Ch.
3 Working with financial
statements
1. The statement of cash flows: a firm’s financial
statement that summarizes its sources and uses of
cash over a specific period.
In order to evaluate cash flows, we have to understand
the sources of cash (cash in) and uses of cash (cash
out).
In the balance sheet, the increase (decrease) in assets
means cash out (cash in) whereas increase (decrease)
in liabilities and equities means cash in (cash out).
Cash, beginning of the year
Operating activity
Net income
Depreciation
Increase in account payable
Increase in account recievable
Increase in inventory
Net cash from operating activities
Investment activity
Fixed asset acquisitions
Net cash from investment activity
Financing activity
Decrease in note payable
Decrease in long term debt
Dividend paid
Increase in common stock
Net cash from financing activity
Net increase in cash
Cash, end of year
Another form of cash flow statement
Cash, beginning of the year
Source of Cash
Operation
Net Income
Depreciation
Working capital:
Increase in accounts payable
Long term financing:
Increase in common stock
Total sources of cash
Uses of Cash
Working capital:
Increase in accounts receivable
Increase in inventory
Decrease in notes payable
Long term financing:
Decrease in long term debt
Fixed asset acquisition
Dividends paid
Total uses of cash
Net addition to cash
Cash, end of year
2. Standardized financial statements
• In order to compare companies’ financial statements without
size or scale issues.
• Also standardized financial statements can be used for trend
analysis.
1) Common size statement.
• Items in balance sheet are expressed by the percentage of asset.
• Items in income statement are expressed by the percentage of
sale.
• Items in cash flow statement are expressed by the percentage of
total sources of cash supplied or as the percentage of total uses
of cash for a particular item.
2) Common-base year financial statement: trend
analysis
• A standardized financial statement presenting
all items relative to a certain base year
amount.
3) Combined common-size and base year
analysis. Common-base year financial statement
is influenced by size of asset.
3. Ratio analysis: Here ratios commonly used are
introduced.
Five categories of ratios (Table 3.8):
• - short term solvency or liquidity ratios
• - long term solvency or financial leverage ratios
• - asset management ratios or turnover
• - profitability ratios
• - market value ratios
3-1) Short term solvency or Liquidity ratio
Information regarding firm’s ability to pay its bills over the
short run without undue stress.
• Current ratio = current assets/current liabilities
• Quick (Acid test) ratio = (current asset –inventory)/
current liabilities.
• Cash ratio = cash/current liabilities
• Net working capital to total assets = net working capital /
total assets
• Interval measure (how long business could keep running)
= current assets/average daily operating costs
3-2) long term solvency or financial leverage
Information regarding firm’s long term ability to
meet its financial obligations.
• Total debt ratio =(total assets – total
equity)/total assets
• Debt to equity ratio = total debts /total equity
• Equity multiplier = total assets/total equity
• Time interest earned = EBIT/interest
• Cash coverage = (EBIT + depreciation)/ Interest
3-3) Asset management
• How effectively and intensively the firm use assets to
generate sales.
• Inventory turnover = Cost of goods sold/ inventory
• - how many times inventory was filled and empty?
• Days’ sales in inventory = 365/Inventory turn over
• - how many days it takes to reload inventory?
• Receivable turnover =sale/account receivable
• - how many times firm collected its outstanding credit and
reloaned it?
• Days’ sales in receivables = 365/ Receivable
turnover
• - how many days it takes to collect account
receivable
• Net working capital turnover = sales/ NWC
• Fixed asset turnover = sales/fixed assets
• Total asset turnover = sales/total asset
turnover
3-4) Profitability measures
• Profit margin = net income/sales
• Return on assets = net income/total assets
• Return on equity = net income/total equity
3-5) Market value measures
Information regarding market value
• Earnings per share = Net income / shares outstanding
• Price –Earnings per share (PE ratio) = price per share/ Earnings per
share. It relates to growth potential of the firm.
• Price –sales ratio = price per share /sales per share. It is used when
EPS is negative.
• Market to book ratio = market value per share / book value per share.
Here book value = total equity.
4. Du Pont Identity
• Decomposing ROE into three components.
• ROE = net income/total equity
• = net income / total asset * total asset/total equity
• = net income/total asset * Equity multiplier
• = net income / total asset * (1+ debt to equity
ratio)
• = net income/sales * sales/total asset * equity
multiplier
• = profit margin * asset turnover * equity multiplier
5. Why evaluate financial statements?
• Internal uses: performance evaluation and
planning for future.
• External uses: information for deciding
whether to grant credit to a new customer,
Evaluating major competitors, and information
for evaluating potential target firms in merger
attempts.
6. Choosing benchmarks.
1) Time trend analysis: evaluate its own historical ratios in order to
understand whether they improve.
2) Peer group analysis: SIC (standard industry classification) code. But
SIC code is not perfect due to firms with various sub-businesses.
Table 3.10. NAICS (North American Industry Classification System) is
intended to replace SIC.
3) Problems with Financial Statement Analysis
• - no guideline for value and risk
• - consolidated financial statements do not fit any neat industry
category.
• - peer group or major competitors from foreign markets.
• - different accounting and fiscal times for each firm.
