WORKING WITH

FINANCIAL
STATEMENTS
STANDARDISED
FINANCIAL STATEMENTS
Common-size balance sheets
 Compute all accounts as a percentage of total
assets
Common-size income statements
 Compute all line items as a percentage of sales
Standardised statements make it easier
to compare financial information,
particularly as the company grows.
They are also useful for comparing
companies of different sizes, particularly
within the same industry.

3-2
SWAGMAN CAMPING LTD
BALANCE SHEET—TABLE 3.1

3-3
SWAGMAN CAMPING LTD
(CONT.)
COMMON-SIZE BALANCE
SHEET—TABLE 3.2

3-4
SWAGMAN CAMPING LTD
(CONT.)
INCOME STATEMENT—
TABLE 3.3

3-5
SWAGMAN CAMPING LTD
(CONT.)
COMMON-SIZE INCOME
STATEMENT—TABLE 3.4

3-6
RATIO ANALYSIS
Allows for better comparison over time
or between companies
Used both internally and externally
For each ratio, several questions arise:
How is it computed ?
What is the ratio trying to measure
and why is that information important?
What is the unit of measurement?
What might a high or low value be
telling us? How might such values be
misleading?
 How could this measure be improved?

3-7
CATEGORIES OF
FINANCIAL RATIOS
Short-term solvency or liquidity
ratios
Long-term solvency or financial
leverage ratios
Asset management or turnover
ratios
Profitability ratios
Market value ratios
3-8
COMMON FINANCIAL
RATIOS
TABLE 3.5

3-9
SHORT-TERM SOLVENCY
OR LIQUIDITY RATIOS SWAGMAN CAMPING LTD
Balance Sheet -2010
ASSETS Liabilities & Owners Equity
Current Assets Current Liabilities
Cash $ 98 Accounts Payable $ 344
Accounts Receivable $ 188 Notes Payable $ 196
Inventory $ 422 Total $ 540
Total $ 708 Long term debt $ 457
Owners' Equity
Common Stock and paid in surplus $ 550
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588

Current ratio = Current assets / Current liabilities

708 / 540 = 1.31 times
Quick ratio (or acid-test ratio) = (Current assets –
Inventory) / Current liabilities
(708-422) / 540 = 0.53 times
Cash ratio= Cash / Current liabilities
98/ 540 = 0.18 times

3-10
LONG-TERM SOLVENCY
MEASURES SWAGMAN CAMPING LTD
Balance Sheet -2010
ASSETS Liabilities & Owners Equity
Current Assets Current Liabilities
Cash $ 98 Accounts Payable $ 344
Accounts Receivable $ 188 Notes Payable $ 196
Inventory $ 422 Total $ 540
Total $ 708 Long term debt $ 457
Owners' Equity
Common Stock and paid in surplus $ 550
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588

Total debt ratio

 (TA – TE) / TA

(3588-2591) / 3588 = 0.28 times

Debt/Equity
 TD / TE

0.28/0.72) = 0.39 times

Equity multiplier
 TA/TE = 1 + D/E

($1 /0.72) = 1.39

3-11
LONG-TERM SOLVENCY
MEASURES (CONT.)SWAGMAN CAMPING LTD
Income Statement - 2010
Sales $ 2,311
COGS $ 1,344
Depreciation $ 276
EBIT $ 691
Interest $ 141
Taxable Income $ 550
Taxes $ 165
Net Income $ 385

Dividends $ 143
Addition to RE $ 242

Times interest earned

 EBIT/Interest

691/ 141 = 4.9 times

Cash coverage
 (EBIT + Depreciation)/Interest
(691 + 276) / 141 = 6.9 times

3-12
 ASSET MANAGEMENT:
INVENTORY RATIOS SWAGMAN CAMPING LTD
Balance Sheet -2010
SWAGMAN CAMPING LTD
Income Statement - 2010
ASSETS Liabilities & Owners Equity Sales $ 2,311
Current Assets Current Liabilities COGS $ 1,344
Cash $ 98 Accounts Payable $ 344 Depreciation $ 276
Accounts Receivable $ 188 Notes Payable $ 196 EBIT $ 691
Inventory $ 422 Total $ 540 Interest $ 141
Total $ 708 Long term debt $ 457 Taxable Income $ 550
Owners' Equity Taxes $ 165
Common Stock and paid in surplus
$ 550 Net Income $ 385
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591 Dividends $ 143
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588 Addition to RE $ 242

Inventory turnover = Cost of goods sold/Inventory

1344/422 = 3.2 times
Days’ sales in inventory = 365/Inventory turnover
365 / 3.2 = 114 days

3-13
 ASSET MANAGEMENT:
RECEIVABLES RATIOS SWAGMAN CAMPING LTD
Balance Sheet -2010
SWAGMAN CAMPING LTD
Income Statement - 2010
ASSETS Liabilities & Owners Equity Sales $ 2,311
Current Assets Current Liabilities COGS $ 1,344
Cash $ 98 Accounts Payable $ 344 Depreciation $ 276
Accounts Receivable $ 188 Notes Payable $ 196 EBIT $ 691
Inventory $ 422 Total $ 540 Interest $ 141
Total $ 708 Long term debt $ 457 Taxable Income $ 550
Owners' Equity Taxes $ 165
Common Stock and paid in surplus
$ 550 Net Income $ 385
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591 Dividends $ 143
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588 Addition to RE $ 242

•Receivables Turnover = Sales/Accounts Receivable

2311 / 188= 12.3 times

•Days’ Sales in Receivables = 365/Receivables Turnover

365 / 12.3= 30 days

3-14
 ASSET MANAGEMENT:
ASSET TURNOVER RATIOS
ASSETS
SWAGMAN CAMPING LTD
Balance Sheet -2010
Liabilities & Owners Equity
SWAGMAN CAMPING LTD
Income Statement - 2010
Sales $ 2,311
Current Assets Current Liabilities COGS $ 1,344
Cash $ 98 Accounts Payable $ 344 Depreciation $ 276
Accounts Receivable $ 188 Notes Payable $ 196 EBIT $ 691
Inventory $ 422 Total $ 540 Interest $ 141
Total $ 708 Long term debt $ 457 Taxable Income $ 550
Owners' Equity Taxes $ 165
Common Stock and paid in surplus
$ 550 Net Income $ 385
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591 Dividends $ 143
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588 Addition to RE $ 242

Total asset turnover (TAT) = Sales/Total assets

 2311/3588 = 0.64 times
Measure of asset use efficiency
Not unusual for TAT <1, especially if a firm has a large amount of
fixed assets
Capital intensity ratio = 1/TAT
 1/0.64 = 1.56

3-15
 PROFITABILITY
ASSETS
MEASURES SWAGMAN CAMPING LTD
Balance Sheet -2010
Liabilities & Owners Equity
SWAGMAN CAMPING LTD
Income Statement - 2010
Sales $ 2,311
Current Assets Current Liabilities COGS $ 1,344
Cash $ 98 Accounts Payable $ 344 Depreciation $ 276
Accounts Receivable $ 188 Notes Payable $ 196 EBIT $ 691
Inventory $ 422 Total $ 540 Interest $ 141
Total $ 708 Long term debt $ 457 Taxable Income $ 550
Owners' Equity Taxes $ 165
Common Stock and paid in surplus $ 550 Net Income $ 385
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591 Dividends $ 143
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588 Addition to RE $ 242

Profit margin = Net income/Sales

385/2311 = 16.7%
Return on assets (ROA) = Net income/Total assets
385/3588 = 10.73%
Return on equity (ROE) = Net income/Total equity
363 / 2591 = 14.9%

3-16
MARKET VALUE
MEASURES
Market price = $88 per share = PPS
Shares outstanding = 35 million

Earnings per share = EPS = Net income/Shares

outstanding
 385/35 = $11

PE ratio = Price per share (PPS )/ Earnings per share

(EPS)
 $88 / $11 = 8 times
Market-to-book ratio = Market value per share/ Book
value per share
 Book value per share = Total equity/Shares outstanding
= $2591/35 = $74
 Market-to-book = $88/74 = 1.19 times

3-17
SWAGMAN RATIOS

SWAGMAN CAMPING LTD RECAP

Liquidity Ratios Financial Leverage Ratios
Current Ratio 1.31 Total Debt Ratio 0.28
Quick Ratio 0.53 Debt to Equity 0.39
Cash Ratio 0.18 Equity Multiplier 1.39
Asset Management Ratios Times Interest Earned 4.9
Inventory Turnover 3.20 Cash Coverage 6.9
Days' Sales in Inventory 114 Profitability Measures
Receivables Turnover 12.30 Profit Margin 16.70%
Days' Sales in Receivables 30 ROA 10.73%
Total Asset Turnover 0.64 ROE 14.90%
Capital Intensity Ratio 1.56
Market Value Measures
Market Price $ 88.00
Shares Outstanding 35 m
EPS $ 11.00
PE Ratio 8.0 Book value per share $74.00
Market to Book 1.19

3-18
THE DU PONT IDENTITY
Return on equity (ROE) = Net income
(NI)/ Total equity (TE)= Basic formula
Du Pont identity
 ROE = Profit margin (PM) * Total asset
turnover (TAT) * Equity multiplier (EM)
 PM = Net income / Sales
 TAT = Sales / Total assets
 EM = Total assets / Total equity

 NI   Sales   TA  NI
ROE     
 Sales   TA   TE  TE

3-19
USING THE DU PONT
IDENTITY
ROE = PM*TAT*EM
Profit margin (PM) is a measure of a
firm’s operating efficiency—how well it
controls costs.
Total asset turnover (TAT) is a measure
of the firm’s asset-use efficiency—how
well it manages its assets.
Equity multiplier (EM) is a measure of
the firm’s financial leverage.

3-20
 SWAGMAN—DU PONT
IDENTITY
SWAGMAN CAMPING LT D RECAP
Liquidity Ratios Financial Leverage Ratios
Current Ratio 1.31 Total Debt Ratio 0.28
Quick Ratio 0.53 Debt to Equity 0.39
Cash Ratio 0.18 Equity Multiplier 1.39
Asset Management Ratios Times Interest Earned 4.9
Inventory Turnover 3.20 Cash Coverage 6.9
Days' Sales in Inventory 114 Profitability Measures
Receivables Turnover 12.30 Profit Margin 16.70%
Days' Sales in Receivables 30 ROA 10.73%
Total Asset Turnover 0.64 ROE 14.90%
Capital Intensity Ratio 1.56
Market Value Measures
Market Price $ 88.00
Shares Outstanding 35 m
EPS $ 11.00
PE Ratio 8.0 Book value per share $74.00
Market to Book 1.19

ROE = PM * TAT * EM
 PM = 16.7%
 TAT = .64
 EM = 1.39

ROE = .167 x .64 x 1.39

= .149= 14.9%

3-21
AN EXPANDED DU PONT
ANALYSIS

3-22
AN EXPANDED DU PONT
ANALYSIS

3-23
 INTERNAL AND SUSTAINABLE
GROWTH
DIVIDEND PAYOUT AND EARNINGS
RETENTION RATIOS

Dividend payout ratio (b) = Cash

dividends/Net income
Retention ratio(1-b) = Additions
to retained earnings/Net income =
1 – Payout ratio (b)

3-24
 INTERNAL AND SUSTAINABLE
GROWTH
DIVIDEND PAYOUT AND EARNINGS
RETENTION RATIOS (CONT.)
SWAGMAN CAMPING LTD SWAGMAN CAMPING LTD
Balance Sheet -2010 Income Statement - 2010
ASSETS Liabilities & Owners Equity Sales $ 2,311
Current Assets Current Liabilities COGS $ 1,344
Cash $ 98 Accounts Payable $ 344 Depreciation $ 276
Accounts Receivable $ 188 Notes Payable $ 196 EBIT $ 691
Inventory $ 422 Total $ 540 Interest $ 141
Total $ 708 Long term debt $ 457 Taxable Income $ 550
Ow ners' Equity Taxes $ 165
Common Stock and paid in surplus $ 550 Net Income $ 385
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591 Dividends $ 143
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588 Addition to RE $ 242

Dividend payout ratio (‘b’) =

 Cash dividends / Net income (DIV / NI)
 143/385 = 37%
Retention ratio (‘1 – b’) = (NI - DIV)/ NI
 Addition to Retained earnings / Net income
 $242/385 = 63%

3-25
INTERNAL GROWTH
RATE
The internal growth rate tells us how much the firm can
grow assets using retained earnings (internal financing)
as the only source of financing.

ROA  b
Internal Growth Rate 
1 - ROA  b
.1012  .667

1  .1012  .667
 7.23%
3-26
SUSTAINABLE GROWTH
RATE
The sustainable growth rate tells us how much the firm
can grow by using internally generated funds and
issuing debt to maintain a constant debt ratio.

ROE  b
Sustainable Growth Rate 
1 - ROE  b
.149  .63
  .1036
1  .149  .63
 10.36%
3-27
DETERMINANTS OF
GROWTH
Profit margin—operating efficiency
Total asset turnover—asset use
efficiency
Financial leverage—choice of
optimal debt ratio
Dividend policy—choice of how
much to pay to shareholders versus
reinvesting in the firm
3-28
SUMMARY OF INTERNAL AND
SUSTAINABLE GROWTH
RATES

3-29
 USING FINANCIAL INFORMATION—

WHY EVALUATE FINANCIAL

STATEMENTS?

Internal uses
Performance evaluation—
compensation and comparison
between divisions
Planning for the future—guide in
estimating future cash flows
External uses
Creditors
Suppliers
Customers
Shareholders
3-30
 USING FINANCIAL STATEMENT
INFORMATION—
BENCHMARKING

Ratios are not very helpful by

themselves; they need to be compared
with something
Time-trend analysis
 Used to see how the firm’s performance is
changing over time
 Internal and external uses
Peer-group analysis
 Compare with similar companies or within
industries
 GICS codes
 International codes used to classify a firm by its type of business operations

3-31
PROBLEMS WITH
FINANCIAL STATEMENT
ANALYSIS
Conglomerates
No readily available comparables
Global competitors
Different accounting procedures
Different fiscal year ends
Differences in capital structure
Seasonal variations and one-time
events
3-32
QUICK QUIZ
How do you standardise balance sheets and
income statements?
 Why is standardisation useful?

What are the major categories of ratios and

how do you compute specific ratios within
each category?
What are the major determinants of a firm’s
growth potential?
What are some of the problems associated
with financial statement analysis?
COPYRIGHT © 2011 MCGRAW-HILL AUSTRALIA PTY LTD
PPTS T/A ESSENTIALS OF CORPORATE FINANCE 2E BY ROSS ET AL. 3-33
SLIDES PREPARED BY DAVID E. ALLEN AND ABHAY K. SINGH