Chapter 3 Lecture Outline

Chapter 3 Lecture Outline

Chapter 3. Working with Financial Statements

3.1. Cash Flow and Financial Statements: A Closer Look

3.2. Standardized Financial Statements

3.3. Ratio Analysis

3.4. The DuPont Identity

3.5. Using Financial Statement Information

Key Concepts and Skills

•Understand sources and uses of cash and the Statement of Cash Flows

•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

Sources and Uses of Cash

•Sources

Cash inflow – occurs when we “sell” something
A Decrease in asset account

•Accounts receivable, inventory, and net fixed assets

An Increase in liability or equity account

•Accounts payable, other current liabilities, and common stock

•Uses

Cash outflow – occurs when we “buy” something
An Increase in asset account

•Cash and other current assets

A Decrease in liability or equity account

•Notes payable and long-term debt

Slide 4

Standardized Financial Statements(or Common-Sized Financial Statements)

The basic idea: Divide Everything on the page by the main number on the page

Balance Sheet: is Total Assets

Income Statement is Sales

Ratio Analysis

Short-Term Solvency
Long-Term Solvency
Asset Management
Profitability Ratios
Market Value Ratios

Some things to think about as we look at ratios:

Definition of the Ratio - How is it computed? Is it always the same? (It will be for us)
Use the Beginning, Ending or Average B-S value?
What is the unit of Measure? dollars, years, dollars per dollars of assets…
What are HIGH values? What are LOW values? Company, industry, sector, companies

First Some Notation:

•Current Assets = CA

•Current Liabilities = CL

•Long-Term Assets (or Fixed Assets) = LTA

•Long-Term Debt = LTD

•Total Assets = TA = A

•Total Liabilities = TL = L = Total Debt = TD = Debt =D

•Total Equity = TE = E

Category 1: Short-Term Solvency(Aka short term liquidity)

[3.1] Current Ratio = CA/CL = 708/540 = 1.31

[3.2] Quick Ratio = (CA – Inv)/CL = (708 – 442)/540 = 0.53

[3.3] Cash Ratio = Cash/CL = 98/540 = 0.18

[3.4] NWC to TA = (CA – CL)/TA = (708 – 540)/3,588 = 168/3,588 = 4.7%

[3.5] Interval Measure = CA/Avg Daily Op Costs

Total Op Costs (excluding Dep and Int Exp) = $1,344

Avg Daily Op Costs = $1,344/365 = $3.68/day

Interval Measure = CA/Avg Daily Op Costs = $708/$3.68/day = 192 days

Category 2: Long-Term Solvency and Leverage

Balance Sheet:

[3.6] Total Debt Ratio = Debt to Assets = D/A = 997/3,588 = 0.28

[3.7] Debt to Equity = D/E = 997/2,591 = 0.38

[3.8] Equity Multiplier (EM) = A/E = 3,588/2,591 = 1.38

[3.9] Long-Term Debt = LTD/(LTD + TE)

Income Statement:

[3.10] Times Interest Earned (TIE) = EBIT/In Exp= 691/141 = 4.9 times

[3.11] Cash Coverage = EBITDA/In Exp = 967/141 = 6.9 times

Category 3: Asset Management or Efficiency

[3.12] Inventory Turnover = COGS/Inventory = 1,344/422 = 3.2 times

[3.13] Days’ Sales in Inventory = 365/Inventory Turnover = 365/3.2 = 115 days

[3.14] Receivables Turnover = Sales/(A/R) = 2,311/188 = 12.3 times

[3.15] Days’ Sales in Receivables = 365/Receivables Turnover = 365/12.3 = 30 days

[3.16] NWC Turnover = Sales/NWC = 2,311/168 = 13.8 times

[3.17] Fixed Asset Turnover = Sales/LTA = 2,311/2,880 = 0.80 times

[3.18] Total Asset Turnover = Sales/TA = 2,311/3,588 = 0.64 times

Category 4: Profitability (Really Efficiency)

[3.19] Profit Margin (PM) PM = NI/Sales = 363/2,311 = 15.7%

[3.20] Return on Asset (ROA) ROA= NI/Assets = 363/3,588 = 10%

[3.21] Return on Equity (ROE) ROE = NI/Equity = 363/2,591 = 14%

Important Relationship:

ROE = NI/Equity (Profitability)

ROA = NI/Assets (Efficiency)

EM = Assets/Equity (Leverage)

Profitability = Efficiency X Leverage

ROE = ROA X EM

NI/Equity = NI/Assets X Assets/Equity

Category 5: Market Value Measures

# of Shares Outstanding is 33m and Price is $88 per share

[3.21] Earnings per Share (EPS) = NI/Shares = $363/33 = $11/Share

[3.22] Price-Earnings Ratio (PE or P/E) = Price/EPS = $88/$11 = 8 times

[3.23] Market-to-Book = Price per Share/Book Val of Equity per Share

[3.24] Enterprise Value (EV) = Mkt Cap + Mkt Val Debt – Cash= Shares x Price + Notes + LTD – Cash

= 33 m x $88 + $196 + $457 – $98 = $3,465

[3.25] Enterprise Value Multiple = EV/EBITDA = $3,465/$967 = 3.6 times

One More Efficiency Measure…

EBITDA Margin = EBITDA/Sales = $967/$2,311 = 41.8%

Compare EBITDA Margin to Profit Margin:

Profit Margin (PM) = NI/Sales = $363/$2,311 = 15.7%

•What is the difference in the numerators?

EDITDA – Dep – Amort – Int Exp – Taxes = NI

DuPont Identity

•A method of calculating the contribution of different parts to overall profitability

•Also called Profitability decompositionor ROE Decomposition

•Profitability is measured by ROE = NI/E

The Du Pont Identity:

[3.26] ROE = AT x PM x EM

NI/E = Sales/A x NI/Sales x A/E

Profit = Sales Efficiency x Expense Efficiency x Leverage

First: Decompose Profitability (ROE) into broad measures of Efficiency (ROA) and Leverage (EM)

•EfficiencyROA = NI/A

•LeverageEM = A/E

•ROE = ROA x EMNI/E = NI/A x A/E

•Profit = Efficiency X Leverage

Second: Decompose Efficiency into

Sales generated from Assets (AT) and

Expenses needed to generate the sales (PM)

•Sales Generated from Assets (Asset Turnover) AT = Sales/A

•Earnings kept from each dollar of sales PM = NI/Sales

NI/A = Sales/A x NI/Sales

ROA = AT x PM

Total Efficiency is a function of Sales and Expenses

Third: Decompose AT (Sales/A) into different types of Sales

•Manufactured Products, Servicing, Consulting…

•AT Product Sales/A, Servicing/A, Consulting/A,

•What break-down categories are appropriate? Depends on the company and its business

Fourth:Decompose PM (NI/Sales) into different expenses

•COGS/Sales, SG&A/Sales, Int Exp/Sales, Tax Exp/Sales, Dep Exp/Sales

•PM = NI/Sales = (Sales – Expenses)/Sales