CHAPTER 3: Understanding Financial Statements, Taxes, and Cash Flows
A. Four basic financial statements and basic information for each
Income Statement – includes the revenue, expense, and profit made by the firm over
a specific period of time
Balance Sheet – is a snapshot of the firms assets, liabilities, and owner’s equity for a
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
Statement of Shareholder’s Equity – provides detailed accounts on firm’s activities
Common and Preferred stock accounts
Retained earning accounts
Changes in owner’s 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
For the year end December 31, 2010
Cost of goods sold
General and administrative expense
Depreciation and amortization expense
Total Operating Expenses
Net Operating Income
Earnings before taxes
Dividends paid to stockholders during 2010
Number of common shares outstanding
Earnings per share
Dividends per share
For the year end December 31, 2010
Liabilities and Owner’s Equity
$ xxx Accounts payable
xxx Accrued expenses
xxx Short-term notes
Other Current Assets
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
Common stock-par value
Pain in capital
Total common stockholders’ equity
Total liability and stockholders’ equity
CHAPTER 4: Financial Analysis
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
How efficient has the firm’s management
been in utilizing its assets to generate
Has the firm earned adequate returns on
Are the firm’s managers creating value
Category of Ration Used to Address the
Capital Structure Ratio
Asset Management Efficiency Ratios
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
Assumes that the firm’s 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
Acid Test (Quick) Ratio
Assumes that the firm’s inventories might not be very liquid
Acid Test Ratio = Current Assets - Inventories
Average Collection Period (Daily Collection)
Measures how many days it takes for the firm to collect its receivables
Average Collection Period=
Annual Credit Sales/365 days
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
Inventory Turnover Ratio
A key indication of the quality of a firm’s 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
B. Capital Structure Ratio
The mix of debts and equity securities a firm uses to finance its assets
Measures the percentage of the firm’s assets that were financed using current plus longterm liabilities
Debt Ratio= Total Debt
Times Interest Earned
Measures the firm’s 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
C. Assets Management Efficiency Ratios
Measures how well assets are managed to generate sales
Total Asset Turnover
Measures how well a firm’s assets are managed.
Represents the amount of sales generated per dollar invested in the firm’s assets.
Total Asset Turnover=Sales
Fixed Asset Turnover
Measures how well the inventory assets generate sales
Fixed Asset Turnover=
Net Plant and Equipment
C. Market Value Ratio
Answers the question: How are the firm’s 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 firm’s
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 firm’s profitability and returns on investment:
Cost Control- how well the firm controlled its costs?
Efficiency of asset utilization-How efficient is the firm’s management at using the firm’s assets
to generate sales?
i. Gross Profit Margin
Indicates how well the firm’s management controls its expenses determines the firm’s
Gross Profit Margin = Gross Profit
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
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
iv. Operating Return on Assets
Shows how well the firm has controlled its costs and the efficiency in using assets to
Operating Return on Assets= Net Operating Income / EBIT
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 .