Working with Financial Statements Chapter 3

1. Working with Financial StatementsChapter 3 • Financial ratios vary widely across firms and industries. For example, P/E ratios. • What is the ‘right’ P/E ratio for a firm? • What do we learn by comparing financial ratios of different firms? • A key to this chapter is to understand sources and uses of cash and the Statement of Cash Flows • Let’s use an example of a balance sheet, an income statement, and see where cash comes in and out for the statement of cash flows.

2. StandardizedorCommon-SizedFinancial StatementsEasier to Use to Compare Firms 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

3. Given in $ 2017 and 2018 2017 2018 http://www.bartleby.com/198/1.html The Love Song of J. Alfred Prufrock By T.S. Eliot (1914) An American in London just before WW1. First modernist poem of dreary cities, fear, war, and boredom. 8 Minute YouTube: https://www.youtube.com/watch?v=JAO3QTU4PzY

4. 2017 and 2018 2017 2018 Given in % of Total Assets

5. Given in $ 2018

6. Given as % of Sales 2018 Tells us what happened to each dollar of sales. N.I./Sales = 15.7% = Profit Margin

7. RDM CorpBalance Sheet Numbers in millions

8. RDM CorpIncome Statement Numbers in millions, except EPS & DPS

9. Sources andUses Sources • Cash inflow – occurs when we “sell” something • Decrease in asset account • 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

10. Statement of Cash Flows Statement that summarizes the sources and uses of cash 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

11. RDM Corp Statement of Cash Flows Numbers in millions

12. What did this Statement of Cash Flows reveal? • We see cash balances are rising, but why? A firm that is liquidating its inventory would also show this. • Most of the change in cash balances is accounted for by Net Income. This is a good sign. • Much of its income went to reduce its indebtedness. We use statements such as this to analyze and make critical judgments. It is not just to fill them out correctly.

13. Ratios also 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 Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Coverage ratios Inventory ratios Receivable ratios Asset turnover ratios Profitability ratios Market value ratios 8 Categoriesof Financial Ratios Ratio Analysis

14. 1. Liquidity Ratios • Current Ratio = CA / CL • 2,256 / 1,995 = 1.13 times for RDM Corp. • As CA sold over 12 months, we’re liquid • Quick Ratio = (CA – Inventory) / CL • (2,256 – 301) / 1,995 = .98 times or Acid Test • Inventory isn’t always liquid or well valued • Different for Manpower than for Wal-Mart • Cash Ratio = Cash / CL • 696 / 1,995 = .35 times – lots of cash • NWC to Total Assets = NWC / TA • Net Working Capital (2,256 – 1,995) / 5,394 = .05 • Interval Measure = CA /average daily operating costs • 2,256 / ((2,006 + 1,740)/365) = 219.8 days • CA / [ (CGS + SG&A)/365 ] not depreciation. How long can last in bad times.

15. 2. LT Solvency Ratios • Total Debt Ratio = (TA – TE) / TA • (5,394 – 2,556) / 5,394 = 52.61% for RDM Corp • Percentage debt used to finance the firm • Debt/Equity = TD / TE • (5,394 – 2,556) / 2,556 = 1.11 times • Implicit in the Total Debt Ratio it’s about one to one • Equity Multiplier = TA / TE = 1 + D/E • 1 + 1.11 = 2.11 • Assets are 2.11 times equity • Long-term debt ratio = LTD / (LTD + TE) • 843 / (843 + 2,556) = 24.80% • Concentrates on the proportion of LT debt in the firm’s capitalization EM

16. 3. Coverage Ratios • Times Interest Earned = EBIT / Interest • 1,138 / 7 = 162.57 times • Interest is very well covered, tends to show solvency • Cash Coverage = (EBIT + Depreciation) / Interest • (1,138 + 116) / 7 = 179.14 times • EBITD much larger than interest, so interest is easily covered • Note: What is EBITDA?

17. 4. Inventory Ratios • Inventory Turnover = Cost of Goods Sold / Inventory • 2,006 / 301 = 6.66 times • RDM Corp turned over its inventory over 6 times per year • Days’ Sales in Inventory = 365 / Inventory Turnover • 365 / 6.66 = 55 days • Flipped inventory every 55 days

18. 5. Receivables Ratios • Receivables Turnover= Sales / Accounts Receivable • 5,000 / 956 = 5.23 times • Assumes all RDM Corp sales are credit sales • Days’ Sales in Receivables= 365 / Receivables Turnover • 365 / 5.23 = 70 days • Note that receivables are collected at a longer period than inventory

19. 6. Asset Turnover Ratios TAT • Total Asset Turnover = Sales / Total Assets • 5,000 / 5,394 = .93 for RDM Corp. • It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets • A dollar of TA generated $.93 of sales • NWC Turnover = Sales / NWC • 5,000 / (2,256 – 1,995) = 19.16 times • The bigger the better, as NWC often has lower returns than other assets • Fixed Asset Turnover = Sales / NFA • 5,000 / 3,138 = 1.59 times

20. 7. Profitability Measures All of These PM • Profit Margin = Net Income / Sales • 689 / 5,000 = 13.78% or • RDM Corp earned about 14 cents on a dollar of sales • 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%

21. 8. Market Value Measures • 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 • Market-to-book ratio = market value per share / book value per share • 87.65 / (2,556 / 190.9) = 6.55 times

22. Deriving the DuPont Identity • ROE = NI / TE or net income / total equity • 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 ROE = Profit Margin * Total Asset Turnover * Equity Multiplier

23. Using the DuPont Identity ROE = PM * TAT * EM • Profit marginis a measure of the firm’s operating efficiency – how well it controls costs • Total asset turnoveris a measure of the firm’s asset use efficiency – how well does it manage its assets • Equity multiplieris a measure of the firm’s financial leverage Whenever ROE declines, we can uncover the source of the problem!

24. Problems • XYZ Corporation has the following financial information for the previous year: Sales: $8M, PM = 8%, CA = $2M, FA = $6M, NWC = $1M, LTD = $3M Compute the ROE using DuPont Analysis. HINT: ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = ( ) ( ) ( ) = • Aunt Fran has a $2,000 knitting machine and sells 20 sweaters a year at $50 each. She has no debt on her machine. Her profit margin on a sweater is 50%. What is the ROE for Aunt Fran’s sweaters using the DuPont Identity? What actions could help her increase that ROE?

25. Answers: Don’t Look Yet 1. Total assets = CA + FA = $2M + $6M = $8M; so TAT = Sales / TA = $8M / $8M = 1; also NWC = CA – CL so CL= CA – NWC = $2M - $1M = $1M Total liabs. = CL + LTD = $1M + $3M = $4M; Total equity = total assets – total liabs. = $8M - $4M = $4M; EM = assets / equity = $8M / $4M = 2 THEREFORE: ROE = PM X TAT X EM = 8% X 1 X 2 = 16%; or Without using DuPont, ROE = NI / total equity = PM * sales / total equity = 8% X $8M / 4M = 16%. 2. .5 (or PM) * 1,000/2,000 ( or TAT) * 1 (or EM) = .25 = 25%

26. Why Do We 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

27. Benchmarking other firms • Ratios are not very helpful by themselves; they need to be compared to somethingelse. 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 and Industry Center http://biz.yahoo.com/ic/http://www.naics.com/search.htm

28. Problems with Financial Ratios • There is no real underlying theory, so there is no way to know which ratios are most relevant – more an art than a science • 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

29. Quick Quiz • What is the Statement of Cash Flows and how do you determine sources and uses of cash? • How do you standardize balance sheets and income statements and why is standardization useful? • Name a liquidity ratio? How is it measured? • Name a profitability ratio? How measured? • What are some of the problems associated with financial statement analysis? • Do you have to memorize every ratio?