chapter 3 - cash flows and financial analysis. users of financial information investors –make...
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Chapter 3 - Cash Flows And Financial Analysis
Users of Financial Information
Investors– Make judgments about the firm's securities – Financial Analysts report to investment community
Vendors– Sell to the firm on credit
Management – Highlight areas in which attention will improve
performance
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Sources of Financial Information
Annual Report– Management's report
card to stockholders on own performance
– The primary source of financial information
– Required of publicly traded companies
– Must be audited– GAAP
Other Sources– Reports from
brokerage firms and advisory services
– Value Line– Credit reports
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Orientation of Financial Analysts
Critical and investigative
Looking for current or potential problems
Looking for the physical reasons behind financial results
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Statement of Cash Flows
Businesses run on cash, not accounting profits
It is possible for a business to go out of business while making a profit
Statement of Cash Flows – Reports inflows and outflows of money– Developed from the income statement and
balance sheet
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Building the Statement of Cash Flows – Basic Approach
Build a Statement of Cash Flows from two balance sheets and an income statement
Analyze where money has come from and gone to
Begin with some personal examples
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Table 3-1 Cash Flow Rules
Asset Increase = UseLiability Increase = SourceAsset Decrease = Source
Liability Decrease = Use
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Buying a Car on CreditJoe Jones and His New Car
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Buying and Selling Cars -Sally Smith and Her Two Cars
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Buying and Selling Cars -Sally Smith and Her Two Cars
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Business Cash Flows
Three sources of cash flows:
Operating Activities – day-to-day activities
Investing Activities – firm buys or sells ( or invests in) fixed assets that enable it to do business.
Financing Activities – borrow money, pay off loans, sell stock, pay dividends.
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Figure 3.2 BUSINESS CASH FLOWS
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Example 3-1 Business Cash Flows
Belfry also sold new stock during the year receiving a total of $800 and paid its shareholders dividends of $500.
Additional Information
Operating Activities
Net Income $ 1,000
Depreciation 500Net Change in Current Accts
(600)Cash from Operating Activities $ 900
Detail of Changes in Current Accounts Account Begin End Source/(Use)Receivables $3,000 $2,900 $ 100Inventory 2,000 3,200 (1,200)Payables 1,500 2,100 600
Accruals 500 400 (100) $
(600)
Investing Activities
Purchase of Fixed Assets $(2,000)
Use Change in Gross Fixed Asset Account
Financing Activities
Increase in Long Term Debt $ 1,200
Sale of Stock 800
Dividends Paid (500)
Cash from Financing Activities $ 1,500
Free Cash Flows (FCF)
Used to estimate whether a company will provide or require cash in futureCash generated by operations that’s available for distribution to investors.If negative, owners must borrow or sell equity just to keep going as before
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Calculating Free Cash Flow
NOPAT is net operating profit.T = tax rate
NOPAT = EBIT – (T)(EBIT) = EBIT (1 – T)
Note: If there is no debt, NOPAT equals net income
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Calculating Free Cash Flow
Depreciation is subtracted from revenue when calculating EBIT.
Depreciation is a noncash charge, so EBIT understates cash flow by at least that amount.
Adding back depreciation gives a figure that’s closer to cash flow called operating cash flow.
Operating Cash Flow = NOPAT + Depreciation
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Calculating Free Cash Flow
Money available to investors can be written as:
FCF = Operating Cash Flow
– Increase in Gross Fixed Assets
– Increase in Current Accounts
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Calculating Free Cash Flow to Equity (FCFE)
If a company is able to distribute cash to stockholders, then the equation becomes:
FCFE = Operating Cash Flow
– Increase in Gross Fixed Assets
– Increase in Current Accounts
– (1-T)Interest – Principal Reduction
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The Cash Conversion CycleRacetrack Diagram
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RATIO ANALYSIS
COMPARISONS
Ratios are most meaningful when compared with similar figures
Three comparisons:– History– Competitors– Budget
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Common Size Statements - Example
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CATEGORIES OF RATIOS
Five Classifications
Liquidity
Asset Management
Debt Management
Profitability
Market Value
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LIQUIDITY RATIOS
Liquidity ratios measure the company’s ability to meet short-term financial obligations
Current Ratio – primary measurement of a company’s
liquidity
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sliabilitiecurrent assetscurrent
= RatioCurrent
LIQUIDITY RATIOS
Quick Ratio (acid test) – A liquidity measure that does not depend on inventory
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sliabilitie currentinventory - assets current
Ratio Quick
ASSET MANAGEMENT RATIOS
The fundamental efficiency with which a company is run
Average Collection Period (ACP) – the time it takes to collect on credit sales
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360 sales
receivable accounts = ACP
salesdaily averagereceivable accounts = ACP
Interpretation: Customers pay slowly OR there are a few very old accounts that will probably never be collected.
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INVENTORY TURNOVER
Inventory turnover ratio measures whether the firm has excess funds tied up in inventory.
Interpretation: Too much inventory is expensive to carry. Too little causes stockouts which lead to inefficient production and lost sales
inventorysold goodsof cost turnoverInventory =
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FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER
Measures the relationship of the firm’s assets to a year’s sales
assets fixedsales turnover asset Fixed
assets totalsales turnover asset Total
DEBT MANAGEMENT RATIOS
Measures the firm’s debt level relative to assets, equity, and income
DEBT RATIOUses a broad concept of debt including current liabilities
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assets total
sliabilitiecurrent +debt term-long = ratioDebt
DEBT TO EQUITY RATIO
Measures the mix of debt and equity within total capital.
Debt to Equity Ratio = Long Term Debt : Equity
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TIMES INTEREST EARNED (TIE)
Measures the number of times interest can be paid out of earnings before interest and taxes (EBIT)
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interest
EBIT = TIE
CASH COVERAGE
A variation on TIE. Adds depreciation to EBIT to better approximate the cash available to cover
interest.
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interest
ondepreciati + EBIT = coverage Cash
FIXED CHARGE COVERAGE
A variation on TIE to include lease payments asfixed financial charges equivalent to interest
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payments lease +interest
payments lease + EBIT = coverage charge Fixed
DEBT MANAGEMENT RATIOS
Compares fixed (obligatory) payments with the cash available to pay (cover) them.
repayments principalpayments leaseinterestpayments leaseEBITDA
ecoveragEBITDA
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PROFITABILITY RATIOS
Relative measures of the firm’s money-makingsuccess, also called profit margin.
RETURN ON SALES (ROS)
sales
incomenet = ROS
RETURN ON ASSETS (ROA)
Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit
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assets total
incomenet = ROA
RETURN ON EQUITY (ROE)
The most fundamental profitability ratio
Measures the firm’s ability to earn a return on the owners’ invested capital.
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equity
incomenet = ROE
MARKET VALUE RATIOS
PRICE / EARNINGS RATIO (P/E)
Measures market’s opinion of the stock as an investment
Interpretation: The amount investors will pay for each dollar of earnings. Based primarily on expected growth.
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EPS
price stock = Ratio P/E
MARKET TO BOOK VALUE RATIO
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shareper value book
price stock = ratio value book toMarket
DU PONT EQUATIONS
Equations show relationships between ratios
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turnoverasset total ROS = ROA
assets total
sales
sales
incomenet = ROA
sales
sales
assets total
incomenet = ROA
Extended Du Pont Equation
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multiplier equity ROA = ROE
multiplier equity turnoverasset total ROS = ROE
equityassets total
assets totalsales
salesincomenet
= ROE
assets totalassets total
salessales
equityincomenet
= ROE
Using the Du Pont Equations
Focus attention on revenue or assets rather than on cost or expense
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ROA = ROS X Total Asset Turnover
Sampson Inc. 12% 6% 2x
Industry 15% 5% 3x
Limitations and Weaknesses of Ratio Analysis
Diversified Companies– Analysis of consolidated results is confused
Window Dressing– Year end tricks can artificially improve ratios
Accounting Principles– Allow latitude in reporting
Inflation Can Distort Financial Results
Interpretation of Ratios is Often Unclear
Ratio Analysis Doesn’t Give Us Answers, It Helps Us Ask the Right Questions
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