Download - Cash Flows and Financial Analysis
Slides developed by:Pamela L. Hall, Western Washington University
Cash Flows and Financial Analysis
Chapter 3
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Financial Information—Where Does It Come From, etc.
Financial information is the responsibility of management Created by within-firm accountants Creates a conflict of interest because
management wants to portray firm in a positive light
Published to a variety of audiences
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Users of Financial Information
Investors and Financial Analysts Financial analysts interpret information about
companies and make recommendations to investors Major part of analyst’s job is to make a careful study
of recent financial statements
Vendors/Creditors Use financial info to determine if the firm is expected
to make good on loans
Management Use financial info to pinpoint strengths and
weaknesses in operations
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Sources of Financial Information
Annual Report Required of all publicly traded firms Tend to portray firm in a positive light Also publish a less glossy, more businesslike
document called a 10K with the SEC Brokerage firms and investment advisory
services (Value Line Investment Survey)
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The Orientation of Financial Analysis Accounting is concerned with creating
financial statements Finance is concerned with using the data
contained within financial statements to make decisions The orientation of financial analysis is critical
and investigative
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The Statement of Cash Flows
Income doesn’t represent cash in the firm’s pocket
The Statement of Cash Flows (AKA: Statement of Changes in Financial Position) provides info on the actual movement of cash in and out of the company
Constructed from the Balance Sheet and Income Statement
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How the Statement of Cash Flows Works—Preliminary Examples
Requires two consecutive balance sheets and one income statement from which the statement of cash flows is generated
Takes net income for the period and makes adjustments
Then takes the balance sheet items and examines the changes
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How the Statement of Cash Flows Works—Preliminary Examples
Q: Suppose Joe Jones has after-tax income of $50,000 and spends $40,000 on normal living expenses during the year. Also assume that at the beginning of the year he had a bank balance of $10,000 and no other assets or liabilities. Further, assume that during the year he bought a new car costing $30,000, financing $25,000 at the bank with a car loan. At the end of the year he has $15,000 in the bank. Generate a Statement of Cash Flows for Joe.
A: Inflows of cash are known as sources and outflows are known as uses. The Statement of Cash Flows will show how Joe ended up with $15,000 in his bank account.
Joe generated a net source of cash of $10,000, or the difference between his income and normal living expenses. He also experienced an inflow of $25,000 from the car loan and used $30,000 to buy the car. Thus, Joe’s Statement of Cash Flows is:
Exa
mpl
e
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How the Statement of Cash Flows Works—Preliminary Examples
Exa
mpl
e
$15,000 Ending cash balance
$5,000 Net cash flow
$10,000 Beginning cash balance
$5,000Net inflow/(outflow) of cash
($30,000)Use of cash to buy auto
(40,000)
$50,000
$25,000Source of cash from loan
$10,000Net source of cash from income
Cash used on living expenses
Cash income
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Business Cash Flows
Cash Flows Rules The following rules can be applied to any
business’s financial statements• Asset increase use of cash• Asset decrease source of cash• Liability increase source of cash• Liability decrease use of cash
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Business Cash Flows
Standard Presentation Statement of Cash Flows organized to show
• Operating activities• Running business on day-to-day basis
• Investing activities• When firm buys or sells things to do business
• Includes long-term purchases and sales of financial assets
• Financing activities• When firm borrows money, pays off loans, sells stock or
pays dividends
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Figure 3.2: Business Cash Flows
A successful business has to withdraw cash to
finance growth and replace worn out assets, pay taxes
and for profit.
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Figure 3.3: The Cash Conversion Cycle
Product is converted into cash, which is
transformed into more product,
creating the cash conversion cycle.
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Belfry Company Belfry CompanyBalance Sheet Income StatementFor the period ended 12/31/X2 For the period ended 12/31/X2
Sales 10,000$ 12/31/X1 12/31/X2 COGS 6,000$
Cash 1,000 1,400 Gross margin 4,000$ Accounts receivable 3,000 2,900Inventory 2,000 3,200 Expense 1,600$ CURRENT ASSETS 6,000 7,500 Depreciation 500$ Fixed assets EBIT 1,900$ Gross 4,000 6,000 Interest 400$ Accumulated deprec. (1,000) (1,500) EBT 1,500$ Net 3,000 4,500 Tax 500$ TOTAL ASSETS 9,000 12,000 Net Income 1,000$
Accounts payable 1,500 2,100Accruals 500 400CURRENT LIABILITIES 2,000 2,500Long-term debt 5,000 6,200Equity 2,000 3,300TOTAL CAPITAL 7,000 9,500
TOTAL LIABILITIES AND EQUITY 9,000 12,000
Assets
Liabilities
Constructing the Statement of Cash Flows
Also assume firm paid a $500 dividend and sold stock for $800
during the year.
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Constructing the Statement of Cash Flows Operating Activities
Involve the Income Statement and current Balance Sheet accounts
Involves activities firm does on a day-to-day basis such as
• Buying inventory• Producing and selling product• Paying expenses and taxes• Collecting credit sales
Focus of activitiesis generating net
income—the beginning of a
cash flowstatement.
Money from operating transactions runs through current balance sheet accounts
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Constructing the Statement of Cash Flows Thus, for Belfry the cash from Operating
Activities isNet Income $1,000
+ Depreciation $500
= Operating Income $1,500
+ increase in Receivables $100
- increase in Inventory ($1,200)
+ increase in Payables $600
- decrease in Accruals ($100)
Cash from operating activities $900
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Constructing the Statement of Cash Flows Investing Activities
Typically include purchasing Fixed Assets Examine the change in GROSS Fixed Assets, not net
• Because the net value includes an adjustment for depreciation
• Depreciation has already been included under operating activities
Thus, for Belfry the cash from investing activities is• Purchase of Fixed Assets ($2,000)
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Constructing the Statement of Cash Flows Financing Activities
Deal with the capital accounts, long-term debt and equity
Thus, for Belfry the cash from financing activities is
Increase in long-term debt $1,200
Sale of stock $800
Dividend paid ($500)
Cash from financing activities $1,500
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Constructing the Statement of Cash Flows The Equity and Cash Accounts
The change in equity is not included because the changes are reflected elsewhere in the Statement of Cash Flows
• Net Income is included in Cash Flows from Operations• Sale of stock and dividends are considered under financing
activities The change in the cash account isn’t considered
because the sum of cash flows from operations, financing activities and investing activities must equal the change in the cash account
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Constructing the Statement of Cash Flows Thus, for Belfry, the final portion of the
Statement is
Beginning Cash Balance $1,000
Net cash flow 400
Ending Cash Balance $1,400
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Constructing the Statement of Cash Flows
While the firm was profitable it still had to
borrow money and sale stock to finance the
increase in Fixed Assets.
Belfry CompanyStatement of Cash FlowsFor the period ended 12/31/X2CASH FROM OPERATING ACTIVITIESNet income 1,000$ Depreciation 500$ Net changes in current accounts (600)$ Cash from operating activities 900$ CASH FROM INVESTING ACTIVITIESPurchase of fixed assets (2,000)$ CASH FROM FINANCING ACTIVITIESIncrease in long-term debt 1,200$ Sale of stock 800$ Dividend paid (500)$ Cash from financing activities 1,500$ NET CASH FLOW 400$
Beginning cash balance 1,000$ Net cash flow 400$ Ending cash balance 1,400$
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Free Cash Flows
Refers to cash generated beyond reinvestment needs
Under normal conditions most firms generate positive cash flow from operations Some of these funds are used to maintain
long-run competitive position• Replace worn-out fixed assets• Pay dividends on Preferred Stock
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Ratio Analysis
Used to highlight different areas of performance
Involves taking sets of numbers from the financial statement and forming ratios with them
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Comparisons
Ratios when examined separately don’t convey much information History—examine trends (how the value has
changed over time) Competition—compare with other firms in the
same industry Budget—compare actual values with
expected or desired values
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Common Size Statements
First step in a financial analysis is usually the calculation of a common size statement Common size income statement
• Presents each line as a percent of revenue Common size balance sheet
• Presents each line as a percent of total assets
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Common Size Statements
$ % $ %Sales 2,187,460$ 100.0% 150,845$ 100.0%COGS 1,203,103$ 55.0% 72,406$ 48.0%Gross margin 984,357$ 45.0% 78,439$ 52.0%
Expenses 505,303$ 23.1% 39,974$ 26.5%EBIT 479,054$ 21.9% 38,465$ 25.5%Interest 131,248$ 6.0% 15,386$ 10.2%EBT 347,806$ 15.9% 23,079$ 15.3%Tax 118,254$ 5.4% 3,462$ 2.3%Net Income 229,552$ 10.5% 19,617$ 13.0%
Alpha Beta
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Ratios
Designed to illuminate some aspect of how the business is doing
Average Versus Ending Values When a ratio calls for a balance sheet item, may
need to use average values (of the beginning and ending value for the item) or ending values
• If an income or cash flow figure is combined with a balance sheet figure in a ratio—use average value for balance sheet figure
• If a ratio compares two balance sheet figures—use ending value
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Ratios
Categories of Ratios Liquidity—indicate firm’s ability to pay its bills in the
short run Asset Management—show how the company uses its
resources to generate revenue, profit and to avoid cost
Debt Management—show how effectively the firm has used borrowed funds and whether or not it has a high amount of leverage
Profitability—allow assessment of the company’s ability to make money
Market Value—give an indication of how investors feel about the company’s financial future
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Liquidity Ratios
Current Ratio
Current Assets
Current Ratio Current Liabilities
To ensure solvency the current ratio has to exceed 1.0 Generally a value greater than 1.5 or 2.0 is
required for comfort
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Liquidity Ratios
Quick Ratio (or Acid-Test Ratio)
current assets - inventoryQuick Ratio
current liabilities
Measures liquidity without considering inventory (the firm’s least liquid current asset)
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Asset Management Ratios
Average Collection Period (ACP)
accounts receivableACP
average daily (credit) sales
Measures the time it takes to collect on credit sales
AKA days sales outstanding (DSO) Should use an average Accounts Receivable
balance, net of the allowance for doubtful accounts
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Asset Management Ratios
Inventory Turnovercost of goods sold
Inventory Turnover inventory
Gives an indication of the quality of inventory as well as how it is managed
Measures how many times a year the firm uses up an average stock of goods
A higher turnover implies doing business with less tied up in inventory
Should use average inventory balance
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Asset Management Ratios
Fixed Asset TurnoverSales (Total)
Fixed Asset Turnover Fixed Assets (Net)
Appropriate in industries where significant equipment is required to do business
Long-term measure of performance Average balance sheet values are
appropriate
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Asset Management Ratios
Total Asset Turnover
Sales (Total)Total Asset Turnover
Total Assets
More widely used than Fixed Asset Turnover Long-term measure of performance Average balance sheet values are
appropriate
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Debt Management Ratios
Need to determine if the company isn’t using so much debt that it is assuming excessive risk
Debt could mean long-term debt and current liabilities Or it could mean just interest-bearing obligations—generally
long-term debt
Debt Ratio
Long-term debt Current LiabilitiesDebt Ratio
Total Assets
A high debt ratio is viewed as risky by investors Usually stated as percentages
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Debt Management Ratios
Debt-to-equity ratio Can be stated several ways (as a percentage,
or as a x:y value)
Debt-to-Equity LT debt : Common Equity
or
LT DebtDebt-to-Equity
Common Equity
Measures the mix of debt and equity within the firm’s total capital
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Debt Management Ratios
Times Interest EarnedEBIT
TIE Interest Expense
TIE is a coverage ratio• Reflects how much EBIT covers interest expense• A high level of interest coverage implies safety
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Debt Management Ratios
Cash CoverageEBIT depreciation
Cash coverage Interest Expense
TIE ratio has problems• Interest is a cash payment but EBIT is not exactly
a source of cash• By adding depreciation back into the numerator
we have a more representative measure of cash
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Debt Management Ratios
Fixed Charge Coverage
EBIT Lease PaymentsFixed Charge Coverage
Interest Expense Lease Payments
Interest payments are not the only fixed charges
Lease payments are fixed financial charges similar to interest
• They must be paid regardless of business conditions
• If they are contractually non-cancelable
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Profitability Ratios
Return on Sales (AKA: Profit Margin, Net Profit Margin)
Net IncomeROS
Sales
Measures control of the income statement: revenue, cost and expense
Represents a fundamental indication of the overall profitability of the business
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Profitability Ratios
Return on AssetsNet Income
ROA Total Assets
Adds the effectiveness of asset management to Return on Sales
Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit
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Profitability Ratios
Return on EquityNet Income
ROE Stockholders' Equity
Adds the effect of borrowing to ROA Measures the firm’s ability to earn a return
on the owners’ invested capital If the firm has substantial debt, ROE tends to
be higher than ROA in good times and lower in bad times
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Market Value Ratios
Price/Earnings Ratio (PE Ratio)
Current stock pricePE Ratio
Earnings per share (EPS)
An indication of the value the stock market places on a company
Tells how much investors are willing to pay for a dollar of the firm’s earnings
A firm’s P/E is primarily a function of its expected growth
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Market Value Ratios
Market-to-Book Value RatioCurrent stock price
Market-to-Book-Value book value per share (of equity)
A healthy company is expected to have a market value greater than its book value
• Known as the going concern value of the firm
Idea is that the combination of assets and human resources will create an company able to generate future earnings worth more than the assets alone today
A value less than 1.0 indicates a poor outlook for the company’s future
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Du Pont Equations
Ratio measures are not entirely independent
Performance on one is sometimes tied to performance on others
Du Pont equations express relationships between ratios that give insights into successful operation
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Du Pont Equations
Du Pont equation involves ROE, which can be written several ways:
Net Income salesROA
Total Assets salesor
Net Income salesROA
sales Total Assetsor
ROE = ROS total asset turnover
States that to run a business
well, a firm must manage costs and expenses
as well as generate lots of sales per dollar
of assets.
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Du Pont Equations
Extended Du Pont equation states ROE in terms of other ratios
Equity Multiplier
Net Income sales total assetsROE
Stockholders' Equity sales total assets
or
Net Income sales total assetsROE
sales total assets Stockholders' Equity
or
ROE = ROS Total Asse
ROA
t Turnover Equity Multiplier
or
ROE = ROA Equity Multiplier
Related to the proportion to
which the firm is financed by other people’s
money as opposed to
owner’s money.
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Du Pont Equations
Extended Du Pont equation states that the operation of a business is reflected in its ROE However, this result—good or bad—can be
multiplied by borrowing The way you finance a business can
exaggerate the results from operations The Du Pont equations can be used to
isolate problems
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Sources of Comparative Information Generally compare a firm to an industry average
Dun and Bradstreet publishes Industry Norms and Key Business Ratios
Robert Morris Associates publishes Statement Studies
U.S. Commerce Department publishes Quarterly Financial Report
Value Line provides industry profiles and individual company reports
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Limitations/Weaknesses of Ratio Analysis Ratio analysis is not an exact science and
requires judgment and experienced interpretation Examples of significant problems
• Diversified companies—because the interpretation of ratios is dependent upon industry norms, comparing conglomerates can be problematic
• Window dressing—companies attempt to make balance sheet items look better than they would otherwise through improvements that don’t last
• Accounting principles differ—similar companies may report the same thing differently, making their financial results artificially dissimilar
• Inflation may distort numbers