The Investment Process Rivanna Investments: The Investment Process September 28, 2012

Rivanna Investments Cash Flow and Financial Statements: A Closer Look Ratio Analysis The DuPont Identity Using Financial Statement Information

Sample Balance Sheet Rivanna Investments 2007 2006 Cash 696 58 A/P 307 303 A/R 956 992 N/P 26 119 Inventory 301 361 Other CL 1,662 1,353 Other CA 264 Total CL 1,995 1,775 Total CA 2,256 1,675 LT Debt 843 1,091 Net FA 3,138 3,358 C/S 2,556 2,167 Total Assets 5,394 5,033 Total Liab. & Equity I just want to go over the difference between Current Assets and Fixed Assets. Essentially Total Assets is comprised of both Current Assets and Fixed Assets Current Assets are assets that are highly liquid and are expected to be converted to cash within one year in the normal course of business or may be so converted within such time. This includes cash, accounts receivable, prepaid expenses, and inventory. On the other side of the balance sheet are both Current Liabilities and Long Term Liabilities. Similar to Current Assets, Current Liabilities are liabilities that are expected to come due within the next year.

Sample Income Statement Rivanna Investments Sample Income Statement Revenues 5,000 Cost of Goods Sold (2,006) Expenses (1,740) Depreciation (116) EBIT 1,138 Interest Expense (7) Taxable Income 1,131 Taxes (442) Net Income 689 EPS 3.61 Dividends per share 1.08 Depreciation is a method by which a tangible asset’s cost is allocated over its useful life. Amortization is a similar concept. It only differs from depreciation in the sense that amortization is used for intangible assets such as patents and copyrights. It’s important to realize that although are deducting these expenses annually, they have no actual cash flow effect. Which means that when it comes time to constructing a DCF, these expenses are added back.

Sources and Uses Rivanna Investments Sources Uses Cash inflow – occurs when we “sell” something Decrease in asset account Accounts receivable, inventory, and net fixed assets Increase in liability or equity account Accounts payable, other current liabilities, and common stock Uses Cash outflow – occurs when we “buy” something Increase in asset account Cash and other current assets Decrease in liability or equity account Notes payable and long-term debt

Statement of Cash Flows Rivanna Investments Statement of Cash Flows Statement that summarizes the sources and uses of cash Changes divided into three major categories Operating Activity – includes net income and changes in most current accounts Investment Activity – includes changes in fixed assets Financing Activity – includes changes in notes payable, long-term debt, and equity accounts as well as dividends

Sample Statement of Cash Flows Rivanna Investments Sample Statement of Cash Flows 696 638 -641 -206 -94 -248 -93 Cash End of Year Net Increase in Cash Net Cash from Financing Dividends Paid Decrease in C/S (minus RE) Decrease in LT Debt Decrease in Notes Payable Financing Activity 104 Net Cash from Investments Sale of Fixed Assets Investment Activity 1,175 Net Cash from Operations -39 Less: Increase in other CA 309 Increase in Other CL 4 Increase in A/P 60 Decrease in Inventory 36 Decrease in A/R 116 Plus: Depreciation 689 Net Income Operating Activity 58 Cash, beginning of year

Ratio Analysis Rivanna Investments Ratios also allow for better comparison through time or between companies As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important Ratios are used both internally and externally

Categories of Financial Ratios Rivanna Investments Categories of Financial Ratios Short-term solvency or liquidity ratios Long-term solvency or financial leverage ratios Asset management or turnover ratios Profitability ratios Market value ratios

Computing Liquidity Ratios Rivanna Investments Computing Liquidity Ratios Current Ratio = CA / CL ____________________ Quick Ratio = (CA – Inventory) / CL Cash Ratio = Cash / CL Current ratio is a liquidity ratio that is used to calculate the company’s ability to pay off its short term obligations Quick ratio measures the company’s ability to pay off its short term obligation with only its most liquid assets. As you can see in the formula, inventories are subtracted out of the current assets figure because inventories are not always easily convertible to cash Cash ratio measures the company’s ability to pay off its short term obligation with only its cash and cash equivalents (which include CD’s)

Computing Long-term Solvency Ratios Rivanna Investments Computing Long-term Solvency Ratios Total Debt Ratio = (TA – TE) / TA Debt/Equity = TD / TE Equity Multiplier = TA / TE = 1 + D/E Long-term debt ratio = LTD / (LTD + TE) Total Debt Ratio gives an idea of how levered a company is. In other words, the proportion of debt a company has relative to its assets The Debt/Equity ratio tells us what proportion of debt and equity the company is using in order to finance its assets. The higher the ratio, the more the company is using debt in order to finance its assets. The Equity Multiplier is another ratio we use to determine the amount of debt used to generate a company’s assets. Again a higher ratio indicates a higher level of leverage. Long-term debt ratio is a measurement representing the percentage of a corporation's assets that are financed with loans and financial obligations lasting more than one year. A year-to-year decline in this ratio indicates that a company is becoming progressively less dependent on dependent to grow.

Computing Coverage Ratios Rivanna Investments Computing Coverage Ratios Times Interest Earned = EBIT / Interest _________________________ Cash Coverage = (EBIT + Depreciation) / Interest Times Interest Earned is a metric used to measure a company's ability to meet its debt obligations. It is usually quoted as a ratio and indicates how many times a company can cover its interest charges on a pretax basis. A high ratio can indicate that a company has an undesirable lack of debt or is paying down too much debt with earnings that could be used for other projects. Cash Coverage ratio indicates the amount of cash a company has available to cover its interest expense

Computing Inventory Ratios Rivanna Investments Computing Inventory Ratios Inventory Turnover = Cost of Goods Sold / Inventory _____________________________ Days’ Sales in Inventory = 365 / Inventory Turnover ______________________________ The Inventory Turnover ratio shows how many times a company's inventory is sold and replaced over a period. A lower ratio indicates poor sales The Day’s Sales in Inventory ratio shows us how many days it takes to get rid of inventory

Computing Receivables Ratios Rivanna Investments Computing Receivables Ratios Receivables Turnover = Sales / Accounts Receivable _________________________ Days’ Sales in Receivables = 365 / Receivables Turnover __________________________ The Receivables Turnover Ratio calculates how effective a firm collects on debts that it is owed. A higher ratio indicates either that a firm is highly efficient in collecting on such debts or that it operates highly on a cash basis Days’ Sales in Receivables indicates the number of days to collect on such debts

Computing Total Asset Turnover Rivanna Investments Computing Total Asset Turnover Total Asset Turnover = Sales / Total Assets _________________________________ It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets NWC Turnover = Sales / NWC Fixed Asset Turnover = Sales / NFA __________________________________ Total Asset Turnover shows us how efficient a firm is at using its assets in generating sales or revenues. The higher the ratio, the better NWC Turnover shows us how efficient a firm is at using its NWC in generating sales or revenues. NWC is the difference in CA and CL. Or in other words, it’s whatever is left after a firm uses its current assets to pay of its short-term obligations. Fixed Asset Turnover shows us how efficient a firm is at using its fixed assets in generating sales and revenues. This ratio is particularly relevant in manufacturing industries where a large portion of assets comprise of plant, property, & equipment. Investors tend to look at how this ratio changes year-to-year following a company’s major fixed asset purchase

Computing Profitability Measures Rivanna Investments Computing Profitability Measures Profit Margin = Net Income / Sales Return on Assets (ROA) = Net Income / Total Assets Return on Equity (ROE) = Net Income / Total Equity The Profit Margin tells us how much of every dollar in sales that the company actually keeps. This ratio is useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Return on Assets gives an idea as to how efficient management is at using its assets to generate earnings. The higher the ROA number, the better, because the company is earning more money on less investment. ROA is most effective when used in comparing companies in similar industries since the ratio widely varies by industry Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Again this ratio is most useful when comparing companies within the same or similar industries.

Computing Market Value Measures Rivanna Investments Computing Market Value Measures Market Price = $87.65 per share Shares outstanding = 190.9 million PE Ratio = Price per share / Earnings per share _____________________________ Shares Outstanding is stock currently held by investors, including restricted shares owned by the company's officers and insiders PE Ratio a valuation ratio of a company's current share price compared to its per-share earnings. A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, it is useful to compare PE ratios to competitors

Why Evaluate Financial Statements? Rivanna Investments Why Evaluate Financial Statements? Internal uses Performance evaluation – compensation and comparison between divisions Planning for the future – guide in estimating future cash flows

Benchmarking Rivanna Investments Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis Used to see how the firm’s performance is changing through time Internal and external uses Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes

Potential Problems Rivanna Investments There is no underlying theory, so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures, i.e. FIFO vs. LIFO Different fiscal years (different firms end their fiscal year at different times), seasonality effects Extraordinary events (e.g., one time profit from an asset sale)