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?