chatper 3 ppt

1© 2008 Thomson South-Western

Chapter 3Chapter 3

Cash Flows andFinancial Analysis

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Users of Financial InformationUsers of Financial Information

Investors and Financial Analysts○ Make judgments about the firm’s securities○ Financial Analysts report to investment

community

Vendors○ Sell to the firm on credit

Management ○ Hi-light areas in which attention will improve

performance

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SOURCES OF FINANCIAL SOURCES OF FINANCIAL INFORMATIONINFORMATION

Annual Report○ Management's report

card to stockholders on own performance

○ Positively biased

○ The primary source of financial information

○ Required of publicly traded companies

○ Must be audited

Other Sources○ Reports from

brokerage firms and advisory services

○ Value Line

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STATEMENT of CASH FLOWSSTATEMENT of CASH FLOWS

Businesses run on cash, not accounting profits

Statement of Cash Flows ○ Also called or Sources and Uses of Cash or

Statement of Changes in Financial Position ○ Shows where money comes from - goes to ○ Developed from the Income

Statement and Balance Sheet

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Building the Statement of Cash Building the Statement of Cash Flows – Basic ApproachFlows – 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 by:○ Adjusting net income for non-cash items○ Analyzing changes between beginning

and ending Balance Sheets • Classify as sources or uses of cash

Begin with a personal example

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Buying a Car on CreditJoe Jones and His New Car

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Cash Flow RulesCash Flow Rules

Asset Increase = Use

Asset Decrease = Source

Liability Increase = Source

Liability Decrease = Use

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Buying and Selling Cars -Sally Smith and Her Two Cars

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Business Cash FlowsBusiness Cash Flows

Three sources of cash flows:

Operating Activities – day-to-day activities

Investing Activities – firm buys or sells fixedassets that enable it to do business, long-term purchases, and sales of financial assets.

Financing Activities – borrow money, pay off

loans, sell stock, pay dividends.

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BUSINESS CASH FLOWSBUSINESS CASH FLOWS Figure 3.2

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Free Cash FlowsFree Cash Flows

Cash generated beyond reinvestment needs is free cash flow

Net cash flow less non-operating cash requirements (such as worn out fixed assets)

If negative, then borrow or sell equity

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RATIO ANALYSISRATIO ANALYSIS

Pairs of financial statement numbers formed into ratios

Ratios highlight different aspects of performance

The current ratio measures liquidity - ability to pay bills in the short run

Current Assets: Money coming in within a yearCurrent Liabilities: Money going out within a yearNeeded for solvency: Current ratio >> 1.0

sliabilitiecurrent assetscurrent = ratioCurrent

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CATEGORIES OF RATIOSCATEGORIES OF RATIOS

Five Classifications

Liquidity

Asset Management

Debt Management

Profitability

Market Value○ Ratios Don’t Provide Answers -

They Help You Ask the Right Questions

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LIQUIDITY RATIOSLIQUIDITY RATIOS

Measure the ability to meet short term financial obligations

Current Ratio – primary measurement of a company’s liquidity

sliabilitiecurrent assetscurrent = ratiocurrent

current ratio = $7,500

$2,500 = 3.0

(Examples from Belfry Company)

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LIQUIDITY RATIOSLIQUIDITY RATIOS

Quick Ratio (Acid Test) – A liquidity measure that does not depend on inventory

1.72 = $2,500

$3,200 - $7,500 = Ratio Quick

sliabilitiecurrent

inventory - assestscurrent = Ratio Quick

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ASSET MANAGEMENT RATIOSASSET MANAGEMENT RATIOS

The fundamental efficiency with which a company is run

AVERAGE COLLECTION PERIOD (ACP) AVERAGE COLLECTION PERIOD (ACP) – the time it – the time it takes to collect on credit salestakes to collect on credit sales

days 104.4 = 360 $10,000

$2,900 = ACP

360 sales

receivable accounts = ACP

sales daily average

receivable accounts = ACP

Interpretation: Customers pay slowly OR there are a few very old accounts that will probably never be collected.

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ASSET MANAGEMENT RATIOSASSET MANAGEMENT RATIOS

INVENTORY TURNOVERINVENTORY TURNOVER

Measures efficiency of inventory use

Interpretation: Too much inventory is expensive to carry. Too little causes stockouts which lead to inefficient production and lost sales

3.1 = $3,200

$10,000 =turnover Inventory

1.9 = $3,200

$6,000 =turnover Inventory

inventory

sales =turnover Inventory

OR inventory

sold goods ofcost =turnover Inventory

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ASSET MANAGEMENT RATIOSASSET MANAGEMENT RATIOS

FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER

Measure the relationship of the firm’s assets to a year’s sales

Interpretation: Are there idle or inefficient assets?

.83 = $12,000$10,000 =turnover asset Total

2.2 = $4,500$10,000 =turnover asset Fixed

assets totalsales =turnover asset Total

assets fixedsales =turnover asset Fixed

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DEBT MANAGEMENT RATIOSDEBT MANAGEMENT RATIOS

Measures the firm’s debt level relative to assets, equity, and income

DEBT RATIOUses a broad concept of debt including current liabilities

A high debt ratio is viewed as risky by investors

Debt ratio = long- term debt + current liabilities

total assets

Debt ratio = $6,200 + $2,500

$12,000 = 72.5%

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DEBT MANAGEMENT RATIOSDEBT MANAGEMENT RATIOS

DEBT TO EQUITY RATIODEBT TO EQUITY RATIO Measures the mix of debt and equity within total capital. An important risk measurement - a high debt level burdens the

income statement with excessive interest making failure more likely.

Debt to Equity Ratio = Long Term Debt : Equity

Debt to Equity = $6,200 : $3,300 = 1.9 : 1

(Stated as 1.9 to 1, since $6,200/$3,300 = 1.9)

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DEBT MANAGEMENT RATIOSDEBT MANAGEMENT RATIOS

TIMES INTEREST EARNED (TIE) Measures the number of times interest can be paid out of earnings

before interest and taxes (EBIT)

TIE = EBIT

interest

TIE = $1,900

$400 = 4.8

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DEBT MANAGEMENT RATIOSDEBT MANAGEMENT RATIOS

Cash CoverageA variation on TIE. Adds depreciation to EBIT to better

approximate the cash available to interest.

Cash coverage = EBIT + depreciation

interest

Cash coverage = $1,900 + $500

$400 = 6.0

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DEBT MANAGEMENT RATIOSDEBT MANAGEMENT RATIOS

FIXED CHARGE COVERAGEFIXED CHARGE COVERAGE

A variation on TIE to include lease payments as fixed financial charges equivalent to interest

Interpretation: Business failure is often a result of the inability to pay interest. Coverage ratios measure the interest burden relative to the ability to pay.

Fixed charge coverage = EBIT + lease payments

interest + lease payments

Fixed charge coverage = $1,900 + $700

$400 + $700 = 2.4

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PROFITABILITY RATIOSPROFITABILITY RATIOS

Relative measures of the firm’s money-making success

RETURN ON SALES (ROS)RETURN ON SALES (ROS)

ROS = net income

sales

ROS = $1,000

$10,000 = 10%

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PROFITABILITY RATIOSPROFITABILITY RATIOS

RETURN ON ASSETS (ROA)RETURN ON ASSETS (ROA)Measures the overall ability of the firm to utilize the

assets in which it has invested to earn a profit

8.3% = $12,000

$1,000 = ROA

assets total

incomenet = ROA

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PROFITABILITY RATIOSPROFITABILITY RATIOS

RETURN ON EQUITY (ROE)RETURN ON EQUITY (ROE)The most fundamental profitability ratio

Measures the firm’s ability to earn a return on the owners’ invested capital.

30.3% = $3,300

$1,000 = ROE

equity

incomenet = ROE

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MARKET VALUE RATIOSMARKET VALUE RATIOS

PRICE / EARNINGS RATIO (P/E)Measures the 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.

11.4 = $3.33

$38 = P/E

$3.33 = 300

$1,000 = EPS

EPS

price stock = Ratio P/E

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MARKET VALUE RATIOSMARKET VALUE RATIOS

MARKET TO BOOK VALUE RATIOMARKET TO BOOK VALUE RATIOTotal value of the equity on the balance sheet

Market to book value ratio = stock price

book value per share

Market to book value ratio = $38

$11 = 3.5

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Financial Ratios

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Financial Ratios

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Financial Ratios

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Limitations and Weaknesses of Ratio Analysis

Diversified Companies○ Analysis of consolidated results generally

offers limited insight

Window Dressing○ Yearend efforts to make ratios look good

Accounting Principles○ Allow a great deal of reporting latitude