The statement of cash flows Free cash flow: Cash available for distribution to investors after firm pays for new investments or additions to working capital.

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Presentation transcript:

The statement of cash flows Free cash flow: Cash available for distribution to investors after firm pays for new investments or additions to working capital Free cash flow = EBIT – taxes + depreciation - change in net working capital - capital expenditures

Accounting malpractice Managers of public companies faces pressure about accounting earnings They could conceal unflattering information without adjusting the firm’s operations by misusing the discretion in accounting rules or simply breaking those rules. They could make changes in: – Revenue recognition: E.g. Xerox : Inflate the revenue – Cookie-jar reserves: E.g. Freddie Mac :Over-reserve in good years and release those reserves in bad years to smooth earnings growth – Off-balance sheet assets & liabilities: E.g. Enron: creating special-purpose vehicles for excluding liabilities from their financial statements

3. Financial analysis and planning Financial analysis Financial planning

Financial analysis In analysing a firm’s performance using its financial statements, it is useful to apply some financial analysing approaches: – Cross-sectional: Comparison against peers – Time-series: Comparison against self over time – Common-size (vertical) analysis – Trend (horizontal) analysis – Financial ratios: allow comparison between different size firms on a common basis To measure the outcome of these analyses, you need to compare: – Against self (time-series, vertical, horizontal) and – Against peers/industry/market (cross-sectional, ratio) – Against general measures For the best result, these approaches usually be applied simultaneously.

Financial ratios Categories of financial ratios The DuPont system of analysis Limitations of ratio analysis

Categories of financial ratios Profitability ratios Asset turnover (Efficiency/Activity) ratios Debt (Financial leverage) ratios Liquidity ratios Market value ratios

Profitability ratios Net profit margin Return on assets (ROA) Return on Equity (ROE) Earning per share (EPS)

Net profit margin Net profit margin: measures the percentage of each sales dollar remaining after all expenses, including interest and taxes, have been deducted

Return on Assets (ROA) Return on assets: measures the overall effectiveness of management in generating profits with its available assets.

Return on equity (ROE) Return on equity: measures the return earned on the ordinary shareholder’s investment in the firm.

Earning per share (EPS) Earning per share: represents the number of dollar earned on behalf of each share. Note that it does note represent the amount of earnings actually distributed to shareholders (dividend per share - DPS).

Asset turnover ratios Inventory turnover Average collection period (average age of accounts receivables) Average payment period (average age of accounts payables) Total asset turnover

Inventory turnover Inventory turnover measures the activity, or liquidity, of a firm’s inventory Inventory turnover can be converted to the average age of inventory by dividing it into the numbers of day in a year.

Average collection period Average collection period (average age of accounts receivables): the average amount of time needed to collect accounts receivable.

Average payment period Average payment period (average age of accounts payables): the average amount of time needed to pay account payable. Annual purchases can be calculated by deducting beginning inventory from annual cost of goods sold plus ending inventory.

Total asset turnover Total asset turnover: indicates the efficiency with which the firm uses all its assets to generates sales.

Debt ratios Debt ratio Time interest earned ratio

Debt ratio Debt ratio: measures the proportion of total assets financed by the firm’s creditors.

Time interest earned ratio Time interest earned ratio: measures the firm’s ability to make contractual interest payments.

Liquidity ratios Current ratio Quick (acid test) ratio

Current ratio Current ratio: is a measure of liquidity calculated by dividing the firm’s current assets by current liabilities.

Quick (acid test) ratio Quick (acid test) ratio: a measure of liquidity calculated by dividing the firm’s current assets minus inventory by current liabilities.

Market value ratios Price to earnings (P/E) ratio Market to book (M/B) ratio

Price to earning ratio Price to earnings (P/E) ratio: measures the amount that investors are willing to pay for each dollar of a firm’s earnings; the higher the P/E ratio, the greater is investor confidence.

Market to book ratio Market to book (M/B) ratio: provides an assessment of how investors view the firm’s performance. Firms expected to earn high returns relative to their risk typically sell at higher M/B multiples.

The DuPont analysis The DuPont formula: relates the firm’s net profit margin and total asset turnover to its ROA. The ROA is the product of the net profit margin and the total asset turnover.

The DuPont analysis The modified DuPont formula: relates the firm’s ROA to its ROE using the financial leverage multiplier.

Limitations of ratios analysis There is no absolute standard by which to judge whether the ratios are too high or too low Historical data (not necessarily an indication of future) Poor or inadequate accounting methods Inflation or changes to fair values It is difficult to define a set of comparable firms Changes to economy, markets condition,...

Financial planning Financial planning provides road maps for guiding, coordinating and controlling the firm’s actions in order to achieve its objectives. Financial planning process: is the planning the begins with long-run (strategic) financial plans that in turn guide the formulation of short run (operating) plans and budgets.