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Chapter 3 Working with Financial Statements Homework: 13-17.

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Presentation on theme: "Chapter 3 Working with Financial Statements Homework: 13-17."— Presentation transcript:

1 Chapter 3 Working with Financial Statements Homework: 13-17

2 Topics Sources and Uses of Cash Financial Ratio Analysis The Du Pont Identity Using Financial Statement Information

3 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

4 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

5 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

6 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

7 Example: Hermetic, Inc., Balance Sheet Hermetic, Inc. Balance Sheet as of December 31 ($ in thousands) Assets Current Assets Cash$ 45$ 50 Accounts receivable Inventory Total$ 625$ 745 Fixed assets Net plant and equipment Total assets$1610$1845

8 Hermetic, Inc., Balance Sheet (concluded) Liabilities and equity Current liabilities Accounts payable$ 210$ 260 Notes payable Total$ 320$ 435 Long-term debt Stockholders’ equity Common stock and paid-in surplus Retained earnings Total Total liabilities and equity$1610$1845

9 Hermetic, Inc., Income Statement ($ in thousands) Net sales$ Cost of goods sold Depreciation30.00 Earnings before interest and taxes$ Interest20.00 Taxable income Taxes53.45 Net income$ Retained earnings $ Dividends 26.55

10 Hermetic, Inc., Statement of Cash Flows Operating activities  + Net income  + Depreciation  + Increase in payables  – Increase in receivables–  – Increase in inventory– Investment activities  + Ending fixed assets+1,  – Beginning fixed assets–  + Depreciation (145.00)

11 Hermetic, Inc., Statement of Cash Flows (concluded) Financing activities  + Increase in notes payable  + Increase in long-term debt  – Dividends– Putting it all together – = 5.00

12 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

13 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

14 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

15 Quick Ratio Includes only current assets that can be converted quickly to cash. Quick Ratio = Current Assets - Inventory Current Liabilities

16 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.

17 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

18 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

19 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

20 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.

21 Long-Term Solvency Ratios Cash 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.

22 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.

23 Asset Management Ratios Inventory Turnover Ratio Measures how many times a firm sold off its inventory Inventory Turnover Ratio = Cost of Goods Sold Inventory

24 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

25 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

26 Asset Management Ratios Receivables Turnover Ratio Measures how fast a firm collects on the credit sales of inventory Receivables Turnover Ratio = Sales Accounts Receivable

27 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

28 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

29 Asset Management Ratios NWC Turnover Ratio Measures the efficiency of a firm's NWC NWC Turnover Ratio = Sales NWC

30 Asset Management Ratios Total Asset Turnover Ratio Measures the efficiency of a firm's Total Assets Total Asset Turnover Ratio = Total Assets Sales

31 Profitability Ratios Profit Margin Measures how well a firm is managing its costs relative to its sales Profit Margin = Net Income Sales

32 Profitability Ratios Return of Assets (ROA) Measures how hard a firm's assets are working ROA = Net Income Total Assets

33 Profitability Ratios Return of Equity (ROE) Measures how efficient a firm's equity is being employed to generate profit ROE = Net Income Total Equity

34 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

35 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

36 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

37 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

38 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.

39 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?

40 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?


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