Lecture 2

REVIEWING FINANCIAL
STATEMENTS
- CHAPTER 2 M: Finance 3rd Edition
Cornett, Adair, and Nofsinger
Copyright 2016 by McGraw-Hill Education. All rights reserved.

Introduction
Annual report provides 4 basic financial

statements :
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Retained Earnings

Financial statements give an accounting-

based picture of financial position of a

firm.

Introduction (cont.)
Accountants use financial statements

to show the picture of past financial

performance of a firm.
Finance professionals use financial
statements to draw future inferences
about the firm.

Balance Sheet
Reports firms assets, liabilities and equity

at a point in time.
Assets = Liabilities + Equity
Assets : shown in order of liquidity left

side
Liabilities : shown in order of maturity right
side
Equity listed last never matures

Table 2.1 Balance Sheet for DPH

Assets = Liabilities + Equity

Assets
Current Assets
Normally convert into cash within a year.

Cash (and marketable securities)

Accounts Receivable
Inventory

Assets
Fixed Assets
Useful life exceeding one year.

Physical (tangible) assets (e.g. net plant and

equipment)
Less tangible, long-term assets (e.g. patents
and trademarks)

Liabilities
Liabilities are loans to the firm
Current Liabilities
Obligations due within a year.
Accruals (accrued wages and accrued taxes)
Accounts Payable
Notes Payable

Long-term Debt
Long-term loans and bonds have maturities greater
than one year.

Equity
Firms Total Assets minus Total Liabilities.
Types of Equity :
Preferred Stock
Hybrid security characteristics of both long-term debt and

common stock.
Common Stock and Paid-in-Surplus
Fundamental ownership claim in public or private company.

Retained Earnings
Cumulative earnings reinvested not paid as dividends.

Managing the Balance Sheet

Level of net working capital.
Firms liquidity position.
Method for financing firms assets.
Debt Financing vs. Equity Financing.

Difference between firms book value

and true market value.

Net Working Capital

Net Working Capital =
Current assets - Current liabilities
Net working capital : a measure of

firms ability to pay obligations.

Healthy firms have positive net
working capital.

Liquidity
Ability to convert assets into cash at

Fair Market Value (FMV).

Current Assets -- most liquid
Cash, marketable securities, accounts

receivable, and inventory.

Inventory is the least liquid of current assets.

Fixed Assets -- less liquid

Liquidity (cont.)
Liquidity is a double-edged sword.
Risk-Return trade-off.
More liquidity means lower risk.
firm can more easily pay obligations.
But, liquid assets offer low returns. (e.g. cash

offers zero return)

Fixed assets are illiquid but they help generate
revenue and profits.

Debt vs. Equity Financing (Capital Structure)

Financial Leverage = Using debt

securities
Magnifies gains and losses.
Debt holders -- fixed claim on firms cash flows

(interest paid on securities).

Stockholders -- claim on remaining cash flow.

Choice of firms capital structure

represents managements preference

on risk and return.

Book Value vs. Market Value

Book Value (historical cost)
Assets listed on balance sheet at purchase

price.

Market Value
Assets listed at value if sold in todays market.

Income Statement
A record of a firms total earned

revenues and total incurred expenses

over a period of time.
Income statement top line = revenues
Expenses listed below revenues
Bottom line = Revenues - Expenses

Basic Income Statement

Example : DPH Tree Farm Income

Statement

Income/Firm Value Summary Below the

Bottom Line

Income/Firm Value Summary Below the Bottom Line (cont.)

Corporate Income Taxes

Firms are taxed on their earnings.
U.S. tax code determines corporate tax

obligations and it has progressive tax structure.

the larger the income, the higher the taxes

assessed.

Corporate Income Taxes (cont.)

Average Tax Rate
Percentage of each dollar of taxable income

that the firm pays in taxes.

Marginal Tax Rate

Taxes paid for each dollar of firms additional

taxable income.

Statement of Cash Flows

Financial statement that shows firms cash

flows over given period of time.

includes only inflows and outflows of cash and

marketable securities.
excludes transactions with no direct effect on cash
receipts and payments.
Statement of Cash Flow bottom line
Reflects difference between cash sources and uses.
Equals the change in cash on the firms balance
sheet.

Sources and Uses of Cash

Sources and Uses of Cash

Statement of Cash Flows reflects :
Operating Activities
Investing Activities
Financing Activities
Net Change in Cash and Marketable Securities

Example : DPH Tree Farm Statement of

Cash Flows

Cash Flows from Operating Activities

Represents items directly associated

with producing and selling the firms

products.

Cash Flows from Investing Activities

Represents cash flows associated with

buying or selling fixed or other longterm assets.

Reflects the firms investment in fixed
assets.

Cash Flows from Financing Activities

Cash flows from debt and equity

financing transactions. Examples :

Issuing short- or long-term debt
Issuing stock
Using cash to pay dividends
Using cash to pay off debt
Using cash to buy back stock

Net Change in Cash and Marketable

Securities
Statement of Cash Flows bottom line :
Total of cash flows from operating, investing,

and financing activities.

Reconciles to the net change in cash and
marketable securities on the balance sheet over
the period.

Free Cash Flow

Free Cash Flow (cont.)

Operating Cash Flow (OCF)
Generated from operations after necessary

operating expenses and taxes are paid.

Net Operating Profit after Taxes (NOPAT)

Net profit firm earns after taxes but before

financing costs.

Investment in Operating Capital (IOC)

Includes fixed assets, current assets, and

spontaneous current liabilities.

Free Cash Flow (cont.)

Firms with positive Free Cash Flow

(FCF) have funds available for

distribution to investors.
Potential negative FCF implications for
firms :
Experiencing operating or managerial problems.
Investing heavily in operating capital to support

growth.
Note: FCF might be negative while OCF is positive

Statement of Retained Earnings

Shows detailed changes in retained

earnings during the reporting period.

Reconciles net income and dividends
paid with changes in retained earnings
from one period to the next.

Cautions in Interpreting Financial

Statements
GAAP standards required for financial

statements.
Firms can use earnings management
with GAAP accounting rules.
Smooth earnings
Use different depreciation methods

Sarbanes-Oxley Act passed in 2002.

Prevents deceptive accounting and management

practices

ANALYZING FINANCIAL
STATEMENTS
- CHAPTER 3 M: Finance 3rd Edition
Cornett, Adair, and Nofsinger
Copyright 2016 by McGraw-Hill Education. All rights reserved.

Introduction
Uses of Financial Statements
Analyze firm performance.
Develop plans to improve performance.

Ratio Analysis
Calculating and analysing financial ratios to assess firms

performance and to identify actions that could improve

firm performance.
Also used to :
compare to the same firm over time. (Trend

Analysis)
compare to

competitors.

Five Groups of Financial Ratios

Liquidity
Asset Management
Debt Management
Profitability
Market Value

Liquidity Ratios
Relationship between firms current

assets and current liabilities.

Common liquidity ratios :

Current ratio
Quick (or Acid-Test) ratio
Cash ratio

Current Ratio
Broadest liquidity measure.
Measures current assets available to

pay current liabilities.

Quick Ratio
Excludes inventory (which is usually

not very liquid) in the numerator.

Measures a firms ability to pay shortterm obligations without inventory
sales.

Cash Ratio
Measures ability of the firm to pay

short-term obligations only with

available cash and marketable
securities.

Asset Management Ratios

Measure efficiency of firms asset use.
Inventory
Accounts Receivable
Accounts Payable
Fixed Assets, Total Assets and Working
Capital

Inventory Management
Inventory Turnover Ratio
Dollar of sales produced per dollar of inventory.
Often uses cost of goods sold instead of sales

because inventory is listed on the balance sheet at

cost.
Days Sales in Inventory Ratio
Measures the average number of days inventory is

held before final product is sold.

Accounts Receivable
Management
Average Collection Period (ACP) Ratio
Measures number of days accounts receivable are

held until cash is collected from the sale.

Accounts Receivable Turnover Ratio

Measures dollars of sales produced per dollar of

accounts receivable.

Accounts Payable Management

Average Payment Period (APP) Ratio
Measures the number of days accounts payable

held before extending cash to pay for raw materials

Accounts Payable Turnover Ratio

Measures dollar of COGS per dollar of accounts

payable.

Fixed Asset and Working Capital

Management

Fixed Asset Turnover Ratio

Measures dollars of sales produced per dollar of
net fixed assets.

Sales to Working Capital Ratio

Measures dollar of sales produced per dollar of

working capital. (Current Assets Current

Liabilities)

Total Asset Management

Total Asset Turnover Ratio
Measures dollars of sales produced per dollar of

total assets.

Capital Intensity Ratio

Measures dollars of total assets needed to

produce a dollar of sales.

Debt Management Ratios

Two Major Types :
Measure debt amount.
Measure firms ability to service debt.

Debt vs. Equity Financing

Three Measures :
Debt Ratio
Debt-to-Equity Ratio
Equity Multiplier Ratio
Debt Ratio

Measures percentage of total assets financed

with debt.

Debt vs. Equity Financing

Debt-to-Equity Ratio

Measures dollars of debt financing for every

dollar of equity financing.

Equity Multiplier Ratio

Measures the dollars of assets on balance sheet

for every dollar of equity financing.

Coverage Ratios
Times Interest Earned Ratio

Measures operating earnings dollars available to

meet interest obligations.

Cash Coverage Ratio

Measures operating cash available to meet

interest and other fixed charges, and indicates if

debt burden is too large.

Profitability Ratios
Show the combined effect of liquidity,

asset management and debt

management on firms operating
results.
Closely monitored by investors since
stock prices react very quickly to unexpected
changes in these ratios.

Profit Margin & Return on Assets (ROA)

Percent of sales left after all firm expenses are paid.

Measures overall return on firms assets inclusive of

leverage and taxes.

Return on Equity (ROE)

Measures return on common

stockholders investment.
Affected by net income and amount of

financial leverage.
High ROE is usually a positive sign,
unless driven by excessively high
leverage.

Dividend Payout Ratio

Measures fraction of earnings paid out

to common stockholders as dividends.

Market Value Ratios

Market prices of publicly-traded firms

incorporate risk.
Market values reflect what investors
think of the companys future
performance and risk.

Price-Earnings Ratio
Best known and most often quoted

figure.
Measures price investors will pay per dollar of

earnings.
High PE ratio usually indicates projected
growth.
Drives stock classification as growth or value.

DuPont Analysis
Uses both Balance Sheet and Income

Statements.
Breaks ROA and ROE into components to
explain why the ratios are low or high.
ROA = Profit Margin x Total Asset Turnover
ROE = ROA x Equity Multiplier
ROE = Profit Margin x Total Asset Turnover x
Equity Multiplier

= Net Profit/Sales x Sales/Total Assets x

Total Assets/Equity Capital

DuPont Analysis

Standardized Financial Statements

Common-Size Financial Statements :
Divide balance sheet amounts by total assets.
Divide all income statement amounts by net sales.
Standardized statements are useful for :
- Comparing financial information year-to-year.
Time Series Analysis
- Comparing companies of different sizes,
particularly within the same industry.
Cross-Sectional Analysis

End of Lecture 2