Chapter 3 Working with financial statements

Standardized financial statement

Standardized statements make it easier to compare financial information as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry Common size statement is to standardize the balance sheet and income percentages instead of dollars.

Common-Size Balance Sheets - All items are presented as percentage of total assets (%TA)

Common-Size Income Statements - All items are presented as percentage of sales or revenue (%SLS)

Ratio Analysis
Another way in avoiding problems involved in comparing companies of different size is to calculate and compare Financial ratios - Financial ratios are grouped in the following categories Categories of financial Ratios Liquidity ratios or Short-term solvency Financial leverage ratios or Long-term solvency ratios Asset management or Turnover ratios Profitability ratios Market value ratios -

Liquidity ratios or Short-term solvency The ability of the firm to pay its bills over the short run without too much stress. Current Ratio = Current Assets / Current Liabilities It Indicates liquidity, inefficient use of cash and other short-term assets. Quick Ratio = (Current Assets Inventory)/ Current Liabilities Inventory is relatively illiquid compared to cash so its omitted from the Quick Ratio. Cash Ratio = Cash / Current Liabilities

Financial leverage ratios or Long-term solvency ratios The firms long-run ability to meet its obligations. Total Debt Ratio = Total Assets Total Equity/ total asset Debt/Equity = Total Debt / Total Equity

Equity Multiplier = Total Assets / Total Equity = 1 + D/E Times Interest Earned = EBIT / Interest Cash Coverage = (EBIT + Depreciation) / Interest

Asset management or Turnover ratios How efficient the firm is in using its assets to generate sales. Inventory Ratios How fast the firm can sell its products - Inventory Turnover = COGS / Inventory The higher the ratio, the more efficiently the firm is managing the inventory. - Days Sales in Inventory = 365 / Inventory Turnover This ratio tells us on average how long the inventory stays before being sold Receivables Ratios How fast the firm collects its receivables. - Receivables Turnover = Sales / AR This ratio quantifies a firm's effectiveness in setting the credit policy as well as collecting debts. - Days Sales in Receivables = 365 / Receivables Turnover The number of days the firm needs to collect its credit sales. Asset Turnover Ratios - Total Asset Turnover = Sales / Total Assets How much money the firm generates in sales for each dollar invested in assets. - Capital Intensity Ratio = 1/TAT The dollar investment in assets needed to generate $1 in sales Profitability measures - Profit Margin = Net Income / Sales How many dollars were generated in profit for every dollar in sales Return on Assets (ROA) = Net Income / Total Assets A measure of profit per dollar of assets Return on Equity (ROE) = Net Income / Total Equity How efficient the firm uses its assets & how efficiently the firm manages its operations

Market Value Measures - Earnings per Share (EPS) = NI / Number of shares outstanding - Price Earnings(PE) Ratio = Price per share (PPS)/ Earnings per share (EPS) o The shares sell for how many times of earnings. o How much investor is willing to pay per dollar of current earnings? - Price/Sales Ratio = PPS/Sales per share - Market-to-book ratio = PPS / Book value per share - Book value per share = Total Equity/shares outstanding

THE DU PONT IDENTITY

ROE = PM * TAT * EM Profit margin Total asset turnover Equity multiplier