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

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

3. 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.

4. 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.

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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)

11. 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.

12. 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

13. 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

14. 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

15. 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

16. 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.

17. Computing Market Value Measures
Rivanna Investments
Computing Market Value Measures
Market Price = $87.65 per share
Shares outstanding = 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

18. 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

19. 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

20. 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)