Chapter 2 financial statements

Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Chapter 2
Financial
Statements
and Analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-2
Learning Goals
1. Review the contents of the stockholders’ report and
the procedures for consolidating international
financial statements.
2. Understand who uses financial ratios, and how.
3. Use ratios to analyze a firm’s liquidity and activity.
4. Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.

Learning Goals (cont.)
5. Use ratios to analyze a firm’s profitability and
market value.
6. Use a summary of financial ratios and the
DuPont system of analysis to perform a
complete ratio analysis.

Financial (Accounting) Statements
• Financial or Accounting statements are used
for reporting corporate activity.
4

Users of Financial Statements
External Users
•Lenders
•Shareholders
•Governments
•Consumer Groups
•External Auditors
•Customers
Internal Users
•Managers
•Officers
•Internal Auditors
•Sales Staff
•Budget Officers
•Controllers
5

The Four Key Financial Statements:
The Income Statement
• The income statement provides a financial
summary of a company’s operating results
during a specified period.
• Although they are prepared annually for
reporting purposes, they are generally computed
monthly by management and quarterly for tax
purposes.

The Income Statement
 The income statement measures
performance over a specific period of time,
say, a year.
 The accounting definition of income is:
Revenues – Expenses = Income
Are increases in ownership
claims arising from the
delivery of goods or
services.
Are decreases in ownership
claims arising from
delivering goods or services
or using up asset.
7

The Four Key Financial Statements
Table 2.1 Bartlett
Company Income
Statements ($000)

The Balance Sheet
• The balance sheet (also called statement of
financial position or statement of financial
condition) is a snapshot of the financial status of
an organization at a point in time.
• The balance sheet shows the assets owned by a
company, and how those assets are financed
(debt and equity).
9

The Balance Sheet
• The balance sheet presents a summary of a
firm’s financial position at a given point in time.
• Assets indicate what the firm owns, equity
represents the owners’ investment, and liabilities
indicate what the firm has borrowed.

The Balance Sheet (Cont.)
Assets = Liabilities + Equity
What the company
owns (used to generate
income)
• How the ownership of assets
was financed (By third parties or
by the owners)
• Equity = book value of company
1
1

What the company
income)
Assets are economic resources that a
company owns and expects to provide
future benefits.
Consist of:
1- Current assets
2- Fixed assets
1
2

Fixed assets are reported at
the cost to purchase or
acquire the asset minus the
depreciation accumulated
on the assets since the time
of purchase.
by the owners)
• Current assets are those the business
expects to turn into cash during the next
year.
(Cash, account receivable, inventory,
prepaid expenses)
• Fixed assets are things of value that will
provide benefits to the company for one or
more years.
(Machines, lands, equipment, plants)
1
3

by the owners)
Liabilities are the
obligations to non owners.
Consist of:
1- Current liabilities.
2- Long term liabilities.
1
4

by the owners)
• Current liabilities are the
debts that a company must
pay off within the coming
year.
(Accounts payable, notes
payable, taxes payable)
1
5

What the company
income)
by the owners)
• Long term liabilities are
obligations, usually loans,
that are due to be paid not in
the current year but in some
future period.
The amount specified in the
balance sheet is equal to the
total amount borrowed.
(long term debt, deferred
taxes)
1
6

What the company
income)
by the owners)
Equity is the excess of the
assets over the liabilities.
It summarizes the owners‘
investment in the business.
(Stockholders’ equity,
accumulated retained
earnings, capital surplus)
1
7

Table 2.2a Bartlett
Company Balance
Sheets ($000)

The Four Key
Financial Statements (cont.)
Table 2.2b Bartlett
Company Balance
Sheets ($000)

Statement of Retained Earnings
• The statement of retained earnings reconciles the
net income earned and dividends paid during the
year, with the change in retained earnings.

Table 2.3 Bartlett Company Statement of Retained Earnings
($000) for the Year Ended December 31, 2009

Statement of Cash Flows
• The statement of cash flows provides a
summary of the cash flows over the period of
concern, typically the year just ended.
• This statement not only provides insight into a
company’s investment, financing and operating
activities, but also ties together the income
statement and previous and current balance
sheets.

Statement of Cash Flows
(Cont.)
• The fundamental approach to the statement of cash
flows includes two steps:
1- List the activities that increased cash (cash
inflows) and those that decreased cash (cash
outflows).
2- place each cash inflow and outflow into one of
three categories according to the type of activity
that caused it: operating activities, investing
activities, and financing activities.
23

24
Statement of Cash Flows (Cont.)
• Cash flow from operating activities is the cash
flow that results from the firm’s normal activities
producing and selling goods and services.
• Cash flow from investing activities.
• Cash flow from financing activities is the net
payments to creditors and owners made during
the year.

25
Statement of Cash Flows (Cont.)
• The three components of the statement of cash
flows are:
1- Cash flow from Operating Activities
2- Cash flow from Investing Activities
3- Cash flow from Financing Activities

Table 2.4 Bartlett
Company Statement of
Cash Flows ($000) for
the Year Ended
December 31, 2009

Using Financial Ratios:
Interested Parties
• Ratio analysis involves methods of calculating
and interpreting financial ratios to assess a
firm’s financial condition and performance.
• It is of interest to shareholders, creditors, and the
firm’s own management.

Types of Ratio Comparisons
• Trend or time-series analysis: Evaluation of
the firm’s financial performance over time using
financial ratio analysis.
• Cross-sectional analysis: Comparison of
different firms’ financial ratios at the same point
in time; involves comparing the firm’s ratios to
those of other firms in its industry or to industry
averages.

Types of Ratio Comparisons (cont.)
Table 2.5 Industry Average Ratios for Selected Lines of
Businessa

Types of Ratio Comparisons (cont.)
Figure 2.1 Combined Analysis

Cautions for Doing Ratio Analysis
1. Ratios must be considered together; a single ratio by
itself means relatively little.
2. Financial statements that are being compared should
be dated at the same point in time.
3. The financial data being compared should have been
developed in the same way.

Ratio Analysis
Liquidity Ratios
– Current Ratio
• The current ratio, measures the firm’s ability to
meet its short-term obligations.
• Generally, the higher the current ratio, the more
liquid the firm is considered to be.

Current ratio = total current assets
total current liabilities
Current ratio = $1,233,000 = 1.97
$620,000
Ratio Analysis
• Liquidity Ratios
– Current Ratio

Quick ratio = Total Current Assets - Inventory
total current liabilities
Quick ratio = $1,233,000 - $289,000 = 1.51
$620,000
Ratio Analysis (cont.)
– Current Ratio
– Quick Ratio

– The quick ratio provides a better measure of overall
liquidity only when a firm’s inventory cannot be
easily converted into cash.
– If inventory is liquid, the current ratio is a preferred
measure of overall liquidity.

Activity Ratios
Activity ratios measure the speed with which various
accounts are converted into sales or cash—inflows or
outflows.
– Inventory Turnover
The resulting turnover is meaningful only when it is
compared with that of other firms in the same industry
or to the firm’s past inventory turnover.

Inventory Turnover = Cost of Goods Sold
Inventory
Inventory Turnover = $2,088,000 = 7.2
$289,000
• Activity Ratios
– Inventory Turnover

Average Age of Inventory = 360
Inventory Turnover
Inventory Turnover = 360 = 50.0 days
7.2
• Activity Ratios
– Average Age of Inventory
• This value can be viewed as the average number of days’ sales in
inventory.

ACP = Accounts Receivable
Net Sales/360
ACP = $503,000 = 58.9 days
$3,074,000/360
• Activity Ratios
– Average Collection Period
is the average amount of time needed to collect
accounts receivable.

– Average Collection Period
• The average collection period is meaningful only in
relation to the firm’s credit terms.
• If the firm had extended 60-day credit terms, the 58.9-
day average collection period would be acceptable.
• If the firm had extended 30-day credit terms to
customers, an average collection period of 58.9 days
may indicate a poorly managed credit or collection
department, or both.

APP = Accounts Payable
Annual Purchases/360
APP = $382,000 = 94.1 days
1461600/360
• Activity Ratios
– Average Payment Period
Is the average amount of time needed to pay accounts payable.
If the firm’s suppliers have extended, on average, 30-day credit
terms, an analyst would give the firm a low credit rating.

Total Asset Turnover = Net Sales
Total Assets
Total Asset Turnover = $3,074,000 = .85
$3,597,000
• Activity Ratios
– Total Asset Turnover
It indicates the efficiency with which the firm uses its assets to
generate sales.

– Total Asset Turnover
• Generally, the higher a firm’s total asset turnover, the
more efficiently its assets have been used.
• This measure is probably of greatest interest to
management, because it indicates whether the firm’s
operations have been financially efficient.

Table 2.6 Financial Statements Associated with Patty’s
Alternatives

Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
Financial Leverage Ratios
– Debt Ratio
The debt ratio measures the proportion of total assets
financed by the firm’s creditors.

• Financial Leverage Ratios
– Debt Ratio measures the proportion of total assets
financed by the firm’s creditors.
• This value indicates that the company has
financed close to half of its assets with debt.
• The higher this ratio, the greater the firm’s
degree of indebtedness and the more financial
leverage it has.

Times Interest Earned = EBIT/Interest
Times Interest Earned = $418,000/$93,000 = 4.5
• Leverage Ratios
– Times Interest Earned Ratio
Measures the firm’s ability to make contractual interest
payments.
A value of at least 3.0—and preferably closer to 5.0—is
often suggested.

Profitability Ratios
– Common-Size Income Statement
Is an income statement in which each item is expressed
as a percentage of sales.

Table 2.7
Bartlett Company
Common-Size
Income
Statements

GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
• Profitability Ratios
– Gross Profit Margin
It measures the percentage of each sales dollar
remaining after the firm has paid for its goods sold.
– The higher the gross profit margin, the better.

OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%
– Operating Profit Margin (OPM)
A high operating profit margin is preferred.

NPM = Earnings Available to Common Stockholders
Sales
NPM = $221,000/$3,074,000 = 7.2%
– Net Profit Margin (NPM)
It measures the percentage of each sales dollar remaining
after all costs and expenses, including interest, taxes, and
preferred stock dividends, have been deducted.

EPS = Earnings Available to Common Stockholders
Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90
– Earnings Per Share (EPS)

ROA = Earnings Available to Common Stockholders
Total Assets
ROA = $221,000/$3,597,000 = 6.1%
– Return on Total Assets (ROA)
The higher the firm’s return on total assets, the better.

ROE = $221,000/$1,754,000 = 12.6%
ROE = Earnings Available to Common Stockholders
Total Equity
– Return on Equity (ROE)
It measure the return earned on the common stockholders’
investment in the firm.
• The higher this return, the better off are the owners.

P/E = Market Price Per Share of Common Stock
Earnings Per Share
P/E = $32.25/$2.90 = 11.1
Market Ratios
– Price Earnings (P/E) Ratio
The P/E ratio measures the amount that investors are willing to pay
for each dollar of a firm’s earnings.
• It indicates the degree of confidence that investors have in the
firm’s future performance.

M/B Ratio = Market price per share of common stock
Book value per share of common stock
M/B Ratio = $32.25/$23.00 = 1.40
• Market Ratios
– Market/Book (M/B) Ratio
It provides an assessment of how investors view the
firm’s performance.
It means that investors are currently paying $1.40 for each $1.00
of book value of the company’s stock.

Summarizing All Ratios
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)

Summarizing All Ratios (cont.)
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)

DuPont System of Analysis
• The DuPont system of analysis is used to dissect the firm’s
financial statements and to assess its financial condition.
• It merges the income statement and balance sheet into two summary
measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA to its ROE
using the financial leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
• ROA and ROE as shown in the series of equations on the following
slide and in Figure 2.2 on the following slide.

DuPont System of Analysis

DuPont System of Analysis (cont.)
Figure 2.2 DuPont
System of Analysis

ROE = 6.1% X 2.06 = 12.6%
Modified DuPont Formula (cont.)
• Use of the FLM to convert ROA into ROE reflects the
impact of financial leverage on the owner’s return.
• Substituting the values for Bartlett Company’s ROA of
6.1 percent calculated earlier, and Bartlett’s FLM of
2.06 ($3,597,000 total assets ÷ $1,754,000 common
stock equity) into the Modified DuPont formula yields:

Chapter 2 financial statements

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