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3
Working With Financial Statements
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1.
2.
3.
4.
Know how to standardize financial statements for
comparison purposes
Know how to compute and interpret important
financial ratios
Be able to compute and interpret the DuPont
Identity
Understand the problems and pitfalls in financial
statement analysis
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Numbers in millions, except EPS & DPS
Revenues
5,000
Cost of Goods Sold
(2,006)
Expenses
(1,740)
Depreciation
(116)
EBIT
1,138
Interest Expense
(7)
Taxable Income
Taxes
1,131
(442)
Net Income
689
EPS
3.61
Dividends per share
1.08
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Numbers in millions, except EPS & DPS
Revenues
5,000
100%
Cost of Goods Sold
(2,006)
(40.1)
Expenses
(1,740)
(34.8)
Depreciation
(116)
(2.3)
EBIT
1,138
22.8
(7)
(0.1)
1,131
22.6
(442)
(8.8)
689
13.8
Interest Expense
Taxable Income
Taxes
Net Income
EPS
3.61
Dividends per share
1.08
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
Common-Size Balance Sheets
◦ Compute all accounts as a percent of total assets
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Common-Size Income Statements
◦ Compute all line items as a percent of sales
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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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2005
Revenues
Cost of
Goods
EBIT
Net Income
Cost of
Goods
EBIT
Net Income
2007
2008
5000
6000
6500
7000
2006
2230
2400
2700
1138
1300
1400
1450
689
730
751
770
2005
Revenues
2006
2006
2007
2008
100%
120%
130%
140%
100%
111%
119%
135%
100%
114%
123%
127%
100%
106%
109%
112%
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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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Short-term solvency or liquidity ratios
Long-term solvency or financial leverage
ratios
Asset management or turnover ratios
Profitability ratios
Market value ratios
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Numbers in millions, except EPS & DPS
Revenues
5,000
Cost of Goods Sold
(2,006)
Expenses
(1,740)
Depreciation
(116)
EBIT
1,138
Interest Expense
(7)
Taxable Income
Taxes
1,131
(442)
Net Income
689
EPS
3.61
Dividends per share
1.08
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Numbers in millions
2007
2006
2007
2006
Cash
696
58 A/P
307
303
A/R
956
992 N/P
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119
Inventory
301
361 Other CL
1,662
1,353
Other CA
303
264 Total CL
1,995
1,775
Total CA
2,256
1,675 LT Debt
843
1,091
Net FA
3,138
3,358 C/S
2,556
2,167
Total Assets
5,394
5,033 Total Liab. &
Equity
5,394
5,033
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
Current Ratio = CA / CL
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Quick Ratio = (CA – Inventory) / CL
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Cash Ratio = Cash / CL
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NWC to Total Assets = NWC / A
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Interval Measure = CA / average daily
operating costs
◦ 2,256 / 1,995 = 1.13 times
◦ (2,256 – 301) / 1,995 = .98 times
◦ 696 / 1,995 = .35 times
◦ (2,256 – 1,995) / 5,394 = .05
◦ 2,256 / ((2,006 + 1,740)/365) = 219.8 days
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Total Debt Ratio = (A –E) / A
◦ (5,394 – 2,556) / 5,394 = 52.61%
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Debt/Equity = D / E
◦ (5,394 – 2,556) / 2,556 = 1.11 times
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Equity Multiplier = A / E = 1 + D/E
◦ 1 + 1.11 = 2.11
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Long-term debt ratio = LTD / (LTD + E)
◦ 843 / (843 + 2,556) = 24.80%
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Times Interest Earned = EBIT / Interest
◦ 1,138 / 7 = 162.57 times
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Cash Coverage = (EBIT + Depreciation) /
Interest
◦ (1,138 + 116) / 7 = 179.14 times
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Inventory Turnover = Cost of Goods Sold /
Inventory
◦ 2,006 / 301 = 6.66 times
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Days’ Sales in Inventory = 365 / Inventory
Turnover
◦ 365 / 6.66 = 55 days
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Receivables Turnover = Sales / Accounts
Receivable
◦ 5,000 / 956 = 5.23 times
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Days’ Sales in Receivables = 365 /
Receivables Turnover
◦ 365 / 5.23 = 70 days
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Total Asset Turnover = Sales / Total Assets
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NWC Turnover = Sales / NWC
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Fixed Asset Turnover = Sales / NFA
◦ 5,000 / 5,394 = .93
◦ It is not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets
◦ 5,000 / (2,256 – 1,995) = 19.16 times
◦ 5,000 / 3,138 = 1.59 times
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Profit Margin = Net Income / Sales
◦ 689 / 5,000 = 13.78%
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Return on Assets (ROA) = Net Income / Total
Assets
◦ 689 / 5,394 = 12.77%
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Return on Equity (ROE) = Net Income / Total
Equity
◦ 689 / 2,556 = 26.96%
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Market Price = $87.65 per share
Shares outstanding = 190.9 million
PE Ratio = Price per share / Earnings per
share
◦ 87.65 / 3.61 = 24.28 times
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Market-to-book ratio = market value per
share / book value per share
◦ 87.65 / (2,556 / 190.9) = 6.55 times
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ROE = NI / E
Multiply by 1 (A/A) and then rearrange
◦ ROE = (NI / E) (A / A)
◦ ROE = (NI / A) (A / E) = ROA * EM
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Multiply by 1 (Sales/Sales) again and then
rearrange
◦ ROE = (NI / A) (A / E) (Sales / Sales)
◦ ROE = (NI / Sales) (Sales / A) (A / E)
◦ ROE = PM * TAT * EM
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ROE = PM * TAT * EM
◦ Profit margin is a measure of the firm’s operating
efficiency – how well it controls 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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
Bal. Sheet (1/28/06)
Data (millions, $U.S.)
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◦
◦
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Cash = 225.27
Inventory = 91.91
Other CA = 22.16
Fixed Assets = 164.62
Computations
◦ TA = 503.96
◦ TAT = 2.39
◦ EM = 1.77
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2006 Inc. Statement
Data (millions, $U.S.)
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Sales = 1,204.35
COGS = 841.87
SG&A = 227.04
Interest = (3.67)
Taxes = 55.15
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NI = 83.96
PM = 6.97%
ROA = 16.66%
ROE = 29.49%
Computations
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ROE = 29.49%
ROA = 16.66%
EM = 1.77
x
PM = 6.97%
TAT = 2.39
x
NI = 83.96
Total Costs = - 1,120.39
+
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Sales = 1,204.35
Sales = 1,204.35
Sales = 1,204.35

TA = 503.96
Fixed Assets = 164.62
+ Current Assets = 339.34
COGS = - 841.87
SG&A = - 227.04
Cash = 225.27
Interest = - (3.67)
Taxes = - 55.15
Other CA = 22.16
Inventory = 91.91
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A firm has an equity multiplier of 1.90, an
asset turnover of 1.2 and a profit margin of
8%. What is the firm’s ROA, and ROE.
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Liquidity ratios
◦ Current ratio = 1.40x; Industry = 1.8x
◦ Quick ratio = .45x; Industry = .5x
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Long-term solvency ratio
◦ Debt/Equity ratio (Debt / Worth) = .54x; Industry =
2.2x.
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Coverage ratio
◦ Times Interest Earned = 2282x; Industry = 3.2x
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Asset management ratios:
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Profitability ratios
◦ Inventory turnover = 4.9x; Industry = 3.5x
◦ Receivables turnover = 59.1x (6 days); Industry =
24.5x (15 days)
◦ Total asset turnover = 1.9x; Industry = 2.3x
◦ Profit margin before taxes = 10.6%; Industry = 2.7%
◦ ROA (profit before taxes / total assets) = 19.9%;
Industry = 4.9%
◦ ROE = (profit before taxes / tangible net worth) =
34.6%; Industry = 23.7%
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Internal uses
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External uses
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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
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Peer Group Analysis
◦ Compare to similar companies or within
industries
◦ SIC and NAICS codes
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There is no underlying theory, so there is no way to
know which ratios are most relevant
Benchmarking is difficult for diversified firms
Globalization and international competition makes
comparison more difficult because of differences in
accounting regulations
Varying accounting procedures, i.e. FIFO vs. LIFO
Different fiscal years
Extraordinary events
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Enron - a natural gas, natural gas liquids,
electricity, exploration and production,
operator of power plants and natural gas
pipelines.
Enron stock price fell from $75 to nothing
due to bankruptcy. One aspect of their
collapse was the way they managed to
keep debt off their balance sheet and hid
commitments to honor the debt. Without
full disclosure, no one knew the true
situation.
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Make companies and managers look good
because return on capital looks better.
Investors and regulators do not freak out when
debt balloons.
Spreads confusion
These off balance sheet debt obligations are
typically triggered (parent requited to pay debt) if
stock falls bellow a certain level or its debt is
downgraded.
That is why the SEC is taking care of these issues.
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How do you standardize balance sheets and
income statements and why is standardization
useful?
What are the major categories of ratios and what
are they good for?
What are some of the problems associated with
financial statement analysis?
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XYZ Corporation has the following financial
information for the previous year:
Sales: $8M, PM = 8%, CA = $2M, FA = $6M,
NWC = $1M, LTD = $3M
Compute the ROE using the DuPont Analysis.
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
A Simple Cycle of Operations:
CASH
CASH
RAW MATERIALS
INVENTORY
RECEIVABLES
RECEIVABLES
FINISHED GOODS
INVENTORY
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Assume: AVG. Inventory – 352.5; AVG AR=285;
AVG AP=235; COGS=480; Sales (all on credit)
= 710 – calculate cash cycle:
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