introduction to finance, part 2wood465-kozak.sites.olt.ubc.ca/files/2018/02/gaston...26/02/2018 1...

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Introduction to Finance, Part 2: Cash Flow Statement & Financial Statement Analysis CHRIS GASTON AND JENNIFER DEBOER

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Review & Roadmap � Balance Sheet: a summary of a company’s financial position at a specific point in time (e.g. a snapshot); total assets = total liabilities + owner’s equity

� Income Statement: a summary of a company’s revenues and expenses over a specific period of time; determines net income or loss for the period considered

� Cash Flow Statement: a summary of the flows of cash in and out of the company; the statement reveals where a company spends its money (cash outflows) and where a company receives its money (cash inflows).

� Trend Analysis & Financial Ratios: analyzes the financial health of a company or compare the financial health of companies

� Dragon's Den expectations

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Please note all three financial statements as well as four types of financial

statements will be required in your final report.

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Balance sheet• How much debt the business has relative to its equity

• How quickly customers are paying their bills.

• Whether short-term cash is declining or increasing.

• The percentage of assets that are tangible (factories, plants, machinery)

and how much comes from accounting transactions.

• Whether products are being returned at higher-than-average historical rates.

• How many days it takes, on average, to sell the inventory the business keeps on hand.

• Whether the research and development budget is producing good results.

• Whether the interest coverage ratio on the bonds is declining.

• The average interest rate a company is paying on its debt.

• Where profits are being spent or reinvested.

Source: https://www.thebalance.com/investing-lesson-3-analyzing-a-balance-sheet-357264

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Income statement

• The primary purpose of any income statement is to report a company's earnings

• Also known as a "Profit and Loss Statement“

• Provides important insights into how effectively management is controlling expenses, the amount

of interest income and expense, and the taxes paid.

• Can be used to calculate financial ratios that will reveal the rate of return the business is earning

on the shareholders' retained earnings and assets (in other words, how well they are investing the

money under their control).

• Can also compare a company's profits to its competitors by examining various profit margins such

as the gross profit margin, operating profit margin, and net profit margin.

Source: https://www.thebalance.com/investing-lesson-4-income-statement-analysis-357580

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Cash flow statement• Developed from Balance Sheet and Income Statement data

• The purpose of the cash flow statement is to show where an entities cash is being generated (cash inflows), and where its cash is being spent (cash outflows), over a specific period of time (usually quarterly and annually). It is important for analyzing the liquidity and long term solvency of a company.

• The cash flow statement uses cash basis accounting instead of accrual basis accounting which is used for the balance sheet and income statement by most companies. This is important because a company may accrue accounting revenues but may not actually receive the cash. This could produce profits and taxes payable but not provide the resources to stay solvent.

• Cash flow from

• Cash

• Operating activities: Cash in and out from the day-to day business operations

• Investing activities: Outflow of cash for long term assets (land, buildings, etc.) and inflows from sale of assets, business, securities, etc.

• Finance activities: cash outflow to investors and inflow from sales of bonds, issuing stocks, etc.

https://www.slideshare.net/MohdAadil/cash-flow-analysis-12201160

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Cash and Cash equivalents• Cash• Treasury bills maturing within 90 days or less• Investment funds• Foreign currency on hand• Checking account• `Free’ savings account

Operating Activities• Cash flows related to selling goods and services• `Cash effects’ of transaction associated with the determination of income• Examples

• Cash received from sales• Cash payments to suppliers or employees• Cash payments for taxes and other expenses

Investing Activities• Acquiring / disposing of securities• Acquiring / disposing of non-current assets• Lending money / collecting on loans• Example

• Cash payments to acquire property, plant and equipment

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Financing Activities• Borrowing from creditors / repaying the principal• Obtaining resources from owners• Providing owners with a return on their investment• Examples

• Cash received from issuing shares, bonds, etc.• Cash repayment of loans• Cash payments to shareholders as dividends

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https://www.google.com/finance

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https://www.google.com/finance

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Trend Analysis

�Horizontal Analysis

�Vertical Analysis

�Ratio Analysis

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vrpacioli.loyola.edu/ac102/chapter17/chapter17.pp

Horizontal Analysis – Balance Sheet 14


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Horizontal Analysis - Balance Sheet 15

$12,000 – $23,500 = $(11,500)



CLOVER CORPORATION

Comparative Balance Sheets

December 31, 1999 and 1998

Increase (Decrease)

1999 1998 Amount %

Assets

Current assets:

Cash 12,000$ 23,500$ (11,500)$ (48.9)

Accounts receivable, net 60,000 40,000

Inventory 80,000 100,000

Prepaid expenses 3,000 1,200

Total current assets 155,000 164,700

Property and equipment:

Land 40,000 40,000

Buildings and equipment, net 120,000 85,000

Total property and equipment 160,000 125,000

Total assets 315,000$ 289,700$

($11,500 ÷ $23,500) × 100% = 48.9%


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CLOVER CORPORATION

Comparative Balance Sheets

December 31, 1999 and 1998

Increase (Decrease)

1999 1998 Amount %

Assets

Current assets:

Cash 12,000$ 23,500$ (11,500)$ (48.9)

Accounts receivable, net 60,000 40,000 20,000 50.0

Inventory 80,000 100,000 (20,000) (20.0)

Prepaid expenses 3,000 1,200 1,800 150.0

Total current assets 155,000 164,700 (9,700) (5.9)

Property and equipment:

Land 40,000 40,000 - 0.0

Buildings and equipment, net 120,000 85,000 35,000 41.2

Total property and equipment 160,000 125,000 35,000 28.0

Total assets 315,000$ 289,700$ 25,300$ 8.7


Horizontal Analysis – Income Statement 18

CLOVER CORPORATION

Comparative Income Statements

For the Years Ended December 31, 1999 and 1998

Increase (Decrease)

1999 1998 Amount %

Net sales 520,000$ 480,000$ 40,000$ 8.3

Cost of goods sold 360,000 315,000 45,000 14.3

Gross margin 160,000 165,000 (5,000) (3.0)

Operating expenses 128,600 126,000 2,600 2.1

Net operating income 31,400 39,000 (7,600) (19.5)

Interest expense 6,400 7,000 (600) (8.6)

Net income before taxes 25,000 32,000 (7,000) (21.9)

Less income taxes (30%) 7,500 9,600 (2,100) (21.9)

Net income 17,500$ 22,400$ (4,900)$ (21.9)

Sales increased by 8.3% while net income decreased by 21.9%.

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the

increase in sales, yielding an overall decrease in net income.


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Vertical Analysis – Balance Sheet 19

Sample Company

Balance Sheet (Assets)

At December 31, 1999 and 1998

% of Total Assets

1999 1998 1999 1998

Cash 82,000$ 30,000$ 17% 8%

Accts. Rec. 120,000 100,000 25% 26%

Inventory 87,000 82,000 18% 21%

Land 101,000 90,000 21% 23%

Equipment 110,000 100,000 23% 26%

Accum. Depr. (17,000) (15,000) -4% -4%

Total 483,000$ 387,000$ 100% 100%

$82,000 ÷ $483,000 = 17% rounded$30,000 ÷ $387,000 = 8% rounded


Vertical Analysis – Balance Sheet 20

Sample Company

Balance Sheet (Liabilities & Stockholders' Equity)

At December 31, 1999 and 1998

% of Total Assets

1999 1998 1999 1998

Acts. Payable 76,000$ 60,000$ 16% 16%

Wages Payable 33,000 17,000 7% 4%

Notes Payable 50,000 50,000 10% 13%

Common Stock 170,000 160,000 35% 41%

Retained Earnings 154,000 100,000 32% 26%

Total 483,000$ 387,000$ 100% 100%

$76,000 ÷ $483,000 = 16% rounded


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Questions so far?

Next, financial ratios…

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Financial Ratios

� Financial ratios allow internal and external users to analyze the financial health of a company

� Financial ratios allow the analysis of (a) the health of an individual company, (b) the health of an individual company over time, (c) the health of companies in combination, and/or (d) the health of companies in comparison

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Types of Financial Ratios

1. Liquidity

2. Operating/Efficiency/Activity

3. Financial Leverage/Debt

4. Profitability/Performance

5. Valuation: ratios based on share price

(e.g. price/earnings, price/sales, etc.),

will not be discussed in this class

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(1) Liquidity

What is liquidity?

Liquidity describes the degree to which an asset can be quickly bought or sold in the market without affecting the asset's price.

Liquidity ratio: shows a firm’s ability to cover its current and short-term financial liabilities with its current assets; the higher the liquidity, the more liquid the company is

� These are of particular interest to those extending short-term credit to the company

�Uses financial numbers from the Balance Sheet

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Liquidity Ratios Current ratio = Current Assets / Current Liabilities

� A current ratio of 2 is generally acceptable; it's a comfortable financial position for most

� Short-term creditors may prefer a high current ratio to reduce their risk whereas shareholders may prefer a low current ratio, which indicate the company’s assets are working to grow the business

Quick ratio = (Current Assets – Inventory) / Current Liabilities

�Current assets include cash, accounts receivable, and notes receivable; these assets include current assets minus inventory.

� The quick ratio is helpful because not all assets liquidate quickly or have easily identifiable liquidation values.

� Also referred to as the acid test.

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2017 Current Ratio

= Total Assets / Total Liabilities

= 14365.60 / 8915.50

= 1.61

2016 Current Ratio

= Total Assets / Total Liabilities

= 14312.50 / 8428.50

= 1.69

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Liquidity/Acid Test Exercise Form a group of 2 – 3 students. Visit the course website, select ‘Readings.’ Choose a pair of related companies. Open both companies’ financial statements and select ‘Annual Data.’ Compare data for the most recent period or date. Assume you’re an investor interested in purchasing stock.

� Calculate the Quick Ratio for both companies

*Quick ratio = (Total Assets – Total Inventory) / Total Liabilities*

� Based only on this information, which company would you be more

likely to invest in? Why?

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(2) Operating/Efficiency Ratios� Measures the efficiency of a company's use of its assets and liabilities in generating sales revenue to the company (the higher the ratio, the more efficient).

� Asset turnover ratios consider how efficiently a company uses its assets

� Total Assets Turnover = Annual Sales / Total Assets

� Measures a company's ability to generate sales from its assets

� Inventory Turnover = Cost of Goods Sold / Average Inventory

� Measures the number of times inventory is sold or used in a time period (e.g. a year)

� In Google Finance, Cost of Goods Sold (COGS) = Cost of Revenue

� Average Inventory = (2017 Inventory + 2016 Inventory) / 2

� Use both the Income Statement (COGS) and Balance Sheet (Inventory)

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Operating Ratio Exercise Form a group of 2 – 3 students. Visit the course website, select ‘Readings.’ Choose a pair of related companies. Open both companies’ financial statements and select ‘Annual Data.’ Compare data for the most recent period or date.

� Calculate the Inventory Turnover for both companies

*Inventory Turnover = Cost of Goods Sold / Average Inventory*

� Which company has a higher inventory turnover? Why do you

think this is?

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(3) Financial Leverage/Debt Ratios� Measures the ability of a company to meet its long-term debt obligations, such as long term loans, pension liabilities, lease payments, interest payments on debt, etc.

� Debt ratios compare the overall debt of a company to its assets or equity;

� Debt Ratio = Total Debt / Total Assets

� A high ratio implies that assets are being financed primarily with debt, rather than equity, and is considered to be a risky approach to financing

� Debt-to-Equity = Total Liabilities / Shareholders' Equity

� Measures a company’s debt relative to the total value of its stock, often used to gauge the extent to which a company is taking on debt as a means of leveraging (i.e. attempting to increase its value by using borrowed money to fund various projects)

� A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt (aggressive leveraging practices are often associated with high levels of risk)

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Financial Leverage Exercise Form a group of 2 – 3 students. Visit the course website, select ‘Readings.’ Choose a pair of related companies. Open both companies’ financial statements and select ‘Annual Data.’ Compare data for the most recent period or date. Assume you’re an investor interested in purchasing stock.

� Calculate the Debt Ratio for both companies

*Debt Ratio = Total Debt / Total Assets*

� Based only on this information, which company would you be more

likely to invest in? Why?

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(4) Profitability/Performance Ratios � Measures a company’s overall efficiency and performance

� More specifically, profitability ratios measure a company’s ability to generate earnings compared to the company’s expenses over a specific period of time.

� Profit Margin (Return on Sales) = Net Income / Net Sales

� Measures the percentage of profit from operations after deducting operating expenses, interest expense, taxes, and preferred stock dividends from revenues (common stock dividends are the only major debit item left out of the equation)

� Return on Equity = Net Income / Owner’s Equity

� Measures the profitability of a company in relation to the book value of shareholder equity (i.e. how well a company uses investments to generate earnings growth

� Owner’s/Stockholder’s Equity = Common Stock + Retained Earnings

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Profitability Exercise Form a group of 2 – 3 students. Visit the course website, select ‘Readings.’ Choose a pair of related companies. Open both companies’ financial statements and select ‘Annual Data.’ Compare data for the most recent period or date. Assume you’re an investor interested in purchasing stock.

� Calculate the Profit Margin for both companies

*Profit Margin = Net Income / Net Sales*

� Which company has a greater profit margin? Why do you think this is

the case for the most recent year?

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Problems with Financial Ratios � Lack of comparability – different companies may use different accounting policies, which will impact their financial ratios. For example, a company using a last-in-first-out valuation will be considerably different from a company using a first-in-first-out. The ratios won’t be comparable because the valuations aren’t comparable.

� Ratios are based on book value – ratios are often based on historical numbers, which can be misleading. Assets are a good example – they maybe worth more or less, thus influencing liquidity ratios.

� Lack of understanding causation – ratios tell us what happened, but not why it happened. Often, the why is more important than the what.

� Lack of management measurements – although ratios are based on indicators of how well a company is doing, one of the key determinents of a successful company is the quality of management. The quality of management is not well captured by financial ratios.

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Important Resources � Business Backer: provides a helpful infographic explaining the financial statements we’ve discussed in class

https://www.businessbacker.com/blog/visual-guide-business-financial-statement/

� BDC’s Financial Ratio Tools: includes many of the ratios discussed in class

https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/ratio-calculators/pages/default.aspx

� BDC’s Business Plan Template: a very helpful tool to use when putting your business plan together; includes templates for the financial statements we’ve discussed in class

https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/pages/business-plan-template.aspx

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Dragon’s Den Report Requirements� A Balance Sheet

� An Income Statement

� A Cash Flow Statement

� Vertical / horizontal analysis

� At least one liquidity ratio

� At least one operating ratio

� At least one leverage ratio

� At least one profitability ratio

*We highly encourage you to review your financial statements and analyses with us prior to submitting your final report*

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WOOD 465

Questions?

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introduction to finance, part 2wood465-kozak.sites.olt.ubc.ca/files/2018/02/gaston...26/02/2018 1...

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