Chapter 3

I. Sample Statement of Cash Flows

Operating Activities
+ Net Income
+ Depreciation
+ Decrease in current asset accounts (except cash)
+ Increase in current liability accounts (except notes payable)
- Increase in current asset accounts (except cash)
- Decrease in current liability accounts (except notes payable)

Investment Activities
+ Ending net fixed assets
- Beginning net fixed assets
+ Depreciation

Financing Activities
± Change in notes payable
± Change in long-term debt
± Change in common stock
- Dividends

Putting it all together:

± Net cash flow from operating activities

± Fixed asset acquisition
± Net cash flow from financing activities
= Net increase (decrease) in cash over the period

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II. Categories of Financial Ratios

A. Short-term solvency, or liquidity, ratios:

The ability to pay bills in the short-run

B. Long-term solvency, or financial leverage, ratios:

The ability to meet long-term obligations

C. Asset management, or turnover, ratios:

Efficiency of asset use

D. Profitability ratios:
Efficiency of operations and how that translates to the “bottom line”

E. Market value of ratios:

How the market values the firm relative to the book values

A. Short-term Solvency, or Liquidity, Ratios

Current Ratio = current assets / current liabilities

Quick Ratio = (current assets – inventory) / current liabilities

Cash Ratio = cash / current liabilities

NWC to TA = (current assets – current liabilities) / total assets

Interval Measure = current assets / average daily operating costs

Note that average daily operating costs generally exclude depreciation

expense (since it is not a cash expense) and interest expense (since it is not
an operating expense).

B. Long-Term Solvency Measures

Total debt ratio = (total assets – total equity) / total assets

variations:
debt/equity ratio = (total assets – total equity) / total equity
equity multiplier = 1 + debt/equity ratio

Long-term debt ratio = long-term debt / (long-term debt + total equity)

Times interest earned ratio = EBIT / interest

Cash coverage ratio = (EBIT + depreciation) / interest

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C. Asset Management, or Turnover, Measures

Inventory turnover = cost of goods sold / inventory

Days’ sales in inventory = 365 days / inventory turnover

Receivables turnover = sales / accounts receivable

Days’ sales in receivables = 365 days / receivables turnover

This ratio may also be called “average collection period” or “days’
sales outstanding.”

Total asset turnover = sales / total assets

Net working capital turnover = sales / (current assets – current liabilities)

Net fixed asset turnover = sales / net fixed assets

D. Profitability Measures

These measures are based on book values, so they are not comparable with
returns that you see on publicly traded assets.

Profit margin = net income / sales

Return on assets = net income / total assets

Return on equity = net income / total equity

E. Market Value Measures

Earnings per share = net income / shares outstanding

Price-earnings ratio = price per share / earnings per share

Market-to-book ratio = market value per share / book value per share

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III. Du Pont Identity

ROE = (NI / total equity)

multiply by one (assets / assets) and rearrange

ROE = (NI / assets) (assets / total equity) = ROA*EM

multiply by one (sales / sales) and rearrange

ROE = (NI / sales) (sales / assets) (assets / total equity)
ROE = PM*TAT*EM