Cash Flows and Financial Analysis

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					                    Chapter 3

Cash Flows and Financial

 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

Users of Financial Information
 Investors and Financial Analysts
   Financial analysts interpret information about
    companies and make recommendations to
   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                           3
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

 Data sources for term project
   See the course links page for link to MEL

The Orientation of Financial
 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

Ratio Analysis
 Used to highlight different areas of
 Generate hypotheses regarding
  things going well and things to
 Involves taking sets of numbers from
  the financial statement and forming
  ratios with them

 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

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

Common Size Statements
                      Alpha                    Beta
                      $          %           $          %
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%

 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


 5 Categories of Ratios
1. Liquidity: indicates firm’s ability to pay its
   bills in the short run
2. Asset Management: Right amount of assets
   vs. sales?
3. Debt Management: Right mix of debt and
4. Profitability— Do sales prices exceed unit
   costs, and are sales high enough as reflected
   in PM, ROE, and ROA?
5. Market Value— Do investors like what they
   see as reflected in P/E and M/B ratios?
Liquidity Ratios
 Current Ratio
                     Current Assets
  Current Ratio 
                    Current Liabilities

  To ensure solvency the current ratio
   should exceed 1.0
    Generally a value greater than 1.5 or 2.0
     is required for comfort
    As always, compare to the industry

Liquidity Ratios
 Quick Ratio (or Acid-Test Ratio)
                 current assets - inventory
   Quick Ratio 
                      current liabilities
    Measures liquidity without considering
     inventory (often the firm’s least liquid
     current asset)
    Not a good ratio for grain farms

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
Asset Management Ratios
 Inventory Turnover
                       cost of goods sold
  Inventory Turnover 
    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
Asset Management Ratios
 Inventory conversion period -- Days
  of sales in inventory
 An alternate measure of inventory
 Has the same information as ITO
 Inventory/COGS/360
 360/ITO
 Used in cash conversion cycle (CCC)
  calculation                           17
Asset Management Ratios
 Fixed Asset Turnover
                               Sales (Total)
   Fixed Asset Turnover 
                            Fixed Assets (Net)

    Appropriate in industries where
     significant equipment is required to do
    Long-term measure of performance
    Average balance sheet values are

Asset Management Ratios
 Total Asset Turnover
                          Sales (Total)
   Total Asset Turnover 
                          Total Assets
    More widely used than Fixed Asset
    Long-term measure of performance
    Average balance sheet values are

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 
 A high debt ratio is viewed as risky by investors
 Usually stated as percentages

Debt Management Ratios
 Debt-to-equity ratio
   Can be stated several ways (as a percentage, or
    as a x:y value)
                        Total Liabilities TL
   Debt  to  Equity                   
                        Common Equity E
   Many sources use long term debt instead
    of total liabilities
   Measures the mix of debt and equity
    within the firm’s total capital
 Sometimes you are given the debt-equity ratio (TL/E) or
  you may find it in a source for industry ratios. In AGEC
  424, I normally want you to use TL/TA. So you need to
  convert the debt-equity ratio into the TL/TA ratio. The
  conversion is according to the equation:

   Steps in derivation:
   First use TA = TL+E, to replace TA in the denominator.
   Second divide numerator and denominator by TL.
   Third multiply numerator and denominator by TL/E.

Debt Management Ratios
 Times Interest Earned
   TIE 
         Interest Expense
    TIE is a coverage ratio
       Reflects how much EBIT covers interest
       A high level of interest coverage implies

Debt Management Ratios
 Cash Coverage1
                         EBIT  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

   1   EBITDA or “earnings before interest taxes depreciation and   24

          amortization” is a commonly used measure of cash flow.
Debt Management Ratios
 Fixed Charge Coverage
                                 EBIT  Lease Payments
   Fixed Charge Coverage 
                           Interest Expense  Lease Payments
    Interest payments are not the only fixed
    Lease payments are fixed financial
     charges similar to interest
       They must be paid regardless of business
          If they are contractually non-cancelable

Debt Management Ratios
 Days of sales in accounts payable
 Accounts Payable deferrals
 Accounts Payable/(COGS/360)
 A measure of how large accounts
  payable are in comparison to COGS
 Used in CCC calculation

Profitability Ratios
 Return on Sales (AKA:Profit Margin (PM), Net
  Profit Margin)

                 Net Income
      PM  ROS 
    Measures control of the income
     statement: revenue, cost and expense
    Represents a fundamental indication of
     the overall profitability of the business

Profitability Ratios
 Return on Assets
        Net 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

Profitability Ratios
 Return on Equity
              Net 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

Profitability Ratios
   Basic earnings power
   BEP = EBIT/Total Assets
   Compare to the pre-tax interest rate
   Return on capital employed
   ROCE = EBIT(1-T)/Total Assets
   Compare to after tax interest rate

Market Value Ratios
 Price/Earnings Ratio (PE Ratio)
                 Current stock price
   PE 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
Market Value Ratios
 Market-to-Book Value Ratio
                                Current 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
    A value less than 1.0 indicates a poor outlook for
     the company’s future
Du Pont Equations
 Ratio measures are not entirely
 Performance on one is sometimes
  tied to performance on others
 Du Pont equations express
  relationships between ratios that give
  insights into successful operation

  Du Pont Equations
 Du Pont equations start with expressing
  ROA in terms of ROS and asset turnover:
                                       States that to
                                      run a business
        Net Income      Sales        well, a firm must
  ROA             x                  manage costs
          Sales      Total Assets     and expenses
                                        as well as
 or                                  generate lots of
                                     sales per dollar
  ROA  ROS x Total Asset Turnover      of assets.

Extended Du Pont Equation

 Designed to explain ROE
 Not Designed to Calculate ROE
 Can get EM from:

Du Pont Equations
 Extended Du Pont equation states
  that the operation of a business is
  reflected in its ROA
   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
 Operations—Cash Conversion
 A firm begins with cash which then
  ―becomes‖ inventory
   Which then becomes a product which is
   Eventually this will turn into cash again
 The firm’s operating cycle is the time
  from the acquisition of inventory until
  cash is collected from product sales

Figure 15.2: Time Line Representation
of the Cash Conversion Cycle

Cash Conversion Cycle
 CCC = ICP + DSO – AP Deferral
 The shorter the CCC the less interest
  bearing and/or equity capital is
  needed to fund operations.
 This can be very significant for
  businesses with high working capital

Wal Mart CCC
sales per day         1126.69
COGS per day           850.44
RECEIVABLES              3905
INVENTORIES             34511

Wally World CCC – 2010 data
from Yahoo finance

 ICP                          40.6

 DSO                      +3.47

 AP deferrals             -55.65

 CCC                      -11.58
Sources of Comparative
 Generally compare a firm to an industry
   Dun and Bradstreet publishes Industry Norms
    and Key Business Ratios
   Robert Morris Associates publishes Statement
   U.S. Commerce Department publishes Quarterly
    Financial Report
   Value Line provides industry profiles and
    individual company reports
   Go to MEL page for AGEC 424
Limitations/Weaknesses of Ratio

 Ratio analysis is not an exact science and
  requires judgment and experienced
   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