Post on 06-May-2015
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