3

Working With
Financial Statements

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 Sources and Uses
 Sources

Cash inflow – occurs when we “sell” something

Decrease in asset account (Sample
( B/S)
• Accounts receivable, inventory, and net fixed assets

Increase in liability or equity account
• Accounts payable, other current liabilities, and common stock
 Uses

Cash outflow – occurs when we “buy” something

Increase in asset account
• Cash and other current assets

Decrease in liability or equity account
• Notes payable and long-term debt

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 Statement of Cash Flows
 Statement that summarizes the sources and
uses of cash
 Changes divided into three major categories

Operating Activity – includes net income and changes
in most current accounts

Investment Activity – includes changes in fixed assets

Financing Activity – includes changes in notes
payable, long-term debt, and equity accounts as well
as dividends

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 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

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Common-Size Income Statement

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 Ratio Analysis
 Ratios also allow for better comparison through
time (Time trend analysis) or between
companies (Peer group analysis)
 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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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

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 Computing Liquidity Ratios
 Current Ratio = CA / CL

2,256 / 1,995 = 1.13 times
 Quick Ratio = (CA – Inventory) / CL

(2,256 – 301) / 1,995 = .98 times
 Cash Ratio = Cash / CL

696 / 1,995 = .35 times
 NWC to Total Assets = NWC / TA

(2,256 – 1,995) / 5,394 = .05
 Interval Measure = CA / average daily
operating costs

2,256 / ((2,006 + 1,740)/365) = 219.8 days

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Computing Long-term Solvency
Ratios
 Total Debt Ratio = (TA – TE) / TA

(5,394 – 2,556) / 5,394 = 52.61%
 Debt/Equity = TD / TE

(5,394 – 2,556) / 2,556 = 1.11 times
 Equity Multiplier = TA / TE = 1 + D/E

1 + 1.11 = 2.11
 Long-term debt ratio = LTD / (LTD + TE)

843 / (843 + 2,556) = 24.80%

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 Computing Coverage Ratios
 Times Interest Earned = EBIT / Interest

1,138 / 7 = 162.57 times
 Cash Coverage = (EBIT + Depreciation) /
Interest

(1,138 + 116) / 7 = 179.14 times

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 Activity Ratios
a) Inventory Turnover = Cost of Goods Sold / Inventory.
b) Day’s Sales in Inventory= 365/Inventory Turnover
c) Accounts Receivables Turnover = Sales/Accounts receivables.
d) Average Collection Period = 365 / Receivables Turnover.
e) Accounts Payable Turnover = Credit Purchase/Accounts Payable
f) Average Payment Period = 365/Accounts Payable Turnover
g) Net Working Capital Turnover= Sales/NWC
h) Total Asset Turnover = Sales / Total Assets.
i) Fixed Asset Turnover = Sales / Fixed Assets.

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 Computing Inventory Ratios
 Inventory Turnover = Cost of Goods Sold /
Inventory

2,006 / 301 = 6.66 times
 Days’ Sales in Inventory = 365 / Inventory
Turnover

365 / 6.66 = 55 days

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Computing Receivables Ratios
 Receivables Turnover = Sales / Accounts
Receivable

5,000 / 956 = 5.23 times
 Days’ Sales in Receivables = 365 /
Receivables Turnover

365 / 5.23 = 70 days

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 Computing Total Asset
Turnover
 Total Asset Turnover = Sales / Total Assets

5,000 / 5,394 = .93

It is not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets
 NWC Turnover = Sales / NWC

5,000 / (2,256 – 1,995) = 19.16 times
 Fixed Asset Turnover = Sales / NFA

5,000 / 3,138 = 1.59 times

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Computing Profitability Measures
 Profit Margin = Net Income / Sales

689 / 5,000 = 13.78%
 Return on Assets (ROA) = Net Income /
Total Assets

689 / 5,394 = 12.77%
 Return on Equity (ROE) = Net Income /
Total Equity

689 / 2,556 = 26.96%

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Computing Market Value Measures
 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
 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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 Deriving the DuPont Identity
 ROE = NI / TE
 Multiply by 1 (TA/TA) and then rearrange

ROE = (NI / TE) (TA / TA)

ROE = (NI / TA) (TA / TE) = ROA * EM
 Multiply by 1 (Sales/Sales) again and then
rearrange

ROE = (NI / TA) (TA / TE) (Sales / Sales)

ROE = (NI / Sales) (Sales / TA) (TA / TE)

ROE = PM * TAT * EM

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 Using the DuPont Identity
 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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 Expanded DuPont Analysis –
Aeropostale Data
 Bal. Sheet (1/28/06) Data  2006 Inc. Statement Data
(millions, $U.S.) (millions, $U.S.)

Cash = 225.27 
Sales = 1,204.35

Inventory = 91.91 
COGS = 841.87

Other CA = 22.16 
SG&A = 227.04

Fixed Assets = 164.62 
Interest = (3.67)

Total Equity = 284.71 
Taxes = 55.15

 Computations  Computations

TA = 503.96 
NI = 83.96

TAT = 2.39 
PM = 6.97%

EM = 1.77 
ROA = 16.66%

ROE = 29.49%
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 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

Stockholders

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 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

SIC and NAICS codes

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