Chapter 3: working with Financial Statements
3.1 Cash Flow and Financial statements: A Closer Look
Personal discussion about 3.1: Why are they showing us a financial statement that is no
longer used (Sources and uses of Cash) instead of just further explaining how to
understand the Statement of Cash Flows and how it is categorized? The book literally says,
“There is no such statement in financial accounting, but this arrangement resembles one
used many years ago. As we will discuss, this form can come in handy, but we emphasize
again it is not the way this information is normally presented.
Firms do two things; generate and spend cash.
Selling a security involves either borrowing or selling an equity interest (shares of stock) in
the firm.
Sources of cash are a firm’s activities that generate cash.
Example: a decrease in an asset account or an increase in a liability (or equity)
account
Uses (or applications) of Cash is a firm’s activities in which cash is spent.
Example: increase in a left-side (asset) account or a decrease in a right-side (liability
or equity) account
Statement of Cash Flows is a firm’s financial statement that summarizes its sources and
uses of cash over a specified period.
• Operating Activities
• Financing Activities
• Investment Activities
Concept Questions:
3.1a What is a source of cash? Give three examples.
3.1b What is a use, or application, of cash? Give three examples.
3.2 Standardized Financial Statements
Personal discussion about 3.2: comparing companies based off percentages is the key
concept for standardizing and comparing data on financial statements. This is because
companies differ in sizes and sometimes even types of currency. This is why percentages
give you a better number for each company as their own and as a whole.
Key performance indicators (KPI) are measurable values that shows how a company is
progressing toward achieving a key business objective.
Two different ways to standardize statements:
1. A common-size statement is a standardized financial statement presenting all
items in percentage terms. Balance sheet items are shown as a percentage of
assets and income statement items as a percentage of sales.
2. A common-base year statement is a standardized financial statement presenting
all items relative to a certain base year amount.
Concept Questions:
3.2a Why is it often necessary to standardize financial statements?
allows for easier comparisons between companies and overtime by using ratios or
percentages.
3.2b Name two types of standardized statements and describe how each is formed.
The two types of standardized statements are Common Size Statements and
Common Base Year Financial statements.
Common size statements are formed by expressing each item on a balance sheet as
a percentage of total assets and each item on an income statement as a percentage
of total sales.
Common Base Year statements are formed by choosing a base year and then
express each item relative to the base amount.
3.3 Ratio Analysis
Personal discussion for 3.3: This chapter consisted of 25 different equations. I will receive
more knowledge on working actual problems than reading this chapter. These are also
mostly given on the exam, which seems given since there are 25 equations just for this
section alone.
*Refer to given equation formula sheet for this section
Return on Assets (ROA) is a measure of profit per dollar of assets.
Return on Equity (ROE) is a measure of how stockholders fared during the year.
• Benefiting shareholders is our goal
• ROE in an accounting sense is the true bottom-line measure of performance
(The difference between these two profitability measures reflects the use of debt,
financing, or financial leverage.)
3.4 the DuPont Identity
The DuPont Identity is a popular expression breaking ROE into three parts: operating
efficiency, asset use efficiency, and financial leverage.
• operating efficiency (as measured by profit margin)
• asset use efficiency (as measured by total asset turnover)
• financial leverage (as measured by the equity multiplier)
The amount of leverage a firm uses is governed by its capital structure policy.
If ROE is unsatisfactory by some measure, DuPont identity tells you where to start
looking for the reasons.
3.5 Using Financial Statement Information
Why Evaluate Financial Statements?
Internal:
• performance evaluation
• division performance comparisons
External:
• deciding whether to grant credit to a new customer
• evaluate suppliers
• evaluating competitors
• acquiring multiple firms
Benchmarks serve as a critical standard for measuring an asset's value change or other
investment metrics over time.
How do we choose a benchmark or standard comparison?
Time trend Analysis – History
Peer group Analysis – to identify a peer group
Standard Industrial Classification (SIC) Codes are U.S. government codes used to
classify a firm by its type of business operations.
Aspirant group – we aspire to be like its members
NAICS – North American Industry Classification System (pronounced “nakes”) was a new
industry classification system to replace SIC but both are still used.
Problems on judgments about value and risk and why ratios can’t “matter the most”:
-unrelated lines of business (consolidation records)
-scattered across globe
-financial statements outside of the US don’t conform to GAAP (hard to compare)
-different accounting procedures, ex: FYs and Inventory