Chapter 3 - Cash Flows And Financial Analysis

Users of Financial Information Investors –Make judgments about the firm's securities –Financial Analysts report to investment community Vendors –Sell to the firm on credit Management –Highlight areas in which attention will improve performance 2

Sources of Financial Information Annual Report – Management's report card to stockholders on own performance – The primary source of financial information – Required of publicly traded companies – Must be audited – GAAP Other Sources – Reports from brokerage firms and advisory services – Value Line –Credit reports 3

Orientation of Financial Analysts Critical and investigative Looking for current or potential problems Looking for the physical reasons behind financial results 4

Statement of Cash Flows Statement of Cash Flows Businesses run on cash, not accounting profits It is possible for a business to go out of business while making a profit Statement of Cash Flows –Reports inflows and outflows of money –Developed from the income statement and balance sheet 5

Building the Statement of Cash Flows – Basic Approach Build a Statement of Cash Flows from two balance sheets and an income statement Analyze where money has come from and gone to Begin with some personal examples 6

Table 3-1 Cash Flow Rules Asset Increase = Use Liability Increase = Source Asset Decrease = Source Liability Decrease = Use 7

Buying a Car on Credit Joe Jones and His New Car 8

Buying and Selling Cars - Sally Smith and Her Two Cars 9

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Business Cash Flows Three sources of cash flows: Operating Activities – day-to-day activities Investing Activities – firm buys or sells ( or invests in) fixed assets that enable it to do business. Financing Activities – borrow money, pay off loans, sell stock, pay dividends. 12

Figure 3.2 BUSINESS CASH FLOWS 13

Example 3-1 Business Cash Flows

Belfry also sold new stock during the year receiving a total of $800 and paid its shareholders dividends of $500. Additional Information

Operating Activities Net Income$ 1,000 Depreciation 500 Net Change in Current Accts (600) Cash from Operating Activities $ 900 Detail of Changes in Current Accounts Account Begin EndSource/(Use) Receivables$3,000 $2,900 $ 100 Inventory 2,000 3,200 (1,200) Payables 1,500 2, Accruals (100) $ (600)

Investing Activities Purchase of Fixed Assets$(2,000) Use Change in Gross Fixed Asset Account

Financing Activities Increase in Long Term Debt $ 1,200 Sale of Stock 800 Dividends Paid (500) Cash from Financing Activities $ 1,500

Free Cash Flows (FCF) Used to estimate whether a company will provide or require cash in future Cash generated by operations that’s available for distribution to investors. If negative, owners must borrow or sell equity just to keep going as before 21

Calculating Free Cash Flow NOPAT is net operating profit. T = tax rate NOPAT = EBIT – (T)(EBIT) = EBIT (1 – T) Note: If there is no debt, NOPAT equals net income 22

Calculating Free Cash Flow Depreciation is subtracted from revenue when calculating EBIT. Depreciation is a noncash charge, so EBIT understates cash flow by at least that amount. Adding back depreciation gives a figure that’s closer to cash flow called operating cash flow. Operating Cash Flow = NOPAT + Depreciation 23

Calculating Free Cash Flow Money available to investors can be written as: FCF = Operating Cash Flow – Increase in Gross Fixed Assets – Increase in Current Accounts 24

Calculating Free Cash Flow to Equity (FCFE) If a company is able to distribute cash to stockholders, then the equation becomes: FCFE = Operating Cash Flow – Increase in Gross Fixed Assets – Increase in Current Accounts – (1-T)Interest – Principal Reduction 25

The Cash Conversion Cycle Racetrack Diagram 26

RATIO ANALYSIS RATIO ANALYSIS 27

COMPARISONS Ratios are most meaningful when compared with similar figures Three comparisons: – History – Competitors – Budget 28

Common Size Statements - Example 29

CATEGORIES OF RATIOS Five Classifications Liquidity Asset Management Debt Management Profitability Market Value 30

LIQUIDITY RATIOS Liquidity ratios measure the company’s ability to meet short-term financial obligations Current Ratio – primary measurement of a company’s liquidity 31

LIQUIDITY RATIOS Quick Ratio (acid t est) – A liquidity measure that does not depend on inventory 32

ASSET MANAGEMENT RATIOS The fundamental efficiency with which a company is run Average Collection Period (ACP) – the time it takes to collect on credit sales 33 Interpretation: Customers pay slowly OR there are a few very old accounts that will probably never be collected.

INVENTORY TURNOVER Inventory turnover ratio measures whether the firm has excess funds tied up in inventory. Interpretation: Too much inventory is expensive to carry. Too little causes stockouts which lead to inefficient production and lost sales 34

FIXED ASSET TURNOVER AND TOTAL ASSET TURNOVER Measures the relationship of the firm’s assets to a year’s sales 35

DEBT MANAGEMENT RATIOS Measures the firm’s debt level relative to assets, equity, and income DEBT RATIO Uses a broad concept of debt including current liabilities 36

DEBT TO EQUITY RATIO Measures the mix of debt and equity within total capital. Debt to Equity Ratio = Long Term Debt : Equity 37

TIMES INTEREST EARNED (TIE) Measures the number of times interest can be paid out of earnings before interest and taxes (EBIT) 38

CASH COVERAGE A variation on TIE. Adds depreciation to EBIT to better approximate the cash available to cover interest. 39

FIXED CHARGE COVERAGE A variation on TIE to include lease payments as fixed financial charges equivalent to interest 40

DEBT MANAGEMENT RATIOS Compares fixed (obligatory) payments with the cash available to pay (cover) them.

PROFITABILITY RATIOS PROFITABILITY RATIOS Relative measures of the firm’s money-making success, also called profit margin. RETURN ON SALES (ROS) 42

RETURN ON ASSETS (ROA) RETURN ON ASSETS (ROA) Measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit 43

RETURN ON EQUITY (ROE) The most fundamental profitability ratio Measures the firm’s ability to earn a return on the owners’ invested capital. 44

MARKET VALUE RATIOS PRICE / EARNINGS RATIO (P/E) Measures market’s opinion of the stock as an investment Interpretation: The amount investors will pay for each dollar of earnings. Based primarily on expected growth. 45

MARKET TO BOOK VALUE RATIO 46

DU PONT EQUATIONS Equations show relationships between ratios 47

Extended Du Pont Equation 48

Using the Du Pont Equations Focus attention on revenue or assets rather than on cost or expense 49 ROA=ROSXTotal Asset Turnover Sampson Inc.12%6%2x Industry15%5%3x

Limitations and Weaknesses of Ratio Analysis Diversified Companies –Analysis of consolidated results is confused Window Dressing –Year end tricks can artificially improve ratios Accounting Principles –Allow latitude in reporting Inflation Can Distort Financial Results Interpretation of Ratios is Often Unclear Ratio Analysis Doesn’t Give Us Answers, It Helps Us Ask the Right Questions 50