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

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

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

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 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 accounts payable Increase in common stock Increase in retained earnings

Uses of cash: Increase in accounts receivable Increase in inventory   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/(Total assets) 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

Extended DuPont Equality ROE = NI/E = (EBT/TA)(TA/E)(NI/EBT) ROE = [EBIT/TA – I/TA](TA/E)(EBT/EBT – Tax/EBT)‏ ROE = [(EBIT/S)(S/TA) – I/TA](TA/E)(1- Tax/EBT)‏ ROE = [(Operating margin) (TAT) – Interest expense rate] (Equity multiplier) (Tax retention rate)‏

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