Finance Analysis

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2 Part 1: Introduction
1 The Scope of Corporate Finance
Financial Statement and Cash Flow Analysis 2 Financial Statement and Cash Flow Analysis
2.1 Financial Statements
2.2 Cash Flow Analysis
2.3 Analyzing Financial Performance Using
Ratio Analysis
2.4 Summary
3 Present Value
Part 2: Risk, Return and Valuation
4 Bond and Stock Valuation
5 Risk and Return
6 Risk and Return: The CAPM and Beyond
Part 3: Capital Budgeting, Processes
and Techniques
7 Capital Budgeting Process and Techniques
8 Cash Flow and Capital Budgeting
OPENING FOCUS 9 Risk and Capital Budgeting
Porsche Removed from Stock Index Part 4: Capital Structure and Dividend
for Inadequate Financial Reporting Policy
10 Market Efficiency and Modern Financial
How far would you go to make a point? On August 7, 2001, exec- Management
utives of the Deutsche Börse took the extraordinary step of voting 11 An Overview of Long-Term Financing
to remove Porsche, the famous German sports car maker, from its 12 Capital Structure: Theory and Taxes
M-Dax Index of midcap stocks. This ended a long standoff be- 13 Capital Structure: Nontax Determinants of
Corporate Leverage
tween Germany’s main stock exchange and one of the country’s
14 Dividend Policy
most respected, and most profitable, companies. What offense did
Porshce commit to warrant removal from the exchange’s index? The Part 5: Long-Term Financing
15 Entrepreneurial Finance and Venture Capital
company refused to comply with the Börse’s requirement that com-
16 Investment Banking and the Public Sale of
panies in the index provide quarterly financial statesments. Porsche Equity Securities
maintained that quarterly financial statements would only confuse 17 Long-Term Debt and Leasing
shareholders seeking to analyze the performance of a firm oper-
Part 6: Options and Other Derivatives
ating in such a highly cyclical industry. Besides, Porsche had just
18 Options Basics
been selected for inclusion in Morgan Stanley Capital International’s
19 Black-Scholes and Beyond
(MSCI) index—arguably the most prestigious global stock index—
20 International Financial Management
and Porsche executives believed that this would increase worldwide 21 Risk Management and Financial Engineering
demand for its shares. Given its recent high profitability, Porsche also
Part 7: Short-Term Financing Decisions
had no need for external funding, and thus felt free to ignore the
22 Strategic and Operational Financial Planning
Börse’s rules.
23 Short-Term Financial Management
However, the Börse is certainly correct in demanding that Ger-
man companies increase the frequency and transparency of their fi- Part 8: Special Topics
nancial disclosures. Over the past decade, the percentage of Ger- 24 Mergers, Acquisitions, and Corporate Control
many’s adult population that owns shares has increased from less 25 Bankruptcy and Financial Distress
than 4 percent to more than 20 percent. This surge in stock owner-
ship coincided with a dramatic increase in the number of companies
“going public,” or selling shares to the public for the first time. In
1997, the Deutsche Börse created the Neuer Markt as a venue for
growth-oriented companies to sell stock, and in its first three years
of existence, the Neuer Markt experienced rapid growth in both the
number and value of listed companies. However, in March 2000, a
series of accounting scandals, coupled with the global contraction in
stock prices, launched an 18-month slide that wiped out more than
24
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Chapter 2 Financial Statement and Cash Flow Analysis 25
90 percent of the value of stocks listed on the Neuer Markt. The Börse’s new financial
disclosure requirements were adopted as a response to the crisis in investor confidence
these scandals had precipitated. They were also designed to persuade companies to aban-
don Germany’s rather murky accounting rules in favor of more transparent international
standards.
Source: Bettina Wassener, “Porsche Exits Deutsche Börse with Regret,” Financial Times (August 8, 2001).
It is often said that accounting is the language of business. Corporate finance relies
heavily on accounting concepts and language, but the primary focus of finance
professionals and accountants differs significantly. Accountants apply generally ac-
cepted accounting principles (GAAP) to construct financial statements that attempt
to portray fairly how a company has performed in the past. Accountants generally
construct these statements using an accrual-based approach, which means that ac-
countants record revenues at the point of sale and costs when they are incurred, not
necessarily when a firm receives or pays out cash. In contrast, financial professionals
use a cash flow approach that focuses their attention to a greater degree on current
and prospective inflows and outflows of cash. This chapter describes how financial
professionals use accounting information and terminology to analyze the firm’s cash
flows and financial performance. We begin with a brief review of the four major fi-
nancial statements. Next, we use these statements to demonstrate some of the key
SMART PRACTICES VIDEO concepts involved in cash flow analysis. We
Jon Olson, Vice President give special emphasis to the effect of depre-
of Finance, Intel Corp. ciation and other noncash charges on cash
“At Intel, accounting is a fundamental flows and the various inflows and outflows
requirement of a financial analyst.” of cash to the firm. Finally, we discuss the
use of some popular financial ratios to ana-
See the entire interview at
lyze the firm’s financial performance.
2.1 FINANCIAL STATEMENTS

Although our discussion in this chapter is based on U.S. accounting statements and
conventions, the principles covered are actually quite general, because many national
governments require public companies to generate financial statements based on
widely accepted accounting rules. In the United States, these rules are the GAAP de-
veloped by the Financial Accounting Standards Board (FASB). The FASB is a non-
governmental, professional standards body that examines controversial accounting
topics and then issues “rulings” that almost have the force of law, at least in terms of
their impact on accounting practices. The SEC is responsible for regulating publicly
traded U.S. companies, as well as the nation’s stock and bond markets. Every other
industrialized country also has an agency similar to the SEC, and most developed
countries mandate that companies generate financial statements following interna-
tional accounting standards (IAS). These are broadly similar to GAAP, although
GAAP rules tend to place greater emphasis on public information disclosure than do
IAS rules. The SEC has thus far adamantly insisted that all non-U.S. companies re-
port results based on GAAP in order to sell their securities directly to U.S. investors.
However, the corporate accounting scandals of 2001 and 2002 have tarnished the
reputation of GAAP and enhanced that of IAS.
The four key financial statements required by the SEC are (1) the balance sheet,
(2) the income statement, (3) the statement of retained earnings, and (4) the statement
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26 Part 1 Introduction
of cash flows.1 Our chief concern in this section is to review the information pre-
sented in these statements. Given the importance of cash flow in financial analysis, we
provide in-depth coverage of the statement of cash flows in Section 2.2.
In what follows, we present the financial statements from the 2004 stockholders’
report of the Global Petroleum Corporation (GPC). Though fictional, GPC’s ac-
counts are based on the actual statements of the five largest international petroleum
companies. Three of these firms (BP Amoco, Royal Dutch Shell, and Total Elf Fina)
are headquartered in Europe, and two are based in the United States (Exxon Mobil
and Chevron Texaco).2 The values constructed for GPC mirror those of a globally ac-
tive oil company.
BALANCE SHEET
A firm’s balance sheet presents a “snapshot” view of the company’s financial position
at a specific point in time. By definition, a firm’s assets must equal the combined value
of its liabilities and stockholders’ equity. Phrased differently, either creditors or equity
investors finance all a firm’s assets. A balance sheet shows assets on the left-hand side
and the claims of creditors and shareholders on the right-hand side. Both assets and
liabilities appear in descending order of liquidity, or the length of time it will take for
accounts to be converted into cash in the normal course of business. The most liquid
asset, cash, appears first, and the least liquid, fixed assets, comes last. In a similar fash-
ion, accounts payable represents obligations the firm must pay with cash within the
next year, whereas the last entry on the right-hand side of the balance sheet, stock-
holders’ equity, quite literally never matures.
Table 2.1 presents Global Petroleum Corporation’s balance sheet as of Decem-
ber 31, 2004. As is standard practice in annual reports, the table also shows the prior
year’s (2003) accounts for comparison. Cash and cash equivalents are assets such as
checking account balances at commercial banks that can be used directly as means of
payment. Marketable securities represent very liquid, short-term investments, which
financial analysts view as a form of “near cash.” Accounts receivable represent the
amount customers owe the firm from sales made on credit. Inventories include raw
materials, work in process (partially finished goods), and finished goods held by the
firm. The entry for gross property, plant, and equipment is the original cost of all real
property, structures, and long-lived equipment owned by the firm. Net property,
plant, and equipment represents the difference between this original value and ac-
cumulated depreciation —the cumulative expense recorded for the depreciation of
fixed assets since their purchase. Governments allow companies to depreciate, or
charge against taxable earnings, a fraction of a fixed asset’s value each year to re-
flect a decline in the asset’s economic value over time. The one fixed asset that is not
1.
The SEC requires publicly held corporations —those whose stock is traded on either an organized securities exchange
or the over-the-counter exchange and/or those with more than $5 million in assets and 500 or more stockholders—to
provide their stockholders with an annual stockholders’ report that includes these statements.
Whereas these statement titles are consistently used throughout the text, it is important to recognize that in practice,
companies frequently use different statement titles. For example, General Electric uses “Statement of Earnings” rather
than “Income Statement” and “Statement of Financial Position” rather than “Balance Sheet”; Bristol Myers Squibb uses
“Statement of Earnings and Retained Earnings” rather than “Income Statement”; and Pfizer uses “Statement of Share-
holders’ Equity” rather than “Statement of Retained Earnings.”
2.
Interestingly, two of the three European companies (BP Amoco and Royal Dutch Shell) report their results in U.S. dol-
lars, despite being headquartered in Europe, because international petroleum trading has traditionally been a dollar-based
business—as is true for over half of all products traded internationally. Total Elf Fina’s accounts are denominated in euros.
02-S2374 1/2/03 7:06 PM Page 27
Table 2.1
Balance Sheet for Global Petroleum Corporation
Global Petroleum Corporation Balance Sheets as at December 31, 2003 and 2004 ($ in millions)
Liabilities and
Assets 2004 2003 Stockholders’ Equity 2004 2003
Current assets Current liabilities
Cash and cash equivalents $ 440 $213 Accounts payable $1,697 $1,304
Marketable securities 35 28 Notes payable 477 587
Accounts receivable 1,619 1,203 Accrued expenses ffs440 ffs379
Inventories 615 530 Total current $2,614 $2,270
liabilities
Other (mostly prepaid ffs170 ffs176 Long-term liabilities
expenses) Deferred taxes $907 $793
Total current assets $2,879 $2,150 Long-term debt f1,760 f1,474
Fixed assets Total long-term $2,667 $2,267
Gross property, plant, and $9,920 $9,024 liabilities
equipment Total liabilities $5,281 $4,537
Less: Accumulated 3,968 3,335 Stockholders’ equity
depreciation Preferred stock $30 $30
Net property, plant, and $5,952 $5,689 Common stock ($1 par 373 342
equipment value)
Intangible assets and ffs758 ffs471 Paid-in capital in excess 248 229
others of par
Net fixed assets $6,710 $6,160 Retained earnings 4,271 3,670
Total assets $9,589
nnnnnss $8,310
nnnnnss Less: Treasury stock ff 614 f f498
Total stockholders’ equity $4,308 $3,773
Total liabilities and $9,589
nnnnnn $8,310
nnnnnn
stockholders’ equity
depreciated is land, because it generally does not decline in value over time. Finally,
intangible assets include items such as patents, trademarks, copyrights, or—in the
case of petroleum companies—mineral rights entitling the company to extract oil
and gas on specific properties. Although intangible assets are usually nothing more
than legal rights, they are often extremely valuable, as the discussion of the market
value of global brands in this chapter’s Comparative Corporate Finance insert vividly
demonstrates.
Now turn your attention to the right-hand side of the balance sheet. Current
liabilities include accounts payable, amounts owed for credit purchases by the firm;
notes payable, outstanding short-term loans, typically from commercial banks; and
accrued expenses, costs incurred by the firm that have not yet been paid. Examples
of accruals include taxes owed to the government and wages due employees.
In the United States and many other countries, laws permit firms to construct two
sets of financial statements, one for tax purposes and one for reporting to the public.
For example, when a firm purchases a long-lived asset, it can choose to depreciate
this asset rapidly for tax purposes, resulting in large immediate tax write-offs and
smaller tax deductions later. When the firm constructs financial statements for re-
lease to the public, however, it may choose a different depreciaton method, perhaps
02-S2374 1/2/03 7:06 PM Page 28
C O M PA R AT I V E C O R P O R AT E F I N A N C E 2
Assessing the Market Value of Global Brands
2001 Brand 2000 Brand

Value ($ in Value ($ in Percent Country of
Rank Brand billions) billions) Change Ownership
1 Coca-Cola 68.95 72.54 5 U.S.
2 Microsoft 65.07 70.20 7 U.S.
3 IBM 52.75 53.18 1 U.S.
4 GE 42.40 38.13 11 U.S.
5 Nokia 35.04 38.53 9 Finland
6 Intel 34.67 39.05 11 U.S.
7 Disney 32.59 33.55 3 U.S.
8 Ford 30.09 36.37 17 U.S.
9 McDonald’s 25.29 27.86 9 U.S.
10 AT&T 22.83 25.55 11 U.S.
11 Marlboro 22.05 22.11 0 U.S.
12 Mercedes 21.73 21.11 3 Germany
13 Citibank 19.01 18.81 1 U.S.
14 Toyota 18.58 18.82 1 Japan
15 Hewlett-Packard 17.98 20.57 13 U.S.
16 Cisco Systems 17.21 20.07 14 U.S.
17 American Express 16.92 16.12 5 U.S.
18 Gillette 15.30 17.36 12 U.S.
19 Merrill Lynch 15.02 NA NA U.S.
20 Sony 15.01 16.41 9 Japan
21 Honda 14.64 15.25 4 Japan
22 BMW 13.86 12.97 7 Germany
23 Nescafe 13.25 13.68 3 Switzerland
24 Compaq 12.35 14.60 15 U.S.
25 Oracle 12.22 NA NA U.S.
How much is a global brand name worth? Interbrand sets such as patents, copyrights, and trademarks, as well
Corporation, a New York–based consulting firm, has as brand names and business relationships that are not
been trying to answer this question for several years. accounted for at all. Until 2001, goodwill was treated as
The table details what this firm considers the 25 most an expense to be charged against the acquiring firm’s
valuable brands in 2001. The table also lists the values earnings over a period of years. Now, however, the Fi-
of these brands in 2000, which makes it clear that the nancial Accounting Standards Board requires firms to
global business environment declined considerably in periodically assess the fair value of assets that they pur-
2001. The total brand values are large and are domi- chase through acquisitions. If the fair value of those as-
nated by brands of U.S.-based companies. Although sets declines significantly over time, then firms must rec-
American companies are not required to disclose esti- ognize “goodwill impairment,” meaning that some of
mated brand values in their financial statements, large the value of their intangible assets has vanished. Charges
publicly traded British and Australian firms must do so. arising from goodwill impairment can have a dramatic
Brand values do, however, have a significant impact on effect on reported earnings, as we will see in the open-
U.S. accounting rules in one important area—accounting focus to Chapter 8.
ing for the “goodwill” created when a firm is acquired
by another company for more than the acquired firm’s Source: Interbrand Corporation, as reported in Gerry Khermouch, “The
book value. This premium over book value represents Best Global Brands,” Business Week (August 6, 2001), pp. 5 – 64.
the higher market (versus book) value of intangible as-
02-S2374 1/2/03 7:06 PM Page 29
one that results in higher reported earnings in the early years of the asset’s life and
lower earnings later. The deferred taxes entry on the balance sheet reflects the dis-
crepancy between the taxes that firms actually pay and the tax liabilities they report
on their public financial statements. Long-term debt represents debt that matures
more than one year in the future. The stockholder’s equity section provides informa-
tion about the claims against the firm held by investors who own preferred and com-
mon shares. The preferred stock entry shows the historic proceeds from the sale of
preferred stock ($30 million for GPC). Next, the amount paid in by the original pur-
chasers of common stock is shown by two entries— common stock and paid-in capi-
tal in excess of par. The common stock entry equals the number of outstanding com-
mon shares times the par value per share. The par value of a share of stock is an
arbitrary value with little or no economic significance. The entry, paid-in-capital in
excess of par, equals the number of shares outstanding times the original selling price
of the shares, net of the par value. Therefore, the combined value of common stock
and paid-in-capital equals the proceeds the firm received when it originally sold shares
to investors. Retained earnings are the cumulative total of the earnings that the firm
has reinvested since its inception. It is important to recognize that retained earnings
do not represent a reservoir of unspent cash. The retained earnings “vault” is empty
because the firm has already reinvested the earnings in new assets. Finally, the Trea-
sury stock entry records the value of common shares that the firm currently holds in
reserve. Usually, Treasury stock appears on the balance sheet because the firm has re-
acquired previously issued stock through a share repurchase program.
GPC’s balance sheet in Table 2.1 shows that the firm’s total assets increased by
$1,279 million, from $8,310 million in 2003 to $9,589 million in 2004. Other sig-
nificant changes in GPC’s balance sheet include sizable increases in cash, accounts re-
ceivable, and intangible assets, coupled with a massive $896 million increase in gross
property, plant, and equipment. Balancing these increases in asset accounts is an in-
crease of $393 million in accounts payable plus $601 million in new retained earn-
ings. In other words, GPC financed increases in asset accounts mainly by borrowing
more from suppliers (accounts payable) and by reinvesting profits (retained earnings).
We will discover additional insights into these changes when we look more closely at
the statement of cash flows.
INCOME STATEMENT
Table 2.2 presents Global Petroleum Corporation’s income statement for the year
ended December 31, 2004. As with the balance sheet, GPC’s income statement also
includes data from 2003 for comparison.3 In the vocabulary of accounting, income
(also called profit, earnings, or margin) equals revenue minus expenses. GPC’s income
statement, however, that there are several measures of “income” appearing at differ-
ent points on the statement. The first income measure is gross profit, the amount by
which sales revenue exceeds the cost of goods sold (the direct material and labor cost
of producing the goods sold). Next, various operating expenses, including selling ex-
pense, general and administrative expense, and depreciation expense, are deducted
from gross profits.4 The resulting operating profit of $1,531 million represents the
profits earned from producing and selling products, although this amount does not
include financial and tax costs. Other income, which includes interest earned on
3.
When reporting to shareholders, firms typically also include a common-size income statement that expresses all income-
statement entries as a percentage of sales.
4.
Depreciation expense can be, and frequently is, included in manufacturing costs— cost of goods sold—to calculate gross
profits. Depreciation is shown as an expense in this text to isolate its impact on cash flows.
02-S2374 1/2/03 7:06 PM Page 30
Table 2.2
Income Statement for Global Petroleum Corporation Income Statements for the years ended
Global Petroleum December 31, 2003 and 2004 ($ in millions)
Corporation
2004 2003
Sales revenue $12,843 $9,110
Less: Cost of goods sold a p 8,519 n5,633
Gross profit $4,324 $3,477
Less: Operating and other expenses 1,544 1,521
Less: Selling, general, and administrative expenses 616 584
Less: Depreciation nns633 ns608
Operating profit $1,531 $764
Plus: Other income nsn140 nn82
Earnings before interest and taxes (EBIT) $1,671 $846
Less: Interest expense nsn123 n112
Pretax income $1,548 $734
Less: Taxes
Current 367 158
Deferred n232 n105
Total taxes n599 n263
Net income (net profit after tax) $949 $471
Less: Preferred stock dividends nnn3 nnn3
Earnings available for common stockholders $946 $468
Less: Dividends n345 n326
To retained earnings $601 $142
Per-share data b
Earnings per share (EPS) $5.29 $2.52
Dividends per share (DPS) $1.93 $1.76
Price per share $76.25 $71.50
a
Annual purchases have historically represented about 80 percent of cost of goods sold. Using this relationship,
its credit purchases in 2004 were $10,274 and in 2003, they were $7,288.
b
Based on 178,719,400 and 185,433,100 shares outstanding as of December 31, 2004 and 2003, respectively.
marketable securities, is added to operating income to yield earnings before interest

and taxes (EBIT) of $1,671 million. When a firm has no “other income,” its operat-
ing profit and EBIT are equal. Next, $123 million of interest expense —represent-
ing the cost of debt financing—is subtracted from EBIT to find pretax income of
$1,548 million.
The final step is to subtract taxes from pretax income to arrive at net income,
or net profits after taxes, of $949 million. Note that GPC incurred a total tax liabil-
ity of $599 million during 2004, but only the $367 million current portion must be
paid immediately. Although the remaining $232 million in deferred taxes must be
paid eventually, these are noncash expenses for year 2004. Net income is the prover-
bial “bottom line” and is the single most important accounting number for both cor-
porate managers and external financial analysts. From its net income the firm paid
$3 million in dividends on its $30 million of preferred stock outstanding during both
2003 and 2004. Dividing earnings available for common stockholders (net income
net of preferred stock dividends) by the number of shares of common stock outstand-
ing results in earnings per share (EPS). EPS represents the amount earned during the
period on each outstanding share of common stock. Because there are 178,719,400
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Table 2.3
Global Petroleum Corporation Statement of Retained Earnings Statement of Retained
for the Year Ended December 31, 2004 ($ in millions) Earnings for Global
Petroleum Corporation
Retained earnings balance (January 1, 2004) $3,670
Plus: Net income (for 2004) 949
Less: Cash dividends (paid during 2004)
Preferred stock $3
Common stock 345
Total dividends paid p n$348
Retained earnings balance (December 31, 2004) $4,271
nnnnnn
shares of GPC stock outstanding on December 31, 2004, its EPS for 2004 is $5.29,
which represents a significant increase from the EPS of $2.52 GPC managed during
2003. The cash dividend per share (DPS) paid to GPC’s common stockholders dur-
ing 2004 is $1.93, up slightly from the dividend of $1.76 per share paid in 2003.
STATEMENT OF RETAINED EARNINGS

The statement of retained earnings reconciles the net income earned during a given
year, and any cash dividends paid, with the change in retained earnings between the
start and end of that year. Table 2.3 presents this statement for Global Petroleum
Corporation for the year ended December 31, 2004. A review of the statement shows
that the company began the year with $3,670 million in retained earnings and had
net profits after taxes of $949 million, from which it paid a total of $348 million in
preferred and common stock dividends, resulting in year-end retained earnings of
$4,271 million. Thus, the net increase for GPC is $601 million ($949 million net in-
come minus $348 million in dividends) during 2004.
Two aspects of the change in GPC’s retained earnings between 2003 and 2004
merit explicit mention. First, note that 2004 was a very good year for GPC compared
to 2003 in terms of increased sales and profits. GPC’s net income more than doubled
between 2003 and 2004, rising from $471 million to $949 million, so it is not sur-
prising that the amount of earnings retained in the firm during 2004 ($601 million)
was much larger than in 2003 ($142 million).5 Second, note that while GPC in-
creased its dividend payment to common shareholders from $326 million in 2003 to
$345 million in 2004, this increase was far smaller proportionally than was the in-
crease in net income. Another way to phrase this is to say that GPC’s dividend payout
ratio—the fraction of current earnings available for common stockholders paid out
as dividends— declined from 69.7 percent ($326 million $468 million) in 2003 to
36.5 percent ($345 million $946 million) in 2004.
5.
Also note that the two broadest measures of income (EBIT and net income) increased proportionally far more than did
sales revenue. Whereas sales increased by 41 percent—from $9,110 million to $12,843 million—EBIT and net income
increased by 98 percent and 101 percent, respectively. This suggests that the firm’s extensive use of fixed-cost assets (re-
fineries, pipelines, tankers, etc.) imparts to it a high degree of operating leverage, meaning that a given percentage in-
crease (decrease) in sales yields a much larger percentage increase (decrease) in operating profits (same as EBIT). Even
with higher taxes, this increased operating income also translates into higher net profits. Finally, note that the increased
operating income is not a result of a higher profit margin on each sale. The gross profit margin per sales dollar (gross
profit sales) declined from 38.2 percent in 2003 to 33.7 percent in 2004. As a result, GPC’s gross profit increased by a
smaller percentage than its sales did. EBIT and net income surged because GPC’s operating, selling, general, administrative,
and depreciation expenses remained largely unchanged between 2003 and 2004. Though not absolutely “fixed costs,”
these expense items increased very little during 2004, and this magnified the impact of the sales increase on EBIT and on
net income.
02-S2374 1/2/03 7:06 PM Page 32
Why did GPC effectively cut its dividend payout ratio in half during 2004? Al-
though we defer an in-depth analysis of dividend policy until Chapter 14, we can
quickly present the two most likely reasons for this change. First, GPC’s managers
may have concluded that the increase in 2004 sales and profits might be reversed dur-
ing 2005 or subsequent years. In that case, GPC would either have to cut dividends
or pay out an uncomfortably large fraction of earnings during 2005 —perhaps even
more than the firm’s net profits. Empirical research suggests that firms do have a “tar-
get” payout ratio, but this target is based on the level of sustainable, or “permanent,”
earnings. Thus, GPC’s managers would be reluctant to increase dividends until they
are convinced the firm’s earnings have reached a permanently higher level. Second,
managers typically follow a “partial adjustment” strategy when they change dividend
payments. This means that even if GPC’s managers are convinced earnings have per-
manently increased and they wish to keep the firm’s long-term payout ratio at 2003’s
level of nearly 70 percent, they will only gradually raise the dividend payment each
year until they reach the target payout ratio.
STATEMENT OF CASH FLOWS

The statement of cash flows provides a summary of a firm’s cash flows over the year.
This is accomplished by isolating the firm’s operating, investment, and financing cash
flows and reconciling them with changes in its cash and marketable securities during
the year. GPC’s statement of cash flows for the year ended December 31, 2004, is pre-
sented in Table 2.5. However, before we look at the preparation of this statement,
it is helpful to understand how both noncash expenses, such as depreciation, and in-
vestments impact a firm’s cash flow. We should also stress that other information pre-
sented in financial statements can be very useful to financial managers and analysts,
and this is especially true about the “notes” to financial statements.
NOTES TO FINANCIAL STATEMENTS

A public company’s financial statements will include detailed explanatory notes
keyed to the relevant accounts in the statements. These notes provide detailed in-
formation on the accounting policies, calculations, and transactions underlying en-
tries in the financial statements. For example, the notes to General Motors’ 2001
financial statements cover 25 of the 50 pages in its annual report. Notes typically pro-
vide additional information about a firm’s revenue recognition practices, income
taxes, fixed assets, leases, and employee compensation plans. This information is
particularly useful to professional security analysts. As they try to assess whether a
firm’s stock is under- or overvalued, analysts scour the notes to the firm’s financial
statements, looking for clues that will shed more light on the firm’s past and future
performance.
Concept 1. Are balance sheets and income statements prepared with the same purpose in mind?
Review How are these two statements different, and how are they related?
Questions 2. Which statements are of greatest interest to creditors, and which would be of greatest in-
terest to stockholders?
3. Why are the notes to financial statements important to professional security analysts?
02-S2374 1/2/03 7:06 PM Page 33
2.2 CASH FLOW ANALYSIS

Although the financial manager is interested in the information contained in the firm’s
accrual-based financial statements, the primary focus is on cash flows. Without ade-
quate cash to pay obligations on time, to fund operations and growth, and to com-
pensate owners, the firm will fail. The financial manager and other interested parties
can gain insight into the firm’s cash flows over a given period of time by both utilizing
some popular measures of cash flow and analyzing the firm’s statement of cash flows.
THE FIRM’S CASH FLOWS

Figure 2.1 illustrates the firm’s cash flows. Note that the figure treats cash and market-
able securities as perfect substitutes. Both cash and marketable securities represent a
reservoir of liquidity that increases with cash inflows and decreases with cash out-
flows. Also note that the figure divides the firm’s cash flows into (1) operating flows,
(2) investment flows, and (3) financing flows. The operating flows are cash inflows
and outflows directly related to the production and sale of the firm’s products or ser-
vices. Investment flows are cash flows associated with the purchase or sale of both
fixed assets and business equity. Clearly, purchases would result in cash outflows,
whereas sales would generate cash inflows. The financing flows result from debt and
equity financing transactions. Taking on new debt (short-term or long-term) results
in a cash inflow, whereas repaying existing debt represents a cash outflow. Similarly,
the sale of stock results in a cash inflow, while the payment of cash dividends or re-
purchase of stock generates a cash outflow. In combination, the firm’s operating, in-
vestment, and financing cash flows during a given period will affect the firm’s cash
and marketable securities balances. Two popular measures of cash flow are cash flow
from operations and free cash flow.
Cash Flow from Operations

The financial manager’s primary focus is on cash flows. To adjust the income state-
ment to show cash flow from operations, all noncash charges must be added back to
the firm’s net profits after taxes. Noncash charges, such as depreciation, amortiza-
tion, and depletion allowances, are expenses that appear on the income statement but
do not involve an actual outlay of cash. Almost all firms list depreciation expense on
their income statements, so we focus our attention on depreciation rather than amor-
tization or depletion allowances, but they are treated in a similar fashion. A simple
estimate of cash flow from operations often found in accounting textbooks is given
in the following equation:6
Cash flow from operations net profits after taxes depreciation (Eq. 2.1)
Applying Equation 2.1 to the 2004 income statement for Global Petroleum Cor-
poration yields a cash flow from operations of $1,582 million ($949 million net in-
come $633 million depreciation). This $1,582 million is the amount of cash gen-
erated by GPC’s normal operating activities, and the firm’s managers can use it to
purchase additional assets, to repay debt, to pay dividends to GPC’s shareholders, or
6.
This formula is viewed as an accounting “estimate” because its accuracy is predicated on the assumption that invento-
ries, accounts receivable, and accounts payable did not change over the period covered by this measure.
02-S2374 1/2/03 7:06 PM Page 34
(1) Operating Flows (2) Investment Flows
Accrued Payment
Labor
Wages
Purchase
Accounts Payment
Materials Sale Fixed Assets
Payable
Depreciation
Production Overhead Business

Equity
Products or
Services Purchase
Sale
Operating (incl. Cash

Depreciation) and and
Interest Expense Marketable
(3) Financing Flows
Securities
Borrowing
Payment Debt
Taxes Repayment
(Short-Term and
Refund Long-Term)
Cash Sales
Sales Revenue Sale of Stock
Repurchase of Stock
Equity
Payment of Cash Dividends
Accounts Collection
Receivable
Figure 2.1
The Pattern of Cash Flows Through a Firm
to do all the above. This internal cash flow provides the bulk of net new financing for
U.S. corporations every year, and the same is true in most other industrialized coun-
tries. External debt and equity financing, in contrast, usually account for less than
one-third of new corporate funding.
Free Cash Flow

Although cash flow from operations is important, finance places more emphasis on
the firm’s free cash flow. Free cash flow (FCF) is the amount of cash flow available to
investors—the providers of debt and equity capital. It represents the net amount of
cash flow remaining after the firm has met all operating needs and paid for invest-
02-S2374 1/2/03 7:06 PM Page 35
ments—both long-term (fixed) and short-term (current). Free cash flow for a given
period can be calculated in two steps.
First, we find the firm’s operating cash flow (OCF), which is defined by the fol-
lowing equation:
OCF EBIT taxes depreciation (Eq. 2.2)
Substituting the values from GPC’s 2004 income statement (from Table 2.2), we get
GPC’s operating cash flow:
OCF $1,671 $599 $633 $1,705
Comparing GPC’s OCF of $1,705 million to its cash flow from operations of $1,582
million calculated earlier, the difference of $123 million ($1,705 million – $1,582 mil-
lion) represents interest expense. The accounting measure of cash flow from opera-
tions deducts interest expense, whereas the finance measure, operating cash flow,
does not. The difference is subtle but important. In many settings, financial analysts
want to separate the cash flows that a firm generates by producing goods and services
from those associated with financing decisions. Clearly, interest is a cash expense that
occurs because a firm chooses to finance part of its operations with debt rather than
with equity, so financial analysts often ignore that item when assessing a firm’s over-
all ability to generate cash.
Next, we convert operating cash flow to free cash flow (FCF). This is done by de-
ducting the firm’s net investments in fixed and current assets from operating cash flow
as shown in the following equation:
FCF OCF FA (CA A /P accruals) (Eq. 2.3)
where ¢FA change in gross fixed assets,

¢CA change in current assets,
¢A/P change in accounts payable, and
¢accruals change in accrued liabilities.
Note that only spontaneous current liability changes are deducted from current as-
sets to find the net change in short-term investment. From the preceding calculation,
we know that GPC’s OCF in 2004 was $1,705 million. Using GPC’s 2003 and 2004
balance sheets (Table 2.1), we can calculate the changes in gross fixed assets, current
assets, accounts payable, and accruals between 2003 and 2004:
¢FA $9,920 $9,024 $896

¢CA $2,879 $2,150 $729
¢A/P $1,697 $1,304 $393
¢accruals $440 $379 $61
Substituting these values into Equation 2.3, we get the following:
FCF $1,705 $896 1$729 $393 $612

$1,705 $896 $275
$534
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Reviewing the second line of the FCF calculation above, we see that after subtracting
$896 million in net fixed asset investment and $275 million in net current asset invest-
ment, GPC has free cash flow in 2004 of $534 million. During 2004, the firm there-
fore had $534 million available to pay investors who provide the firm with debt and
equity financing. Free cash flow will be used in Chapter 4 to estimate the value of a
firm. At this point, suffice it to say that FCF is an important measure of cash flow used
by corporate finance professionals.
INFLOWS AND OUTFLOWS OF CASH

The statement of cash flows summarizes the inflows and outflows of cash during a
given period. Table 2.4 classifies the basic inflows and outflows of cash for corpora-
tions. For example, if a firm’s accounts payable increases by $1,000 during the year,
this change would be an inflow of cash. If the firm’s inventory increases by $2,500, the
change would be an outflow of cash.
Table 2.4
The Inflows and Outflows Inflows Outflows
of Corporate Cash
Decrease in any asset Increase in any asset
Increase in any liability Decrease in any liability
Net income (profit after tax) Net loss
Depreciation and other noncash charges Dividends paid
Sale of common or preferred stock Repurchase or retirement of stock
A few additional points can be made with respect to the classification scheme in
Table 2.4.
1. A decrease in an asset, such as the firm’s inventory balance, is an inflow of cash
because cash that has been tied up in the asset is released and managers can use
it for some other purpose, such as repaying a loan. In contrast, an increase in the
firm’s inventory balance (or any other asset) is an outflow of cash because addi-
tional inventory ties up more of the firm’s cash. Similar logic explains why an in-
crease in any liability is an inflow of cash, and a decrease in any liability is an out-
flow of cash.
2. Our earlier discussion of cash flow from operations explains why net income and
depreciation are considered cash inflows. The same logic suggests that a net loss
(negative net profits after taxes) would be an outflow of cash. The firm must bal-
ance its losses with an inflow of cash—such as selling off some of its fixed assets
(reducing an asset) or increasing external borrowing (increasing a liability). Note
that a firm can have a net loss and still have positive cash flow from operations
when depreciation and other noncash charges during the period are greater than
the net loss. Therefore, the statement of cash flows treats net income (or net losses)
and noncash charges as separate entries.
APPLYING THE MODEL
On June 30, 2002, and on March 31, 2002, Procter & Gamble Co. (P&G) (ticker
symbol, PG) reported the following balances in certain current asset and liabilities
accounts ($ in millions).
02-S2374 1/2/03 7:06 PM Page 37
June 30, March 31,

Account 2002 2002
Cash $3,427 $3,061
Short-term investments 196 470
Accounts receivable 3,611 3,403
Inventory 3,456 3,772
Accounts payable 8,973 9,137
Short-term debt 3,731 5,993
In terms of current assets, short-term investments and inventory declined during the
second quarter of 2002, providing an inflow of cash for P&G. Cash and accounts re-
ceivable increased during the quarter, representing a cash outflow. It may seem strange
to think of an increase in cash balances as a use of cash, but that simply means that
P&G used some of its cash flow to “invest in liquidity” rather than using the cash for
another purpose. On the liabilities side, accounts payable and short-term debt de-
clined, both representing an outflow of cash for P&G.
DEVELOPING THE STATEMENT OF CASH FLOWS

Accountants construct the statement of cash flows by using the income statement for
a given year, along with the beginning- and end-of-year balance sheets. The procedure
involves classifying balance sheet changes as inflows or outflows of cash; obtaining
income statement data; classifying the relevant values into operating, investment, and
financing cash flows; and presenting them in the proper format.7 The statement of
cash flows for the year ended December 31, 2004, for Global Petroleum Corpora-
tion appears in Table 2.5. Note that the statement assigns positive values to all cash
inflows and negative values to all cash outflows. Notice under the investment activi-
ties section that the statement records the increase in gross fixed assets, rather than
net fixed assets, as a cash outflow. Depreciation accounts for the difference between
changes in gross and net fixed assets, but depreciation expense appears in the oper-
ating activities section of the statement. Thus, the focus on changes in gross fixed as-
sets avoids double-counting depreciation in the statement. For a similar reason, the
statement does not show a specific entry for the change in retained earnings as an
inflow (or outflow) of cash. Instead, the factors that determine the change in retained
earnings—profits or losses and dividends—appear as separate individual entries in
the statement.
By adding up the items in each category— operating, investment, and financing
activities—we obtain the net increase (decrease) in cash and marketable securities for
the year. As a check, this value should reconcile with the actual change in cash and
marketable securities for the year, which is obtained from the beginning- and end-of-
year balance sheets.
By applying this procedure to GPC’s 2004 income statement and 2003 and 2004
balance sheets, we obtain the firm’s 2004 statement of cash flows (see Table 2.5). This
statement shows that GPC experienced a $234 million increase in cash and mar-
ketable securities during 2004. Looking at GPC’s 2003 and 2004 balance sheets in
Table 2.1, we see that the firm’s cash increased by $227 million and its marketable
7.
For a description and demonstration of the detailed procedures for developing the statement of cash flows, see any re-
cently published financial accounting text, such as Chapter 14 of Corporate Financial Accounting, 7th ed., by Warren,
Reeve, and Fess (2002).
02-S2374 1/2/03 7:06 PM Page 38
Table 2.5
Statement of Cash Flows Global Petroleum Corporation Statement of Cash Flows for Year
for Global Petroleum Ended December 31, 2004 ($ in millions)
Corporation
Cash flow from operating activities
Net income (net profit after tax) $949
Depreciation 633
Increase in accounts receivable (416)
Increase in inventories (85)
Decrease in other current assets 6
Increase in accounts payable 393
Increase in accrued expenses ppppppp61p
Cash provided by operating activities $1,541
Cash flow from investment activities

Increase in gross fixed assets ($896)
Increase in intangible and other assets pp(287)
Cash provided (consumed) by investment activities ($1,183)
Cash flow from financing activities

Decrease in notes payable ($110)
Increase in deferred taxes 114
Increase in long-term debt 286
Changes in stockholders’ equity (66)
Dividends paid ppp(348)
Cash provided (consumed) by financing activities ($124)
Net increase in cash and marketable securities $234s

snnnn
securities increased by $7 million between December 31, 2003, and December 31,
2004. The $234 million net increase in cash and marketable securities from the state-
ment of cash flows reconciles with the total change of $234 million in these accounts
during 2004. GPC’s statement of cash flows therefore reconciles with the balance
sheet changes.
INTERPRETING THE STATEMENT

The statement of cash flows allows the financial manager and other interested parties
to analyze the firm’s cash flow over a period of time. Unusual changes in either the ma-
jor categories of cash flow or in specific items may offer clues to problems that a firm
may be experiencing. For example, an unusually large increase in accounts receivable
and inventories resulting in major cash outflows may signal credit or inventory prob-
lems, respectively. Financial managers and analysts can also prepare a statement of
cash flows developed from projected, or pro forma, financial statements. They use
this approach to determine whether the firm will require additional external financ-
ing or whether it will generate excess cash that can be reinvested or distributed to
shareholders.
Analysis of Global Petroleum Corporation’s statement of cash flows for 2004 does
not indicate major problems for the company. GPC used the $1,541 million of cash
02-S2374 1/2/03 7:06 PM Page 39
provided by operating activities primarily to purchase an additional $896 million

in property, plant, and equipment and increase intangibles and other fixed assets by
$287 million. Financing activities were basically a wash, with increases in deferred
taxes and long-term debt contributing a combined cash inflow of $400 million.
Roughly offsetting the inflows of cash from increased long-term debt and deferred
taxes were outflows from a reduction of notes payable ($110 million), payment of
common and preferred stock dividends ($348 million), and a net reduction in com-
mon stock outstanding of $66 million. In addition to cash provided by net income
($949 million) and depreciation ($633 million), major cash inflows were realized
by increasing accounts payable ($393 million) and long-term debt ($286 million).
The $1,183 million increase in fixed assets was unusually large, by recent historical
standards, but consistent with the significant growth in revenue that occurred dur-
ing 2004.
One financially encouraging step taken by GPC during 2004 was to increase its
net working capital by $385 million. Net working capital, defined as current assets
minus current liabilities, is a measure of the firm’s overall liquidity; higher values re-
flect greater solvency, and vice versa. GPC’s net working capital at the end of 2003
was $120 million. As of December 31, 2004, GPC’s net working capital had risen
to a positive level of $265 million. GPC engineered this $385 million increase in net
working capital by increasing its investment in current assets by $729 million while
increasing its current liabilities by only $344 million. Cash and marketable securi-
ties, accounts receivable, and inventories increased by $234 million, $416 million,
and $85 million, respectively, while the other current assets decreased by $6 million.
Large increases occurred in two of the three categories of current liabilities—accounts
payable ($393 million) and accrued expenses ($61 million)—and they were partially
offset by a $110 million decline in notes payable. In general, it appears that GPC is
growing and is managing its cash flows reasonably well.
4. How do depreciation and other noncash charges act as sources of cash inflow to the firm? Concept
Why does a depreciation allowance exist in the tax laws? For a profitable firm, is it better to Review
depreciate an asset quickly or slowly for tax purposes? Explain. Questions
5. What is cash flow from operations? Why do finance professionals prefer operating cash
flow (OCF)? What is free cash flow (FCF), and how is it related to OCF?
6. Why is the financial manager likely to have great interest in the firm’s statement of cash
flows? What type of information can be obtained from this statement?
2.3 ANALYZING FINANCIAL PERFORMANCE USING RATIO ANALYSIS

Analysis of a firm’s financial statements is of interest to shareholders, creditors, and
the firm’s own management. In many cases, the constituents of a firm want to com-
pare its financial condition to that of other similar firms, but doing so can be very
tricky. For example, suppose you are introduced to a new acquaintance named Bill
who tells you that he runs a company that earned a profit of $10 million last year.
Would you be impressed by that feat? What if you knew that Bill’s last name was
Gates? Most people would agree that a profit of $10 million would be a great disap-
pointment for Microsoft, the firm run by Bill Gates.
02-S2374 1/2/03 7:06 PM Page 40
The point here is that the sales, profits, or almost any other item that appears on
a firm’s financial statements is difficult to interpret unless we have some way to put
that number in perspective. To analyze financial statements, we need relative mea-
sures that in effect normalize size differences. Effective analysis of financial statements
is thus based on the knowledge and use of ratios or relative values. Ratio analysis in-
volves calculating and interpreting financial ratios to assess the firm’s performance
and status.
TYPES OF FINANCIAL RATIOS

Different constituents will focus on different types of financial ratios. The firm’s credi-
tors are primarily interested in ratios that measure the short-term liquidity of the com-
pany and its ability to make interest and principal payments. A secondary concern of
creditors is the firm’s profitability; they want assurance that the business is healthy
and will continue to be successful. Both present and prospective shareholders are in-
terested in ratios that measure the firm’s current and future levels of risk and return,
because these two dimensions directly affect the firm’s share price. The firm’s man-
agers must be concerned with all aspects of the firm’s financial situation, so they use all
the ratios to generate an overall picture of the company’s financial health. In addition,
management uses ratios to monitor the firm’s performance from period to period. The
managers examine unexpected changes carefully to isolate developing problems.
An additional complication of ratio analysis is that for any given ratio, what is
normal in one industry may be highly unusual in another. For example, by dividing
a firm’s net income by its sales, we obtain the net profit margin ratio. Net profit mar-
gins vary dramatically across industries. What might be considered an outstanding net
profit margin in the retail grocery industry would look paltry in the software business.
Therefore, when making subjective judgments about the health of a given company,
analysts usually compare the firm’s ratios to two benchmarks. First, analysts compare
the financial ratios in the current year to previous years’ ratios. By doing so, analysts
hope to identify trends that they can use to evaluate the firm’s prospects. Second, ana-
lysts usually compare the ratios of one company to those of other “benchmark” firms
in the same industry or to an industry average obtained from a trade association or
third-party provider.
We will use the 2004 and 2003 balance sheets and income statements for Global
Petroleum Corporation, presented earlier in Tables 2.1 and 2.2, to demonstrate ratio
calculations. We will delete the millions after GPC’s values. Note that the ratios pre-
sented in the remainder of this chapter can be applied to nearly any company. Of
course, many companies in different industries use ratios that are particularly focused
on aspects peculiar to their industry.8 We will cover the most common financial ra-
tios, and we group them into five categories: liquidity, activity, debt, profitability, and
market ratios.
LIQUIDITY RATIOS
The liquidity of a firm is measured by its ability to satisfy its short-term obligations
as they come due. Because a common precursor to financial distress and bankruptcy
is low or declining liquidity, liquidity ratios are good leading indicators of cash flow
8.
For example, airlines pay close attention to the ratio of revenues to passenger miles flown. Retailers diligently track the
growth in same-store sales from one year to the next.
02-S2374 1/2/03 7:06 PM Page 41
problems. The two basic measures of liquidity are the current ratio and the quick
(acid-test) ratio.
The current ratio, one of the most commonly cited financial ratios, measures the
firm’s ability to meet its short-term obligations. It is defined as current assets divided
by current liabilities, and thus presents in ratio form what net working capital mea-
sures by subtracting current liabilities from current assets. The current ratio for GPC
on December 31, 2004, is computed as follows:
current assets $2,879

Current ratio 1.10
current liabilities $2,614
How high should the current ratio be? The answer depends on the type of busi-
ness under consideration and on the costs and benefits of having too much versus too
little liquidity. For example, a current ratio of 1.0 would be considered acceptable for
a utility but might be unacceptable for a manufacturing firm. The more predictable a
firm’s cash flows, the lower the acceptable current ratio. Because GPC is in a business
(oil exploration and development) with notoriously unpredictable annual cash flows,
its current ratio of 1.10 indicates that GPC takes a fairly aggressive approach to man-
aging its liquidity.
The quick (acid-test) ratio is similar to the current ratio except that it excludes
inventory, which is usually the least-liquid current asset. The generally low liquidity of
inventory results from two factors: (1) many types of inventory cannot be easily sold
because they are partially completed items, special-purpose items, and the like; and
(2) inventory is typically sold on credit, which means that it becomes an account re-
ceivable before being converted into cash. The quick ratio is calculated as follows:
current assets inventory $2,879 $615

Quick ratio 0.866
current liabilities $2,614
The quick ratio for GPC in 2004 is 0.866. The quick ratio provides a better measure
of overall liquidity only when a firm’s inventory cannot be easily converted into cash.
If inventory is liquid, the current ratio is a preferred measure of overall liquidity. Be-
cause GPC’s inventory is mostly petroleum and refined products, both of which can
be readily converted into cash, the firm’s managers will probably focus on the current
ratio rather than the quick ratio.
ACTIVITY RATIOS
Activity ratios measure the speed with which various accounts are converted into
sales or cash. Managers and outsiders use activity ratios as guides to assess how effi-
ciently the firm manages assets such as inventory, receivables, and fixed assets, and the
current liability, accounts payable.
Inventory turnover provides a measure of how quickly a firm sells its goods. GPC’s
2004 inventory turnover ratio appears below:
cost of goods sold $8,519

Inventory turnover 13.85
inventory $615
Notice that we used the ending inventory balance of $615 to calculate this ratio. If
inventories are growing over time or exhibit seasonal patterns, analysts sometimes
use the average level of inventory throughout the year rather than the ending balance
02-S2374 1/2/03 7:06 PM Page 42
to calculate this ratio. The resulting turnover of 13.85 is meaningful only when it is
compared with that of other firms in the same industry or to the firm’s past inventory
turnover. An inventory turnover of 20.0 would not be unusual for a grocery store,
whereas a common inventory turnover for an aircraft manufacturer would be 4.0.
This value for GPC is in line with that for other oil and gas companies, and a bit above
the firm’s own historic norms.
Inventory turnover can be easily converted into an average age of inventory by
dividing the turnover figure into 365 —the number of days in a year. For GPC, the
average age of inventory would be 26.4 days (365 13.85). This result means that
GPC’s inventory balance turns over about every 26 days.
APPLYING THE MODEL
Inventory ratios, like most other financial ratios, vary a great deal from one industry
to another. For example, for the four quarters ending March 30, 2002, Intel Corp.
reported inventory of $2.48 billion and cost of goods sold of $13.56 billion. This im-
plies an inventory turnover ratio for Intel of about 5.5, or an average age of inventory
of about 66 days. With the rapid pace of technological change in the semiconductor
industry, Intel cannot afford to hold inventory too long. In contrast, for the four quar-
ters ending March 30, 2002, Robert Mondavi Corp., one of the few publicly traded
wineries in the United States, reported cost of goods sold of $265.7 million and in-
ventory of $417.1 million. This yields an inventory turnover ratio for Mondavi of just
0.64, or an average age of inventory of about 570 days. Clearly, the differences in these
inventory ratios reflect differences in the economic circumstances of the industries.
Whereas the value of semiconductors declines as they age, just the opposite occurs in
the wine business, at least up to a point.
The average collection period, or average age of accounts receivable, is useful in

evaluating credit and collection policies.9 It is computed for GPC by dividing the firm’s
average daily sales into the accounts receivable balance. On average, it takes the firm
46.0 days to receive payment from a credit sale.
annual sales $12,843

Average sales per day $35.19
365 365
accounts receivable $1,619

Average collection period 46.0 days
average sales per day $35.19
The average collection period is meaningful only in relation to the firm’s credit
terms. If GPC extends 30-day credit terms to customers, an average collection period
of 46.0 days may indicate a poorly managed credit or collection department, or both.
The lengthened collection period could also be the result of an intentional relaxation
of credit-term enforcement in response to competitive pressures. If the firm had ex-
tended 60-day credit terms, the 46.0-day average collection period would be quite
9.
The average collection period is sometimes called the days’ sales outstanding (DSO). As with the inventory turnover
ratio, the average collection period can be calculated using end-of-year accounts receivable or the average receivables bal-
ance for the year. The evaluation and establishment of credit and collection policies are discussed in Chapter 23.
02-S2374 1/2/03 7:06 PM Page 43
acceptable. Clearly, additional information is required to evaluate the effectiveness of

the firm’s credit and collection policies.
Firms us the average payment period to evaluate their performance in repaying
suppliers. It equals the firm’s average daily purchases divided by the accounts payable
balance. To calculate average daily purchases, an analyst may have to estimate the
firm’s annual purchases, often by taking a specified percentage of cost of goods sold.
This estimate is necessary because annual purchases are not reported on a firm’s pub-
lished financial statements and are instead embodied in its cost of goods sold. In the
case of GPC, its annual purchases in 2004 were estimated at 80 percent of cost of
goods sold, as shown in footnote 1 to its income statement in Table 2.1. Using the an-
nual purchase estimate of $10,274, GPC’s average payment period indicates that the
firm takes, on average, 60.3 days to pay its bills.
annual purchases $10,274

Average purchases per day $28.15
365 365
accounts payable $1,697

Average payment period 60.3 days
average purchases per day $28.15
In a fashion similar to the average collection period, the average payment period
is meaningful only when viewed in light of the actual credit terms extended the firm
by its suppliers. If GPC’s suppliers, on average, extend 30-day credit terms, the firm’s
average payment period of 60.3 days indicates that the firm is generally slow in pay-
ing its payables. The fact that it takes GPC twice as long to pay its suppliers as the
30 days of credit they extended GPC could damage the firm’s ability to obtain addi-
tional credit and raise the cost of any credit that it may obtain. On the other hand, if
the average credit terms granted GPC by its suppliers were 60 days, its 60.3-day aver-
age payment period would be very good. It should be clear that an analyst would need
further information to draw definitive conclusions from the average payment period
with regard to the firm’s overall payment policies.
The fixed asset turnover measures the efficiency with which a firm uses its fixed
assets. The ratio tells analysts how many dollars of sales the firm generates per dollar
of fixed asset investment. The ratio equals sales divided by net fixed assets:
sales $12,843
Fixed asset turnover 1.91
net fixed assets $6,710
The fixed asset turnover for GPC in 2004 is 1.91. This means that the company turns
over its net fixed assets 1.91 times a year; or stated another way, GPC generates al-
most $2 in sales for every dollar of fixed assets. As with other ratios, the “normal”
level of fixed asset turnover varies widely from one industry to another.
An analyst, when using this ratio and the total asset turnover ratio described
next, must be aware that the calculations use the historical costs of fixed assets. Be-
cause some firms have significantly newer or older assets than others do, comparing
fixed asset turnovers of those firms can be misleading. Firms with newer assets will
tend to have lower turnovers than those with older assets—which have lower book
(accounting) values. A naive comparison of fixed asset turnover ratios for different
firms might lead an analyst to conclude that one firm operates more efficiently than
another, when in fact the firm that appears to be more efficient simply has older (i.e.,
more depreciated) assets on its books.
02-S2374 1/2/03 7:06 PM Page 44
The total asset turnover ratio indicates the efficiency with which a firm uses all
its assets to generate sales. Like the fixed asset turnover ratio, total asset turnover in-
dicates how many dollars of sales a firm generates per dollar of asset investment. All
other factors being equal, analysts favor a high turnover ratio because it indicates
that a firm generates more sales (and hopefully more cash flow for investors) from a
given investment in assets. GPC’s total asset turnover in 2004 equals 1.34, calculated
as follows:
sales $12,843
Total asset turnover 1.34
total assets $9,589
DEBT RATIOS
Firms finance their assets from two broad sources, equity and debt. Equity comes
from shareholders, whereas debt comes in many forms and from many different lend-
ers. Firms borrow from suppliers, from banks, and from widely scattered investors
who buy publicly traded bonds. Debt ratios measure the extent to which a firm uses
money from creditors rather than shareholders to finance its operations. Because cred-
itors’ claims must be satisfied before firms can distribute earnings to shareholders,
present and prospective investors pay close attention to the debts on a firm’s balance
sheet. Lenders share these concerns because the more indebted the firm, the higher the
probability that the firm will be unable to satisfy the claims of all its creditors.
In general, the more debt a firm uses in relation to its total assets, the greater its
financial leverage. Fixed-cost sources of financing, such as debt and preferred stock,
creates financial leverage that magnifies both the risk and the expected return on the
firm’s securities.10 The more a firm borrows, the riskier its outstanding stock and
bonds will be, and the higher the return will be that investors require on those secu-
rities. A detailed discussion of the impact of debt on the firm’s risk, return, and value
is included in Chapters 12 and 13. Here, we emphasize the use of debt ratios to as-
sess the degree of a firm’s indebtedness and its ability to meet the fixed payments asso-
ciated with debt.
Broadly speaking, there are two types of debt ratios. One type focuses on balance
sheet measures of outstanding debt relative to other sources of financing. The other
type, known as the coverage ratio, focuses more on income statement measures of the
firm’s ability to generate sufficient cash flow to make scheduled interest and princi-
pal payments. Investors and credit-rating agencies use both types of ratios to assess
a firm’s creditworthiness.
The debt ratio measures the proportion of total assets financed by the firm’s credi-
tors. The higher this ratio, the greater is the firm’s reliance on “other people’s money”
to finance its activities. The ratio equals total liabilities divided by total assets, and
GPC’s debt ratio in 2004 is 0.551, or 55.1 percent:
total liabilities $5,281

Debt ratio 0.551 55.1%
total assets $9,589
10.
By fixed cost we mean that the cost of this financing source does not vary over time in response to changes in the firm’s
revenue and cash flow. For example, when a firm borrows money at a variable rate, the interest cost of that loan is not fixed
through time, but the firm’s obligation to make interest payments is “fixed” regardless of the level of the firm’s revenue and
cash flow.
02-S2374 1/2/03 7:06 PM Page 45
This figure indicates that the company has financed over half of its assets with debt.
A close cousin of the debt ratio is the assets-to-equity (A /E) ratio, sometimes called
the equity multiplier:
total assets $9,589
Assets-to-equity 2.24
common stock equity $4,278
Note that only common stock equity of $4,278 ($4,308 of total equity – $30 of pre-
ferred stock equity) is used in the denominator of this ratio. The resulting value in-
dicates that GPC’s assets in 2004 are 2.24 times greater than its equity This value
seems reasonable given that the debt ratio shows that slightly more than half (55.1%)
of GPC’s assets in 2004 are financed with debt.
An alternative measure of the firm’s leverage that focuses solely on the firm’s long-
term debt is the debt-to-equity ratio, calculated by dividing long-term debt by stock-
holders’ equity. The 2004 value of this ratio for GPC is calculated as follows:
long-term debt $1,760
Debt-to-equity ratio 0.409 40.9%
stockholders’ equity $4,308
GPC’s long-term debts are therefore only 40.9 percent as large as its stockholders’
equity. Note, however, that both the debt ratio and the debt-to-equity ratio use book
values of debt, equity, and assets. Analysts should be aware that the market values of
these variables may differ substantially from book values.
The times interest earned ratio, which equals earnings before interest and taxes
divided by interest expense, measures the firm’s ability to make contractual interest
payments. A higher ratio indicates a greater capacity to meet scheduled payments. The
times interest earned ratio for GPC equals 13.59, indicating that the firm could expe-
rience a substantial decline in earnings and still meet its interest obligations:
earnings before interest and taxes $1,671
Times interest earned 13.59
interest expense $123
PROFITABILITY RATIOS
Several measures of profitability relate a firm’s earnings to its sales, assets, or equity.
Profitability ratios are among the most closely watched and widely quoted financial
ratios. Many firms link employee bonuses to profitability ratios, and stock prices react
sharply to unexpected changes in these measures.
The gross profit margin measures the percentage of each sales dollar remaining
after the firm has paid for its goods. The higher the gross profit margin, the better.
GPC’s gross profit margin in 2004 was 33.7 percent:
gross profit $4,324
Gross profit margin 0.337 33.7%
sales $12,843
The operating profit margin measures the percentage of each sales dollar remain-
ing after deducting all costs and expenses other than interest and taxes. As with the
gross profit margin, the higher the operating profit margin, the better. This ratio is
of interest because it tells analysts what a firm’s bottom line looks like before deduc-
tions for payments to creditors and tax authorities. GPC’s operating profit margin is
11.9 percent:
operating profit $1,531
Operating profit margin 0.119 11.9%
sales $12,843
02-S2374 1/2/03 7:06 PM Page 46
The net profit margin measures the percentage of each sales dollar remaining after
all costs and expenses, including interest, taxes, and preferred stock dividends, have
been deducted. Net profit margins vary widely across industries. For example, con-
sider two very profitable U.S. companies, Microsoft and Wal-Mart. For the quarter
ending in June 2002, Microsoft reported a net profit margin of 21.0 percent, more
than 6 times larger than the 3.4 percent net profit margin reported by Wal-Mart one
month later. GPC’s net profit margin of 7.4 percent is calculated as follows:
earnings available for common stockholders

Net profit margin
sales
$946
0.074 7.4%
$12,843
Probably the most closely watched financial ratio of them all is earnings per share.
The earnings per share represent the number of dollars earned on behalf of each out-
standing share of common stock. The investing public closely watches EPS figures
and considers them an important indicator of corporate success. Many firms tie man-
agement bonuses to meeting specific EPS targets. Earnings per share are calculated
as follows:

Earnings per share
number of shares of common stock outstanding
$946
$5.29
178.7
SMART ETHICS VIDEO The value of GPC’s earnings per share on common stock out-
Frank Popoff, Chairman of the Board standing in 2004 is $5.29.11 This figure represents the dol-
(retired), Dow Chemical lar amount earned on behalf of each share outstanding. The
“Overstating or understating the amount of earnings actually distributed to each shareholder is
performance of the enterprise is the dividend per share, which as noted in GPC’s income state-
anathema . . . it’s just not on.”
ment (Table 2.2), rose to $1.93 in 2004 from $1.76 in 2003.
See the entire interview at The return on total assets (ROA), often called the return on
investment (ROI), measures the overall effectiveness of manage-
ment in generating returns to common stockholders with its available assets.12 The
return on total assets for GPC equals 9.9 percent:

Return on total assets
total assets
$946
0.099 9.9%
$9,589
A closely related measure of profitability is the return on common equity (ROE),

which captures the return earned on the common stockholders’ (owners’) investment
11.
All per-share values are stated strictly in dollars and cents; they are not stated in millions as are the dollar values used to
calculate these and other ratios.
12.
Naturally, all other things being equal, firms prefer a high ROA. However, as we will see later, analysts must be cautious
when interpreting financial ratios. We recall an old Dilbert comic strip in which Wally suggests boosting his firm’s ROA
by firing the security staff. The reduction in expenses would boost the numerator while the reduction in security would
lower the denominator.
02-S2374 1/2/03 7:06 PM Page 47
in the firm. For a firm that uses only common stock to finance its operations, the ROE
and ROA figures will be identical. With debt or preferred stock on the balance sheet,
these ratios will usually be different. When the firm earns a profit, even after making
interest payments to creditors and paying dividends to preferred stockholders, then
the firm’s use of leverage magnifies the return earned by common stockholders, and
ROE will exceed ROA. Conversely, if the firm’s earnings fall short of the amount it
must pay to lenders and preferred stockholders, then leverage causes ROE to be less
than ROA. For GPC, the return on common equity for 2004 is 22.1 percent, substan-
tially above GPC’s return on total assets:

Return on common equity
common stock equity
$946
0.221 22.1%
$4,278
Financial analysts sometimes conduct a deeper analysis of the ROA and ROE ra-
tios using the DuPont system, which uses both income and balance sheet information
to break the ROA and ROE ratios into component pieces. This approach highlights
the influence of the net profit margin, total asset turnover, and financial leverage on a
firm’s profitability. In the DuPont formula, the return on total assets equals the prod-
uct of the net profit margin and total asset turnover:
ROA net profit margin total asset turnover
By definition, the net profit margin equals earnings available for common stockhold-
ers divided by sales, and asset turnover equals sales divided by assets. When we mul-
tiply these two ratios together, the sales figure cancels, resulting in the familiar ROA
measure:
earnings available for common stockholders sales

ROA
sales total assets
$946 $12,843
0.099 9.9%
$12,843 $9,589
Naturally, the ROA value for GPC in 2004 obtained using the DuPont formula
is the same value we calculated before, but now we can think of the ROA as a product
of how much profit the firm earns on each dollar of sales and of the efficiency with
which the firm uses its assets. Holding the net profit margin constant, an increase in
total asset turnover would increase the firm’s ROA. Similarly, holding total asset turn-
over constant, an increase in the net profit margin would increase ROA.
We can push the DuPont analysis one step further by multiplying the ROA times
the ratio of assets-to-equity (A /E), or the equity multiplier. The product of these two
ratios equals the return on equity. Notice that for a firm that uses no debt and has no
preferred stock, the ratio of assets to equity equals 1.0, so the ROA equals the ROE.
For all other firms, the ratio of assets to equity exceeds 1. It is in this sense that the
ratio of assets to equity represents a leverage multiplier.
ROE ROA A/E

02-S2374 1/2/03 7:06 PM Page 48
We can apply this version of the DuPont formula to GPC in 2004 to recalculate its
return on common equity:
ROE net profit margin total asset turnover equity multiplier
i
ROA
$946 $12,843 $9,589
0.074 1.34 2.24 0.221 22.1%
$12,843 $9,589 $4,278
Notice that for GPC, the ratio of assets to equity is 2.24, which means that GPC’s
return on common equity is more than twice as large as its return on total assets. Of
course, using financial leverage has its risks. Notice what would happen if GPC’s re-
turn on total assets were a negative number rather than a positive one. The financial
leverage multiplier would cause GPC’s return on common equity to be even more neg-
ative than its ROA.
The advantage of the DuPont system is that it allows the firm to break its return
on common equity into a profit-on-sales component (net profit margin), an efficiency-
of-asset-use component (total asset turnover), and a financial-leverage-use compo-
nent (assets-to-equity ratio). Analysts can then study the impact of each of these fac-
tors on the overall return to common stockholders.13
MARKET RATIOS
Market ratios relate the firm’s market value, as measured by its current share price, to
certain accounting values. These ratios provide analysts with insight into how inves-
tors think the firm is performing. Because the ratios include market values, they tend
to reflect on a relative basis the common stockholders’ assessment of all aspects of
the firm’s past and expected future performance. Here we consider two popular mar-
ket ratios, one that focuses on earnings and the other that considers book value.
The most widely quoted market ratio, the price/earnings (P/E) ratio, is often used
as a barometer of a firm’s long-term growth prospects. The P/E ratio measures the
amount investors are willing to pay for each dollar of the firm’s earnings. The price/
earnings ratio indicates the degree of confidence that investors have in the firm’s fu-
ture performance. A high P/E ratio indicates that investors believe a firm will achieve
rapid earnings growth in the future; hence, companies with high P/E ratios are re-
ferred to as growth stocks. Using the per-share price of $76.25 for Global Petroleum
Corporation on December 31, 2004, and its 2004 EPS of $5.29, the P/E ratio at year-
end 2004 is computed as follows:
13.
Keep in mind that the ratios in the DuPont formula are interdependent and that the equation is just a mathematical iden-
tity. It is easy to draw questionable conclusions about lines of causality using the DuPont formula. For example, consider
this farcical version of the formula:
earnings available for common stockholders sales assets CEO age

ROE
sales assets CEO age common stock equity
In this equation, we might interpret the third term on the right as the efficiency with which a CEO of a given age manages
the firm’s assets. If a younger CEO could be found who could manage the same quantity of assets, then this ratio would
increase, and holding all other factors constant, we might say that the firm’s ROE would increase. This is clearly silly, but
mathematically this expression does ultimately give you the firm’s ROE.
02-S2374 1/2/03 7:06 PM Page 49
market price per share of common stock $76.25

Price/earnings 1P/E2 ratio
earnings per share $5.29
14.41
This figure indicates that investors were paying $14.41 for each $1.00 of GPC’s earn-
ings. It is interesting to note that GPC’s price/earnings ratio one year before (on De-
cember 31, 2003) had been almost twice as high at 28.37 ($71.50 per share stock
price $2.52 earnings per share).
The market /book (M /B) ratio provides another assessment of how investors view
the firm’s past and, particularly, expected future performance. It relates the market
value of the firm’s shares to their book value. The stocks of firms that are expected
to perform well—improve profits, grow market share, launch successful products,
and so forth—typically sell at higher M /B ratios than those firms with less attractive
prospects. Simply stated, firms that investors expect to earn high returns relative to
their risk typically sell at higher M /B multiples than those expected to earn low re-
turns relative to risk. To calculate the M /B ratio for GPC in 2004, we first need to find
book value per share of common stock:
common stock equity

Book value per share
number of shares of common stock outstanding
$4,278
$23.94
178.7 Smart
Concepts
Market to book value is then computed by dividing this book value into the current See the
price of the firm’s stock: concept
explained step-by-step at
market value per share of common stock
Market/book 1M/B2 ratio
book value per share of common stock
$76.25
3.19 SMART IDEAS VIDEO
$23.94 Michael Brennan, UCLA
“In no markets is the role of information
Investors are currently paying $3.19 for each $1.00 of book more important than it is in financial
value of GPC’s stock. Clearly, investors expect GPC to continue markets.”
to grow in the future because they are willing to pay more than
See the entire interview at
book value for the firm’s shares.
7. Which of the categories and individual ratios described in this chapter would be of great- Concept
est interest to each of the following parties? Review
a. Existing and prospective creditors (lenders) Questions
b. Existing and prospective shareholders
c. The firm’s management
8. How could the availability of cash inflow and cash outflow data be used to improve on the
accuracy of the liquidity and debt coverage ratios presented previously? What specific ratio
measures would you calculate to assess the firm’s liquidity and debt coverage, using cash flow
rather than financial statement data?
02-S2374 1/2/03 7:06 PM Page 50
Concept 9. Assume that a firm’s total assets and sales remain constant. Would an increase in each of
Review the ratios below be associated with a cash inflow or a cash outflow?
Questions a. Current ratio d. Average payment period
b. Inventory turnover e. Debt ratio
c. Average collection period f. Net profit margin
10. Use the DuPont system to explain why a slower-than-average inventory turnover could
cause a firm with an above-average net profit margin and an average degree of financial
leverage to have a below-average return on common equity.
11. How can you reconcile investor expectations for a firm with an above-average M /B ra-
tio and a below-average P/E ratio? Could the age of the firm have any impact on this ratio
comparison?
2.4 SUMMARY
• The four key financial statements are (1) the balance sheet, (2) the income state-
ment, (3) the statement of retained earnings, and (4) the statement of cash flows.
Notes describing the technical aspects of the financial statements are normally in-
cluded with them.
• Depreciation is the most common noncash expense on income statements. To esti-
mate cash flow from operations, add depreciation and other noncash charges back
to net profit after taxes. A measure of cash flow that is important to financial an-
alysts is free cash flow, the cash flow available to investors. Free cash flow equals
operating cash flow less the firm’s net investment in fixed and current assets.
• The statement of cash flows, in effect, summarizes the firm’s cash flows over a spec-
ified period of time, typically one year. It presents cash flows divided into operat-
ing, investment, and financing flows. When interpreting the statement, an analyst
typically looks at both the major categories of cash flow and the individual items
of cash inflow and outflow to assess the reasonableness of the firm’s cash flows
over the given period.
• Financial ratios are a convenient tool for analyzing the firm’s financial statements
to assess its performance over the given period. A variety of financial ratios are
available for assessing various aspects of a firm’s liquidity, activity, debt, profita-
bility, and market value. The DuPont system is often used to assess various aspects
of a firm’s profitability, particularly the returns earned on both the total asset in-
vestment and the owners’ common stock equity in the firm.
INTERNET RESOURCES
Note: This textbook includes numerous Internet links throughout the text, both within the
discussions and at the end of each chapter. Because some links will likely change or be elimi-
nated during the life of this edition, please go to this book’s website (http://smart.swcollege
.com) to obtain updated links in the event you encounter a dead link.
www.sec.gov—SEC site containing the document search and retrieval engine, EDGAR; use-
ful for obtaining up-to-date financial statements for publicly traded U.S. firms
02-S2374 1/2/03 7:06 PM Page 51
www.quicken.com— Can retrieve a fairly extensive ratio analysis of a given company by

typing in a ticker symbol
www.yahoo.com— Contains a link to Yahoo! Finance for retrieval of recent financial state-
ments and a wide variety of other financial information for any listed U.S. firm and many
foreign firms
KEY TERMS
accrual-based approach free cash flow (FCF)

activity ratios gross profit margin
assets-to-equity (A /E) ratio inventory turnover
average age of inventory investment flows
average collection period liquidity
average payment period long-term debt
cash flow approach market /book (M /B) ratio
cash flow from operations net profit margin
common stock net working capital
common-size income statement noncash charges
coverage ratio operating cash flow (OCF)
current ratio operating flows
debt ratio operating profit margin
debt-to-equity ratio paid-in-capital
deferred par value
dividend payout ratio preferred stock
dividend per share (DPS) price/earnings (P/E) ratio
DuPont system quick (acid-test) ratio
earnings available for common ratio analysis
stockholders retained earnings
earnings per share (EPS) return on common equity (ROE)
equity multiplier return on total assets (ROA)
financial leverage times interest earned ratio
financing flows total asset turnover
fixed asset turnover Treasury stock
QUESTIONS
2-1. What information (explicit and implicit) can be derived from financial statement anal-
ysis? Does the standardization required by GAAP add greater validity to comparisons
of financial data between companies and industries? Are there possible shortcomings
to relying solely on financial statement analysis to value companies?
2-2. Distinguish between the types of financial information contained in the various finan-
cial statements. Which statements provide information on a company’s performance
over a reporting period, and which present data on a company’s current position?
What sorts of valuable information may be found in the notes to financial statements?
Describe a situation in which the information contained in the notes would be essen-
tial to making an informed decision about the value of a corporation.
2-3. If you were a commercial credit analyst charged with the responsibility of making an
accept /reject decision on a company’s loan request, with which financial statement
02-S2374 1/2/03 7:06 PM Page 52
would you be most concerned? Which financial statement is most likely to provide
pertinent information about a company’s ability to repay its debt?
2-4. What is cash flow from operations? How is it calculated? What benefit does the firm
receive from the presence of “noncash charges”?
2-5. What is operating cash flow (OCF)? How is it calculated? Why do financial managers
prefer this measure of operating flows over the accountants’ use of cash flow from
operations?
2-6. What is free cash flow (FCF)? How is it calculated from operating cash flow (OCF)?
Why do financial managers focus attention on the value of FCF?
2-7. Describe the common definitions of “inflows of cash” and “outflows of cash” used by
analysts to classify certain balance sheet changes and income statement values. What
three categories of cash flow are used in the statement of cash flows? To what value
should the net value in the statement of cash flows reconcile?
2-8. What precautions must one take when using ratio analysis to make financial deci-
sions? Which ratios would be most useful for a financial manager’s internal financial
analysis? For an analyst trying to decide on which stocks are most attractive within
an industry?
2-9. How do analysts use ratios to analyze a firm’s financial leverage? Which ratios con-
vey more important information to a credit analyst—those revolving around the lev-
els of indebtedness or those measuring the ability to meet the contractual payments
associated with debt? What is the relationship between a firm’s levels of indebted-
ness and risk? What must happen in order for an increase in financial leverage to be
successful?
2-10. How is the DuPont system useful in analyzing a firm’s ROA and ROE? What informa-
tion can be inferred from the decomposition of ROE into contributing ratios? What is
the mathematical relationship between each of the individual components (net profit
margin, total asset turnover, and assets-to-equity ratio) and ROE? Can ROE be raised
without affecting ROA? How?
PROBLEMS
Financial Statements
2-1. Obtain financial statements for Microsoft for the last five years either from its web-
site (www.microsoft.com) or from EDGAR online (www.sec.gov/edgar/searchedgar/
webusers.htm). First, look at the statements without reading the notes. Then, read
the notes carefully, concentrating on those regarding executive stock options. Do you
have a different perspective after analyzing these notes?
Cash Flow Analysis

2-2. Given the balance sheets and selected data from the income statement of SMG Indus-
tries that follow, answer parts (a) – (d).
Smart
Solutions a. Calculate the firm’s accounting cash flow from operations for the year ended De-
See the cember 31, 2004, using Equation 2.1.
problem and b. Calculate the firm’s operating cash flow (OCF) for the year ended December 31,
solution explained step-by-step at 2004, using Equation 2.2.
c. Calculate the firm’s free cash flow (FCF) for the year ended December 31, 2004,
using Equation 2.3.
d. Interpret, compare, and contrast your cash flow estimates in parts (a), (b), and (c).
02-S2374 1/2/03 7:06 PM Page 53
SMG Industries Balance Sheets ($ in millions)

December 31
Assets 2004 2003
Cash $ 3,500 $ 3,000
Marketable securities 3,800 3,200
Accounts receivable 4,000 3,800
Inventories pppp4,900 pppp4,800
Total current assets $16,200 $14,800
Gross fixed assets $31,500 $30,100
Less: Accumulated depreciation f14,700 pp13,100
Net fixed assets $16,800 $17,000
Total assets $33,000 $31,800
Liabilities and Stockholders’ Equity

Accounts payable $ 3,600 $ 3,500
Notes payable 4,800 4,200
Accruals ff1,200 ff1,300
Total current liabilities $f9,600 $f9,000
Long-term debt $f6,000 $f6,000
Common stock $11,000 $11,000
Retained earnings ff6,400 ff5,800
Total stockholders’ equity $17,400 $16,800
Total liabilities and stockholders’ equity $33,000 $31,800
Income Statement Data (2004, $ in millions)

Depreciation expense $1,600
Earnings before interest and taxes (EBIT) 4,500
Taxes 1,300
Net profits after taxes 2,400
2-3. Classify each of the following items as an inflow (I) or an outflow (O) of cash, or as
neither (N).
Item Change ($) Item Change ($)

Cash 600 Accounts receivable 900
Accounts payable 1,200 Net profits 700
Notes payable 800 Depreciation 200
Long-term debt 2,500 Repurchase of stock 500
Inventory 400 Cash dividends 300
Fixed assets 600 Sale of stock 1,300
Analyzing Financial Performance Using Ratio Analysis

2-4. Manufacturers Bank is evaluating Aluminum Industries, Inc., which has requested a
$3 million loan, to assess the firm’s financial leverage and risk. On the basis of the
debt ratios for Aluminum, along with the industry averages and Aluminum’s recent
financial statements (which follow), evaluate and recommend appropriate action on
the loan request.
02-S2374 1/2/03 7:06 PM Page 54
Aluminum Industries, Inc. Income Statement for the Year Ended December 31, 2004
Sales revenue $30,000,000
Less: Cost of goods sold f21,000,000
Gross profit $ 9,000,000
Less: Operating expenses
Selling expense $3,000,000
General and administrative expenses 1,800,000
Lease expense 200,000
Depreciation expense 1,000,000
Total operating expense $6,000,000
Operating profit $3,000,000
Less: Interest expense f1,000,000
Net profit before taxes $2,000,000
Less: Taxes (rate 40%) ffs800,000
Net profits after taxes $1,200,000
Aluminum Industries, Inc. Balance Sheet as of December 31, 2004

Assets Liabilities and Stockholders’ Equity
Cash $ 1,000,000 Accounts payable $ 8,000,000
Marketable securities 3,000,000 Notes payable 8,000,000
Accounts receivable 12,000,000 Accruals fffs500,000
Inventories ff7,500,000 Total current liabilities $16,500,000
Total current assets $23,500,000 Long-term debt (including finan- $20,000,000
Gross fixed assets (at cost) cial leases)
Land and buildings $11,000,000 Stockholders’ equity
Machinery and equipment 20,500,000 Preferred stock (25,000 shares, $ 2,500,000
Furniture and fixtures nn8,000,000 $4 dividend)
Gross fixed assets $39,500,000 Common stock (1 million shares, 5,000,000
Less: Accumulated depreciation f13,000,000 $5 par)
Net fixed assets $26,500,000 Paid-in capital in excess of par 4,000,000
Total assets $50,000,000 value
Retained earnings ff2,000,000
Total stockholders’ equity $13,500,000
Total liabilities & stock- $50,000,000
holders’ equity
Industry Averages
Debt ratio 0.51
Debt-equity ratio 1.07
Times interest earned ratio 7.30
02-S2374 1/2/03 7:06 PM Page 55
Use the following information for Problems 2-5 and 2-6.
Income Statements for the Year Ended December 31, 2004

Heavy Metal Metallic High-Tech
Manufacturing Stamping Software
(HMM) Inc. (MS) Co. (HTS)
Sales $75,000,000 $50,000,000 $100,000,000
Operating expenses f65,000,000 f40,000,000 ff60,000,000
Operating profit $10,000,000 $10,000,000 $ 40,000,000
Interest expenses ff3,000,000 ff3,000,000 ffffffffff0
Earnings before taxes $ 7,000,000 $ 7,000,000 $ 40,000,000
Taxes ff2,800,000 ff2,800,000 ff16,000,000
Net income $f4,200,000 $f4,200,000 $f24,000,000
Balance Sheets as of December 31, 2004

Heavy Metal Metallic High-Tech
Manufacturing Stamping Software
(HMM) Inc. (MS) Co. (HTS)
Current assets $ 10,000,000 $ 5,000,000 $ 20,000,000
Net fixed assets ff90,000,000 f75,000,000 ff80,000,000
Total assets $100,000,000 $80,000,000 $100,000,000
Current liabilities $ 20,000,000 $10,000,000 $ 10,000,000

Long-term debt ff40,000,000 f40,000,000 ffsfffsffff0
Total liabilities $f60,000,000 $50,000,000 $f10,000,000
Common stock $ 15,000,000 $10,000,000 $ 25,000,000
Retained earnings ff25,000,000 f20,000,000 ff65,000,000
Total common equity $f40,000,000 $30,000,000 $f90,000,000
Total liabilities and $100,000,000 $80,000,000 $100,000,000
common equity
2-5. Use the DuPont system to compare the two heavy metal companies shown above
(HHM and MS) during 2004. Which of the two has a higher return on common eq-
uity? What is the cause of the difference between the two?
2-6. Continuing with Problem 2-5, calculate the return on common equity of the software
company, HTS. Why is this value so different from those of the heavy metal compa-
nies calculated in Problem 2-5? Compare the leverage levels between the industries.
Which industry receives a greater contribution from return on total assets? Which in-
dustry receives a greater contribution from the financial leverage as measured by the
assets-to-equity ratio? Can you make a meaningful DuPont comparison across indus-
tries? Why or why not?
2-7. Refer back to Problems 2-5 and 2-6, and perform the same analysis with real data.
Download last year’s financial data from Ford Motor Company (www2.ford.com),
General Motors (www.gm.com), and Microsoft (www.microsoft.com). Which ratios
demonstrate the greatest difference between Ford and General Motors? Which of the
two is more profitable? Which ratios drive the greater profitability?
2-8. A common-size income statement for Aluminum Industries’ 2003 operations follows.
Using the firm’s 2004 income statement presented in Problem 2-4, develop the 2004
common-size income statement and compare it to the 2003 statement. Which areas
require further analysis and investigation?
02-S2374 1/2/03 7:06 PM Page 56
Aluminum Industries, Inc. Common-Size Income Statement

for the Year Ended December 31, 2003
Sales revenue ($35,000,000) 100.0%
Less: Cost of goods sold n65.9
Gross profit 34.1%
Selling expense 12.7%
General and administrative expenses 6.3
Lease expense 0.6
Depreciation expense f3.6
Total operating expense n23.2
Operating profit 10.9%
Less: Interest expense nf1.5
Net profit before taxes 9.4%
Less: Taxes (rate 40%) nf3.8
Net profits after taxes nf5.6%
2-9. Use the following financial data for Greta’s Gadgets, Inc., to determine the impact of
using additional debt financing to purchase additional assets. Assume that an addi-
tional $1 million of assets is purchased with 100 percent debt financing with a 10 per-
cent annual interest rate.
Greta’s Gadgets, Inc.

Income Statement for the Year Ended
December 31, 204 Balance Sheet as of December 31, 2004
Sales $4,000,000 Current assets $ 0
Costs and expenses @90% f3,600,000 Fixed assets f2,000,000
Earnings before interest Total assets $2,000,000
& taxes $400,000
Interest (.10 $1,000,000) ffs100,000 Current liabilities $ 0
Earnings before taxes $ 300,000 Long-term debt @10% f1,000,000
Taxes @40% ffs120,000 Total liabilities $1,000,000
Net income $fs180,000 Common stock equity $1,000,000
Total liabilities & $2,000,000
stockholders’ equity
a. Calculate the current (2004) net profit margin, total asset turnover, assets-to-
equity ratio, return on total assets, and return on common equity for Greta’s.
b. Now, assuming no other changes, determine the impact of purchasing the $1 mil-
lion in assets using 100 percent debt financing with a 10 percent annual inter-
est rate. Further, assume that the newly purchased assets generate an additional
$2 million in sales and that the costs and expenses remain at 90 percent of sales.
For purposes of this problem, further assume a tax rate of 40 percent. What is the
effect on the ratios calculated in part (a)? Is the purchase of these assets justified
on the basis of the return on common equity?
c. Assume that the newly purchased assets in part (b) generate only an extra
$500,000 in sales. Is the purchase justified in this case?
d. Which component ratio(s) of the DuPont system is not affected by the change in
sales? What does this imply about the use of financial leverage?
2-10. Tracey White, the owner of the Buzz Coffee Shop chain, has decided to expand her op-
erations. Her 2004 financial statements follow. Tracey can buy two additional coffee-
houses for $3 million, and she has the choice of completely financing these new coffee-
houses with either a 10 percent (annual interest) loan or the issuance of new common
stock. She also expects these new shops to generate an additional $1 million in sales.
02-S2374 1/2/03 7:06 PM Page 57
Assuming a 40 percent tax rate and no other changes, should Tracey buy the two cof-
feehouses? Why or why not? Which financing option results in the better ROE?
Buzz Coffee Shops, Inc. 2004 Financial Statements

Balance Sheet Income Statement
Current assets $ 250,000 Sales $500,000
Fixed assets sff750,000 Costs and expenses @40% f200,000
Total assets $1,000,000 Earnings before interest
and taxes (EBIT) $300,000
Current liabilities $ 300,000 Interest expense ffsffff0
Long-term debt ffffffff0 Net profit before taxes $300,000
Total liabilities $ 300,000 Taxes @40% f120,000
Common equity $sf700,000 Net income $180,000
Total liabilities and stock- $1,000,000
holders’ equity
2-11. The financial statements of Access Corporation for the year ended December 31,
2004, follow.
Access Corporation Income Statement for the Year Ended December 31, 2004
Sales revenue $160,000
Less: Cost of goods sold a f106,000
Gross profit $ 54,000
Selling expense $16,000
General and administrative expense 10,000
Lease expense 1,000
Depreciation expense f10,000
Total operating expense $f37,000
Operating profit $ 17,000
Less: Interest expense fff6,100
Net profit before taxes $ 10,900
Less: Taxes @40% fff4,360
Net profits after taxes $ff6,540
a
Access Corporation’s annual purchases are estimated to equal 75 percent of cost of goods sold.
Access Corporation Balance Sheet as of December 31, 2004

Cash $ 500 Accounts payable $ 22,000
Marketable securities 1,000 Notes payable ff47,000
Accounts receivable 25,000 Total current liabilities $ 69,000
Inventories ff45,500 Long-term debt $f22,950
Total current assets $f72,000 Total liabilities $ 91,950
Land $ 26,000 Common stock a $ 31,500
Buildings and equipment 90,000 Retained earnings ff26,550
Less: Accumulated Total liabilities and
depreciation ff38,000 stockholders’ equity $150,000
Net fixed assets $f78,000
Total assets $150,000
a
The firm’s 3,000 outstanding shares of common stock closed 2004 at a price of $25 per share.
02-S2374 1/2/03 7:06 PM Page 58
a. Use the preceding financial statements to complete the following table. Assume
that the industry averages given in the table are applicable for both 2003 and 2004.
b. Analyze Access Corporation’s financial condition as it relates to (1) liquidity,
(2) activity, (3) debt, (4) profitability, and (5) market value. Summarize the com-
pany’s overall financial condition.
Access Corporation’s Financial Ratios

Industry Actual Actual
Ratio Average 2003 2004
Current ratio 1.80 1.84 ______
Quick (acid-test) ratio .70 .78 ______
Inventory turnover 2.50 2.59 ______
Average collection period a 37 days 36 days ______
Average payment period a 72 days 78 days ______
Debt-to-equity ratio 50% 51% ______
Times interest earned ratio 3.8 4.0 ______
Gross profit margin 38% 40% ______
Net profit margin 3.5% 3.6% ______
Return on total assets (ROA) 4.0% 4.0% ______
Return on common equity (ROE) 9.5% 8.0% ______
Market /book (M /B) ratio 1.1 1.2 ______
a
Based on a 365-day year and on end-of-year figures.
2-12. Given the following financial statements, historical ratios, and industry averages, cal-
culate the MBA Company’s financial ratios for 2004. Analyze its overall financial sit-
uation both in comparison to industry averages and over the period 2002 –2004.
Break your analysis into an evaluation of the firm’s liquidity, activity, debt, profitabil-
ity, and market value.
MBA Company Income Statement for the Year Ended December 31, 2004
Sales revenue $10,000,000
Less: Cost of goods sold a ff7,500,000
Gross profit $ 2,500,000
Selling expense $300,000
General and administrative
expense 650,000
Lease expense 50,000
Depreciation expense f200,000
Total operating expense ff1,200,000
Operating profit (EBIT) $ 1,300,000
Less: Interest expense fffs200,000
Net profits before taxes $ 1,100,000
Less: Taxes (rate 40%) fffs440,000
Net profits after taxes $ 660,000
Less: Preferred stock dividends ffffs50,000
Earnings available for common
stockholders $ffs610,000
Earnings per share (EPS) $ 3.05
a
Annual credit purchases of $6.2 million were made during the year.
02-S2374 1/2/03 7:06 PM Page 59
MBA Company Balance Sheet as of December 31, 2004

Cash $ 200,000 Accounts payable $ 900,000
Marketable securities 50,000 Notes payable 200,000
Accounts receivable 800,000 Accruals fffs100,000
Inventories fffs950,000 Total current liabilities $f1,200,000
Total current assets $ 2,000,000 Long-term debt (including $ 3,000,000
Gross fixed assets $12,000,000 financial leases)
(at cost) Stockholders’ equity
Less: Accumulated ff3,000,000 Preferred stock (25,000 shares, $ 1,000,000
depreciation $2 dividend)
Net fixed assets $ 9,000,000 Common stock 600,000
Other assets $f1,000,000 (200,000 shares, $3 par) a
Total assets $12,000,000 Paid-in capital in excess of par 5,200,000
Retained earnings ff1,000,000
Total stockholders’ equity $f7,800,000
Total liabilities and stock- $12,000,000
holders’ equity
a
On December 31, 2004, the firm’s common stock closed at $27.50.
Historical and Industry Average Ratios for MBA Company

Industry
Actual Actual Average
Ratio 2002 2003 2004
Current ratio 1.40 1.55 1.85
Quick (acid-test) ratio 1.00 0.92 1.05
Inventory turnover 9.52 9.21 8.60
Average collection period a 45.0 days 36.4 days 35.0 days
Average payment period a 58.5 days 60.8 days 45.8 days
Fixed asset turnover 1.08 1.05 1.07
Total asset turnover 0.74 0.80 0.74
Debt ratio 0.20 0.20 0.30
Debt-to-equity ratio 0.25 0.27 0.39
Times interest earned ratio 8.2 7.3 8.0
Gross profit margin 0.30 0.27 0.25
Operating profit margin 0.12 0.12 0.10
Net profit margin 0.067 0.067 0.058
Return on total assets (ROA) 0.049 0.054 0.043
Return on common equity (ROE) 0.066 0.073 0.072
Earnings per share (EPS) $1.75 $2.20 $1.50
Price/earnings (P/E) ratio 12.0 10.5 11.2
Market /book (M /B) ratio 1.20 1.05 1.10
a
Based on a 365-day year and on end-of-year figures.
2-13. Choose a company that you would like to analyze, and obtain its financial statements.
Now, select another firm from the same industry, and obtain its financial data from
the Internet. Perform a complete ratio analysis on each firm. How well does your se-
lected company compare to its industry peer? Which components of your firm’s ROE
are superior, and which are inferior?

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Use the learning tools at http://smartﬁnance.swcollege.com

Chapter 2 Financial Statement and Cash Flow Analysis 25

2.1 FINANCIAL STATEMENTS

Chapter 2 Financial Statement and Cash Flow Analysis 27

2001 Brand 2000 Brand

Chapter 2 Financial Statement and Cash Flow Analysis 29

marketable securities, is added to operating income to yield earnings before interest

Chapter 2 Financial Statement and Cash Flow Analysis 31

STATEMENT OF RETAINED EARNINGS

STATEMENT OF CASH FLOWS

NOTES TO FINANCIAL STATEMENTS

Chapter 2 Financial Statement and Cash Flow Analysis 33

2.2 CASH FLOW ANALYSIS

THE FIRM’S CASH FLOWS

Cash Flow from Operations

(1) Operating Flows (2) Investment Flows

Production Overhead Business

Operating (incl. Cash

Free Cash Flow

Chapter 2 Financial Statement and Cash Flow Analysis 35

OCF  EBIT taxes depreciation (Eq. 2.2)

OCF  $1,671 $599 $633  $1,705

FCF  OCF FA (CA A /P accruals) (Eq. 2.3)

where ¢FA  change in gross ﬁxed assets,

¢FA  $9,920 $9,024  $896

Substituting these values into Equation 2.3, we get the following:

FCF  $1,705 $896 1$729 $393 $612

INFLOWS AND OUTFLOWS OF CASH

APPLYING THE MODEL

Chapter 2 Financial Statement and Cash Flow Analysis 37

June 30, March 31,

DEVELOPING THE STATEMENT OF CASH FLOWS

Cash ﬂow from investment activities

Cash ﬂow from ﬁnancing activities

Net increase in cash and marketable securities $234s

INTERPRETING THE STATEMENT

Chapter 2 Financial Statement and Cash Flow Analysis 39

provided by operating activities primarily to purchase an additional $896 million

2.3 ANALYZING FINANCIAL PERFORMANCE USING RATIO ANALYSIS

TYPES OF FINANCIAL RATIOS

Chapter 2 Financial Statement and Cash Flow Analysis 41

current assets $2,879

current assets inventory $2,879 $615

cost of goods sold $8,519

APPLYING THE MODEL

The average collection period, or average age of accounts receivable, is useful in

annual sales $12,843

accounts receivable $1,619

Chapter 2 Financial Statement and Cash Flow Analysis 43

acceptable. Clearly, additional information is required to evaluate the effectiveness of

annual purchases $10,274

accounts payable $1,697

total liabilities $5,281

Chapter 2 Financial Statement and Cash Flow Analysis 45

earnings available for common stockholders

earnings available for common stockholders

earnings available for common stockholders

A closely related measure of proﬁtability is the return on common equity (ROE),

Chapter 2 Financial Statement and Cash Flow Analysis 47

earnings available for common stockholders

ROA  net proﬁt margin  total asset turnover

earnings available for common stockholders sales

OCF EBIT taxes depreciation (Eq. 2.2)

OCF $1,671 $599 $633 $1,705

FCF OCF FA (CA A /P accruals) (Eq. 2.3)

where ¢FA change in gross ﬁxed assets,

¢FA $9,920 $9,024 $896

FCF $1,705 $896 1$729 $393 $612

ROA net proﬁt margin total asset turnover

ROE ROA A/E

ROE net proﬁt margin total asset turnover equity multiplier