Chapter 3

Working With
Financial
Statements

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• Standardized Financial Statements
• Ratio Analysis
• The Du Pont Identity
• Internal and Sustainable Growth
• Using Financial Statement Information

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Standardized Financial
Statements
• Common-Size Balance Sheets
– Compute all accounts as a percent of total assets
• Common-Size Income Statements
– Compute all line items as a percent of sales
• Standardized statements make it easier to
compare financial information, particularly as
the company grows
• They are also useful for comparing
companies of different sizes, particularly
within the same industry

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Ratio Analysis
• Ratios also allow for better comparison
through time or between companies
• As we look at each ratio, ask yourself
what the ratio is trying to measure and
why that information is important
• Ratios are used both internally and
externally

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Categories of Financial Ratios

1. Short-term solvency or liquidity ratios
2. Long-term solvency or financial
leverage ratios
3. Asset management or turnover ratios
4. Profitability ratios
5. Market value ratios

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Table 3.5

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Sample Balance Sheet

Numbers in thousands

Cash 680,623 A Payable 318,301

A/Receivable 1,051,438 N Payable 4,613

Inventory 300,459 Other CL 1,645,748

Other CA 415,310 Total CL 1,968,662

Total CA 2,447,830 LT Debt 909,814

Net Fixed Assets 3,415,159 Total Equity 2,984,513

Total Assets 5,862,989 Total Liab. & Equity 5,862,989

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Sample Income Statement
Numbers in thousands
Revenues 5,250,538
- Cost of Goods Sold (2,046,645)
- Expenses (1,904,556)
- Depreciation & Amortization (124,647)
EBIT 1,174,690
- Interest Expense (5,785)
Taxable Income 1,168,905
- Taxes (412,495)
Net Income 756,410
Additional to Retained Earnings 524,810
Total Dividends 231,600
Number of shares outstanding (unit) 193,000
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1. Computing Liquidity Ratios

• Current Ratio = CA / CL

• Quick Ratio = (CA – Inventory) / CL

• Cash Ratio = Cash / CL

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2. Computing Leverage Ratios

• Total Debt Ratio = (TA – TE) / TA

• Debt/Equity = TD / TE

• Equity Multiplier = TA / TE = 1 + D/E

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…Computing Leverage Ratios

• Times Interest Earned = EBIT / Interest

• Cash Coverage = (EBIT+Depr & Amort)/Interest

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3. Computing Inventory Ratios

• Inventory Turnover = COGS / Inventory

• Days’ Sales in Inventory = 365/ Inv t/o

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3. Computing Receivables Ratios

• Receivables Turnover = Sales/A Rec.

• Days’ Sales in Receivables = 365 /Rec t/o

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3. Computing Payables Ratios

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3. Computing Total Asset

Turnover
• Total Asset Turnover = Sales / TA

• Measure of asset use efficiency

• Not unusual for TAT < 1, especially if a
firm has a large amount of fixed assets

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4. Computing Profitability
Measures
• Profit Margin = Net Income / Sales

• Return on Assets (ROA) = Net Income / TA

• Return on Equity (ROE) = Net Income / TE

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5. Computing Market Value

Measures
• Additional information:
– Market Price (Dec 31,2007) = $91.54 / share

• PE Ratio = Price per share / EPS

• Market-to-book ratio = MV pershare / BV pershare

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Deriving the Du Pont Identity

• ROE = NI / TE
• Multiply by 1 and then rearrange
– ROE = (NI / TE) (TA / TA)
– ROE = (NI / TA) (TA / TE)

Multiply by 1 again and then rearrange

– ROE = (NI / TA) (TA / TE) (Sales / Sales)
– ROE = (NI / Sales) (Sales / TA) (TA / TE)

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Using the Du Pont Identity

• ROE = PM * TAT * EM
– Profit margin is a measure of the firm’s
operating efficiency – how well does it
control costs
– Total asset turnover is a measure of the
firm’s asset use efficiency – how well does
it manage its assets
– Equity multiplier is a measure of the firm’s
financial leverage

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Payout and Retention Ratios

• Dividend payout = Total Div / NI

• Retention ratio (b) = Add.R/E / NI

• Retention ratio (b) = 1 – Div payout

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The Internal Growth Rate

• The internal growth rate tells us how
much the firm can grow assets using
retained earnings as the only source of
financing.
ROA × b
Internal Growth Rate =
1 - (ROA × b)

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The Sustainable Growth Rate

• The sustainable growth rate tells us how
much the firm can grow by using
internally generated funds and issuing
debt to maintain a constant debt ratio.
ROE × b
Sustainabl e Growth Rate =
1- (ROE × b)

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Determinants of Growth
• Profit margin – operating efficiency
• Total asset turnover – asset use
efficiency
• Financial leverage – choice of optimal
debt ratio
• Dividend policy – choice of how much
to pay to shareholders versus
reinvesting in the firm
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Why Evaluate Financial

Statements?
• Internal uses
– Performance evaluation – compensation and
comparison between divisions
– Planning for the future – guide in estimating future
cash flows
• External uses
– Creditors
– Suppliers
– Customers
– Stockholders

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Benchmarking
• Ratios are not very helpful by themselves;
they need to be compared to something
• Time-Trend Analysis
– Used to see how the firm’s performance is
changing through time
– Internal and external uses
• Peer Group Analysis
– Compare to similar companies or within
industries

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Quick Quiz
• How do you standardize balance sheets
and income statements and why is
standardization useful?
• What are the major categories of ratios
and how do you compute specific ratios
within each category?
• What are the major determinants of a
firm’s growth potential?

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Tutorial
• Problem 26 of page 86
• Problem 34 and 35 of page 88,
• Problem 42 of page 89

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