Fundamentals of corproate finance 3e chapter 03

Chapter Three
Working with Financial
Statements

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Chapter Organisation
3.1 Cash Flow and Financial Statements: A Closer
Look
3.2 Financial Statements of Publicly Listed Firms
3.3 The Du Pont Identity
3.4 Using Financial Statement Information
3.5 Summary and Conclusions

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Chapter Objectives
• Identify the ways that firms obtain and use cash as
•
•
•
•

reported in the Statement of Cash Flows.
Calculate and interpret key financial ratios.
Discuss the Du Pont identity as a method of
financial analysis.
Understand the use of financial information for
comparative purposes.
Outline the problems associated with using
financial ratios.

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Cash
• Cash is generated by selling a product or service,

asset or security.
• Cash is spent by paying for materials and labour to
produce a product or service and by purchasing
assets.
• Recall:
Cash flow from assets = Cash flow to debtholders
+ Cash flow to shareholders

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Cash Flow
• Sources of cash are those activities that bring in

cash.
• Uses of cash are those activities that involve

spending cash.
• The firm’s statement of cash flows is the firm’s

financial statement that summarises its sources
and uses of cash over a specified period.
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Statement of Financial Position
('000s)
Assets (‘000s)
Current assets
Cash
Accounts receivable
Inventory
Total
Fixed assets
Net plant and equipment

2003

2004

$

45
260
320
$ 625

$

50
310
385
$ 745

985

1 100

$1 610

$1 845

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TOTAL ASSETS


Statement of Financial Position
('000s)
Liabilities and equity (‘000s)
Current liabilities
Accounts payable
Notes payable
Total

2003

2004

$

210
110
$ 320

$

Long-term debt

$ 205

$ 225

Shareholders’ equity
Ordinary shares
Retained earnings
Total
TOTAL LIABILITIES AND EQUITY

290
795
$1 085
$1 610

290
895
$1 185
$1 845

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260
175
$ 435

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Statement of Financial Performance
('000s)
Net sales
Cost of goods sold

Depreciation
EBIT
Interest
Taxable income
Tax
Net profit
Dividends
Addition to retained earnings

$710.00
480.00
30.00
$200.00
20.00
180.00
53.45
$126.55
26.55
$100.00

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Statement of Cash Flows
• A statement that summarises the sources and uses

of cash.

• Changes are divided into three main categories:
–
–
–

Operating activities—includes net profit and changes in
most current accounts
Investment activities—includes changes in fixed assets
Financing activities—includes changes in notes payable,
long-term debt and equity accounts as well as dividends.

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Statement of Cash Flows
• Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
– Any increase in current assets (except cash)
– Decrease in accounts payable

• Investment activities
+ Ending fixed assets
– Beginning fixed assets
+ Depreciation

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Statement of Cash Flows
• Financing activities
– Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
– Dividends paid

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Statement of Cash Flows
• Operating activities
+ Net profit + $ 126.55
+ Depreciation
+
30.00
+ Increase in payables
+

– Increase in receivables –
– Increase in inventory
–
$ 91.55

50.00
50.00
65.00

• Investment activities
+ Ending fixed assets
+$1 100.00
– Beginning fixed assets
– 985.00
+ Depreciation
+
30.00
( $ 145.00)

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Statement of Cash Flows
• Financing activities
–
–
–

+ Increase in notes payable
+ Increase in long-term debt
– Dividends
– 26.55
$ 58.45

+ $ 65.00
+ 20.00

Putting it all together, the net addition to cash for the
period is:
$91.55 – 145.00 + 58.45 = $5.00

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‘Players’ in Accounting Standards
• Accountants
• Government
• Regulators
• Other users

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Ratio Analysis
• Financial ratios are relationships determined from

a firm’s financial information.
• Used to compare and investigate relationships

between different pieces of financial information,
either over time or between companies.
• Ratios eliminate the size problem.

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Categories of Financial Ratios
• Liquidity—measures the firm’s short-term solvency.
• Capital structure—measures the firm’s ability to

meet long-run obligations (financial leverage).
• Asset management (turnover)—measures the
efficiency of asset usage to generate sales.
• Profitability—measures the firm’s ability to control
expenses.
• Market value—per-share ratios.

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Liquidity Ratios

Current assets
Current ratio =
Current liabilities
Current assets − Inventory
Quick ratio =
Current liabilities − Bank overdraft

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Capital Structure Ratios
Total financial debt − Cash
Total equity − Intangibles
Total debt
Debt/equity ratio =
Total equity
Total assets
Equity multiplier =
Total equity
EBIT

Net interest cover =
Interest + finance charges
Interest - bearing debt
Debt to gross cash flow =
Net profit after tax + depreciation + amortisation
Net debt/equity ratio =

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Turnover Ratios
Cost of goods sold
Inventory turnover =
Inventory
365 days
Days' sales in inventory =
Inventory turnover
Sales
Receivables turnover =
Accounts receivable
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Turnover Ratios (continued)

365 days
Days' sales in receivables =
Receivables turnover
Sales
Fixed asset turnover =
Non - current assets
Sales
Total asset turnover =
Total assets
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Profitability Ratios
Profit margin =

Net profit
Sales

Net profit
Return on assets (ROA) =
× 100%
Total assets
EBIT
Return on investment =
×100%
Total assets
Return on equity (ROE) =

Net profit
×100%
Total equity

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Market Value Ratios
Price per share
Price/earning ratio =
Earnings per share
Market value per share
Market - to - book ratio =
Book value per share

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The Du Pont Identity
• Breaks ROE into three parts:
–
–
–

operating efficiency
asset use efficiency
financial leverage

Net profit Sales Assets
ROE =
×
×
Sales
Assets Equity
= Profit margin × Total asset turnover × Equity multiplier
= ROA × Equity multiplier

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Uses for Financial Statement
Information
• Internal uses:
–
–

performance evaluation
planning for the future

• External uses:

–
–
–

evaluation by outside parties
evaluation of main competitors
identifying potential takeover targets

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Benchmarks for Comparison
• Ratios are most useful when compared to a

benchmark.
• Time-trend analysis—examine how a particular
ratio(s) has performed historically.
• Peer group analysis—using similar firms
(competitors) for comparison of results.
• Global Industry Classification Standard (GICS)
used by ASX is a useful way to find a peer
company.
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