CHAPTER 3: Understanding Financial Statements, Taxes, and Cash Flows

A. Four basic financial statements and basic information for each i. Income Statement includes the revenue, expense, and profit made by the firm over a specific period of time ii. Balance Sheet is a snapshot of the firms assets, liabilities, and owners equity for a particular date iii. Cash Flow Statement cash received and spent over a specific period of time. Operating Activities includes sales and expenses (cash activity that affects net income) Investment Activities includes cash flow that arise out of the purchase and sale of long-term assets such as plant and equipment Financing Activities represents changes in debts and equity. It includes the sale of new shares of stock, the repurchase of outstanding shares, and the payment of dividends iv. Statement of Shareholders Equity provides detailed accounts on firms activities such as: Common and Preferred stock accounts Retained earning accounts Changes in owners equity that do not appear in the income statement B. Three uses of financial statements in management 1) Financial Statement Analysis asses current performance 2) Financial Control monitor and control operations using accounting measures 3) Financial Forecasting or Planning financial statements are universally understood format for describing operations and is used as a prototype for financial planning models Income Statement For the year end December 31, 2010 Sales Cost of goods sold Gross Profit Operating Expenses Selling Expense General and administrative expense Depreciation and amortization expense Total Operating Expenses Net Operating Income Interest Expense Earnings before taxes Income tax Net Income Additional Information: Dividends paid to stockholders during 2010 Number of common shares outstanding Earnings per share Dividends per share $ xxx (xxx) xxx

(xxx) (xxx) (xxx) (xxx) $ xxx (xxx) $ xxx (xxx) $ xxx

xx xx xx xx

Balance Sheet For the year end December 31, 2010 Assets Liabilities and Owners Equity Cash $ xxx Accounts payable Accounts receivables xxx Accrued expenses Inventory xxx Short-term notes Other Current Assets xxx Total current liabilities Total current assets $ xxx Long-term debt Gross plant and property and equipment xxx Total liabilities Less accumulated depreciation (xxx) Common stockholders equity Net plant and equipment $ xxx Common stock-par value Total Assets $ xxx Pain in capital Retained earnings Total common stockholders equity Total liability and stockholders equity

$ $

xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx

$ $

CHAPTER 4: Financial Analysis

Questions: 1. 2. 3. 4. 5. How liquid is the firm? Will it be able to pay its bills as they come due? How has the firm finance the purchase of its assets? How efficient has the firms management been in utilizing its assets to generate sales? Has the firm earned adequate returns on its investments? Are the firms managers creating value for shareholders? Category of Ration Used to Address the Questions Liquidity Ratio Capital Structure Ratio Asset Management Efficiency Ratios Profitability Ratio Market Value Ratio

A. Liquidity Ratio Measures of the ability of the firm to pay its bills in a timely manner when they come due i. Current Ratio Assumes that the firms accounts receivable will be collected and turned into cash into cash on a timely basis and that its inventories can be sold without an extended delay

Current Ratio = Current Assets Current Liabilities

ii. Acid Test (Quick) Ratio Assumes that the firms inventories might not be very liquid

Acid Test Ratio = Current Assets - Inventories Current Liabilities

iii. Average Collection Period (Daily Collection) Measures how many days it takes for the firm to collect its receivables

Average Collection Period =

Accounts Receivables Annual Credit Sales/365 days

iv.

Accounts Receivables Turnover Ratio (Collections in a year) Measures how any times accounts receivables are rolling over during a year

Accounts Receivable Turnover Ratio = Annual Credit Sales Accounts Receivable

v. Inventory Turnover Ratio A key indication of the quality of a firms inventory length is the length of time it is held before bing sold. Shorter inventory cycle leads to greater liquidity since the items in the inventory are converted to cash more quickly.

Inventory Turnover Ratio =

Cost of Goods Sold Inventories

B. Capital Structure Ratio The mix of debts and equity securities a firm uses to finance its assets i. Debt Ratio Measures the percentage of the firms assets that were financed using current plus long term liabilities

Debt Ratio = Total Debt Total Assets

ii. Times Interest Earned Measures the firms ability to serve its debts or pay the interest on the debt. Computation indicates if a firm can afford to pay interest expense with the net operating income it earns.

Times Interest Earned = Net Operating Income/EBIT Interest Expense

C. Assets Management Efficiency Ratios Measures how well assets are managed to generate sales i. Total Asset Turnover Measures how well a firms assets are managed. Represents the amount of sales generated per dollar invested in the firms assets.

Total Asset Turnover = Sales . Total Assets

ii. Fixed Asset Turnover Measures how well the inventory assets generate sales

Fixed Asset Turnover =

Sales . Net Plant and Equipment

C. Market Value Ratio Answers the question: How are the firms shares valued in the stock market? i. Price / Earnings Ratio Indicate how much investors have been willing to pay for $1 of reported earnings.

Price / Earnings Ratio = Market Price per Share Earning Price per Share
ii. Market-to-Book Ratio A market-to-book ratio greater than 1 indicates that the market value of the firms shares is greater than the book value of the accumulated investment in the firm s equity. Conversely, a ratio less than 1 suggests that the stocks is worth less than the accumulated investment made by shareholders in the firm.

Market-to-Book Ratio = Market Price per Share Book Value per Share

E. Profitability Ratio Answer the question: Has the firm earned adequate returns on its investments? The fundamental determinants to a firms profitability and returns on investment: Cost Control- how well the firm controlled its costs? Efficiency of asset utilization-How efficient is the firms management at using the firms assets to generate sales? i. Gross Profit Margin Indicates how well the firms management controls its expenses determines the firms profit margin

Gross Profit Margin = Gross Profit Sales

ii. Operating Profit Margin (OPM) Indicates how much profit is generated from each dollar of sales after accounting for both costs of good sold and operating expense.

Operating Profit Margin = Net Operating Income / EBIT Sales

iii. Net Profit Margin (NPM) Shows how well the firm has controlled its costs but does not show efficiency in asset use to generate sale.

Net Profit Margin = Net Income Sales

iv. Operating Return on Assets Shows how well the firm has controlled its costs and the efficiency in using assets to generate sale

Operating Return on Assets = Net Operating Income / EBIT Total Assets

v. Return on Equity A measure of the return rate of earned on the common shareholders investment in the firm equal to net income divided by common equity.

Return on Equity =

Net Income . Common Equity