Financial statements and ratios
Preamble
The overview of Financial Statements reveals information about past and current performance of the firm.
When combining this information with other sources, we might be able to form expectations about the firm’s future cash flows.
Outline
• • • •
The Balance Sheet The Income Statement The Statement of Cash Flows On ratio analysis
Balance Sheet
Financial Statement showing a firm’s accounting value on a particular date.
Balance Sheet
ASSETS
Cash Accounts receivable Inventory Total current assets: Net, plant and equipment Fixed assets TOTAL ASSETS
1994 $114 $445 $553 $1,112 $1,644 $1,664 $2,756
1995 $160 $688 $555 $1,403 $1,709 $1,709 $3,112
LIABILITIES & EQUITY
Accounts payable Notes payable Total current liabilities: Long-term debt Common shares Retained earnings Total owners’ equity TOTAL LIABILITIES & EQUITY
1994 $232 $196 $428 $408 $600 $1,320 $1,920 $2,756
1995 $266 $123 $389 $454 $640 $1,629 $2,269 $3,112
Reminder
Assets are listed in the order of decreasing liquidity
Liquidity = the degree of ease to which an asset can be converted to cash without a substantial loss or price reduction.
The balance sheet does not reflect the real value of firm's assets.
The balance sheet reflects the historical cost of firm's assets.
The Income Statement
Reveals how profitable the firm is over a certain period of time.
The Income Statement
Net sales Cost of goods sold Depreciation EBIT Interest paid Taxable income Taxes paid Net income (Earnings) Addition to retained earnings Dividends paid
$1,509 ($750) ($65) $694 ($70) $624 ($250) $374 $309 $65
Statement of cash flows
Integrates the Balance Sheet and the Income Statement CF from operating activities + CF from investing + Cf from financing Interpretation Net increase or decrease in the firm’s cash
Other statements
Free Cash Flows Read chapter 12
Cash flows identities
In any given year:
Cash flow from assets = CF to creditors + CF to shareholders
where: CF to creditors = Interest paid - Net new debt raised CF to shareholders = Dividends paid - Net new equity raised
Cash flow from assets = OCF - NCS - Additions to NWC
where: Operating CF = EBIT + Depr. - Taxes NCS = Ending Fixed Assets - (Beginning Fixed Assets - Depr.) Additions to NWC = NWCt - NWCt-1
Cash flows identities
In our example: CF to creditors = $70 - ($454-$408) = $24 CF to shareholders = $65 - ($640-$600) = $25 Operating CF = $694 + $65 - $250 = $509 Net capital spending = $1,709 - (1,644 - $65) = $130 Additions to NWC = ($1,403-$389) - ($1,112-$428) = $330
Cash flow from assets= ($24 + $25) = ($509 - $130- $330) = $49
Sources of cash:
•
Increase in accounts payable Increase in common stock Increase in retained earnings
Uses of cash:
• • • • •
Increase in accounts receivable Increase in inventory Decrease in notes payable Decrease in long-term debt Net fixed asset acquisitions
Ratio analysis
When analyzing a firm, we want to know: • • • • •
if the firm is able to meet its short-term financial obligations (is it solvent?); if the firm is able to meet its long-term financial obligations (going bankrupt in the future?); how well the assets of the firm are managed; how well the overall operations of the firm are managed (is it profitable?); how the market interprets accounting data and what expectations are factored in.
Ratio analysis
Short-term solvency and liquidity ratios:
Indicate the firm’s ability to pay its bills over the short run without undue stress.
Financial leverage:
Describe a firm’s long-term ability to meet its financial obligations
Asset utilization turnover ratios:
Describe how efficiently (intensively) a firm uses its assets to generate sales.
Profitability ratios:
Describes how efficiently the firm manages its overall operations (the higher, the better !!!!!)
Market ratios
Describe how the market values the firm.
Short-term solvency and liquidity ratios
Current ratio = Current assets/Current liabilities
Quick ratio = (Current assets-Inventory)/Current liabilities
Cash ratio = Cash/Current liabilities
NWC to total assets = (Current assets - Current liabilities)/Total assets
Interval measure = Current assets/Avg. daily op. costs
Short-term solvency and liquidity ratios
Current ratio = $708/540 = 1.31 Quick ratio =($708-$422)/$540 = 0.53 Cash ratio = $98/$540 = 0.1815 NWC to total assets = ($708 - 540)/$3,588 = 0.047 Interval measure = $708/[$1,344/365] = 192 days
Financial leverage
Total debt ratio = (Total assets-Total equity)/Total assets Debt/equity ratio = Total debt/total equity Equity multiplier = Total assets/Total equity = 1 + Debt/Equity Long-term debt ratio = Long-term debt/(Long-term debt + Total equity) Times interest earned = EBIT/Interest
Cash coverage ratio = (EBIT + Depreciation)/Interest
Financial leverage
Total debt ratio = ($3,588 - $2,591)/$3,588 = 0.28
Debt/equity ratio = $997/$2,591 = 0.28/0.72 = 0.39
Equity multiplier = 1 + 0.39
Long-term debt ratio = $457/[$457 + $2,591] = 0.15
Times interest earned = $691/$141 = 4.9 times
Cash coverage ratio = ($691 +$276)/$141 = 6.9
Asset utilization turnover ratios
Inventory turnover = Cost of goods sold/Inventory Day’s sales inventory = 365/Inventory turnover Day’s sales inventory =(365)Inventory/Cost of goods sold
Receivables turnover = Sales/Accounts receivable Day’s sales in receivables = 365/Receivables turnover Day’s sales in receivables = (365)Accounts receivables/Sales
NWC turnover = Sales/(Current assets - Current liabilities)
Fixed asset turnover = Sales/Net fixed assets
Total asset turnover = Sales/Total assets
Asset utilization turnover ratios
Inventory turnover =$1,344/$422 = turned out the inventory 3.2 times Day’s sales inventory = 365/3.2 = 114 days of sales in inventory Receivables turnover = $2,311/$188 = 12.3 times Day’s sales in receivables = 365/12.3 = 30
The average collection period (ACP) is 30 days
NWC turnover = $2,311/($708 - $540) = 13.8 Fixed asset turnover = $2,311/$2,880 = 0.8 Total asset turnover = $ 2,311/$3,588 = 0.64
Profitability ratios
Profit margin = Net income/Sales Return on assets (ROA) = Net income/Total assets Return on equity (ROE) = Net income/Total equity
Profitability ratios
Profit margin = $363/$2,311 = 0.157 Return on assets (ROA) = $363/$3,588 = 0.1012 Return on equity (ROE) = $363/$2,591 = 0.14 ROE is the ultimate accounting measure for profitability
Du Pont identity
Shows which variables account for profitability
ROE = Net income/Total Equity
ROE= (Net income/Sales)(Sales/Total Assets)(Total Assets/Total Equity)
ROE = (Profit margin)(Total asset turnover)(Equity multiplier)
ROE = (0.157)(0.64)(1.39) = 0.14
Market ratios
Price/Earnings ratios = Price per share/Earnings per share
Market-to-book ratio = Market value per share/Book value per share Tobin’s Q Q = (Mkt. value of debt + Mkt. value of equity)/Replacement value of assets Higher Q’s indicate higher investment opportunities and/or comparative advantage)
Market ratios
Assume: There are 33,000 shares outstanding and P = $88
P/E = $88/$11 = 8 Market-to-book ratio = $88/($2,591/33) = 1.12
P/E and Market-to-book are also measures of cheapness