Understanding

Financial
Statements

Types of Financial Statement

Income Statement
Balance Sheet
Statement of Change in Equity
Statement of Cash Flows

Income Statement
SALES
- EXPENSES
= PROFIT

Cost of Goods Sold

Operating Expenses
(marketing, administrative)

Financing Costs
Taxes

SALES
- Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS

SALES
- Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS

SALES
- Cost of Goods Sold

Income Statement

GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS

Balance Sheet

Total Assets =

Outstanding
Debt
+
Shareholders
Equity

Balance Sheet
Assets
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses

Fixed Assets
Machinery &
Equipment
Buildings and Land

Other Assets
Investments & patents

Liabilities (Debt) & Equity

Current Liabilities

Accounts Payable
Accrued Expenses
Short-term notes

Long-Term Liabilities
Long-term notes
Mortgages

Equity

Preferred Stock
Common Stock (Par
value)
Paid in Capital
Retained Earnings

Assets
Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.

Assets
Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
Fixed Assets: machinery
and equipment, buildings,
and land.

Assets
Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
Fixed Assets: machinery and equipment,
buildings, and land.
Other Assets: any asset that is not a current
asset or fixed asset.
Intangible assets, such as patents and
copyrights.

Financing
Debt Capital: financing provided by a creditor.
Short-term debt: borrowed money that must
be repaid within the next 12 months.
Accounts payable, other payables such as
interest or taxes payable, accrued expenses,
short-term notes.
Long-term debt: loans from banks or other
sources that lend money for longer than 12
months.

Financing
Equity Capital: shareholders investment in
the firm.
Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of liquidation
of the firm.
Common Stockholders: residual owners of a
business. They receive whatever is left after
creditors and preferred stockholders are paid.

Free Cash Flows

Free cash flow: cash flow that is free and
available to be distributed to the firms
investors (both debt and equity investors).

The Interrelations among the Financial

Statements
Income Statement
2010

Balance Sheet
2009

Statement of Cash Flows

2010

Statement of Retained Earnings

2010

Balance Sheet
2010

Evaluating a Firms
Financial Performance

Financial Ratio Analysis

Are our
decisions
maximizing
shareholder
wealth?

We will want to answer

questions about the firms
Liquidity
Efficient use of Assets
Leverage (financing)
Profitability

We will want to answer

questions about the firms
Liquidity
Efficient use of Assets
Leverage (financing)
Profitability

Financial Ratios
Tools that help us determine the
financial health of a company.
We can compare a companys financial
ratios with its ratios in previous years
(trend analysis).
We can compare a companys financial
ratios with those of its industry
(benchmark)

Liquidity Ratios
Do we have enough liquid
assets to meet approaching
obligations?

Efficiency Ratios
Do firm has good ability to use its
assets on its operations?

Measure how efficiently

the firms assets generate
operating profits.

Leverage Ratios
(financing decisions)
Measure the impact of using debt capital
to finance assets.
Firms use debt to lever (increase)
returns on common equity.

Profitability Ratios
Measure the ability of the company
to produce earnings/profit.

LIQUIDITY RATIOs

Current Ratio (CR)

current assets
current liabilities

Acid Test Ratio (Quick Ratio/QR)

current assets - inventories

current liabilities

Cash Ratio (CR)

cash + marketable securities

current liabilities

EFFICIENCY RATIOS

Inventory Turnover

cost of goods sold

inventory

Days Sales in Inventory

Low inventory turnover:

The firm may have too much
inventory, which is expensive
because:
Inventory takes up costly
warehouse space.
Some items may become
spoiled or obsolete.

Accounts Receivable Turnover

Average Collection Period

(Days sales outstanding)

Total Asset Turnover

Fixed Asset Turnover

Leverage RATIOs

Debt Ratio

total debt
total assets

Debt to Equity Ratio

total debt
total equity

Equity Ratio

total equity
total assets

Equity Multiplier

Times Interest Earned Ratio

operating income (EBIT)

interest expense

PROFITABILITY RATIOS

Gross Profit Margin

Operating Profit Margin

operating income (EBIT)

sales

Net Profit Margin

Net income
Net sales

Operating Income Return on Investment

(OIROI) / EBIT Return on Assets (EROA)

operating income (EBIT)

total assets
The OIROI reflects product pricing and the
firms ability to keep costs down.

Return on Asset (ROA)?

Net Income (EAT)
Total Assets

Return on Equity

How well are the firms managers

maximizing shareholder wealth?

Return on Equity (ROE)

net income (EAT)
total equity

MARKET VALUE RATIOS

Earnings Per Shares (EPS)

Net Income (EAT)
Shares Outstanding

Dividend Per Shares (DPS)

Dividend Payout Ratio (DPR)

Plowback Ratio

DuPont Analysis

The DuPont Model

Brings together:
Profitability
Efficiency
Leverage

DuPont System (1)

A diagnostic tool that uses financial ratios to evaluate
a companys financial health
The process has three steps:
1. Management assesses the companys financial
health using the DuPont ratios.
2. If any problems are identified, management
corrects them.
3. Management monitors the firms financial
performance over time, looking for differences
from ratios established as benchmarks by
management.

DuPont System (2)

The system identifies three areas where management
should focus its efforts in order to maximize the firms
ROE:
1. How much profit management can earn on sales
2. How efficient management is in using the firms
assets
3. How much financial leverage management is
using.

DuPont Equation