Chapter 3 Cash Flows and Financial Analysis Our main coverage for this chapter is financial ratios
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
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Data sources for term project
See the course links page for link to MEL page
http://www.lib.purdue.edu/mel/inst/agec_42
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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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Ratio Analysis
Used to highlight different areas of performance Generate hypotheses regarding things going well and things to improve Involves taking sets of numbers from the financial statement and forming ratios with them 7
Comparisons
A ratio when examined alone doesn’t convey much information – but..
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 Alpha
Beta
$ % Sales $ 2,187,460 100.0% COGS $ 1,203,103 55.0% Gross margin $ 984,357 45.0%
$ $ 150,845 $ 72,406 $ 78,439
Expenses EBIT Interest EBT Tax Net Income
$ $ $ $ $ $
$ $ $ $ $ $
505,303 479,054 131,248 347,806 118,254 229,552
23.1% 21.9% 6.0% 15.9% 5.4% 10.5%
39,974 38,465 15,386 23,079 3,462 19,617
% 100.0% 48.0% 52.0% 26.5% 25.5% 10.2% 15.3% 2.3% 13.0%
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Look at ANF income statement
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Ratios
Designed to illuminate some aspect of how the business is doing Average Versus Ending Values
When a ratio calls forvalues a balance sheet item, may need to use average (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
1. 2. 3. 4. 5.
5 Categories of Ratios Liquidity: indicates firm’s ability to pay its bills in the short run Asset Management: Right amount of assets vs. sales? Debt Management: Right mix of debt and equity? Profitability— Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market Value— Do investors like what they see as reflected in P/E and M/B ratios? 13
Liquidity Ratios
Current Ratio
Current Ratio
=
Current Assets 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 As always, compare to the industry 14
Liquidity Ratios
Quick Ratio (or Acid-Test Ratio) Quick Ratio
=
current assets - inventory
current liabilities Measures liquidity without considering inventory (the firm’s least liquid current asset) Not a good ratio for grain farms
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Asset Management Ratios
Average Collection Period (ACP) accounts receivable ACP = DSO =
sales per day 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 16
Asset Management Ratios
Inventory Turnover Inven tory Turnover
=
cost of good s sol d 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 17
Asset Management Ratios
Fixed Asset Turnover Fixed Asset Turnover
=
Sales (Total) 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 18
Asset Management Ratios
Total Asset Turnover Total Asset Turnover
=
Sales (Total) Total Assets
More widely used than Fixed Asset Turnover Long-term measure of performance Average balance sheet values are appropriate 19
Debt Management Ratios
Need to determine if the company is 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—often sources just use long-term debt
Debt Ratio
Debt Ratio =
TL TA
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 = Total Liabilities Common Equity
=
TL E
Many sources use long term debt instead of total liabilities Measures the mix of debt and equity within the firm’s total capital 21
Debt Management Ratios
Times Interest Earned TIE
=
EBIT 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 Coverage Cash coverage
=
EBIT + depreciation 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 Fixed Charge Coverage
=
EBIT + Lease Payments 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 24
Profitability Ratios
Return on Sales (AKA:Profit Margin (PM), Net Profit Margin)
PM = ROS = Net Income Sales
Measures control of the income statement: revenue, cost and expense Represents a fundamental indication of the overall profitability of the business 25
Profitability Ratios
Return on Assets ROA
=
Net Income 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 Equity ROE
=
Net Income 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 27
Market Value Ratios
Price/Earnings Ratio (PE Ratio) PE Ratio
=
Current stock price 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 28
Market Value Ratios
Market-to-Book Value Ratio Market-to-Book-Value
=
Current stock price 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 29
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: ROA
=
Net Income Total Assets
×
sales sales
or ROA
=
Net Income sales
×
sales Total Assets
or 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. 31
Du Pont Equations
Extended Du Pont equation states ROE in terms of other ratios ROE
=
Net Income sales total assets × Stockholders' Equity sales × total assets
or ROE
=
NetIncome sales
×
sales total assets
×
totalassets Stockholders' Equity 1 4 4 44 2 4 4 4 4 3 Equity Multiplier
or ROE = ROS Turnover 1 4 4 ×4 Total 4 44 2Asse 4 4t 4 4 44 3
×
Equity Multiplier
ROA
or ROE = ROA
×
Equity Multiplier
EM = [1/(1-L)]; where L = TL/TA
Related to the proportion to which the firm is financed by other people’s money as opposed to owner’s money. 32
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 33
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
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