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- 1. Working With Financial Statements Chapter 3
2. Topics
- How To Standardize Financial Statements For Comparison Purposes
- How To Compute And Interpret Some Common Ratios
- The Determinants Of A Firms Profitability And Growth
- Some Problems And Pitfalls In Financial Statement Analysis
3. Financial Statements:
- Financial statements convey information from within the firm controlled by managers to outside the firm (owners, investors, bankers, suppliers, customers, other constituents)
- Internal managers also use theinformation internally to guide the firm to a profitable future
4. Financial Statements:
- Financial managers would like to have market value information, but often times this is not possible so financial managers rely on financial statements
- Accounting numbers are just pale reflections of economic reality, but they frequently are the best available information
- So, lets learn how to use and interpret financial statements:
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- Common sized statements
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- Ratio analysis
5. Standardized Financial Statements: Common-Size Balance Sheet Common-Size Income Statement
- Standardized statements make it easier to compare financial information:
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- As the company grows, comparing one year to the next
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- For comparing different companies of different sizes, particularly within the same industry
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- For comparing companies when the statements are in different currencies
- Standardized statements use % instead of dollars
6. Balance Sheet Common-Size Balance Sheet Compute all accounts as a percent of total assets 7. Income Statement Common-Size Income Statement Compute all line items as a percent of sales 8. Standardized: Krispy Kream 9. How To Compute And Interpret Some Common Ratios
- Liquidity, or short-term solvency ratios
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- Current ratio
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- Quick ratio
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- Cash ratio
- Leverage, or long-term solvency ratios
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- Total debt ratio
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- Debt/equity ratio
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- Equity multiplier
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- Times interest earned ratio
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- Cash coverage ratio
- Asset turnover, or utilization ratios
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- Inventory Turnover
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- Days sales in inventory
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- Receivables turnover
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- Days sales in receivables
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- Total asset turnover
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- Capital intensity
- Profitability ratios
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- Profit margin
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- Return on assets
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- Return on equity
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- Du Pont Identity
- Market value ratios
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- Price-earnings ratio
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- Market-to-book ratio
10. Ratio Analysis
- Ratios also allow for better comparison through time or between companies
- Ratios are used both internally and externally
- Ratios are computed differently by different people
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- The ones we see in this book are only one of many possible ways to compute them!
3. 11. Hints About Financial Ratios
- In calculating any ratio, we mean the ratio of one thing to something else
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- When we write the ratio as a fraction, we put theofpart in the numerator and thetopart in the denominator
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- Example:
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- Current ratio: find the ratio of current assets to current liabilities
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- (Current Assets)/(Current Liabilities) = $45,000/$30,000 = 1.5
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12. Hints About Financial Ratios
- If you keep the unit of measure (dollars) in both the numerator and denominator, the answer will hint at what the ratio means
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- (Current Assets)/(Current Liabilities) = $45,000/$30,000 = $1.50/$1.00
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- In this case the ratio indicates that for every $1.00 of current liabilities, there is $1.50 worth of current assets to use to pay off the current liabilities
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- In general, this trick can be used with all ratios
13. Financial Ratios:
- Who uses them? Why we might be interested?
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- Stock analysts
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- Should I buy/sell this stock?
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- Auditors
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- Are the financial statements free from material misstatement?
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- Internal Managers
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- How is the firm doing?
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- Investors
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- Should I sell/buy this stock?
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- Banks
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- Will the borrower be able to pay back the loan?
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- Basically: almost everyone
14. Questions To Ask When You Use Ratios:
- How is it computed?!
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- Not everyone agrees about how to calculate a given ratio
- What is it intended to measure and why might we be interested?
- What is the unit of measure?
- What might a high or low value be telling us?
- How might such values be misleading?
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- Accounting behind the numbers?
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- Does a low CA/CL mean trouble for a large firm?
- How could the measure be improved?
15. Liquidity, Or Short-term Solvency Ratios
- Current ratio
- Quick ratio
- Cash ratio
16. Current Ratio
- Current Ratio = CA/CL
- Measure of short term liquidity
- $2/$1 = $2 CA for every $1 of CL
- If you were to sell all CA and pay off all CL, you would have $2 for every $1 of CL
- Above 1, in general is good
- Less than 1, in general is not so good
- High could mean firm saving up cash to make acquisition, or it could mean that they do not see profitable fixed assets to purchase
- Low could mean that they may have a hard time paying short-term debt
- CA/CL is used in debt contracts as indicator of short term liquidity
17. Current Ratio
- If you incur long-term debt, CA /CL, (CA/CL)
- If you pay off short-term creditors: 5/2 = 2.5(5-1)/(2-1) = 4/1 = 4
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- Firms may do these things before the report there numbers at the end of the period
- An apparent low CA/CL may not be bad for a company with a large reserve of untapped borrowing power
- Firm buys inventory with $, CA/CL stays same
- Firm sells inventory for more than they have it on the books for, (CA/CL)
18. Quick Ratio (Acid Test)
- Quick Ratio = (CA-INV)/CL = (Quick Assets)/CL
- Measure of immediate short-term liquidity
- Why take out inventory?
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- Inventory may not be at market value
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- May be hard to sell
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- May be obsolete
- Using cash to buy inventory reduces the Quick Ratio
- People who are interested in whether firm can pay bills or purchase assets in the short term may use this ratio:
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- Creditors, internal managers, investors
19. Cash Ratio
- Cash Ratio = Cash/CL
- Do we even need to define this?
20. Liquidity, Or Short-term Solvency Ratios
- Current Ratio = CA/CL
- Quick Ratio = (CA-INV)/CL
- Cash Ratio = Cash/CL
- What does it mean when these ratios are greater than 1?
- What does it mean when these ratios are less than 1?
21. Leverage, Or Long-term Solvency Ratios
- Total debt ratio
- Debt/equity ratio
- Equity multiplier
- Times interest earned ratio
- Cash coverage ratio
22. Leverage, Or Long-term Solvency Ratios
- Capital Structure = Relationship Between Debt & Equity
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- A = L + E
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- 10 = 2 + 8
- Solvency = the position of having enough money to cover expenses and debts
- Banks, Investors look at these ratios
23. Variables
- Equity = TE = E
- Liability = Debt = TL = D
- Assets = TA = A
24. Leverage (Capital Structure)
- Total Debt Ratio
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- Total Debt Ratio = TL/TA = (TATE)/TA
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- Amount of debt for every $1 of assets
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- How much of every $1 of assets is financed with debt
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- Debt/Equity Ratio
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- Debt/Equity Ratio = TL/TE = D/E
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- Amount of debt for every $1 of equity
- Equity Multiplier
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- Equity Multiplier = Leverage = TA/TE = (1+D/E)
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- For every $1 of equity how many dollars of assets are there
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- Shows us the amount ofleverage
25. TL/TA, TL/TE, TA/TE: From one, you can find the others 26. Times Interest Earned Ratio
- Times Interest Earned Ratio =EBIT/Interest
- How many times over interest can be paid
- Who might be interested in this ratio?
27. Cash Coverage Ratio
- Cash Coverage Ratio = (EBIT+Depr.)/Interest =EBDIT/Interest
- One possible measure of cash flow to meet financial obligations
- If the company has a great deal of non-cash deprecation expense, then it makes sense to use this one
28. Asset Turnover, Or Utilization Ratios
- Inventory Turnover
- Days sales in inventory
- Receivables turnover
- Days sales in receivables
- Total asset turnover
- Capital intensity
29. Inventory Turnover
- Inventory Turnover =COGS/Inv.
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- Alternative = COGS/((Beg.Inv.+EndInv.)/2)
- How many times we run inventory down to zero and then immediately restock
- How many times did we buy and sell our inventory during the year
- As long as we are not running out of stock and foregoing sales, the higher the ratio, the more efficient we are at managing inventory
- Example: COGS/Inv.=5,000/1,000 = 5
30. Days Sales In Inventory
- Days Sales In Inventory = 365/Inv. Turn
- How long inventory sits before it is sold
- Example:
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- If Inv. Turn = 5
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- Days Sales In Inventory = 365days/5 =73 days
31. Receivables Turnover
- Receivables Turnover = Sales/AR
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- Alternative = (Credit _ Sales)/((Beg.AR+EndAR)/2)
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- How fast we collect our receivable
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- # of times we collect and reloan the $ per year
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- Example: 10,000/1,000 = 10
- Days Sales In Receivables = 365/(Days Sales In Receivables)
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- Average time it takes to collect the AR
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- Example: 365days/10 = 36.5 days
32. Payables Turnover
- Payables Turnover = COGS/AP
- Example:
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- COGS/AP = 5,600/800 = 7
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- 365 days/752 days to pay bill
33. What does this tell us?
- Operating cycle = days inventory sits + days to collect after selling
- Cash cycle = operating cycle payables period
34. Asset Turnover
- Total Asset Turnover = Sales/TA
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- Alternative = (Total _ Operating _ Revenue)/((Beg.TA+EndTA)/2)
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- How many sales do we generate from $1 of assets
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- The higher, the better, or the more efficient
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- Sales/TA , more efficient use of assets!
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- If a firm has newer assets that have not been depreciated, book value for assets may be high and may temporarily lower the ratio
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- Measure of asset use efficiency
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- Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets
- Capital Intensity = TA/Sales
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- For every $1 of sales how many $ of assets did it take to generate that $1
35. Profitability Ratio
- Profit margin
- Return on assets
- Return on equity
- Du Pont Identity
36. Profit Margin
- Profit Margin = NI/Sales
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- For every $1 of sales, what is the profit?
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- Example: $60/$400 = .15
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- High PM corresponds to low expense ratios relative to sales
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- High PM:
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- Internal managers could be managing cost efficiently
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- Product/service could be superior to others and could thus demand a high price
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37. Return On Assets
- Return On Assets = NI/TA = ROA
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- Profit per $1 of asset
- ROA = NI/Sales*Sales/TA
- ROA = Profit Margin*Asset Turnover
38. Return On Equity
- Return On Equity = ROE = NI/Equity
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- Return to shareholders
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- What is the profit per $1 of equity?
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- When there is no debt, ROE = ROA
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- When there is debt this should happen: ROE > ROA
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- Why? Because the assets must earn a return for both the creditors and owners
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- The more debt there is, the higher (ROE ROA) must be!
39. Return On Equity
- ROE = NI/Equity
- ROE = NI/Equity x TA/TA
- ROE = NI/TA x TA/Equity
- Since
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- ROA = NI/TA
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- Equity/TA = Equity Multiplier = (1+D/E)
- ROE = ROA xEquity Multiplier
- ROE = ROA x(1+D/E)
- ROE = ROA + (ROA R d )*D/E (chapter 13)
40. ROE
- If ROE goes up or down, what causes this?
- The financial managers at DuPont Copr. Came up with a metric that helps analyze a few of the reasons that may cause ROE to change:
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- Profit margin
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- Efficient use of assets (Asset Turnover)
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- Leverage (Equity Multiplier)
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- ROE= NI/Equity =
- NI/Equity x Sales/Sales x TA/TA =
- (NI x Sales x TA)/(Equity x Sales x TA) =
- NI/Salesx Sales/TA x TA/Equity
Du Pont Identity Decomposing Into Component Parts NI/Sales x Sales/TAx TA/Equity NI/Sales x Sales/TA x TA/Equity 42. Analyze With TheDu Pont Identity ROA ROE 43. Du Pont Analysis: Why did the firms ROE go down? 44. Market Value Ratios(For publicly traded companies)
- Price-Earnings Ratio = (Market Price per Share)/EPS)
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- Note: EPS = NI/(# Shares Outstanding)
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- $ paid for $1 of earnings
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- Surrogate for growth
- Market-To-Book Ratio
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- Note:Book Value per Share = TE/ (# Shares Outstanding)
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- (Market Value per Share)/(Book Value per Share)
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- >1, stock market believes that firm is worth more than the book value of equity