Presentation on theme: "Key Concepts and Skills"— Presentation transcript:
0 Working With Financial Statements ChapterThreeWorking With Financial Statements
1 Key Concepts and Skills Understand sources and uses of cash and the Statement of Cash FlowsKnow how to standardize financial statements for comparison purposesKnow how to compute and interpret important financial ratiosBe able to compute and interpret the Du Pont IdentityUnderstand the problems and pitfalls in financial statement analysis
2 Chapter OutlineCash Flow and Financial Statements: A Closer LookStandardized Financial StatementsRatio AnalysisThe Du Pont IdentityUsing Financial Statement Information
3 See 3.5: Sources & Uses of Cash Balance Sheet, As of Dec 3120062005Cash & Equivalents3,1716,489A/P313,286340,220A/R1,095,1181,048,991N/P227,84886,631Inventory388,947295,255Other CL1,239,6511,098,602Other CA314,454232,304Total CL1,780,7851,525,453Total CA1,801,6901,583,039LT Debt1,389,615871,851Net FA3,129,7542,535,072C/S1,761,0441,648,490Total Assets4,931,4444,118,111Total Liab. & EquityThe numbers in this sample balance sheet are based on the 2000 annual report for McGraw-Hill. The categories were condensed for simplicity.See 3.5: Sources & Uses of Cash
4 Income Statement: Jan 1 – Dec 31, 2006 Revenues4,335,491Cost of Goods Sold1,762,721Expenses1,390,262Depreciation362,325EBIT820,183Interest Expense52,841Taxable Income767,342Taxes295,426Net Income471,916EPS (Earnings Per Share)2.41Dividends per share0.93This sample income statement is based on information from the McGraw-Hill 2000 annual report.Numbers are in thousands, except EPS & DPS
5 Sources and Uses of Cash 3.1 Cash inflow – occurs when we “sell” somethingDecrease in asset account (sell inventory, fixed assets, etc)Increase in liability or equity account (sell a bond, common stock, etc)UsesCash outflow – occurs when we “buy” somethingIncrease in asset account (buy inventory or fixed assets)Decrease in liability or equity account (Redeem bonds or shares)Click on Sample B/S to go to the Balance Sheet to illustrate the accounts that are sources and uses, On the B/S Click on the small green arrow to return to this slide.
6 Statement of Cash Flows Statement of Cash Flows – the statement that summarizes the sources and uses of cashChanges divided into three major categoriesOperating Activity – includes net income and changes in most current accountsInvestment Activity – includes changes in fixed assetsFinancing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends
7 Sample Statement of Cash Flows Numbers are in thousandsCash, beginning of year6,489Financing ActivityOperating ActivityIncrease in Notes Payable141,217Net Income471,916Increase in LT Debt517,764Plus: Depreciation362,325Decrease in C/S-36,159Increase in Other CL141,049Dividends Paid-395,521Less: Increase in A/R-46,127Net Cash from Financing227,301Increase in Inventory-93,692Net Decrease in Cash-3,319Increase in Other CA-82,150Cash End of Year3,170*Decrease in A/P-26,934Net Cash from Operations726,387Investment ActivityFixed Asset Acquisition-957,007Net Cash from Investments*Difference due to rounding of dividendsRemind students that part of the increase in the C/S account shown on the balance sheet is the increase in Retained Earnings. That is already incorporated in the net income under operating activity.Additions to RE = 471,916 – 395,521 = 76,395Change in C/S = 1,761,044 – 1,648, ,395 = -36,159From the B/S
8 Standardized Financial Statements 3.2 Common-Size Balance SheetsCompute all accounts as a percent of total assetsCommon-Size Income StatementsCompute all line items as a percent of salesStandardized statements make it easier to compare financial information, particularly as the company growsThey are also useful for comparing companies of different sizes, particularly within the same industry
9 Common Size Income Statement: Example Income Common SizeStatement Income StatementRevenue $70, %Cost of Goods Sold $44, %Gross Profit $25, %SG&A $13, %Operating Income $12, %Interest Expense $2, %Taxes $3, %Net Income $5, %
12 As we look at each ratio, ask yourself Ratio Analysis 3.3Ratios also allow for better comparison through time or between companiesAs we look at each ratio, ask yourselfHow is the ratio computed?What is it intended to measure (and why do I care about measuring this variable)?What might a high or a low value tell us? How might such a value be misleading?How could this measure be improved?Ratios are used both internally and externallywww: Click on the web surfer to go to CNBC’s stock screener. Choose the “Advanced Search” option to show students the wide range of ratios that can be used for making investment decisions.
13 Categories of Financial Ratios Liquidity ratios (Measure short term solvency)Financial leverage ratios (Long-term solvency)Asset management ratiosProfitability ratiosMarket value ratios
14 Liquidity Ratios Current Ratio = Current Assets / Current Liabilities 1,801,690 / 1,780,785 = 1.01 timesQuick Ratio = Current Assets – InventoryCurrent Liabilities(1,801,690 – 388,947) / 1,780,785 = .793 timesCash Ratio = Cash / Current Liabilities3,171 / 1,780,785 = .002 timesThe firm is just barely able to cover current liabilities with it’s current assets. A short-term creditor might find this a bit disconcerting and may reduce the likelihood that they would lend money to the company. The ratio should be compared to the industry – it’s possible that this industry has a substantial amount of cash flow and that they can meet their current liabilities out of cash flow instead of relying solely on the liquidation of current assets that are on the books.The quick ratio is a little lower than the current ratio, but overall inventory seems to be a small component of current assets.This company carries a very low cash balance. This may be an indication that they are aggressively investing in assets that will provide higher returns. We need to make sure that we have enough cash to meet our obligations, but too much cash reduces the return earned by the company.
15 Computing Long-term Solvency Ratios Total Debt Ratio = Total Assets – Total EquityTotal Assets(4,931,444 – 1,761,044) / 4,931,444 = times or 64.29%The firm finances approximately 64% of its assets with debt.Debt/Equity = Total Debt / Total Equity(4,931,444 – 1,761,044) / 1, 761,044 = timesEquity Multiplier = Total Assets / Total Equity = 1 + D/E= 2.800Note that these are often called leverage ratios.TE = total equity and TA = total assets, the numerator in the total debt ratio could also be found by adding all of the current and long-term liabilities.Another way to compute the D/E ratio if you already have the total debt ratio:D/E = Total debt ratio / (1 – total debt ratio) = / ( ) = 1.800The EM is one of the ratios that is used in the Du Pont Identity as a measure of the firm’s financial leverage.
16 Computing Coverage Ratios Times Interest Earned = EBIT / Interest820,183 / 52,841 = 15.5 timesCash Coverage = (EBIT + Depreciation) / Interest(820, ,325) / 52,841 = timesEven though the company is financed with over 64% debt, they have a substantial amount of operating income available to cover the required interest payments.Remember that depreciation is a non-cash deduction. A better indication of a firm’s ability to meet interest payments may be to add back the depreciation to get an estimate of cash flow before taxes.
17 Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / Inventory1,762,721 / 388,947 = 4.53 timesDays’ Sales in Inventory = 365 / Inventory Turnover365 / 4.53 = 81 daysInventory turnover can be computed using either ending inventory or average inventory when you have both beginning and ending figures. It is important to be consistent with whatever benchmark you are using to analyze the company’s strengths or weaknesses.It is also important to consider seasonality in sales. If the balance sheet is prepared at a time when there is a large inventory build-up to meet seasonal demand, then the inventory turnover will be understated and you might believe that the company is not performing as well as it is. On the other hand, if the balance sheet is prepared when inventory has been drawn down due to seasonal sales, then the inventory turnover would be overstated and the company may appear to be doing better than it really is. Averages using annual data may not fix this problem. If a company has seasonal sales, you may want to look at quarterly averages to get a better indication of turnover.
18 Computing Receivables Ratios Receivables Turnover = Sales / Accounts Receivable4,335,491 / 1,095,118 = 3.96 timesDays’ Sales in Receivables = 365 / Receivables Turnover365 / 3.96 = 92 daysTechnically, the sales figure should be credit sales. This is often difficult to determine from the income statements provided in annual reports. If you use total sales instead of credit sales, you will overstate your turnover level. You need to recognize this bias when credit sales are unavailable, particularly if a large portion of the sales are cash sales.As with inventory turnover, you can use either ending receivables or an average of beginning and ending.You also run into the same seasonal issues as discussed with inventory.Probably the best benchmark for days’ sales in receivables is the company’s credit terms. If the company offers a discount (1/10 net 30), then you would like to see days’ sales in receivables less than 30. If the company does not offer a discount (net 30), then you would like to see days’ sales in receivables close to the net terms. If days’ sales in receivables is substantially larger than the net terms, then you first need to look for biases, such as seasonality in sales. If this does not provide an explanation for the difference, then the company may need to take another look at its credit policy (who it grants credit to and its collection procedures).
19 Computing Total Asset Turnover NWC Turnover = Sales / NWC4,335,491 / (1,801, ,780,785) = timesFixed Asset Turnover = Sales / Net Fixed Assets4,335,491 / 3,129,754 = timesTotal Asset Turnover = Sales / Total Assets4,335,491 / 4,931,444 = .88 timesMeasure of asset use efficiencyNot unusual for TAT < 1, especially if a firm has a large amount of fixed assetsHaving a TAT of less than one is not a problem for most firms. Fixed assets are expensive and are meant to provide sales over a long period of time. This is why the matching principle indicates that they should be depreciated instead of immediately expensed.This is one of the ratios that will be used in the Du Pont identity.
20 Computing Profitability Measures Profit Margin = Net Income / Sales471,916 / 4,335,491 = times or 10.88%Return on Assets (ROA) = Net Income / Total Assets471,916 / 4,931,444 = times or 9.57%Return on Equity (ROE) = Net Income / Total Equity471,916 / 1,761,044 = times or 26.8%You can also compute the gross profit margin and the operating profit margin.Profit margin is one of the components of the Du Pont identity and is a measure of operating efficiency. It measures how well the firm controls the costs required to generate the revenues. It tells how much the firm earns for every dollar in sales. In the example, the firm earns almost $0.11 for each dollar in sales.Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return on investment). As with many of the ratios, there are variations in how they can be computed. The most important thing is to make sure that you are computing them the same way as the benchmark you are using.ROE will always be higher than ROA as long as the firm has debt. The greater the leverage the larger the difference will be. ROE is often used as a measure of how well management is attaining the goal of owner wealth maximization. The Du Pont identity is used to identify factors that affect the ROE.
21 Computing Market Value Measures Market Price = $60.98 per shareShares outstanding = 205,838,910PE Ratio = Price per share / Earnings per share60.98 / 2.41 = 25.3 timesMarket-to-book ratio = market value per share / book value per share60.98 / (1,761,044,000 / 205,838,910) = 7.1 timesBe sure and point out that the numbers in the tables are presented in thousands, so the BV of equity has to have the extra three zeros in order for the market-to-book ratio to work.
24 Deriving the Du Pont Identity 3.4 Multiply by 1 and then rearrangeNI = Net IncomeTE = Total EquityTA = Total Assets
25 Deriving the Du Pont Identity Multiply by 1 again and then rearrange
26 Using the Du Pont Identity ROE = PM * AY * EMProfit margin is a measure of the firm’s operating efficiency – how well does it control costsAsset Yield (Total asset turnover) is a measure of the firm’s asset use efficiency – how well does it manage its assets in driving salesEquity multiplier is a measure of the firm’s financial leverageImproving our operating efficiency or our asset use efficiency will improve our return on equity. If the TAT is low compared to our benchmark, then we can break it down into more detail by looking at inventory turnover and receivables turnover. If those areas are strong then we can look at fixed asset turnover and cash management.We can also improve our ROE by increasing our leverage – up to a point. Debt affects a lot of other factors, including profit margin, so we have to be a little careful here. We want to make sure we have enough debt to utilize our interest tax credit effectively, but we don’t want to overdo it. The choice of leverage is discussed in more detail in chapter 13.
27 Using Financial Statement Information 3.5 Internal usesPerformance evaluation – compensation and comparison between divisionsPlanning for the future – guide in estimating future cash flowsExternal usesCreditorsSuppliersCustomersStockholders
28 BenchmarkingRatios are not very helpful by themselves; they need to be compared to somethingTime-Trend AnalysisUsed to see how the firm’s performance is changing through timeInternal and external usesPeer Group AnalysisCompare to similar companies or within industriesNAICS (North American Industry Classification System) codes, RMA, Financial Post Datagroup, and Dun & Bradstreet CanadaSIC codes have been used many years to identify industries and allow for comparison with industry average ratios. The SIC codes are limited however and have not kept pace with a rapidly changing environment. Consequently, the North American Industry Classification System was introduced in 1997 to alleviate some of the problems with SIC codes.www: Click on the web surfer to go the NAICS home page. It provides information on the change to the NAICS and conversion between SIC and NAICS codes.
29 Potential Problems with Ratios There is no underlying theory, so there is no way to know which ratios are most relevantBenchmarking is difficult for diversified firmsGlobalization and international competition makes comparison more difficult because of differences in accounting regulationsVarying accounting procedures, i.e. FIFO vs. LIFODifferent fiscal yearsExtraordinary events
30 Quick QuizWhat is the Statement of Cash Flows and how do you determine sources and uses of cash?How do you standardize balance sheets and income statements and why is standardization useful?What are the major categories of ratios and how do you compute specific ratios within each category?What are some of the problems associated with financial statement analysis?
31 Summary 3.6 You should be able to: Identify sources and uses of cash Understand the Statement of Cash FlowsUnderstand how to make standardized financial statements and why they are usefulCalculate and evaluate common ratiosUnderstand the Du Pont identityDescribe how to establish benchmarks for comparison purposes and understand some key problems that can arise