chapter 3 working with financial statements
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Chapter 3 Working with Financial Statements. Homework: 13-17. Topics. Sources and Uses of Cash Financial Ratio Analysis The Du Pont Identity Using Financial Statement Information. Sources and Uses of Cash. Sources of cash include: Decrease in assets Increase in liabilities - PowerPoint PPT PresentationTRANSCRIPT
Chapter 3Working with Financial
Statements
•Homework: 13-17
Topics
•Sources and Uses of Cash
•Financial Ratio Analysis
•The Du Pont Identity
•Using Financial Statement Information
Sources and Uses of Cash
Sources of cash include: Decrease in assets Increase in liabilities Increase in common stock Increase in retained earnings
Uses of cash include: Increase in assets Decrease in liabilities Decrease in common stock Decrease in retained earnings
Operating Activities
•Revenues from sales of goods and services
•Costs associated with productions
Investment Activities
•Acquisition of a new production plan
•Proceeds from selling equipment
Financing Activities
•Issuing long-term debt
•Payments associated with retiring long-term debt
•Proceeds from issuing equity
•Cash Dividends paid to shareholders
Organizes cash flows into 3 main categories
Statement of Cash Flows
Operating activities + Net income + Depreciation + Any decrease in current assets (except cash) + Increase in accounts payable – Any increase in current assets (except cash) – Decrease in accounts payable
Investment activities + Ending fixed assets – Beginning fixed assets + Depreciation
Statement of Cash Flows (concluded)
Financing activities
– Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in common stock
– Dividends paid
Example: Hermetic, Inc., Balance Sheet
Hermetic, Inc.Balance Sheet as of December 31
($ in thousands)
Assets 1999 2000
Current Assets
Cash $ 45 $ 50
Accounts receivable 260 310
Inventory 320 385
Total $ 625 $ 745
Fixed assets
Net plant and equipment 985 1100
Total assets $1610 $1845
Hermetic, Inc., Balance Sheet (concluded)
Liabilities and equity 1999 2000
Current liabilities
Accounts payable $ 210 $ 260
Notes payable 110 175
Total $ 320 $ 435
Long-term debt 205 225
Stockholders’ equity
Common stock and
paid-in surplus 290 290
Retained earnings 795 895
Total 1085 1185
Total liabilities and equity $1610 $1845
Hermetic, Inc., Income Statement
($ in thousands)
Net sales $710.00
Cost of goods sold 480.00
Depreciation 30.00
Earnings before interest and taxes $200.00
Interest 20.00
Taxable income 180.00
Taxes 53.45
Net income $126.55
Retained earnings $100.00
Dividends 26.55
Hermetic, Inc., Statement of Cash Flows
Operating activities + Net income + 126.55
+ Depreciation + 30.00
+ Increase in payables + 50.00
– Increase in receivables – 50.00
– Increase in inventory – 65.00
91.55
Investment activities + Ending fixed assets +1,100.00
– Beginning fixed assets – 985.00
+ Depreciation + 30.00
(145.00)
Hermetic, Inc., Statement of Cash Flows (concluded)
Financing activities
+ Increase in notes payable + 65.00
+ Increase in long-term debt + 20.00
– Dividends – 26.55
58.45
Putting it all together 91.55 – 145.00 + 58.45 = 5.00
Financial Ratios
Short-Term Solvency or Liquidity Ability to pay bills in the short-run
Long-Term Solvency Ability to meet long-term obligations
Asset Management Intensity and efficiency of asset use
Profitability
Market Value Going beyond financial statements
Short-Term Liquidity Ratios
The Current Ratio
•Indicates a firm's ability to meet its short-term obligations
•What Does This Number Mean?
•Question: If you are a short-term creditor, the higher the current ratio the better?
Current Ratio =Current Assets
Current Liabilities
•Changes in the trend are difficult to interpret
•Equal increases and decreases in current assets and current liabilities have different effects on the current ratio.
•Depends on whether the current ratio is greater or less than one.
Current Ratio
Notes of Caution
Quick Ratio
Includes only current assets that can be converted quickly to cash.
Quick Ratio = Current Assets - Inventory
Current Liabilities
Short-term Solvency Ratios:
The Bottom Line
•Use both measures when assessing a firm's short-term liquidity
•Using only the current ratio will overstate a firm's liquidity in the short-term.
•By using both measures, we can see why the firm's current assets are increasing over time.
Long-Term Solvency Ratios
The Total Debt Ratio
Takes into account all debt of all maturities of all creditors
Total Debt Ratio =Total Assets - Total Equity
Total Assets
Long-Term Solvency Ratios
Debt/Equity Ratio
•Variation of the total debt ratio.
•Measures total debt as a multiple of total equity.
Debt/Equity Ratio =Total Debt
Total Equity
Long-Term Solvency Ratios
Long-Term Debt Ratio
•Most popular leverage ratio
•Omits short-term liabilities which are changing often.
•Account payables: more a reflection of trade practices than of debt management
Long-Term Debt Ratio = Tot. Long-term Debt
Tot. L.T. Debt + Tot. Equity
Long-Term Solvency Ratios
Times Interest Earned Ratio
•Also called interest coverage ratio.
•Measures the multiple of interest expense that a firm could support given its current level of earnings.
Times Interest Earned Ratio =EBIT
Interest expense
The Lower this ratio, the more levered the firm.
Long-Term Solvency RatiosCash Coverage Ratio
•EBIT includes depreciation
•Measures the multiple of interest expense that a firm could support given its level of cash.
Cash Coverage Ratio =EBIT + depreciation
Interest Expense
The Lower this ratio, the more levered the firm.
Long-term Solvency Ratios
•Measure a firm's ability to meet its long-term financial obligations.
•Three Debt Ratios: The higher the ratios the more levered the firm.
•Times Interest Earned and Cash Coverage Ratios: The lower the ratio the more levered the firm.
•What is a good ratio?
•Analysts vary the standard in direct relation to the stability of the firm's earnings and cash flows.
•Different standards for different industries.
Asset Management Ratios
Inventory Turnover Ratio
Measures how many times a firm sold off its inventory
Inventory Turnover Ratio =Cost of Goods Sold
Inventory
Asset Management Ratios
Days' Sale in Inventory Ratio
Measures how long it took a firm to sell inventory
Days' Sales in Inventory =365
Inventory Turnover
Inventory Management Ratios
•Measure how quickly a firm can convert inventory into cash.
•Important in industries where inventory becomes obsolete relatively quickly.
Fashion industry
•Inventory becomes obsolete and can't be converted into cash.
liquidate below costs => losses for the firm
Asset Management Ratios
Receivables Turnover Ratio
Measures how fast a firm collects on the credit sales of inventory
Receivables Turnover Ratio =Sales
Accounts Receivable
Asset Management Ratios
Days' Sale in Receivables Ratio
Measures how long it took a firm to collect on its credit sales
Days' Sales in Receivables =365
Receivables Turnover
Receivables Management Ratios
•Measure how quickly a firm can convert receivables into cash.
•If we observe an increase in days' sales in receivables, what does it indicate?
•Loan officers will ask for a list of top customers and percentage of sales accounted by these customers.
•Assess credit quality of the firm's main sources of revenues
Asset Management Ratios
NWC Turnover Ratio
Measures the efficiency of a firm's NWC
NWC Turnover Ratio =Sales
NWC
Asset Management Ratios
Total Asset Turnover Ratio
Measures the efficiency of a firm's Total Assets
Total Asset Turnover Ratio =Total Assets
Sales
Profitability Ratios
Profit Margin
Measures how well a firm is managing its costs relative to its sales
Profit Margin =Net Income
Sales
Profitability Ratios
Return of Assets (ROA)
Measures how hard a firm's assets are working
ROA =Net Income
Total Assets
Profitability Ratios
Return of Equity (ROE)
Measures how efficient a firm's equity is being employed to generate profit
ROE =Net Income
Total Equity
Market Value Measures
Price/Earnings (P/E) Ratio
Measures what investors are willing to pay per $1 of current earnings
P/E Ratio =Price Per Share
Earnings Per Share
Market Value Measures
Market-to-Book Ratio
Measures the market value of the firm's investments to their historical costs.
Mkt-to-Book =Market Value Per Share
Book Value Per Share
Example
The Cross Companies
45 Million Shares Outstanding
Stock sells for $80 per share at fiscal year-end
Net Income = $675 million
Total Equity = $3,375 million
ROE = Profit Margin x Asset Turnover x Equity Multiplier
ROE Can be Decomposed into 3 Components:
ROE = Net income/Sales x Sales/Assets x Assets/Equity
The Du Pont Identity
Operating Efficiency
Asset Use Efficiency
Financial Leverage
Standardized Financial Statements
Common Size Balance Sheet
All items are presented as a percentage of total assets
=> Divided all items by total assets
Common Size Income Statement:
All items are presented as percentage of total sales
=> Divide all items by total sales
Common-Base Year Financial Statement
=> Present relative to a certain base year.
Things to Consider When Using Financial Ratios
What goes into a particular ratio? Historical cost? Market values? Accounting conventions?
What is the unit of measurement? Dollars? Days? Turns?
What would a desirable ratio value be? What is the benchmark? Time-series analysis? Cross-sectional analysis?
Problems with Financial Analysis
•Very little underlying financial theory
•Differences in accounting practices
•Finding comparable firms is difficult
•Differences in fiscal-year ends
•One-time events
•Seasonal variations
•Conglomerates
•Choosing Benchmark: Which industry?