Lecture Essentials of corporate finance (2/e) – Chapter 3: Working with financial statements

In this chapter, you will 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.

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Working with financial

statements

Chapter 3

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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

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Chapter outline

• Standardised financial statements

• Ratio analysis

• The Du Pont identity

• Internal and sustainable growth

• Using financial statement information

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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

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Swagman Camping Ltd

Balance sheet—Table 3.1

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Swagman Camping Ltd (cont.)

Common-size balance sheet—

Table 3.2

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Income statement—Table 3.3

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Common-size income statement—

Table 3.4

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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?

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Categories of financial

ratios

• Short-term solvency or liquidity ratios

• Long-term solvency or financial

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Common financial ratios

Table 3.5

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Short-term solvency or

liquidity ratios

• 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

ASSETS Liabilities & Owners Equity

Current Assets Current Liabilities

Cash $ 98 Accounts Payable $ 344

Accounts Receivable $ 188 Notes Payable $ 196

Inventory $ 422 Total $ 540

Total $ 708 Long term debt $ 457

Owners' Equity Common Stock and paid in surplus $ 550 Fixed Assets Retained Earnings $ 2,041

Net Plant & Equipment $ 2,880 Total $ 2,591

Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588

SWAGMAN CAMPING LTD Balance Sheet -2010

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Long-term solvency

measures

• 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

ASSETS Liabilities & Owners Equity

Current Assets Current Liabilities

Cash $ 98 Accounts Payable $ 344

Accounts Receivable $ 188 Notes Payable $ 196

Inventory $ 422 Total $ 540

Total $ 708 Long term debt $ 457

Owners' Equity Common Stock and paid in surplus $ 550 Fixed Assets Retained Earnings $ 2,041

Net Plant & Equipment $ 2,880 Total $ 2,591

Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588

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Long-term solvency measures

(cont.)

• Times interest earned

– EBIT/Interest

691/ 141 = 4.9 times

• Cash coverage

– (EBIT + Depreciation)/Interest

(691 + 276) / 141 = 6.9 times

Sales $ 2,311 COGS $ 1,344

Depreciation $ 276

EBIT $ 691

Interest $ 141

Taxable Income $ 550

Taxes $ 165

Net Income $ 385

Dividends $ 143

Addition to RE $ 242 SWAGMAN CAMPING LTD Income Statement - 2010

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Asset management:

Inventory ratios

• Inventory turnover = Cost of goods

sold/Inventory

1344/422 = 3.2 times

• Days’ sales in inventory = 365/Inventory

ASSETS Liabilities & Owners Equity Sales $ 2,311 Current Assets Current Liabilities COGS $ 1,344

Cash $ 98 Accounts Payable $ 344 Depreciation $ 276

Accounts Receivable $ 188 Notes Payable $ 196 EBIT $ 691

Inventory $ 422 Total $ 540 Interest $ 141

Total $ 708 Long term debt $ 457 Taxable Income $ 550

Owners' Equity Taxes $ 165

Common Stock and paid in surplus $ 550 Net Income $ 385

Fixed Assets Retained Earnings $ 2,041 Net Plant & Equipment $ 2,880 Total $ 2,591 Dividends $ 143

Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588 Addition to RE $ 242

SWAGMAN CAMPING LTD Income Statement - 2010

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Asset Management:

Receivables Ratios

• Receivables Turnover = Sales/Accounts

Receivable

2311 / 188= 12.3 times

• Days’ Sales in Receivables = 365/Receivables

ASSETS Liabilities & Owners Equity Sales $ 2,311

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Asset management:

Asset turnover ratios

• 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

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Profitability measures

• 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%

Current Assets Current Liabilities COGS $ 1,344

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Market value measures

• Market price = $88 per share = PPS

• Shares outstanding = 35 million

• Earnings per share = EPS = Net income/Shares

• Market-to-book ratio = Market value per share/ Book

value per share

– Book value per share = Total equity/Shares outstanding

= $2591/35 = $74

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Swagman 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

Times Interest Earned 4.9 Inventory Turnover 3.20 Cash Coverage 6.9 Days' Sales in Inventory 114

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 Price $ 88.00

Shares Outstanding 35 m

EPS $ 11.00

PE Ratio 8.0 Book value per share $74.00

Market Value Measures

SWAGMAN CAMPING LTD RECAP

Financial Leverage Ratios

Profitability Measures Asset Management Ratios

Liquidity Ratios

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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 = Net income / Sales

• TAT = Sales / Total assets

• EM = Total assets / Total equity

TE

NI TE

TA TA

Sales Sales

NI ROE

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Using the Du Pont identity

– Equity multiplier (EM) is a measure of the firm’s financial leverage.

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Market Value Measures

SWAGMAN CAMPING LTD RECAP

Financial Leverage Ratios

Profitability Measures Asset Management Ratios

Liquidity Ratios

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An expanded Du Pont analysis

Table 3.6

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An expanded Du Pont analysis

(cont.)—Figure 3.1

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Internal and sustainable

• Retention ratio(1-b) = Additions to

retained earnings/Net income = 1 –

Payout ratio (b)

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Internal and sustainable growth

Dividend payout and earnings retention

ratios (cont.)

• 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%

Current Assets Current Liabilities COGS $ 1,344

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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.

.667 1012

1

.667 1012

b ROA

1

-b

ROA Rate

Growth Internal

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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.

% 36 10

1036

63 149

1

63 149

b ROE

1

b

ROE

Rate Growth

e Sustainabl

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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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Summary of internal and

sustainable growth rates

Table 3.6

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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

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Using financial statement

– Used to see how the firm’s performance is

changing over time

– Internal and external uses

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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

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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 <

• 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

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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?

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Chapter 3

END

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