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1
CHAPTER 17 CHAPTER 7, THIRD EDITION
Projecting Cash Flow and Earnings
Financial Statements and Ratio Analysis, Chapter 7, Third Edition
Chapter Sections:
Sources of Financial Information
Financial Statements
Financial Statement Forecasting
Starbucks Company Case Study (Adolph Coors, Chapter 7, Third Edition)
Chapter 17 of the fourth edition and Chapter 7 of the third edition
deal mainly with financial statements and ratio analysis. It is
important enough to warrant our attention. We will look at all the
ratios but only compute a few. We will skip the forecasting.
2
Financial Statements
Balance Sheet
A financial summary of a firm’s assets, liabilities,
and shareholders’ equity at a given point in time
Income Statement
A financial summary of the operating results of firm
covering a specified period of time, usually 3
months (quarterly results) and 1 year (annually results)
Cash Flow Statement
A financial summary of a firm’s cash flow and
other events that caused changes in the
company’s cash position (again, quarterly & annually)
3
Financial Statements (continued)
Balance Sheet
Assets
Anything a company owns that has value
Liabilities
A firm’s financial obligations
Equity
An ownership interest in the company
Assets = Liabilities + Equity
Assets – Liabilities = Equity
Current versus Long-term
Balance Sheet Example
4
Financial Statements (continued)
Income Statement
Income
The difference between a company’s revenues
and expenses, used to pay dividends to
stockholders or kept as retained earnings within
the company to finance future growth
Net Income = Revenue – Expenses
But some income and expenses are not always
received or paid in cash
That’s why there is the Cash Flow Statement…
Income Statement Example
5
Financial Statements (continued)
Cash Flow Statement
a.k.a. Statement of Cash Flows
Cash Flow – Income realized in cash form
Non-cash Item – Income and expense items not
realized in cash form
Operating Cash Flow – Cash generated by a firm’s
normal business operations
Investment Cash Flow – Cash flow resulting from
purchases and sales of fixed assets and investments
Financing Cash Flow – Cash flow originating from the
issuance or repurchase of securities and payment of
dividends
Cash Flow Statement Example
6
Sources of Financial Statements
SEC EDGAR
Annual Report – 10K
Quarterly Update – 10Q
Regulation FD (Fair Disclosure)
Requires companies to make public disclosures of
material information fairly
An “Earnings Call” is scheduled for a set date & time
Countless Other Sources
I have heard many investors opine that nowadays there is
simply too much information.
“Wisdom Sold Separately.” – Nick Murray
7
Financial Ratios
Financial Ratios
The relation between two financial quantities
expressed as the quotient of one divided by the
other
Ratio Analysis
The study of the relationships between financial
statement accounts
Recall that that there is no one ratio that can accurately sum up the overall
general state of a company. Each ratio must be considered in the context of all
the information gathered. Plus you must consider any ratio in the context of
the industry the company exists within. (We will see an example soon.)
8
Financial Ratios – Common Stock
Common Stock Ratios – a.k.a. Market Ratios
Financial ratios that convert key information about
a firm to a per-share basis
Price/Earnings Ratio – P/E
Price/Earnings to Growth Ratio – PEG
Dividends per Share
Dividend Yield
Dividend Payout Ratio
Book Value per Share
Price-to-Book-Value, Price-to-Cash Flow, Price-to-
Sales
These ratios use data from the Balance Sheet or the Income Statement or both.
9
Financial Ratios – Common Stock
(continued)
Price / Earnings Ratio – a.k.a. P/E
Market Price divided by Earnings per Share
Market Price of Common Stock
Price / Earnings Ratio = –––––––––––––––––––––––––––––
Earnings per Share
REVIEW: The most popular stock market statistic. Historically, P/E ratios
were in the 5 to 12 range for mature companies and 14 to 20 range for
growing companies. Greater than 20 was unusual. Today, it is commonplace.
The P/E ratio also tells you how long it will take in years (assuming no
changes in earnings) for the company to earn back its price. A P/E of 3 will
take three years; a P/E of 20 will take twenty years.
10
P/E Ratios and Specific Industries
Exxon – 11.89 Google – 22.92
Royal Dutch Shell – 12.31 Yahoo – 23.51
Chevron – 9.66 Sina – 7.42 ?
CononoPhillips – 9.10 Bidu – 108.27 !
Gilead Sciences – 10.87 Wells Fargo – 15.11
Biogen Idec – 14.09 US Bank – 15.56
Amgen – 11.67 J.P. Morgan – 11.32
Life Technologies – 30.62 ! B of A – N/A
Hormel – 15.91 Merck – 9.46
General Mills – 15.91 Bristol Myers – 4.78
Kellogg’s – 15.48 Eli Lilly – 9.04
Kraft – 11.37 Pfizer – 16.48
As of 29 September 2010
11
P/E Ratios and Specific Industries
(continued)
How can we account for the wide P/E
disparity between different industries and
different companies within industries?
Again, it is the expectation of future earnings and
dividend growth by investors
“Take a nice little company that has been making shoelaces for 40 years and sells at a
respectable six times earning ratio. Change the name from Shoelaces, Inc. to Electronics
and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are
worth 15 times earnings. However, the real play comes from the word “furth-burners”
which no one understands. A word that no one understands entitles you to double your
entire score. Therefore, we have six times earnings for the shoelace business and 15
earnings for electronics and silicon, or a total of 21 times earnings. Multiply this by two
for furth-burners and we now have a score of 42 times earnings for the new company” –
Jack Dreyfus, Founder, Dreyfus Funds
Today, replace electronics and silicon with biotechnology and nanotechnology.
12
Financial Ratios – Common Stock
(continued)
Price/Earnings to Growth Ratio – a.k.a. PEG
Compares the P/E ratio to the rate of growth
Stock’s P/E Ratio
PEG Ratio = ––––––––––––––––––––––––––––––––––––
3- or 5-Year Growth Rate in Earnings
REVIEW: A PEG Ratio of 1.0 means that P/E Ratio matches its growth rate.
Again, historically, a PEG Ratio of 1.0 was desirable. Anything above 1.0
was considered high. Now, greater than 1.0 is common.
13
Financial Ratios – Common Stock
(continued)
Dividends per Share
Measure of how much dividends each share of
stock will receive
Dividends Annual Dividends Paid to Stockholders
per = –––––––––––––––––––––––––––––––––––––––
Share Number of Shares Outstanding
REVIEW: As we discussed, dividends became taboo during the 1990’s. Since
the 2000-2002 bear market, investors have changed their minds about
dividends. Dividends can be discussed in polite company again!
14
Financial Ratios – Common Stock
(continued)
Dividend Yield
Measure of how much dividends are as a
percentage of the stock price
Dividend Dividends per Share
= ––––––––––––––––––––––––––––
Yield Market Price per Share
REVIEW: This important statistic allows an investor to compare a company to
other forms of investments that pay income (such as savings accounts or bonds).
Traditionally, 5% to 7% was considered good. After the market turmoil and
rebound, stocks are yielding about 2½% (while 10-year Treasury bonds are also
yielding about 2½% and savings accounts are yielding less than 1%.)
15
Financial Ratios – Common Stock
(continued)
Dividend Payout Ratio
Measures of how much of a company earnings are
being paid out to shareholders in the form of
dividends
Dividends per Share
Payout Ratio = ––––––––––––––––––––––
Earnings per Share
REVIEW: More mature companies often pay out almost all their earnings in
the form of dividends. Growing companies retain their earnings (called
Retained Earnings) to support the growth of the company.
16
Financial Ratios – Common Stock
(continued)
Book Value per Share
Measure of the net worth of a company on a per
share basis
Book Value Common Stockholders’ Equity
per = ––––––––––––––––––––––––––––––––
Share Number of Shares Outstanding
REVIEW: Book Value per Share tells an investor how much assets are
behind each share of stock. In other words, if all the assets of the company
were liquidated, how much would each shareholder receive? It is common
for the actual market price of a share to be above the book value per share
since the company is worth more intact than if it were dissolved. Today, it is
common for the market price to be far above the book value.
17
Financial Ratios – Common Stock
(continued)
Price-to-Book-Value per Share
Ratio of the market price to the book value per
share
Price-to- Market Price per Share
Book-Value = ––––––––––––––––––––––––
per Share Book Value per Share
REVIEW: Given that the Book Value per Share is often less than the market
price, the Price-to-Book-Value Per Share tells an investor how far above
the book value the market value is. If the Price-to-Book-Value per Share =
1.0, they are the same. Today, Price-to-Book-Value per Shares of 3 to 4 are
not uncommon and some are much higher.
18
Financial Ratios – Common Stock
(continued)
Price-to-Cash Flow Ratio
Current price divided by current cash flow per share
Cash flow often differs from earnings per share
For several reasons, but the most common reason is…
Depreciation is not an actual cash expenditure
But there are many reasons cash flow & earnings differ
“Good quality” versus “poor quality” earnings
Current Price
Price-Cash Flow Ratio = ––––––––––––––––––––––––––––
Cash Flow per Share
REVIEW: During the Internet mania, many companies were reporting record
earnings. At the same time, their cash flow was negative. How could that be?
19
Financial Ratios – Common Stock
(continued)
Price-to-Sales Ratio
Current price divided by annual sales per share
Historically, a higher Price-to-Sales Ratio
suggested a higher sales growth
And a lower Price-to-Sales Ratio suggested a lower
sales growth
Current Price
Price-to-Sales Ratio = –––––––––––––––––––––––––––––
Annual Sales per Share
REVIEW: During the Internet mania, many analysts used Price-to-Sales
instead of Price-to-Earnings since most all of the new companies never
generated any earnings!
20
Financial Ratios – Profitability
Profitability Ratios
Financial ratios that measure a firm’s returns by
relating profits to sales, assets, or equity
Net Profit Margin – a.k.a. After-Tax Profit Margin
Gross Margin
Operating Margin
Return on Assets
Return on Equity – a.k.a. Return on Investment
Profitability Ratios allow one to measure the ability of a firm to earn an
adequate return on sales, total assets and invested capital.
21
Financial Ratios – Profitability (continued)
Net Profit Margin – a.k.a. After-Tax Profit
Margin
The rate of profit being earned from earnings after
expenses and taxes
Net Income
Net Profit Margin = ––––––––––––––––––
Total Revenue
The higher, the better. It varies greatly from industry to industry.
22
Financial Ratios – Profitability (continued)
Gross Margin
The rate of profit being earned from gross profit
Gross Profit
Gross Margin = –––––––––––––––––––––
Total Revenue
Again, the higher, the better. And again, it varies greatly from industry
to industry.
23
Financial Ratios – Profitability (continued)
Operating Margin
The rate of profit being earned from net income
adjusting for non-cash items
Operating Income
Operating Margin = –––––––––––––––––––––––
Total Revenue
Yep, you guessed it. The higher, the better. And it varies greatly from
industry to industry. So when we are looking at a specific company, we
always need to look at its competitors within the industry. When we find a
company that is atypical of its competitors in an industry, it’s a signal that
we have more investigative work to do.
24
Financial Ratios – Profitability (continued)
Return on Assets (ROA)
Measures how profitable a company is relative to
its total assets
Net Income
Return on Assets = ––––––––––––––––––––––
Total Assets
Return on Assets looks at the amount of resources a company needs to
support operations. It reveals how effective the company is in generating
profits from the assets it has available. The higher, the better.
Very popular ratio.
25
Financial Ratios – Profitability (continued)
Return on Equity (ROE) – a.k.a. Return on Investment
Measure of the overall profitability of a company in
relation to the shareholders’ equity
Net Income
Return on Equity = ––––––––––––––––––––––––––––
Total Stockholders’ Equity
Because Return on Equity uses Stockholders’ Equity instead of Total Assets
for the denominator, Return on Equity is sensitive to the amount of debt a
company is carrying. Specifically, if a company carries a great amount of
debt, ROE will be much larger than ROA. “You are using other people’s
money to make your money.” Some investors think this is good; others are
worried about the possible negative consequences of too much debt.
26
Financial Ratios – Liquidity
Liquidity Ratios
Financial ratios concerned with a firm’s ability to
meet its day-to-day operating expenses and
satisfy its short-term obligations as they come due
Current Ratio
Ratio of current assets to current liabilities
Net Working Capital
Current assets – current liabilities
Acid Test Ratio – a.k.a. Quick Ratio
These ratios use data from the Balance Sheet
27
Financial Ratios – Liquidity (continued)
Current Ratio
One of the more popular financial measures
Current Assets
Current Ratio = –––––––––––––––––––
Current Liabilities
The Current Ratio is a good indicator of how stable a company is.
Anything over 1.0 is normally considered acceptable. If your current assets
equal or exceed your current liabilities, you should be able to satisfy your
short-term obligations without any problems. Obviously, the greater the
number is, the better.
28
Financial Ratios – Liquidity (continued)
Net Working Capital
Absolute dollar measure of liquidity
Net Working Capital = Current Assets – Current Liabilities
Net Working Capital is the Current Ratio in dollar terms. If the Current
Ratio is greater than 1.0, then Net Working Capital will be positive. If the
Current Ratio is less than 1.0, then Net Working Capital will be negative.
The higher the Net Working Capital, the better. (This statistic is less
popular than the Current Ratio.)
29
Financial Ratios – Liquidity (continued)
Acid Test Ratio – a.k.a. Quick Ratio
A more stringent version of the Current Ratio
Acid Cash + Accts recv + Short-term investments + Other current assets
Test = ––––––––––––––––––––––––––––––––––––––––––
Ratio Current Liabilities
Unlike the Current Ratio, the Acid Test Ratio excludes inventory. This ratio
measures the ability of the company to meet its short-term obligations even
if its current inventory becomes obsolete or undesirable and hence, difficult
or impossible to be turned into cash. Anything greater than 1.0 is
considered adequate.
30
Financial Ratios – Activity
Activity Ratios
Financial ratios that are used to measure how well
a firm is managing its assets
Accounts Receivable Turnover
Inventory Turnover
Total Asset Turnover
These ratios use data from the Balance Sheet and
the Income Statement
Activity ratios measure a firm’s ability to convert different accounts within
their balance sheets into cash or sales. Companies will try to turn their
production into cash or sales as fast as possible because this will generally
lead to higher revenues.
31
Financial Ratios – Activity (continued)
Accounts Receivable Turnover
Measure of how accounts receivable are managed
Total Revenue
Accounts Receivable Turnover = –––––––––––––––––––––
Accounts Receivable
The higher the number, the better. It indicates the return a company is
getting from its investment in accounts receivable. By maintaining accounts
receivable, firms are indirectly extending interest free loans to their clients. A
high ratio implies that the company operates either on a cash basis, or its
extension of credit and collection of accounts receivable is efficient. A low
ratio implies that the company should re-assess its credit policies in order to
ensure the timely collection of imparted credit not earning interest for the
firm. (Or that may just be how that industry operates. Example: Defense.)
32
Financial Ratios – Activity (continued)
Inventory Turnover
Measure of how inventory is managed
Total Revenue
Inventory Turnover = ––––––––––––––––––
Inventory
The higher the number, the less time an item spends in inventory and the
better the return the company is able to earn from funds tied up in inventory.
As with all ratios, this ratio must be compared against industry averages.
A low turnover implies poor sales and, therefore, excess inventory. A high
ratio implies either strong sales or ineffective inventory buying /
maintenance. High inventory levels are unhealthy because they represent an
investment with a rate of return of zero. It also opens the company up to
trouble in the case of falling prices or obsolete products.
33
Financial Ratios – Activity (continued)
Total Asset Turnover
Measure of how total assets are managed
Total Revenue
Total Asset Turnover = ––––––––––––––––––––
Total Assets
The Total Asset Turnover Ratio measures the firm’s efficiency at using
assets to support sales and revenue, the higher the number the better.
Companies with low profit margins tend to have high asset turnover, those
with high profit margins have low asset turnover.
34
Financial Ratios – Leverage
Leverage Ratios
Financial ratios that are used to measure the
amount of debt being used to support operations
and the ability of the firm to service its debt
Debt-Equity Ratio – a.k.a. Debt-to-Equity Ratio
Times Interest Earned
Total Debt to Total Assets
These ratios use data from the Balance Sheet or
the Income Statement
Debt is often referred to as leverage. The idea is that you are using other
people’s money to make money. You are using the borrowed money as a
“lever” to increase your earnings. When one firm buys another firm using
borrowed money, it is often referred to as a “leveraged buyout.”
35
Financial Ratios – Leverage (continued)
Debt-Equity Ratio
A measure of a company's financial leverage
calculated by dividing long-term debt by
shareholders’ equity. It indicates what proportion of
equity and debt the company is using to finance its
assets
Long-term Debt
Debt-Equity Ratio = –––––––––––––––––––––––––––
Total Stockholder’s Equity
A higher Debt-Equity Ratio generally means that a company has been
aggressive in financing its growth with debt. This can result in lower
earnings as a result of the additional interest expense. Sometimes investors
only use interest bearing long-term debt instead of total liabilities. The
lower, the better.
36
Financial Ratios – Leverage (continued)
Times Interest Earned (TIE)
Measures the ability of a company to meet its fixed
interest payments
Times Earnings before Interest & Taxes
Interest = –––––––––––––––––––––––––––––––––
Earned Interest Expense
Times Interest Earned is used to determine how frequently interest payments
are earned by the company during a year. The higher, the better. Normally,
3 or 4 is considered adequate.
37
Financial Ratios – Leverage (continued)
Total Debt to Total Assets
Measure of how much of the company’s total
assets have been financed by debt
Total Liabilities
Total Debts to Total Assets = –––––––––––––––––––
Total Assets
Total Debt to Total Assets includes both short-term and long-term debt and
assets. If it varies substantially from the Debt-Equity Ratio, the company
may be relying heavily on short-term debt. A heavy reliance on short-term
debt can denote more risk.
38
CHAPTER 17 – REVIEW
Financial Statements and Ratio Analysis
Chapter Sections:
Sources of Financial Information
Financial Statements
Financial Statement Forecasting
Adolph Coors Company Case Study
Next week: Chapter 7, Stock Price Behavior and
Market Efficiency
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