Chapter 3 Working with financial statement
3.1 Cash flow and financial statement: A closer look
Cash is generated by selling a product, an asset, or a security. Selling a security involves
either borrowing or selling an equity interest (i.e. shares of stock) in the firm.
Source and uses of cash
Source of cash: activities that generate cash
Uses of cash: A firm’s activity in which cash is spent.
An increase in a left-hand side (asset) account or a decrease in a left-hand side (liability or
equity) account is a use of cash. Likewise, a decrease in an asset account or an increase in a
liability (or equity) account is a source of cash.
The net addition to cash is just the difference between sources and uses.
The statement of cash flows
Statement of cash flow is a firm’s financial statement that summarizes its sources and uses of
cash over a specific period. We are trying to group all changes into three categories: operating
activities, financing activities and investment activities.
It might seem appropriate to express the change in cash on a per share basis, much as we did
for net income.
3.2 Standardized financial statements
Purpose: to compare companies to those of other, similar companies. One very common and
useful way of doing this is to work with percentage instead of total dollars. Here’s two ways of
standardizing financial statements.
1) Common-size statement
A standardized financial statement presents all items in percentage terms. Balance
sheets are shown as a percentage of asset and income statement as a percentage of
Common-size balance sheet
The way is to express each item as a percentage of total assets.
The total change has to be zero, since the beginning and ending numbers must add up
www.notesolution.com When we transform the number to percentage in balance sheet, it is relatively easy to
read and compare. We can compare the increase or decrease of investment, current
asset and so on based on their change in percentage, which is more obvious than
Common-size income statements
The way is to express each item as a percentage of total sales.
Common-size income statements tell us what happens to each dollar in sales.
The percentages are very useful in comparisons.
Common-size statements of cash flow
Each item can be expressed as a percentage of total sources or total uses. The results
can then be interpreted as the percentage of total source of cash supplied or as the
percentage of total uses of cash for a particular item.
2) Common-base-year financial statements: trend analysis
It is a standardized financial statement presenting all items relative to a certain year
amount. For example, a company’s inventory rose from 393 to 422. If we pick 2008 as
our base year, then we would set inventory equal to 1 for that year. For 2009, we would
calculate 422/393=1.07, which means 7 percent increase during the year. If we had
multiple years, we would just divide each one by 393.
Combined common-size and base-year analysis
Reason: As total asset grow, most of other accounts grow as well. By first forming the
common-size statements, we eliminate the effect of this overall growth.
For example, a company’s accounts receivable were 165 or 4.9% of total asset in 2008.
In 2009, they had risen to 188, which is 5.2% of total asset. If we do trend analysis in
terms of dollars, the 2009 figure would be 188/165=1.14, a 14% increase in receivable.
However, if we work with the common-size statements, the 2009 figure would be
5.2%/4.9%=1.06. This tells us that accounts receivable, as a percent of total asset, grew
by 6%. Roughly speaking, what we see is that of the 14% total increase, about 8% (14%-
6%) is attributable simply to growth in total asset.
3.3 Ratio analysis.
It is relationships determined from a firm’s financial information and used for comparison
purposes. Using ratios eliminates the size problem since the size effectively divides out. We are
then left with percentage, multiples, or time periods.
For each of the ratios we discuss, several questions come to mind:
www.notesolution.com 1. How is it computed?
2. What is it intended to measure, and why might we be interested?
3. What might a high or low value be telling us? How might such values be misleading?
4. How could this measure be improved?
Financial ratios are traditional grouped into the following categories:
1. Short term solvency or liquidity ratios
2. Long-term solvency or financial leverage rations
3. Asset management or turnover ratios.
4. Profitability ratios
5. Market value ratios.
Short term solvency or liquidity measures
Short-term-solvency ratios are intended to provide information about a firm’s liquidity, and
these ratios are sometime called liquidity measures. The primary concern is the firm’s ability to
pay its bills over the short run without undue stress. Consequently, these ratios focus on
current assets and current liabilities.
Liquidity ratios are particularly interesting to short-term creditors.
Why look at current assets and current liabilities: their book value and market value are likely to
On the other hand, current assets and liabilities can and do change fairly rapidly, so today’s
amounts may not be a reliable guide for the future.
Current ratio (a measure of short-term liquidity)
Current ratio= current asset/current liabilities
To a creditor, particular a short-term creditor such as a supplier, the higher the current ratio,
the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an
inefficient use of cash and other short-term assets.
It is better that current ratio is more than 1, in this case, net working capital is positive and it
indicates the firm is healthy.
Note that a low current ratio may not be a bad sign for a company with large reverse of
untapped borrowing power.
The quick ratio
www.notesolution.com Quick ratio= (current assets-inventory)/current liabilities
Notice that using cash to buy inventory does not affect the current ratio, but it reduces the
Other liquidity ratios
A very short-term creditor might be interested in the cash ratio:
N Cash ratio= cash+ cash equivalents/current liabilities
N Net working capital to total assets= Net working capital/ total assets
A relatively low value might indicate relatively low levels of liquidity.
Imagine a firm a facing a strike and cash inflow are beginning to dry up. How long could the
business keep running? One answer is given by interval measure.
N Interval measure=current asset/average daily