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Working with financial
statements
Chapter 3
Key concepts and skills
• Know how to standardise financial
statements for comparison purposes
• Know how to compute and interpret
important financial ratios
• Know the determinants of a firm’s
profitability and growth
• Understand the problems and pitfalls in
financial statement analysis
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-2
Chapter outline
•
•
•
•
•
Standardised financial statements
Ratio analysis
The Du Pont identity
Internal and sustainable growth
Using financial statement information
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-3
Standardised financial statements
• Common-size balance sheets
– Compute all accounts as a percentage of total
assets
• Common-size income statements
– Compute all line items as a percentage of sales
• Standardised 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.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-4
Swagman Camping Ltd
Balance sheet—Table 3.1
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-5
Swagman Camping Ltd (cont.)
Common-size balance sheet—Table 3.2
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-6
Swagman Camping Ltd (cont.)
Income statement—Table 3.3
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-7
Swagman Camping Ltd (cont.)
Common-size income statement—
Table 3.4
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-8
Ratio analysis
• Allows for better comparison over time or
between companies
• Used both internally and externally
• For each ratio, several questions arise:
– How is it computed ?
– What is the ratio trying to measure and why is that
information important?
– What is the unit of measurement?
– What might a high or low value be telling us? How
might such values be misleading?
– How could this measure be improved?
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-9
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
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-10
Common financial ratios
Table 3.5
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-11
Short-term solvency or liquidity
ratios
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Asets
SWAGMAN CAMPING LTD
Balance Sheet -2010
Liabilities & Owners Equity
Current Liabilities
$
98
Accounts Payable
$
188
Notes Payable
$
422
Total
$
708
Long term debt
Owners' Equity
Common Stock and paid in surplus
Retained Earnings
$
2,880
Total
$
3,588
Total Liabilties & Owners' Equity
$
$
$
$
344
196
540
457
$
$
$
$
550
2,041
2,591
3,588
• Current ratio = Current assets / Current liabilities
708 / 540 = 1.31 times
• Quick ratio (or acid-test ratio) = (Current assets – Inventory) /
Current liabilities
(708-422) / 540 = 0.53 times
• Cash ratio= Cash / Current liabilities
98/ 540 = 0.18 times
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-12
Long-term solvency measures
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Asets
•
SWAGMAN CAMPING LTD
Balance Sheet -2010
Liabilities & Owners Equity
Current Liabilities
$
98
Accounts Payable
$
188
Notes Payable
$
422
Total
$
708
Long term debt
Owners' Equity
Common Stock and paid in surplus
Retained Earnings
$
2,880
Total
$
3,588
Total Liabilties & Owners' Equity
$
$
$
$
344
196
540
457
$
$
$
$
550
2,041
2,591
3,588
Total debt ratio
–
(TA – TE) / TA
(3588-2591) / 3588 = 0.28 times
•
Debt/Equity
–
TD / TE
0.28/0.72) = 0.39 times
•
Equity multiplier
–
TA/TE = 1 + D/E
($1 /0.72) = 1.39
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-13
Long-term solvency measures
(cont.)
SWAGMAN CAMPING LTD
Income Statement - 2010
Sales
$
2,311
COGS
$
1,344
Depreciation
$
276
EBIT
$
691
Interest
$
141
Taxable Income
$
550
Taxes
$
165
Net Income
$
385
Dividends
Addition to RE
$
$
143
242
• Times interest earned
– EBIT/Interest
691/ 141 = 4.9 times
• Cash coverage
– (EBIT + Depreciation)/Interest
(691 + 276) / 141 = 6.9 times
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-14
Asset management:
Inventory ratios
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Asets
SWAGMAN CAMPING LTD
Balance Sheet -2010
Liabilities & Owners Equity
Current Liabilities
$
98
Accounts Payable
$
344
$
188
Notes Payable
$
196
$
422
Total
$
540
$
708
Long term debt
$
457
Owners' Equity
Common Stock and paid in surplus
$
550
Retained Earnings
$ 2,041
$ 2,880
Total
$ 2,591
$ 3,588
Total Liabilties & Owners' Equity
$ 3,588
SWAGMAN CAMPING LTD
Income Statement - 2010
Sales
$ 2,311
COGS
$ 1,344
Depreciation
$
276
EBIT
$
691
Interest
$
141
Taxable Income $
550
Taxes
$
165
Net Income
$
385
Dividends
Addition to RE
$
$
143
242
• Inventory turnover = Cost of goods sold/Inventory
1344/422 = 3.2 times
• Days’ sales in inventory = 365/Inventory turnover
365 / 3.2 = 114 days
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-15
Asset Management:
Receivables Ratios
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Asets
SWAGMAN CAMPING LTD
Balance Sheet -2010
Liabilities & Owners Equity
Current Liabilities
$
98
Accounts Payable
$
344
$
188
Notes Payable
$
196
$
422
Total
$
540
$
708
Long term debt
$
457
Owners' Equity
Common Stock and paid in surplus
$
550
Retained Earnings
$ 2,041
$ 2,880
Total
$ 2,591
$ 3,588
Total Liabilties & Owners' Equity
$ 3,588
SWAGMAN CAMPING LTD
Income Statement - 2010
Sales
$
2,311
COGS
$
1,344
Depreciation
$
276
EBIT
$
691
Interest
$
141
Taxable Income $
550
Taxes
$
165
Net Income
$
385
Dividends
Addition to RE
$
$
143
242
• Receivables Turnover = Sales/Accounts Receivable
2311 / 188= 12.3 times
• Days’ Sales in Receivables = 365/Receivables Turnover
365 / 12.3= 30 days
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al
Slides prepared by David E Allen and Abhay K Singh
3-16
Asset management:
Asset turnover ratios
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Asets
SWAGMAN CAMPING LTD
Balance Sheet -2010
Liabilities & Owners Equity
Current Liabilities
$
98
Accounts Payable
$
344
$
188
Notes Payable
$
196
$
422
Total
$
540
$
708
Long term debt
$
457
Owners' Equity
Common Stock and paid in surplus
$
550
Retained Earnings
$ 2,041
$ 2,880
Total
$ 2,591
$ 3,588
Total Liabilties & Owners' Equity
$ 3,588
SWAGMAN CAMPING LTD
Income Statement - 2010
Sales
$
2,311
COGS
$
1,344
Depreciation
$
276
EBIT
$
691
Interest
$
141
Taxable Income $
550
Taxes
$
165
Net Income
$
385
Dividends
Addition to RE
$
$
143
242
• Total asset turnover (TAT) = Sales/Total assets
– 2311/3588 = 0.64 times
• Measure of asset use efficiency
• Not unusual for TAT <1, especially if a firm has a large amount of fixed
assets
•
Capital intensity ratio = 1/TAT
– 1/0.64 = 1.56
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-17
Profitability measures
SWAGMAN CAMPING LTD
Balance Sheet -2010
ASSETS
Current Assets
Liabilities & Owners Equity
Sales
$
2,311
Current Liabilities
COGS
$
1,344
Cash
$
98
Accounts Receivable
$
188
Inventory
$
422
Total
$
708
Long term debt
Total
SWAGMAN CAMPING LTD
Income Statement - 2010
Accounts Payable
$
344
Depreciation
$
276
Notes Payable
$
196
EBIT
$
691
$
540
Interest
$
141
$
457
Taxable Income
$
550
Taxes
$
165
Common Stock and paid in surplus
$
550
Net Income
$
385
Retained Earnings
$
2,041
$
2,591
Dividends
$
143
$
3,588
Addition to RE
$
242
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Asets
$
2,880
$
3,588
Total
Total Liabilties & Owners' Equity
• Profit margin = Net income/Sales
385/2311 = 16.7%
• Return on assets (ROA) = Net income/Total assets
385/3588 = 10.73%
• Return on equity (ROE) = Net income/Total equity
363 / 2591 = 14.9%
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-18
Market value measures
• Market price = $88 per share = PPS
• Shares outstanding = 35 million
• Earnings per share = EPS = Net income/Shares outstanding
– 385/35 = $11
• PE ratio = Price per share (PPS )/ Earnings per share (EPS)
– $88 / $11 = 8 times
• Market-to-book ratio = Market value per share/ Book value
per share
– Book value per share = Total equity/Shares outstanding
= $2591/35 = $74
– Market-to-book = $88/74 = 1.19 times
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-19
Swagman ratios
SWAGMAN CAMPING LTD RECAP
Liquidity Ratios
Financial Leverage Ratios
Current Ratio
1.31
Total Debt Ratio
0.28
Quick Ratio
0.53
Debt to Equity
0.39
Cash Ratio
0.18
Equity Multiplier
1.39
Asset Management Ratios
Times Interest Earned
4.9
Inventory Turnover
3.20
Cash Coverage
6.9
Days' Sales in Inventory
114
Profitability Measures
Receivables Turnover
12.30
Profit Margin
16.70%
Days' Sales in Receivables
30
ROA
10.73%
Total Asset Turnover
0.64
ROE
14.90%
Capital Intensity Ratio
1.56
Market Value Measures
Market Price
$ 88.00
Shares Outstanding
35 m
EPS
$ 11.00
PE Ratio
8.0
Book value per share
$74.00
Market to Book
1.19
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-20
The Du Pont identity
• Return on equity (ROE) = Net income (NI)/ Total
equity (TE)= Basic formula
• Du Pont identity
– ROE = Profit margin (PM) * Total asset turnover (TAT)
* Equity multiplier (EM)
• PM
• TAT
• EM
= Net income / Sales
= Sales / Total assets
= Total assets / Total equity
 NI   Sales   TA  NI
ROE  



 Sales   TA   TE  TE
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-21
Using the Du Pont identity
• ROE = PM*TAT*EM
– Profit margin (PM) is a measure of a firm’s
operating efficiency—how well it controls
costs.
– Total asset turnover (TAT) is a measure of the
firm’s asset-use efficiency—how well it
manages its assets.
– Equity multiplier (EM) is a measure of the
firm’s financial leverage.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-22
SWAGMAN—Du Pont identity
SWAGMAN CAMPING LT D RECAP
Liquidity Ratios
Financial Leverage Ratios
Current Ratio
1.31
Total Debt Ratio
0.28
Quick Ratio
0.53
Debt to Equity
0.39
Cash Ratio
0.18
Equity Multiplier
1.39
Asset Management Ratios
Times Interest Earned
4.9
Inventory Turnover
3.20
Cash Coverage
6.9
Days' Sales in Inventory
114
Profitability Measures
Receivables Turnover
12.30
Profit Margin
16.70%
Days' Sales in Receivables
30
ROA
10.73%
Total Asset Turnover
0.64
ROE
14.90%
Capital Intensity Ratio
1.56
Market Value Measures
Market Price
$ 88.00
Shares Outstanding
35 m
EPS
$ 11.00
PE Ratio
8.0
Book value per share
$74.00
Market to Book
1.19
•
ROE = PM * TAT * EM
– PM = 16.7%
– TAT = .64
– EM = 1.39
•
ROE = .167 x .64 x 1.39
= .149= 14.9%
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-23
An expanded Du Pont analysis
Table 3.6
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-24
An expanded Du Pont analysis
(cont.)—Figure 3.1
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-25
Internal and sustainable growth
Dividend payout and earnings retention
ratios
• Dividend payout ratio (b) = Cash
dividends/Net income
• Retention ratio(1-b) = Additions to
retained earnings/Net income = 1 – Payout
ratio (b)
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-26
Internal and sustainable growth
Dividend payout and earnings retention ratios
(cont.)
SWAGMAN CAMPING LTD
Balance Sheet -2010
ASSETS
Current Assets
Cash
$
98
Accounts Receivable
$
188
Inventory
$
422
$
708
Total
SWAGMAN CAMPING LTD
Income Statement - 2010
Liabilities & Owners Equity
Sales
$
2,311
Current Liabilities
COGS
$
1,344
Accounts Payable
$
344
Depreciation
$
276
Notes Payable
$
196
EBIT
$
691
Total
$
540
Interest
$
141
Long term debt
$
457
Taxable Income
$
550
Taxes
$
165
Net Income
$
385
Owners' Equity
Fixed Assets
Net Plant & Equipment
Total Asets
$
2,880
$
3,588
Common Stock and paid in surplus
$
550
Retained Earnings
$
2,041
$
2,591
Dividends
$
143
$
3,588
Addition to RE
$
242
Total
Total Liabilties & Owners' Equity
• Dividend payout ratio (‘b’) =
– Cash dividends / Net income (DIV / NI)
– 143/385 = 37%
• Retention ratio (‘1 – b’) = (NI - DIV)/ NI
– Addition to Retained earnings / Net income
– $242/385 = 63%
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-27
Internal growth rate
• The internal growth rate tells us how much
the firm can grow assets using retained
earnings (internal financing) as the only
source of financing.
Internal Growth Rate 

ROA  b
1 - ROA  b
.1012  .667
1  .1012  .667
 7.23%
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-28
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
.149  .63

 .1036
1  .149  .63
 10.36%
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-29
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
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-30
Summary of internal and
sustainable growth rates
Table 3.6
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-31
Using financial information—
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
– Shareholders
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-32
Using financial statement information—
Benchmarking
• Ratios are not very helpful by themselves;
they need to be compared with something
• Time-trend analysis
– Used to see how the firm’s performance is
changing over time
– Internal and external uses
• Peer-group analysis
– Compare with similar companies or within
industries
– GICS codes
• International codes used to classify a firm by its
type of business operations
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-33
Problems with financial statement
analysis
• Conglomerates
– No readily available comparables
•
•
•
•
•
Global competitors
Different accounting procedures
Different fiscal year ends
Differences in capital structure
Seasonal variations and one-time events
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-34
Example: Work the Web
• The Internet makes ratio analysis much easier than
it has been in the past.
• Click on the information icon to go to
<www.asx.com.au >.
• Go to ‘Prices Research and Announcements’.
• Click on ‘Company Research’ and enter DJS
(company code for David Jones).
• Look under ‘Company Announcements’ and find
the latest annual report.
• Extract the relevant number from the balance
sheet to calculate the financial ratios.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-35
Quick quiz
• How do you standardise balance sheets and
income statements?
– Why is standardisation 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?
• What are some of the problems associated with
financial statement analysis?
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
3-36
Chapter 3
END