Copyright 2004 McGraw-Hill AustraliaPty Ltd3-1Chapter ThreeWorking with FinancialStatements
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-23.1 Cash Flow and Financial Statements: A CloserLook3.2 Financial Statements of Publicly Listed Firms3.3 The Du Pont Identity3.4 Using Financial Statement Information3.5 Summary and ConclusionsChapter Organisation
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-3Chapter Objectives• Identify the ways that firms obtain and use cash asreported in the Statement of Cash Flows.• Calculate and interpret key financial ratios.• Discuss the Du Pont identity as a method offinancial analysis.• Understand the use of financial information forcomparative purposes.• Outline the problems associated with usingfinancial ratios.
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-4Cash• Cash is generated by selling a product or service,asset or security.• Cash is spent by paying for materials and labour toproduce a product or service and by purchasingassets.• Recall:Cash flow from assets = Cash flow to debtholders+ Cash flow to shareholders
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-5Cash Flow• Sources of cash are those activities that bring incash.• Uses of cash are those activities that involvespending cash.• The firm’s statement of cash flows is the firm’sfinancial statement that summarises its sourcesand uses of cash over a specified period.
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-8Statement of Financial Performance(000s)Net sales $710.00Cost of goods sold 480.00Depreciation 30.00EBIT $200.00Interest 20.00Taxable income 180.00Tax 53.45Net profit $126.55Dividends 26.55Addition to retained earnings $100.00
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-9Statement of Cash Flows• A statement that summarises the sources and usesof cash.• Changes are divided into three main categories:– Operating activities—includes net profit and changes inmost current accounts– Investment activities—includes changes in fixed assets– Financing activities—includes changes in notes payable,long-term debt and equity accounts as well as dividends.
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-10Statement of Cash Flows• Operating activities+ Net profit+ Depreciation+ Any decrease in current assets (except cash)+ Increase in accounts payable– Any increase in current assets (except cash)– Decrease in accounts payable• Investment activities+ Ending fixed assets– Beginning fixed assets+ Depreciation
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-11Statement of Cash Flows• Financing activities– Decrease in notes payable+ Increase in notes payable– Decrease in long-term debt+ Increase in long-term debt+ Increase in ordinary shares– Dividends paid
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-13Statement of Cash Flows• Financing activities– + Increase in notes payable + $ 65.00– + Increase in long-term debt + 20.00– – Dividends – 26.55$ 58.45Putting it all together, the net addition to cash forthe period is:$91.55 – 145.00 + 58.45 = $5.00
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-14‘Players’ in Accounting Standards• Accountants• Government• Regulators• Other users
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-15Ratio Analysis• Financial ratios are relationships determined froma firm’s financial information.• Used to compare and investigate relationshipsbetween different pieces of financial information,either over time or between companies.• Ratios eliminate the size problem.
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-16Categories of Financial Ratios• Liquidity—measures the firm’s short-term solvency.• Capital structure—measures the firm’s ability tomeet long-run obligations (financial leverage).• Asset management (turnover)—measures theefficiency of asset usage to generate sales.• Profitability—measures the firm’s ability to controlexpenses.• Market value—per-share ratios.
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-23The Du Pont Identity• Breaks ROE into three parts:– operating efficiency– asset use efficiency– financial leveragemultiplierEquityROAmultiplierEquityoverasset turnTotalmarginProfitEquityAssetsAssetsSalesSalesprofitNetROE×=××=××=
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-24Uses for Financial StatementInformation• Internal uses:– performance evaluation– planning for the future• External uses:– evaluation by outside parties– evaluation of main competitors– identifying potential takeover targets
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-25Benchmarks for Comparison• Ratios are most useful when compared to abenchmark.• Time-trend analysis—examine how a particularratio(s) has performed historically.• Peer group analysis—using similar firms(competitors) for comparison of results.• Global Industry Classification Standard (GICS)used by ASX is a useful way to find a peercompany.
Copyright 2004 McGraw-Hill AustraliaPty Ltd3-26Problems with Ratio Analysis• No underlying theory to identify correct ratios touse or appropriate benchmarks.• Benchmarking is difficult for diversified firms.• Firms may use different accounting procedures.• Firms may have different recording periods.• One-off events can severely affect financialperformance.