Working with Financial Statements

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1 Working with Financial Statements Faculty of Business Administration Lakehead University Spring 2003 May 6, 2003 Outline of the Chapter 3.1 Cash Flow and Financial Statements: A Closer Look 3.2 Standardized Financial Statements 3.3 Ratio Analysis 3.4 The DuPont Identity 3.5 Using Financial Statement Information 1

2 3.1 Cash Flow and Financial Statements We have seen in Chapter 2 that the cash activities of the firm are summarized by CF(A) = CF(B) + CF(S). In this chapter, we take a closer look at the cash events that occurred during the year. To this end, we need to defined sources and uses of cash. 2 Sources and Uses of Cash Activities that bring cash to the firm are called sources of cash. Activities that involve spending cash are called uses of cash. An increase (decrease) in accounts payable is a source (use) of cash. An increase (decrease) in accounts receivable is a use (source) of cash. 3

3 Moraldo, Inc and 2001 Balance Sheets (in millions of $) Assets Change Cash Accounts receivable Inventory Total current assets Net fixed assets 1,200 1, Total assets 1,903 1, Liabilities and Stockholders Equity Accounts payables Notes payable Total current liabilities Long-term debt Common stock Accum. retained earnings Total equity Total liabilities and equity 1,903 1, From the previous balance sheet, sources of cash can be summarized as follows: Sources of cash Decrease in inventory 30 Increase in accounts payable 25 Increase in long-term debt 42 Increase in common stock 21 Increase in retained earnings 140 Total sources of cash $258 5

4 From the previous balance sheet, uses of cash can be summarized as follows: Uses of cash Increase in accounts receivable 30 Increase in net fixed assets 170 Decrease in notes payable 10 Total uses of cash $210 6 The net addition to cash is the difference between total sources of cash and total uses of cash: Total sources Total uses = Net addition to cash = 48. We can verify that Cash in 2002 Cash in 2001 = Net addition to cash = 48. 7

5 The Statement of Changes in Financial Position The last statements provide some information about what happened during the year but they do not tell the whole story. To further investigate the flow of cash during the year, we need the income statement. Using the balance sheets for 2001 and 2001 and the 2002 income statement, we can produce the statement of changes in financial position. There is no standard way of producing this statement, so don t be surprise if you come across different arrangements. 8 Moraldo, Inc Income Statement (in millions of $) Sales 2,446 Cost of goods sold (1,624) Depreciation (356) Earnings before interest and taxes 466 Interest expense (64) Pretax income 402 Taxes (169) Net income 233 Earnings retained: $140 Dividends: $93 9

6 Moraldo, Inc Statement of Changes in Financial Position Operating activities Net income 233 Add: Depreciation 356 Decrease in inventory 30 Increase in accounts payable 25 (Deduct): Increase in accounts receivable (30) Net cash from operating activities 614 Investment activities Fixed assets acquisitions (526) Net cash from investment activities (526) Financing activities Decrease in notes payable (10) Increase in long-term debt 42 Dividends paid (93) Increase in common stock 21 Net cash from financing activities (40) Net change in cash Common-Size Financial Statements How to compare balance sheets from different companies? One useful way is to standardize their financial statements. Financial statements can be standardized according to size, i.e. balance sheet items are expressed as fractions of total assets; income statement items are expressed as fractions of total sales. 11

7 Moraldo, Inc and 2001 Common-Size Balance Sheets Assets Change Cash Accounts receivable Inventory Total current assets Net fixed assets Total assets Liabilities and Stockholders Equity Accounts payables Notes payable Total current liabilities Long-term debt Common stock Accum. retained earnings Total equity Total liabilities and equity Moraldo, Inc Common-Size Income Statement Sales 1.00 Cost of goods sold (0.66) Depreciation (0.15) Earnings before interest and taxes 0.19 Interest expense (0.03) Pretax income 0.16 Taxes (0.07) Net income 0.10 Earnings retained: 0.06 Dividends:

8 3.2 Common-Base-Year Financial Statements Common-base-year financial statements help us see the trends in the different items. Values in a common-base-year statement as calculated as follows: If base year is 1999, say, then Common-base-year cash in 2000 = Common-base-year cash in 2001 = Common-base-year inventory in 2000 =. Cash in 2000 Cash in 1999 Cash in 2001 Cash in 1999 Inventory in 2000 Inventory in Combined Common-Size and Common-Base-Year Financial Statements Combining common-size (CS) and common-base-year (CBY) yields involves taking ratios of the common-size ratios. Take for instance, inventory. These were 280, or 17% of total assets, in 2001 and 250, or 13% of total assets, in If 2001 is the base year, CBY inventory in 2002 = = 0.89 Combined CS and CBY inventory in 2002 = =

9 Moraldo, Inc and 2001 Assets CS CS CBY Combined Cash A/R Inv Total CA NFA 1,200 1, TA 1,903 1,

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