Ch. 3 Working with financial statements

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					Ch. 3 Working with financial
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).
Another form of cash flow statement
• 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
• 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

• 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.
• 5 categories of ratios:
• - short term solvency or liquidity ratios
• - long term solvency or financial leverage
• - 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)/
• 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
• - how many days it takes to collect account

• Net working capital turnover = sales/ NWC
• Fixed asset turnover = sales/fixed assets
• Total asset turnover = sales/total asset
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
• = 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.

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