Chapter 3 Working with Financial Statements Homework: 13-17

Topics Sources and Uses of Cash Financial Ratio Analysis The Du Pont Identity Using Financial Statement Information

Sources and Uses of Cash Sources of cash include: Decrease in assets Increase in liabilities Increase in common stock Increase in retained earnings Uses of cash include: Increase in assets Decrease in liabilities Decrease in common stock Decrease in retained earnings

Investment Activities Organizes cash flows into 3 main categories Operating Activities Revenues from sales of goods and services Costs associated with productions Investment Activities Acquisition of a new production plan Proceeds from selling equipment Financing Activities Issuing long-term debt Payments associated with retiring long-term debt Proceeds from issuing equity Cash Dividends paid to shareholders

Statement of Cash Flows Operating activities + Net income + Depreciation + Any decrease in current assets (except cash) + Increase in accounts payable – Any increase in current assets (except cash) – Decrease in accounts payable Investment activities + Ending fixed assets – Beginning fixed assets

Statement of Cash Flows (concluded) Financing activities – Decrease in notes payable + Increase in notes payable – Decrease in long-term debt + Increase in long-term debt + Increase in common stock – Dividends paid

Example: Hermetic, Inc., Balance Sheet Balance Sheet as of December 31 ($ in thousands) Assets 1999 2000 Current Assets Cash $ 45 $ 50 Accounts receivable 260 310 Inventory 320 385 Total $ 625 $ 745 Fixed assets Net plant and equipment 985 1100 Total assets $1610 $1845

Hermetic, Inc., Balance Sheet (concluded) Liabilities and equity 1999 2000 Current liabilities Accounts payable $ 210 $ 260 Notes payable 110 175 Total $ 320 $ 435 Long-term debt 205 225 Stockholders’ equity Common stock and paid-in surplus 290 290 Retained earnings 795 895 Total 1085 1185 Total liabilities and equity $1610 $1845

Hermetic, Inc., Income Statement ($ in thousands) Net sales $710.00 Cost of goods sold 480.00 Depreciation 30.00 Earnings before interest and taxes $200.00 Interest 20.00 Taxable income 180.00 Taxes 53.45 Net income $126.55 Retained earnings $100.00 Dividends 26.55

Hermetic, Inc., Statement of Cash Flows Operating activities + Net income + 126.55 + Depreciation + 30.00 + Increase in payables + 50.00 – Increase in receivables – 50.00 – Increase in inventory – 65.00 91.55 Investment activities + Ending fixed assets +1,100.00 – Beginning fixed assets – 985.00 (145.00)

Hermetic, Inc., Statement of Cash Flows (concluded) Financing activities + Increase in notes payable + 65.00 + Increase in long-term debt + 20.00 – Dividends – 26.55 58.45 Putting it all together 91.55 – 145.00 + 58.45 = 5.00

Financial Ratios Short-Term Solvency or Liquidity Long-Term Solvency Ability to pay bills in the short-run Long-Term Solvency Ability to meet long-term obligations Asset Management Intensity and efficiency of asset use Profitability Market Value Going beyond financial statements

Short-Term Liquidity Ratios The Current Ratio Current Assets Current Ratio = Current Liabilities Indicates a firm's ability to meet its short-term obligations What Does This Number Mean? Question: If you are a short-term creditor, the higher the current ratio the better?

Changes in the trend are difficult to interpret Current Ratio Notes of Caution Changes in the trend are difficult to interpret Equal increases and decreases in current assets and current liabilities have different effects on the current ratio. Depends on whether the current ratio is greater or less than one.

Includes only current assets that can be converted quickly to cash. Quick Ratio Includes only current assets that can be converted quickly to cash. Current Assets - Inventory Quick Ratio = Current Liabilities

Short-term Solvency Ratios: The Bottom Line Use both measures when assessing a firm's short-term liquidity Using only the current ratio will overstate a firm's liquidity in the short-term. By using both measures, we can see why the firm's current assets are increasing over time.

Long-Term Solvency Ratios The Total Debt Ratio Takes into account all debt of all maturities of all creditors Total Assets - Total Equity Total Debt Ratio = Total Assets

Long-Term Solvency Ratios Debt/Equity Ratio Variation of the total debt ratio. Measures total debt as a multiple of total equity. Total Debt Debt/Equity Ratio = Total Equity

Long-Term Solvency Ratios Long-Term Debt Ratio Most popular leverage ratio Omits short-term liabilities which are changing often. Account payables: more a reflection of trade practices than of debt management Tot. Long-term Debt Long-Term Debt Ratio = Tot. L.T. Debt + Tot. Equity

Long-Term Solvency Ratios Times Interest Earned Ratio Also called interest coverage ratio. Measures the multiple of interest expense that a firm could support given its current level of earnings. EBIT Times Interest Earned Ratio = Interest expense The Lower this ratio, the more levered the firm.

Long-Term Solvency Ratios Cash Coverage Ratio EBIT includes depreciation Measures the multiple of interest expense that a firm could support given its level of cash. EBIT + depreciation Cash Coverage Ratio = Interest Expense The Lower this ratio, the more levered the firm.

Long-term Solvency Ratios Measure a firm's ability to meet its long-term financial obligations. Three Debt Ratios: The higher the ratios the more levered the firm. Times Interest Earned and Cash Coverage Ratios: The lower the ratio the more levered the firm. What is a good ratio? Analysts vary the standard in direct relation to the stability of the firm's earnings and cash flows. Different standards for different industries.

Asset Management Ratios Inventory Turnover Ratio Measures how many times a firm sold off its inventory Cost of Goods Sold Inventory Turnover Ratio = Inventory

Asset Management Ratios Days' Sale in Inventory Ratio Measures how long it took a firm to sell inventory 365 Days' Sales in Inventory = Inventory Turnover

Inventory Management Ratios Measure how quickly a firm can convert inventory into cash. Important in industries where inventory becomes obsolete relatively quickly. Fashion industry Inventory becomes obsolete and can't be converted into cash. liquidate below costs => losses for the firm

Asset Management Ratios Receivables Turnover Ratio Measures how fast a firm collects on the credit sales of inventory Sales Receivables Turnover Ratio = Accounts Receivable

Asset Management Ratios Days' Sale in Receivables Ratio Measures how long it took a firm to collect on its credit sales 365 Days' Sales in Receivables = Receivables Turnover

Receivables Management Ratios Measure how quickly a firm can convert receivables into cash. If we observe an increase in days' sales in receivables, what does it indicate? Loan officers will ask for a list of top customers and percentage of sales accounted by these customers. Assess credit quality of the firm's main sources of revenues

Asset Management Ratios NWC Turnover Ratio Measures the efficiency of a firm's NWC Sales NWC Turnover Ratio = NWC

Asset Management Ratios Total Asset Turnover Ratio Measures the efficiency of a firm's Total Assets Sales Total Asset Turnover Ratio = Total Assets

Profitability Ratios Profit Margin Net Income Profit Margin = Sales Measures how well a firm is managing its costs relative to its sales Net Income Profit Margin = Sales

Profitability Ratios Return of Assets (ROA) Net Income ROA = Measures how hard a firm's assets are working Net Income ROA = Total Assets

Profitability Ratios Return of Equity (ROE) Net Income ROE = Measures how efficient a firm's equity is being employed to generate profit Net Income ROE = Total Equity

Price/Earnings (P/E) Ratio Market Value Measures Price/Earnings (P/E) Ratio Measures what investors are willing to pay per $1 of current earnings Price Per Share P/E Ratio = Earnings Per Share

Market Value Measures Market-to-Book Ratio Measures the market value of the firm's investments to their historical costs. Market Value Per Share Mkt-to-Book = Book Value Per Share

Example The Cross Companies 45 Million Shares Outstanding Stock sells for $80 per share at fiscal year-end Net Income = $675 million Total Equity = $3,375 million

The Du Pont Identity ROE Can be Decomposed into 3 Components: ROE = Net income/Sales x Sales/Assets x Assets/Equity ROE = Profit Margin x Asset Turnover x Equity Multiplier Operating Efficiency Financial Leverage Asset Use Efficiency

Standardized Financial Statements Common Size Balance Sheet All items are presented as a percentage of total assets => Divided all items by total assets Common Size Income Statement: All items are presented as percentage of total sales => Divide all items by total sales Common-Base Year Financial Statement => Present relative to a certain base year.

Things to Consider When Using Financial Ratios What goes into a particular ratio? Historical cost? Market values? Accounting conventions? What is the unit of measurement? Dollars? Days? Turns? What would a desirable ratio value be? What is the benchmark? Time-series analysis? Cross-sectional analysis?

Problems with Financial Analysis Very little underlying financial theory Differences in accounting practices Finding comparable firms is difficult Differences in fiscal-year ends One-time events Seasonal variations Conglomerates Choosing Benchmark: Which industry?