ACST252 FINANCE AND

FINANCIAL REPORTING

Week 3
Financial Statement Analysis
(Part 1)
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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-1
 CHAPTER THREE
Working with financial
statements

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-2
Learning objectives
LO3.1 Understand how to standardise financial
statements for comparison purposes.
LO3.2 Understand how to compute and, more
importantly, interpret some common ratios.
LO3.3 Understand the determinants of a firm’s
profitability.
LO3.4 Understand some of the problems and pitfalls
in financial statement analysis.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-3
Chapter organisation
• Cash flow and financial statements: a
closer look
• Financial statements of publicly listed
firms
• The Du Pont identity
• Using financial statement information
• Summary and conclusions

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-4
Cash
• Cash is generated by selling a product or
service, asset or security.
• Cash is spent by paying for materials and
labour to produce a product or service, and
by purchasing assets.
• Recall:
Cash flow from assets = Cash flow to
debtholders + Cash flow to shareholders

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-5
Sources and uses of cash
• At the most fundamental level, firms do two
things: generate cash and spend cash.
• Activities that bring in cash are called
sources of cash.
• Activities that involve spending cash are
called uses (or applications) of cash.

continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-6
Sources and uses of cash
• An increase in an asset account or a
decrease in a liability or equity account is a
use of cash.
• A decrease in an asset account or an
increase in a liability or equity account is a
source of cash.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-7
Example―Sources and uses of
cash ($000s)
Sources of cash
Increase in creditors $32
Increase in issued capital 50
Increase in retained earnings 264
Total sources $346

Uses of cash
Increase in receivables $23
Increase in inventory 29
Decrease in notes payable 7
Decrease in non-current debt 74
Non-current asset acquisitions 149
Total uses $282
Net addition to cash $ 64

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-8
Cash flow statement
• A firm’s financial statement that summarises
its sources and uses of cash over a specified
period.
• The presentation of cash flows in annual
reports is determined by an Accounting
Standard.

continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-9
Cash flow statement
• Changes are divided into three main
categories:
– Operating activities—includes net profit and
changes in most current accounts.
– Investment activities—includes changes in non-
current assets.
– Financing activities—includes changes in notes
payable, long-term debt and equity accounts, as
well as dividends.

continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-10
Cash flow statement
• 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 non-current assets
– Beginning non-current assets
+ Depreciation
continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-11
Cash flow statement
• 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

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-12
Example―Balance Sheet
Assets ($’000s) 2010 2011

Current assets
Cash $90 $100
Accounts receivable 520 620
Inventory 640 770
Total $1 250 $1 490

Non-current assets
Net plant and equipment 1 970 2 200

TOTAL ASSETS $3 220 $3 690

continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-13
Example―Balance Sheet
Liabilities and equity ($’000s) 2010 2011
Current liabilities
Accounts payable $420 $520
Notes payable 220 350
Total $640 $870
Long-term debt $410 $450
Shareholders’ equity
Ordinary shares 580 580
Retained earnings 1 590 1 790
Total $2 170 $2 370
TOTAL LIABILITIES AND EQUITY $3 220 $3 690

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-14
Example―Income Statement
($000s)
Sales $1 420.00
Cost of goods sold 960.00
Depreciation 60.00
EBIT $400.00
Interest 40.00
Taxable income 360.00
Tax 108.00
Net profit $252.00
Dividends 52.00
Addition to retained earnings $200.00

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-15
Example―Cash flow statement
• Operating activities
(+) Net profit $252
(+) Depreciation 60
(+) Increase in payables 100
(–) Increase in receivables (100)
(–) Increase in inventory (130)
$182
• Investment activities
(+) Ending non-current assets $2 200
(–) Beginning non-current assets (1 970)
(+) Depreciation 60
($290) continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-16
Example―Cash flow statement
• Financing activities
(+) Increase in notes payable $ 130
(+) Increase in long-term debt 40
(–) Dividends (52)
$ 118

• Putting it all together, the net addition to

cash for the period is:

$182 – 290 + 118 = $10

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-17
‘Players’ in Accounting
Standards
• Accountants
• Government
• Regulators
• Other users of financial statements

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-18
Ratio analysis
• Financial ratios are relationships determined
from a firm’s financial information, and used
for comparison purposes.
• Used to compare and investigate relationships
between different pieces of financial
information, either over time or between
companies.
• Ratios eliminate the size problem.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-19
Categories of financial ratios
• Liquidity—measures the firm’s short-term
solvency.
• Capital structure—measures the firm’s ability
to meet long-run obligations (financial
leverage).
• Asset management (or turnover)—measures
the efficiency of asset usage to generate
sales.
• Profitability—measures the firm’s ability to
control expenses.
• Market value—per-share ratios.
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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-20
Ratio analysis: questions to
consider for each ratio
• How is it computed?
• What is it intended to measure, and why
might we be interested?
• 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?

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-21
Liquidity ratios

Current assets
Current ratio 
Current liabilities

Current assets  Inventory

Quick ratio 
Current liabilities  Bank overdraft

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-22
Capital structure ratios

Interest - bearing debt  Cash

Net debt/equit y ratio 
Ordinary Shareholde rs' equity  Intangible s
Total debt
Debt/equit y ratio 
Total equity
Total assets
Equity multiplier 
Total equity
EBIT
Net interest cover 
Net interest, including finance lease charges
Interest - bearing debt
Debt to gross cash flow 
Net profit after tax  Depreciation  Amortisat ion

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-23
Turnover ratios

Cost of goods sold

Inventory turnover 
Inventory

365 days
Days' sales in inventory 
Inventory turnover

Sales
Receivable s turnover 
Accounts receivable
continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-24
Turnover ratios
365 days
Days' sales in receivable s 
Receivable s turnover

Sales
Fixed asset turnover 
Non - current assets

Sales
Total asset turnover 
Total assets

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-25
Profitability ratios
Net profit
Profit margin   100%
Sales

Net profit
Return on assets (ROA)   100%
Total assets

EBIT
Return on investment   100%
Total assets

Net profit
Return on equity (ROE)   100%
Total equity

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-26
Market value ratios

Price per share

Price/earning ratio 
Earnings per share

Market value per share

Market - to - book ratio 
Book value per share

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-27
The Du Pont identity
• Breaks ROE into three parts:
– operating efficiency (as measured by profit margin)
– asset use efficiency (as measured by total asset
turnover)
– financial leverage (as measured by the equity
multiplier).
Net profit Sales Assets
ROE   
Sales Assets Equity

 Profit margin  Total asset turnover  Equity multiplier

 ROA  Equity multiplier .

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-28
 Du Pont identity

• Du Pont started in business in the US in

1802, manufacturing gunpowder.
• Du Pont is now one of the world’s largest
chemical companies.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-29
Example: The Du Pont identity

• Sales are $7 000, net profit is $250, total

assets are $3 500 and equity is $1 900.

Net profit Sales Assets

ROE   
Sales Assets Equity

250 7000 3500

  
7000 3500 1900

 3.57%  2.00  1.84  13.14%

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-30
Grow Force Australia Ltd
• Grow Force Australia Ltd used to be listed on
the ASX. It is a distributor of fertiliser
products. It is now a part of Ruralco Holdings
Ltd.
• https://www.growforce.com.au/

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-31
Grow Force Australia Ltd

• It is a superb example of how one can use Du

Pont analysis to understand how they make
their profit and excellent returns.
• The EBIT/Sales margin is only 1-2%, but
ROE can be above 20%. If margins are low,
high turnover is needed.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-32
Why evaluate financial
statements?
• Internal uses:
– performance evaluation
– planning for the future.
• External uses:
– evaluation by outside parties
– evaluation of main competitors
– identifying potential takeover targets.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-33
Benchmarks for comparison
• Ratios are most useful when compared to a
benchmark.
• Time-trend analysis—examine how a
particular ratio(s) has performed historically.
• Peer group analysis—using similar firms
(competitors) for comparison of results.

continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-34
Benchmarks for comparison
• One common way of identifying potential
peers is based on the Global Industry
Classification Standard (GICS) used by the
Australian Securities Exchange (ASX).
• GICS is a code used globally to classify a
firm by its type of business operations.

continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-35
Benchmarks for comparison
• GICS consists of 10 economic sectors, 24
industry groups, 68 industries, and 154 sub-
industries, covering over 12 000 companies
globally.
• The basis of classification is the area from
which most revenue is generated.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-36
Problems with financial
statement analysis
• No underlying theory to identify correct ratios
to use, nor 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 financial
performance.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-37
Web example
• The Internet makes ratio analysis much
easier than it has been in the past
• Click on the web surfer to go to
http://www.reuters.com/finance/stocks/
– Click on 'Stocks', then choose a company and
enter its ticker symbol
– Click on 'Ratios' to see what information is
available.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-38
Quick quiz
• What is the statement of cash flows and how
do you determine sources and uses of cash?
• How do you standardise Balance Sheets
and Income Statements, and why is
standardisation useful?
• What are the major categories of ratios, and
how do you compute specific ratios within
each category?
• What are some of the problems associated
with financial statement analysis?

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-39
Summary and conclusions
• Activities that bring in cash are called
‘sources of cash’, and activities that involve
spending cash are called ‘uses of cash’.
• A cash flow statement summarises sources
and uses of cash over a specified period.

continued

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-40
Summary and conclusions
• Financial ratios are grouped together into
five main categories: liquidity, capital
structure, asset management, profitability
and market value.
• Ratios are most useful when compared to a
benchmark (e.g. time-trend and peer group
analysis).
• Problems can arise in using financial
statements.

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PPTs to accompany Fundamentals of Corporate Finance 7e by Ross et al. 2-41