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**Chapter 3 Working with Financial Statements**

Homework: 13-17

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**Topics Sources and Uses of Cash Financial Ratio Analysis**

The Du Pont Identity Using Financial Statement Information

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**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

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**Investment Activities**

Organizes cash flows into 3 main categories 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

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**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

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**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

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**Example: Hermetic, Inc., Balance Sheet**

Balance Sheet as of December 31 ($ in thousands) Assets Current Assets Cash $ $ 50 Accounts receivable Inventory Total $ $ 745 Fixed assets Net plant and equipment Total assets $1610 $1845

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**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

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**Hermetic, Inc., Income Statement**

($ in thousands) Net sales $710.00 Cost of goods sold Depreciation 30.00 Earnings before interest and taxes $200.00 Interest 20.00 Taxable income Taxes 53.45 Net income $126.55 Retained earnings $100.00 Dividends

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**Hermetic, Inc., Statement of Cash Flows**

Operating activities + Net income + Depreciation + Increase in payables – Increase in receivables – – Increase in inventory – 91.55 Investment activities + Ending fixed assets +1,100.00 – Beginning fixed assets – (145.00)

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**Hermetic, Inc., Statement of Cash Flows (concluded)**

Financing activities + Increase in notes payable + Increase in long-term debt – Dividends – 58.45 Putting it all together 91.55 – = 5.00

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**Financial Ratios Short-Term Solvency or Liquidity Long-Term Solvency**

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

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**Short-Term Liquidity Ratios**

The Current Ratio Current Assets Current Ratio = Current Liabilities 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?

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**Changes in the trend are difficult to interpret**

Current Ratio Notes of Caution 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.

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**Includes only current assets that can be converted quickly to cash.**

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

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**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.

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**Long-Term Solvency Ratios**

The Total Debt Ratio Takes into account all debt of all maturities of all creditors Total Assets - Total Equity Total Debt Ratio = Total Assets

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**Long-Term Solvency Ratios**

Debt/Equity Ratio Variation of the total debt ratio. Measures total debt as a multiple of total equity. Total Debt Debt/Equity Ratio = Total Equity

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**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 Tot. Long-term Debt Long-Term Debt Ratio = Tot. L.T. Debt + Tot. Equity

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**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. EBIT Times Interest Earned Ratio = Interest expense The Lower this ratio, the more levered the firm.

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**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. EBIT + depreciation Cash Coverage Ratio = Interest Expense The Lower this ratio, the more levered the firm.

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**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.

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**Asset Management Ratios**

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

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**Asset Management Ratios**

Days' Sale in Inventory Ratio Measures how long it took a firm to sell inventory 365 Days' Sales in Inventory = Inventory Turnover

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**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

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**Asset Management Ratios**

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

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**Asset Management Ratios**

Days' Sale in Receivables Ratio Measures how long it took a firm to collect on its credit sales 365 Days' Sales in Receivables = Receivables Turnover

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**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

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**Asset Management Ratios**

NWC Turnover Ratio Measures the efficiency of a firm's NWC Sales NWC Turnover Ratio = NWC

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**Asset Management Ratios**

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

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**Profitability Ratios Profit Margin Net Income Profit Margin = Sales**

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

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**Profitability Ratios Return of Assets (ROA) Net Income ROA =**

Measures how hard a firm's assets are working Net Income ROA = Total Assets

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**Profitability Ratios Return of Equity (ROE) Net Income ROE =**

Measures how efficient a firm's equity is being employed to generate profit Net Income ROE = Total Equity

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**Price/Earnings (P/E) Ratio**

Market Value Measures Price/Earnings (P/E) Ratio Measures what investors are willing to pay per $1 of current earnings Price Per Share P/E Ratio = Earnings Per Share

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**Market Value Measures Market-to-Book Ratio**

Measures the market value of the firm's investments to their historical costs. Market Value Per Share Mkt-to-Book = Book Value Per Share

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**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

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The Du Pont Identity ROE Can be Decomposed into 3 Components: ROE = Net income/Sales x Sales/Assets x Assets/Equity ROE = Profit Margin x Asset Turnover x Equity Multiplier Operating Efficiency Financial Leverage Asset Use Efficiency

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**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.

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**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?

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**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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