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

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 CHAPTER OUTLINE
• Cash Flow and Financial Statements: A Closer
Look

• Standardized Financial Statements

• Ratio Analysis

• The Du Pont Identity

• Using Financial Statement Information

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 SAMPLE BALANCE SHEET

2015 2014 2015 2014

Cash 696 58 A/P 307 303

A/R 956 992 N/P 26 119

Inventory 301 361 Other CL 1,662 1,353

Other CA 303 264 Total CL 1,995 1,775
Total CA 2,256 1,675 LT Debt 843 1,091

Net FA 3,138 3,358 C/S 2,556 2,167

Total 5,394 5,033 Total Liab. 5,394 5,033

Assets & Equity

Numbers in millions of dollars

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SAMPLE INCOME STATEMENT
Revenues 5,000
Cost of Goods Sold (2,006)
Expenses (1,740)
Depreciation (116)
EBIT 1,138
Interest Expense (7)
Taxable Income 1,131
Taxes (442)
Net Income 689
EPS 3.61
Dividends per share 1.08

Numbers in millions of dollars, except EPS & DPS

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SOURCES AND USES OF CASH
• Sources
 Cash inflow – occurs when we “sell” something
 Decrease in asset account (Sample B/S)
• Accounts receivable, inventory, and net fixed assets
 Increase in liability or equity account
• Accounts payable, other current liabilities, and common stock

• Uses
 Cash outflow – occurs when we “buy” something
 Increase in asset account
• Cash and other current assets
 Decrease in liability or equity account
• Notes payable and long-term debt

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 STATEMENT OF CASH FLOWS

• Statement that summarizes the sources and uses of

cash

• Changes divided into three major categories

 Operating Activity – includes net income and changes
in most current accounts
 Investment Activity – includes changes in fixed assets
 Financing Activity – includes changes in notes
payable, long-term debt, and equity accounts, as well
as dividends

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SAMPLE STATEMENT OF CASH
FLOWS
Cash, beginning of year 58 Financing Activity

Operating Activity Decrease in Notes Payable -93

Net Income 689 Decrease in LT Debt -248

Plus: Depreciation 116 Decrease in C/S (minus RE) -94

Decrease in A/R 36 Dividends Paid -206

Decrease in Inventory 60 Net Cash from Financing -641
Increase in A/P 4
Increase in Other CL 309 Net Increase in Cash 638
Less: Increase in other CA -39
Net Cash from Operations 1,175 Cash End of Year 696

Investment Activity
Sale of Fixed Assets 104
Net Cash from Investments 104

Numbers in millions of dollars

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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

• 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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 RATIO ANALYSIS

• Ratios 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 that
information is important

• Ratios are used both internally and externally

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 CATEGORIES OF
FINANCIAL RATIOS
• Short-term solvency or liquidity ratios

• Long-term solvency or financial leverage ratios

• Asset management or turnover ratios

• Profitability ratios

• Market value ratios

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COMPUTING LIQUIDITY RATIOS
• Current Ratio = CA / CL
B/S
 2,256 / 1,995 = 1.13 times
I/S
• Quick Ratio = (CA – Inventory) / CL
 (2,256 – 301) / 1,995 = .98 times
• Cash Ratio = Cash / CL
 696 / 1,995 = .35 times

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 COMPUTING LONG-TERM
SOLVENCY RATIOS

• Debt Ratio = TD / TE
 (5,394 – 2,556) / 2,556 = 1.11 times

• Equity Multiplier = TA / TE = 1 + D/E

 1 + 1.11 = 2.11

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 COMPUTING COVERAGE RATIOS

B/S
• Times Interest Earned = EBIT / Interest I/S
 1,138 / 7 = 162.57 times

• Cash Coverage = (EBIT + Depreciation) / Interest

 (1,138 + 116) / 7 = 179.14 times

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 COMPUTING INVENTORY RATIOS

• Inventory Turnover = Cost of Goods Sold / Inventory

 2,006 / 301 = 6.66 times

• Days’ Sales in Inventory = 365 / Inventory Turnover

 365 / 6.66 = 55 days

B/S
I/S

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 COMPUTING
RECEIVABLES RATIOS
• Receivables Turnover = Sales / B/S
Accounts Receivable I/S
 5,000 / 956 = 5.23 times

• Days’ Sales in Receivables =

365 / Receivables Turnover
 365 / 5.23 = 70 days

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 COMPUTING TOTAL
ASSET TURNOVER
• Total Asset Turnover = Sales B/S
/
Total Assets I/S
 5,000 / 5,394 = .93
 It is not unusual for TAT < 1, especially if a firm
has a large amount of fixed assets

• Fixed Asset Turnover = Sales / NFA

 5,000 / 3,138 = 1.59 times

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 COMPUTING PROFITABILITY
MEASURES
B/S
• Profit Margin = Net Income / Sales I/S
 689 / 5,000 = 13.78%

• Return on Assets (ROA) = Net Income / Total Assets

 689 / 5,394 = 12.77%

• Return on Equity (ROE) = Net Income / Total Equity

 689 / 2,556 = 26.96%

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 COMPUTING MARKET VALUE
MEASURES - I
• Market Price = $87.65 per share

• Shares outstanding = 190.9 million

• PE Ratio = Price per share / Earnings per

share
 87.65 / 3.61 = 24.28 times

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DERIVING THE DUPONT IDENTITY
• ROE = NI / TE

• Multiply by 1 (TA/TA) and then rearrange

 ROE = (NI / TE) (TA / TA)
 ROE = (NI / TA) (TA / TE) = ROA * EM

• Multiply by 1 (Sales/Sales) again

and then rearrange
 ROE = (NI / TA) (TA / TE) (Sales / Sales)
 ROE = (NI / Sales) (Sales / TA) (TA / TE)
 ROE = PM * TAT * EM

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 USING THE DUPONT IDENTITY

• ROE = PM * TAT * EM
 Profit margin is a measure of the
firm’s operating efficiency – how well
it controls costs

 Total asset turnover is a measure of

the firm’s asset use efficiency – how well does it manage its assets

 Equity multiplier is a measure of

the firm’s financial leverage

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WHY EVALUATE FINANCIAL
STATEMENTS?
• Internal uses
 Performance evaluation – compensation
and comparison between divisions
 Planning for the future – guide in
estimating future cash flows

• External uses
 Creditors
 Suppliers
 Customers
 Stockholders
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 BENCHMARKING
• Ratios are not very helpful by themselves; they
need to be compared to something

• Time-Trend Analysis
 Used to see how the firm’s performance
is changing through time
 Internal and external uses

• Peer Group Analysis

 Compare to similar companies
or within industries
 SIC and NAICS codes

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 POTENTIAL PROBLEMS
• There is no underlying theory, so there is no way to know
which ratios are most relevant

• Benchmarking is difficult for diversified firms

• Globalization and international competition makes

comparison more difficult because of differences in
accounting regulations

• Varying accounting procedures, i.e. FIFO vs. LIFO

• Different fiscal years

• Extraordinary events

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 CHAPTER 3
END OF CHAPTER

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