Net FA 3,358 3,138 -220
TOTAL ASSETS 5,033 5,394 361
LIABILITIES AND OWNERS' EQUITY
CURRENT LIABILITES 2020 2021
A/P 303 307 4
N/P 119 26 -93
Other CL 1,353 1,662 309
Total CL 1,775 1,995 220
LT Debt 1,091 843 -248
C/S 2,167 2,556 389
TOTAL LIAB. & EQUITY 5,033 5,394 361
3-7
 Sources and Uses of Cash
XYZ Corporation - December 31, 202X

SOURCES OF CASH
Decrease in account receivables 36
Decrease in inventories 60
Decrease in Net fixed assets 220
Increase in account payables 4
Increase in other CL 309
Increase in common stock 389
TOTAL SOURCES 1,018
USES OF CASH
Increase in cash 638
Increase in other CA 39
Decrease in Note payables 93
Decrease in Long-term debt 248
TOTAL USES 1,018
3-8
 Statement of Cash
Flows
Statement that
summarizes the sources
and uses of cash

3-9
 Statement of Cash
Flows
Changes divided into three
major categories:
1. Operating Activity – includes
net income and changes in
most current accounts
2. Investment Activity – includes
changes in fixed assets
3. Financing Activity – includes
changes in notes payable,
long-term debt, and equity
3-10
accounts, as well as dividends
 Sample Statement of Cash Flows
(Numbers in millions of
Cash, beginning of year 58 Financing Activity
dollars)
Operating Activity Decrease in Notes Payable -93
Net Income 689 Decrease in LT Debt -248
Plus: Depreciation 116 Decrease in C/S (minus RE) -94
Decrease in A/R 36 Dividends Paid -206
Decrease in Inventory 60 Net Cash from Financing -641
Increase in A/P 4
Increase in Other CL 309 Net Increase in Cash 638
Less: Increase in other CA -39
Net Cash from Operations 1,175 Cash End of Year 696

Investment Activity
Sale of Fixed Assets 104
Net Cash from Investments 104
3-11
 Chapter Outline

• Cash Flows and Financial

Statements: A Closer Look
• Sources and Uses of Cash
• Standardized Financial
Statements
• Ratio Analysis
• The DuPont Identity
• Using Financial Statement
3-12 Information
 Standardized Financial
Statements
• 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

3-13
 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 net sales
3-14
 Common-Size Balance Sheets:
XYZ Corporation - December 31, 202X
ASSETS 2020 2021 Change
Current assets
Cash 1.2% 12.9% 11.8%
A/R 19.7% 17.7% -2.0%
Inventory 7.2% 5.6% -1.6%
Other CA 5.2% 5.6% 0.4%
Total CA 33.3% 41.8% 8.5%
Net FA 66.7% 58.2% -8.5%
TOTAL ASSETS 100.0% 100.0% 0.0%
LIABILITIES AND OWNERS' EQUITY
CURRENT LIABILITES 2020 2021 Change
A/P 6.0% 5.7% -0.3%
N/P 2.4% 0.5% -1.9%
Other CL 26.9% 30.8% 3.9%
Total CL 35.3% 37.0% 1.7%
LT Debt 21.7% 15.6% -6.0%
C/S 43.1% 47.4% 4.3%
3-15
TOTAL LIAB. & EQUITY 100.0% 100.0% 0.0%
 Common-Size Income Statements:
XYZ Corporation
January 1 – December 31, 202X
( Figures in millions of dollars)

Net Revenues 100.0%

Cost of Goods Sold 40.1%
Expenses 34.8%
Depreciation 2.3%
EBIT 22.8%
Interest Expense 0.1%
Taxable Income 22.6%
Taxes 8.8%
Net Income 13.8%

3-16
 Chapter Outline

• Cash Flows and Financial

Statements: A Closer Look
• Sources and Uses of Cash
• Standardized Financial
Statements
• Ratio Analysis
• The DuPont Identity
• Using Financial Statement
3-17 Information
 Ratio Analysis
The goal of ratio analysis is to
take the numerous lines from
both the income statement
and balance sheet and to
interpret this information in a
meaningful way.

There is simply too much

3-18
information to grasp at one
3-19
 Ratio Analysis

Ratios are simply the

construction of a Numerator
numerator ____________
and a
denominator Denominator
using data from
a balance sheet
and/or an
3-20
income
 Ratio Analysis
• Ratios 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?
3-21
 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
3-22
 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
3-23
 Sample Balance
Sheet
XYZ Corporation
December 31, 202X
(Figures in millions of dollars)
2021 2020 2021 2020
58 A/P 307 303
Cash 696
A/R 956 992 N/P 26 119

361 Other CL 1,662 1,353

Inventory 301
Other CA 303 264 1,775
Total CL 1,995
1,675 LT Debt 843 1,091
Total CA 2,256
Net FA 3,138 3,358 C/S 2,556 2,167

Total 5,394 5,033 Total Liab. 5,394 5,033

Assets & Equity
3-24
 Computing Liquidity
Ratios
Current Ratio = CA / CL
2,256 / 1,995 = 1.13 times
Quick Ratio = (CA – Inventory)
/ CL
(2,256 – 301) / 1,995 = .98 times
Cash Ratio = Cash / CL
696 / 1,995 = .35 times
(Quick Ratio also has the name Acid-
3-25
test ratio)
 Example: Comments on current ratio

2019 2020 2021 Ind.

Current ratio 1.34x 0.943 x 1.13x 1.70x

 Expected to improve but still below the industry average.

 Liquidity position is weak.

(Ind. is the Industry average (Mức trung bình ngành) of 2021).

3-26
 Sample Income Statement
XYZ Corporation
January 1 – December 31, 202X
( Figures in millions of dollars)
Revenues $5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (442)
Net Income $689
EPS $3.61
3-27 Dividends per share $1.08
 Computing Liquidity
Ratios
NWC to Total Assets = NWC /
TA
(2,256 – 1,995) / 5,394 = .05

Interval Measure = CA /
average daily operating
costs
2,256 / ((2,006 + 1,740)/365)
= 219.8 days
3-28
 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

3-29
4.Profitability ratios
 Sample Balance Sheet
XYZ Corporation
December 31, 202X
(Figures in millions of dollars)
2021 2020 2021 2020

Cash 696 58 A/P 307 303

A/R 956 992 N/P 26 119

Inventory 301 361 Other CL 1,662 1,353

Other CA 303 264 Total CL 1,995 1,775

Total CA 2,256 1,675 LT Debt 843 1,091

Net FA 3,138 3,358 2,167

C/S 2,556
Total 5,033 Total Liab. 5,394 5,033
5,394 & Equity
3-30 Assets
 Computing Long-term
Solvency Ratios

Total Debt Ratio = (TA – TE) / TA

=TD/TA
(5,394 – 2,556) / 5,394 =
52.61%

Debt/Equity = TD / TE

3-31
(5,394 – 2,556) / 2,556 = 1.11
 Sample Balance Sheet
XYZ Corporation
December 31, 202X
(Figures in millions of dollars)
2021 2020 2021 2020
Cash 696 58 A/P 307 303
A/R 956 992 N/P 26 119

Inventory 301 361 Other CL 1,662 1,353

Other CA 303 264 Total CL 1,995 1,775
Total CA 2,256 1,675 LT Debt 1,091
843
Net FA 3,138 3,358 2,167
C/S 2,556
Total 5,394 5,033 Total Liab. 5,394 5,033
Assets & Equity

3-32
 Computing Long-term
Solvency Ratios

Equity Multiplier = EM
= TA / TE = 1 + TD/TE
1 + 1.11 = 2.11

Long-term debt ratio

= LTD / (LTD + TE)
3-33
843 / (843 + 2,556) =
 How do the debt management ratios
compare with industry averages?
2019 2020 2021 Ind.
D/A 44.2% 56.94% 52.61% 50.0%

 D/A are larger than the industry average.

 Sample Income Statement
XYZ Corporation
January 1 – December 31, 202X
( Figures in millions of dollars)
Revenues $5,000
Cost of Goods Sold (2,006)
Expenses (1,740)

Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (442)
Net Income $689

3-35
 Computing Coverage
Ratios
Times Interest Earned
= EBIT / Interest
1,138 / 7 = 162.57 times
Cash Coverage
= (EBIT + Depreciation) /
Interest
3-36 (1,138 + 116) / 7 = 179.14
 How do the debt management ratios
compare with industry averages?
2019 2020 2021 Ind.
TIE 107.0x 110x 162.57x 22.5x
EBITDA
165.9x 160.2x 179.14x 28.0x
coverage

 TIE and EBITDA coverage are better than the industry average.
 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
3-38
 Computing Inventory
Ratios
Inventory Turnover =
Cost of Goods Sold /
Inventory
2,006 / 301 = 6.66
times
Days’ Sales in
3-39
Inventory = 365 /
What is the inventory turnover vs. the industry average?

2019 2020 2021 Ind.

Inventory
6.8x 6.7x 6.66x 7.1x
Turnover
 Computing Receivables
Ratios
Receivables Turnover =
Sales / Accounts
Receivable
5,000 / 956 = 5.23 times
Days’ Sales in
Receivables = 365 /
3-41
Receivables Turnover
 Appraisal of DSO (Days sales
outstandings)
2019 2020 2021 Ind.

DSO 39.2 48.2 70 32.0

 XYZ collects on sales too slowly, and is getting worse.

 XYZ has a poor credit policy.
 Computing Total Asset
Turnover
Total Asset Turnover = TAT
= Sales / Total Assets
5,000 / 5,394 = .93
NWC Turnover = Sales /
NWC
5,000 / (2,256 – 1,995) =
19.16 times
Fixed Asset Turnover =
Sales / NFA
3-43
 Evaluating the FA turnover and TA turnover ratios

2019 2020 2021 Ind.

FA TO 1.45x 1.55x 1.59x 1.5x
TA TO 1.2x 1.1x 0.93x 1.1x

 FA turnover projected to exceed the industry average.

 TA turnover below the industry average. Caused by excessive
currents assets (A/R and Inv).
 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

3-45
 Computing
Profitability Measures
Profit Margin = PM = Net Income /
Sales
689 / 5,000 = 13.78%
Return on Assets (ROA) = Net
Income / Total Assets
689 / 5,394 = 12.77%
Return on Equity (ROE) = Net
Income / Total Equity
3-46 689 / 2,556 = 26.96%
Appraising profitability with the profit margin

2019 2020 2021 Ind.

PM 8.6% 4.7% 13.78% 13.5%

 Profit margin was bad in 2020, but is projected to exceed the

industry average in 2021. Looking good.
 Appraising profitability with the return on
assets and return on equity
2019 2020 2021 Ind.
ROA 8% 5.6% 12.77% 14.85%
ROE 12.7% 12.0% 26.96% 29.7%

 Both ratios rebounded from 2020, but ROA and ROE are
still below the industry average. More improvement is
needed.
 Wide variations in ROE illustrate the effect that profit
margin have on profitability.
 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
3-49
 Computing Market Value
Measures

If the Market Price = $87.65 per

share
and if the number of shares of
common stock outstanding is:
190.9 million,

Then the PE Ratio = Price per

share / Earnings per share
3-50
 Computing Market
Value Measures
If the Market Price
= $87.65 per share and
If the number of shares of common
stock outstanding is: 190.9 million,

and the book value of the equity is

$2,556,

Then the Market-to-book ratio =

Market value per share / book value per
3-51 share
 Computing Market
Value Measures
The Price/Earnings (P/E) ratio focuses on
the market price of a share of stock and
compares it to the Net Earnings of a
company.

The EBITDA ratio uses the book value of

the company to value all of the operating
assets (the enterprise value) and
compare them to the operating cash flow
generated by those assets (EBITDA).
3-52
 Computing Market
Value Measures
The Enterprise Value = Total market
value of the stock + Book value of all
liabilities - Cash
The EBITDA ratio = the Enterprise
Value EBITDA

where EBITDA is Earnings Before

Interest, Taxes, Depreciation and
Amortization
3-53
 Chapter Outline

• Cash Flows and Financial

Statements: A Closer Look
• Standardized Financial
Statements
• Ratio Analysis
• The DuPont Identity
• Using Financial Statement
Information
3-54
 The DuPont Identity
The DuPont
Identity allows
us to get a big
picture of how
the puzzle
pieces of
different
ratios fit
3-55
together
 Deriving the DuPont
Identity
ROE = NI / TE

ROE= (NI/Net sales)*(Net

sales/TA)*(TA/TE)

ROE = ROA * EM

3-56
 Deriving the DuPont
Identity
ROE = (NI / Sales) (Sales / TA) (TA
/ TE)
ROE = PM * TAT * EM
The Return on Equity (ROE) =
Profit Margin on Sales * Total
Asset Turnover * Equity
Multiplier

3-57
 Using the DuPont
Identity
• ROE = PM * TAT * EM
• Profit margin is a measure of
the firm’s operating
efficiency – how well it
controls costs

• Total asset turnover is a

measure of the firm’s asset
use efficiency – how well does
it manage its assets
3-58

• Equity multiplier is a measure

Extended DuPont equation:
Breaking down Return on equity
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)
= 13.78% x 0.93 x 2.11
= 26.96%
PM TA TO EM ROE
2019 8.6% 1.2 1.23 12.7%
2020 4.7% 1.1 2.32 11.99%
2021 13.78% 0.93 2.11 26.96%
Ind. 13.5% 1.1 2.0 29.7%
 Result from Dupont Analysis

- The analyses show that the main cause

of low ROE is Total Assets Turnover which
is considerably lower than the industry
average.
- Looking at the analysis of TATO and
FATO (slide 40,42 and 44), we found
that the main problems are the Account
Receivables and Inventories.
 It seems that the firm could not sell its
inventories and has a bad credit policy.
60
 Expanded DuPont
Analysis –
DuPont Data

3-61
 Extended Du Pont
Chart

3-62
 Chapter Outline

• Cash Flows and Financial

Statements: A Closer Look
• Standardized Financial
Statements
• Ratio Analysis
• The DuPont Identity
• Using Financial Statement
Information
3-63
 Why Evaluate
Financial
Statements?
External
uses:
• Creditors
• Suppliers
• Customers
• Stockholde
3-64 rs
 Why Evaluate
Financial
Statements?
• Internal uses:
• Performance
evaluation –
compensation
and comparison
between
divisions
• Planning for the
3-65
future – guide in
estimating future
 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
• Data is used from comparative
year’s income statements and
3-66
balance sheets of the same
 Benchmarking
Ratios are not very helpful by
themselves; they need to be
compared to something
• Peer Group Analysis:
• Compare to similar
companies or within
industries
• SIC and NAICS codes

3-67
 Potential Problems
• There is no underlying theory,
so there is no way to know
which ratios are most relevant

• Benchmarking is difficult for

diversified firms

• Globalization and
international competition
makes comparison more
3-68 difficult because of
 More Potential
Problems
• Some industries have
specialized ratios that have
no comparisons to any other
industry

• Varying accounting
procedures, i.e. FIFO vs. LIFO

• Different fiscal years

3-69
• Extraordinary events
 Work the Web
• The Internet makes ratio analysis
much easier than it has been in
the past
• Click on the web surfer to go to
www.reuters.com
• Click on Stocks, then choose a
company and enter its ticker symbol
• Click on Ratios to see what
information is available
3-70
 Ethics Issues

Should financial analysts be held

liable for their opinions regarding the
financial health of firms?

How closely should ratings agencies

work with the firms they are
reviewing? For example, what level of
independence is appropriate?

3-71
 Quick Quiz

What is the Statement of Cash Flows

and how do you determine sources
and uses of cash?
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 some of the problems
3-72

associated with financial statement

 Comprehensive
Problem
• XYZ Corporation has the
following financial
information for the previous
year:

• Sales: $8M, PM = 8%, CA =

$2M, FA = $6M, NWC = $1M,
LTD = $3M
3-73

• Compute the ROE using the

 Terminology

• Sources and Uses of Funds

• Liquidity ratios
• Long-term solvency ratios
• Asset management ratios
• Turnover ratios
• Profitability ratios
• Market value ratios
• DuPont Identity
3-74
 Formulas

ROE = PM * TAT * EM
The Return on Equity
(ROE) =
Profit Margin on Sales *
Total Asset Turnover *
Equity Multiplier
3-75
 Key Concepts and
Skills
• Differentiate the sources and
uses of funds in an organization
• Identify the items on a
Statement of Cash Flows
• Describe the two units of
measure used for standardizing
financial statements
3-76
 Key Concepts and
Skills
• Construct and interpret
the ratios from each of
the five categories
• Compute and interpret
the DuPont Identity
• Describe the problems
and pitfalls in the use of
financial statement
3-77
 What are the most
important topics of
this chapter?
1. The Statement of Cash
Flows document identifies
the sources and uses of
funds in an organization

2. Ratio analysis dissects

income statement and
balance sheet information
into understandable,
3-78
discrete components in a
ratio format
 What are the most
important topics of
this chapter?
3. The five categories of ratio
analysis helps to group
ratios

4. The DuPont identity puts

ratios into an organizational
format to demonstrate the
relationship of some of the
key ratios
3-79
5. Trend analysis and industry
Questions?

3-80