Presentation on theme: "Chapter 3 Working with Financial Statements"— 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 IdentityUsing Financial Statement Information
3 Sources and Uses of Cash Sources of cash include:Decrease in assetsIncrease in liabilitiesIncrease in common stockIncrease in retained earningsUses of cash include:Increase in assetsDecrease in liabilitiesDecrease in common stockDecrease in retained earnings
4 Investment Activities Organizes cash flows into 3 main categoriesOperating ActivitiesRevenues from sales of goods and servicesCosts associated with productionsInvestment ActivitiesAcquisition of a new production planProceeds from selling equipmentFinancing ActivitiesIssuing long-term debtPayments associated with retiring long-term debtProceeds from issuing equityCash Dividends paid to shareholders
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 payableInvestment activities+ Ending fixed assets– Beginning fixed assets
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 Balance Sheet as of December 31($ in thousands)AssetsCurrent AssetsCash $ $ 50Accounts receivableInventoryTotal $ $ 745Fixed assetsNet plant and equipmentTotal assets $1610 $1845
9 Hermetic, Inc., Income Statement ($ in thousands)Net sales $710.00Cost of goods soldDepreciation 30.00Earnings before interest and taxes $200.00Interest 20.00Taxable incomeTaxes 53.45Net income $126.55Retained earnings $100.00Dividends
10 Hermetic, Inc., Statement of Cash Flows Operating activities+ Net income+ Depreciation+ Increase in payables– Increase in receivables –– Increase in inventory –91.55Investment activities+ Ending fixed assets +1,100.00– Beginning fixed assets –(145.00)
11 Hermetic, Inc., Statement of Cash Flows (concluded) Financing activities+ Increase in notes payable+ Increase in long-term debt– Dividends –58.45Putting it all together91.55 – = 5.00
12 Financial Ratios Short-Term Solvency or Liquidity Long-Term Solvency Ability to pay bills in the short-runLong-Term SolvencyAbility to meet long-term obligationsAsset ManagementIntensity and efficiency of asset useProfitabilityMarket ValueGoing beyond financial statements
13 Short-Term Liquidity Ratios The Current RatioCurrent AssetsCurrent Ratio =Current LiabilitiesIndicates a firm's ability to meet its short-term obligationsWhat Does This Number Mean?Question: If you are a short-term creditor, the higher the current ratio the better?
14 Changes in the trend are difficult to interpret Current RatioNotes of CautionChanges in the trend are difficult to interpretEqual 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.
15 Includes only current assets that can be converted quickly to cash. Quick RatioIncludes only current assets that can be converted quickly to cash.Current Assets - InventoryQuick Ratio =Current Liabilities
16 Short-term Solvency Ratios: The Bottom LineUse both measures when assessing a firm's short-term liquidityUsing 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 RatioTakes into account all debt of all maturities of all creditorsTotal Assets - Total EquityTotal Debt Ratio =Total Assets
18 Long-Term Solvency Ratios Debt/Equity RatioVariation of the total debt ratio.Measures total debt as a multiple of total equity.Total DebtDebt/Equity Ratio =Total Equity
19 Long-Term Solvency Ratios Long-Term Debt RatioMost popular leverage ratioOmits short-term liabilities which are changing often.Account payables: more a reflection of trade practices than of debt managementTot. Long-term DebtLong-Term Debt Ratio =Tot. L.T. Debt + Tot. Equity
20 Long-Term Solvency Ratios Times Interest Earned RatioAlso called interest coverage ratio.Measures the multiple of interest expense that a firm could support given its current level of earnings.EBITTimes Interest Earned Ratio =Interest expenseThe Lower this ratio, the more levered the firm.
21 Long-Term Solvency Ratios Cash Coverage RatioEBIT includes depreciationMeasures the multiple of interest expense that a firm could support given its level of cash.EBIT + depreciationCash Coverage Ratio =Interest ExpenseThe 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 RatioMeasures how many times a firm sold off its inventoryCost of Goods SoldInventory Turnover Ratio =Inventory
24 Asset Management Ratios Days' Sale in Inventory RatioMeasures how long it took a firm to sell inventory365Days' Sales in Inventory =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 industryInventory becomes obsolete and can't be converted into cash.liquidate below costs => losses for the firm
26 Asset Management Ratios Receivables Turnover RatioMeasures how fast a firm collects on the credit sales of inventorySalesReceivables Turnover Ratio =Accounts Receivable
27 Asset Management Ratios Days' Sale in Receivables RatioMeasures how long it took a firm to collect on its credit sales365Days' Sales in Receivables =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 RatioMeasures the efficiency of a firm's NWCSalesNWC Turnover Ratio =NWC
30 Asset Management Ratios Total Asset Turnover RatioMeasures the efficiency of a firm's Total AssetsSalesTotal Asset Turnover Ratio =Total Assets
31 Profitability Ratios Profit Margin Net Income Profit Margin = Sales Measures how well a firm is managing its costs relative to its salesNet IncomeProfit Margin =Sales
32 Profitability Ratios Return of Assets (ROA) Net Income ROA = Measures how hard a firm's assets are workingNet IncomeROA =Total Assets
33 Profitability Ratios Return of Equity (ROE) Net Income ROE = Measures how efficient a firm's equity is being employed to generate profitNet IncomeROE =Total Equity
34 Price/Earnings (P/E) Ratio Market Value MeasuresPrice/Earnings (P/E) RatioMeasures what investors are willing to pay per $1 of current earningsPrice Per ShareP/E Ratio =Earnings Per Share
35 Market Value Measures Market-to-Book Ratio Measures the market value of the firm's investments to their historical costs.Market Value Per ShareMkt-to-Book =Book Value Per Share
36 Example The Cross Companies 45 Million Shares OutstandingStock sells for $80 per share at fiscal year-endNet Income = $675 millionTotal Equity = $3,375 million
37 The Du Pont IdentityROE Can be Decomposed into 3 Components:ROE = Net income/Sales x Sales/Assets x Assets/EquityROE = Profit Margin x Asset Turnover x Equity MultiplierOperating EfficiencyFinancial LeverageAsset Use Efficiency
38 Standardized Financial Statements Common Size Balance SheetAll items are presented as a percentage of total assets=> Divided all items by total assetsCommon Size Income Statement:All items are presented as percentage of total sales=> Divide all items by total salesCommon-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 theoryDifferences in accounting practicesFinding comparable firms is difficultDifferences in fiscal-year endsOne-time eventsSeasonal variationsConglomeratesChoosing Benchmark: Which industry?