mcgraw-hill/irwin ©2001 the mcgraw-hill companies all rights reserved 3.0 chapter 3 working with...
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McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
3.1
Chapter
3Working With Financial Statements
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
3.2
Key Concepts and Skills
Know how to standardize 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
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
3.3
Chapter Outline
Standardized Financial StatementsRatio AnalysisThe Du Pont IdentityInternal and Sustainable GrowthUsing Financial Statement Information
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3.4
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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3.5
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 and why is that information important
Ratios are used both internally and externally
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3.6
Categories of Financial Ratios
Short-term solvency or liquidity ratiosLong-term solvency or financial leverage ratiosAsset management or turnover ratiosProfitability ratiosMarket value ratios
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3.7
Sample Balance Sheet
Cash 6,489 A/P 340,220
A/R 1,052,606 N/P 86,631
Inventory 295,255 Other CL 1,098,602
Other CA 199,375 Total CL 1,525,453
Total CA 1,553,725 LT Debt 871,851
Net FA 2,535,072 C/S 1,691,493
Total Assets 4,088,797 Total Liab. & Equity
4,088,797
Numbers in thousands
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3.8
Sample Income Statement
Revenues 3,991,997
Cost of Goods Sold 1,738,125
Expenses 1,269,479
Depreciation 308,355
EBIT 739,987
Interest Expense 42,013
Taxable Income 697,974
Taxes 272,210
Net Income 425,764
EPS 2.17
Dividends per share 0.86
Numbers in thousands, except EPS & DPS
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3.9
Computing Liquidity Ratios
Current Ratio = CA / CL1,553,725 / 1,525,453 = 1.02 times
Quick Ratio = (CA – Inventory) / CL(1,553,725 – 295,225) / 1,525,453 = .825 times
Cash Ratio = Cash / CL6,489 / 1,525,453 = .004 times
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3.10
Long-term Solvency Measures
Total Debt Ratio = (TA – TE) / TA(4,088,797 – 1,691,493) / 4,088,797 = .5863 times or
58.63%The firm finances almost 59% of their assets with
debt.
Debt/Equity = TD / TE(4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times
Equity Multiplier = TA / TE = 1 + D/E1 + 1.417 = 2.417
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3.11
Computing Coverage Ratios
Times Interest Earned = EBIT / Interest739,987 / 42,013 = 17.6 times
Cash Coverage = (EBIT + Depreciation) / Interest(739,987 + 308,355) / 42,013 = 24.95 times
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3.12
Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory1,738,125 / 295,255 = 5.89 times
Days’ Sales in Inventory = 365 / Inventory Turnover365 / 5.89 = 62 days
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3.13
Computing Receivables Ratios
Receivables Turnover = Sales / Accounts Receivable3,991,997 / 1,052,606 = 3.79 times
Days’ Sales in Receivables = 365 / Receivables Turnover365 / 3.79 = 96 days
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3.14
Computing Total Asset Turnover
Total Asset Turnover = Sales / Total Assets3,991,997 / 4,088,797 = .98 times
Measure of asset use efficiencyNot unusual for TAT < 1, especially if a firm
has a large amount of fixed assets
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3.15
Computing Profitability Measures
Profit Margin = Net Income / Sales425,764 / 3,991,997 = .1067 times or 10.67%
Return on Assets (ROA) = Net Income / Total Assets425,764 / 4,088,797 = .1041 times or 10.41%
Return on Equity (ROE) = Net Income / Total Equity425,764 / 1,691,493 = .2517 times or 25.17%
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3.16
Computing Market Value Measures
Market Price = $61.625 per shareShares outstanding = 205,838,594PE Ratio = Price per share / Earnings per share
61.625 / 2.17 = 28.4 times
Market-to-book ratio = market value per share / book value per share61.625 / (1,691,493,000 / 205,838,594) = 7.5 times
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3.17
Deriving the Du Pont Identity
ROE = NI / TEMultiply by 1 and then rearrange
ROE = (NI / TE) (TA / TA)ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then rearrangeROE = (NI / TA) (TA / TE) (Sales / Sales)ROE = (NI / Sales) (Sales / TA) (TA / TE)ROE = PM * TAT * EM
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3.18
Using the Du Pont Identity
ROE = PM * TAT * EMProfit margin is a measure of the firm’s operating
efficiency – how well does it control costsTotal asset turnover is a measure of the firm’s asset
use efficiency – how well does it manage its assetsEquity multiplier is a measure of the firm’s financial
leverage
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3.19
Payout and Retention Ratios
Dividend payout ratio = Cash dividends / Net income0.86 / 2.17 = .3963 or 39.63%
Retention ratio = Additions to retained earnings / Net income = 1 – payout ratio1.31 / 2.17 = .6037 = 60.37%Or 1 - .3963 = .6037 = 60.37%
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3.20
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.
%71.6
0671.6037.1041.1
6037.1041.bROA - 1
bROA RateGrowth Internal
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3.21
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.
%92.17
1792.6037.2517.1
6037.2517.bROE-1
bROE RateGrowth eSustainabl
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3.22
Determinants of Growth
Profit margin – operating efficiencyTotal asset turnover – asset use efficiencyFinancial leverage – choice of optimal debt
ratioDividend policy – choice of how much to pay
to shareholders versus reinvesting in the firm
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3.23
Why Evaluate Financial Statements?
Internal usesPerformance evaluation – compensation and
comparison between divisionsPlanning for the future – guide in estimating future
cash flowsExternal uses
CreditorsSuppliersCustomersStockholders
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3.24
Benchmarking
Ratios are not very helpful by themselves; they need to be compared to something
Time-Trend AnalysisUsed to see how the firm’s performance is changing
through timeInternal and external uses
Peer Group AnalysisCompare to similar companies or within industriesSIC and NAICS codes
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3.25
Real World Example
Ratios are figured using financial data from the 1999 Annual Report for Ethan Allen
Compare the ratios to the industry ratios in Table 3.9 in the book
Ethan Allen’s fiscal year end is June 30.Be sure to note how the ratios are computed in
the table so that you can compute comparable numbers.
Ethan Allan sales = $762 MM
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3.26
Real World Example - II
Liquidity ratiosCurrent ratio = 2.433x; Industry = 1.4xQuick ratio = .763x; Industry = .6x
Long-term solvency ratioDebt/Equity ratio (Debt / Worth) = .371x; Industry =
1.9x.
Coverage ratioTimes Interest Earned = 70.6x; Industry = 3.4x
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3.27
Real World Example - III
Asset management ratios: Inventory turnover = 2.8x; Industry = 3.6x Receivables turnover = 22.2x (16 days); Industry = 17.7x
(21 days) Total asset turnover = 1.6x; Industry = 2.2x
Profitability ratios Profit margin before taxes = 17.4%; Industry = 3.1% ROA (profit before taxes / total assets) = 27.6%; Industry
= 5.8% ROE = (profit before taxes / tangible net worth) = 37.9%;
Industry = 17.6%
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3.28
Quick Quiz
How do you standardize balance sheets and income statements and why is standardization 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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