Chapter 3: Working With Financial Statements

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements Standardized Financial Statements To start making comparisons, one obvious thing we might try to do is to somehow standardize the financial statements. One very common and useful way of doing this is to work with percentages instead of total dollars. The resulting financial statements are called common-size statements. (used For comparing competitors, Firms OF different sizes, year-10-year FOR your Firm.) Common-Size Balance Sheets For easy reference, Prufrock Corporation's 2021 and 2022 balance sheets; we construct common-size balance sheets by expressing each item as a percentage of total assets. used 10 track changes ina Firm's capital structure. Common-Size Income Statements Auseful way of standardizing the income statement is to express each item as a percentage of total sales. Ratio Analysis Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. We cover some of the more common ratios next, but there are many others that we don't touch on. One problem with ratios is that different people and different sources frequently don't compute them in exactly the same way, and this leads to much confusion. The specific definitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are using rations as a tool for analysis, you should be careful to document how you calculate each one, and, if you are comparing your numbers to those of another source, be sure you know how their numbers are computed Current Ratio One of the best-known and most widely used ratios is the current ratio. As you might guess, the current ratio is defined as: Current ratio = Current assets/ Current liabilities To a creditor, particularly a short-term creditor such as a supplier, the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short term assets. (accounts payable) Absent some extraordinary circumstances, we would expect to see a current ratio of at least 1 because a current ratio of less than 1 would mean that net working capital (current assets less current liabilities) is negative. This would be unusual in a healthy firm, at least for most types of businesses. The current ratio, like any ratio, is affected by various types of transactions.

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements For example, suppose the firm borrows over the long-term to raise money. The short-run effect would not be an increase in cash from the issue proceeds and an increase in long-term debt. Current liabilities would not be affected, so the current ratio would rise. Finally, note that an apparently low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power. Quick (or Acid-Test) Ratio To further evaluate liquidity, the quick, or acid-test, ratio is computed like the current ration, except inventory is omitted: Quick Ratio = Current assets - Inventory/ Current liabilities Note that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. Cash Ratio A very short-term creditor might be interested in the cash ratio. Cash ratio = Cash/ Current liabilities Long-Term Solvency Measures Long-term solvency ratios are intended to address the firm's long-run ability to meet its obligations, or, more generally, its financial leverage. These ratios are sometimes called financial leverage ratios or leverage ratios. Total Debt Ratio The total debt ratio takes into account all debts of all maturities to all creditors. It can be defined in several ways, the easiest of which is: Total debt ratio = Total assets - Total equity/ Total assets In this case, an analyst might say that Prufrock uses 28 percent debt. Whether this is high or low or whether it even makes any difference depends on whether or not capital structure matters, a subject we discuss in a later chapter. Times Interest Earned Another common measure of long-term solvency is the times interest earned (TIE) ratio. Once again, there are several possible (and common) definitions, but we'll stick with the most traditional: Times interested earned ratio = EBIT/ Interest

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements Cash Coverage Because interest is most definitely a cash outflow (to creditors), one way to define the cash coverage ratio is: Cash coverage ratio = EBIT + Depreciation/ Interest The numerator here, EBIT plus depreciation, is often abbreviated EBITD (earnings before interest, taxes, and depreciation) It is a basic measure of the firm's ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations. Inventory Turnover and Days' Sales in Inventory With these numbers, inventory turnover can be calculated as: Inventory turnover = Cost of goods sold/Inventory Receivables Turnover and Days' Sales in Receivables Our inventory measures give some indication of how fast we can sell products. We now look at how fast we collect on those sales. The receivables turnover is defined in the same way as inventory turnover: Receivables turnover = Sales/ Accounts receivables Loosely speaking, we collected our outstanding credit accounts and reloaned the money 12.56 times during the year. This ratio makes more if we convert it to days, so the days' sales in receivables is: Days sales in receivables = 365 days/ Receivables turnover Therefore, on average, we collect on our credit sales in about 29 days. For obvious reasons, this ratio is very frequently called the average collection period (ACP). Total Asset Turnover Moving away from specific accounts like inventory or receivables, we can consider an important "big picture" ratio, the total asset turnover ratio. As the name suggests, total asset turnover is: Total asset turnover = Sales/ Total assets Profit Margin Companies pay a great deal of attention to their profit margin: Profit Margin = Net income/ Sales All other things being equal, a relatively high profit margin is obviously desirable. This situation corresponds to low expense ratios relative to sales.

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements However, we hasten to add that other things are often not equal. For example, lowering our sales price usually will increase unit volume, but normally will cause profit margins to shrink. Total profit (or, more importantly, operating cash flow) may go up or down, so the fact that margins are smaller isn't necessarily bad. After all, isn't it possible that, as the saying goes, "Our prices are so low that we lose money on everything we sell, but we make it up in volume!"? Return on Assets Return on assets (ROA) is a measure of profit per dollar of assets. It can be defined several ways, but the most common is: Return on assets = Net income/Total assets Return on Equity Return on equity (ROE) is a measure of how the stockholders fared during the year. Because benefiting shareholders is our goal, ROE is, in an accounting sense, the true bottom-line measure of performance. measures profibility Return on equity = Net income/ Total equity Price-Earnings Ratio The first of our market value measures. the price earnings, or PE, ratio (or multiple), is defined as: PE ratio = Price per share/ Earnings per share smarket value) Because the PE ratio measures how much investors are willing to pay per dollar of current earnings, higher PEs are often taken to mean that the firm has significant prospects for future growth. Of course, if a firm had no or almost no earnings, its PE would probably be quite large; so, as always, care is needed in interrupting this ratio. Price-Sales Ratio In some cases, companies will have negative earnings for extended periods, so their PE ratios are not very meaningful. A good example is a recent start-up. Such companies usually do have some revenues, so analysts will often look at the price- sales ratio: Price-sales ratio = Price per share/Sales per share

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements Market-to-Book Ratio Another commonly quoted measure is the market-to-book ratio: Market-to-book ration = Market value per share/Book value per share Notice that book value per share is total equity (not just common stock) divided by the number of shares outstanding. Because book value per share is an accounting number, it reflects historical costs. Therefore, in a loose sense, the market-to-book ratio compares the market value of the firm's investments to their costs. A value less than 1 could mean that the firm has not been successful overall in creating value for its stockholders. The DuPont Identity To begin, let's recall the definition of ROE: Return on equity = Net Income/ Total equity If we were so inclined, we could multiply this ratio by Assets/ Assets without changing anything: Return on equity = (Net Income/ Total equity) X (Assets/ Assets) (Net Income/ Assets) X (Assets/ Total equity) Notice that we have expressed the ROE as the product of two other ration - ROA and the equity multiplier: ROE = ROA X Equity multiplier = ROA X (1 + Debt-equity ratio) We can further decompose ROE by multiplying the top and bottom by total sales: ROE = (Sales/ Sales) X (Net Income/ Assets X (Assets/Total equity) If we rearrange things a bit, ROE is: What we have now done is to partition ROA into its two component parts, profit margin and total asset turnover. This last expression is called the DuPont identity, after the DuPont Corporation, which is popularized its use. Dividend Payout and Earnings Retention If we express dividends paid as a percentage of net income, the result is the dividend payout ratio: Dividend payout ratio = Cash dividends/ Net income The Internal Growth Rate Suppose a firm has a policy of financing growth using only internal financing. This means that the firm won't borrow any funds and won't sell any new stock.

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements How rapidly can the firm grow? The answer is given by the internal growth rate: Internal growth rate = ROA x b/ 1 - ROA X b Where ROA is, as usual, return on assets and b is the retention, or plowback, ratio we just discussed. The Sustainable Growth Rate With this in mind, we now consider hoe rapidly a firm can grow if (1) it wishes to maintain a particular total debt ratio and (2) it is unwilling to sell new stock. There are various reasons a firm might wish to avoid selling stock, and equity sales by established firms area actually a relatively rare occurrence. Given these two assumptions, the maximum growth rate that can be achieved, called the sustainable growth rate, is: Sustainable growth rate =ROE x b/1 - ROE x b Why Evaluate Financial Statements? It is important to emphasize that, whenever we have market information, we will use it instead of accounting data. Also, if there is a conflict between accounting and market data, market data should be given precedence. Financial statement analysis is essentially an application of "management by exception" In many cases, such analysis will boil down to comparing ratios for one business with some kind of average or representative ratios. Those ratios that seem to differ the most from the averages are tagged for further study. Internal Uses Financial statement information has a variety of uses within a firm Among the most important of these is performance evaluation. For example, managers are frequently evaluated and compensated on the basis of accounting measures of performance such as profit margin and return on equity. Also, firms with multiple divisions frequently compare the performance of those divisions using financial statement information Another important internal use of financial statement information involves planning for the future. Historical financial statement information is very useful for generating projections about the future and for checking the realism of assumptions made in those projections. External Uses Financial statements are useful to parties outside the firm, including short-term and long- term creditors and potential investors. For example, we could find such information quite useful in deciding whether or not to grant credit to a new customer.

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements We also would use this information to evaluate suppliers, and suppliers would use our statements before deciding to extend credit to us. Large customers use this information to decide if we are likely to be around in the future. Credit-rating agencies rely on financial statements are a prime source of information about a firm's financial health. Time-Trend Analysis One standard we could use is history. Suppose we found that the current ratio for particular firm is 2.4 based on the most recent financial statement information. Looking back over the last 10 years, we might find that this ratio has declined fairly steadily over that period. Based on this, we might wonder if the liquidity position of the firm has deteriorated. It could be, of course, that the firm has made changes that allow it to use its current assets more efficiently, that the nature of the firm's business has changed, or that business practices have changed. If we investigate, we might find any of these possible explanations. This is an example of what we mean by management by exception - a deteriorating time trend may not be bad, but it does merit investigation. Problems with Financial Statements Analysis In one way or another, the basic problem with financial statement analysis is that there is no underlying theory to help us identify which items or ratios to look at and to guide us in establishing benchmarks. As we discuss in other chapters, there are many cases in which financial theory and economic logic provide guidance in making judgements about value and risk. Very little such help exists with financial statements. This is why we can't say which ratios matter the most and what a high or low value might be. One particularly severe problem is that many firms, such as General Electric (GE), are conglomerates owning more or less unrelated line of business. The consolidated financial statements for such firms don't really fit any neat industry category. More generally, the kind of peer group analysis we have been describing is going to work best when the firms are strictly in the same line of business, the industry is competitive, and there is only one way of operating. Another problem that is becoming increasingly common is that major competitors and natural peer group members in an industry may be scattered around the globe. The automobile industry is an obvious example. The problem here is that financial statements from outside the United States do not necessarily conform at all to GAAP (more precisely, different countries can have different countries can have different GAAPs). The existence of different standards and procedures makes it very difficult to compare financial statements across national borders. Even companies that are clearly in the same line of business may not be comparable.

FIN3403: Corporate Finance Chapter 3: Working with Financial Statements For example, electric utilities engaged primarily in power generation are all classified in the same group (SUC 4911). This group is often thought to be relatively homogeneous However, utilities generally operate as regulated monopolies, so they don't compete with each other. Many have stockholders, and many are organized as cooperatives with no stockholders There are several different ways of generating power, ranging from hydroelectric to nuclear, so the operating activities can differ quite a bit. Finally, profitability is strongly affected by the regulatory environment, so utilities in different locations can be very similar but show very different profits. Several other general problems frequently crop up. First, different firms use different accounting procedures for inventory, for example. This makes it difficult to compare statements. Second, different firms end their fiscal years at different times. For firms in seasonal businesses (such as a retailor with a large Christmas season), this can lead to difficulties in comparing balance sheets because of fluctuations in accounts during the year. Finally, for any particular firm, unusual or transient events, such as a one-time profit from an asset sale, may affect financial performance. In comparing firms, such events can give misleading signals.