Chapter 3

1. Chapter 3 • Working With Financial Statements

2. Key Concepts and Skills • Know how to standardize financial statements for comparison purposes • Know how to compute and interpret important financial ratios • Know the determinants of a firm’s profitability and growth • Understand the problems and pitfalls in financial statement analysis

3. Cash Flow and Financial Statement • Sources and Uses of Cash The statement of cash flow or sources and uses of cash reflects an enterprise’s major sources of cash receipts and cash payment. -Activities that bring cash in are sources. Firms raise cash by selling assets, borrowing money or selling securities. -Activities that involve cash outflows are uses. Firms use cash to buy assets, pay off debt, repurchase stock or pay dividends.

4. Mechanical Rules for Determining Sources and Uses • Sources: Decrease in asset account Increase in liabilities or equity account • Uses: Increase in asset account Decrease in liabilities or equity account

6. Sources of cash: Increase in accounts payable $32 Increase in common stock 50 Increase in retained earnings 242 Total sources $324 Uses of cash: Increase in accounts receivable $23 Increase in inventory 29 Decrease in notes payable 35 Decrease in long term debt 74 Net fixed assets acquisitions 149 Total uses $310 Net additional cash 14

7. The Statement of Cash Flows Provides a summary of cash flows over the period concerned, typically the year just ended. Sometimes call sources and uses statement. The idea is to group cash flows into one of three categories: operating activities, investing activities, and financing activities.

10. Standardized Financial Statement • 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. Common-size statements Useful in comparison of unequal size: Common-size balance sheet: express each account as a percentage of total assets. Common-size income statement: express each item as a percentage of sales.

13. Ratio Analysis Financial ratios are traditionally grouped into the following categories: 1. Short-term solvency or liquidity ratios. 2. Long-term solvency or financial leverage ratios. 3. Asset management or turnover, ratios. 4. Profitability ratios. 5. Market value ratios.

14. Short-Term Solvency or Liquidity Ratios • Current Ratio Measures short-term liquidity, the ability of a firm to meet need for cash they arise. • To a creditor, particularly a short-term creditor such as a supplier, the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets.

15. Quick Ratio Measures short-term liquidity more rigorously than current ratio by eliminating inventory, generally the least liquid current asset. The quick ratio here tells a somewhat different story than the current ratio, because inventory accounts for more than half of Prufrock's current assets. To exaggerate the point, if this inventory consisted of, say, unsold nuclear power plants, then this would be a cause for concern.

16. Long-Term Solvency Measures • Total Debt Ratio Measures the prudence of the firm’s debt management policies. Prufrock has $.28 in debt for every $1 in assets. Therefore, there is $.72 in equity ($1 - .28) for every $.28 in debt. With this in mind, we can define two useful variations on the total debt ratio, the debt-equity ratio and the equity multiplier:

18. Time Interest Earned Ratio Measures how many times interest expense is covered by operating earnings. • Cash Coverage Ratio • Measures how many times interest expense is covered by cash available.

19. Asset Management, or Turnover, Measures • Inventory Turnover Measures efficiency of the firm in managing and selling inventory. In a sense, we sold off, or turned over, the entire inventory 3.2 times. As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we are managing inventory.

20. If we know that we turned our inventory over 3.2 times during the year, then we can immediately figure out how long it took us to turn it over on average. The result is the average days' sales in inventory: • Day’s Sales in Inventory Measures how long the inventory sells in the average term. This tells us that, roughly speaking, inventory sits 114 days on average before it is sold. Alternatively, assuming we used the most recent inventory and cost figures, it will take about 114 days to work off our current inventory.

21. Receivables Turnover Indicates how many times receivables are collected during a year on average. Loosely speaking, we collected our outstanding credit accounts and reloaned the money 12.3 times during the year. This ratio makes more sense if we convert it to days, so the days' sales in receivables is:

22. Days’ Sales in Receivable or Average Collection Period Indicates how many day receivables are collected on average. Therefore, on average, we collect on our credit sales in 30 days. For obvious reasons, this ratio is very frequently called the average collection period (ACP).

23. Asset Turnover Ratios • NWC Turnover This ratio measures how much work we get out of our working capital. NWC Turnover = Sales / NWC = 2,311/ (708 -540) = 13.8 times • Fixed Asset Turnover Measures efficiency of the firm in managing fixed assets.

24. Fixed Asset Turnover = Sales / Fixed Assets = 2,311 / 2,880 = 0.80 times • Total Asset Turnover Measures efficiency of the firm in managing all assets.

25. 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 Measures profit generated after consideration of all expenses and revenues. This tells us that Prufrock, in an accounting sense, generates a little less than 16 cents in profit for every dollar in sales.

26. Return on Assets Measures overall efficiency firm in managing assets and generate profits. • Return on Equity • Measures rate of return on common stockholders’ (owners) investment.

27. Market Value Measures Earning per share shows about net income for one share. We assume that Prufrock has 33 million shares outstanding and the stock sold for $88 per share at the end of the year. • Price-earning Ratio • Price earning ratio measures the price of the share in market to net income per share.

28. Market-to-Book Ratio • It shows about the stock price in the market to stock price in the book.

29. The Du Pont Identity • The Du Pont Identity provides a way to breakdown ROE and it is popular expression breaking ROE into three parts: 1. Operating efficiency (as measured by profit margin) 2. Asset use efficiency ( as measured by total asset turnover) 3. Financial leverage ( as measured by the equity multiplier) efficiency, and financial leverage.

31. 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.

32. Common Financial Ratios

33. End of Chapter 3

34. 1-The Hooya Company has a long-term debt ratio (i.e. the ratio of long-term debt to long-term debt plus equity) of 0.60 and a current ratio of 1.3. Current liabilities are $900, sales are $6,590, profit margin is 9 percent, and ROE is 16 percent. What is the amount of the firm's net fixed assets? 2-Kaleb's Karate Supply had a profit margin of 9 percent, sales of $17 million, and total assets of $7 million. What was t0tal asset turnover? If management set a goal of increasing total asset turnover to 2.75 times, what would the new sales figure need to be, assuming no increase in total assets?