FIN 2704/2704X

Week 2 Slides
Balance Sheet
 Learning objectives
• Understand what an annual report and why it is
important
• Understand the Financial Statements included in
an annual report
• Understand what a Balance Sheet is

3
 Financial Statements and the Annual Report

• Annual report is a report issued annually by a corporation

to its stockholders.
– Contains basic financial statements as well as
management’s analysis of the firm’s past operations
and future prospects.

• Example: Berkshire Hathaway’s website: visit

www.berkshirehathaway.com for its annual reports for the
past 2 decades.

• In general, see also www.annualreportservice.com

4
 Example: Accounting Fraud

https://visual.ly/community/infographic/business/10-worst-corporate-accounting-scandals-all-time 6
 Accounting fraud example

7
https://visual.ly/community/infographic/business/10-worst-corporate-accounting-scandals-all-time
The Annual Report
1. Balance sheet – provides a snapshot of a
firm’s financial position at one point in time.

2. Income statement – summarizes a firm’s

revenues and expenses over a given period
of time.

3. Statement of retained earnings – shows how

much of the firm’s earnings were retained,
rather than paid out as dividends.

4. Statement of cash flows – reports the impact

of a firm’s activities on cash flows over a
given period of time.

8
 Balance Sheet Characteristics

ASSETS = LIABILITIES + EQUITY

1. Resources must equal Claims

2. Order of Listing – Highest to Lowest Liquidity
3. Valuing of Items – Generally at original cost
(also known as Historical Cost)
Exceptions: Marketable Securities and Inventories

9
 Sample Balance Sheet
December 31, 2019
Numbers in thousands ($’000s)
Assets Liabilities
Cash & Equivalents 3,171 Accounts Payable 313,286
Accounts Receivable 1,095,118 Notes Payable 227,848
Inventory 388,947 Other CL 1,239,651

Other CA 314,454 Total CL 1,780,785

Total CA 1,801,690 LT Debt 1,389,615

Net FA 3,129,754
S/H Equity
Common Stock 963,841
Retained Earnings 797,203
Total Assets 4,931,444 Total Liab. & Equity 4,931,444
Equity = Assets - Liabilities 10
 Sample Balance Sheet
Numbers in thousands ($’000s)
2019 2018 2019 2018
Cash & Equiv. 3,171 6,489 A/P 313,286 340,220
A/R 1,095,118 1,048,991 N/P 227,848 86,631

Inventory 388,947 295,255 Other CL 1,239,651 1,098,602

Other CA 314,454 232,304 Total CL 1,780,785 1,525,453

Total CA 1,801,690 1,583,039 LT Debt 1,389,615 871,851

Net FA 3,129,754 2,535,072 C/S 963,841 1,000,000

R/E 797,203 720,807
Total Assets 4,931,444 4,118,111 Total Liab. 4,931,444 4,118,111
& Equity
11
 Book Values and Market Values
• Book Values (historical costs less accumulated depreciation)
are determined by IFRS, GAAP*
• Market Values are determined by current trading values in the
market
NOTE: Market Value of Shareholders’ Equity
= “Market Capitalization”
= Share Price x Number of Outstanding Shares

EXAMPLE: Market Value vs Book Value

According to IFRS (and/or GAAP), a firm has equity worth $6 billion,
debt worth $4 billion, assets worth $10 billion. The market values the
firm’s 100 million shares at $75 per share and the debt at $4 billion.
What is the market value of the firm’s assets?

*International Financial Reporting Standards, Generally Accepted Accounting Principles 12

 Example: Market Value vs. Book Value
Answer:
Since (Assets = Liabilities + Equity), your assets must have a
market value of $11.5 billion

Market Value “Balance Sheet”

Assets = $11.5b = Debt ($4b) +

Equity ($7.5b)

13
 Summary
• Annual report & financial statements

• Balance sheet
– Assets = Liabilities + Equity

• Book value vs. market value

– Market value of equity (market capitalization)
– Market value of assets

14
Income Statement & Statement of
Retained Earnings
 Learning objectives

• Understand what an Income Statement is

• Understand what a Statement of Retained
Earnings is

16
 Sample Income Statement
For Year Ending December 31, 2019
Numbers in thousands ($’000s)
Revenues $4,335,491
Shows:
Cost of Goods Sold 1,762,721 1. Revenues
Operating Expenses 1,390,262 2. Expenses
Depreciation 362,325 3. Taxes associated with
EBIT $820,183 those revenues
Interest Expense 52,841
Taxable Income $767,342 For some financial period,
Taxes 295,426 typically a month, a quarter
Net Income $471,916
or a year

17
Sample Statement of Retained Earnings
Numbers in thousands ($’000s)

Retained Earnings, beginning of year 720,807

Add: Net Income 471,916

1,192,723
Less: Dividends -395,520
Retained Earnings, end of year 797,203

18
How Does Retained Earnings Change?
• Look at the Statement of Retained Earnings:
 Add Net income ∆ Retained Earnings
 Less Dividends

• Dividend Payout Ratio = 395,520/471,916 = 83.81%

Retained Earnings, beginning of year 720,807

Add: Net Income 471,916

1,192,723

Less: Dividends -395,520

Retained Earnings, end of year

797,203
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 Summary
Income Statement
– Revenue
– Expenses
– Taxes

Statement of Retained Earnings

– Add net income
– Less dividend

20
Statement of Cash Flows
 Learning objectives
• Understand the difference between profits
and cash flows and why cash flows are
important

• Understand what a Statement of Cash

Flows is

• Understand what a standardized statements

are and why they are useful 22
 Sample Statement of Cash Flows
Numbers in thousands ($’000s)
Refer to Income
Cash, beginning of year 6,489 Financing Activity Statement

Operating Activity Increase in Notes Payable 141,217

Net Income 471,916 Increase in LT Debt 517,764
Plus: Depreciation 362,325 Decrease in Common Stock -36,159
Increase in Other CL 141,049 Dividends Paid -395,520
Less: Increase in A/R -46,127 Net Cash from Financing 227,301
Increase in Inventory -93,692 Net Decrease in Cash -3,318
Increase in Other CA -82,150 Cash End of Year 3,171

Decrease in A/P -26,934 Refer to Balance Sheet

Net Cash from Operations 726,387
Investment Activity - (Change in net fixed assets
Fixed Asset Acquisition -957,007 + depreciation for the year)
Net Cash from Investments -957,007 23
 Profits vs. cash flows
Differences
• “Profits” subtract depreciation (a non-cash expense)
• “Profits” ignore cash expenditures on new fixed
assets (the expense is capitalized)
• “Profits” record income and expenses at the time of
sales, not when the cash exchanges actually occur
• “Profits” do not consider changes in working capital
(consider, why do changes in working capital not
show up in the ‘profits’,i.e., Income Statement?)
24
 The Importance of Cash Flows
• Cash is King: firms generate cash and they
spend it
• Sources of cash (activities that bring in cash):
– decreases in assets (other than cash)
– increases in equity and liabilities

• Uses of cash (activities that involve cash

outflows):
– increases in assets (other than cash)
– decreases in equity & liabilities
25
 Statement of Cash Flows
Summarizes the sources and uses of cash over the
period under consideration.

Changes divided into 3 major categories:

1. Operating Activities – includes net income and
changes in most current accounts (A/P, A/R, Inv)
2. Investment Activities – includes changes in fixed
assets
3. Financing Activities – includes changes in notes
payable, long-term debt and equity accounts as well as
dividends 26
 Understanding the Statement of Cash Flows
The Balance Sheet Identity
Assets = Liabilities + Equity

Current assets + net fixed assets = current liabilities+ lt debt + common stock
+ retained earnings

Cash + current assets other than cash + net fixed assets =

current liabilities + long-term debt + retained earnings + common stock

∆Cash = ∆retained earnings - ∆current assets other than cash - ∆net fixed
assets + ∆current liabilities + ∆long-term debt + ∆common stock

27
 Understanding the Statement of Cash Flows
The Balance Sheet Identity
Assets = Liabilities + Equity

Current assets + net fixed assets = current liabilities+ lt debt + common stock
+ retained earnings

Net working capital = Current Assets – Current Liabilities

Net working capital + net fixed assets = long-term debt + common stock +
retained earnings
CL = non-interest bearing CL + interest-bearing CL
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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
• Common-Base Year Statements
– Compute all line items as a percent of base year

• 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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 Example: Standardized Balance Sheet

Common Size
Balance Sheet
Balance Sheet

2017 2016 2017 2016

Cash 1,000 1,200 15% 18%

Inventory 2,300 2,000 34% 30%

Receivables 1,500 2,000 22% 30%

Investments 2,000 1,500 29% 22%

Total Assets 6,800 6,700 100% 100%

30
 Summary
• Profit vs. cash
– Importance of cash flows

• Statement of cash flows

– Operating activities
– Investment activities
– Financing activities

• Standardized financial statements

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Financial Statements
& Market Value
 Learning objectives

Understand how to use Financial statements

to infer market value

37
 Financial Statements & Market Value
• Detailed market information for assets is needed, but
often not readily available
• Although accounting figures are often pale reflections of
economic reality, they are frequently the best available
 Thus we have to rely on accounting figures as a starting
point to extract the information we actually seek
“Objectively determinable current values of many assets do not exist.
Faced with a trade-off between relevant, but subjective current values,
and irrelevant, but objective historical costs, accountants have opted for
irrelevant, but objective historical costs. This means that it is the user’s
responsibility to make adjustments”
Robert Higgins of Highland Capital Partners

38
 The Finance Concept of Cash Flow
• Cash flow is one of the most important pieces of information that
a financial manager can derive from financial statements.
• We will look at how cash is generated from utilizing assets and
how it is paid to those that finance the purchase of the assets.
• “Cash is King” in the study of finance. Finance professionals are
not concerned with accrual accounting, but rather whether there
is enough cash generated to pay bills, investors, etc.
• In finance, our concept of “cash flow from assets” is different
from the accounting “Statement of Cash Flows”. We care about
cash generated from operations over the life of the
asset/investment.
39
 We are interested in “Operating Working Capital”
• Business operations generally require investment in net
operating working capital.
– We may need operating cash on hand
– Inventory
– Accounts receivable
– But we may also enjoy increases in Accounts Payable from
our suppliers

• Funds are required for the above items to support sales

although the related cash has not yet been collected from
any sale.

• Note that we only consider operating working capital.

40
 Operating Working Capital
Working capital stemming from our operating policies (A/R, Inventory,
A/P, etc.) and removed from our financing decisions
• Thus, we exclude non-operating working capital such as Notes
Payable from our calculation of changes in Net Operating Working
Capital

Recall that there are two types of Current Liabilities

1. Interest Bearing Liabilities (a result of financing activities)
– Short Term Loans (less than 1 year maturity)
– Notes Payables
These are part of our financing choices, not our operating choices

2. Non-Interest Bearing Liabilities (a result of operating activities)

– Accounts Payables (extended from our suppliers)
41
 Cash Flow Identity:
Cash Flow From Assets* (CFFA)
*also referred to as Free Cash Flows

Cash Flow From Assets (CFFA^) =

Operating Cash Flow (OCF)
– Net Capital Spending (NCS)
– Changes in NOWC (Net Operating Working Capital)

^CFFA  Cash flow generated from a firm’s operating assets after taking into
account all present investment needed for its on-going operations.

Cash Flow From Assets (CFFA) + Interest Tax Shield =

Cash Flow to Creditors + Cash Flow to Stockholders

42
 Note: Interest is tax deductible
• Recall from the Income Statement (slide 17) that any interest payments
are deducted from EBIT (Earnings Before Interest and Tax) before
calculation of Taxes.
– This means that interest payments function to reduce the amount of taxes
paid. Thus although interest payments are paid out in cash, they also result in
the company paying less tax than it otherwise would. The reduction in the
amount of tax paid is referred to as the Interest Tax Shield.
– Dividend payments are not tax deductible and do not reduce the amount of
taxes paid. Thus dividend payments are paid out in cash, with no offsetting
tax shield.

• When determining “cash flow from assets” we do not take into account
the interest tax shield
– We separate operations from financing. Thus, we consider the Interest Tax
Shield separately
– This Tax Shield increases the amount of cash flow available to Creditors
and Shareholders
 BIZ Corporation example (info)
BIZ Corporation
2015 and 2016 Balance Sheets
(in $ Millions)
Assets Liabilities & Stockholder's Equity
2015 2016 2015 2016
Current Assets Cuurent Liabilities
Cash $104 $160 A/P $232 $266
A/R 455 688 N/P 196 123
Inventory 553 555 Total $428 $389
Total $1,112 $1,403
Long-term Debt $408 $454
Fixed Assets
Net PP&E $1,644 $1,709 Stockholder's Equity
Common Stock and
Pain-in Surplus $600 $640
Retained Earnings 1320 1629
Total $1,920 $2,269
Total Liabilities &
Total Assets $2,756 $3,112 Stockholder's Equity $2,756 $3,112 44
BIZ Corporation example (info cont.)
BIZ Corporation
2016 Income Statement
(in $ Millions)

Net Sales $1,509

Cost of Goods Sold 750
Depreciation 65
Earnings Before Interest and Taxes $694
Interest Paid 70
Taxable Income $624
Taxes (34%) 212
Net Income $412
Dividends $103
Addition to Retained Earnings $309
45
 BIZ Corporation example – Part 1
• Operating Cash Flow:
OCF = EBIT*(1-Tax Rate) + Depreciation
= 694*(1 – 0.34 = 0.66) + 65 = 523

• Net Capital Spending:

NCS = Ending Net Fixed Assets – Beg. Net Fixed Assets +
Depreciation
= 1709 – 1644 + 65 = $130

• Changes in Net Operating Working Capital

Changes in NOWC = Ending NOWC – Beginning NOWC
= (160 + 688 + 555 – 266) - (104 + 455 +553 - 232) = $257
• CFFA = 523 – 130 – 257 = $136
46
 Example: BIZ Corporation – Part 2
Interest Tax Shield
= Cash generated from the reduction in the amount of taxes
paid due to tax deductibility of interest
= $70 * 0.34
= $24

47
 Example: BIZ Corporation – Part 3
(Refer to Balance Sheet & Income Statement)

• Cash Flow to Creditors

= interest paid – net new borrowing (LT Debt and Notes
Payable)
= $70 – [(123+454) – (196+408)] = $70 – -$27 = $97

• Cash Flow to Stockholders

= dividends paid – net new equity raised
= $103 – ($640 - $600) = $63

• Cash flow to Creditors and Stockholders

= $97 + $63 = $160

 Cross Check Answer:

CFFA + Interest Tax Shield = $136 + $24 = $160 48
 Enterprise Value
• Enterprise value of a firm:
Assesses the value of the underlying business assets (however
financed) while excluding the value of any non-operating assets.
– A common non-operating asset is “excess cash” (i.e., the amount
of cash that the firm has that is cash not needed for the firm’s
operations) but can include other assets like unused land, etc.

• Thus, generally when there are no other non-operating

assets:
Enterprise Value
= Market Value of Equity + Debt – Excess Cash
• In theory, it is the cost of a company’s operating assets if
someone were to acquire only those assets.
49
 Computing enterprise value example

Problem: Lulu Co. is a public company with a share price of

$46.78, 319.1 million shares outstanding, a market-to-book equity
ratio of 8.00, a book debt-equity ratio of 2.62, and excess cash of
$576 million. What is Lulu’s market capitalization? What is its
enterprise value?

Share Price $46.78

Shares outstanding 319.1 million
Market-to-book 8.00
Cash $576 million
Debt-to-equity (book) 2.62
50
 Computing enterprise value example (answer)

• Lulu, Co. has a market capitalization of

= 319.1M shares x $46.78/share = $14.93B

• Since Lulu, Co.’s market-to-book ratio (= market value of equity

/ book value of equity) = 8.00
market-to-book ratio = market capitalization / book equity
then book equity = $14.93B / 8.00 = $1.865B

• Given that the book equity is $1.865B and the book debt-to-
equity ratio is 2.62, the total value of Lulu, Co.’s debt is
$4.888B

Enterprise value = $14.93B + $4.888B - $0.576B = $19.254B

51
 Basic Stock Concepts
Nature/Composition of Contributed Capital
.

Authorized Capital Stock

# shares can issue legally

Issued Capital Stock Unissued Capital Stock

# shares issued to outsiders # shares not issued to
outsiders

Outstanding Capital Stock Treasury Stock

# shares held by outsiders # shares bought back
& held by company
52
 Summary
• Finance concept of cash flows:
– CFFA
– Net Operating Working Capital
– Interest tax shield

• Enterprise value

53
Ratio Analyses
 Learning objectives
• Know how to compute and interpret important
financial ratios
• Be able to compute and interpret the Du Pont
Identity

55
 Ratio Analysis
• Ratios are not very helpful by themselves; they need to be
compared to something
– Time-Trend Analysis (over time)
Used to see how the firm’s performance is changing
through time
– Peer Group Analysis (with others)
Compare to similar companies or within industries (e.g.
based on SIC codes)

• 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
56
 Things To Consider Concerning Financial Ratios

1. What aspects of the firm are we attempting to analyze?

2. What information goes into computing a particular ratio

and how does that information relate to the aspect of the
firm being analyzed?

3. What is the unit of measurement (times, days, percent)?

4. What are the benchmarks used for comparison?

5. What makes a ratio “good” or “bad”?

57
 The 5 Major Categories of Ratios
1. Liquidity ratios (Short-term solvency)
– Measure the firm’s ability to pay bills in the short run
– Can we make required payments as they fall due?

2. Long-Term Solvency ratios (Financial leverage)

– Show how heavily the company is in debt
– Do we have the right mix of debt and equity?

3. Asset management ratios (Turnover / Efficiency)

– Measure how productively the firm is using its assets
– Do we have the right amount of assets for the level of
sales?

58
 The 5 Major Categories of Ratios
3. Profitability ratios
– Measure the firm’s return on its investments
– Do sales prices exceed unit costs, and are sales high
enough as reflected in PM, ROE, and ROA?

4. Market value ratios

– Provides indications on the firm’s prospects and how
the market values the firm
– Do investors like what they see as reflected in Price-
Earning (P/E) and Market-to-Book (M/B) ratios?

59
Example: D’Leon’s Financial Statements
Balance Sheet: Assets
2019 2018
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
60
Example: D’Leon’s Financial Statements
Balance Sheet: Liabilities and Stockholder’s Equity
2019 2018
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
61
Example: D’Leon’s Financial Statements
Income Statement
2019 2018
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
62
Example: D’Leon’s Financial Statements
Additional Data

2019 2018
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price
$12.17 $2.25

63
 1. Liquidity ratios
• Liquidity is the ability to convert assets to cash
quickly without a significant loss in value
• Liquidity ratios indicate a firm’s ability to meet its
maturing short-term obligations

Is high liquidity always good?

Kirk Kerkorian’s takeover bid for Chrysler in April, 1995, is an
example of investor dissatisfaction with excess liquidity. At the
time, Chrysler’s management had accumulated $7.3 billion in
cash and marketable securities as a cushion against an
economic downturn. Mr. Kerkorian instigated a takeover bid
because Chrysler’s management refused to pay this cash to
stockholders.
64
Example: US Companies’ Cash Pile hits $1.7tn
Five US tech giants are hoarding more than half a trillion dollars, a
record sum that underscores how cash has become increasingly
concentrated at a handful of groups seeking to avoid a tax hit.
Apple, Microsoft, Alphabet, Cisco and Oracle had amassed $504bn
of cash by the end of 2015, nearly a third of the total $1.7tn held on the
balance sheets of US non-financial companies, according to a new
report from rating agency Moody’s.

The ever increasing amount of cash also highlights how US boardrooms

are reticent to invest in their businesses, choosing instead to increase
dividends, in a sign of the continued anxiety that economic activity
could still slow at home or in China.

The failure of companies to invest their cash pile has frustrated investors who say
companies are not ploughing enough back into their underlying businesses, in research
and development, to reinvigorate sales.
65
- Financial Times, 20 May 2016
D’Leon’s Current & Quick Ratios for 2019
Current ratio = Current assets / Current liabilities
= $2,680 / $1,145 = 2.34x

Quick Ratio = (CA – Inventory) / CL

= ($2,680 - $1,716)/$1,145 = 0.84x

2019 2018 2017 Ind.

Current Ratio 2.34x 1.20x 2.30x 2.70x
Quick Ratio 0.84x 0.39x 0.94x 1.28x

• Seemingly improving but still below the industry average

• Liquidity position is weak
66
 Other Liquidity Ratios
• Cash Ratio = Cash / CL
= 86/1,145 = 0.075x

• NWC to Total Assets = NWC / TA

= (2,680 – 1,145) / 3,497
= 0.439x
• Interval Measure = CA / avg. daily operating costs
= 2,680 / ((5,876 + 550)/365)
= 152.2 days
67
 2. Long-term Solvency
Also known as financial leverage ratios
Financial leverage relates to the extent that a firm relies on debt
financing rather than equity.
– Generally, the more debt a firm has, the more likely it is the firm will
become unable to fulfill its contractual obligations.

Total Debt Ratio = Total Debt / Total Assets

Variations
• Debt/Equity Ratio = (total assets – total equity) / total equity
• Equity Multiplier = total assets/total equity = 1 + debt/equity ratio
• Long-Term Debt Ratio = long-term debt / (long-term debt + total equity)

Coverage ratios:
• Times Interest Earned Ratio = EBIT / interest
• Cash Coverage Ratio = (EBIT + depreciation) / interest 68
D’Leon’s Long-Term Solvency Ratios
Total Debt Ratio = Total debt / Total assets
= ($1,145 + $400) / $3,497
= 0.442 or 44.2%

Times Interest Earned = EBIT / Interest expense

= $492.6 / $70 = 7.0x

2019 2018 2017 Ind.

D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
• At this point, D/A and TIE appear to be better than the industry
average.
69
 3. Asset Management Ratios
Also known as activity ratios
They measure how effectively the firm’s assets are being
managed
• Inventory ratios measure how quickly inventory is produced
and sold
• Receivable ratios provide information on the success of the
firm in managing its collection from credit customers
• Fixed asset and total asset turnover ratios show how
effective the firm is in using its assets to generate sales

70
 D’Leon’s Inventory turnover for 2019
Inventory Turnover = COGS / Inventory = $5,876/$1,716 = 3.42x

2019 2018 2017 Ind.

Inventory Turnover 3.42x 4.30x 4.51x 4.82x

• Inventory turnover below industry average. D’Leon might

have old inventory, or its control might be poor.
Days’ Sales in Inventory = 365 / Inventory Turnover
= 365/3.42 = 106.7 days

2019 2018 2017 Ind.

Days’ Sales in 106.7 84.9 80.9 75.7
Inventory days days days days
71
D’Leon’s Receivables Turnover for 2019
Rec. turnover = Sales / Receivables
= $7,036 / $878 = 8.01x sales

2019 2018 2017 Ind.

Receivables Turnover 8.01x 9.55x 9.76x 11.4x
Days Sales Outstanding or Account Receivable Days or Average
Collection Period: the average number of days after making a sale
before receiving cash
Accounts Receivable
DSO =
Average Daily Sales = Sales / 365
or
DSO = 365 / Receivables Turnover
72
D’Leon’s Days Sales Outstanding for 2019
DSO = Accounts Receivable / Average Daily Sales
= Accounts Receivable / Sales/365
= $878 / ($7,036/365)
= $878 / $19.277
= 45.6 days

2019 2018 2017 Ind.

DSO 45.6 38.2 37.4 32.0

• D’Leon collects on sales too slowly, and this is getting

worse.
• D’Leon has a poor credit policy.
73
 D’Leon’s Fixed Asset and
Total Asset Turnover Ratios for 2019
FA Turnover = Sales / Net fixed assets
= $7,036 / $817 = 8.61x

TA Turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

2019 2018 2017 Ind.

FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x

• FA turnover exceeded the industry average in 2019

• TA turnover below the industry average. Caused by excessive
currents assets (A/R and Inv)
74
 4. Profitability
Measure how successfully a business earns a return on its investment
Show the combined effects of liquidity, asset management, and debts on
operating results
• Profit margin = Net income / Sales = $253.6 / $7,036 = 3.6%
• BEP (Basic Earning Power) = EBIT/Total assets = $492.6 /$3,497 =
14.1%
BEP removes the effects of taxes and financial leverage. It is useful for
comparison
2019 2018 2017 Ind.
PM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%
• Profit margin improving.
• BEP has improved substantially, but still below the industry average.
Room for improvement. 75
 Other Profitability Ratios
Return on Assets
ROA = Net income / Total assets = $253.6 / $3,497 = 7.3%
Return on Equity
ROE = Net income* / Total common equity = $253.6 / $1,952 =
13.0%
*If there is preferred dividend, you should deduct it from net income

2019 2018 2017 Ind.

ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%
• Both ratios rebounded from the previous year, but are still below the
industry average. More improvement needed.
• Wide variations in ROE illustrate the effect that leverage can have on
profitability. 76
 Effects of Debt on ROA and ROE
• ROA is lowered by debt
– Interest expense lowers net income, which also lowers ROA
• However, the use of debt lowers equity, and if equity is lowered more
than net income, ROE would increase
Problems with ROE
• ROE and shareholder wealth are correlated, but problems can arise
when ROE is the sole measure of performance
– ROE does not consider risk
– ROE does not consider the amount of capital invested
– Might encourage managers to make investment decisions that do not
benefit shareholders
• ROE focuses only on return. It is better to have measures that consider
both risk and return.
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 5. Market Value Ratios
A set of ratios that relate the firm’s stock price to its earnings, cash flows
and book value per share
1. P/E: How much investors are willing to pay for $1 of earnings.
2. M/B: How much investors are willing to pay for $1 of book value
equity.
For each ratio, in general, the higher the number, the better.

• P/E = Price / Earnings per share = $12.17 / $1.014 = 12.0x

• M/B = Mkt price per share / Book value per share
= $12.17 / ($1,952 / 250) = 1.56x Book value of equity

2019 2018 2017 Ind.

P/E 12.0x -1.4x 9.7x 14.2x
M/B 1.56x 0.5x 1.3x 2.4x 78
 The Dupont System
• Some profitability and efficiency measures can be linked
in useful ways
• These relationships are often referred to as the Du Pont
system in recognition of the chemical company that
popularized them

79
 Deriving the extended Du Pont
• Identity
ROE = NI
TE
• Multiply by TA/TA (= 1) and then rearrange
NI TA
• ROE = X
TE TA
NI TA
• ROE = X = ROA * EM
TA TE

• Multiply by Sales/Sales (=1) and then rearrange

NI TA Sales
• ROE = X X
TA TE Sales
NI Sales TA
• ROE = X X
Sales TA TE
ROE = PM * TA TO * EM 80
The Three Ratios of the Dupont Identity

ROE = PM * TA TO * EM
1. Profit margin (PM) is a measure of the firm’s operating
efficiency – how well does it control costs
2. Total asset turnover (TA TO) is a measure of the firm’s
asset use efficiency – how well does it manage its
assets
3. Equity multiplier (EM) is a measure of the firm’s financial
leverage

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 D’Leon’s Extended DuPont Equation:
Return on Equity
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)
= 3.6% x 2 x 1.8
= 13.0%

PM TA TO EM ROE
2017 2.6% 2.3 2.2 13.3%
2018 -2.7% 2.1 5.8 -32.5%
2019 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
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Ratio Analysis: Potential Problems/ Limitations
• Comparison with industry averages is difficult if the firm operates
many different divisions (a diversified firm).
• “Average” performance is not necessarily good. Use the leader’s?
• Seasonal factors can distort ratios.
• Window dressing techniques can make statements and ratios look
better.
• Different accounting and operating practices can distort comparisons.
• Sometimes it is difficult to tell if a ratio value is “good” or “bad.”
• Often, different ratios give different signals, so it is difficult to tell, on
balance, whether a company is in a strong or weak financial
condition.

83
 Some Qualitative Factors
Analysts should also consider the followings when
evaluating a company’s likely future financial performance:
• Are the company’s revenues tied to a single customer?
• To what extent are the company’s revenues tied to a single
product?
• To what extent does the company rely on a single supplier?
• What percentage of the company’s business is generated
overseas?
• What is the competitive situation?
• What is the company’s legal and regulatory environment?

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 Summary
Financial Statements are used for:
1. Credit Decisions
2. Risk Analysis
3. Financial Distress Prediction
4. Management Evaluations
5. Investment Selection

Du Pont Identity: ROE = PM * TA TO * EM

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