Chapter 3 – Working with Financial Statements

This chapter starts a new unit in the textbook, dealing with Understanding Financial Statements and Cash Flow. You will use your knowledge of accounting in a new way — the way that a financial manager uses it — to determine the current condition of the company and to make good financial decisions.

LEARNING OBJECTIVES

When you finish your study of this chapter, you should know:

1. Take a normal financial statement and standardize it so that you can COMPARE it with statements from other enterprises.
2. ANALYZE a financial statement, using it to COMPUTE and INTERPRET some common financial ratios. (See table 3.5 on page 61)
3. CALCULATE and INTERPRET the DuPont Identity.
4. EXPLAIN, ANALYZE and INTERPRET the Internal Growth rate and the Sustainable Growth rate, thereby EXPLAINING the things that determine a firm’s profitability and growth.

The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!

Key terminology:

Study Tip

The ratio analysis section of this chapter is the part that seems to give some students problems, since they have the very common, and irrational, “fear of math complex”. However, do not let the ratio analysis blind you to the concepts that are also important in this chapter, such as using common size balance sheets and income statements to compare companies of different sizes, and how to use the DuPont identity to find out what is really going on with a corporation. Finally, be sure that you understand the reasons for doing financial statement analysis, both as an internal manager and an outside investor or creditor.

The definitions in Table 3.5 on page 61 are key. Notice that there are five different groups of financial ratios:

1. Measures of short-term solvency or liquidity
2. Measures of long-term solvency or leverage
3. Asset utilization or turnover measures
4. Measures of Profitability
5. Measures of Market Valuation

Don’t think of these financial ratios as equations (although of course they are equations), but as definitions. If you think about what they mean, rather than trying to memorize them, you have a much better chance of remembering them. Clearly, if you are a lending officer at a bank who the firm is asking for a short-term line of credit, you will want to know if the firm is solvent in the short-term. Think about what you need to know to determine if they are solvent. Do they have enough cash to pay their current bills? Use your common sense to make the ratios make sense.

If you break these equations down into the five groups, you will often see that the first equation is the key measure, and the others are simply ways of restating that first concept in another way. For example, there are two equations for ROE (return on equity). The second one looks very complicated, but if you examine it more closely, you see that the first term is simply profit margin, the second term is asset turnover, and the third term is the equity multiplier. In addition, if you write the second equation out, and use the old arithmetic trick of canceling out terms in the numerator and denominator, you get back to the first equation. Playing around with the equations like that will help you remember them.

Don’t forget! Homework is due by 6:30 PM on class day by e-mail to homework@nyfinancial.com! Don’t suffer a zero by being late.