Professor John ZietlowMBA 621

Professor John ZietlowMBA 621

Spring 2006Spring 2006

Financial Statements And Cash Flow Analysis

Financial Statements And Cash Flow Analysis

Chapter 2Chapter 2

Chapter 2 OverviewChapter 2 Overview

• 2.1 Financial Statements– Balance Sheet

– Income Statement

– Statement of Retained Earnings

– Statement of Cash Flows

– Notes to Financial Statements

• 2.2 Cash Flow Analysis– The Firm’s Cash Flows

– Depreciation and Cash Flows

– Sources and Uses of Cash

– Developing and Interpreting the Statement of Cash Flows

• 2.3 Analyzing Performance Using Ratio Analysis– Liquidity Ratios

– Activity Ratios

– Debt Ratios

– Profitability Ratios

– Market Ratios

Four Key Financial Statements Are Required By U.S. Securities & Exchange CommissionFour Key Financial Statements Are Required By U.S. Securities & Exchange Commission

1. Income Statement– Details Firm’s Revenues, Expenses & Profits During Period– By Definition: Profit (Income) = Revenues - Expenses

2. Balance Sheet– Details Firms Assets, Liabilities & Capital At Period’s End– By Definition: Assets = Liabilities + Stockholders’ Equity– Assets Listed In Decreasing Order of Liquidity; Cash First

3. Statement Of Retained Earnings– Reconciles Net Income, Cash Dividends & Change In

Retained Earnings Between Beginning & End Of Period4. The Statement Of Cash Flows

– Summarizes Firm’s Sources & Uses Of Cash and How Cash Position Changes Over A Period

The Uses (And Misuses) Of Financial Statements

The Uses (And Misuses) Of Financial Statements

• All Public Companies Must Provide These Statements– Must Be Filed With SEC, Given To Shareholders

• Must Be Prepared & Audited According To GAAP– U.S. Accounting Standards More “Rigorous” Than Most– Enron Collapse Has Thrown U.S. Accounting Into Crisis

• Accrual Accounting: When Revenue & Expenses Realized? – Realized When Sale Is Made; Not When Payment Received

• In U.S., Must Prepare Quarterly & Annual Statements– Other Countries Only Require Semi-Annual Or Annual Filings

• Statements Are The Principal Tools Used To Evaluate Firm– Used By Management, S/Hs, Creditors, Security Analysts– Typically Use “Ratio Analysis” To Evaluate Firm’s Condition

• Are Imperfect Measures Of Firm’s Condition Or Prospects– Though Essential, Statements Must Be Interpreted Cautiously

Global Petroleum Company Balance Sheet Assets ($ Millions) December 31

Global Petroleum Company Balance Sheet Assets ($ Millions) December 31

Current assets 2003 2002

Cash & cash equivalents $440 $213 Marketable securities 35 28 Accounts receivable 1,619 1,203 Inventories 615 530 Other (mostly prepaid expenses) 170 176 Total current assets $2,879 $2,150 Fixed assets Gross property, plant and equipment $9,920 $9,024 Less accumulated depreciation (3,968) (3,335) Net property, plant and equipment $5,952 $5,689 Intangible assets and others 758 471 Net fixed assets $6,710 $6,160 Total assets $9,589 $8,310

Global Petroleum Company Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31Global Petroleum Company Balance Sheet

Liabilities & Stockholders’ Equity ($Mn) 12/31

Current liabilities 2003 2002 Accounts payable $1,697 $1,304 Notes payable 477 587 Accrued expenses 440 379 Total current liabilities $2,614 $2,270 Long-term liabilities Deferred taxes $907 $793 Long-term debt 1,760 1,474

Total long-term liabilities $2,667 $2,267 Total liabilities $5,281 $4,537 Shareholders’ equity Preferred stock $30 $30 Common stock ($1 par value) 373 342 Capital in excess of par 248 229 Retained earnings 4,271 3,670 Less treasury stock (614) (498) Total shareholders’ equity $4,308 $3,773 Total liabilities & stockholders’ equity $9,589 $8,310

Global Petroleum Company Income Statement ($ Millions) December 31Global Petroleum Company Income Statement ($ Millions) December 31

2003

2002

Sales revenue $12,843 $9,110 Cost of goods sold (8,519) (5,633) Gross margin $4,324 $3,477 Operating and other expenses (1,544) (1,521) Selling, general, administ expenses (616) (584) Depreciation (633) (608) Operating income $1,531 $764 Other income 140 82 Earnings before interest and taxes $1,671 $846 Interest expense (123) (112) Pretax income $1,548 $734 Taxes (599) (263) Current (367) (158) Deferred (232) (105) Net income $949 $471

Global Petroleum Comp Income Statement Dividends & Earnings Per Share ($Mn) 12/31Global Petroleum Comp Income Statement

Dividends & Earnings Per Share ($Mn) 12/31

2003

2002

Net income $949 $471

Preferred stock dividends $3 $3

Retained earnings $601 $142

Dividends $345 $326

Per share data 1

Earnings per share $5.31 $2.54

Dividends per share $1.93 $1.76

Price per share $76.25 $71.50

1 Based on 178,719,400 and 185,433,100 shares outstanding as of

December 31, 2003 and 2002, respectively.

Global Petroleum Co Statement Of Retained Earnings ($ Mn), Year Ending Dec 31, 2003

Global Petroleum Co Statement Of Retained Earnings ($ Mn), Year Ending Dec 31, 2003

Retained earnings balance (Jan 1, 2003)

$3,670

Plus: Net income (for 2003) 949

Less: Cash dividends (paid during 2003)

Preferred stock ($3)

Common stock (345)

Total dividends paid ($348)

Retained earnings balance (Dec 31, 2003) $4,271

Pattern of Cash Flows Through a FirmPattern of Cash Flows Through a FirmCash FlowsThe firm’s cash flows

(1) Operating flows (2) Investment flows

LaborLabor Accrued Wages

Accrued Wages

Cashand

MarketabaleSecurities

Cashand

MarketabaleSecurities

Payment of accruals

Raw Materials

Raw Materials

AccountsPayable

AccountsPayable

Work inProcessWork inProcess

OverheadExpensesOverheadExpenses

FinishedGoods

FinishedGoods

Operating (incl.Depreciation)

andInterest Expense

Operating (incl.Depreciation)

andInterest Expense

TaxesTaxes

SalesSales

AccountsReceivablesAccounts

Receivables

Payment of CreditPurchases

Payment

Refund

Cash Sales

Collection of Credit Sales

(3) Financing flows

Fixed AssetsFixed

Assets

Business InterestsBusiness Interests

Purchase

Sale

Depreciation

Purchase

Sale

Debt (Short Term

and Long Term)

Debt (Short Term

and Long Term)

EquityEquity

Borrowing

Repayment

Sale of Stock

Repurchase of Stock

Payment of Cash Dividends

Sources and Uses of Corporate Cash FlowSources and Uses of Corporate Cash Flow

Sources• Decreases in any asset• Increase in any liability• Net profits after taxes• Depreciation and other

non-cash charges• Sale of stock

Uses• Increase in any asset• Decrease in any liability• Net loss• Dividends paid• Repurchase or

retirement of stock

Global Petroleum Co Statement Of Cash Flows ($ Millions), Year Ending Dec 31, 2003

Global Petroleum Co Statement Of Cash Flows ($ Millions), Year Ending Dec 31, 2003

Cash Flow From Operating Activities

Net income (net profit after tax) $949

Depreciation 633

Increase in accounts receivable (416)

Increase in inventories (85)

Decrease in other assets 6

Increase in accounts payable 393

Increase in accrued expenses 61

Cash provided by operating activities $1,541

Cash Flow from Investment Activities

Increase in gross fixed assets ($896)

Increase in intangible and other assets (287)

CF provided (consumed) by investments ($1,183)

Global Petroleum Comp Statement Of Cash Flows ($Mn), Year Ending Dec 31, 2003

Global Petroleum Comp Statement Of Cash Flows ($Mn), Year Ending Dec 31, 2003

Cash Flow From Financing Activities

Decrease in notes payable ($110)

Increase in deferred taxes 114

Increase in long-term debt 286

Changes in stockholders’ equity (66)

Dividends paid (348)

CF provided (consumed) by financing ($124)

Net Increase in Cash & Cash Equivalents

$234

Five Basic Types Of Financial Ratios Used To Analyze A Firm

Five Basic Types Of Financial Ratios Used To Analyze A Firm

• Liquidity Ratios measure a firm’s ability to satisfy its short-term obligations as they come due. Greater liquidity preferred.

• Activity ratios measure the speed with which various accounts are converted into sales or cash. Higher activity preferred.

• Debt Ratios indicate the amount of borrowed money being used by the firm. Lower debt ratio implies greater safety.

• Profitability Ratios measure the returns of the firm to its sales, assets, or equity. Higher profitability (almost) always preferred.

• Market ratios relate the firm’s market value as measured by its current share price to certain accounting values. Higher valuation ratios preferred.

Exxon Mobil Company Balance Sheet Assets ($ Millions) December 31

Exxon Mobil Company Balance Sheet Assets ($ Millions) December 31

Current assets 2001 2000 Cash & cash equivalents $6,547 $7,080 Notes and accounts receivable, less estimated doubtful amounts

19,549 22,996

Inventories Crude oil, products and merchandise 6,743 7,244 Materials and supplies 1,161 1,060 Prepaid taxes and expenses 1,681 2,019 Total current assets $35,681 $40,399 Fixed assets Investments and advances $10,768 $12,618 Property, plant and equipment, at cost, less accumulated depreciation and depletion

89,602 89,829

Other assets, including intangibles, net 7,123 6,154 Total assets $143,174 $149,000

Exxon Mobil Company Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

Exxon Mobil Company Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

Current liabilities 2001 2000

Notes and loans payable $3,703 $6,161 Accounts payable and accrued liabilities 22,862 26,755 Income taxes payable 3,549 5,275 Total current liabilities $30,114 $38,191 Long-term liabilities Deferred Income Taxes $16,359 $16,442 Long-term debt 7,099 7,280

Other non-current liabilities 13,616 13,100 Minority interest 2,825 3,830 Total long-term liabilities $39,899 $40,052 Total liabilities $70,013 $78,243

Shareholders’ equity Preferred stock 0 0 Common stock ($1 par value) 73,161 70,757 Total shareholders’ equity $73,161 $70,757 Total liabilities & stockholders’ equity $143,174 $149,000

Liquidity Ratios For Exxon Mobil Corporation

Liquidity Ratios For Exxon Mobil Corporation

The current ratio measures the firm’s ability to meet its short-termobligations. Should be greater than 1.00.

The quick ratio (also known as acid-test ratio) subtracts inventoryfrom current ratio. Theory: quick ratio measures current assets thatcan be turned into cash quickly. Inventory difficult to liquidate fast.

18.1114,30$

681,35$

seitilibailcurrent

assetscurrent = ratioCurrent

92.0114,30$

904,7681,35$

seitilibailcurrent

inventoryassets-current = ratioQuick

Dell Computer Corporation Balance Sheet Assets ($ Millions) February 1

Dell Computer Corporation Balance Sheet Assets ($ Millions) February 1

Current assets 2002 2001 Cash & cash equivalents $3,641 $4,910 Short-term investments 273 525 Account receivables, net 2,269 2,424 Inventories 278 400 Total current assets $7,877 $9,726 Fixed assets Property, plant and equipment, net 826 996 Investments 4,373 2,418 Other non-current assets 459 530 Total assets $13,535 $13,670

Dell Computer Corporation Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 02/01

Dell Computer Corporation Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 02/01

Current liabilities 2002 2001 Accounts payable $5,075 $4,286 Accrued and other 2,444 2,492 Total current liabilities $7,519 $6,778 Long-term liabilities Long-term debt 520 509 Other non-current liabilities 802 761

Total liabilities $8,841 $8,048 Shareholders’ equity Common stock 5,605 4,795 Treasury stock, at cost (2,249) 0 Retained earnings 1,364 839 Other comprehensive income 38 62 Other (64) (74) Total shareholders’ equity $4,694 $5,622 Total liabilities & stockholders’ equity $13,535 $13,670

Dell Computer Corporation Income Statement ($ Millions) February 1

Dell Computer Corporation Income Statement ($ Millions) February 1

2002

2001

Sales revenue $31,168 $31,888 Cost of revenue (25,661) (25,445) Gross margin $5,507 $6,443 Operating expenses Selling, general, administrative expenses (2,784) (3,193) Research, development, and engineering (452) (482) Special charges (482) (105) Total operating expenses $3,718 $3,780 Operating income $1,789 $2,663 Investment and other income (loss), net (58) 531 Income before income taxes and cumulative effect of change in accounting principle 1,731 3,194

Provision for income taxes 485 958 Income before cumulative effect of change in accounting principle 1,246 2,236

Cumulative effect of change in accounting principle, net

- 59

Net income $1,246 $2,177

Activity Ratios For Dell Computer Corporation

Activity Ratios For Dell Computer Corporation

Inventory turnover measures how many times each year the firm “turnsover” (sells) its inventory. Use cost of goods sold (“cost of revenue”) rather than sales in the numerator of this ratio.

Fixed asset turnover measures the efficiency with which the firm usesits fixed assets to generate sales. This ratio varies greatly by industry;Ratio will be low for capital-intensive firms (steelworks), high for labor-intensive companies (grocery stores).

3.92278$

661,25$

inventory

sold goods ofcost = turnoverInventory

5.5658,5$

168,31$

assets fixednet

sales = overasset turn Fixed

Activity Ratios For Dell Computer Corporation (Continued)

Activity Ratios For Dell Computer Corporation (Continued)

Average collection period is used to evaluate credit and collectionpolicies. Computed by dividing accounts receivable by average daily sales, which must itself be computed by dividing annual sales by 365.

Average collection period is often called days’ sales outstanding (DSO).This directly measures how much the firm has invested in A/R.

days57.2639.85$

269,2$

daypersalesAverage

receivableAccounts = periodcollectionAverage

39.85$365

168,31$

365

salesAnnual = daypersalesAverage

Activity Ratios For Dell Computer Corporation (Continued)

Activity Ratios For Dell Computer Corporation (Continued)

Total asset turnover measures the efficiency with which the firm usesall its assets to generate sales. This ratio also varies greatly by industry.

30.2535,13$

168,31$

assets total

sales = overasset turn Total

The Uses Of Debt RatiosThe Uses Of Debt Ratios

• Financial leverage : the use of fixed-cost financing by firms to magnify returns to shareholders– Also magnifies financial risk (risk of failure & default)

• There are two general types of debt measures: – measures of the degree of indebtedness and – measures of the ability to service debts.

• The degree of indebtedness measures debt relative to other balance sheet amounts.– A popular measure is the debt ratio.

• The ability to service debts measures a firm’s ability to make contractual payments required over the life of a debt.– The firm’s ability to pay certain fixed charges is measured by

using coverage ratios.• Higher coverage ratios are preferred, but not too high.

– Almost all debt ratios show strong industry patterns

Lowe’s Companies, Inc. Balance Sheet Assets ($ Millions) December 31

Lowe’s Companies, Inc. Balance Sheet Assets ($ Millions) December 31

Current assets 2001 2000 Cash & cash equivalents $798.8 $455.7 Receivables 165.6 161.0 Inventories 3,610.8 3,285.4 Other current assets 345.2 273.0 Total current assets $5,562 $5,973 Non-Current Assets Property, plant and equipment, gross 10,632.3 8,628.4 Accum. Depreciation & depletion 1,978.9 1,593.4 Property, plant and equipment, net 8,653.4 7,035.0 Intangibles 0.0 0.0 Other non-current assets 162.4 165.8 Non-current assets $8,815.8 7,200.8 Total Assets $13,736.2 11,375.8

Lowe’s Companies, Inc. Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

Lowe’s Companies, Inc. Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

2001 2000

Current liabilities

Accounts payable 1,718.8 1,732.0

Short-term debt 159.3 292.2

Other current liabilities 1,142.8 904.5

Total current liabilities 3,016.8 2,928.6 Non-current liabilities Long term debt 3,743.0 2,697.7 Deferred income taxes 304.7 251.5 Other non-current liabilities 6.2 3.2 Total non-current liabilities 4,044.9 2,952.4 Total liabilities 7,061.8 5,881.1 Shareholder’s equity Preferred stock equity 0.0 0.0 Common stock equity 6,674.4 5,494.9 Total equity $6,674.4 5,494.9 Total Liabilities and stock equity 13,736.2 11,376.0

Lowe’s Companies, Inc. Income Statement ($ Millions) December 31

Lowe’s Companies, Inc. Income Statement ($ Millions) December 31

2001 200

Sales $22,111.1 $18,778.6 Cost of sales 15,744.2 13,486.9 Gross operating profit 6,366.9 5,291.7 Selling, general, administrative expenses 4,053.2 3,479.9 Other taxes 0.0 0.0 EBITDA 2,313.7 1,811.8 Depreciation and amortization 534.1 409.5 EBIT 1,779.6 1,402.3 Other income, net 24.7 0.0 Total income avail. for interest expense 1,804.3 1,402.3 Interest expense 180.0 120.8 Pre-tax income 1,624.3 1,281.5 Income taxes 601.0 471.6 Total net income 1023.3 809.9

%9.55559.0 = 4.674,6$

0.734,3$

equityrs'Stockholde

debttermLong = ratioequity Debt-

Debt Ratios For Lowe’s Companies, Inc. Debt Ratios For Lowe’s Companies, Inc.

The debt ratio measures the proportion of the firm’s total assets financedby creditors. This is the broadest measure of indebtedness; includes loansplus accounts payable, taxes payable and other accrued liabilities.

An alternative measure of indebtedness, the debt-equity ratio, focuses only on long-term debt and equity. Thus often called a capitalization ratio.

%3.51513.02.736,13$

8.061,7$

assets total

seitilibail total = ratioDebt

Debt Ratios For Lowe’s Companies, Inc. (Continued)

Debt Ratios For Lowe’s Companies, Inc. (Continued)

887.90.180$

6.779,1$

interest

taxesandinterest before earnings = earnedinterest Times

The times interest earned ratio measures the firm’s ability to makecontractual interest payments. The higher the ratio, the more easilythe firm can make its interest payments. Does not measure ability to cover principal repayments.

Using Profitability RatiosUsing Profitability Ratios

• Profitability Ratios allow analysts to evaluate the firm’s earnings with respect to sales, assets, or equity. – Important indicator of current status, profitability ratios also

watched for signs of future problems• A common-size income statement expresses revenues &

expenses as a percentage of sales.– Especially useful in comparing performance across years

• Three frequently cited ratios of profitability are:– The gross profit margin– The operating profit margin, and – The net profit margin

Wal-Mart Stores, Inc. Balance Sheet Assets ($ Millions) December 31

Wal-Mart Stores, Inc. Balance Sheet Assets ($ Millions) December 31

Current assets 2001 2000

Cash & cash equivalents $2,161 $2,054 Receivables 2,000 1,768 Inventories 22,614 21,442 Other current assets 1,471 1,291 Total current assets 28,246 26,555 Non-Current Assets Property, plant and equipment, net 45,750 40,934 Intangible assets, net 8,595 9,059 Other non-current assets 860 1,582 Non-current assets 55,205 51,575 Total Assets $83,451 $78,130

Wal-Mart Stores, Inc. Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

Wal-Mart Stores, Inc. Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/31

2001 2000

Current liabilities

Accounts payable 15,617 15,092

Short-term debt 3,148 6,661

Other current liabilities 8,517 7,196

Total current liabilities 27,282 28,949 Non-current liabilities Long term debt 18,732 15,655 Deferred income taxes 1,128 1,043 Minority interest 1,207 1,140 Total non-current liabilities 21,067 17,838 Total liabilities $48,349 $46,787 Shareholder’s equity Preferred stock equity 0.0 0.0 Common stock equity 35,102 31,343 Total equity $35,102 $31,343 Total Liabilities and Stock. Equity $83,451 $78,130

Wal-Mart Stores, Inc. Income Statement ($ Millions) December 31

Wal-Mart Stores, Inc. Income Statement ($ Millions) December 31

2001 2000 Sales $217,799 $191,329 Cost of sales 168,272 147.387 Gross operating profit 49,527 43,942 Selling, general, administrative expenses 36,173 31,550 Other taxes 0.0 0.0 EBITDA 13,354 12,392 Depreciation and amortization 3,290 2,868 EBIT 10,064 9,524 Other income, net 2,013 1,966 Total income avail. for interest expense 12,077 11,490 Interest expense 1,326 1,374 Pre-tax income 10,751 10,116 Income taxes 3,897 3,692 Total net income 6,671 6,295

Profitability Ratios for Wal-Mart Stores, Inc. Profitability Ratios for Wal-Mart Stores, Inc.

%6.4046.0799,217$

064,10$

sales

taxes&interestbeforeEarnings = marginprofit Operating

The gross profit margin measures the percentage of each sales dollarremaining after the firm pays the direct costs of the goods produced (gross profit = sales – cost of goods sold).

The operating profit margin measures profitability as EBIT divided bysales. EBIT measures profits remaining after all costs deducted from sales except interest and taxes.

%7.22227.0799,217$

527,49$ =

sales

profitsGross = marginprofit Gross

Profitability Ratios For Wal-Mart Stores, Inc. (Continued)

Profitability Ratios For Wal-Mart Stores, Inc. (Continued)

%06.30306.0799,217$

671,6$

sales

incomeNet = marginprofit Net

The net profit margin measures the percentage of each sales dollarremaining after all costs are deducted. Highly variable across industries.

Earnings per share measures net profit earned by the firm per share ofcommon stock outstanding.

49.1$billion 4.5

$6,671

goutstandinstock common of shares ofnumber

incomeNet = shareper Earnings

Profitability Ratios For Wal-Mart Stores, Inc. (Cont)

Profitability Ratios For Wal-Mart Stores, Inc. (Cont)

The return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with its available assets.

The return on equity (ROE) measures the return earned on the owners’investment in the firm. This is the closest thing to a single “universal” ratio as a measure of performance.

%99.70799.0451,83$

671,6$

assets Total

incomeNet = assets on totalReturn

%0.1919.0102,35$

671,6$

equity rs'Stockholde

incomeNet = equitycommon on Return

Using Financial Ratios For Cross-Sectional and Trend Analysis

Using Financial Ratios For Cross-Sectional and Trend Analysis

• Cross-sectional analysis: comparing different firms’ financial ratios at the same point in time.– Usually compared to firm(s) in same industry– Sources of comparison data include D& B Industry Norms &

Key Business Ratios, RMA Studies– In benchmarking, a firm compares its ratio values to those

of competitors that it wishes to emulate• Trend analysis is applied when a financial analyst evaluates

performance over time.– Developing trends can be seen using multiyear comparison

• The DuPont system used as a search technique to find the key areas responsible for the firm’s financial condition.

The DuPont System of AnalysisThe DuPont System of Analysis

• The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition.– Developed by DuPont in late-1950s; still widely used

• The system merges the income statement and balance sheet into two summary measures of profitability: – return on assets (ROA) and – return on equity (ROE).

• The DuPont system first brings together a firm’s net profit margin with its total asset turnover.– Profit margin measures the firm’s profitability on sales– Turnover indicates how efficiently the firm has used its

assets to generate sales.

ROA = Net Profit Margin x Total Asset Turnover

Using The DuPont System of AnalysisUsing The DuPont System of Analysis

Substituting the net profit margin and total asset turnover formulas into the DuPont equation and simplifying results in the formula given earlier:

%99.7451,83$

671,6$

assetstotal

incomeNet =ROA

%99.7451,83$

699,217$

799,217$

671,6$

assetstotal

sales x

sales

incomeNet = ROA

If the 2001 values of the net profit margin and total asset turnover for Wal-Mart, are substituted into the DuPont formula, the result is:

ROA = 3.06% x 2.608= 7.99%

Using The DuPont System of Analysis (Continued)

Using The DuPont System of Analysis (Continued)

The second step in the DuPont system uses the modified DuPontformula. This formula relates the firm’s return on assets (ROA) to the return on equity (ROE). ROE is calculated by multiplying the returnon assets (ROA) by the financial leverage multiplier, the ratio of totalassets to stockholders’ equity:

%99.18102,35$

671,6$

equity rs'Stockholde

incomeNet =ROE

18.99%2.377x 0799.0$35,102

$83,451 x

$83,451

$6,671

equity rs'Stockholde

assets total x

assets total

incomeNet = ROE

The advantage of the DuPont system is that it allows the firm to break its ROE into a profit-on-sales component (net profit margin), an efficiency-of-asset-use component (total asset turnover), and a use-of-leverage component (financial leverage multiplier).

PepsiCo, Inc. Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/29

PepsiCo, Inc. Balance Sheet Liabilities & Stockholders’ Equity ($Mn) 12/29

2001 2000

Current liabilities

Short-term borrowings $354 202 Accounts payable and other current assets 4,461 4,529

Total current liabilities 4,998 4,731

Non-current liabilities Long term debt 2,651 3,009 Deferred income taxes 1,496 1,367 Other non-current liabilities 3,876 3,960 Total non-current liabilities 8,023 8,336 Total liabilities Shareholder’s equity Common stock equity 8,648 7,604 Total equity 8,648 7,604 Total Liabilities and stock equity $21,695 $20,757

PepsiCo Inc. Income Statement ($ Millions) December 31

PepsiCo Inc. Income Statement ($ Millions) December 31

2001 200

Sales $26,935 $25,479 Costs and expenses Cost of sales 10,754 10,226 Selling, general, administrative expenses 11,608 11,104 Amortization of intangible assets 165 147 Merger-related costs 356 - Other impairment and restructuring charges 31 184 Total costs and expense 22,914 21,661 Operating profit 4,021 3,818 Bottling equity income and transaction gains/ (losses), net 160 130

Interest expense (219) (272) Interest income 67 85 Income before taxes 4,029 3,761 Provision for income taxes 1,367 1,218 Total net income $2,662 $2,543 Net income per common share $1.47 $1.42

Market Ratios For PepsiCoMarket Ratios For PepsiCo

06.3347.1$

6.48$

shareper earnings

stockcommon of shareper pricemarket = ratio (P/E) ingsPrice/earn

The price/earnings (P/E) ratio measures the amount investors are willingto pay for each dollar of the firm’s earnings. Varies widely by industry.

The market-to-book (M/B) ratio assesses how investors view the firm’s past and expected future performance. It relates the market value of the firm’s shares to their book (accounting) value. To calculate the M/B ratio for PepsiCo, first need to find book value per share.

8.4$billion8.1

million$8,648

goutstandinstock common of shares ofnumber

equitystock common = shareper Book value

125.10 = 8.4$

6.48$ =

stockcommonofsharepervalueBook

stockcommonofsharepervalueMarketratio (M/B)k Market/boo

Caveats On The Use Of Ratio AnalysisCaveats On The Use Of Ratio Analysis

• No single ratio can provide sufficient information to judge the overall performance of the firm– Only ROE remotely useful for comparing all firms

• The financial statements being compared should be dated at the same point in time during the year– Seasonality can be very important for certain firms

• Use audited financial statements whenever possible• Financial data must be developed consistently

– Use of differing accounting treatments—especially relative to inventory and depreciation—can distort ratio results

• Consider the effects of inflation in C-S or T-S comparisons.• International comparisons should be viewed with suspicion

– Especially true comparing across systems (US vs German)

Demonstrating Translation ExposureDemonstrating Translation Exposure

• Translation exposure is a purely accounting concept– It measures the potential change in a consolidated financial

statement from a change in exchange rates • Key measure is the difference between exposed assets and

exposed liabilities– Exp assets: those whose $ value will change if ER changes– Exp liabilities: those whose $ value will change if ER changes– $ values of non-exposed assets do not change if ER changes

• Assume a US Firm has a UK subsidiary and that ER initially $2.00/£, but then changes to $1.50/£ (pound depreciates)– Under Current Rate method, all assets and liab translated at

new (current) ER of $1.50/£ – Equity accounts translated at old ER of $2.00/£

Translation Gains & Losses For US Firm With UK Subsidiary After £ DepreciationTranslation Gains & Losses For US Firm With UK Subsidiary After £ Depreciation

Account

Value in £

Initial $ Value ($2.00/£)

New $ Value ($1.50/£)

Current assets

£10,000,000

$20,000,000

$15,000,000

Other assets

£5,000,000

$10,000,000

$7,500,000

Total assets

£15,000,000

$30,000,000

$22,500,000

Total liabilities

£5,000,000

$10,000,000

$7,500,000 Equity (not exposed)

£10,000,000

$20,000,000

$20,000,000

Total liab & capital

£10,000,000

$30,000,000

$27,500,000

Accounting For Translation Gains And Losses

Accounting For Translation Gains And Losses

• In our example, US parent company suffered $5,000,000 translation loss– $ value of assets declined by $7.5 mm ($30 mm - $22.5 mm)– $ value of liab declined by only $2.5 mn ($30 mm-$27.5 mm)– $ value of equity accounts remain unchanged; translated at

historical ER • Translation loss accounted for in a “Cumulative Translation

Adjustment” equity account– Debit (loss) balance increased by translation losses,

reduced by translation gains– Not actually realized (run through income statement) unless

subsidiary sold or closed down.