Transcript Chapter 3 Working with Financial Statements
Chapter 3
Working with Financial Statements
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
Chapter Outline Standardized Financial Statements Ratio Analysis The Du Pont Identity
Who needs to understand ratios?
Managers Use ratios to evaluate various aspects of the firm Profitability Productivity Marketers Use ratios dealing with costs, markups, and margins Production personnel Use ratios that deal with issues such as operating efficiency
Standardized Financial Statements Common-size statement: a standardized financial statement presenting all items in percentage terms Common-size Balance Sheet Balance sheet items shown as a percentage of total assets Common-size Income Statement Income statement items shown as a percentage of total sales
Standardized Financial Statements (continued) Standardized statements make it easier to compare financial information Standardized statements are useful for comparing companies of different sizes, especially within the same industry
Ratio Analysis
Financial ratios: Relationships determined from a firm’s financial information and used for comparison purposes Ratios allow for comparison over time or between firms Ratios are used both internally and externally
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
Analyzing ratios
Questions to ask when analyzing ratios: How is the ratio computed?
What does the ratio measure? Why do we care?
What is the unit of measurement?
What does a high/low value tell us? How might such values be misleading?
How could this measure be improved?
Short-term Solvency/Liquidity Ratios Current Ratio Formula What does it measure?
Quick (Acid Test) Ratio Formula What does it measure?
Short-term Solvency/Liquidity Ratios (continued) Cash ratio Formula What does it measure?
Financial Leverage Ratios
Total Debt Ratio Formula What does it measure?
Debt/Equity Ratio Formula What does it measure?
Financial Leverage Ratios (continued)
Equity Multiplier Formula What does it measure?
Coverage Ratios
Times Interest Earned ratio Formula What does it measure?
Cash Coverage ratio Formula What does it measure?
Inventory Ratios
Inventory Turnover ratio Formula What does it measure?
Days’ Sales in Inventory Formula What does it measure?
Receivables ratios
Receivables Turnover Formula What does it measure?
Days’ Sales in Receivables Formula What does it measure?
Total Asset Turnover
Total Asset Turnover ratio Formula Measures asset use efficiency It is not unusual for total asset turnover to be less than one, especially if the firm has a large amount of fixed assets
Profitability Ratios
Profitability ratios are the best known and most widely used of all financial ratios Profit Margin Formula What does it measure?
Profitability Ratios (continued)
Return On Assets (ROA) Formula What does it measure?
Return On Equity (ROE) Formula What does it measure?
Budweiser
Profit margin 12.23% ROA 12.31% ROE 61.19%
YUM!
Profit Margin 8.63% ROA 12.79% ROE 51.19%
GOOGLE!
Profit margin 23.87% ROA 21.24% ROE 23.74%
Market Value Measures
Earnings per share Net income/number of shares outstanding $200,000 NI/100,000 shares = $2.00 earnings per share Price to earnings (PE) ratio Measures how much investors are willing to pay per dollar of current earnings Higher PE ratios are often interpreted to mean that the firm has significant prospects for future growth
Market Value Measures
Price per share/Earnings per share $20 price per share/$2.00 earnings per share = PE ratio of 10
Market Value Measures (continued) Market-to-book ratio Compares the market value of the firm’s investments to their cost Market value per share/book value per share
The Du Pont Formula
The Du Pont formula is named after the Du Pont Corporation, which popularized its use Allows us to break down ROE into its three basic components Profit margin, a measure of the firm’s operating efficiency Total asset turnover, a measure of how well the firm manages its assets Equity multiplier, a measure of the firm’s financial leverage
The Du Pont Formula (continued) Du Pont Formula Profit margin x total asset turnover x equity multiplier ROE = PM x TAT x EM If ROE is unsatisfactory, Du Pont tells the financial manager where to start looking for the reasons why
QUIZ
Why is it necessary to standardize financial statements?
How are common-size balance sheets and common-size income statements formed?
What are the five groups of ratios?
Profitability ratios all have the same figure in the numerator. What is it? What do the profitability ratios measure?
QUIZ (continued)
What two ratios can be computed if you are given the total debt ratio?
ROA is the product of what two ratios?
ROE is the product of what three ratios?