Chapter 3

Working With Financial Statements

Financial statement information

Objectively determinable current values of many assets do not exist

Accountants have irrelevant, but objective historical costs. This means that it is the
user’s responsibility to make adjustments.

Financial statement information is often our ONLY source of information. Consequently,

we use the information we have and make adjustments where appropriate

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

A firm has inventory of $700, accounts payable of $300, cash of $80, fixed assets of
$1,600, long-term debt of $1,400, accounts receivable of $320, and total equity of
$1,000. What is the common-size percentage for the accounts receivable?

a. 10.67 percent b. 11.11 percent c. 11.85 percent d.12.33 percent

Total assets = ($700 + $80 + $1,600 + $320) = 2700

Common-size percentage = $320 / 2700 = 11.85 percent

A Firm has a profit margin of 6 percent and net income of $42,000. What is the
common-size percentage for the interest expense if the firm paid $6,500 in interest for
the year?

a. .93 percent b. 1.55 percent c. 2.48 percent d. 15.48

percent

Sales = $42,000 * 100/ 6 = $700,000

Or:

Sales = $42,000 / .06 = $700,000

Common-size percentage = $6,500 / $700,000 = .93 percent

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?

• How it is computed?

• Why that information is important?

• How could this measure be improved?

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

 Categories of Financial Ratios

• Short-term solvency or liquidity ratios

• Long-term solvency or financial leverage ratios

• Asset management or turnover ratios

• Profitability ratios

• Market value ratios

Sample Balance Sheet

Numbers in millions

Sample Income Statement

Numbers in millions
 1.Short Term Solvency Or Liquidity Ratios

Current Ratio = CA / CL

708 / 540 = 1.31 times

Quick Ratio = (CA – Inventory) / CL

(708 – 422) / 540 = .53 times

Cash Ratio = Cash / CL

98 / 540 = .18 times

• Short-term solvency, or liquidity, ratios attempt to measure a firm’s ability to pay

bills in the short-run

• A high current ratio is, in and of itself, a good thing.

• This may be true if you are a short-term creditor, but liquid assets are generally
less profitable for the company.

• Consequently, too large an investment in current assets may reduce the earnings
power of the firm and actually reduce the stock price.

A Firm has current liabilities of $5,600, net working capital of $2,100, inventory of
$3,900, and sales of $13,500. What is the quick ratio?

a. .68 b. .70 c. 1.38 d. 1.47

Current assets = current liabilities + net working capital

Current assets = $5,600 + $2,100 = $7700

Quick ratio = $7700 - $3,900, / $5,600 = .68

2- Long Term Solvency Measures

A- Leverage Ratios

• Total Debt Ratio = (TA – TE) / TA

– (3,588 – 2,591) / 3,588 = .28 times

– The firm finances slightly over 28% of their assets with debt.

• Debt/Equity = TD / TE

– (997/ 2,591) = .39 times

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

– 3,588/ 2,591 = 1.39 times

– or 1 + .39 = 1.39 times

Roy’s Shop has sales of $639,320, total assets of $527,200, a debt-equity ratio of .75,
and a profit margin of 5 percent. What is the equity multiplier?

a. 1.21 b. 1.38 c. 1.75 d. 1.61

If equity is $1, then debt must be $.75, which means that total assets are $1.75.

Equity multiplier = $1.75 / $1.00 = 1.75

(The equity multiplier = 1 + debt-equity ratio.)

B- Coverage Ratios

• Times Interest Earned = EBIT / Interest

– 691/141 = 4.9 times

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

– (691+ 276) / 141 = 6.9 times

Black and White, Inc., has net income of $8,840, a tax rate of 35%, and interest
expense of $3,400. What is the times interest earned ratio?

a. 2.50 b. 2.60 c. 3.33 d. 5.00

EBIT $17000

Interest ($3,400)

Taxable income $13600 [$8,840/ (1 − .35)]

Net income $8,840

Times interest earned = $17,000 / $3,400 = 5

• Long-term solvency, or financial leverage, ratios attempt to

measure a firm’s ability to meet long-term obligations:

• The level of indebtedness and it is indicative of the firm’s

debt capacity .

• The ability to service debt and it is more closely relates to

the likelihood of default.
 3- Asset Management Or Turnover Measures
A- Inventory Ratios

• Inventory Turnover = Cost of Goods Sold / Inventory

– 1,344 / 422 = 3.2 times

• Days’ Sales in Inventory = 365 / Inventory Turnover

– 365 / 3.2 = 114 days

A Company has sales of $984,600, cost of goods sold of $702,100, and inventory of
$5,120. How long on average does it take to sell its inventory?

a. 1.92 days b. 2.33 daysc. 2.66 days d.3.71 days

Inventory turnover rate = $702,100 / $5,120 = 137.129

Days’ sales in inventory = 365 / 137.129 = 2.66

B- Receivables Ratios

• Receivables Turnover = Sales / Accounts Receivable

– 2,311 / 188 = 12.3 times

• Days’ Sales in Receivables = 365 / Receivables Turnover

– 365 / 12.3 = 30 days

A Company has sales of $498,000, cost of goods sold of $263,000, and accounts
receivable of $61,000. How long on average does it take the firm’s customers to pay
for their purchases?

a. 42.25 days b. 42.33 days c. 44.71 days d. 84.66 days

Accounts receivable turnover rate = $498,000 / $61,000 = 8.164

Days’ sales in receivables = 365 / 8.164 = 44.71

• C- Total Asset TurnoverTotal Asset Turnover = Sales / Total Assets

– 2,311 / 3,588 = .64 times

 • Measure of asset use efficiency

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

A firm has $61,300 in receivables and $391,400 in total assets. The firm has a total
asset turnover rate of 1.4 and a profit margin of 6.3 percent. What is the days’ sales in
receivables?

a. 40.23 days b. 40.83 days c. 43.40 days d. 43.67 days

Total sales = ($391,400)(1.4) = $547,960

Accounts receivable turnover rate = $547,960 / $61,300 = 8.939

Days’ sales in receivables = 365 / 8.939 = 40.83

A manufacturer would typically consider inventory at cost and thus relate inventory to
cost of goods sold. However, a retailer might maintain its inventory level based on retail
price. In the latter case, inventory should be related to sales to compute inventory
turnover.

Suppose a firm’s average collection period is significantly higher than the industry norm.
What questions might one ask to make a final determination about the firm’s ability to
manage its assets?
 What are the firm’s credit terms?

What are the industry’s terms on average?

Has the average collection period been trending upward, or is this an aberration?

Which consumers are contributing to the relatively high average collection period?

Is this an industry or economy wide phenomenon?

Making generalizations across industries, intra-industry generalizations should be

made with great caution.

For example, a high fixed asset turnover ratio relative to that of the industry can be the
result of efficient asset utilization, or it can indicate that the firm is utilizing old or
inefficient equipment, while others in the industry have invested in modern equipment.

The firm using inefficient equipment would display a favorable fixed asset turnover
ratio, but would be likely to display a higher level of expenses, lower profitability –
based on cash flow.

• 4- Profitability MeasuresProfit Margin = Net Income / Sales

– 363 / 2,311 = 15.7%

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

– 363/ 3,588 = 10.12%

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

– 363 / 2,591= 14%

A Firm has sales of $489,700. Earnings before interest and taxes is equal to 16 percent
of sales. For the period, the firm paid $5,200 in interest. The tax rate is 35 percent.
What is the profit margin?

a. 6.91 percent b. 7.25 percent c. 8.13 percent d. 9.71 percent

Earnings before interest and taxes = ($489,700)(.16) = $78,352

Net income = ($78,352 – $5,200)(1 − .35) = $47,548.80

Profit margin = $47,548.80 / $489,700 = 9.71 percent

A firm has total debt of $364,000, total equity of $520,000, and a return on equity of
12.5 percent. What is the return on assets?

a. 5.36 percent b. 6.00 percent c. 7.35 percent d. 7.75 percent

Net income = $520,000 × .125 = $65,000

Total assets = $364,000 + $520,000 = $884,000

Return on assets = $65,000 ÷ $884,000 = 7.35 percent

A Firm has total assets of $212,000, a debt-equity ratio of .6, and net income of
$9,500. What is the return on equity?

a. 6.87 percent b. 7.17 percent c. 7.34 percent d. 7.50 percent

Equity multiplier = 1 + .6 = 1.6

Total equity = $212,000 ÷ 1.6 = $132,500

Return on equity = $9,500 ÷ $132,500 = 7.17 percent

• These measures are based on book values, so they are not comparable with
returns that you see on publicly traded assets

• It is inappropriate to compare these results to, for example, an interest rate

observed in financial markets
 5- Market Value Measures

Market Price = $88 per share

Shares outstanding = 33 million

Earnings per share = NE/ no. of shares

= 363/ 33 = $11

P/E Ratio = Price per share/ Earnings per share

88/ 11 = 8 times

Market-to-book ratio = market value per share / book value per share

88/ (2,591 / 33) = 1.12 times

Computers Inc., has a market-to-book ratio of 3.5, net income of $84,000, a book
value per share of $20.16, and 50,000 shares of stock outstanding. What is the
price-earnings ratio?
 a. 21 b. 27 c. 42 d. 49

Price = ($20.16)(3.5) = $70.56

Earnings per share = ($84,000 / 50,000) = $1.68

Price-earnings ratio = $70.56 / $1.68 = 42

• If the benchmark market P/E is higher than it used to be, what does that
suggest for the interpretation of company P/Es?

• How the market-to-book ratio could be interpreted if one was considering the
purchase of a company’s stock?

Differences in generally accepted accounting practices used to compute EPS make

international comparisons risky.

The market is evaluating the company’s future earning power, while the book value
figures reflect the cost at which stock had previously been issued and the earnings that
had been retained in the firm.

Economic Value Added (EVA) is relatively recent addition to the analyst’s toolbox.

EVA is the difference between the firm’s after-tax net operating profit and its cost of
funds.
 Problem

Complete the balance sheet and sales information in the table that follows using the
following financial data:

Debt ratio: 50%

Quick ratio: 0.8x

Total assets turnover: 1.5x

Days’ sales in receivables: 36.5 days (Calculation based on a 365-day year).

Gross profit margin on sales: (Sales- cost of goods sold)/sales = 25%

Inventory turnover ratio: 5x

1. Debt = (0.50)(Total assets) =

(0.50)($300,000) = $150,000.

2. Accounts payable = Debt – Long-term debt

= $150,000 - $60,000 = $90,000

3. Common stock = Total liabilities and equity - Debt - Retained earnings

= $300,000 - $150,000 - $97,500 = $52,500.

4. Sales = (1.5)(Total assets) =

(1.5)($300,000) = $450,000.
5. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500.

6. Inventory = cost of good sold/5 = $337,500 /5 = $67,500.

7. Days’ sales in receivables: =

365/ receivable turnover = 36.5 days

Receivable turnover =356 days/ 36.5 days = 10x

Accounts receivable = (Sales/Receivable turnover)

= ($450,000/36.5) = $45,000.

8. Cash + Accounts receivable = (0.80)(Accounts payable)

= Cash + $45,000 = (0.80)($90,000)

Cash = $72,000 - $45,000 = $27,000

9. Fixed assets = Total assets –

(Cash + Accts rec. + Inventories)

= $300,000 - ($27,000 + $45,000 + $67,500)

= $160,500.
 Deriving the Du Pont Identity

The Du Pont identity provides a way to breakdown ROE and investigates what areas of
the firm need improvement.

• ROE = NI / TE

• ROE = ROA * EM

• ROE = (NI / TA) (TA / TE)

• ROA = PM * TAT

• = (NI / Sales) (Sales / TA)

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

• ROE = PM * TAT * EM

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

A firm has a return on assets of 6.75 percent, a total asset turnover rate of 1.3, and an
equity multiplier of 1.6. What is the return on equity?

a. 8.30 percent b. 8.78 percent c. 10.80 percent d. 14.04

percent

ROE = ROA * EM

Return on equity = (.0675)(1.6) = 10.80 percent

A Firm has total assets of $12,500, a total asset turnover rate of 1.2, a debt-equity
ratio of .8, and a return on equity of 14.04 percent. What is the firm’s net income?
 a. $975 b. $1,150 c. $1,200 d. $1,275

Equity multiplier = 1 + .8 = 1.8

Total equity = $12,500 ÷ 1.8 = $6,944.44

Net income = $6,944.44 × .1404 = $975.00

Another Solution

ROE = PM × TAT × EM

14.04% = PM × 1.2 × 1.8

PM = 14.04% / (1.2 × 1.8) = 14.04% / 2.16 = 6.5%

TAT = Sales / TA

Sales = TAT × TA = 1.2 × 12500 = 15,000

NI = 15,000 × 6.5% = $975

Internal and Sustainable Growth

Dividend Payout and Earnings Retention

Net income = dividends paid + additions to retained earnings
Retention ratio (b) = 1 – dividend payout ratio

• Dividend payout ratio = Cash dividends / Net income

121 / 363 = 33.33%

• Retention ratio = Addn. to R/E / Net income

242/ 363 = 66.67%

• Or: Retention ratio = 1 – Dividend Payout Ratio

1 - 33.33% = 66.67%

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.
 A firm has sales of $84,000, total assets of $92,000, net income of $4,600, and
dividends paid of $1,610. What is the internal growth rate?

a. 3.36 percent b. 3.67 percent c. 4.04 percent d. 4.25 percent

Retention ratio = ($4,600 − $1,610) / $4,600 = 0.65

Return on assets ={($4,600 / $92,000) = 0.05

Internal growth rate = {0.05 * .65} / {1 − 0.05 * 0.65} = 0.0325 / .9675 = 3.36
percent

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.

A Firm maintains a constant debt-equity ratio of 0.60. This year the firm has net
income of $43,200 and is paying $15,120 in dividends. The firm has total assets of
$525,000. What is the maximum growth rate of the firm given this information?

a. 8.08 percent b. 8.31 percent c. 8.98 percent d. 9.36 percent

Plowback ratio = ($43,200 − $15,120) / $43,200 =.65

Total equity = $525,000 / 1.6 = $328,125

ROE = {($43,200 / $328,125) = 13.166 percent

Or: ROE = ROA * EM

= (43,200 / 525,000)* 1.6 = 13.166 percent

Sustainable growth rate = (13.166 *.65) / (1 − 13.166*.65) =

0.0856 / 0.9144 = 9.36 percent

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

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, and Stockholders

Problems with Financial Statement Analysis

 No underlying financial theory

 Finding comparable firms
 What to do with conglomerate, multidivisional firms
 Differences in accounting practices
 Differences in capital structure
 Seasonal variations, one-time events